A Securities Lending Exchange?

Researcher Notes Securities Lending's Large Unrealized Potential

Securities lending, a sometimes disorderly business with myriad standards, could have a formal exchange within five years, an industry researcher predicts. As far as transparency goes, the equity securities lending business now resembles the credit derivatives market of the 1990s or the Nasdaq prior to order-handling rules, according to a recent report by researcher Vodia Group. An exchange would help the equity securities lending market provide clearer pricing and also give the practice more credibility, the report says.

“The emergence of a viable exchange will push more asset holders into securities lending and will introduce more trading firms to the notion of securities lending as an asset class,” says the report, “Securities Lending and Asset Holding: Tracking U.S. Equity Inventory Supply.”


The U.S. equities securities lending market is now $717 billion, the report says. This means that stocks represent about 15 percent of the total assets on loan, with bonds and other securities making up the balance of what Vodia estimates is a $5 trillion market.

A clearinghouse or a brokerage might sponsor this exchange, which would have one central electronic trading platform, says Josh Galper, a principal of Vodia Group. “An exchange would create a more true market price for securities loans,” Galper adds. So why hasn’t it happened already?

A small securities lending player, who declined to be quoted by name, says “it is financially to the benefit of big dealers to delay an exchange as long as possible, because an opaque market will produce bigger margins for them.”

Securities lending is a tough business. It is competitive and at times confusing. Prices, and even the nature of the business, can be confusing. For example, the securities lending market can be mixed up with short selling. Short selling often contains transactions involving an unknown number of naked or phantom shares.

By contrast, securities loans are at times used to cover failed positions. These loans can be passed from broker to broker, while a short sale is made by one firm or individual.

In a typical securities lending transaction, the agent lender or the custodian lends the security to a client, the prime broker. The prime broker lends it to a mutual fund or hedge fund, which is often engaging in some kind of hedging strategy.

Show Me the Collateral

At each step, the client must produce collateral, which is usually cash. Who holds these loaned securities? Pension plans, mutual funds, retail investors, hedge funds and the proprietary desks of broker-dealers. A securities lending exchange, if it ever happens, would provide a key advantage, advocates say. Securities lending now operates in ways that can confuse many would-be clients, who fear they are overpaying because inventory is limited and loan standards vary.

Indeed, EquiLend formed a consortorium to bring common standards to a business in which pricing and standards are often a mishmash (See Traders Magazine, June).

So the Vodia report says that securities lending today exists within a set of illiquid, over-the-counter marketplaces, each setting its own prices, enforcing its own rules and usually having too many or too few stocks.

Yet securities lending is a growing business with some clearers active in the business (see chart). It is also a big factor in the profits of prime brokerages, generating about $8 billion in annual revenues for lenders to hedge funds, Vodia Group says. The business is a kind of derivatives market. One makes money by borrowing a security at one interest rate and then lending it at a higher rate.

Lenders make money by using the spread between the federal funds rate, less the rebate rate paid to the borrower. At its best, with an easy-to-borrow security, securities lending is a good business. A lender will offer the securities at a rebate rate, then invest the collateral from the loan at the federal funds rate, which can be 10 basis points higher.

How profitable is this business for lenders?

Vodia Group estimates that mutual funds are making 1 to 2 percent a year on loaned positions, but custodians and prime brokers are earning between 3.5 and 7.25 percent annually. Besides prime brokers, pension funds are also big players. Still, the report predicts that hedge funds will start to become more active because they have growing untapped inventory. Hedge fund assets, which have seen substantial growth in recent years, are close to $2 trillion.

Nevertheless, Vodia estimates that only a small percentage of hedge fund assets are loaned. And only the largest hedge funds today “have enough size and diversity of positions to warrant the interest of a broker,” Galper says. Hedge funds will do more securities lending themselves, bypassing prime brokers, he adds.

Typically, the lender will be someone at a hedge fund “confident in their belief in their long position. So that security has value in the marketplace, and it can be gaining an extra 2 percent a year,” Galper says.


Besides hedge funds and prime brokerages, some clearing firms are also securities lending players. These clearers typically run conduit, or match, books. These books allow the clearer to lend and borrow based on market needs.

Big securities lenders in clearing are Pershing, Penson Financial and Raymond James Correspondent Services, the study says. None of these firms would comment on their lending operations. Other major players in the securities lending business include Fidelity Brokerage, E*Trade, Charles Schwab and TD Ameritrade (see table).

Fidelity Brokerage declined comment. E*Trade spokeswoman Tina Martineau says the firm believes there is no need for such an exchange. “We find the market to be efficient.”Still, James Frawley, a spokesman for TD Ameritrade, says if an “exchange would promote a better market, we would certainly take a look at it.” And Howie Kennedy, director of securities lending at Charles Schwab, says the exchange idea is interesting.

“I do believe there is a need for it. I totally agree that this business is inefficient. You have a lot of different players coming at it from different perspectives,” Kennedy said.

But Kennedy wonders who would have the incentive to set up an exchange.Possible exchange candidates would be a hedge fund, a custodian bank or a prime brokerage, he says.

Kennedy says that Schwab wouldn’t create a securities lending exchange because it is just a niche player in the business today, only providing the service to some retail customers who occasionally need it. Schwab also loans customer securities to hedge funds.

Nevertheless, he adds that the idea of such an exchange is good and that “we would probably want to leverage it if it benefited our clients, which it sounds like it would.”