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Benefits of Securities Lending & Borrowing

Securities lending & borrowing plays an important role in today’s global markets, facilitating market efficiency and offers distinct advantages to both lenders and borrowers, as well as contributing to a healthy overall financial system

Key benefits of securities lending & borrowing include:

The Provision of Secondary Market Liquidity and Market Making

Secondary market liquidity refers to the ease with which you can buy or sell securities on a secondary market. This is where investors trade securities with each other after their initial offering on the primary market. A well-functioning, liquid market relies on the ability of certain participants to be able and willing to “make markets” in the secondary market. Regulation often requires such intermediaries to provide constant two-way (i.e. buy and sell) pricing to their clients, often refereed to as the bid and ask prices. In order to meet their obligations as market makers therefore need to be able to access securities at all times in order to fulfil sell orders and maintain continuous bid-ask quote. Securities lending is a vital channel to ensuring this happens, and therefore enhances market liquidity.

Further benefits of securities lending & borrowing for market makers are:

  • It allows them to optimise the use of their capital by efficiently deploying it in their trading and hedging activities. By borrowing securities when needed, market makers can maintain flexibility in their capital allocation.
  • Securities can be used to hedge market makers’ positions and manage risk. By borrowing securities, market makers can hedge against potential price movements, ensuring their exposure to market fluctuations is minimised.
  • There is also a direct positive link between a liquid secondary market and the cost of issuing in the primary market, making it easier and cheaper for companies to enter and raise capital.

Helping Financial Institutions meet their Risk Management Regulatory Requirements, thus Reducing Systemic Risk

Post-financial crisis reforms have put many safeguards in place to protect investors, market participants and market infrastructures. For example, EU legislation rightly requires banks and other market participants to hedge risk by ‘collateralising’ their exposures to counterparties for example through mandatory bilateral margin requirements under the European Market Infrastructure Regulation (EMIR) for over the counter (OTC).

In prudential legislation, banks are incentivised to hold High Quality Liquid Assets, such as government bonds, to ensure their own health. An example of this is the Liquidity Coverage Ratio (LCR)  and the Net Stable Funding Ration (Net Stable Funding Ration (NSFR) requirement for banks under the Basel Capital Requirements framework. Securities lending is one of the essential mechanisms by which market participants can access the securities they need to meet such requirements.

 

Generating Additional Income for Investors

Additional portfolio income is the main reason institutional investors lend securities as the practice can produce consistent, predictable incremental returns for long-term asset holders.

Securities lending & borrowing is a low-risk way for investors to generate income from their holdings, potentially offsetting some of the costs associated with holding assets. This can improve the overall performance of the investment portfolio, for the benefit of the end-users, such as retail investors. For example, the emergence of low-cost retail investment products, such as zero fee tracker funds, is in part due to management costs being supported by revenue gained from securities lending & borrowing. As such, securities lending also stimulates retail investment flowing into capital markets, an important objective of the effectiveness of global capital markets.

Securities lending & borrowing can also be beneficial for investors with a mid to long term horizon who hold assets that are not actively traded on a daily basis. Lending out these idle securities can generate income without the need to sell the assets.

In addition, lenders can raise finance against their long-term investments by using their holdings to access cash. Cash re-investment refers to when an investor uses the cash collateral they receive from the borrower. This can be re-invested into other financial products such as money market funds.

Supporting Collateral Mobilisation that Further Strengthens Market Resiliency

Securities lending & borrowing transactions involve the provision of collateral by the borrower to the lender. Collateralisation helps mitigate counterparty risk, providing a level of security in case of default by the borrower. It also gives lenders the opportunity to diversify their collateral portfolios. By accepting a variety of HQLA securities as collateral, lenders can reduce concentration risk and enhance the overall risk profile of their collateral holdings.

Collateral mobilisation through securities lending & borrowing therefore further contributes to overall market efficiency and resiliency. It ensures that participants can access the collateral they need to support their activities, whether it’s for trading, hedging, or meeting regulatory requirements.

Reducing the Risk of Settlement Fails

Securities lending & borrowing contributes to the overall efficiency of the settlement process in financial markets, again by providing market participants with the ability to access a diverse range of securities. This enhances the flexibility of participants in managing settlement requirements.

In the event of a failed trade, for example, securities lending can provide a temporary solution. The party failing to deliver can borrow the securities needed for settlement, preventing a prolonged settlement failure and reducing any associated penalties.

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