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.
Why does the Eurosystem lend its securities?
The aim of our securities lending is to help the financial markets keep functioning smoothly. This is particularly important during our expanded asset purchase programme (APP). The Eurosystem – the ECB and the 19 national central banks of the euro area – is buying large amounts of securities from banks to address the risks of inflation being too low for too long. Large-scale purchases of securities by a central bank are likely to gradually lead to fewer securities being available on the market. Lending our securities holdings back to the market allows them to continue to be used by others for their transactions.
Find out more about APP securities lending
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.
Explainer: What is 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.
Source: European Central Bank
Published: 8 December 2016
The above presenation was created for educational purposes.