Section 1 - Background and Introduction
Over the past decade securities lending has evolved from a back office, operational function to an investment
management and trading function worthy of greater focus and attention. This transformation was accelerated by
market events of 2008 and 2009 where credit and liquidity challenges affected most cash collateral pools.
Additionally, the default of Lehman Brothers tested the unwinding procedures of the lending and collateralization
processes at agent and principal lenders alike. Short sale bans and negative press only added to the negativity
around the securities lending product especially at the senior levels of mutual fund firms and independent Boards.
As a result, many mutual fund lenders restricted, curtailed or suspended their programs.
Today, many mutual fund lenders are reengaging in the product. This renewed focus comes with varying
perspectives, oversight and control expectations as firms and providers learn from the challenges of the past.
The product has a risk/return profile and should be evaluated based on the risks inherent to each program’s
specific structural characteristics.
As a result of recent events, education has improved but what has been lacking is a coordinated and
comprehensive effort, particularly focused in the US Mutual Fund space. In 2010, a Securities Lending Best
Practice Group, chaired by David Schwartz, Senior Counsel for the MFDF and coordinated with eSecLending,
was established to assemble feedback from group members consisting of market participants from across the
industry including lending providers, beneficial owners, investment management attorneys, independent directors,
compliance firms, consultants and academics. The goal of the Securities Lending Best Practice Group is to
produce a guidance document with the purpose of promoting sound securities lending practices and enhance the
understanding of the product while discussing key issues and concerns that arise when starting, monitoring or
changing a securities lending program. Although this paper is sponsored by the US based MFDF, this guide will
be helpful to global beneficial owners whether they be a Mutual Fund, Pension Fund, Insurance Company or notfor-profit organization.
Section 2 – Executive Summary (potentially combine with section 1)
Securities lending is a long established collateralized practice and, according to statistics provided by industry
data specialist Data Explorers, the balance of securities on loan exceeds $1.8 trillion globally as of the end of
2010. Securities lending plays a significant role in today’s capital markets as it contributes to overall market
efficiency and liquidity.
The market for securities lending is driven by the demand of investment managers, large banks and
broker/dealers and their hedge fund clients around the world. It is a critical element of hedging and risk
management for trading and investment strategies and also helps facilitate timely settlement of securities.
Beneficial owners (lenders) participate to achieve incremental returns on their portfolios and increase overall
performance (increase alpha) for portfolio managers. The view of securities lending has changed significantly
over the last several years and particularly following the credit crisis. As a product once viewed as an ancillary
service to custody, lenders in today’s market are increasingly managing securities lending as an investment
product with diversification of service providers becoming a prominent global trend.
This paper will provide both education and guidance but is not intended to be a lengthy publication, rather it is an
explanation of the market mechanics with best practice notes incorporated. We have noted in the text potential
additional reading in certain areas that the reader may wish to refer to.
The securities lending industry continue to evolve and therefore it is out intention to maintain and update this
paper as it does so. The paper will continue to be available at [MFDF website].
Section Three – What is Securities Lending?
Securities Lending is a collateralized transaction that usually takes place between two institutions.
The beneficial owner (lender) temporarily transfers title of the security and associated rights and privileges to a
borrower who is required to return the security either on demand (commonly referred to as an open loan) or at an
agreed date in the future (commonly referred to as a term loan). The borrower, who as the new legal owner of the
security will receive dividends, interest, corporate action rights etc, is required to “manufacture” all economic
benefits back to the original lender. The “manufactured” payment from the borrower to the lender is a substitute
payment that replaces the dividend or interest the lender would have received had the security still been in
custody.
Outstanding point – Tax sensitive funds where in lieu of payments are currently qualifying income and are taxed
at ordinary rates – require more detail on this.
The lender maintains an economic interest in the security on loan and therefore is still exposed to the price
fluctuations of the security as if it was still physically held in its custodial account.
Proxy voting rights remain with the borrower of the security. During the term of the loan the lender gives up its
right to vote as the borrower has legal title over the security. However, under the legal contract between the
lender and the borrower, the lender has the right to recall the security for any reason, including voting at an
Annual General Meeting (AGM) or Extraordinary General Meeting (EGM).
Best practice notes: Lenders should ensure that the person responsible for corporate governance is part of the
securities lending working group internally. Language describing the approach to lending in advance of a
company meeting should be defined in the Securities Lending Policy document – this should focus on types of
votes for which it is important to recall securities, for example where a strategic stake is held.
In return for lending the security, the lender receives collateral from the borrower, generally either cash or liquid
securities such as government bonds or equities that is valued higher than the value of the lent securities. The
typical market practice for the collateral value is 102% (same currency) or 105% (different currency) of the value
of the lent security. It should be noted that in recent years the margin (2% or 5% in this example) has become
more dynamic with lenders looking to set unique margin levels based on securities loans, credit quality of the
borrower etc. The margin levels are “marked to market”, or valued, on a daily basis to ensure that the loan is
sufficiently collateralized at all times.
The borrower will pay the lender a fee for borrowing the security. This fee is usually calculated in basis points, for
example an annualized rate of 50bps, which is then calculated daily and paid to the lender on a monthly basis.
The majority of lenders will employ an agent to act on their behalf in negotiating and administering the securities
lending program. These intermediaries are either the lender's custodian, a specialist third party lending agent
(non-custodian) or, another custodian who offers a third party lending product. The agent receives the minority
share of gross earnings from the securities lending program as compensation for their service.
