A securities lending transaction starts when a borrower, in most cases a broker-dealer, seeks to borrow shares of a particular security.  This must be for an “approved purpose”; that is, they must be borrowed in order to cover the need for shares, and not for an alternate purpose such as the desire to vote in a stockholder proxy.

Funds can lend in three ways: 1) principal transactions (typically done only by the largest fund complexes, handled internally with the largest returns and costs), 2) through their custodial agent (typically convenient but results in a shared return), or 3) through a third party (brings a specialized agent in to the transaction for a higher return but additional commission).

When shares are loaned out, the lender receives collateral—typically cash—in the amount of approximately 102% of the value of the shares.  It is then the lenders obligation to invest this cash at an appropriate rate to generate a return.  When the shares are returned (shares can be taken back at any time), the lender must return the collateral, and in addition pay interest to the borrower on the collateral.  It is the spread between the rate the lender receives on the collateral and the rate he must pay back to the lender which represents the profit on the transaction.  This profit is typically then split with the lending or custodial agent that handles the transaction. The split typically used to be 50-50 but in recent years the fund industry has succeeded in claiming a larger share.
 

Directors have many issues to consider regarding securities lending, some of which are touched on below:

Potential Returns

The size of the fund complex as well as the types of securities held can be a significant factor in the decision to lend and the potential for gain in the portfolio.  Smaller complexes may not have enough scale for the process to be worthwhile.  Funds with a higher proportion of large-cap US stocks may find the returns on these stocks, which are widely available and provide much smaller returns, are not worth the effort.  Conversely, funds with significant holdings of international or small cap stocks will find greater opportunities and demand for the shares, resulting in higher returns.  Once a program is in place, a review of the program using performance benchmarks is necessary to determine its level of success.

Risks

The risk of default—that is, a borrower not returning the shares—is for the most part not an issue.  Borrowers are indemnified and there are numerous regulations in place to protect lenders.  The more significant risk is that of collateral management.  If mutual funds are not able to maximize the return on the collateral they risk earning less return or perhaps none at all.  Just like any other money market investment, great care has to be taken to ensure that the collateral is invested in secure instruments, typically short term government securities. Some funds groups have been embarrassed by using less than AAA bonds—such as extendible commercial paper –for their collateral investments. The SEC has been looking for such cases in recent months.

A common concern for many is that loaning shares to be shorted may exert downward pressure on their portfolio’s positions.   However market wisdom would hold that securities lending promotes market efficiency and liquidity, and that short sellers are critical to efficient market theory.  Given the long term hold strategy held by most mutual funds, this should not be a factor over time.
 

Voting

Funds that lend shares lose the right to vote on them.  Directors must weigh what is best for shareholders—the vote or the return added to the portfolio by lending them out.  If a vote is material then the board may be obligated to take back the shares.

New Developments

Finally, directors must constantly re-evaluate their funds’ securities lending program or lack thereof.  The pace of development in securities lending is rapid and all directors –whether their funds are lending or not—need to stay current with industry developments given the improvements to the process and potential benefits. Furthermore, financial market activity—such as the current credit crisis—can also have a direct impact on the risks and returns of these programs. 

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Securities lending can be an important additional source of return for mutual funds. However, the transaction is relatively complicated. Fund directors need to fully understand the structural components and execution principles of the arrangements.