A more transparent securities-lending industry is emerging, thanks to new indexes that benchmark the sector.

Securities lending is one of the dirty little secrets of the mutual fund industry. Securities lending is the process whereby investors—typically large, established index mutual funds—will “lend out” the securities they hold to short-sellers, in exchange for a fee. This fee is sometimes paid to shareholders of the mutual fund; sometimes it’s arrogated by the fund company; sometimes it’s split.

Often, fund companies don’t actively disclose how they divvy up this revenue. Nor do they disclose how they manage the risk associated with this process, which is small but significant.

Over the past few years, there have been concentrated efforts to increase the quality of data available about this notoriously opaque practice.

Last month, Standard & Poor’s launched the first-of-its-kind index series that seeks to measure the average cost of borrowing U.S. stocks.

The S&P Securities Lending Index Series aims to reflect the average securities-lending rate for the constituents of the S&P 500, S&P MidCap 400, S&P SmallCap 600 and the underlying S&P GICS sector subindexes for all three leading U.S. equity benchmarks.

The way the securities-lending market functions, and the way fund companies make money from it, is complicated. In essence, the short-seller borrowing a security will give the lending firm collateral for that loan—typically cash, but sometimes other securities. The lending company will then invest this in interest-bearing products, earning a return.

Sometimes, if there are a lot of people willing to lend a given security, the lending firm will offer to “rebate” back to the short-seller a portion of the collateral interest income. Other times, if there is a lot of demand to borrow a security and few firms willing to lend it, the lender will keep all of the collateral and may charge a fee above and beyond that rate.

The rebate rate is determined, in a way, by the rules of supply and demand, Craig Feldman, director at S&P’s Index Services, says.

“All else remaining equal, the lower a rate, the higher the demand of a given stock,” he said.

The indexes aim to provide investors, as well as securities-lending participants, with additional transparency on the aggregate rebate rates charged for domestic equities, David Guarino, manager of Global Index Communications for S&P, adds.

Why now?

“Given the post-market events of late last year and this year, to some extent, we launched these indices to provide greater insight into how these markets move along with the rest of the financial markets,” Guarino said.

On what was termed coincidental timing, Markit, a financial information services company, and Data Explorers, a provider of data, analysis and insight into short-selling, also launched last month an index that is based on securities-lending rates … albeit with a different purpose.

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