The securities lending industry is a testament to the creativity of equity fund managers that do everything possible to monetize assets. The fully-paid securities lending process originated with large equity funds that held substantial positions in stocks that were subject to speculation and large daily trading volumes. Rather than simply holding large blocks of stock in a static environment, fund managers began to lend them to third party borrowers (typically, short sellers) that gave cash consideration back to the lender fund to secure the transaction. The lender fund could then use the cash for other investments and the borrower could short sell the stock or insert it into other transactions until the end of the loan term or earlier upon a demand from the fund for return of the stock. This highly speculative transaction enabled both parties to realize additional profits, albeit with substantial risks.
One potential transactional risk is that the entity that borrows stock to cover short sales or similar transactions is unable to return the stock to the lender fund. The industry manages this risk by requiring the short seller to put up sufficient cash or other collateral to cover a loss at the beginning of the securities lending transaction. The short seller also pays a periodic borrowing fee to the lender fund while the transaction remains open.
The potentially more significant counter-party risk is that the lender fund might tie the cash collateral into an illiquid transaction and have insufficient immediate cash to return to the borrower at the end of the term of the transaction. The funds that lend stock into fully-paid securities lending environments are generally managed or sponsored by well-capitalized investment banks. The economic crisis of 2007, however, revealed that even large investment banks are subject to defaults.
Fortunately for both securities lenders and short seller borrowers, the securities lending industry has matured and has developed internal controls to manage and reduce the inherent transactional risks. Deliver-versus-payment (“DVP”) mechanisms, for example, provide simultaneous transfer of securities to the borrower and cash collateral to a lender fund to eliminate the possibility that the short seller borrower will commence transactions with borrowed stock before the lender fund receives cash collateral to secure the transaction.
Full-paid securities lending transactions that were once the exclusive province of large investment banks are now available to individual investors with substantial stock portfolios that are not otherwise subject to restrictions, liens, or encumbrances. Although the industry has evolved to control inherent risks, fully-paid securities lending continues to be a sophisticated transaction involving complex arrangements for the transfer and use of publicly-traded stock. These transactions are suitable only for investors that have substantial market experience and that are able to absorb substantial portfolio losses.
Individual investors that are interested in utilizing a portion of their portfolio holdings in a fully-paid securities lending environment can best protect themselves by retaining financial consultants and advisors that have the extensive knowledge, sophistication, and internal resources to manage and administer these transactions on behalf of their clients. A fully-paid securities lending transaction can give an investor a quick path toward cash liquidity that can be used for generally any purpose and with few restrictions, but before participating in a transaction, the investor should consult with his or her tax, legal, financial, and accounting consultants to perform the due diligence that is required for the investor to understand and internalize all of the risks and benefits that the transaction might provide.