Some lenders, particularly those with a large asset pool, choose to lend directly i.e. not appoint an agent. Others
may choose to utilize multiple providers, lend assets through both a custodian and third party agent, or a
combination of the above.
Section 4 – Who lends and Why? Why Do Funds Lend Securities?
US Mutual Funds represent a significant portion of the $12.7 trillion global securities lending inventory with the
following chart indicating they represented 18.5% as at the end of 2010.
US Mutual Funds vs Global Securities Lending
Inventory
US Mutual Funds
US Pension Funds
Remainder
Source: Data Explorers
As the chart shows, securities lending is a global industry. Other significant lenders are global pension funds,
insurance companies, investment funds and sovereign wealth funds. Many investment funds in securities lending
are based in offshore locations e.g. Ireland, Luxembourg, Cayman Islands.
Funds will, in the majority of cases, lend securities for one reason only – to improve performance for the benefit
of fund shareholders. The revenue from securities lending should be returned to the Fund, adding additional yield
and assist in improving performance versus a fund’s specific benchmark. The amount of additional yield will
depend on many factors including the composition of the portfolio, the parameters applied to the lending program
and the collateral received.
Mutual Funds will not usually lend all their Funds as not all may be appropriate portfolios for securities lending.
Some beneficial owners may also utilize securities lending as a means to raise cash. The cash collateral
received against the lent security may be a cheaper cash raising option than more traditional methods. The cash
can be used to finance specific projects or other fund specific cash requirements.
Best practice notes:
 Lenders should be clear on why they lend in advance of confirming lending arrangements and this should be
made clear in their Securities Lending Policy which is shared with the agent. This is important as it drives risk
– cash raising options could be viewed as higher risk than lending only in-demand securities for short periods.
 Most agents will now provide benchmarking services using industry standard vendor solutions. Lenders
should become familiar with the process for benchmarking which typically involves the use of filters to ensure
a fair comparison can be made. Lenders should also ensure benchmarking is provided in all asset classes
and, as a result, understand their agent’s strengths and weaknesses.
Section 5 - Who borrows and why?
The majority of securities borrowing is conducted through intermediaries, commonly referred to as prime brokers
or broker-dealers.
Re-insert the Market Map with the Borrower side enhanced?
There are a number of generators of demand for the securities that are being lent. In many cases it is demand
from the prime brokers and broker-dealers themselves that is driving the need for a security. The reasons for this
demand are as follows:
Market-making and sell fail protection – The broker-dealers are market makers who are required to make two
way prices in a security. The market makers do not hold every security they make a market for and the only
reason they are able to perform their function is because of the capability to borrow a security to settle a
purchase request from one of their clients. In addition, the broker-dealer is able to assist clients (both internal and
external) with providing securities via a stock borrow to prevent sales failing in a market, particularly where there
may be significant costs associated with a fail e.g. buy-ins.
Collateralization – A significant contribution to the demand for high quality sovereign debt in a securities lending
program is the requirement to borrow the security in order to collateralize other transactions, including securities
lending. For example, a broker-dealer’s equity desk may be borrowing equities from a lender who requires
sovereign debt as collateral; therefore they will borrow the sovereign debt to collateralize this transaction. Other
financial transactions that may require sovereign debt as collateral include derivatives and futures and options.
Arbitrage – Arbitrage is a strategy that exists to take advantage of discrepancies between prices or markets, for
Example:
Index arbitrage
Discrepancies between prices of a company listed on more than one exchange. The borrower will sell short the
security with the higher price and purchase the security with the lower price in the expectation that the gap
between prices will eventually close.
Convertible Bond and Preference shares arbitrage
Discrepancies between prices of the convertible or preference bond and equity issued by the same company.
Similar to the Index arbitrage, the borrower will short one and purchase the other. A recent example was
Citigroup's issuance of Preference Shares in 2009 (further reading on Page 14 of the Data Explorers Securities
Lending Yearbook 2009/10 1 ) which for holders of Citigroup shares contributed to high securities lending
revenues.
Dividend Arbitrage
Discrepancies between the net dividend received by beneficial owners in different markets. The borrower will
take shares from a lender required to pay withholding tax on a dividend and transfer the shares to a beneficial
owner subject to no, or less, withholding tax. The lender is able to essentially receive a higher dividend in the
form of additional securities lending revenue than if the security remained in custody.
There are many reasons for broker-dealers to borrow securities before we establish the role of the prime broker.
Prime brokers service the requirements of their typical clients, hedge funds. Once again, there are many reasons
why a hedge fund will borrow securities including some of those we listed above. The following chart shows
hedge fund strategies as of …...[need updated graphic and confirm attribution with CS]
Source:
Hedge Funds employ prime brokers for a variety of services but one of the most important is to source securities
when they are required to perform a short sale. “shorting” a security is the practice of selling a security you do not
own. However it is important to distinguish between the following two types of short selling as one is recognized
as a benefit to capital markets but the other is not perceived to be beneficial:
Covered Short Selling
Covered short selling requires securities lending as it requires the entity to either have obtained, or be in the
1
http://www.dataexplorers.com/sites/default/files/data-explorers-yearbook-2009-10.pdf
process of obtaining, the security they are selling – by borrowing it. This is a legitimate tool which is recognized
by regulators as adding liquidity and price discovery to the capital markets.
