Collective Investment Funds

Securities Lending

A CIF may lend its portfolio securities to certain creditworthy borrowers, such as broker-dealers or banks, in order to generate incremental revenue at relatively low risk. Firms, such as broker-dealers, that routinely borrow securities do so to facilitate their securities trading business.

To mitigate the risk of borrower default, a bank engaged in securities lending must require the borrower to provide collateral. Collateral is generally in the form of cash, securities issued or guaranteed by the U.S. government or its agencies or instrumentalities, or a letter of credit. Borrowers of securities are also customarily required to pay to the CIF the value of any interest, cash, or noncash distributions paid on the securities during the period they are on loan. Industry practice enables either the bank lending the securities or the borrower of the securities to terminate a loan at any time. Upon the termination of a securities lending relationship, the bank obtains from the borrower the return of the securities loaned.

If a borrower collateralizes a securities lending relationship with cash, the borrower will customarily be entitled to receive a portion of the interest earned on the temporary investment of that cash, based upon a negotiated rate. A CIF will generally receive compensation for lending its securities that is based upon the difference between the amount that the CIF earns on the reinvestment of cash collateral and the fee that it pays to the borrower. When a borrower provides noncash collateral, the CIF is compensated through a fee paid by the borrower on the loaned securities. The bank generally receives its compensation for facilitating the securities lending activity by sharing a percentage of the CIF’s earnings on the loaned securities, subject to any restrictions under applicable law. Banks with multiple CIFs that may benefit from securities lending need to have procedures in place to ensure that the benefits of securities lending programs are allocated across those funds.

Securities lending involves exposure to operational risk (i.e., the risk of losses resulting from problems in the settlement and accounting process), “gap” risk (i.e., the risk of a mismatch between the return on cash collateral reinvestments and the fees the CIF has agreed to pay a borrower), and credit, legal, counterparty, and market risks. In the event a borrower does not return a CIF’s securities as agreed, the CIF may experience losses if the proceeds received from liquidating the collateral do not at least equal the value of the loaned security at the time the collateral is liquidated, plus the transaction costs incurred in purchasing replacement securities.

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