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MARKET GUIDE
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2008
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SLMG 2007 pp1-16 ML 10/9/07 11:08 am Page 1
INTRODUCTION
SECURITIES LENDING
MARKET GUIDE
2008
Fast times
It has been a year of great change for
the securities lending market
Welcome to the 2008 edition of ISJ’s annual rounding proxy voting’s relationship to securities
Securities Lending Market Guide. It has been a lending and the potentially negative influence of
busy year for securities lending and borrowing, and hedge funds have gained notoriety in the press.
there has been no shortage of press coverage sur- Hedge funds in particular, have faced increased
rounding the market and its potential in the future. scrutiny for allegedly borrowing to buy votes.
This guide aims to bring you up to speed with the The International Corporate Governance Network
latest market developments and act as a reference (ICGN), whose members include some of the
handbook to the particularities of this rapidly evolv- world’s largest pension funds, has publicly urged
ing business. regulators to force funds to make detailed disclo-
Our special feature examines the last 12 months in sures of sale and repurchase agreements. The
the market and what we can expect from the next ICGN has accordingly drawn up a code of best
year in terms of progress. The impact of hedge practice on stock lending in all jurisdictions and is
funds and 130/30 funds is of particular interest, as campaigning for the authorities to support it. Dr
they are the underlying cause of a large part of the Andrew Clearfield, member of the ICGN board of
growth that is happening in the securities lending governors, spoke to ISJ about his perspective on
market at the moment. Securities financing is the the matter for our special feature.
bridge between hedge funds, one of the main bor- The Markets in Financial Instruments Directive
rowers of stocks, and institutional investors such as (MiFID), due to be implemented on 1 November this
insurance companies, mutual funds and pension year, could also mean more scrutiny of lending pro-
funds, the dominant lenders of securities. grammes. It could potentially result in loans being
Furthermore, if you believe the hype, the growth of made based on price and best execution, rather than
traditional long only funds’ investment in 130/30 relationships, thus increasing the transparency of the
strategies could overtake the growth of hedge funds market as a whole.
and become the largest single driver of securities With these opportunities
lending over the next five years. and challenges in mind, we
The growth of the market is set to continue, have gathered together the
according to reports by a number of financial serv- leading lights of the securities
ices analyst firms. For example, Celent expects lending industry to provide
growth in the US securities lending market alone to you with a comprehensive
increase at a rate of 5% per year. insight into the market as it
However, it has not been smooth sailing for the stands today.
market over the last year, as industry practices sur- Virginie O’Shea
Group Editor
SLMG 2007 pp1-16 ML 10/9/07 11:08 am Page 2
Asian perspective
The Pan Asia Securities Lending Association
(PASLA) has witnessed a year of great change
in the Asian markets, says Sunil Daswani
Securities borrowing and lending activity contin- Australia and Hong Kong have both seen lending
ues to expand in Asia and spans a range of levels flows expand dramatically over the last 12
of maturity, from Japan, which represents the sec- months; and the South Korean market has grown
ond largest securities borrowing and lending mar- rapidly during the five years in which securities
ket globally, through to Vietnam and Pakistan, in borrowing and lending has been permitted.
which it is still not permitted. Several other markets have made big strides for-
Testament to the degree to which lending vol- wards during the last 12 months in setting in
umes have increased in Asia (ex Japan) is that five place an efficient regulatory and infrastructure
to seven years ago, securities borrowing and lend- framework to support securities borrowing and
ing flows through Japan accounted for, on average, lending activity. The Philippines has made impor-
about 90% of participants' securities borrowing tant advances in this area - and the Philippines
and lending activity throughout the region. As Stock Exchange recently invited comment from
Japan was one of the first to establish a market in the region and this remains
substantially the largest market in terms of transaction flow
these flows in other markets have grown relative to PASLA members on its proposed regulations on
Japan, this figure has now fallen to roughly 50%. short selling, upon which it soft launched a securi-
To reflect this, a growing number of hedge ties borrowing and lending model in February of
funds have established offices in Asia - particular- this year. Malaysia has set securities borrowing
ly in Hong Kong, Singapore and Australia - and and lending arrangements in place and is progres-
leading global prime brokers have extended their sively refining its operational procedures in close
presence in the region to support this activity. consultation with market participants. In India,
Three years ago, the hedge fund market in Asia the Securities and Exchange Board of India has
represented approximately USD250 billion out of put out discussion papers and it is hoped that it
a total USD1 trillion hedge fund market globally. will bring proposed laws on short selling and secu-
These ratios have remained broadly consistent rities borrowing and lending into line with interna-
during the subsequent period, with total hedge tional standards.
fund assets in Asia doubling to approximately PASLA has been working closely with regulators
USD500 billion, balanced against total global and with market participants in highlighting the
hedge fund assets of USD2 trillion. benefits of an active securities borrowing and
Looking at the development of Asia's securities lending market that is compliant with international
borrowing and lending markets more closely, best practice. This can serve as an important route
Japan was one of the first to establish a market in to international investment: foreign institutional
the region and this remains substantially the investors may be willing to allocate a larger per-
largest market in terms of transaction flow. centage of assets to more liquid markets that offer
efficient price discovery mechanisms - and securi- Sunil Daswani is a director and the regional
ties borrowing and lending facilities can be key to manager for Securities Lending, Asia, at Northern
delivering this liquidity. Trust Global Investments. His primary
To facilitate the extension of a seamless and responsibility revolves around addressing and
transparent market, PASLA has been working with evaluating securities lending initiatives for lenders
regulators and market participants to identify and and borrowers where Northern Trust acts as an
address areas where a market's securities borrow- agent lender. Additionally he focuses on building
ing and lending procedures differ from internation- the supply of Asian assets for Northern Trust global
securities lending programme, ensuring that the
al best practice. We recognise that these changes
PASLA has been working closely with regulators and with market participants in
highlighting the benefits of an active securities borrowing and lending market that is
compliant with international best practice
due diligence is carried out when lending its clients
will not be achieved overnight - but our goal is to assets in each jurisdiction.
