Securities lending, which can involve the lending of bonds as well as stock lending, involves the transfer of securities from one party to another – such as from a mutual fund or institutional investor to a hedge fund. The borrower gives collateral in the form of shares, bonds or cash and also pays the lender a fee each month for the loan (it would be more accurate to think of securities lending as securities renting). The borrower is also contractually obliged to return the securities on demand within the standard market settlement period, which would be three days for UK equities.
Securities lending generates revenue for the lenders, who might otherwise see little return from long-term holding of low-yielding stock. It also provides liquidity in the market. Securities lenders retain their right to any stock dividends that are paid to them by the borrower, but lose their right to vote the shares while they are lent out. This means in order to vote, they need to recall the shares.
There are broad risks in securities lending. One is borrower risk – the borrower might default on the loan, for example, if the borrower becomes insolvent. The other risk is collateral risk. This is the risk that the value of the collateral falls below the replacement cost of the securities that are lent.
In May 2013 The Economist reported on how the practice of securities lending could be vulnerable to the proposed financial transaction tax in eurozone countries: "For now, the future of securities lending looks uncertain rather than outright gloomy. The danger is that it will be stymied just when it will be needed to fuel derivatives trade. Regulators in both America and Europe now want all derivatives contracts to change in ways that will require much higher levels of collateral—and thus securities lending. Should such financial activity indeed be severely limited, nobody will much miss the tax-dodging holiday of European shares in springtime. Other benefits would be harder to replace."
Also in May 2013 a post on FT Alphaville warned that the financial transaction tax could extinguish the repo and securities lending markets.