Introduction

An exchange-traded fund (ETF) may lend its underlying securities to a financial institution (typically a broker-dealer or hedge fund) in exchange for fees and collateral received from the borrower to generate income for the ETF. Financial institutions typically borrow the securities to benefit from making short sales in the market or to facilitate settlement of trades that could otherwise fail. In this installment of the ETF Know:How series, we explore the concept of securities lending and examine the potential benefits and risks.

What is securities lending?

Securities lending is a common, well-established practice in which an ETF, as the beneficial owner of a security (“lender”), lends that security to a financial institution (“borrower”) in exchange for a fee. The borrower pledges collateral, generally in the form of cash, to the lender for the duration that the security is on loan. The collateral is held by the lender to protect against loss if the borrower should fail to return the security. Cash collateral is invested in a cash reinvestment vehicle, from which the lender typically earns income. The lender returns the collateral to the borrower when the borrower returns the security.

The lending agent facilitates transactions between the lender and the borrower. The lending agent provides services to the ETF, facilitating the lending of securities to approved borrowers, negotiating the loan terms, monitoring the value of loans and collateral on a daily basis, ensuring the investment of cash collateral, and managing recalls of borrowed securities and termination of loans.

How does securities lending work?

1. The borrower communicates a demand for a security to the lending agent. The lending agent and the borrower agree to the terms, price, loan duration, and collateral required to secure the loan.
2. The lending agent facilitates the transaction, including delivering the security to the borrower. In return, the borrower provides collateral, as either cash or securities, to cover the value of the loaned security. Borrowers may pay an incremental fee for securities that are in high demand.
   1. Cash collateral received is invested in an approved cash reinvestment vehicle.
   2. The lending agent performs daily marked-to-market calculations to ensure that the collateral is sufficient to cover the current market value of the security on loan.
   3. All dividends or interest paid from the security while it is on loan are sent to the lender in the form of a substitute payment.
3. The borrower returns the security to the lender via the lending agent, and the lending agent returns the collateral to the borrower upon receipt of the security. The lender may recall a loan at any time.
4. The lending agent distributes the securities lending revenue to the lender. Securities lending revenue represents the income earned from the investment of the cash collateral plus any fees paid by borrowers, less the fees paid to the lending agent and broker rebates. Any expenses charged by the cash collateral fund are in addition to these fees.

Evaluating a securities lending program

An ETF may generate incremental returns and improved benchmark tracking by lending its underlying securities as it continues to receive the economic benefits of the security, such as dividends and interest. ETF shareholders should consider the following key points when evaluating an ETF that engages in securities lending:

What are the risks of securities lending?

Summary

Securities lending is a common, well-established practice that allows borrowers, usually financial institutions, to borrow securities from a lender (ETF). Although the practice of lending securities carries some risk, an ETF may mitigate the risk by implementing specific lending guidelines with the lending agent and thoroughly validating all borrower counterparties on a regular basis. Ultimately, lending securities may generate additional revenue for the ETF, which could result in incremental returns for its shareholders and improved performance.