make securities borrowing and lending functions Daswani is responsible for maintaining updated
more streamlined and convenient for participants market information and knowledge through relation-
to use, thereby meeting the preconditions for lend- ships with regional contacts that may influence or
ing volumes to increase. shape the markets in which Northern Trust lend
As a culture of securities borrowing and lending securities. He has 14 years of experience in the
evolves in Asia, we note a tangible shift in levels securities industry, of which the last five have been
of educational awareness on both sides of the at Northern Trust.
relationship. In the past, lender clients would be In May 2005, Daswani accepted the position of
asking us to explain why it would make sense to chairman for PASLA for one year. He was
lend in a new market and to confirm that this re-elected in 2006 and 2007. In this role he
ensures that the fellow members are kept updated
would generate acceptable revenues to cover the
on key industry events, coordinating as an
risks involved. Now the tables have been industry where necessary responses to various
reversed, with lenders asking why they cannot international regulatory bodies on topical issues,
lend securities in certain markets - and to inquire discussion papers and general market issues
when necessary regulatory amendments will be that feedback may be required or further
passed to make this possible. clarification is sought.
Broadening horizons
Laurence Marshall of the International
Securities Lending Association (ISLA)
highlights the growth the association has
seen over the last 12 months
Since the admission of borrowers to the association controversy over the last year. Our operational group
in 2004, membership has almost doubled and it will is producing a steady stream of best practice papers,
not be long before the numbers reach 100. It was covering all aspects of the back office.
becoming increasingly obvious that we could no In response to members’ demands, we have creat-
longer rely solely on the goodwill of individuals, each ed a New Markets group to help open up new mar-
with primary responsibility to their firms, to carry out kets and work with local exchanges and regulators to
the ever increasing workload. establish best practice from the outset. We will also
I am delighted therefore that the AGM unanimous- be establishing closer contact and dialogue with the
ly approved the board's proposals to expand the asso- regulators in established markets, as well as the
ciation's activities to provide full time support to the European Commission and CESR.
membership. We have been very fortunate to recruit I would encourage all firms who are involved in the
Our new constitution will allow us to take a much more proactive role in representing
our industry, not only in Europe and the Middle East, but globally
David Rule from the Bank of England as our first industry to join ISLA, whether as full members or
chief executive officer. His first priority will be to associates. Full details of our aims and objectives, as
recruit support staff and secure office premises in well as application forms, can be found at
the City. We expect the new infrastructure to be in www.isla.co.uk.
place by autumn.
Our new constitution will allow us to take a much Laurence Marshall is a managing director in Prime
more proactive role in representing our industry, not Brokerage Services with UBS Investment Bank,
only in Europe and the Middle East, but globally. London. He joined UBS in 1993 where he
Our major initiatives to date have included creat- established and managed the Securities Borrowing
ing a new class of membership, associates, to cater and Lending desk.
for those who support our industry, for example Marshall’s current area of responsibility is the
lawyers, accountants and software houses. I am management of the international supply business,
pleased therefore to report that we are receiving a
and is responsible for managing client relation-
steady flow of applications. We are working more
closely with our equivalents in Asia (PASLA) and the ships. He has represented UBS on various industry
United States (RMA) and we are conducting a review bodies and is currently chairman of the European
of the market standard legal agreement (the GMSLA). Equilend Board.
We will continue to rely heavily on our specialist Marshall was appointed ISLA chairman in May
sub-groups for which the contribution of time and 2007.
expertise by our members remains invaluable. Our The views and opinions expressed in this materi-
regulatory group has been spending a considerable al are those of the author and are not those of UBS
amount of time focusing on the large number of new AG, its subsidiaries or affiliate companies.
directives, which will culminate with the implementa- Accordingly, UBS does not accept any liability
tion of MiFID in November. Our governance group is over the content of this material or any claims,
determined to achieve a universally accepted code of losses or damages arising from the use or reliance
practice for voting, a topic which has produced much of all or any part thereof.
From a volume perspective, in the first half of this borrow, EquiLend Dividend Compare and ARMS are
year, we’ve seen broad based growth in on-loan bal- tools that allow participants to increase volumes and
ances, with some lenders’ balances up more than reduce spreads.
40% versus the year earlier period. I think this The industry is not without its challenges, however.
reflects continued growth in demand from hedge I believe one of the major challenges we face is the
funds as well as 130/30 and other alternative invest- ongoing discussion surrounding corporate gover-
ment structures. Some industry watchers speculate nance, proxy voting and securities lending. RMA, the
that 130/30 could grow to be a USD1 trillion asset International Securities Lending Association (ISLA)
class over the next five years, from its current and the Securities Industry and Financial Markets
USD60-70 billion. That may be a bit optimistic; Association (SIFMA) have been vocal in responding
however, there is no doubt that this is an area that to misinformation in the press and taking steps to set
will experience significant growth. the record straight. A number of industry representa-
Away from the equity markets, some short demand tives have spoken at RMA conferences and have
for corporate bonds previously covered through a tra- directly engaged those who have criticised the indus-
ditional securities lending structure is now being sat- try. I believe the RMA Committee on Securities
isfied through the use of credit default swaps. In Lending has done an excellent job of disseminating
addition, we continue to see the use of equity swap information about existing regulations and safeguards
structures in markets that have not yet developed a that protect securities lending clients. However, there
traditional stock loan structure. is still more that needs to be done and we are pursu-
There is also a growing list of new markets in ing several agenda items. For one, RMA and SIFMA
which the borrowing and lending of stocks is begin- are providing seed money for a planned academic
ning to take hold. We’ve seen interest in Taiwan, study of ASTEC Consulting lending data. We hope
Malaysia, the Czech Republic, Hungary, Turkey, the results of this study will serve to substantiate our
Greece and Israel, all at different stages of develop- contention that securities lending has had no dis-
ment. I believe we’ll see revenue growth in these cernible impact on the outcome of important proxy
markets, where the spreads are wider and where vote situations.
hedge funds are looking for exposure. We’re also see- In addition to the proxy voting and corporate gover-
ing a contraction in the development cycle for these nance issue, the committee is also tackling some
markets, as countries work diligently and quickly to other issues affecting the securities lending industry.
