Securities Lending in an Hour

 Note: This is a transcript of my YouTube on Securities Lending. I just read it and… boy… it doesn’t read as well as it sounds. I suggest you listen to (not watch) the YouTube version.

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Good morning! Another gorgeous fall day. Well, early fall. Perfect for ruining with a walk on securities lending. You're welcome. Securities lending started as a practice in London, actually, 50 years ago. It became industry standard practice globally by the early 1980s. Started as a way to help the daily housekeeping that back offices Have to do to settle and clear trades.

But once people figured out that this boring practice was already taking place, institutional investors quickly figured out that there are, or was… there was money to be made from all the stocks that they've bought and have no interest in selling. If you're sitting on millions of dollars of GameStop stock and your investment thesis says to hold that stock until next year-- outside of the dividends that it produced, if it even produces dividends-- that's unused inventory gathering virtual dust.

I haven't seen an industry estimate since 2020, but in that year, the size of the global securities lending industry meaning all of that dusty inventory available for loaning out was... it was around 30 trillion dollars, trillion with a T. I'm going to guess it's closer to 40 now, so the practice has quietly evolved from back office operations in the 1960s to a common investment practice in the 2020s.

Why? On one side of that lending transaction, the lenders, the large financial institutions-- the mutual funds, pension plans, insurance companies, even like sovereign wealth funds and government offices-- they're all enhancing their returns by lending their unused digital inventory of stocks and bonds. Again, why? Because on the other side, the borrowers are using that dusty inventory to settle their trades, to short the market, to make money on arbitrage plays.

So to understand securities lending, we're going to start this walk by getting into the details of 1) long-term investing with a stable asset base. That's how you qualify as a lender of securities. 2) The daily grind of the settlement process, that's one of the driving reasons to become a borrower of securities.

The other two being #3 and #4. Three is short selling and four is arbitrage.

So we're going to learn about all that. But all four are practices that together help explain the why behind securities lending. Once we cover those basics, we'll talk about how or we'll talk about the how of securities lending.

And then at the very end of the walk, just for fun, we'll talk about how to abuse this back-office practice to advance shareholder activism.

Okay, high level and probably worth noting that we talked in detail about some of these topics in two previous videos. "Custody Banking in an Hour", that was my first one ever.

And "Securities Trade Lifecycle: Front, Middle, and Back Office." So, watch them. If, if you have the time. They're good refreshers before watching this one.

If you, if you haven't watched them... I can give you a high level recap. In today's markets, when you buy stock or bonds you're not issued a paper stock certificate, like in the old days. You generally buy those shares electronically. And they're held in book entry form-- that's an account, that's an accounting term, also called dematerialized or immobilized... Anyway they're held in your securities account as little digital bits and bytes at E-Trade or Robinhood or JP Morgan or whatever brokerage you use. But that brokerage isn't the only place, or even the most significant place, where the larger market keeps those digital shares.

Enter what are called intermediaries: custody banks, CSDs which stands for Central Security Depositories, CSD. Industry utilities, who warehouse that digital product, your stocks and bonds. Not just store it, but offer all kinds of services on top of it: accounting, taxes, the management of corporate actions.

All of which we covered in the videos. Again, this is just a high level recap.

That's the business of asset servicing, that servicing of what's being inventoried or warehoused is probably a better word. They're servicing your assets. Again, watch those two earlier videos for all the details. In most cases, digital shares are held by intermediaries for the sake of creating efficient markets, a process also called "indirect holding."

That's industry jargon. So when you buy an Apple share on Robinhood, Robinhood routes your order through a market maker. In their case, a company called Citadel… Who actually… Citadel makes the trades and compensates Robinhood for that business at a rate of like a fraction of a cent per share.

Citadel, that's how Robinhood makes money by the way if you're wondering how they can give shit away for free. Citadel, in turn, doesn't just hold your Apple shares in their databases. They use multiple custodians Bank of America and the Bank of New York, who in turn store all of the securities that Citadel holds for you, for all their other investors, even for themselves.

