Monday, May 23, 2005

Financial transactions: Securities Lending

First of all, what are Securities Lending transactions?

According to owners of securities frequently lend those securities to other parties who may sell them short or deliver them to another party to satisfy some other obligation. Securities may be loaned for a fixed period of time, or the loans may be open-ended. In return for lending its securities, the lender receives a fee, which is quoted as basis points per annum of the original market value of loaned securities. The fee depends upon how scarce a loaned security is in the marketplace. For example, if Treasury bond futures are maturing, the cheapest to deliver Treasury bond will demand a higher fee than other Treasury bonds. Parties who are short the future will want to borrow that bond and deliver it against the future.

A securities loan is typically collateralized. This reduces the lender's credit exposure to the borrower. Collateral may be cash, other securities or a letter of credit. The lender retains the market risk of loaned securities. This is because the borrower is obligated to ultimately return the securities—not the original market value of the securities—to the lender. If the loaned securities pay dividends, coupons or partial redemptions during the loan, these are returned to the lending party. If cash is used as collateral, interest is credited at the repo rate. The securities lending fee is then deducted as a "rebate" from the interest. Many custodians run securities lending programs for their custody clients. Under such programs, the custodian earns income for the client by lending out the securities the custodian is holding for the client.

If securities lending is collateralized with cash, the transaction is economically equivalent to a repo. Rather than be motivated by the borrowing party's need for a particular security, such transactions may be motivated by the lender's need for cash. In this sense, the transaction is economically a cash loan collateralized by the loaned security. Just as a bond dealer might finance its inventory with repos, so might it do so through securities lending.

As you can imagine this type of transactions raise interesting tax issues (from both the lender and the borrower sides). If you transpose them into a cross-border scenario the issues became also very interesting to analyze (for example the treaty issue of determining which article to apply, Art.10 or 11?). Australia, Canada, the United Kingdom and the United States already enacted specific legislation and regulations to tax securities lending transactions on the basis of their economic substance. If you are interested in knowing a bit more about securities lending transactions, read the following New Zealand discussion document, which examines the tax treatment of securities lending transactions and considers the pros and cons of reforming tax legislation in this area. I am sure you will learn something (if you don't ask your money back!)
Paper: “Taxing securities lending transactions: substance over form A government discussion document”


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