put in place the necessary tax, legal and regulatory Among other initiatives planned is a salary survey for
frameworks for securities lending. member organisations, which we believe will be par-
Another important theme in the lending markets ticularly useful as a benchmarking tool. We are also
has been the ongoing move toward greater trans- in the very early planning stages of a Latin American
parency, although certain market participants have lending conference to be jointly sponsored with
not embraced products such as Lending Pit and SIFMA. We’re excited about the prospects for this
Performance Explorer. These products have improved conference, as we believe there are many beneficial
the price discovery process and provided objective owners in these markets who may be interested in
benchmarking information to beneficial owners. In learning more about lending.
addition, with the implementation of the Agency
Lending Disclosure initiative, borrowers’ credit William Tredick McIntire is president, Boston
departments have gained daily visibility into their bal- Global Advisors, and chairman of the RMA
ance with lenders. Committee on Securities Lending. He oversees the
The application of technology also continues to agent securities lending business of Goldman
play a role in the development of the securities Sachs in the US and Europe. He joined the busi-
finance market. With continued margin compression, ness in 1998, after spending the previous two
industry participants are looking to apply technology years as chief financial officer of the Equities
to streamline processes. Applications such as auto-
Division of Goldman Sachs.
6 INVESTOR SERVICES JOURNAL SECURITIES LENDING MARKET GUIDE 2008
SLMG 2007 pp1-16 ML 10/9/07 11:09 am Page 7
SLMG 2007 pp1-16 ML 10/9/07 11:10 am Page 8
Contents
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YEAR IN REVIEW
Main Attraction
lending is on increase, he adds, with the the pursuit of more complex investment strate-
demand for assets in esoteric markets –such as gies, have increased the demand for securities
Russia and India – growing. There is also an lending.
increased appetite by traditional long side Hedge funds and their appetite for securities
investors for short exposure, as demonstrated by driven through their prime brokers represent the
the deployment of 130/30 strategies and short biggest single source of demand in the market,
extension funds. says Coxon. This has been positive for the
Andy Clayton, head of securities lending for growth of securities lending, but the secrecy sur-
Europe Middle East, Africa and Asia Pacific, rounding the activities of these firms has led to
Northern Trust Global Investment, has also wit- some observers questioning their motivations.
nessed an increase in new market activity. “They are perceived to be driven by short term
“There is huge interest from clients who now opportunism, and this has been particularly evi-
The hedge funds’ active trading styles have increased the demand
for securities lending
have more exposure to emerging market man- dent in the sphere of corporate governance,” he
dates and from borrowers who see more hedge adds.
fund activity in these markets. Also, active exten- Although there has been a lot of growth, there
sion is the new buzzword in the industry as has also been a number of firms that have decid-
long/short strategies take hold, this has led to all ed to exit the securities lending market. Andrew
players analysing how they can leverage this Clearfield, president, Investment Initiatives and
trend to best effect.” chairman of the International Corporate
There has been some very successful liaison Governance Network (ICGN) Securities Lending
with market infrastructure providers and regula- Committee, explains: “It seems like the market is
tors in Asia in respect of opening markets for expanding strongly; my impression is that it has
securities lending, says Clayton. He expects that continued to grow. There have been a few major
the market will see the benefits of this period of exceptions to that in that there have been a cou-
consultation over the next few months. Also, he ple of public pension funds in the last 12
adds, the industry associations have led the way months, most notably Ontario Teachers’, that
with discussions with regulators regarding forth- have decided that lending wasn’t worth it
coming regulatory changes such as Basel II and because they were having such problems recall-
MiFID. “At this moment, it looks like the indus- ing in order to vote. They decided that as a
try will reach a position where it can successfully result of this, that the income they were getting
work within the new regulations without incur- from the lending wasn’t worth it. It was
ring huge additional cost to support wholesale announced loudly and publicly all over Canada.”
changes to practice,” he says. Clearfield continues: “I have had conversa-
Despite the recent decision by some invest- tions with some consultants and fund managers
ment banks to impose tougher lending terms on in the industry that have said that unless
hedge funds, their investment strategies are con- investors get a larger cut of lending, they will exit
tinuing to drive forward the growth of securities the market. The brokers currently get the lion’s
lending. The decision to raise margin require- share of the fees and the custodians and inter-
ments is a response to rising credit concerns mediaries get another significant share, although
about the impact of the funds on the wider it is much smaller than that of the brokers. The
financial market. Prime brokerage departments share that goes to the funds is so laughable that
at several investment banks are thus attempting it is hardly worth it for what they get. They are
to insure themselves against the possibility of essentially selling their votes for a few basis
new hedge fund collapses in the vein of the Bear points.”
Stearns’ funds last month. However, regardless It is not just the hedge funds that are proving
of these restrictions, the hedge funds’ active to be influential in this area. A large number of
trading styles, including the use of shorting and traditional fund managers are engaged in devel-
YEAR IN REVIEW
oping absolute return strategies that require between the markets, both are experiencing a
them to go short and this is having a significant high level of growth in securities lending. Denise
impact on the growth of the securities lending Valentine, senior analyst at rival analyst firm Aite
market. The recent popularity of 130/30 funds, Group, explains: “The US market is a very
which effectively involve borrowing for short sell- mature market with a vast inventory of securi-
ing purposes, is testament to this trend. As part ties, and is growing at about 5%. However the
of a 130/30 fund strategy, fund managers run European market is growing at double this rate.”
short positions but remain 100% net invested by The 130/30 funds are not just driving forward
being 130% long of the over-performing stocks the growth of the securities lending market; they
and 30% short of the underperforming stocks. are also altering the participants’ service require-
These funds need stock loan accounts to ments. Fund managers that invest in these
receive the proceeds of the short sales and then funds require fully integrated securities lending,
augment the long positions without the need to borrowing and collateral management, as well as
borrow cash. In order to go short, these market the execution services to affect the initial short
participants must borrow securities. The 130/30 sale and subsequent buy back. Servicing there-
funds are seen as an attractive alternative to fore goes way beyond custody and fund account-
going long only as you are no longer so tied to ing. This requirement for execution services can
the ups and downs of the market and they thus prove an onerous task for those engaged in pro-
provide the ability to more consistently beat the viding securities lending and custodian banks
market. In fact, the funds are so popular at the are accordingly obliged to invest in systems to
moment that market commentators have specu- further integrate their processes.
