Common wisdom and common practice is divided. Before I present my views, I ask another question: Is it ok to not receive interest on your cash…
Clearly, the answer to the latter is a resounding NO. So, if we ask: How do you earn interest on your cash? The answer; by lending it to a party who pays (interest) for its use. Most simply, this is achieved by placing it on deposit (with a financial institution), but the same outcome can also occur by investing it in various debt instruments. The owner of cash has much choice, from short term bank deposits, government bills and bonds, to higher yield investments including longer term deposits, corporate debt and much more. The ultimate choice becomes a balance between duration (for how long do you tie your cash up) and risk (based on the quality of the borrower). There are nuances, including whether your lending is secured or unsecured (do you take collateral for your cash), what recourse do you have to the borrower and more. Overall, in order to receive interest on cash, you need to somehow lend it. By lending it, you are taking on risk (which may be negligible, but ranges widely in degree and character).
So, what about securities lending. If you own a (financial) security, generally it is held on your behalf in a custody account. The mere fact that it is being held by a custodian is in some ways analogous to keeping your money in a bank. Although they are your securities, they are under the control of a third party (ironically, unlike keeping your cash in a bank, where it earns interest, the security holder usually pays the custodian for the privilege). Depending on who you are, and your custody arrangements, there are various options available for lending securities. Lending can be done either directly (where you take control and enter into lending and collateral arrangements), or via an agency program (where the custodian or an authorised third party lends the stock and moves collateral on your behalf). The latter, agency lending, ends up with the security owner receiving share of the lending proceeds (not unlike interest on a bank deposit). With direct lending, the most common practice involves taking some form of collateral (either cash, or another security), in return for securities. For this, the lender is paid interest or a fee. If you take cash as collateral, you earn interest on the cash. You retain an agreed portion of the interest, and pass the balance back to the stock borrower. In the case of taking another security as collateral, the lender receives a fee. The exact nuances around securities lending versus cash or stock, agency or direct, will not be elaborated here. The process may involve haircuts (taking excess notional in collateral to cover a loan), daily mark to market and margin movements to keep the exposure between the borrower and lender within an agreed margin. Generally stock loans are callable with one day or even intraday notice periods.
How does securities’ lending differ from cash lending?
The most notable difference arises from the intrinsic differences between cash and securities.
Cash is easily moved, fungible, “infinitely liquid” and has a directly observable value (I’m not being facetious, just trying to illustrate the differences between lending stock and lending cash). Bank deposits (often regarded as risk free) are actually unsecured borrowings by a bank. This means that if the bank disappears, your cash may do the same. Most cash instruments sit with some degree of risk. Even so called risk free government debt is now regarded as not necessarily risk free (depending on the government).
Securities, in contrast to cash, usually exist within a custody system (illustratively, the equivalent of a bank vault). They can be electronically moved. There are various protocols and methods for their transfer, the most common being DVP (delivery versus payment).DVP broadly ensures that securities and cash move simultaneously, and is probably the least risky way of transferring. Contrast DVP to FOP (free of payment). With FOP, the movement of a security is not necessarily accompanied with a matching movement of cash. There is a degree of risk associated with all security movements, more so for FOP, and movements outside standard DVP processes. There is also a secondary risk, settlement risk, whereby securities are not delivered at a specified time or date. This is evidenced by settlement failures, which are a regular occurrence across most exchanges. Settlement failure is generally not a default event, and in most cases no material losses occur. They are usually quickly rectified, and become more an inconvenience than a catastrophe. In most cases, there is no corresponding movement of cash until the failure is rectified (mostly within a few days). It is only in cases of default, that settlement failure becomes a major problem. Securities are not as liquid or fungible as cash, and there are vastly more securities than there are currencies, which introduces complexity. So, overall, lending of securities not as straightforward, or widely practices, as the lending of cash. There is definitely more operational risk in lending securities compared to lending cash. However, whether securities lending is overall more risky or not depends on the counterparties, the collateralisation, term and many other factors (for example, lending cash to an unsecured low grade creditor is much more risky than a daily margined cash collateralised stock loan between highly rated parties).
From this perspective, provided the risk-return proposition makes sense, not lending securities may actually be as fiducially irresponsible as not placing cash to earn interest. The counter argument takes many forms, which include:
- Lending of securities facilitates short selling, which is overall a “bad” practice
- The risks outweigh the benefits
- There are too many risks, including operational risk, corporate action risk and other risks to make securities lending viable
- It is complex
- It is not in the spirit of owning securities
- and more
Whilst there are (at least) two sides to each of the above arguments, I will briefly cover some points, but not in full detail.
- Short selling – yes, a short seller does need to borrow securities to cover their settlement obligation on the short sale. However, this is only one of many uses for borrowed securities. Other uses include, as collateral to raise cash, as a substitution for other more useful securities (as per the repo programs of most central banks whereby securities can be placed to raise cash or government bonds), in a process to enhance yield (especially in Europe), balance sheet and funding management, as hedges to derivatives and more. On the argument for or against short selling, I go no further.
- Risks – yes, certainly, there are risks around lending securities. These span operational as well as market related and counterparty risks. As mentioned above, the ultimate decision to lend or not to lend securities should be based on whether the return is commensurate with the risks. A thorough understanding of these is thus vital. There has been much press on this, including headlines of the “do you really own what you think you own” ilk. Some of these are well founded, others sensationalised, simplified and incomplete. Without elaborating, understanding and managing risk is key to not being on the end of such a situation. Where such situations have arisen, the root cause is usually a lack of understanding, and the false belief in “a free lunch”.
- Complexity – yes, it is complex, but so is the whole financial system, including managing assets. If an asset manager uses this argument, I would question whether the manager is fit to be managing assets, or perhaps lacks the tools and systems to do this properly.
- It is not in the spirit of owning securities – is it? Shouldn’t an asset owner be trying to maximise the value of their assets. As per the comparison to receiving interest on cash, receiving securities lending revenue should be considered in this context. All the argument about spirit etc., in part comes back to short selling (on which I remain silent here). If there is a borrower prepared to pay to borrow securities, then it should come back to the risk return argument.
There is much more to this, with arguments both ways. Overall, I highlight the proposition that: Asset owners should treat securities lending in the same way as they manage their cash. If there is a return to be made by lending securities, then this should become part of the remit around the managing of assets. To not lend (without justification) may be as irresponsible as not receiving some form of interest on cash. Exactly how and what is lent, and the process around it should be considered in the same way as deciding how to invest cash. Risks, term, counterparty, as well as operational, economic and more are part of the consideration. Ultimately, it comes down to (I say it again), understanding the risks, and being sensible. So just not lending securities without reason or justification is irresponsible, in the same way as not placing cash to receive interest would be.