Naked Short Selling
This has no connection with securities lending as, by its nature, it is a sale by someone who does not have, and
has no intention of obtaining, the security they are selling. This practice has now been banned by a number of
regulators worldwide and has also been condemned by the international securities lending community.
As we have noted, in many investment strategies the requirement to short a security is part of a broader strategy
and is not a pure short sale in the expectation that the share price of the company will fall. Directional short
strategies accounts for less than 1% of hedge fund strategies.
Further reading: For more information on the impact of short selling see the International Securities Lending
Association’s “Securities Lending: Your Questions Answered”. This includes sections on the regulators and short
selling, academic studies around short selling and securities lending and negative stock returns.
Lenders rarely lend directly to hedge funds for the following reasons:
Hedge Funds are unlikely to have the required collateral – the prime broker sources this for them. Regulation
requires that Mutual Funds receive collateral so the inability to provide this hinders a direct relationship.
The lending agent appointed by the lender will typically indemnify, or protect, the lender against a default of the
borrower. As hedge funds are generally small, low capital, entities, the lending agent prefers to take the risk of
the prime broker which is generally a Bank subsidiary.
The advent of a Central Counterparty (CCP) in securities lending may, over time, change this dynamic but, at the
time of writing, it remains true. CCPs have been the subject of much discussion but for the lender they need to
understand how this assists them and how their agent will utilize the CCP service. For additional information it is
worth reading “Good, Bad or Inevitable? The Introduction of CCPs in Securities Lending” 2 written by Roy
Zimmerhanzl and Andrew Howieson and published in September 2010.
Best practice notes:
 It is important to understand what is driving the demand for the lenders securities. Lenders increasingly
should be receiving market color that discusses the strategies and interest for individual securities and asset
classes. It is useful to be able to provide this color to the Board in respect of for example, the Top 5 revenue
earning securities each quarter.
 Lenders should question and understand their agent’s position on the use of a CCP and the relative benefits
for doing so. Lenders should continue to monitor developments with respect to CCPs and ensure their
securities lending strategy is updated to reflect this.
2
http://www.eurexclearing.com/download/documents/publications/The_Introduction_of_CCPs_in_Securities_Landing.pdf
Section 6 - Securities Lending Facilitators and Route To Market/Execution Options
Today's lender has more securities lending options than ever before. In this section we describe the options and
the potential routes to market.
Insert market map with lender side highlighted
Custodian Agency Model
Historically custodians have been the typical facilitator of securities lending, lending as an agent on behalf of their
underlying custody clients. Normally this allows the client to benefit from “bundled” pricing options to include
custody, fund administration etc. However, it is becoming more common to have all products unbundled and
priced on an individual basis
Custodian lending pools are large which can be attractive to borrowers who like the liquidity this provides. The
lenders accounts and assets are pooled together and allocated to individual loans through the use of a queue
calculated using an algorithm to ensure lenders are treated fairly.
Both cash and non-cash collateral received is pooled for operational efficiency. Cash collateral, generally
speaking, is pooled for reinvestment purposes to provide more stable cash balances. Reinvestment options will
include a custodian’s in-house investment management subsidiary if available but will also include selecting an
independent cash liquidity fund.. Increased customization is becoming more common with lenders requiring
separately managed cash collateral strategies.
Third Party (non-custodial) Agency Model
This has similarities to the custodian model but the securities lending program is segregated from any other
custodial activities. Third party agents specialize in securities lending only. Typically, lenders assets are pooled
for lending purposes and loans are negotiated as an agent on behalf of the underlying lenders with borrowers.
Some third party agents have the capability to manage the cash collateral but generally speaking, lenders have
options which also include selection of an independent cash liquidity fund or, in some cases, placing cash in their
own liquidity vehicle.
Increasingly custodian banks are offering third party lending capabilities for assets not held in their custodial
operations.
Once a lender has chosen to utilize the third party route (decoupling from custody) the securities lending
mandate is more portable and can be transitioned regularly to different providers if desired.
Direct Lending Model
Certain lenders have chosen to lend directly to the borrowing community. This is principal to principal lending
activity with the relationship clearly understood to be between the lender and the borrower. The main advantage
of this model is that the lender retains all the securities lending revenue. The downside however, is that the
lender also needs to invest in resources and infrastructure to support the program from both a front and back
office perspective.
Best practice notes:
 In considering the route to market, the lender should ensure it understands the fee implications. For example,
in a custodian program the custodian typically covers the fees associated with the security movements, how
will this work in a third party program?
 In comparing different routes to market, a revenue estimate may be received – lenders should spend time
assessing each estimate and understanding the assumptions made by each agent. Estimates should be
consistent in assumptions around use of past historical rates, market growth, portfolio growth, dividend rates
and demand growth. Ultimately it is difficult to predict which securities will be in most demand in the next year,
however it is possible to demonstrate average returns for an individual asset or asset class over a preceding
period. Assumptions on future growth should not be relied on for estimate purposes unless all agents are
allowed to include the same assumption in their estimates.
 All agents should be able to provide lenders with a SAS 70 report detailing their lending controls.