lated that their growth may supersede the Valentine highlights the recent trends that she
growth in hedge funds over the next few years. believes have influenced the securities lending
This could, in turn, become one of the largest market: “The last 12 months have been about
drivers of securities lending over the next five to increased participation on electronic platforms
10 years. to some degree, the increasing use of securities
There is a slight difference between the lending as the capital markets continue to glob-
American and European model of borrowing for alise, and, finally, hedge funds and large institu-
130/30 funds. The US model involves borrowing tional money managers engaging in short sell-
and shorting in order to execute leverage, where- ing. In the case of the latter, 130/30 funds, which
as in Europe, the leverage is obtained through short securities, have been increasing signifi-
derivatives. This divergence in practice has come cantly as traditional money managers seek high-
about due to the fact that European regulators er investment returns and compete with hedge
do not support the shorting of physical securi- funds for institutional money.”
ties to obtain leverage. Despite the discrepancy Rather than a purely operational activity, secu-
rities lending is now considered to be an invest-
ment management discipline in its own right.
Furthermore, rather than automatically opting to
pass the activity to an institution’s custodian,
these traditionally dominant players are having
to compete for business with third party lenders
and electronic auction platforms. Institutions are
also increasingly using multiple providers across
different parts of their asset base, as beneficial
owners have unbundled the securities lending
function from the custody business.
Valentine adds: “There’s no shortage of partic-
ipants, including principal owners, custodian
banks, third party agents, broker-dealers, prime
brokers, investment banks, and hedge funds. Big
banks use securities lending for market making,
hedge funds often short the security for a strate-
gy play. Owners and lenders participate for prof-
its on the loan.”
In the rush to gain market share, borrowers the borrower side of the business, as hedge
have sought alternative sources of supply, funds demand more information on where their
lenders have developed new routes to market true borrowing costs reside,” he explains.
and exchanges and brokers have developed elec- Northern Trust’s Clayton agrees:
tronic trading platforms. These trends have put “Transparency will not go away so we need to get
downward pressure on pricing and have forced used to living in the new environment. Market
custodians to seriously rethink their business participants will develop their game to play bet-
models. ter under the new rules and increased competi-
The rise of short selling has also raised the tion will result. It is critical that people consider-
profile of issues around fee transparency. The fee ing the data create a level playing field though –
paid by investors to borrow shares they want to with more information available there is
sell short has been notoriously difficult to fore- increased responsibility on the users to ensure
cast. Borrow supply is a key determinant to the they know what they are doing with the data oth-
level of fee paid but the exact calculation is more erwise they may make erroneous assumptions
often than not opaque. Fees for a 130/30 strategy and decisions.”
The 130/30 funds are not just driving forward the growth of the
securities lending market; they are also altering the participants’
service requirements
are higher than long only mandate fees in part Transparency has obviously had a direct
because the manager must go to a prime broker impact on technology spend, as has the increas-
to borrow securities to short. Hedge funds may ing complexity of customer requirements. Firms
be naturally more lenient with regards to trans- have to spend more on their systems in order to
parency, but the traditional asset managers now keep up with demand. The focus of securities
engaged in 130/30 funds are likely to demand lending technology has shifted from the back
increased fee transparency, which will then put office to the front office, says Valentine.
pressure on managers to reduce their fees. “Technology has advanced with electronic plat-
Valentine explains: “Improving transparency forms. By 2008, about 15-18% of securities lend-
has been one of the drivers of changes in recent ing will be done over an electronic platform.
months and that is an ongoing process. Given Examples of trading platforms include EquiLend,
the level of entrenched interests in this market, it eSecLending and SecFinex. Bloomberg instant
will not be an easy process to continue to build messaging continues to be a key method of
on some of the automation and transparency ini- communication for securities lending, and cer-
tiatives.” tainly old manual methods of phone and fax are
ABN AMRO Mellon’s Coxon adds: well entrenched, at least for initial order place-
“Accountability and automation are big themes – ment,” she elaborates.
there is much greater transparency today due to Overall, Valentine believes that the market is
the rise of industry consultants and independent fragmented in its use of technology: “General
benchmarking services like Astec and Data collateral and highly liquid security securities
Explorers. The market has traditionally been fairly lending is as old as the hills and these types of
opaque, with a strong emphasis on relation- securities lending are well suited for automation.
ships. While this still holds true, it is also the This has prompted more technology firms to
case that price and efficiency are becoming enter the market, around 2000. Specials, or hard
determining factors on where business is trans- to borrow securities lending, are complex: they’re
acted.” more profitable and still negotiated by phone.”
Transparency brings challenges, as beneficial The influence of technology has largely been
owners today are much more engaged and the negative, says ICGN’s Clearfield. For example,
degree of scrutiny has increased significantly, commingled accounts from the point of the view
and that additional scrutiny leads to greater com- of the custodian save a lot of money, but they
petition, adds Coxon. “Only those firms that run have made it difficult to track any kind of
accountable programmes can hope to survive in accountability with respect to individual posi-
the new environment. The same holds true on tions. “It is hard to tell if you have had a problem
SECURITIES LENDING MARKET GUIDE 2008 INVESTOR SERVICES JOURNAL 13
SLMG 2007 pp1-16 ML 10/9/07 11:59 am Page 14
YEAR IN REVIEW
with over-voting if you don’t know whose shares Securities lending and its impact on proxy
went where – which shares in an omnibus voting policies and practices has long been the
account were actually lent out. That is a practice concern of the corporate governance industry,
that I predict is going to have to end. since, potentially, market participants can
Technology can have a strongly positive effect of acquire voting rights in a company without an
course, but so far, it hasn’t been used that way; accompanying financial stake. This separation
instead it’s all been about lowering costs and of economic from voting interest in a company
getting more paper out there,” he adds. bends one of the basic assumptions behind the
Coxon is much more positive about the one share, one vote principle, and places
impact of technology on the market: “Auctions, investors who retain the economic interest in a
and by extension auction platforms, have cer- challenging position. However, it seems that
tainly enjoyed a high profile recently. The emer- share lending has become a lucrative practice
gence of players such as eSecLending has creat- for many institutions.