They store them at the DTCC. Meaning the custodians do well, the third party, any, everyone else as you go up the chain. So they, in the US the, the Depository Trust and Clearing Corporation (DTCC), it's a CSD in the US a central securities depository in the US. So lots of layers is what I'm trying to say. Lots of layers between you and your fictitious Apple shares. And that whole chain from Robinhood to Citadel to B of A or BNY to the DTCC is called a "chain of intermediaries." In a typical chain, the top tier intermediary, usually the CSD, the Central Securities Depository holds the grand total. All the grand totals for, for, for that market, that, that region, every intermediary in that chain can keep track of their securities for their own... you know... account or on behalf of their clients in their own databases, and they do, right, but, but for operational efficiency reasons, and for some privacy concerns, the institutions at the top of that, that chain will pool multiple client securities in what are called omnibus accounts, think account of accounts, omnibus accounts, as opposed to holding every tiny client's account on its own…. the jargon for which is individually segregated client accounts. So, if you take that whole chain of intermediaries, all the middling institutions between the actual owner of the stock All the way up the chain to the Custodian and the CSD. That whole digital ecosystem is like a warehouse of digital goods, mostly gathering dust.

Digital dust. Because most of the large holders of stocks and bonds don't trade them every day. They buy and hold. They're going long, you know, in their, in their strategy on, on, on, on that stock or bond. They keep them for a long time. And some clever banker, probably some clever ops person really, 50 years ago, figured out that those long term holders who have their stocks sitting on digital shelves for years at a time could make a buck or two by lending that dusty security to third parties who do trade more often.

So on the lending side, there's good reason to lend. They're not doing anything with that inventory. It's just sitting there. Might as well make use of it.

On the borrower side, there are lots of great reasons to engage in stock lending transactions. It can help you get out of a thorny settlement process.

Where you, you know, unintentionally sell something you don't have. Think operational mistake, which in turn leads to reduced trading costs for you. Because as my video on front to back office stuff shows, when you miss settlement dates, that's expensive. Anyway, securities lending also helps facilitate market pricing mechanisms.

It's just a fancy term for allowing for short selling to correct overvaluations. Don't worry, I'll explain that down the road. And securities lending gives the borrower better liquidity. It's more effective resource management for everyone involved. All of which means from an operational standpoint, securities lending makes for more efficient markets all the while making money for whoever is sitting on a warehouse full of investments that they plan to hold for the long term-- so think additional source of income for mutual funds, pension plans, insurance companies, etc etc with all the extra income stemming from the lending fees that they get. So the exec summary for this first part of the walk is that securities lending is a practice in the financial industry, facilitated by asset servicers, where institutional investors lend their securities to other market participants in exchange for a fee.

Simple enough. Okay, let's talk about how it works. When an investor wants to make a little extra passive income to lend their securities, they enter into what's called a lending agreement with a borrower.

Who facilitates that process? Good question! A lending agent! Usually a custody bank, asset manager, some third party. Going forward that lending agent usually handles the daily operations of those loans on behalf of the lender. That custody bank essentially owns the digital warehouse, so they're in the best position to serve both the lender and the many borrowers of the digital shares, the stocks and bonds... who also store their stuff-- the borrowers, the other borrowers... they store their stuff in, usually in the same warehouse. So the service comes with a price for the borrower, most of which goes to the lender the owner of the shares, with a small percentage going to the warehouse for running the warehouse, for managing the whole process: the contracting between the lender and the borrower, the managing of the collateral that the borrower puts up, all the asset movement involved, the risk management around it all, and when things go south, helping make everyone whole.

So, there's value to paying the custody bank. For no other reason than, you know, you couldn't do it without them. If what I said wasn't explicit enough, let me let me restate one part.

The borrower provides collateral to the investor as a guarantee for the loaned securities for the amount of time that those securities are held.

Most of the time their collateral-- cash or other securities, but mostly cash-- sits in the same warehouse, is managed by the same custody bank, same asset manager, same third party. So, for both parties, lender and borrower, securities lending is relatively seamless. It's like magic.