Once a securities lending model has been established there are then options as to the loan execution method:
Discretionary Lending
The lending agent or principal will negotiate each loan with the borrower. Loans are negotiated directly with the
borrower by telephone or bloomberg communication. In this execution strategy, pricing can fluctuate daily with
market changes and all lending is done on a “best efforts” basis. Increasingly loans are also transacted by
electronic means through file sharing via industry portals such as EquiLend or through securities lending
electronic exchanges such as AQS or SecFinex. In this lending option, the lender has the ability to buy and sell
within the portfolio, recall for proxy voting or place any restrictions on the program strategy.
Principal Exclusive
In this arrangement the lender or its agent will negotiate an exclusive arrangement with a borrower. The borrower
pays a guaranteed fee for exclusive access to borrow a portfolio or subset thereof. Unlike the discretionary
strategy, income is guaranteed and lending fees are stable and consistent during the term of the exclusive
(typically one year). The lender is protected on the downside for revenue decline but also typically gives up
“upside” revenue potential over and above the guaranteed revenue level. It is possible for other financial
arrangements to be included such as tiered revenue or additional profit sharing over and above the guarantee.
In this lending option, the lender should have the full ability to buy and sell within the portfolio, recall for proxy
voting or place any restrictions on the program strategy.
It is possible for a lender to have multiple exclusives with a variety of borrowers for different portions of its
portfolio(s).
In an agent arranged exclusive the lender benefits from indemnification and full program administration and
operational support. Without an agent, the lender must contract with their custodian for administration and
operational support and there may be no indemnification for borrower default.
Best practice notes:
 Each lender should ensure their agent provides a comprehensive trading strategy for their Funds. Will
exclusives be part of the trading mix and will electronic trading tools be used? How will this provide value
from revenue v. risk perspective?
 Lenders should be aware of the agents approach to lending to an agent-affiliated borrower, if any. Due
diligence should cover implications to indemnification policies, operations, demand for securities and loan fee
benchmarking.
Section 7 - What securities can be lent?
Most readily marketable securities can be lent. Data Explorers show lendable inventory as at …… being in the
region of $12trn. This includes the following asset types:
Fixed Income Securities
Government Bonds – US and International
Mortgage Backed Securities
Corporate Bonds
Agency Bonds
Supranational Bonds
Equities
US equities
International equities
Exchange Traded Funds
Global Depository Receipts
American Depository Receipts
Emerging Market Equities
In developed markets, securities have been lent for many years. Emerging markets such as Turkey, Korea and
Mexico have seen securities lending become more common in 2008 and 2009 however markets such as India,
Brazil and Russia are still to witness their first securities lending transactions.
In general, before commencing lending in a new market, the lender or agent will conduct due diligence to
establish whether there are any tax, legal, regulatory or operational considerations with lending securities in the
local market.
It is worth noting that this section refers to transactions conducted under a securities lending agreement and it is
possible that borrowers are able to gain access to securities in emerging markets via swaps or synthetic routes.
Therefore it is possible for lenders to benefit from securities lending type revenues through a different investment
strategy however this is beyond the remit of this paper.
Best practice notes:
 When presented with an opportunity to move into a new market, the Mutual Fund should ensure that it is
familiar with the due diligence undertaken by the agent. This should include introducing the portfolio manager
who is invested in the market and aware of the nuances from an investing perspective.
 As with regular investing, each asset class may require its own securities lending strategy. This could relate
to collateral options, route to market and security level restrictions. The extent to which a lender considers
breaking out its strategy will depend on the size of the assets and its ability to manage multiple strategies
with potentially different vendors.
Section 8 - How does a typical securities lending transaction work?
When considering a securities lending transaction, it is important to separate this into two separate types – loans
against non-cash collateral and loans against cash collateral.
Supply and demand dynamics drive the negotiation of a securities lending transaction. Generally there are many
securities that are very liquid and widely available (known as General Collateral securities as the only reason for
borrowing them is to use them for collateralizing other transactions) and a few that are heavily in demand and are
hard to borrow (known as specials). Specials can earn revenue of anything between 100bps to 6000bps or
higher on an annualized basis.
When lending a special, the lender can be more demanding in terms of the fee required (if accepting non-cash
collateral) or the rebate to be paid (if accepting cash collateral). Also borrowers will be flexible in providing the
collateral that a lender is requiring even if this is quite restrictive.
When borrowing General Collateral securities however, the borrower will only take the securities from a low fee
source which is prepared to accept the most available collateral. Lenders who are more flexible on collateral are
likely to secure more General Collateral volume.
The term of the loan is also important. Most securities lending transactions are callable i.e. they can be recalled
at any time, which allows the investment manager to continue buying and selling securities irrespective of
whether a security is on loan. However, as some strategies that lead to securities being borrowed require
securities to be available to the end borrower for a long duration lenders can generate higher fees by agreeing to
lend securities for a defined term which generally means that securities cannot be recalled. However even in
these cases there is usually a “right of substitution” whereby the borrower is borrowing a “basket” of securities but
is not too concerned what the individual securities are so these can be interchanged as required. The vast
majority of market volume consists of loans that are “on open” or callable daily as it provides the most flexibility to
the portfolio manager.
Best practice notes:
 Term trades are not popular with lenders however for passive funds who are aware that they will be
continuing to hold an asset for a longer period of time, it may be possible to utilize this certainty to provide
term options to borrowers. Lenders should discuss these options with agents to understand the risk/reward
dynamic of doing so.