ed more competition, particularly in respect of This year’s International Securities Lending
agency lending. That has shaken any compla- Association (ISLA) and Pan Asia Securities
cency there may have been out of the industry. Lending Association (PASLA) annual confer-
Certainly it is a great time to be a beneficial ences both covered the subject of proxy voting
owner – there is a good choice of suppliers, and share lending. Speakers stressed that
they enjoy pricing leverage and also have more recent press coverage about the practice of
options in terms of selecting the most appropri- hedge funds obtaining more votes than their
as well as when they will not sacrifice their votes greater in Europe due to the complexity of the
for this reason,” he says. collateral that lenders exchange, the higher
“This is an ongoing engagement and we are number of disclosed lending programmes and
also talking to the issuers, who are also very the decentralised infrastructure.
concerned about the discrepancies in voting ISLA has formed a working group to tackle
(usually manifested by over-votes) and the fact the issue of agent lending disclosure with the
that a few funds have visibly shown up with long term objective of Europe achieving a level
empty votes and tried to influence meetings. of disclosure comparable to the US. The associ-
This is enough of a problem for these issuers to ation’s proposals for disclosure include the
get concerned. I am told that it has also come monthly provision of details regarding the
to the attention of the SEC. I know that it is a underlying counterparty, loaned securities and
concern of the World Federation of Exchanges, collateral. ISLA has indicated that it will be
S TATISTICS
Data Dissected
ISJ examines the RMA’s securities
lending market data for 2007
The Risk Management Association’s credit tiering and instrument types for
securities lending data covers the first both US dollar and euro currency col-
quarter of 2007. Survey data is present- lateral.
ed for primary lending markets world- The data has been collected by the
wide, with cash collateral reinvestment RMA frominstitutions including AIG,
data aggregated to reflect reinvestment Barclays Global Investors, Brown
return, interest rate sensitivity, liquidity, Brothers Harriman and JPMorgan.
Pacific Rim Equities (Includes Australia) $616,818 $44,093 $19,269 $63,362 10%
Japanese Equities $353,467 $20,416 $10,734 $31,150 9%
Hong Kong Equities $60,881 $6,398 $1,599 $7,997 13%
Australia $113,914 $14,305 $4,874 $19,179 17%
All Other Pac-Rim Equities $88,556 $2,974 $2,062 $5,036 6%
All Other Equities (Not Previously Listed) $57,068 $4,115 $273 $4,388 8%
Total Equities (Aggregate Total) $5,561,789 $450,325 $71,769 $522,094 9%
Mark Fieldhouse serves as head, Technical Sales, Americas at RBC Dexia. His
team is responsible for overall growth and development of the Global Products
client base, as well as the product level management of its strategic clients
in North America. Global products include securities lending, foreign
exchange, cash management and portfolio management services. Fieldhouse
brings to his role 12 years experience in the Global Products environment.
Prior to heading up Technical Sales for the Americas, Fieldhouse served as
director, Technical Sales, Securities Lending. He has previously held a num-
ber of progressive positions within the securities lending business, with a
focus on client management and business development.
Paul Wilson is senior vice president and global head of Sales and Client
Management for Securities Lending and Execution Products (SLEP) for JPMorgan
Worldwide Securities Services (WSS). He is based in London. Wilson is responsi-
ble for new business development and initiation as well as client management
across the entire SLEP product range, which includes securities lending, foreign
exchange, transition management, futures and options clearing and commission
recapture within JPMorgan WSS. Additionally, Wilson is the SLEP regional busi-
ness executive for the Europe, Middle East and Africa region. He joined Chase in
1984 and has carried out a number of roles within JPMorgan WSS including
product development, client services and operations.
Melissa Gow
Managing Director
EquiLend
North America +1 212 901 2200 | Europe +44 (20) 7743 9510 | www.equilend.com
EquiLend LLC and EquiLend Europe Limited are subsidiaries of EquiLend Holdings LLC. EquiLend LLC is a member of the FINRA and SIPC. EquiLend Europe Limited is authorized and regulated in the United Kingdom by the Financial
Services Authority. All services offered by EquiLend are offered through EquiLend LLC and EquiLend Europe Limited using EquiLend proprietary technology and software. © 2001-2007 EquiLend Holdings LLC. All Rights Reserved.
SLMG 2007 pp17-33 10/9/07 2:45 pm Page 24
2
enhance
You know that it takes more than good fortune to enhance your portfolio’s returns
while managing risks. In order to make strategic decisions, you need relevant
market research and sound investment recommendations in the borrowing and
lending of domestic and international securities. With our innovative skills and
support, you have a reliable team on your side. www.fortis.com
Key Locations
Amsterdam: + 31 20 527 1499 London: + 44 20 7444 8511
New York: + 1 212 418 6802 Paris: + 33 1 5567 9084
Hong Kong: + 852 2823 2188
domestic tax legislation to create a more level will have to make significant investments in tech-
playing field for cross border, intra-EU investors. nology and infrastructure to better dynamically
For example, early in 2007, the Netherlands manage associated market, operational and cred-
reduced its standard tax withholding rate, provid- it risk. The ability to have dynamic risk and collat-
ing exemption for EU resident pension funds and eral management capabilities will position firms
tax exempt entities (such as charities). to be more responsive than ever to a client’s
changing strategies.
In 2004, the SEC proposed changes in regula-
tion to relax short-sale constraints and the pilot Wilson: The changes enacted by the SEC (Rule
programme began on 2 May 2005, what 10a-1(a)) were intended to expand liquidity in the
impact has this had on the market? marketplace while implementing strict compli-
ance on fails and appear to have succeeded.
