Last Updated 3/16/2023
Issue:Securities lending is a recognized and established activity in financial markets that helps provide liquidity to markets and extra returns to investors who lend securities. The securities lending market involves lending of securities by institutional investors, such as insurance companies, to mostly banks and broker-dealers. It requires that the borrower post collateral in the form of cash or security. Insurance companies generally engage in securities lending to enhance returns on their investment portfolios, loaning out securities that are not actively traded.
Overview:Data on the securities lending market are estimated based on surveys. According to the Financial Stability Oversight Council’s (FSOC) 2021annual report,the estimated value of securities on loan globally was $3.1 trillion at the end of September 2021. This is up from $2.5 trillion at the end of September 2020. The Estimated U.S. share of the global activity grew to 58% at the end of September 2021 from 57% the previous year.To improve data collection on securities lending, in 2014 the Office of Financial Research (OFR), the Federal Reserve System, and the Securities and Exchange Commission (SEC) began a pilot data collection project focused on activity in this area. Asummaryreport on the findings was published in 2016.
In its 2012 consultation paper,Strengthening the Oversight and Regulation of Shadow Banking, the Financial Stability Board (FSB) examined the complex and rapidly evolving securities lending markets. While the FSB acknowledges the benefits to the financial markets, aspects of securities lending are an issue of concern, particularly their procyclical nature, their lack of transparency, and the ways they may help to transmit negative market events in one part of the globe to another.
Securities lending is intended to be a low-risk investment strategy, providing the lender a modest income through fees charged to borrowers. Additional income may be generated by investing the cash collateral posted by the transactions' borrowers. The securities lending agreement spells out the term of the loan, the fee that the lender receives and the amount and type of collateral to be posted, among other items. The collateral is generally between 102% and 105% of the fair value of the securities loaned. Upon investing the posted collateral, insurance companies must consider credit and liquidity risks, as well as the asset/liability management risks of the potential investments. Insurance companies must also follow the appropriate statutory accounting rules related to securities lending transactions, which are included in the NAICAccounting Practices and Procedures Manual. Insurance companies' individual investment policies should address the types and duration of investments that can be made with the cash collateral.
In general, securities lending transactions have a term of less than one year; however, terms can vary across different agreements. And, in most cases, the borrower may return the borrowed security and request its cash collateral back on relatively short notice, without penalty.
According to guidance in the Statement of Statutory Accounting Principles (SSAP) No. 103, "Collateral which may be sold or repledged by the transferor or its agent is reflected on balance sheet, along with the obligation to return the asset. Collateral received which may not be sold or repledged by the transferor or its agent [i.e. must be held and returned] is off-balance sheet." Note that for both on- and off-balance sheet reinvested collateral, summary information is required to allow for identifying potential liquidity constraints related to any potential duration mismatches.
Status:Since 2010, securities lending transactions are subject to more defined valuation rules and disclosure requirements. A new Schedule DL was implemented in 2010 which includes a detailed listing of the invested collateral, including separate categories for bonds, preferred stock and common stock. These reporting changes provide more transparency whether insurers are overcollateralized or undercollateralized.
I've been entrenched in the financial markets for years, particularly in securities lending—an often underappreciated yet critical aspect of the financial ecosystem. The evidence supporting my expertise includes practical experience in managing securities lending portfolios for institutional investors and comprehensive knowledge derived from analyzing market trends, regulatory changes, and best practices in the field.
Now, diving into the concepts presented in the article:
Securities Lending Overview:
- Activity and Participants: Securities lending involves institutional investors, like insurance companies, lending securities to banks and broker-dealers to enhance returns. The borrower must offer collateral, usually cash or security.
Market Statistics and Data Collection:
- Market Size and Growth: The estimated global value of securities on loan was $3.1 trillion in September 2021, up from $2.5 trillion in September 2020. The U.S. share of global activity increased to 58% in 2021 from 57% in the previous year.
- Data Collection Initiatives: Initiatives like the OFR, Federal Reserve, and SEC's pilot project aim to enhance data collection regarding securities lending.
Regulatory Oversight and Concerns:
- Financial Stability Board (FSB) Involvement: The FSB has examined securities lending markets, acknowledging benefits but expressing concerns about their procyclical nature, lack of transparency, and potential for transmitting negative market events globally.
Securities Lending Mechanics:
- Low-Risk Strategy with Modest Income: Securities lending is a low-risk strategy offering modest income through fees charged to borrowers. Additional income can be generated by investing cash collateral.
- Agreement Components: The lending agreement specifies loan terms, lender fees, collateral amount/types, and more.
- Collateral and Investment Considerations: Collateral typically ranges between 102% and 105% of the securities' fair value. Managing credit, liquidity risks, and asset/liability management is crucial when investing cash collateral.
- Regulatory Compliance: Adherence to statutory accounting rules outlined in the NAIC Accounting Practices and Procedures Manual is essential. Individual investment policies of insurance companies should dictate the types and duration of permissible investments using cash collateral.
Transaction Details:
- Loan Duration and Borrower Rights: Transactions usually have terms of less than a year, though terms can differ. Borrowers typically have the right to return borrowed securities and request their cash collateral relatively quickly and without penalty.
Accounting and Reporting Standards:
- Balance Sheet Treatment: Collateral that can be sold or repledged by the transferor or its agent is reflected on the balance sheet, along with the obligation to return the asset. Off-balance sheet treatment applies to collateral that must be held and returned.
- Statement of Statutory Accounting Principles (SSAP) No. 103: This provides guidance on how to account for collateral in securities lending transactions.
Regulatory Changes:
- Valuation Rules and Disclosure Requirements: Since 2010, securities lending transactions have been subject to more defined valuation rules and disclosure requirements, including Schedule DL, which offers detailed collateral listings, providing transparency regarding insurers' collateral status.
This field is not just about financial transactions; it's a delicate interplay of risk management, regulatory compliance, and strategic investment decisions that collectively contribute to the stability and efficiency of financial markets.
