What is securities lending and how does it work?
Securities lending is when a fund that owns fully paid-for securities enters into a programme to lend those securities to other market participants, or “borrowers”. Securities lending is widely used in the market in order to make the most efficient use of funds’ assets and enhance investors’ returns.
Securities lending can either be done directly by the fund’s investment manager, or by using an Agent Lender. An Agent Lender is a third party who sits between the fund and the borrowers to facilitate lending. The most common approach in the market is to use an Agent Lender.
For funds engaging in securities lending via an Agent Lender, potential borrowers will approach the lending agent and request securities to borrow temporarily. The Agent Lender will source the securities from the funds on behalf of which it is acting . The transaction is collateralised by the borrower, who posts high quality liquid securities over and above the value of the borrowed security; this collateral can be called upon in the event that the borrower does not return the borrowed security. The collateral is also indemnified by the Agent Lender, meaning that the Agent Lender will cover any shortfall, and the fund is not at risk of losing the value.
Having an Agent Lender sit between the fund and the borrower aims to mitigate the exposure of the fund to the underlying borrowers. Therefore, the exposure of the fund is to the Agent Lender. AMX will only enter into an agreement with an Agent Lender with a strong credit rating in order to protect investors and the assets of the fund.
Is there any risk?
There is a risk that the borrower defaults on the loan. However, where a lending agent is appointed, the fund is directly exposed to the Agent Lender and this risk is indemnified by the Agent Lender. As with any financial transaction, all potential risks cannot be completely mitigated. However, given AMX will only use high quality Agent Lenders, the risk of a default by a borrower is deemed to be low, given that the transaction will be overcollateralised and additional indemnification provided by the Agent Lender as noted above.
When lenders or their agents receive collateral, they reinvest it to generate additional yield. Cash is the most favoured form of collateral and is often invested in liquid assets, such as money market funds and deposits. Lenders could be exposed to hidden risks if the reinvestment strategy is aggressive and the collateral is invested in volatile and/or illiquid assets. Collateral reinvestment risk should be monitored closely to ensure that this risk is minimal.
In turbulent markets it is possible that the value of the collateral may fall below the value of the repurchase price of the security, resulting in a shortfall. In this case, the Agent Lender should indemnify the loss, making up the shortfall. Underwriting is commonly done by using an insurance policy, but can also be underwritten by the Agent Lender using their own balance sheet.
What are the regulations governing Securities Lending?
The Securities Financing Transactions Regulation (SFTR) is an EU-wide regulation that aims to improve transparency over a number of different types of financial transactions, including securities lending transactions, by:
- imposing conditions on the re-use of collateral;
- ensuring detailed disclosures are made to investors on the extent of securities lending utilised in a fund; and
- by requiring the counterparties to a lending transaction to report these transactions to regulators.
AMX plays a key role in ensuring investors the requirements of SFTR are met, including by:
- Informing investors on the use of any of securities lending in the half-yearly reports when required and annual reports
- Overseeing trades sent by counterparties to the trade repository, such as the Depository Trust & Clearing Corporation (DTCC), and AMX’s Compliance function monitors all transactions and ensures that reporting is in line with SFTR
What are the benefits to investors of securities lending?
Securities lending allows the most efficient use of a fund’s assets, with the aim of enhancing investor returns. Investors benefit directly from the net lending fees that accrue to the fund from the securities lending programme. These fees will vary depending on the assets held by the fund and market conditions, as well as borrowers’ appetite for the assets.
Typically, a fund would receive 70% of the fee charged to the borrower for borrowing the asset. The remaining 30% is taken by the Agent Lender as payment for the service. Many investment managers also retain a portion of the fee paid to the fund for management expenses.
Why is AMX different?
AMX does not take any revenue as part of the securities lending process; securities lending is done purely to make efficient use of the underlying assets for the benefit of the end investor. AMX passes all net lending revenue to the fund and offers a split of 80%/20% between the fund and the lending agent – adding additional value to the end investor.
In addition, AMX works closely with the approved Agent Lender(s), who must have a strong credit rating, and must meet our rigorous selection process. The Agent Lender underwrites any shortfall using their own balance sheet. The advantage of this, above using an insurance policy, is that an insurance policy may come with a limit and with certain terms applied, or the policy may be reinsured, which gives additional counterparty risk. AMX has a dedicated oversight team that monitors all counterparties on the platform to ensure there is no unnecessary risk taken when engaging with them.
AMX’s robust infrastructure ensures that the securities lending programme is managed in the safest possible environment, in order to deliver real and tangible benefits to investors.
Photo credit: Stuart Sergeant