Pursuant to Article 3(7) of the Regulation (EU) 2015/2365 of the European Parliament and of the Council of 25 November 2015 on transparency of securities financing transactions and of reuse and amending Regulation (EU) No 648/2012 (SFTR) 'securities or commodities lending' or 'securities or commodities borrowing' means a transaction by which a counterparty transfers securities or commodities subject to a commitment that the borrower will return equivalent securities or commodities on a future date or when requested to do so by the transferor, that transaction being considered as securities or commodities lending for the counterparty transferring the securities or commodities and being considered as securities or commodities borrowing for the counterparty to which they are transferred.
Securities lending is an agreement whereby one party lends a security (or transfers the legal ownership of a security) to another party against a fee for a limited period of time in exchange for either other securities or cash. The process often involves an agency lender. There may also be more than one collateral provider, i.e. there could be multiple collateral providers lending securities via an agent to one collateral taker.
When cash is used as collateral, there is an obligation on the lender to reinvest the cash and ‘rebate’ the borrower an agreed proportion of the return achieved. In such cases, the reinvestment return is usually deducted from the borrowing fee when the borrower pays the lender. This is a yield-enhancing strategy frequently used by asset managers and institutional investors. Although most of the revenues from lending government bonds still come from fees, the share of revenue from reinvestment is higher for government bonds than for other asset classes (at around 20 per cent in 2013). The revenues from lending corporate bonds and equities rely almost entirely on fees.
In securities lending, equities tend to be used as collateral to a larger extent than in repos. This gives rise to a particular feature related to securities lending – the right to call. This is that, as equities are usually attached to voting rights and corporate actions, the convention in the securities lending market is for loaned securities to be subject to a right to recall by the lender, in case the lender wishes to exercise his voting rights.
Final Report, Technical standards under SFTR and certain amendments to EMIR, 31 March 2017, ESMA70-708036281-82, p. 353, 354
Securities lending transactions are conceptually similar to repos, where one counterparty borrows securities for a fee, against a collateral in the form of cash or non-cash (Report on securities financing transactions and leverage in the EU Report prepared under the mandate in Article 29(3) SFTR, 4 October 2016, ESMA/2016/1415, p. 12).
When cash collateral is provided by the borrower, it can be reinvested into other instruments.
In securities lending arrangements, haircuts apply to the collateral provided and not the securities borrowed.
Functions for the securities or commodities lending/borrowing
According to the ESMA's Final Report of 31 March 2017 Technical standards under SFTR and certain amendments to EMIR (ESMA70-708036281-82) securities or commodities lending or securities or commodities borrowing are used in particular:
- As a yield-enhancing strategy: when a party owns a security that is in high demand in the market, the party can lend it and reinvest the cash, thus increasing the overall yield achieved. The party can either enhance its yield through the borrowing fee, or the reinvestment’s returns. This increased yield also helps to offset the costs of custody;
- For dividend tax arbitrage: in the context of securities lending, when equities are loaned, the borrower becomes legally entitled to receive dividends and exercise voting rights. However, the post-tax dividend must be transferred back to the lender. This allows for tax arbitrage, evidence of which can be seen by analysing the seasonal pattern of EU equity on loan around the time of EU dividend payments (April);
- As a means of conducting monetary policy operations in the case of central banks and as a means of providing emergency liquidity to the market in times of crisis;
- For liquidity and collateral management: an entity can upgrade its assets by lending them against higher- quality non-cash collateral (for instance, to satisfy a central clearing party’s eligibility requirements).
Securities lending is also widely used to prevent settlement fails.
Securities lending market
Securities lending can involve several parties. Collateral providers in securities lending also include hedge funds.
The collateral takers are typically insurance companies and pension schemes.
Few securities lending trades are currently cleared through a CCP, but this could change in the future. The model currently in place involves the novation of a securities lending trade which was initially concluded by two counterparties via an agent lender.
As the lending process requires investment in systems and human resources, counterparties typically employ agents or intermediaries to manage on their behalves.
The collateral taker’s agent is called an agent lender. They negotiate the terms of the loan with the collateral provider’s agent, which is also called a principal intermediary.
In terms of securities lending, the estimates are that the global loan balance in June 2015 was €1.8 trillion, up 11 per cent from a year ago (Final Report, Technical standards under SFTR and certain amendments to EMIR, 31 March 2017, ESMA70-708036281-82).
