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Securities Lending: Hard to Borrow & Failure to Deliver

Instructor: N. Faye Angel

Faye has taught college classes in Business and Information Systems programs, and has a Ph.D. in Technical Education and an M.B.A. in Business Administration.

This lesson defines and provides an overview of securities lending. Hard to borrow securities and failure to deliver by the settlement date are discussed and examples of both are provided.

Defining Securities Lending

Securities lending is defined as securities that are borrowed by one investor from another investor. It involves trades between brokers and/or dealers but does not include individual investors. The securities must eventually be returned to the lender. The borrower is a temporary owner.

Borrowers generally borrow securities in the short term expecting the price to go lower, at which time the borrower buys them back and makes a profit (short sale). The seller (who borrowed the securities) must return equal shares of the securities to the lender at some time in the future.

Selling borrowed securities with the intention of buying them back can be a risky investment if the price at which they were sold does not decline. In this case, borrowers can lose a significant amount of their investment

At the time the securities are loaned, the borrower must put up collateral (cash and noncash) or letters of credit. The collateral must be at least equal to 100% of the value of securities with an additional margin of 2% - 5%. Thus, the value of the collateral should be between 102% - 105% of the value of the securities.

Cash collateral and letters of credit are self-explanatory. Noncash collateral can include bonds (government and corporate), equities, and other securities.

Securities that are loaned include pension funds, insurance company funds, mutual funds, collective funds, exchange-traded funds (ETF), sovereign wealth funds (state owned fund investments), and other large portfolio securities. Lenders have lower custodial cost since they do not hold the securities and may use cash from fees and interest to reinvest in low-risk securities to generate money.

The borrowers receive the title to the securities, have the rights of the owner when earning dividends or interest, and can vote for directors and other important business decisions. Although the borrowers receive the dividends and interest, they 'manufacture' some or all of them back to the lender.

Other fees are negotiated between the borrower and lender and is generally an annualized percentage of the borrowed securities.

The securities lending agreement is integral in determining the conditions between lenders and borrowers for the loaned securities and is completed before the stock is borrowed or when the transaction is finalized. It is signed by the lender and borrower.

The securities lending agreement includes the duration of the loaned securities, lender's fees and compensation (including margins above the value of the securities), and the nature of the collateral (cash and noncash). This agreement is enforced as a legal contract.

Hard to Borrow

Securities held by brokerage firms can be hard to borrow or easy to borrow for the purpose of selling the securities, repurchasing them, and returning them to the investment company. Securities may be hard to borrow because the lender is low on inventory or their price is very volatile. Other securities are plentiful and considered easy to borrow.

Hard to borrow securities are updated on a weekly basis and listed for internal use. Lists of easy to borrow securities are available to clients.

Refer to Figure 1 for five securities that were hard to borrow in March 2020.

Figure 1. Hard to Borrow Securities

Name of Company Symbol
Allied Healthcare Products AHPI
Blue Apron Holdings Inc-A APRN
Biontech SE BNTX
Co-Diagnositcs Inc CODX
Inovio Pharmaceuticals Inc INO

Fees are higher for securities on the hard to borrow list, and in extreme cases, may reach 100% of the value of the securities. Many times these securities cannot be borrowed for short sales.

Example - Hard to Borrow Securities

Mr. Zhang wants to borrow ABC, Inc. stock, but it has been placed on the hard to borrow list. He understands the risk and high fees associated with this stock.

Mr. Zhang finds an investment company that is willing to lend 1,000 shares of ABC, Inc. stock, and he borrows the 1,000 shares. In addition to the collateral he must put up, the fee is 50% of the value of the stock which is $24 a share.

Mr. Zhang sells the stock for $24,000. After 10 days, the weak financial position of ABC, Inc. is exposed, and its stock drops to $10.50 per share. Mr. Zhang repurchases the stock and returns 1,000 shares to the lender.

Mr. Zhang's profit is $13,131.23. See the calculations below.

The lender's fee is calculated based on an annualized percentage of 50%. The formula for calculating the fee is:

(value of stock * percentage fee / days in year) * days borrowed = fee owed to lender

The fee for 10 days would be:

($24,000 * 0.50 / 365) * 10 = $328.77

The formula for calculating profit is:

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