The main reasons for securities lending and borrowing are to cover short positions, to lend cash, or to temporarily transfer ownership. These activities originated as settlement coverage, and the underlying process is still critical. Some securities depositories have automated securities lending options. However, you should still understand the risks associated with securities lending and borrowing. If you're thinking about getting into the business of securities lending, consider the following risks:
Inefficient data. Currently, the securities lending and borrowing market is extremely opaque. Although some private data vendors collect some data, it's often incomplete, forcing market participants to subscribe to multiple feeds for up-to-date data. This lack of transparency leads to information asymmetries between lenders and borrowers and inefficiencies in the market. To address these issues, Congress has instructed the SEC to improve securities lending market transparency. This will help the public by increasing competition.
Transaction fees. The fee charged for securities lending and borrowing varies by lender, security, and duration of the transaction. Some borrowers may pay extra fees to upgrade their securities, raise extra cash, or move to a different lender. Lastly, the securities lending and borrowing industry is regulated, so borrowers should understand their options before making any financial decisions. Securities lending and borrowing transactions have many risks and should only be used when you're sure they're right for you.
Legal risk. Securities lending and borrowing are controversial practices. You can't fake the right to vote, so you must make equivalent payments to the lender as you borrow. The risk of a default is high, so you must be careful when entering this process. In many cases, it's better to use an intermediary who handles the lending process for you. It will save you time and money, so you can focus on more important aspects of securities lending and borrowing.
The principal reason for borrowing securities is to cover a short position. The borrower must return the security or the equivalent in exchange. Typically, securities lenders are large banks and broker-dealers. These intermediaries take a percentage of the lending revenues. They are not necessarily the only ones doing this, but they make up a significant portion of the industry. Securities lending has become a controversial topic, because the security that is borrowed is no longer owned by the borrower.
Another form of securities lending is short selling. In short selling, you sell a security with the expectation of repurchasing it for a lower price at a future date. It requires the borrower to have the ability to sell the security, which is usually achieved through securities lending. The borrower then buys the security at a lower price and returns it to the lender. When short selling, the borrower provides collateral (such as cash or a letter of credit) to cover the loss.
Short selling involves selling securities borrowing and buying them back at a lower price. In both cases, the aim is to sell the securities at a higher price than they were originally sold for. Short sellers rely on price discovery and liquidity to achieve this goal. Securities lending, however, introduces counterparty risk. Short sellers may default on the loan if they cannot sell the securities back at a higher price. However, this risk is relatively small when compared to the risk of the lender defaulting on his loan.