A group of specialist banks are profiting from Europe's financial crisis, thanks to a surge in demand for securities which allow traders to bet against bank stocks and government bonds.

The so-called custody banks that administer securities, a normally unglamorous and low-margin business, include BNY Mellon, JP Morgan and State Street .

The banks, as well as loan specialist Equilend, take a fee for linking lenders with surplus stock -- typically pension funds -- with borrowers such as hedge funds and banks, who want to position themselves in markets by short-selling.

Pension funds and insurers have become increasingly attracted to lending by the fees they accrue from the borrowers at a time when equity returns are off.

The latter want stocks or bonds to sell them in the hope that their price will fall over time. They can then buy back the securities at a lower rate and pocket the difference before returning them to the lender.

There were many trading opportunities in 2011, said James Slater, global head of securities lending at BNY Mellon.

Activity in the second half was driven by (hedge) funds, reacting to global events like the euro zone crisis.

JP Morgan and State Street both saw lending levels rise in 2011, while Equilend, whose electronic systems match firms wanting to lend with prospective borrowers, saw its trading levels spike in August.

Clearly volatility is a part of that but we've added more new clients this year than any other and they are using more of our services, said Equilend Chief Executive Brian Lamb.

The peak activity in August, when Equilend trading hit 27,770 loans worth $21.3 billion in one day, was partly driven by the worsening Euro zone crisis, during which traders borrowed assets to bet on falling markets.

Equilend is owned by 10 large financial firms including Credit Suisse , Goldman Sachs , Morgan Stanley and UBS , custodians Northern Trust and State Street, and fund manager Blackrock.

GAME OF TWO HALVES

The world's top stock lending houses may have ended 2011 up on previous years but sustained volatility and a drop in demand towards the end of the year have raised questions over the outlook for 2012.

Lending rates in the latter part of the year were also affected by bans on the short-selling of some European bank stocks, which were introduced in August and still hold.

The extreme volatility in equity markets coupled with the continuation of short sell bans across many European countries contributed to a decrease in trading opportunities for much of the second half of the year, said Don D'Eramo, senior managing director, securities finance, EMEA, at State Street.

Some volatility tends to help boost trading and stock lending in the short-term but prolonged volatility breeds uncertainty which depresses the markets and, therefore, the ability to make money short-selling.

I suspect 2012 is going to remain challenging, without a speedy resolution to the Euro zone situation and a generally more positive market outlook, said Paul Wilson, global head of client management and sales at JP Morgan Worldwide Securities Services.

But the stock lending agents could benefit from regulatory efforts to force over-the-counter (OTC) derivatives trading to go via clearing houses, known as central counterparties (CCPs), in order to improve transparency.

Cash-strapped banks and brokers are already struggling for collateral to support their trading units and this situation will be compounded when regulators start to demand extra collateral from banks trading in the lucrative OTC markets.

(This) will increase the demand from trading firms and other derivative users for eligible collateral, said JP Morgan's Wilson. Derivatives users will look to borrow credit-worthy fixed income securities.

(Editing by Sophie Walker)