Broker-dealers have adopted additional technical
d’Albrand: The SEC Regulation (SHO in January controls on locating ‘intent to sell’, which includes
2004), where short sellers of equities are client logs for approvals, archiving of data, and
required to locate securities to borrow before sell- pre-borrows of short sales on trade date ahead of
ing, has given a greater role for securities lending settlement date. Borrowing securities for failed
desks. Hedge funds are putting increased pres- deliveries is preferred to effecting a buy-in. Buy-ins
sure on prime broker services. More than ever, have become more efficient, with the introduction
finding the right stock at the right moment is an of netting through the continuous net settlement
important part of the service a prime broker system (CNS) doing away with fails after buy-ins,
must give to their clients. All sources of informa- as sometimes happened in the past. In summary,
tion, electronic or personal relationships, must the SEC changes have had a positive affect in the
be used to their full extent. marketplace, but with some added overhead costs
for compliance monitoring.
The so-called lack of price transparency of lending fees due to
the power of the prime brokers over the industry is quite
disputable. The securities lending industry is an OTC market
and fees are based on various factors, such as creditworthiness,
whether the stock is callable, and ease of location
Fieldhouse: Overall, the impact has been a posi- What will the securities lending market look
tive one for the securities financing and hedge like in the next five years? Are electronic FX
fund industries. Typically, hedge funds like to take markets foreshadowing the evolution of securi-
short positions and therefore need constant ties lending?
access to inventory to finance those positions.
One of the main drivers has been the growing d’Albrand: The securities lending market will be
number of institutional investors pursuing alpha that much more streamlined in five years, and
generating strategies such as the 130/30. This the future success will to some extent be linked
important new source of market demand was to technology. However, I believe that the
expected to have a significant impact on pricing, evolution of the securities lending industry will
as suppliers capitalised on the growing institu- follow a different path than that of FX. The two
tional interest in alternative investments. activities are simply governed differently. FX is
As a result, there has been a strong emphasis highly regulated but flexible, while securities lend-
and focus on credit and risk, as well as compli- ing is much less regulated but more constricted.
ance by regulatory agencies and internal risk Take for example the fact that each securities
departments to ensure a proper risk manage- lending arrangement is bound by a specific con-
ment framework is in place. The changing regula- tract, inhibiting the type of transparency found in
tory environment and increased focus on risk, FX transactions. Amongst the several routes to
credit, compliance and capital usage is now the market, automation is a strong trend, with differ-
norm in the industry, and has forced firms into a ent platforms such as the auction model.
very structured risk management process. Firms However, many participants still prefer to adhere
ABP Investments
Is securities lending a back office or front office function?
At pension fund ABP with assets totalling timed so that we can divide our volatile cash
EUR215 billion, we view securities lending as from cash that is considered core and we can
an investment management function. commit to a manager for a year or longer.
Securities lending is considered an independ- Risk management is a key part of our over-
ent investment strategy. We apply all of the sight function. We look at guideline compli-
same investment disciplines and rigor to secu- ance through a variety of reporting tools and
rities lending that would be applied to any analytics that standardise program data across
investment strategy. Asset allocation, vendor providers. We also measure total exposure
selection, investment guidelines, benchmark- across all of our borrowers taking into account
ing, and performance measurement are all part exposure in our collateral reinvestment portfo-
of the ABP programme. lio. Value at risk (VaR) is measured programme
We take an active approach to securities lend- wide to ensure that programme risks are
ing and aim to optimise providers and counter- appropriate for the fund’s risk tolerance. We
parties based upon their specialties or ability have found that our programme VaR is relative-
to pay guaranteed premiums via the auction ly small when compared to the alpha that it
process for our various portfolios. This delivers. Through our quality management
approach has been the key to the success of function, we are also constantly working to
our program which will top EUR105 million this increase the programme’s operational efficien-
year, up from ¤43.5 million in 2003 prior to the cy to reduce operational risk.
implementation of this strategy. While ABP would never underestimate the
Applying investment management discipline importance of operational support in the
to the inefficient, bundled, securities lending smooth administration of our programme, we
industry has allowed us to maximise perform- primarily view securities lending as an invest-
ance and create a significant source of alpha. ment strategy that generates considerable
We use three primary vendors for securities amounts of money. Thus, we manage our pro-
lending services with a best of breed approach, gramme as we would any of our investment
eSecLending, State Street and JPMorgan. The functions.
eSecLending auction model has been a key Finally, of course, the coin of securities lend-
tool in the management of the programme. ing also has another side: corporate gover-
The auction provides price discovery, bench- nance. ABP has a policy in place to strike a bal-
marking and transparency and has been ance between the returns from securities lend-
employed across all asset classes improving ing and the retention of voting rights in cases
both lending fees and utilisation rates. ‘in which it makes a difference’. A minimum of
At ABP we have built a robust oversight infra- 10% of the shares will always be available for
structure, which has allowed us to maintain voting at AGMs. In case a company is on
control over the programme and make better ABP’s full voting list, ABP
strategic investment decisions. We have used will in principle vote with all
this infrastructure to employ a variety of collat- of its shares. Shares lent
eral management strategies. Key to this has will be recalled for that pur-
been the unbundling of collateral management pose, unless there are no
services and lending. The programme now controversial issues on the
uses five distinct, lowly correlated strategies. AGM agenda.
All managers must comply with ABP’s invest-
ment guidelines, but different managers have Mark Linklater, head of
been hired for different strategies. Our pro- Securities Lending, ABP
gramme is large enough and our auctions are Investments
AT STATE STREET, WE
INSIST ON DOING THINGS
IN A VERY SPECIFIC WAY.
YOURS.
This advertisement is not directed to any person in any jurisdiction where the publication or availability © 2007 STATE STREET CORPORATION. 07-SFI08380807
of such services are prohibited by reason of that person’s nationality, residence or otherwise.
