Securities lending and borrowing (SLB) is a vital aspect of the financial landscape that plays a crucial role in maintaining liquidity and facilitating various investment strategies. This intricate financial practice involves the temporary transfer of securities from one party to another, providing unique opportunities for investors and institutions alike. In this comprehensive guide, we will delve into the intricacies of SLB, exploring its mechanisms, benefits, risks, and the role it plays in the broader financial ecosystem. Whether you are a seasoned investor or just beginning to navigate the complexities of the financial markets, this blog aims to equip you with a comprehensive understanding of securities lending and borrowing.

Defining Securities Lending and Borrowing

Securities lending and borrowing allows traders to either borrow or lend shares from other market participants. This mechanism plays a crucial role in the functioning of the equity markets, enhancing liquidity and enabling various trading strategies. In the context of hedging, SLB provides a robust alternative to the derivatives market.

Short-sellers or borrowers in the SLB market are traders seeking to sell shares they do not own. By borrowing these securities, they can sell them in the market, hoping to repurchase them later at a lower price. Conversely, lenders are shareholders with long-term holdings in shares that are inactive in their demat accounts. The interim loan of securities from a lender to a borrower is referred to as securities lending, which contributes to enhanced liquidity and improved market efficiency in the equity market.

Working of Securities Lending and Borrowing

Securities lending and borrowing is an authorized method established by the Securities and Exchange Board of India (SEBI) in May 1997, with the most recent revision made in November 2012. All market participants in the Indian securities market, including consumers (apart from eligible foreign investors), are permitted to rent and borrow securities, but only through a licensed agent.

Currently, there are two approved intermediaries: NSE Clearing Limited (NCL) and BSE Clearing Corporation (BOISL), with the majority of transactions being processed through NCL. This regulatory framework ensures transparency and security in the lending and borrowing process, allowing participants to engage in SLB with confidence.

Features of Securities Lending and Borrowing Mechanism (SLBM)

Securities lending is crucial for short selling, where a trader borrows securities to sell them quickly. The borrower expects to profit by selling the security and then repurchasing it at a lower price. Since clearing corporations cover transactions in the SLB area, participants are shielded from counterparty risk.

As of August 20, 2018, over 370 stocks are available on the NSE SLB platform, and this list is updated monthly by the exchange. The contracts available for securities lending can range from one month to 12 months, providing flexibility for both lenders and borrowers. Additionally, transactions in SLB are not subject to Securities Transaction Tax (STT) or SEBI’s turnover fees, making it a cost-effective option for market participants.

Benefits of Stock Lending and Borrowing

For Lenders

1. Additional Revenue Generation: One of the primary benefits of SLB for lenders is the opportunity to generate additional revenue. Lenders earn fees from borrowers in exchange for lending their securities. These fees can vary depending on factors such as the demand for the specific stock, market conditions, and the terms of the lending agreement.

2. Enhanced Portfolio Returns: SLB allows lenders to put their idle securities to work, potentially earning returns that would not be possible through traditional buy-and-hold strategies. Instead of leaving securities dormant in their portfolios, lenders can earn fees, which can improve the overall return on their investment portfolios.

3. Risk Mitigation: Despite the temporary transfer of ownership, the lender retains ownership of the securities, which means they continue to benefit from any dividends, interest payments, or capital gains associated with those securities. This characteristic allows lenders to maintain their investment strategy while still capitalizing on the SLB opportunity.

4. Diversification of Revenue Streams: SLB provides lenders with an additional source of revenue that is distinct from their core business activities. This diversification can help financial institutions and institutional investors reduce their reliance on a single revenue stream, making them more resilient to market fluctuations and economic downturns.

5. Improved Liquidity Management: Lenders can recall their loaned securities at any time, subject to the terms of the lending agreement. This flexibility allows lenders to respond to changing market conditions and liquidity needs. In times of high demand for a particular stock, lenders can recall their securities and potentially benefit from increased market prices.

For Borrowers

1. Enables Short Selling: For borrowers, SLB opens the door to engaging in activities like short selling, where investors sell borrowed shares with the expectation of repurchasing them at a lower price later. This strategy can be highly lucrative in bearish market conditions.

2. New Market Perspectives: The ability to borrow securities allows investors to take a more dynamic approach to market conditions. By engaging in SLB, borrowers can execute strategies that align with their market outlook, providing a flexible approach to investing.

3. Enhances Overall Market Liquidity: The increased activity from securities lending and borrowing contributes to overall market liquidity. This growing liquidity leads to tighter spreads, benefiting all market participants by reducing the gap between bid and ask prices.

Lending and Borrowing Stocks

Lending Stocks

The lenders in the SLBM are usually large insurance firms, mutual fund houses, banks, and high-net-worth individuals (HNIs). A lender may ask a stockbroker to place orders in their system to lend their stocks using SLBM. Lenders specify the details of shares included in the SLBM, such as quantity, the upper limit of market price, and expected fees.

This fee is applicable based on each share transacted. In the event of a default, the lender must submit 25% of the amount lent as security. Once the stock is transferred to the respective borrower, the lender receives the due margin amount. If a transaction gets canceled, the lender retains ownership of the stock.

Borrowing Stocks

For borrowers, SLBM provides the opportunity to acquire stocks for arbitrage or to avoid actual share settlement. Investors or traders taking a bearish stance on a stock can sell the borrowed stock, allowing them to capitalize on anticipated price declines.

Borrowers must place orders with a stockbroker, specifying the time period, number of shares, and the lending fee they are comfortable with. When a broker finds an appropriate match for the order, borrowers need to deposit 125% of a stock’s price as margin to mitigate risk. After borrowing, they may sell the stock, leaving behind 25% of the total margin as security.

To ensure compliance and avoid defaults, daily mark-to-market (MTM) valuations are performed on the margin amount, providing additional security for lenders.

Conclusion

Securities lending and borrowing is a financial practice that allows traders to borrow or lend shares from other market participants. This process not only provides an additional avenue for lenders to earn returns on their idle assets but also opens up opportunities for short selling for borrowers. Beyond individual benefits, SLB contributes to market liquidity, fostering efficiency and tighter spreads, ultimately creating a more dynamic and accessible trading environment for all market participants. As we explore SLB, it becomes evident that this practice is a multifaceted tool with implications for investors, short-sellers, and the broader market landscape. Understanding SLB is essential for anyone looking to navigate the complexities of modern financial markets. By leveraging the opportunities offered by SLB, participants can enhance their trading strategies, improve liquidity management, and potentially increase their overall returns. Whether you are an institutional investor or a retail trader, becoming acquainted with the SLB mechanism can provide valuable insights into optimizing your investment approach in today’s fast-paced financial environment.