During the lending period, the borrower can use the securities for various purposes… which I already mentioned, like 50 feet back but just to refresh your memory, the borrower uses the loan securities for operational purposes, i.e. to cover their existing positions in a, in a settlement process or as an investment strategy- i.e., If they're engaging in some arbitrage, which is jargon, arbitrage is the practice of taking advantage of differences in price in two or more markets.

That's arbitrage. Anyway. So they, they do that. They, they use the securities that, that, that they're borrowing for that, or they leverage them for short selling, which I mentioned earlier, but I didn't define. It's industry jargon for investments that profit if the value of an asset falls. Shorting is the opposite of most of what most people think about when they think about investing the, the more conventional long position-- that's the opposite of a short. Most people think of that when they think of investing, where you, where you profit if the value of an asset rises. Shorting, fall, you actually benefit when, when the stock falls. Long, you benefit when the stock increases. Anyway, in return for the privilege of using the lent securities, the borrower pays a fee to the investor for the duration of the loan.

It's just like borrowing money, but securities. There was a great explainer in, in Morningstar last month, that I'll hopefully remember to, to link, you know, in the comments, but it basically used fund management as the context for explaining securities lending. This was last month sometime, and it, and it shared some real numbers from top mutual funds that demonstrated how this boring back office practice-- securities lending-- is actually helping fund managers make enough money, passively, I use that term loosely, not a ton, so they're not making, you know, oodles and oodles of money, but enough money to offset their management fees for their clients. Fees that you and I normally pay when we buy and hold a mutual fund. The Morningstar piece also called out that many people don't talk about this aspect of fund management, which makes complete sense to me, because talking about it will put you to sleep.

And who the hell talks about fund management? Morningstar, please? Literally nobody, other than Morningstar. So, the Morningstar piece went on. Stop making fun of them. Went on to say that not all funds use the practice aggressively, mostly because of their risk management stance. But the ones that do use it aggressively benefit you and me more because when it's done right, securities lending allows the mutual fund to earn back its management fee and increase its returns. And you can sleep easily at night because to protect the lender, your pension and mine, from potential losses, the borrowed securities, as I said multiple times on the walk, are... they're always collateralized using cash or other securities.

What is cash collateral? It's similar to putting your house up as collateral for a loan you want to take out, but there's a little risk of that, you know, home being hard to sell because the home in this case is cash. There's always risk in any financial transaction, but with cash as collateral, the risk is mostly what's, what's called FX risk.

FX is short for foreign exchange which as a lending risk is, how do you define FX risk? It's, it's the chance that the lender will lose money because of currency fluctuations. And, and, by the way, I'll take FX risk over falling home prices any day having lived through 2008. Okay, the Morningstar piece, I guess was a good article, is what I'm getting at.

You should read it. What else? The other point worth calling out, which I haven't called out so far on the walk... is that the lender earns income based on the demand value of the securities lent, which might sound odd. So, the more illiquid the stock, the more they make from lending it. If you own a stock, or the stock equivalent of a bunch of McDonald's barbecue sauce, commonly available.

You can get it anywhere. There won't be much borrower demand. Or there won't be as much as if you owned like a small vat of their magical Szechuan sauce. Not so commonly available. Okay, my obligatory Rick and Morty reference out of the way. Securities lending offers a lot of benefits: additional income for the party doing the lending-- think enhanced returns. And it benefits the party that's borrowing via operational efficiency, risk mitigation, improved liquidity.

It also helps the broader markets by increasing market efficiency. and arguably increasing trading activity. Let's quickly spend a little tiny bit more time on risk because if you're not a good risk manager you shouldn't be anywhere near banking. There are two broad types of risk involved in securities lending.

Operational risk and strategy risk. Operational risk refers to everything and anything that could go wrong in the day to day running of a securities lending program. Strategy risk is the investment risk taken by the lender. The cash reinvestment vehicle used by the lender is a significant component of operational risk because it's cash. While it can contribute to higher returns, it can also lead to unexpected losses. There, I've said my lawyerly piece. Ultimately strategy risk determines the earning potential of a securities lending program.