About 49 per cent of the €1.8 trillion are bonds, while the rest are equities.
EU lenders represent one third of the global total. ESMA estimated that the size of the EU securities lending market is around €500 billion.
Global revenues from securities lending are estimated to be more than €8 billion per annum.
Securities or commodities lending and securities or commodities borrowing transactions are subject to reporting requirements as laid down in Article 4(1) of the SFTR and in the secondary legislation.
For the reporting purposes of with respect to counterparties roles ESMA proposes to use the terms "collateral giver" and "collateral taker".
In the case of securities or commodities borrowing and securities or commodities lending, the counterparty that lends the securities or commodities, subject to a commitment that equivalent securities or commodities will be returned on a future date or on request, shall be identified as the collateral taker.
The other counterparty shall be identified as the collateral giver (Consultation Paper Draft RTS and ITS under SFTR and amendments to related EMIR RTS, 30 September 2016, ESMA/2016/1409, p. 44, 45).
As ESMA argues, the counterparty would always know whether it provides or receives the collateral.
As at the end of 2015 there were around EUR 3tn in EU securities available for lending, including EUR 1.5tn in equities, EUR 1tn in government bonds and EUR 0.5tn in corporate bonds.
The value of EU securities on loan amounted to EUR 500bn, two thirds of which were government bonds and the rest mainly equities and corporate bonds.
Other instruments such as asset-backed securities or exchange-traded funds are also sometimes borrowed, but this remains currently marginal.
EU securities lending markets are, therefore, smaller than repo markets.
Most EU securities on loan are collateralised with non-cash, especially in the case of EU government bonds, and to a lesser extent, equities.
Currently, there are no data available on the sector of the borrowing counterparties, or on the characteristics of the non-cash collateral received, although the feedback received from market participants suggests that a large share of transactions involve bank-to-non-bank exchanges, while the volume of non-bank to non-bank transactions is currently very small.
Public data collected by ESMA on SFTs for some of the largest EU investment funds show only banking sector counterparties, and a relatively high degree of concentration.
Securities lending arrangements may involve the use of tri-party agents, as in repo transactions.
However, a specificity of this market is the very high reliance on agent lenders, for around 75% of EU government bonds, and 90% of EU equities.
Agent lenders are typically large custodian banks or asset managers that lend the securities they hold in custody on behalf of beneficial owners.
Agent lenders reinvest cash collateral on behalf of their clients, but typically do not reuse non-cash collateral.
This set up brings together a much broader range of institutions in EU securities lending markets, compared for example to repo markets.
For example, institutional investors and banks own the largest shares of EU government bonds available for lending, with respectively EUR 275bn (44% of the total) and EUR 124bn (20%) available.
For EU equities, the vast majority available for lending is owned by investment funds, with EUR 719bn available (54% of the total), including EUR 206bn owned by UCITS specifically.
It is worth highlighting that public sector entities (central banks, governments, public sector enterprises and public pension plans) also contribute substantially to securities lending markets.
The structure of securities lending markets reflects the purpose that securities lending transactions serve.
Where repos were originally used by banks for financing purposes, securities are primarily lent by buy-side firms seeking to earn extra returns.
Market participants also borrow securities to cover short positions, avoid settlement fails and perform collateral transformation operations.
The feedback received from UCITS funds suggests that they mainly use SFTs to generate extra returns, rather than obtain financing.
Although there are no quantitative data to confirm this, according to market participants central clearing of securities lending and borrowing arrangements remains marginal.
This can be explained by different factors, including the structure of the market, where the same participants always sit on one side of the trade with thus limited interest in CCP multilateral netting, as well as existing incentives, with central clearing likely to reduce returns from securities lending activities.
Lastly, securities lending transactions tend to have long tenure, reflecting the fact that many transactions are open term (around 80% of the market).
Although term transactions have recently been growing in EU markets, they remain nonetheless less standard than fixed-maturity transactions in repo markets.
In summary, the main trends in securities lending markets are:
a. Use of (high-quality) government bonds and equities as collateral;
b. Predominant use of non-cash collateral, especially for government bond loans;
c. Large reliance on agent lenders;
d. Many bank to non-bank transactions;
e. No central clearing;
f. A growing share of term transactions.
Report on securities financing transactions and leverage in the EU Report prepared under the mandate in Article 29(3) SFTR, 4 October 2016, ESMA/2016/1415, p. 45 - 48