In line with the provisions of the Business Facilitation Act 2023, the National Pension Commission (PenCom), is working on regulations that will enable Pension Fund Administrators (PFAs) to explore the possibility of participating in securities lending as an investment option in the capital market.
Securities lending is a financial practice where investors, often institutional ones like mutual funds, pension funds, and hedge funds, lend their securities (such as stocks, bonds, or other financial instruments) to other investors or financial institutions for a specified period.
The borrower of the securities typically provides collateral to the lender as a guarantee for the value of the borrowed securities.
In a workshop organised by the Nigerian Exchange Limited, Securities and Exchange Commission, and PenCom, the Commission said that the Business Facilitation Act 2023 has enabled it to proceed with developing guidelines for securities lending.
The Head, Investment Supervision at PenCom, Ibrahim Kangiwa, said the provisions of section 89 of the Pension Reform Act 2014 had restricted PFAs from participating in securities lending.
Kangiwa said, “As you know, section 89 of the Pension Reform Act 2014 has provisions regarding restrictions on the sale and borrowing of pension assets. This has been a major encumbrance of securities lending.”
What is securities lending?
As stated, securities lending is a financial transaction in which one party (the lender) temporarily transfers ownership of securities to another party (the borrower) in exchange for collateral.
The borrower then uses the securities to short-sell or for other purposes and returns them to the lender at a later date.
Securities lending is a popular activity among institutional investors, such as hedge funds and investment banks.
These investors often have large portfolios of securities that they are not actively trading.
By lending these securities to other investors, they can earn income in the form of a lending fee. The collateral that the borrower provides is typically equal to or greater than the value of the securities that are being lent. This helps to protect the lender in case the borrower defaults on the loan.
Here's a breakdown of how securities lending works:
● Lender and Borrower
The lender (the owner of the securities) agrees to lend their securities to a borrower, who might be a short-seller, another investor looking to cover a position, or a financial institution seeking to facilitate trading activities.
The borrower provides collateral, often in the form of cash, government bonds, or other highly liquid assets, to the lender. This collateral acts as a security in case the borrower defaults on returning the borrowed securities.
● Loan Terms
The terms of the loan are agreed upon by both parties. This includes details like the duration of the loan, the fee or interest paid to the lender (sometimes referred to as the lending fee), and any potential recalls or early terminations.
In exchange for lending their securities, the lender receives a fee or interest payment from the borrower. This compensation can help generate additional income for the lender's portfolio.
In some cases, the lender might decide to recall the lent securities before the agreed-upon term. This could be due to changes in market conditions or the lender's need to use the securities.
● End of the Loan
At the end of the agreed-upon loan period, the borrower returns the securities to the lender, and the lender returns the collateral to the borrower.
How PFAs Relate To Securities Lending
Pension Fund Administrators (PFAs) are entities that manage pension funds on behalf of contributors or participants in a pension scheme.
Their primary goal is to invest the contributions made by employees and employers in various investment instruments to generate returns that will eventually fund the contributors' retirement benefits.
Securities lending can be a strategy that pension fund administrators utilize to enhance the returns of the pension funds they manage.
Here's how securities lending can relate to pension fund administrators:
● Additional Income
By participating in securities lending, pension funds can lend out the securities they hold in their portfolio to other market participants in exchange for a lending fee.
This fee adds to the income earned by the pension fund, potentially increasing the overall returns of the fund.
● Risk Management
Securities lending can be conducted with risk management in mind. Pension funds can use collateral requirements to mitigate the risk of default by borrowers. Collateral serves as a buffer in case the borrower fails to return the lent securities.
● Cautious Approach
PFAs, being responsible for managing retirement funds, will be expected to take a cautious approach to securities lending. They consider the risks associated with lending securities and ensure that the lending process aligns with the fund's overall risk profile.
● Regulatory Considerations
When given the green light by PenCom, Pension Fund Administrators in Nigeria will be subject to specific regulations regarding their investment activities, including securities lending.
PFAs will need to comply with these regulations and ensure that their securities lending practices are transparent and in line with the fund's objectives.
● Custodian and Third-Party Services
PFAs will be expected to work with custodian banks or specialized third-party service providers to facilitate the securities lending process.
These intermediaries help manage the operational aspects of securities lending, including lending agreements, collateral management, and reporting.
● Communication with Participants
It will also be expected that PFAs communicate with participants (contributors) about the investment activities of the fund, including securities lending. Transparency is crucial to ensure that participants understand how their pension funds are being managed.
Risks and rewards of securities lending
Securities lending is a practice that contributes to market liquidity and allows short-sellers to facilitate their trading strategies.
It can also benefit long-term investors by generating additional income. However, it comes with certain risks and benefits.
It's essential to carefully assess the risks and ensure proper collateral and agreements are in place to safeguard both parties' interests.
While securities lending can generate income, it also involves risks. If the borrower defaults or faces financial trouble, there might be a delay or difficulty in getting back the lent securities.
However, the collateral helps mitigate this risk to some extent.
While securities lending can be profitable, some of the associated risks that come with it may include;
● Counterparty Risk
There's a risk that the borrower might default on returning the securities. Collateral is used to mitigate this risk, but there's still a possibility of loss.
● Market Risk
If the value of the borrowed securities decreases significantly during the loan period, the collateral might not cover the full value, leading to potential losses.
● Operational Risk
There can also be operational complexities in managing the lending process, such as ensuring timely returns, managing recalls, and dealing with potential disputes.
The lender benefits from the lending fees, which can add to their investment returns. It can be particularly profitable when there is a high demand for borrowing specific securities, resulting in higher lending fees.
Securities lending as an investment option
Securities lending can indeed be used as an investment strategy for generating additional income.
Here's how securities lending can be utilised as an investment option:
● Generating Income
As an investor, you can lend out your securities to other market participants, such as short-sellers or financial institutions, in exchange for a lending fee. This fee serves as additional income for your investment portfolio.
● Diversification of Income
Securities lending can diversify your sources of income beyond traditional investment returns, such as dividends and capital gains. This can be especially beneficial in periods when market returns are lower.
● Passive Income
Securities lending can provide a form of passive income, as the lending process doesn't typically require ongoing active management once the lending agreements are in place.
● Enhanced Returns
Securities lending can potentially enhance the overall returns of your investment portfolio, especially in scenarios where the lending fees are significant relative to the securities' value.
Other things to note about securities lending
Securities lending can be a useful way to enhance your investment returns, but it's important to approach it with caution and a clear understanding of the potential risks and rewards.
Other things you need to know about securities lending may include;
● Choosing Securities to Lend
Not all securities are suitable for lending. Highly liquid and widely traded securities are usually preferred, as they are more likely to have demand from borrowers.
However, lending less liquid securities can carry higher fees due to their scarcity.
● Understanding Agreements
Before engaging in securities lending, it's crucial to thoroughly understand the lending agreements, including terms, fees, collateral requirements, and the potential risks involved.
● Professional Guidance
If you're considering securities lending as an investment option, it's advisable to seek guidance from financial professionals who specialize in this area. They can help you navigate the complexities and choose an approach that aligns with your investment goals and risk tolerance.
● Monitoring and Review
Regularly monitor the performance of your securities lending activities. Review the lending fees earned, the risk exposure, and the overall impact on your investment portfolio.
In conclusion, consulting with financial advisors and doing a thorough research will help you make informed decisions about incorporating securities lending into your investment strategy.
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