SLMG 2007 pp17-33 10/9/07 2:45 pm Page 30
International Corporate
Governance Network
The growth in stock lending has been one of customer before a date that is seldom far off
the most spectacular success stories of the cap- when the recall order is given.
ital market liberalisation of the past 20 years. By As it now stands, lending has the effect of
providing the markets with greatly enhanced liq- inuring lenders to their stewardship responsibil-
uidity and greater potential to hedge positions, ities. Fortunately, most shareholders’ votes are
facilitating two way bets in equities, and provid- non-controversial, because until and unless
ing long term holders of equity positions with a some mechanism is developed to reduce this
means of enhancing revenue, the expanded conflict between voting and the continuance of
lending of today’s markets has contributed sig- a borrowed position, lending will continue to
nificantly to the strong performance of equity provide a powerful disincentive to voting.
markets over the period. The threshold problem is that both the
However, as beneficial as it has been, this administrators of a lending programme and
greatly expanded lending activity has not been their counterparts on the borrowing broker’s
without its price. As some of the less fortunate side have a vested interest that the share not be
side effects come to the fore, the danger recalled and the loan terminated. They are apt
increases that regulators will impose rules to point out that the loan will bring in real cash
which have the effect of dramatically inhibiting (however little) and that exercising the share-
lending in order to curb some of those side holder’s franchise has only intangible value. The
effects. Better that the industry address these threat that more than very occasional recall may
issues itself first, than that they be addressed by cause the borrower to stop doing business with
unsympathetic legislators responding to pres- the lender is invoked to stifle debate.
sures from outside the investment industry. It may also be more difficult than advertised
Lending has always been predicated upon the for the borrower to find the needed shares when
assumption that most share owners will not a recall is demanded; in the case of voting, fail-
want to vote. Since the vote is the one thing ure to recall in time seldom results in any penal-
that borrowers and their agents cannot indem- ty clause being invoked by the lender. The net
nify through their lending contracts, this aspect result of this situation, in which proxy voting is
of lending is usually glossed over in the sales made subordinate to lending, is that lenders
pitches made to senior managers and boards of rarely recall for voting, unless a bid is in
trustees. Prospective lenders are of course prospect. Proxy voting teams, and the few port-
assured that the have the right to recall shares folio managers who are interested in corporate
(be bought back in) for any reason. The governance issues, rapidly become discouraged
assumption is that they will not have to do this at this display of corporate priorities. Often con-
very often. troversial voting issues are not even reported to
In the event of a bid, rights offering, or other higher levels of management because of the
transaction, the broker can often ‘assent the conflict with revenue generation, no matter how
shares’ and be on the hook for the substitute small.
equity instead. Dividends and special distribu- A further problem is that both investing insti-
tions are provided for in the contract for differ- tutions and their portfolio companies are fre-
ence that the broker has with the hedge fund on quently uncertain as to the size of their actual
the other side of the trade, and everything is holdings. An investor soon loses credibility
just fine. Except, of course, for voting, which when claiming to represent 3,000,000 shares in
requires that similar shares be delivered to the an engagement with a company, if only 50,000
are eventually voted. I have seen senior man- was less than 0.05%. There was the case where
agers of major funds confidently promise they a group of borrowers voted to derail a friendly
would vote millions of shares in a certain way, transaction, reaping a huge profit on their short
only to see them turn up at an AGM, red faced, position. There have been instances where
with one third that number. The rest were out shareowners, barred from voting because of a
on loan. conflict of interest, could lend some of their
Of course, no one else knows why the broker votes to another, friendly shareholder who was
wants to borrow stock, but the assumption is not similarly prohibited. There have been cases
that on the other side is a hedge fund or other where substantial votes were cast by sharehold-
client who wants to be short. The shares will be ers who had a negative economic interest in a
sold in the market, whoever buys them will be company.
another legitimate investor, and that is that. While it is true that this is always possible
However, the number of cases where it has through the use of derivatives, at least the
been revealed that a client was in fact borrowing investor’s long position in the shares is a mat-
shares for the sole or primary purpose of voting ter of record. The problem with lent and bor-
them, while small, has been rising. rowed positions is that they never have to be
There is every reason to believe that there are reported. A party can show up with 5% or even
other instances where this occurs which are not 25% of the votes without ever having to disclose
widely known because it is never disclosed who his existence, can vote in a manner contrary to
initiates a stock borrowing transaction, let alone the other shareholders’ interest, and disappear
what the motivation was for doing so. without ever having to transact in an open mar-
Borrowing votes is extremely difficult to prove, ket.
and while generally condemned as bad practice, The ICGN Securities Lending Code of Best
in many jurisdictions it is neither illegal nor like- Practice was drafted with these issues in mind.
ly to give rise to sanctions if detected. But even It was conceived to be relatively unobtrusive,
suspicion of the practice is sufficient to com- with the goal of reducing lending activity as lit-
promise the integrity of the shareholders’ meet- tle as possible. Given that many institutions
ing. It also encourages management to take have decided to absent themselves or withdraw
more defensive measures at the expense of from lending activity because of the problems
shareholder value, and plays havoc with our described above, alleviating these problems
notions of liberal capitalism. could actually result in greater activity, with
‘Empty voting,’ to use the term applied to it more entrants returning to this market. The pri-
by Henry Hu of the University of Texas, runs mary objective of the code is to ensure that
directly counter to the concept of collective lenders know what they are doing, and that they
responsibility for decision making which is at keep their beneficiaries or clients apprised of it
the core of the theory of the corporation. When as well, not that lending activity be reduced
the shareholder’s voting interest may be indiscriminately.
detached from his economic interest in the Above all, the ICGN Code calls for greater
prosperity of the corporation, as is the case with transparency. Participants in this market need
the voting of borrowed shares (as well as the to have greater confidence that they are not
use of certain derivative positions) all sorts of lending shares to would be abusers of the sys-
mischief may result. The assumption that the tem. Issuers, which are in a sense involuntary
vote is cast in order to protect the owner’s per- participants, need to have confidence that rights
ceived economic interest is no longer valid, and delegated to shareholders
the vote may be cast in such a way as to actual- are not going to be usurped
ly attempt to destroy the value of the corpora- by those whose interest is in
tion. For anyone attempting to wreak mischief no way allied to the survival
upon the company, borrowing shares for the and prosperity of the enter-
purpose of voting may be a relatively cheap and prise.
easy way to do it.