 Lenders can be specific about the type of lending transactions they wish their agents to undertake. For
example approaches can include:

Special loans only (high fee, low volume)

Special loans and General Collateral loans (lower fees, higher volume)

Lending only for dividend arbitrage opportunity (high fees, short duration)

Lending with minimum fee criteria and loan balance limitations

Recalling securities on-loan for proxy voting

Retaining percentage of each security (referred to as a buffer)
Non-cash securities lending transactions
US Mutual Funds can accept non-cash collateral in the form of US government securities and letters of credit
from unaffiliated banks. Other lenders, certainly those domiciled in Europe, can also accept international
government securities and, in some cases, equities too.
The lender or its agent will ensure that collateral, including margin, is received in advance (known as prepay)
before releasing the lent securities to the borrower. This is important to ensure that the lender is fully
collateralized in the event of a borrower default.
The borrower will pay a fee, generally calculated in basis points, during the period the security is on loan.
The loan and collateral are marked to market each day, this means the prices of both are checked to ensure that
the collateral is still sufficient and meets the value (including margin) required by the lender.
Non-cash collateral management requires the establishment of either a bi-lateral account at a custodian bank or
a tri-party relationship to hold the securities collateral. Bi-lateral accounts generally offer less operational
efficiency for lending agents and borrowers, so tri-party accounts are often preferred. Tri-Party account set-up
requires legal documentation and certain associated fees, which are typically paid for by the borrower.
As the demand for non-cash collateral has grown, so has the level of sophistication on the part of both the
borrowers and the tri-party agents. In the US and Europe there are currently four major tri-party collateral agents:
BNY/Mellon, JPMorgan Chase, Clearstream and Euroclear. Typically a broker will use one or more tri-party
custodians, depending on their individual clearing and custody arrangements, and the type of collateral they wish
to pledge.
A tri-party collateral program gives both borrowers and lenders the freedom to engage in their normal daily
lending activities, while removing the operational burden of allocating, pricing, verifying, delivering and
substituting large volumes of individual securities collateral. Using an agreed-upon collateral schedule that
identifies eligible securities and daily margin requirements, the tri-party agent takes on the role of overseeing the
acceptable collateral, pricing it, marking it to market, and managing all activity on the securities collateral.
Other features offered by tri-party agents include collateral reporting which is provided to the Lender and/or its
Agent daily. This provides complete disclosure and transparency to all parties and enables the collateral receiver
to perform the appropriate due diligence on the progress of the programs. Combined with each tri-party agent’s
expertise in resolving all issues concerning operations, legal, credit and the market, utilizing a tri-party agent is an
effective way for a lender to manage collateral risk.
Best practice notes:
 If there is one essential area of due diligence, the collateral process is it. Understanding how an agent
collateralizes loans, what happens operationally to ensure loans are not released before collateral is received,
and how exceptions are reported is critical to a good securities lending program.
 Where triparty agents are utilized, the lender should review the agent’s due diligence of the triparty agents
and understand how the arrangement is managed operationally and legally.
Cash Securities Lending Transactions
Cash collateral is typically either US dollars, Euro or British Pounds, although it can include other currencies too.
[can US mutual funds accept cash other than USD? We should check]
Cash collateral is more commonly delivered against payment thus the cash collateral and the lent security move
simultaneously. If this is not possible then, as with non-cash collateral, the cash will be prepaid.
Cash collateral received is typically placed in a commingled fund or separate account comprising short term
money market instruments. The lender retains any income earned from the investment of the cash collateral, less
the rebate paid to the borrower. The rebate required by the borrower is negotiated at the outset of the loan and
represents the equivalent calculation to the securities lending fee in the non-cash collateral transaction. The
rebate is usually referred to in respect of a benchmark, normally Fed Funds for USD or EONIA for EUR.
A General Collateral loan lent versus USD cash collateral may be negotiated with a rebate of Fed Funds.
Therefore, the investment of cash collateral will need to earn a yield of higher than Fed Funds in order for the
lender to make any revenue on the loan.
A Special loan lent versus USD cash collateral may be negotiated with a zero rebate (i.e. the borrower receives
no rebate) therefore the lender will retain the full investment earnings on the cash collateral.
When the loan terminates, the borrower returns the lent security and the lender returns the cash collateral to the
borrower plus the negotiated rebate (if applicable).
INCLUDE CASH CALCULATION
It is important to note in both of these types of lending transactions, when a lending agent is employed the agent
will be paid a minority share of the gross revenue earned from the loan. This is usually referred to as a fee split,
when the agent and lender retain a standard proportion of the revenue from each loan.
When an exclusive arrangement is negotiated, the securities lending fee (for non-cash collateral) and rebate (for
cash collateral) are agreed at the outset and will apply to the full term of the exclusive.
Best practice notes:
 It is important for lenders to weigh up the risk/reward benefit of different types of collateral transactions. The
returns versus non-cash collateral may be lower because lenders don’t benefit from the cash reinvestment



yield. However, reinvesting cash may involve additional risk to achieve additional returns.
Lenders should place as much emphasis on due diligence surrounding the reinvestment process as the
securities lending aspect. In fact, treat the appointment of the cash reinvestment manager in exactly the
same way as the appointment of an investment manager, for that is, in effect, the decision being made.
