Why is Securities Lending Practiced?

The main reason why a fund might want to lend out some of the securities it holds is to increase returns and reduce costs. As said, the borrower will pay a certain fee in exchange of the assets. Moreover, in order to reduce risks, the counterparty who is borrowing will also have to provide some kind of collateral to guarantee the loan. The lender has thus the opportunity to reinvest the collateral to generate extra income during the loan period.

On the borrower’s side there are countless possible reasons why it might want to hold some securities for a certain time. Borrowers are typically banks, hedge funds, brokers and many other participants in financial markets who conduct high numbers of transactions every day.

What Are the Risks of a Securities Lending ETF?

By lending the fund’s securities, counterparty risk arises. There is in fact a possibility that the borrower could default and would not be able to return the borrowed securities. In this case the lender would have to sell the collateral and repurchase the securities on the markets. However, under particular market circumstances, liquidity might dry up making it very difficult to sell some kind of assets. In case of a financial crisis or a black swan event, it might become very difficult to trade securities. Attention also needs to be paid to the quality of the collateral provided by the borrower.