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Common Motivations Behind Securities Borrowing
Education | 27 April 2012

By Phillip Securities

In the previous issue, we talked about Securities Lending. Now, we shall address a commonly asked question by lenders, “Why does a borrower want to borrow my securities?”

In the 1960s, most systems were paper-based which resulted in many errors and failed settlements. Securities Borrowing and Lending (“SBL”) began as a back-office function, aimed at reducing and settling the aforementioned errors. Until today, although this function still exists, SBL has evolved to support financial institutions and traders in their various trading strategies. In this article, we will share with you some of the most common motivations behind Securities Borrowing.

The most widely known reason for Securities Borrowing is short selling. When a declining trend is anticipated in a stock, market participants may decide to take a short position with the expectation of buying back the stock at a lower price. Borrowers will take a short position with the borrowed stock and subsequently buy back when the stock has reached their desired price.

However, contrary to popular belief, the interest in Securities Borrowing is not synonymous with the level of short-selling activities in the market. Other reasons for borrowing securities also include covering of failed trades, market making as well as arbitrage trading.

Let us explore the various reasons for short selling further. The existence of failed trades could be due to trading errors, such as sellers selling the wrong stock or wrong quantity. For illustration purposes, we will refer to the stocks traded on the Singapore Exchange. If a seller of a particular stock does not have the shares to deliver on settlement date due to any of these errors, the seller may consider borrowing the relevant securities to settle this shortfall against the sale, thereby avoiding a force buy-in by the Exchange due to failed delivery. This ability for the seller to borrow and avoid a settlement failure is vital to ensure efficient settlement of trades, which in turn promotes market efficiency.

Another use of Securities Borrowing is market making and one typical example of market making, is the provision of the product – Contracts for Difference (CFD) to the investors. Now, the question is, “What has market making got to do with Securities Borrowing?” When engaging in market making activities, the financial institution may need to hedge their positions to reduce their risk in any adverse price movements.

Besides market making, borrowed shares can also be used for the purpose of arbitrage; such as cross border arbitrage and rights arbitrage. Cross border arbitrage involves a simultaneous sale and purchase of the same stock in two different markets and profiting from a price differential. Arbitragers will borrow the stock and sell it in the market that prices the stock higher and buy the stock in another market that prices the stock lower. The borrowed stock will then be returned to the lender once the prices in the two markets reach equilibrium and no further profit can be made.

Another example of an arbitrage is rights arbitrage. This arises when there is a rights issue on a particular stock and the rights issue shares are being traded at a discount. Arbitragers will borrow the stock to sell, simultaneously, buying the rights issue shares in the ready market. The arbitragers will convert the rights into shares and return them back to the lender, thereby profiting from the price differential.

As it can be seen from above, activities that entail the use of Securities Borrowing may not cause a depression in share prices. In fact, some studies have shown that covered short selling actually aid in adding liquidity and eliminating price inefficiencies in the markets.

Traditionally, SBL programmes were only available among financial institutions. Today, it is easily accessible to retail investors through some financial intermediaries, such as Phillip Securities Pte Ltd, a member of PhillipCapital.

Retail investors holding onto a “long” portfolio may consider lending their shares out to potentially earn a lending fee. In fact, for some Securities Lending programmes, even shares pledged as collateral in the margin account, may be made available for lending. Not only does this not affect the margin ratio, it may help to reduce the cost of margin financing as well. Lenders may note that they will not be deprived of any economic benefits or the right to sell their shares even if they are on loan.

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