When accepting cash collateral, lenders should be clear in directing their agent regarding appropriate rebate
levels – this is particularly important if a third party cash manager is being utilized. The lender needs to
ensure that communication between the lender and the cash manager is tight to prevent potential negative
loans (where the rebate is higher than the cash yield). Lenders should be particularly aware of management
fees for third party cash funds.
Lenders should consider fee splits with their agent in the context of the service being provided. Agents should
be compensated for their trading activity but may deserve additional reward if they provide comprehensive
risk management tools aligned with quality reporting and additional market color. However, if cash
management is segregated from the lending agent then there may need to be differing levels of
compensation that reflect this, although recognizing that the agent continues to support this process.
Performance related fee splits are also a potential option.
Section 9 - What risks are associated with Securities Lending, and how are risks mitigated?
When properly planned and executed, securities lending is a low risk investment strategy. However, since all
investment activities involve some risk, lenders should consider certain potential risks primarily counterparty,
collateral, operational, and tax/legal/regulatory. These risks are not unique to one provider and should be properly
managed regardless of program structure or provider.
Further information on how to identify and manage risks in securities lending programs can be found in Data
Explorers’ “Making Better Informed Securities Lending Decisions”3 published in March 2010.
Risks can be further described as follows:
3
http://www.dataexplorers.com/news-and-analysis/research/best-practices-securities-financing
Outline includes the following so the graphic needs to include all of this:
a. Counterparty Risk.
i.
Risk that the borrower defaults and fails to return the borrowed securities.
May be mitigated by
1. Focusing on well capitalized, high quality borrowers
2. Extensive and ongoing credit reviews
3. Limits to the exposure and/or number of approved borrowers in program
4. Daily collateral mark-to-market
5. Indemnification insurance from lending agent or parent company or insurance company in the event
of borrower default
b. Reinvestment Risk. Risk that the invested cash collateral incurs losses or underperforms relative to other
investment
possibilities.
i.
c.
May be mitigated by
1. Establishing conservative reinvestment guidelines
2. Monitoring weighted average maturity, credit quality, sector allocation, and issuer diversification
3. Maintain sufficient ongoing liquidity
4. Establish guidelines on minimum profitability of individual loans and/or overall cash collateral AUM
limits. Some have brought reinvestment in-house when cash management capabilities exist to exercise greater control over investment management process
5. Using noncash collateral (potential mark to market risk - must consider a decrease in the value or liquidity of non-cash collateral)
Operational Risk. Risk of processing, bookkeeping, or other errors, including compliance failure, buy-ins,
corporate actions.4
i.
May be mitigated by
1. Daily reconciliation between program participants
2. Control and confirmation procedures
3. Effective use of technology and reporting
4. E&O Insurance
5. Daily monitoring of yield relative to fed funds rate, overall cash collateral AUM, and split between GC
and specials. Monitoring rebate rates, particularly between affiliated and non affiliated borrowers of
lending agent.
A. Review of SAS 70
B. Control reviews / site visits annually
C. Daily monitoring of failing security lending recalls
d. Legal/Contractual Risk. Risk that the parties are out of compliance, either inadvertently or purposely, with
contractual covenants or laws and regulations governing securities lending activities. Also includes the risk
4
Very important for 40 Act fund – Securities lending regulatory risk should be its own category.
that the contracts do not provide the lender the protections that they should or that the lender does not fully
understand its rights and obligations.
i.
May be mitigated by
1. Audit and compliance reporting
2. Standardized documentation
External legal counsel with expertise in securities lending
Best practice notes:
 A well structured program that considers all risks that may apply can be the best mitigation for potential
issues. Lenders can rely on collateral and indemnification but if a program is well managed and operated this
will assist in limiting the situations where collateral may be insufficient and an indemnification call be required.
 Lenders should not just be aware of risk mitigation processes at the outset of a lending arrangement, they
should be regularly reviewed and any changes to process assessed to determine if they continue to meet
high standards.
 Risk needs to be adequately reported by the agent. Lenders should ensure that their risk requirements are
understood by their agent and reporting of adherence to the requirements is provided as required.
 Lenders should be fully aware of the process that will apply when a counterparty defaults, who will do what
and when? This should be reflected and consistent with language in the legal agreement.
Section 10 – Approval and Oversight of Securities Lending Programs by Fund Boards
Up to this point we have focused predominantly on the way the securities lending market works. This section
specifically addresses the responsibility of the Fund Board with respect to overseeing their fund’s securities
lending activities; however, this is practical and useful information for all lenders as it incorporates best practice
suggestions useful inside and outside the board room.
The Fund Board is responsible for approving and overseeing their fund’s securities lending program and,
depending on the level of oversight chosen, may play a role in defining the parameters of the program and
managing it on an ongoing basis.
A Fund Board needs to ensure that full due diligence has been undertaken at the commencement of a securities
lending arrangement and is required to be regularly reviewed as the program continues.
Best practice notes: Some mutual funds have found it useful to form a small working group comprised of fund
directors and advisor personnel to assist in monitoring the securities lending program and performing due
diligence with respect to providers. The group’s activities focus primarily on monitoring the key elements of the
Securities Lending policy (see below) and reporting periodically to the Fund Board. These working groups often
are made up of Independent Directors, and representatives from the advisor’s Operations, Compliance, Portfolio
Management, Risk Management, Trading and Legal departments.