As I said, like 20 feet back, riskier funds that hold volatile securities-- the GameStops of the world, the Szechuan sauces of the world-- tend to earn higher returns, but also come with higher risks, as we all saw play out with GameStop.

That's another way of saying that not all securities lenders generate the maximum possible revenue from securities lending. The sponsors of large index funds tend to perform better as lenders because of the lower turnover of their assets. They hold their stocks longer. And they have broader portfolios, right?

They're index funds… meaning they take one of everything in an index or not one of, but the same amount or some amount of everything in an index. So together those two tendencies mean that they have the kind of diverse, stable asset base... that's perfect for lending. Diverse because broad number of, of stocks that are in there.

And stable because they're not trading very often. Think about it. Every index fund, which by definition has to hold shares of every company in that index, broad, has some shares of more illiquid stocks... like GameStop.. So when you see outperformance by securities lenders and they are your pension fund or your mutual fund, think companies like State Street, Invesco, right?

Well, their funds, if they're making more than their peers, their funds lean towards owning and reflecting broader indices, leading their securities lending practices to have consistently higher income. And it's not just index funds. More illiquid asset classes like small-caps and mid-cap funds also tend to generate higher returns compared to say taxable bond large caps funds.

Let me try that last paragraph again, but this time in English. If your mutual fund invests in the broadest possible way buying $1,000 of every stock on the Nasdaq... that's called an index fund. When a new company is added to the Nasdaq, your mutual fund buys $1,000 of it. No ifs, ands, or buts there. That's their investment thesis.

That means it owns the highly liquid popular stocks traded by everyone-- Apple as an example-- and the highly illiquid, not so popular stocks, which are harder to buy because no one wants to sell them. If that mutual fund wants to benefit from, lending the securities it owns, it'll get top dollar from borrowers for lending their not so popular stocks because they're illiquid, hard to buy and sell on the open market.

So the demand value of those illiquid stocks is higher and get more money. If you see your mutual fund making top dollar-- relative to other mutual funds-- from their securities lending practice, you should be a little concerned because it means they're using a shotgun for their larger investment thesis, like buy everything in, in, in, in that index or worse/riskier, they're using a sniper rifle and focusing on, intentionally focusing on illiquid securities. They're taking some serious risks. That Morningstar piece which I seem to keep coming back to that now I'm definitely going to link to, shows how much everyone is making from securities lending, at least how much all the big funds are.

If you're a good risk manager, you'll lean towards funds that are In the middle of the pack relative to the other funds, because the ones at the front of the pack are using shotguns on everything or sniper rifles on riskier things. The good news is that we are talking about small percentages of what are massive mutual fund holdings.

Securities lending doesn't generate massive returns, you know, percentage wise, but it can and does help offset fund fees, which are also small percentages, right? In some cases, it can even completely offset a fund's expense ratio, putting more money back in your pockets as an owner of the mutual fund or pension. Cheaper funds usually have an easier time offsetting fees because of their lower expense ratios.

So companies like Vanguard and State Street who are known for their low cost funds have consistently successfully offset a significant portion of their funds fees through securities lending. Before we get to how to abuse all this, my little fun piece at the end, let's do a rapid fire top 10 list of the larger benefits of securities lending.

Let's go. Top 10. #1. Additional income. By lending out securities, institutional investors earn more via borrowing fees and or interest rates for the stuff they have sitting in their digital warehouse, normally collecting dust. #2. Enhanced returns. Securities lending can boost the overall returns of an investment portfolio, especially during periods of low interest rates.

#3. Risk mitigation. Lending securities can help diversify risk by generating income, even when markets are volatile. #4. Improved liquidity securities lending increases the liquidity of the larger market by making more securities available for trading. #5. Enhanced market efficiencies by facilitating short selling that we talked about and hedging strategies, securities lending improves market efficiency. #6. Increased trading activity. I didn't go into this one on the walk because I'm a little skeptical. But, but securities lending, in theory leads to increased trading activity, which can benefit market participants. What was that? 6, 7? #7. Would be like... Cost Reductions. By lending out securities, institutional investors can offset costs associated with holding those securities such as, you know, custody fees.

