Sec Lending: Risks, With Fewer Rewards

March 05, 2013

It would great if answers were easy to come by, but unfortunately, the securities-lending money trail isn’t easy to trace.


Securities lending is a particularly hot topic right now, as BlackRock is currently being sued by a group of pension funds over its securities-lending program. The pension funds claim that BlackRock’s securities lending program is “designed to loot securities lending returns properly due to iShares investors.”

I’m not writing to comment on the case or, in general, over the legality of BlackRock’s or any other fund issuer’s securities-lending program.

Instead, I want to clearly lay out what issuers are doing and how it affects you as an investor so that you can invest with firms most aligned with your views and interests.

After all, securities lending is big business: BlackRock raked in nearly $400 million from securities lending in 2011.

When an issuer lends a security, the borrower provides collateral that is usually cash or cash equivalents equal to 102 percent (varies slightly) of the market price of the lent security. This collateral is usually invested and the return from that investment is the relevant securities-lending revenue.

Is security lending risky?

A fund primarily takes on two additional risks when lending securities. First, there’s the risk that the borrower defaults or fails to return the security.

Second, there is a risk that investments made with collateral decline in value: When a borrower returns the security, the fund must return the borrower’s collateral. If the collateral has declined in value, the fund could be on the hook to make the borrower whole again.

The fund almost always bears both risks, which means that you—as an investor in the fund and owner of its assets—are the ultimate risk bearer. The important caveat here is that this policy does vary slightly among a few issuers.

State Street, for example, specifically discloses in a prospectus that the fund is indemnified against the first risk (borrower default), but that the fund is subject to the second risk (the value of investments made from cash collateral declines).

Why lend securities?

Securities lending can benefit issuers as well as investors, so the real concern is when the balance between those two is skewed away from investors and toward issuers. To assess the legitimacy of that balance, we need to be cognizant of the ways issuers and investors benefit from securities lending.

First, and most importantly, securities lending can be in the best interest of investors and issuers because the additional revenues from securities lending may boost the fund’s performance and help the fund track its index better.

It’s important to note that this is a win-win for investors and issuers: Investors receive extra returns from securities-lending revenues, and issuers get better performance records on their funds. Improved performance records are good for issuers because, in general, it boosts the appeal of their products and, specifically, increases assets and revenues from management fees.

The other, less altruistic reasons that an ETF issuer may opt to lend securities is because doing so will generate additional business for affiliates or because the issuer can retain a percentage of the returns generated from securities lending.

Personally, I prefer to avoid that conflict of interest and stick to issuers whose securities-lending program only benefits them in the first sense; that is, through better fund performance that boosts product appeal and, in turn, ought to increase assets under management and revenue from management fees.

Proportionality of risks and rewards is key.



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