JOHANNESBURG - Securities lending transactions involve the owner of shares or bonds transferring them temporarily to a borrower to meet the temporary needs of the borrower.
In return, the borrower transfers other shares, bonds or cash to the lender as collateral and pays a borrowing fee to the lender. The borrower agrees to return the identical shares or bonds to the lender some stage in the future, while the collateral assets are returned to the borrower. According to Genesis Analytics, who conducted a study on securities lending in South Africa for the Financial Services Board (FSB), securities lending is based on three principles.
Firstly, the lender must be in the same economic position at the completion of the loan than it would have been in had it continued to hold the securities in its portfolio - that includes all corporate actions such as income distributions, share splits, rights issues and others. Secondly, the lender has the right to recall the securities at any time for any reason and thirdly, the borrower is responsible for all costs incurred in transferring the securities.
The benefits for the lenders of securities are that the fees earned generate additional returns on funds’ assets, but the risk of default by the borrower is real. According to Genesis Analytics, the main instrument to minimise the risk of default is the posting of collateral in excess of the value of the loaned security, and marking the collateral to market on a daily basis - but the system is complex, both legally and operationally.
But why would someone want to borrow a security? Sometimes securities sold are not available for delivery for whatever reason and borrowing at short notice allows the completion of the transaction. The majority of borrowing transactions support the many strategies used in the financial markets, though.
It is aptly summed up by the European Central Bank: Borrowing can be used for trading (taking risk for profit), arbitrage (making riskless profit from unjustified price differences) or hedging (reducing risk) purposes. According to the South African Securities Lending Association’s Security Lending Guide (2015) a survey of the market found that 73percent of loans were for strategic purposes.
The lending of securities had beyond a doubt a massive impact on the South African capital markets as derivative instruments mushroomed, allowing the hedging of risks in especially South African equities.
According to Genesis Analytics, a 1999 study for the FSB found that the ability to sell loaned securities has a strong positive impact on liquidity in tightly held securities listed on the JSE, increasing trade by 20percent or more.
But just how big is the market for lending of securities?
Statistics are hard to come by, but an article in securitieslendingtimes.com indicated overall borrowing values ranging between $3billion (R39.56bn) and $5.4bn from April to June last year - down from a peak of approximately R160bn in 2007.
The typical borrowers are investment banks, global banks, market makers and broker-dealers, while the lenders are large scale investors, including collective investment schemes.
Although pure short selling of equities (the practice of borrowing shares and selling them in the belief that they are overvalued and buying them back at lower prices) apparently forms a very small portion of the market. However, many other arbitrage strategies also involve the short selling of equities and therefore require the borrowing of stock.
From a legal point of view, the transaction involves a transfer of title from the lender to borrower, who has the obligation to make the opposite title transfer to the lender at some stage.
None of these two transactions are recorded on the stock exchange, though. This lack of transparency leads to the opacity of securities lending. It is especially worrisome in the case of relatively tightly held shares.
In a discussion paper in May 1997, the International Organisation of Security Commissions warned inter alia about the possibility of severe downward pressure on stock prices or market disruptions arising from manipulative behaviours by short sellers, as well as those attempting to corner the market.
Ordinary investors and even fund managers can be caught totally unawares if a share price suddenly starts to fall on increased volumes as a result of some of the borrowed stock entering the market. Depending on how funds are positioned, their market values and their investors’ savings may be negatively or positively affected. In some instances the lender’s own returns may be diluted due to the lender maintaining his economic exposure to the share.
The benefits of lending the stock may therefore be outweighed by downside risks. It is also evident that the trading volumes of specific shares and that of the stock exchange in total may be distorted by the lending of equities. Trading volumes would increase if the lending volumes are included. As it is virtually impossible for the ordinary investor or fund manager to observe the share lending activities, should it not be compulsory to have the volumes of the lending of shares included in the trading volumes although they are off-market deals?
Or even better, for South African Securities Lending Association to list the trades somewhere?
Ryk De Klerk was co-founder of PlexCrown Fund Ratings and is currently a consultant for PlexCrown Fund Ratings.