The Capital Markets Authority (CMA) in Kenya has given the green light for the rollout of securities lending and borrowing. This provides an opportunity for stock market investors an opportunity to deepen their investment options and also provides an avenue for making the stock market more liquid.We break down how the process works and the opportunities provided by this new concept to be available for trade within the Nairobi Securities Exchange(NSE).
What is Securities Lending?
Securities lending involves the owner of shares or bonds transferring them temporarily to a borrower. In return, the borrower transfers other shares, bonds or cash to the lender as collateral and pays a borrowing fee.Securities lending can, therefore, be used to incrementally increase fund returns for investors.
Why would someone want to borrow a security? Why not simply buy it?
Sometimes a security is only needed temporarily, whether for just one day or a few weeks. If so, it is often cheaper, quicker and/or less risky to borrow a security than to buy it outright. There are a number of reasons for holding securities temporarily:
- Some banks have agreements to “make markets” in certain securities. This means they have to be ready to buy and sell those securities to any of their counterparties, such as pension funds or asset managers, at any time. If they are asked to sell some that they do not currently have, they can borrow them at short notice in order to make the sale.
- Typically, securities are transferred two business days after a sale has been agreed. Sometimes it is very important for a buyer to receive the securities by a specific date. If the securities are going to arrive late for any reason, borrowing at short notice can be a way to get hold of the missing securities in time.
- Many different strategies used in the financial markets rely on borrowing a security temporarily. Borrowing can be used for trading (taking risk for profit), arbitrage (making riskless profit from unjustified price differences) or hedging (reducing risk) purposes.
What about collateral?
Lenders of valuable assets usually ask for collateral, which provides a kind of insurance for the lender. For securities lending, the collateral may be cash or more commonly other securities. In order to avoid operational risk, the securities lent and those provided as collateral are transferred at the same time. Exchanging one security for another at the same time can be technically challenging, so securities lending is often done in two steps. First, the security in demand is lent to the borrower, who transfers cash collateral to the lender. Second, the cash collateral is lent back to the borrower, who exchanges it for securities collateral. The end result is cash-neutral: the borrower is left with only the securities they need and the lender with only the securities collateral.
What does a securities lending transaction look like?
The diagram below shows what happens in a typical securities lending transaction. Bond A is lent to the borrower, who provides cash collateral. Then that cash collateral received is lent back or “reinvested” with the borrower in exchange for securities collateral. When Bond A is returned to the lender, all the other parts of the transaction are reversed too and the borrower also pays the agreed fee in cash to the lender.
What are the costs for borrowers?
Borrowers pay a fee, which can vary a lot depending on which security is being borrowed, who is lending to whom, how long for and so on. In addition, borrowers sometimes have to pay to obtain the collateral needed for the securities lending transaction, which may mean upgrading “normal” securities to high-quality securities or raising extra cash. Finally, borrowers sometimes face legal and administrative costs when they wish to start borrowing from a new lender.
What are the costs for borrowers?
Borrowers pay a fee, which can vary a lot depending on which security is being borrowed, who is lending to whom, how long for and so on. In addition, borrowers sometimes have to pay to obtain the collateral needed for the securities lending transaction, which may mean upgrading “normal” securities to high-quality securities or raising extra cash. Finally, borrowers sometimes face legal and administrative costs when they wish to start borrowing from a new lender.
What about the risks?
As with all investment strategies, lending securities involves risk that needs to be considered. The main risks are that the borrower becomes insolvent and/or that the value of the collateral provided falls below the cost of replacing the securities that have been lent. If both of these were to occur, the lender would suffer a financial loss equal to the difference between the two.
Other potential risks include the following:
- The lender suffers a loss on the re-investment of the cash collateral.
- The securities being lent are delivered to the borrower before the collateral is received.
- The lender’s legal agreement does not provide full protection in the event that the borrower defaults.
Fund managers must also consider other non-financial risks, such as ethical or reputational risks which can sometimes arise due to unforeseen events, or when investments do not perform as anticipated.
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