Securities Lending Policy
Note: the following section should be recognized as forming part of best practice that supplements other best
practice notes in this paper.
The Fund should have written securities lending policies and procedures that have been approved by the Board.
Securities lending policies should define the level of risk the fund and its advisor are willing to accept in the
program and set parameters that will ensure the program will remain within risk tolerances.
Best practice notes: The Board is permitted to delegate the monitoring of the program to the working group
providing it operates within the limits of the Policy. The Board may then require periodic updates from the working
group or make formal requests when the Policy may need changing.
In programs where a lending agent is being appointed, the policies and procedures should state that the lending
agent must be aware of the written Policy and the Securities Lending Agreement should adhere to this. Policy
elements necessarily include:
i.
ii.
iii.
iv.
v.
vi.
vii.
viii.
ix.
Choice of route to market (Custodian, 3rd party, direct etc.)
Fees that should be paid (transaction, agent fees) for securities lending services
Revenues that should be paid to the Fund
What borrowers are approved or what criteria will determine borrower choice e.g. adherence to internal
counterparty requirements.
What borrowers are restricted e.g. affiliate companies
What markets are approved for lending or what criteria will determine market choice
What assets are approved for, or excluded from, lending
What Fund NAV limits exist on lending and specifically how limits should be calculated e.g. 33 1/3 rule for
40 Act Funds
What limits, if any, are on term of loans
x.
xi.
xii.
xiii.
xiv.
Minimum expected spread requirements (if any) e.g. only Special transactions with intrinsic value of
20bps
Proxy voting policy
1. Should all loans be recalled to vote
2. Should loans be recalled for certain votes
3. Should loans be recalled for votes on strategic stakes
4. Who has responsibility for resolving lending/voting conflicts
Policy on recalls over dividend dates for tax reasons
Collateral policies
1. Types of collateral e.g. non-cash and cash
2. Margin levels e.g. 102%
3. Restrictions on collateral e.g. borrowers securities
4. How collateral can be held e.g. bilateral or triparty arrangements, custody arrangements
Reinvestment policies
1. Include liquidity guidelines for cash and cash equivalents within reinvestment vehicle
2. Minimum profitability limits on General Collateral loans to meet risk/return expectations
3. Consider floating rate fund to minimize disproportionate interest gains and losses among investors in
cash collateral pool (last man standing risk)
4. Consider that rising interest rates can cause lending to be less profitable in the short term as the
cash reinvestment portfolio may not be reset based on current rates.
5. Consider that unrealized losses can result from rising interest rates diluting investors’ interest in the
cash collateral pool.
6. Consider that in periods of market volatility, margin calls on the cash reinvestment portfolio can be
managed by putting additional loan balance with the broker to avoid the need to sell securities in a
bad market
7. Restriction on assets that can be purchased, for example securities issued by borrowers
Board Reporting
The Board should receive regular securities lending reporting from the fund’s adviser or the Working Group (who
is monitoring reporting from the lending agent). These periodic reports should include:
i.
ii.
iii.
iv.
Compliance reporting – adherence to the securities lending policy and 40 Act requirements
Risk Management – Updates that can include the following
8. Borrower ratings
9. Operational tracking e.g. sell fails, late manufactured dividends
Performance benchmarking
10. compared to goals
11. compared to peers
Market update
12. Relevant information concerning securities lending trends
Changes to the Securities Lending program
Proposed changes to the securities lending program that require alteration to the securities lending policy must
be approved by the Board.
Proposed changes to the securities lending program that are within the existing parameters set forth in the Policy
should be reported to the Board as an update.
Affiliate Lending Agent
The appointment of an affiliate company as lending agent will require additional scrutiny:
i.
ii.
iii.
iv.
v.
vi.
vii.
The contract with the lending agent must be in the best interest of the fund’s shareholders and the fund
itself
The services of the lending agent must be appropriate for the fund
The nature and quality of the services provided by the lending agent must be at least equal to those provided by other non-affiliated lending agents offering the same or similar services for similar compensation
The lending agent’s fees must be fair and reasonable in light of the usual and customary charges imposed by other lending agents for services of the same nature and quality
Upon initial approval, the adviser must provide to the board quotes from at least three independent lending agents
The fund’s contract with the lending agent must be reviewed annually by the board. To continue the contract, it must be approved by a majority of the independent directors
The board, including a majority of the independent directors, must review the loan transactions at least
quarterly to determine if the transactions are being implemented in compliance with the contract
Section 11 - The SEC: What Are their Guidelines for Securities Lending by Funds?
This section details the SEC rules that US Mutual Funds are required to adhere to. In addition it highlights the SEC further interpretation of the rules that provides additional guidance to Fund Boards.
Source for this?
Best practice notes: It is obvious, but required nonetheless, that the Securities Lending Policy detailed in
the previous section, adheres to the following regulation. Other lenders subject to different regulation
should be aware of this regulation and draft their Policy in recognition of this.
a. The Investment Company Act of 1940, as amended (the “1940 Act”), generally permits a registered investment company to lend its portfolio securities, provided that the fund has adopted a fundamental investment
policy permitting the making of loans to other persons. Since 1972, the SEC staff has developed evolving
guidelines regulating the securities lending activities by registered investment companies. These guidelines
are primarily set forth in a series of SEC staff no-action letters5.
b. At the time each loan is entered into, the investment company lender must receive from the borrower not less
than 100% of the market value of the securities loaned at the time the loan is made. Collateral can consist of
any combination of the following:
i. Cash;
ii. Securities issued or guaranteed by the U.S. Government or its agencies;
iii. Irrevocable, non-negotiable standby letters of credit issued by a bank that qualifies as an investment
company custodian bank under the 1940 Act or an “eligible foreign custodian” as defined in Rule 17f-5
under the 1940 Act; and
IS EUROCLEAR PROGRAM ALLOWED?
c.
