Securities Lending: Enhancing returns and empowering retail investors

Introduction

In the ever-evolving landscape of financial markets, investment firms are continually seeking innovative ways to maximise returns and create value for their clients. Especially with the continuous focus on further democratising retail investments, it’s important to find the right avenues to make access to the financial markets easier, simpler, and more affordable. This is also in line with the Retail Investment Strategy of the European Commission .

One such avenue that has recently gained traction is Securities Lending – a practice where investment firms lend out a portion of the shares held in custody for their clients. Due to the increasing popularity of Securities Lending by retail investment firms, European Securities and Markets Authority (ESMA) published on 12 July 2023 a statement on Securities Lending to retail investors and a set of guidelines for investment firms.

With BUX we also apply the practice of Securities Lending. With this article I therefore would like to clarify that while this practice may raise questions about risk and ethics, a closer look reveals that Securities Lending, when managed prudently, can offer a range of benefits to both investors and the broader financial ecosystem. Let me explain...

?

The benefits of Securities Lending

Let’s first take a close look at the benefits of Securities Lending. There are 4 main benefits for the use of Securities Lending to retail investors:

1.???Enhanced Returns: Securities Lending presents a unique opportunity for investment firms to generate additional income from their clients' idle assets. Consider a scenario where a retail investment firm holds a significant amount of shares in a stable, blue-chip company. While these shares appreciate in value over time, they are not actively contributing to the firm's returns. By lending out a portion of these shares to qualified borrowers, the investment firm can earn lending fees, thereby enhancing the overall return generated from the investment. These returns can subsequently be translated back to further benefits to the end consumer, such as additional features, improved services, or lower costs.

2.???Cost Mitigation: Operational costs associated with custody, maintenance, and administration of assets can add up over time. Securities Lending can play a role in mitigating these costs. For example, a retail investment firm might lend shares of a well-established technology company that is in high demand for short selling. The lending fees earned from such transactions can be used to offset the custody and administrative costs, leading to a reduction in the overall expense ratio of the investment.

3.???Liquidity Enhancement: Market liquidity is crucial for efficient price discovery and seamless trading. Securities Lending can contribute to liquidity by ensuring that there are shares available for short sellers and hedgers. For instance, during a period of increased market volatility, a retail investment firm can lend out shares of a popular energy company that are in demand for hedging purposes. This lending activity provides market participants with the necessary instruments to manage their risks, ultimately fostering a more fluid and efficient market environment.

4.???Diversification: The revenue generated from Securities Lending can offer investment firms the flexibility to diversify their product offerings. Suppose a retail investment firm specialises in providing index-based funds to its clients. By lending out shares from the underlying index constituents, the firm can earn additional income that could potentially be reinvested to expand its range of investment products. This diversification benefits clients by offering them access to a broader array of investment options that align with their risk profiles and preferences.

?

The downside of Securities Lending

As with any innovative initiative for a retail investment firm, Securities Lending has some key disadvantages as well. The 3 main disadvantages are the following:?

1.???Counterparty Risk: Counterparty risk is a valid concern in Securities Lending. To mitigate this risk, retail investment firms can take several precautionary measures. For instance, they can engage in thorough due diligence when selecting borrowers, ensuring they have a solid track record and adequate collateral. Additionally, retail investment firms can cap the amount of shares lent to a single borrower, thereby reducing exposure to any potential defaults. By carefully managing counterparty risk, firms can safeguard their clients' interests while enjoying the benefits of Securities Lending.

2.???Market Volatility: While Securities Lending can potentially contribute to market volatility, the impact is often overstated. Consider a situation where a retail investment firm lends shares of a pharmaceutical company that has recently released positive clinical trial results. If demand for these borrowed shares increases due to short sellers looking to capitalise on perceived overvaluation, the stock's price might experience short-term fluctuations. However, these fluctuations are temporary and tend to normalise over time, reflecting the company's underlying fundamentals.

3.???Ethical Considerations: Critics of Securities Lending often raise ethical concerns, particularly regarding the potential impact on stock prices. To address these concerns, retail investment firms can adopt responsible lending practices. For instance, they can avoid lending shares of companies with limited liquidity, where the borrowing demand might disproportionately affect prices. By exercising discretion in their lending decisions, investment firms can strike a balance between generating income and ensuring the stability of the broader market.

?

The application of a prudent approach

When taking into account both the pros and cons, I believe we should apply a prudent approach. For retail investment firms operating in the European landscape, adopting Securities Lending can be beneficial, provided that they prioritise the interests of their clients and employ diligent risk management strategies. To ensure investor confidence, we as retail investment firms must be transparent about our lending practices, disclose potential risks, and adhere to strict risk-mitigation protocols.

Retail investment firms in Europe can approach Securities Lending with a clear commitment to client welfare. By providing transparent communication about our lending practices, we can alleviate potential concerns clients might have. Implementing strict risk management protocols, such as collateral requirements and borrower evaluation, ensures that Securities Lending remains a valuable tool without unduly jeopardising investor interests.

?

My view towards Securities Lending

In the ever-changing world of finance, embracing innovative practices like Securities Lending can open doors to enhanced returns and improved financial outcomes for end consumers. By offering increased liquidity, offsetting costs, and diversifying investment options, Securities Lending aligns with the goal of empowering investors to achieve their financial aspirations.

As long as investment firms commit to responsible lending practices and transparent communication, Securities Lending can serve as a valuable tool in the arsenal of strategies designed to generate long-term value for clients.

As retail investment firms navigate the intricacies of the European financial landscape, Securities Lending emerges as a practice that can be harnessed to benefit end consumers. Through prudent lending practices, firms can unlock enhanced returns, offset costs, and foster market liquidity. By maintaining transparency and prioritising client interests, investment firms can harness the power of Securities Lending to empower investors on their journey toward financial success.