N°26-61: Price Efficiency in Securities Lending

Securities lending-the temporary transfer of securities in exchange for collateral-is essential to the modern financial system, facilitating short selling, market making, and efficient liquidity management. Yet, little is known about how these contracts are priced. Using comprehensive transaction-level data, we identify the determinants of returns from lending the same security against cash or securities collateral. We develop a model in which lending returns compensate for security risk, illiquidity, and the use of scarce dealer balance-sheet capacity. We also define a return wedge between the two market segments. Consistent with the model, the wedge widens with risk, illiquidity, dealer constraints, and collateral reusability but narrows as participation across both segments increases.