SLB:What benefits can SLB bring to market efficiency — Fintelligents

Securities Lending & Borrowing has gained prominence in the last few decades over the globe. It has helped spur liquidity & market efficiency for price discovery in capital markets. There are two parties-lenders & borrowers. Lenders are long term investors like pension funds, mutual funds, insurance funds, sovereign wealth funds with relatively limited short term liquidity requirements & stable asset portfolios. Such institutional funds lend their financial instruments to borrowers in exchange for fees known as rent/yields etc. Borrowers need such instruments for hedging their exposures in financial markets, for example, short selling. Borrowers can buy back such instruments at lower prices should their markets bets hold true. Such functioning helps lenders generate extra returns in addition to maintaining exposure & ownership of financial instruments over investment horizon & borrowers can generate money from short-selling & covering positions with borrowed shares should asset prices go against their conviction which helps them avoid naked exposure to market bets.

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We take an example of a borrower who borrows 1000 quantity of stock from the lender at Rs. 1000 in anticipation of poor quarterly results resulting in a steep fall in share prices. The borrower immediately sells those shares short and receives cash inflow. Such cash inflow is passed on to the lender that serves as cash collateral margin which is reinvested in money markets in ultra-liquid short term securities. The lender makes an incremental return from such reinvestment proceeds & returns margin to the borrower when the borrower buys back stocks & returns them to the lender. For smooth functioning of SLB markets, lenders have to ensure that cash collateral reinvestment is executed with reasonable risk-reward & doesn’t invite drawdown in invested capital.

The typical process may look like as follows:

• Borrower A borrows 1000 Quantity of ALZ Corporation Limited from Lender B at Rs. 400 and executes short selling in markets.
• Borrower A receives cash inflow that efficiently serves as cash collateral margin and borrower may have to deposit more collateral as per regulatory requirements.
• Lender B receives such margin & reinvests it for incremental gains instead of parking them idle with no returns.
• Borrower A’s conviction pays right and the share price of ALZ Corporation falls to Rs. 350 after reporting poor quarterly results & poor growth guidance on financial parameters. The borrower closes the position by squaring of position at Rs. 350.
• Borrower A returns stocks to Lender B & makes a profit of Rs. 50 per share* 1000 Quantity which means a profit of Rs. 50000. Lender B returns collateral margins & both parties receive their returns after deduction of respective transaction fees.

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• SLB practices help improve liquidity in financial markets. Different sections of market participants lend & borrow stocks for respective purposes. Borrowing stocks help market participants settle trades efficiently or help institutional funds like market makers improve liquidity in offering stocks. Lending stocks remains a useful tool for asset managers with a stable investment horizon to generate incremental returns.
• Passive funds like ETFs hold millions of shares and their investment managers like to lend shares through the SLB route which shall help the fund offset partial running costs of funds which shall help investors seize extra returns.
• Short Sellers want to hedge their exposure where they have placed aggressive bets on potential fall in asset prices. Short-sellers borrow stocks & buy them back later at plummeted prices. The practice alleviates concern about naked exposure to short selling & provides efficient liquidity.

Risks involved in SLB Market:

SLB markets may give a picture of relatively straightforward practice but they are not immune to a few risks such as potential default of counterparty, liquidity risks, cash collateral reinvestment risks, operational risks, etc. Functioning of clearinghouses & settlement houses along with massively conservative risk management practices can mitigate counterparty default risks substantially yet the bigger concern remains cash collateral reinvestment risks.

The lenders receive upfront cash or securities margin to cover their lending positions & they invest such cash to earn an incremental return & provide investment portfolio attractive yields. When such cash gets invested in money market funds/liquid funds, the risk factor of extreme volatility in financial markets can make the value breach crucial levels of original capital which shall make unanticipated losses for the lender. So such risks need to be monitored closely. In unfavorable credit market conditions, liquidity dries up which can further cause distress in the smooth functioning of SLB markets. Along with investing with appropriate risk appetite, investors can continue to mint money using features of SLB markets.

Security lending market after the crisis:

• After the global financial crisis, investors remained reticent for lending securities because of skepticism towards stability in financial markets & participants remained in risk-off mode shrinking demand & supply both. Basel regulations forced to reduce potentially available leverage which also resulted in a reduction in lending program of ~ 2 trillion USD markets during 2008–09 crisis
• Gradually, regulators stepped in with stricter regulations providing a breather to investors to lend securities with better risk management practices.
• SLB markets thrive on volatile environments which began somewhere around 2018. Capital markets witnessed a heightened volatile environment in the last 2 years which intensified the demand for borrowing securities. We could witness hedge fund & investment managers with tactical approaches intervene to borrow stocks aggressively & make gigantic profits from unconventional bets.
• SLB markets also witnessed heavy demand from the progressive rise in passive investing, i.e. through Exchange Traded Funds & funds that closely replicate index benchmarks. Pension funds are one of those funds that also invest through ETFs. Low-interest rate environment makes it difficult for pension fund managers to over-perform & deficits in funds can become a nightmare for them.SLB revenues help them offset partial running costs.

Author: Ashutosh Buch About the Author:

Ashutosh Buch is CFP (FPSB India) & has passed Level-I of CFA Program. His primary interest lies in analyzing investments in primary & secondary markets. At present, he focuses on learning the nuances of financial markets & management consulting. He remains committed to his goal of helping businesses scale up & making them ESG-friendly.

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Originally published at https://blog.fintelligents.com on July 12, 2020.