Under the hood of securities-lending practices

November 27, 2018

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While securities lending is a widespread industry practice, there are meaningful variations in lending programs and the ways lenders use revenues—a source of additional income that can enhance fund returns.

Case-in-point: Vanguard returns all lending revenues, net of direct program costs, which include operating expenses and agent lender fees, to the Vanguard funds. By contrast, other securities-lending programs may retain anywhere from 20.0% to 37.5% of the gross lending revenues.1

These differences are reflected in the many ways in which securities-lending programs are implemented.

The value-volume continuum

At one end of the spectrum—the end where Vanguard sits—is value lending. Value lending is an inherently conservative approach. It generates revenue by lending limited amounts of select, hard-to-borrow securities that are in high demand, to capture a scarcity premium. The scarcity premiums provide the lender with a higher loan fee on loaned securities, though with fewer opportunities to lend. This allows Vanguard to keep the percentage amounts of securities on loan in Vanguard funds far lower than in most other lending programs.

Volume lending is at the spectrum's other end. This approach seeks to lend as many securities as possible, independent of scarcity value. There are more opportunities to lend, but the loan fees are lower. Volume strategies derive most of their revenue from the reinvestment of the cash collateral.


The collateral reinvestment risk spectrum

Because of the collateral requirement, securities lending has generally been viewed as an activity with little risk to the lender.

The industry standard is that borrowers must deliver enough cash collateral to cover 102% of the borrowed security's value (105% for non-U.S. securities). The borrowed securities are valued on a daily basis, and additional collateral is required from the borrower if the securities increase in value. In other words, the fund will always hold at least 102% collateral (105% for international securities). This mark-to-market approach ensures proper coverage in the event of borrower default.

However, collateral reinvestment strategies sit along a spectrum.

Some securities lenders stretch for yield, taking on greater risk for higher income from their invested collateral.

Vanguard takes a conservative approach to collateral management. We limit collateral reinvestment risk by investing cash in Vanguard Market Liquidity Fund, a conservative fund managed by Vanguard Fixed Income Group. The fund seeks to provide current income while maintaining liquidity. It invests in high-quality, short-term money market instruments. To be considered high quality, a security must be determined by Vanguard to present minimal credit risk based in part on a consideration of maturity, portfolio diversification, portfolio liquidity, and credit quality. The Market Liquidity Fund maintains a dollar-weighted average maturity of 60 days or less and a dollar-weighted average life of 120 days or less.

To mitigate the collateral reinvestment risk in our international securities-lending program, we limit noncash collateral to a subset of sovereign debt from France, Germany, the Netherlands, the United Kingdom, and the United States. Additionally, our lenders provide us with borrower default indemnification for the difference between the market value and collateral value of the outstanding loans, providing an additional layer of protection under certain circumstances.

The benefits of Vanguard's conservative approach were apparent in 2008, when many firms other than Vanguard experienced significant losses related to their securities-lending programs. These losses occurred because of significant declines in the value of the securities purchased with the cash collateral and not from the practice of securities lending itself.2

Counterparty risk explained

One potential downside associated with securities lending is counterparty risk.

Counterparty risk is the risk that the borrower of a security will default on its obligation to return securities, which could result in losses to the relevant Vanguard fund.

To reduce counterparty default risk, Vanguard lends securities solely to a limited number of preapproved financial institutions and adheres to strict, self-imposed guidelines on the aggregate dollar amount of loans made to each approved borrower. Our credit research group independently analyzes all borrowers on an ongoing basis to ensure that they meet our standards. If a firm did fail to return a borrowed security, the fund would use the cash collateral to repurchase the security.

We believe that by taking a conservative approach to securities lending, the rewards outweigh what we believe to be relatively low risk.

Effects of securities lending on fund performance

Not all Vanguard funds lend securities. Among those that do, income from securities lending typically has increased annual returns by a few basis points. However, contributions to fund returns vary considerably among individual funds, with several having increases of 10 basis points or more. In the case of Vanguard's equity index funds, contributions from securities-lending revenue accounted for between 0.01% and 0.27% of income as percentage of average fund assets in 2017.3

We can deliver such results because our securities-lending program is an extension of our at-cost model. Because we are owned by our funds, which are owned by their shareholders, no profits are kept by Vanguard. Everything we do, including securities lending, is done for the benefit of our fund shareholders.

1 Flood, Chris. "Securities lending proves lucrative as investors aim for alpha." Financial Times, April 22, 2018.
2 Adrian, Tobias; Brian Begalle; Adam Copeland; and Antoine Martin. Federal Reserve Bank of New York Staff Reports, No. 529 December 2011; revised February 2013.
3 Source: Vanguard.


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