Securities financing refers to the process of borrowing or lending securities in order to complete a trade. This is an alternative method for raising liquidity, compared with using cash or other assets on hand. There are two main types of securities financing: repo and securities lending (see below). The primary difference between them is that in repo, collateral is government-issued debt whereas in securities lending it may be government debt or equity securities.
What is Securities Financing?
Securities financing is a process by which an investor borrows cash or securities from another party in order to complete a trade, and returns the borrowed assets at a later point in time. The borrower may use the borrowed assets to fund a purchase or investment, or to cover short-term liquidity needs.
Depending on what type of securities are being used in this way, the transaction can be structured as either repo or reverse repo. A repo transaction involves borrowing cash collateralized by securities (usually government bonds), while reverse repos involve lending cash collateralized by government bonds.
Two Types of Securities Financing
There are two main types of securities financing: repo and securities lending. The primary difference between the two is that repo refers to a secured loan using government-issued debt as collateral, whereas securities lending uses government debt or equity securities as collateral.
When you trade on margin in your brokerage account, you are essentially borrowing money to make investments. That's where repo and securities lending come in.
In the case of repo, you're borrowing money from your broker or lender in order to buy more stocks or bonds than you could afford with cash alone (say, if you wanted to buy $100 worth of stock but only had $70). In this situation, your lender will be putting up the cash needed for buying those additional investments—you'll get it back later when you close out your position—and therefore holds onto some sort of security from which it can recoup its investment if necessary (in other words: collateral).
Benefits of Securities Lending
Benefits of securities lending include the potential for additional revenue streams from collateral activities, reduced counterparty risk, lower cost of liquidity and more effective trade settlement.
- Proceeds from securities lending can generate additional revenue streams.
- Lending out securities reduces counterparty risk by passing along risk to a third party instead of holding it in your book of business.
- The lower cost of liquidity makes securities lending an attractive alternative to other methods of financing such as repo or collateralized funding transactions.
- Securities lending can improve trade settlement efficiencies by enabling you to reduce your cash balance requirements, thereby allowing your cash flow to be used more effectively elsewhere (e.g., paying down debt).
Ideal Tool for Institutional Investors
Securities lending may be an appropriate tool for institutional investors with large holdings of high-quality bonds, who can generate additional return by lending them out at interest rates higher than the yield on their own portfolio.
For example, a borrower that is holding a bond issuer's debt security has two options: it can sell the bond or it can lend it to other parties in exchange for cash collateral. The borrower benefits from the difference between what he or she pays to buy the bond and what he or she receives when someone else lends it back (the margin). For example, let's say you purchase $100 face value of XYZ Corp.'s 10-year bonds at par ($100 per bond) and hold them until maturity when they pay you $110 per bond—for simplicity's sake ignoring trading costs here! If you sell those same bonds back into the market prior to maturity (that is before they are due), then you will receive only $99 from another investor since this person would need to net off his/her trading costs as well as yours before making an investment decision based on price alone. But if instead of selling early you chose instead
Potential Lucrative Business
In conclusion, securities lending is a lucrative business for institutional investors who wish to generate additional revenue from their bond holdings. It’s important to note that this activity should only be undertaken when one has enough information about the market and experience with securities lending in general. The process of finding a lender may seem simple at first glance but requires careful consideration before executing any agreements or contracts with them.