Securities lending is the transfer of ownership of stocks, bonds, or other assets from one party to another. A lender may participate in this activity to generate gains from a portfolio. Lenders retain ownership rights, but forfeit any voting benefits that might otherwise be granted to shareholders if the borrowed assets are stocks. The borrower becomes legally responsible to return securities that are similar in design and value of the borrowed assets after the term of the loan to the lender. Collateral, including cash or bonds, valued at least the size of the loan is typically used to offset some of the risk.
There are several types of investors who participate in securities lending, although the practice typically takes place among institutional investors that oversee large sums of other people's money more than it involves individual investors. Mutual fund managers, public and private pension funds, as well as endowments and foundations are all active in the practice of securities lending. Typical borrowers might include prime brokers, which are entities that lend money and securities to hedge funds; trading desks at large banks that trade the bank's own money; and hedge funds. Securities lending trades are facilitated by a third party, such as a broker dealer or custodian bank.
Mutual fund managers and other investment advisers oversee baskets of securities for investors and are paid to preserve and grow wealth over time. A manager might opt to participate in securities lending as a way to generate some short-term gains. Other reasons might be to increase overall returns in a portfolio or to offset other investment costs.
Some hedge fund managers are in the business of trading shares they do not own in attempts to bolster returns on a trade. A manager might borrow securities from a prime broker to hedge a position in a trade. There are also some investment strategies that rely on securities lending more heavily, including pairs trading. In this strategy, for every bet a manager makes that a stock will rise, he makes another bet that a similar security will drop in price, which is a way to hedge investments. Some of these trades might be made from a fund manager's own money, but undoubtedly some of the securities will be borrowed given the numerous trades that are involved.
Investing carries no guarantees, and securities lending is no different. Risks include the possibility that a borrower will default on a loan and fail to deliver the promised securities after the term of the contract. This is known as counter-party risk, and a lender can attempt to mitigate this exposure by performing extensive credit checks and performing daily assessments on the value of the borrowed securities.