Are Securities Lenders Seeing the Storm Coming?
Over the last twenty years, the securities lending market has grown impressively. Mutual funds, insurance companies, and large investors temporarily make the securities in their portfolios available in exchange for a commission. For many of them, it is a stable source of additional revenue. These investors were long thought to be passive: they lend securities to earn a little extra, but without any particular information about the quality of the securities themselves. According to the traditional view, the real information lies with those who borrow the securities, often to bet on a price drop.
A new study by Alberto Manconi (Department of Finance, Bocconi University; Baffi Center; CEPR) and Massimo Massa (INSEAD), published in the Journal of Financial Markets (“Informed securities lending: Evidence from structured finance”) challenges this idea. The study focuses on a simple but important question: when the quantity of securities available for lending decreases, is this a sign about their health?
A look inside structured finance
The research looks at structured finance securities, instruments created by “lumping together” many loans, such as mortgages, car loans, and credit cards, and transforming them into bonds that can be traded on the market. The key point is that, in these instruments, the performance of the underlying loans can be observed directly. If the proportion of borrowers who have not paid for more than 90 days increases, the quality of the security is deteriorating. This indicator is called the “90-day delinquency rate,” i.e., the percentage of loans in serious arrears.
Furthermore, speculative short selling is very rare in this market segment. Manconi and Massa document that
“Borrowing is extremely limited: on average, only 0.17% of each security's issuance is on loan”
This means that only a tiny fraction of the securities issued are actually borrowed. This makes it the ideal context for isolating the role of those who offer securities for borrowing, without the results being distorted by strong speculative pressures.
Fewer securities available today, more problems tomorrow
When the amount of securities available for lending decreases, the proportion of loans in difficulty increases in the following months. As the authors write:
“We find that decreases in lendable amounts predict a worsening performance, captured by increasing delinquencies on the loans underlying a given security”
In other words, if a fund or large investor reduces the amount of a certain security it makes available for lending, mortgages or loans linked to that security show a deterioration shortly thereafter. This is not a marginal statistical detail. A 10% reduction in securities offered for lending is associated with a significant increase in the delinquency rate in the following month. The signal comes before the deterioration is fully visible in the aggregate data. The paper also states:
“Taken together, these findings suggest that lenders possess information not available to other investors”
According to the authors, therefore, securities lenders appear to have information that other investors have not yet incorporated into their decisions.
Where does this information advantage come from?
At this point, the question becomes even more interesting. How do these investors gain an advantage? They might be particularly sophisticated individuals who are already better informed than average. In this case, securities lending would be only an ancillary activity carried out by already well-informed investors. But the study also explores another possibility: that the information originates within the securities lending market itself. A central role could be played by custodian banks, i.e., institutions that physically hold securities on behalf of funds and often manage lending transactions as well.
These banks are at the center of a network of exchanges and can monitor flows, requests, and changes in supply. By aggregating this information, they may identify signs of deterioration before they become apparent to the market as a whole.
Evidence shows that the ability to predict deterioration is stronger when a single custodian bank controls the entire amount of securities available for lending for a given issue. This finding is consistent with the idea that information can spread through these intermediaries.
A new perspective
For years, research has focused primarily on those who borrow securities in order to bet on a price drop. This study shifts the focus to the other side of the market, the supply side.
If the supply of securities for borrowing contains information about fundamentals—that is, about the real quality of the underlying loans—then the securities lending market is not just a technical tool for generating commissions or facilitating speculative transactions. It is also a possible channel for producing and circulating information.
In a sector like structured finance, which played a central role in the 2007-2008 crisis, understanding where signs of deterioration originate and how they spread is essential. This work suggests that some signs may emerge earlier precisely through the choices of those who decide to no longer make certain securities available for lending.
