Securities Lending Securities lending is a type of transaction in which an entity ("Lender") with a large portfolio of securities (e.g., a pension fund or endowment) lends its securities to a borrower ("Borrower") in exchange for collateral (often in the form of cash). A Lender enters into these transactions to earn an investment return on the collateral provided by the Borrower. A Borrower may enter into a securities lending arrangement in order to use the borrowed securities for its own investment transactions. Securities lending transactions are often arranged by a lending agent ("Lending Agent"), such as the Lender's custodial bank. The Lender lends its securities through the Lending Agent to the Borrower. The relationship between the Lender and the Lending Agent is governed by a securities lending authorization agreement, in which, among other things, the Lending Agent agrees to invest the collateral provided by the Borrower in order to earn incremental income that is shared by the Lender and the Lending Agent.
Misalignment of Interests Many securities lending authorization agreements enabled Lending Agents to share in the upside of collateral investment returns, but did not provide for sharing in the collateral investment losses. Securities lending authorization agreements often placed the risk of investment losses solely on the Lenders. The recent financial crisis, which precipitated an unprecedented level of collateral investment losses, exposed a misalignment of interests between Lenders and Lending Agents.
Drafting Tips Lenders negotiating securities lending authorization agreements are advised to take note of the following drafting tips in order to better align the interests of the Lending Agent with that of the Lender.
Alignment of Earnings & Losses. Specify in the securities lending authorization agreement that any loss of principal or other diminution of value from investing collateral is shared by the Lending Agent and the Lender in the same proportion as their respective percentage entitlements to incremental income earnings.
Investment Guidelines. Establish preapproved investments that Lending Agents are authorized to invest in, and negotiate strict investment parameters, such as minimum credit quality requirements, maturity limits, and diversification requirements.
Borrower Defaults. Define strict credit criteria for eligible Borrowers in order to minimize the risk of Borrower default, and request Lending Agents to provide Borrower default indemnification.1
1Note, proposed bank regulatory reforms intended to decrease credit exposure and increase capital requirements of Lending Agents (in addition to increased costs associated with regulatory compliance) are expected to indirectly restrict the amount of indemnification exposure that Lending Agents are willing to tolerate.