Securities Lending - Legalities

Legalities

Securities Lending is legal and clearly regulated in most of the world's major securities markets. Most markets mandate that the borrowing of securities be conducted only for specifically permitted purposes, which generally include;

1. to facilitate settlement of a trade,
2. to facilitate delivery of a short sale,
3. to finance the security, or
4. to facilitate a loan to another borrower who is motivated by one of these permitted purposes.

When a security is loaned, the title of the security transfers to the borrower. This means that the borrower has the advantages of holding the security, as they become the full legal and beneficial owner of it. Specifically, the borrower will receive all coupon and/or dividend payments, and any other rights such as voting rights. In most cases, these dividends or coupons must be passed back to the lender in the form of what is referred to as a "manufactured dividend".

The initial driver for the securities lending business was to cover settlement failure. If one party fails to deliver stock to you it can mean that you are unable to deliver stock that you have already sold to another party. In order to avoid the costs and penalties that can arise from settlement failure, stock could be borrowed at a fee, and delivered to the second party. When your initial stock finally arrived (or was obtained from another source) lender would receive back the same number of shares in the security they lent.

The principal reason for borrowing a security is to cover a short position. As you are obliged to deliver the security, you will have to borrow it. At the end of the agreement you will have to return an equivalent security to the lender. Equivalent in this context means fungible, i.e. the securities have to be completely interchangeable. Compare this with lending a ten euro note. You do not expect exactly the same note back, as any ten euro note will do.

Securities lending & borrowing is often required, by matter of law, to engage in short selling. In fact, recent regulation in the United States required that, before short sales were executed for 19 specific financial stocks, the sellers first pre-borrow shares in those issues. This caused securities lending volumes in these 19 issues to double. The SEC is currently evaluating whether to extend such a rule to the wider market.