Collateral must be marked to market daily to cover increases in the market value of the loaned securities
and/or a decline in the market value of the collateral.
d. The investment company lending the securities must have the right to terminate the loan at any time and recall the loaned securities within the normal and customary settlement time for securities transactions.
i. The SEC staff has not been willing to extend the time period for the return of loaned securities beyond
the normal and customary settlement time for loans of securities in the United States. In connection with
the Euroclear Securities Lending Program, the SEC staff has permitted the extension of the recall period
for up to two business days beyond the normal and customary period.
e. The investment company lending the securities must receive a reasonable return on the loan.
5
An individual or entity who is not certain whether a particular product, service, or action would constitute a violation of the federal securities
law may request a "no-action" letter from the SEC staff. Most no-action letters describe the request, analyze the particular facts and circumstances involved, discuss applicable laws and rules, and, if the staff grants the request for no action, concludes that the SEC staff would not
recommend that the Commission take enforcement action against the requester based on the facts and representations described in the
individual’s or entity's original letter. The SEC staff sometimes responds in the form of a no-action letter to requests for clarification of the
legality of certain activities.
i. In addition to receiving all dividends, interest or other distributions on the loaned securities, and any increase in the market value of the loaned securities, the fund must receive a reasonable return on the
loan. A reasonable return on the securities loan may consist of the following:
1. If the collateral is other than cash, a loan fee or premium which gives proper weight to prevailing interest rates and separate payments for dividends, interest and other distributions on loaned securities and any increase in the market value of such securities; and
2. If the collateral is cash, in combination with any loan fee or premium, the retention by the investment
company lender of part or all of the earnings and profits realized by the fund from the investment of
the cash collateral.
3. The SEC staff has noted that the investment of cash collateral is ultimately the responsibility of the
directors of a fund and that this may be delegated only to its properly appointed investment adviser
f.
An investment company may pay reasonable fees approved by its board of directors, including fees to (a) its
custodian in connection with support of the lending activities, (b) the loan broker or lending agent for arranging the securities loan, and (c) the borrower for participating in the loan transaction.
i. An investment company lender may engage an affiliate to perform administrative or ministerial functions
in connection with securities lending activities. Fees paid by an investment company to an affiliate may
not be based on the revenue or profit derived by the fund from securities lending unless an exemptive
order has been obtained from the SEC specifically approving such arrangements.
g. The investment company lender must be able to exercise voting rights in connection with the loaned securities.
i. Voting rights generally will pass when a fund lends its securities. The SEC staff, however, has taken the
position that in certain circumstances the lending fund’s board of directors has a fiduciary duty to exercise voting rights with respect to the loaned securities. In the event that the lender has knowledge that a
material event will occur affecting securities on loan and in respect of which the holder of such securities
will be entitled to vote or consent, the investment company must be entitled to call the loan in time to vote
or consent or otherwise obtain rights to vote or consent.
ii. Programs should be structured in accordance with an investment advisors proxy voting policies and
guidelines. A lending program should allow the investment advisor to recall securities to vote if applicable
h. Securities lending must be permitted by the investment company’s fundamental investment policy.
i. Section 8(b) of the 1940 Act requires an investment company to recite in its registration statement its
fundamental investment policy with respect to making loans to other persons. If an investment company
is not permitted to make loans pursuant to its fundamental investment policy, shareholder approval must
be obtained in order to change this policy.
i.
An investment company may not loan securities with a value in excess of one-third (33 1/3%) of its total asset value, including collateral received from such loans (50% of net assets), based upon market value at the
time of the loan.
i. The SEC staff takes the position that the lending of portfolio securities is analogous to borrowing money
and the pledge of securities. As a result, the SEC staff takes the position that the obligation of the investment company lender to return collateral upon the termination of the loan may involve the issuance
of a senior security within the meaning of Section 18(f) of the 1940 Act. The SEC staff takes the position
that the 300% asset coverage requirement for bank borrowings contained in Section 18(f) also should
apply to a fund’s loan of its portfolio securities. The one-third of total asset value guideline is intended to
ensure that funds comply with the 300% asset coverage requirement when lending portfolio securities.
This paragraphs requires validation per Bob W
ii. In complying with this guideline, the SEC staff permits an investment company lender to calculate the
value of its total assets by including the value of any collateral received in return for its loaned securities,
calculated at the time of the loan. As a result, an investment company with $100 million in assets may
lend securities worth $50 million, since after such loan the fund will have $150 million in total assets including the value of collateral received, and still maintain the 300% assets coverage requirement (and
requirement that loaned securities not exceed one-third of total assets).
j.
An investment company must disclose in its prospectus and/or statement of additional information that (a) it
is authorized to loan securities, and (b) the directors will be entitled to call loaned securities, or otherwise obtain rights to vote or consent, with respect to a material event affecting securities on loan when the board believes it necessary to vote.