How does the securities lending market work?

Question

After doing some research, literature suggests that "most" securities lending happens over-the-counter (OTC) as opposed to securities trading which is mostly done through a centralized electronic exchange.

1. What alternatives are there to OTC for securities lending? is there any type of electronic market for securities lending?

2. How do borrowers source lenders? For example, let's say I want to borrow a million shares of company A. How do I find an investment fund that has a million shares of company A?

I have found many resources online including this detailed IOSCO document [PDF]. However, nobody talks about the process of how lenders and borrowers are matched up.

3. Also, how are pricing/lending fees determined? With securities trading in an electronic market, pricing is mark-to-market. Even in OTC securities trading, the pricing can be determined based on activity in the broader market.

4. If there is no "market" for securities lending how do you structure the pricing? For example, let's say a mutual fund loans a million shares of company A to a hedge fund with a fee of 1%. How is the mutual fund sure it found a competitive fee? Maybe there is another hedge fund that would have agreed to 1.1%.

I would appreciate if anyone with experience in security lending could shed some light, or provide some reading materials/resources.

Answer 1

there is a big, well established market for security lending. Anyone with significant holdings will place the large dealers in competition for the lending of their securities.

Smaller companies will use their prime broker and usually have several in competition. These prime brokers will compete on overall pricing including financing of long and short positions.

There are on-line services like LoanNet that securities lending groups will use in a more exchange like way. These transactions will be visible on LendingPit where you can see these rates.

It is important to realize that few people (especially end-users) focus on one specific securities loan. Instead , securities lending is bid on as part of a general financing package. For example, a hedge fund will approach a dealer and show them their portfolio of long and short securities. The dealer will give them pricing based on the whole.

Answer 2

My experience in fixed income securities financing suggests the financing market is often just bilaterally negotiated if there isn't collateral that can be borrowed against in the money market. Of course, this varies by asset.

Keep in mind structures such as repo, CEF preferreds/VRDPs, TOBs (US munis) and margin lending all generally have some form of price discovery and price close to cash rates.

For specifically equities, some information on hard-to-borrow rates may be implied from option pricing (e.g., if there is a HTB cost on assignment on a put, the market will price that in).Theoretical option pricing only works iff one can finance an exercise at the risk free rate (which is often not the case in practice). You could also look at CEFs holding equities to see where leverage on the collateral was priced.

As with anything that is traded, your price discovery is a component of formality of the market and the liquidity of your underlying instrument. Pricing is a product of creatively using your available data to generate a reference. If you're asking how OTC stock lending is priced, the answer is that you're pretty much at the mercy of your counterparty. If you're financing T, you have pretty good data from the repo market.

In short, it depends. Banks exist to serve the middleman function.