The Risks Of Securities Lending

Yesterday’s post indicated that the reason the db x-trackers DJ Euro Stoxx 50 Index ETF was able to charge a 0.00% MER was due in part to the revenues it collects on lending out securities to short-sellers. Below is a short list of risks involved in securities lending* (taken on by the unitholder, which is important to note).

1. Credit / Counterparty risk – the short seller defaults on returning the securities they borrowed
2. Market risk – Adverse or abrupt movements in the underlying security’s price (which can affect the short sellers’ ability to return the security)
3. Cash Re-investment risk – when the cash collateral is invested in something that falls in value
4. Foreign Exchange risk – when the collateral is denominated in a different currency than the security being lent
5. Legal risk – the enforceability of the contract between the fund and short seller, especially if the companies operate in different countries
6. Mismatch risk – risk of differing price movement behaviour of the collateral and the securities on loan
7. Recall risk – risk of delayed return of securities when requested by the fund
8. Operational risk – inadequate technology or infrastructure to facilitate securities lending properly and competently
9. Settlement risk – if the securities are not returned at the same time that the collateral is given back, there is risk borne in what is known as “daylight” exposure

It should also be noted that there are numerous controls and protocols that are in place to deal with these risks, but given that the total dollar volume of securities on loan in 2007 reached $5.5 Trillion (USD), more attention needs to be paid by regulators. Additionally, the retail investor may or not be participating in the securities lending taking place in their investment funds, but they are most certainly taking part in the risks involved.

*Source: RBC Dexia Investor Services – Demistifying Securities Lending, July 2009

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