What else? Eight or seven. I've lost track. #8. Collateralized borrowing. Lending securities allows fund managers to... Receive collateral in return, reducing what's called counterparty risk... which you can watch some older videos to learn about. #9. Flexible terms. Again, we didn't talk about this, but I'm shooting for 10 and I don't think I'm there yet.

10 is an arbitrary number anyway. I think I was on nine. By flexible terms, I mean that securities lending agreements can be tailored to meet the specific needs and preferences of the parties involved. And I really hope when I get back that, that, that I did 10, but let's say #10 would be market access.

Securities lending provides access to "hard to borrow" securities, enabling investors to take advantage of investment opportunities. I really should have gone with the top five list. Next time.

Okay, my favorite part of the walk. Not just because it's the ending part, but because it's, it's going to be fun.

Let's talk about abuse. We'll start by defining activist investing. If you don't know what I'm talking about, an activist investor is usually a specialized hedge fund. And it buys a significant minority stake in a publicly traded company in order to change how that company is run. The hedge fund's goals may be as innocent as wanting the company to be managed more efficiently.

Or as nefarious as forcing the company's sale. Or divestiture. Or some radical restructuring. Or even replacing the company's board of directors. It can... It can be politically motivated. Last year, for instance, a small activist investor took on BlackRock and accused them of "greenwashing" which is the language political conservatives use when they want the Larry Finks of the world to stop pushing the "liberal ESG strategies" that they do.

Because, you know, caring about the environment-- these trees, social and corporate governance, ESG, Environmental, Social and corporate Governance. It's a liberal thing. Apparently. I guess. It's not! Another example of, of investor activism or shareholder activism: an ESG focused activist investor-- I think their name was Engine #1-- used activist investing to get three directors elected to the board of ExxonMobil. The point here is that unlike private equity-- private equity firms, if you watched that video "Private Equity in an Hour"-- they buy and restructure companies in order to profit when they are resold.

Unlike private equity, activist investors don't try to acquire full or even majority stakes of the companies they're going after. They buy just enough to push their agenda. And the bullhorn they use is voting and corporate governance. If I'm speaking Klingon, corporate governance is the system by which companies are directed and controlled.

Boards of Directors are responsible for the governance of their companies, but so are the company's shareholders. Their role, the shareholders, in governance, is executed via voting. And your ticket to vote comes from whatever you hold, not whatever, whether, comes from whether you hold any shares of the stock.

So, for instance, shareholders participate in appointing the directors of a company. And if you're not familiar with company boards, the board, they're like the CEO's boss. They along with professional auditors keep the company governed. So activist investors buy enough of a company stock, not a lot, but enough.

So that the activists votes kind of jump out from all of the other shareholders who are voting. At the same time, activist investors use the media and their own private networks to amplify that influence with the company's leadership and their fellow shareholders in a company. Okay, so now, you know-- kinda-- the what and how of shareholder activism. Probably deserves its own hour long walk along with like corporate governance. What does it all have to do with securities lending though?

The mischief!! Okay, remember how at the beginning of this walk we talked about securities lenders and how in order to lend their securities they enter into a lending agreement with borrowers?

Well, those are contracts that are usually boilerplate but, with some clever negotiation can be adjusted. For instance, a borrower can, in theory, change their lending agreements to be able to get voting rights on the shares they borrow for the duration that they've borrowed it. So, if you're still not tracking, that means an activist investor-- with a strategically timed set of stock loans-- securities lending-- doesn't need to have the massive amount of money that it takes to actually own a significant percentage of their company's stock. So their votes jump out. They just need a custom securities lending agreement with multiple custodians and enough money not for the purchase of the...

All that stock, but enough money to pay for the borrowing of the stock, so a lot less money. A lot more power. Mischief!! Which, in the right hands, might make the world a better place. So far, not so much. Okay, I'll leave you on that thought. Hope you learned something. Maybe we close with that gorgeous rock in the background.