Securities Lending: Risk Or Reward?

Securities lending is a fairly simple process that can generate extra returns for ETF investors but it also introduces extra risk

ETF.com
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Reviewed by: etf.com Staff
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Edited by: etf.com Staff

[This article was first published in the Learn section of our website, a comprehensive database of educational articles and resources]

The logic behind securities lending is this: The ETF is sitting on thousands of equity shares for which it has no immediate need and for which it can earn additional revenues by loaning them to short-sellers, who will pay a fee. So, why not?

Well, securities lending introduces additional risk into an ETF portfolio. For one, there’s the risk that the borrower defaults and fails to return the borrowed securities. Fortunately, industry practice is for borrowers to provide collateral—with the collateral exceeding the value of the loaned securities by a set margin.

This helps ensure against the most obvious risk—borrower default—but it doesn’t eliminate securities-lending risk entirely. If the borrower is a short-seller (it usually is) and the security that he or she shorted rallies strongly in a single day, the borrower may default and the provided collateral may be insufficient to cover the cost of re-acquiring the security.

There’s still another risk: When ETF issuers receive cash collateral, they don’t just sit on it—they put it into money market securities to earn some small amount of interest on the cash. If the money market securities should have some crisis, the ETF and its investors could be on the hook to make up the difference. It’s unlikely, but it has happened.

The risks of securities lending are always present but the rewards for bearing that risk fluctuate. Just as prices in the rest of the economy are subject to the forces of supply and demand, so too are securities-lending premiums.

Securities that are in high demand in the loan market command higher premiums. ETFs that hold these in-demand securities can earn a significant premium lending out portfolio holdings. Premiums tend to fluctuate as certain sectors, markets or countries fall in and out of favor with short-sellers.

 

 

When these factors align perfectly, ETFs can earn huge premiums for lending securities. Historically, some ETFs (those in solar in 2013, for instance) have paid dividends amounting to a yield as high as 5-7% despite the fact that none of their underlying holdings paid dividends. In these cases, the ETF generated sufficient revenues to enable a hefty dividend for its investors.

Let’s keep things in perspective though; most ETFs don’t earn such lofty premiums for lending their securities. While they certainly provide a tail wind for ETFs, the effect of securities-lending revenue is usually relatively muted and generally serves to offset expenses rather than generate significant outperformance.

It’s worth noting that, rather than distributing securities-lending revenue as dividends, the usual course of business is for ETFs to invest the extra revenue in its portfolio holdings. In this case, investors reap the rewards via fund performance rather than dividend payments.

The takeaway is that securities lending introduces some risk to ETP portfolios—much of which has been mitigated by issuer policies. Meanwhile, the benefits of securities lending range from negligible to highly significant.

 

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