There have been cases recently where a share-
holder attempted to change the outcome of an Andrew Clearfield, chairman
AGM by voting almost 5% of the company’s of the ICGN Committee on
equity when his actual stake in the company Securities Lending
SECURITIES LENDING MARKET GUIDE 2008 INVESTOR SERVICES JOURNAL 31
SLMG 2007 pp17-33 10/9/07 2:45 pm Page 32
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point that drives the concern. This leads to much So, if you have a diverse source of revenue,
misunderstanding, rumour and speculation. great risk management, provide top level infor-
Recalling stock before the record date where vot- mation to your clients and maximise revenues
ing is viewed as important in a given case is a across the range of securities lending routes to
ready made solution, especially when the majori- market mentioned above then you have it all?
ty of positions are lent on an overnight basis. Well no, actually.
Securities lending can certainly sit comfortably The securities lending industry is not immune
with an active corporate governance programme. from the changes taking place across the asset
Best practice dictates that each beneficial owner management world. It has been well document-
develops a policy with regard to how it will han- ed that the lines that separate long managers
dle voting in situations where securities are on from hedge funds look increasingly blurred. The
loan, weighing the value of revenues being more sophisticated institutional investors and
achieved versus the loss of voting rights. 130/30 fund strategies are generating an
The securities lending industry is not immune from the
changes taking place across the asset management world.
It has been well documented that the lines that separate long
managers from hedge funds look increasingly blurred
Tax harmonisation, risk analysis and indemni- increase in shorting from the more traditional
fication quality will influence the industry in managers. These managers, who have worked
coming years, and proxy voting will continue to for many years with their agent lenders are, for
cause debate. the first time, looking for borrowing as well as
Directed lending – Clients have their own lending services. Borrowing a position from an
lending desk, negotiate loans themselves, internally or externally managed account of the
and work in partnership with their custodian same client and having other sources to capture
to administer the programme operationally. good value borrows from your agent can be an
Exclusive lending – Lending to one borrower, attractive proposition. Add that to the same
typically after an auction, often conducted by agent that can manage your collateral delivery
the agent, where the highest bidder wins the against positions borrowed and overlay the
right to exclusive access to one or more port- range of securities lending programmes men-
folios. tioned above across the same securities and
Third party (non-custody) lending – Lending you have a powerful business model.
programmes for those beneficial owners This multi-tasking by agent lenders is the
where the lending agent is not the custodian future; the one dimensional securities lending
bank. model with a captive client base has disap-
Synthetic lending – The use of financial peared. By working closely with beneficial own-
instruments to replicate lending structures. ers so that they can, without multiple contracts
This is used for those markets where an and multiple vendor relationships, also gain sig-
established securities lending structure does nificant economies of scale will see the end
not exist. game winners being those banks with the
Depository lending linkage – Links to lending broadest products, the most healthy balance
programmes of certain depositories, such as sheets, the most diverse sources of revenues
Euroclear. and the best technologies to
Combinations – Mix and matching of all of maximise returns, quantify
the above. risk and provide true per-
All of these structures come with their own formance measurement.
challenges. Technology must be in place and SLMG
legal and regulatory due diligence handled. It’s Paul Wilson, senior vice president
a challenge to offer the whole suite of products, and global head of Sales and Client
but clients expect it and often like to consoli- Management for Securities Lending
date their lending services with one provider and Execution Products (SLEP),
and also want to get maximum value across the JPMorgan Worldwide Securities
whole product set. Services
SECURITIES LENDING MARKET GUIDE 2008 INVESTOR SERVICES JOURNAL 35
SLMG 2007 pp34-49 10/9/07 4:43 pm Page 36
ing. Many beneficial owners, especially in the US, lender to achieve premium, market driven
UK and Europe, have successfully implemented results, in a manner that provides unbiased,
securities lending programmes utilising both measurable results, which they can then produce
third party and custodial agents. for their boards and management.
These beneficial owners are also increasingly
using auctions and third party specialists to Definition of an exclusive principal arrange-
enhance returns on their most attractive assets ment: An exclusive principal arrangement
while continuing to utilise their custodian to lend makes a portfolio, or portion of a portfolio,
their general collateral assets via the agency available to a specific borrower for a fixed
queue. As many beneficial owners are now period of time, in exchange for a guaranteed
understanding that securities lending is primarily return. For this exclusive right, the borrower
a trading and investment management function, pays a guaranteed fixed return to the lender
they are choosing to optimise results by utilising either as a fixed basis point based on the value
specialists. They are now implementing more of the lendable assets in the portfolio, or via a
sophisticated provider selection processes and fixed sum payable monthly over the term.
demanding more sophisticated risk management
and reporting tools. Where it is going
The traditional custodial stock by stock, queue As Lenders and investment managers come to
or pool driven, lending programme has been more fully understand the securities lending mar-
(open or term), loan periods, counterparties, collateral, their cash collateral in various currencies for various
percent on loan limit per issue, overall percent on loan durations and to process FX trades.
limit per fund, and limits per counterparty that very often Since risks related to cash reinvestment are potentially
make every single lending trade a specific transaction. greater than those with securities lending, choosing a
The agent lender should be able to implement these sets hefty structure is advisable: the agent lender should
of constraints and ensure their monitoring at the front share its expertise while setting cash reinvestment guide-
office level and then by the compliance team. lines. Risks and performance are linked, and compliance
Risks associated with securities lending transactions with beneficial owners’ guidelines should be checked pre-
are now well understood and monitored. Risks should be trade - to be performed automatically by the front office -
in line with clients’ investment and general policies. It is and post-trade by the risk and compliance department of
the agent lender’s role to point out risks arising from the lender. Moreover, the agent lender should use its own
market conditions or regulation, mitigate risks as much market knowledge (its own market rating system for
as possible and optimise revenues accordingly, as well as instance) to enforce more stringent rules, whenever
continually reassessing the risk/reward ratio, with the judged necessary, and watch at all times the
aim of achieving maximum performance. issuers/counterparties used.
Monitoring and guidelines The bottom line
As far as counterparty risk, borrowers need to be duly Similar to the utilisation rate, performance is linked to
authorised by beneficial owners and the agent lender. market access and reach. To be fully rewarding for the
Agent lenders should convey their risk department beneficial owner, market access should be independent
expertise and help beneficial owners in further securing from any vested interest. Independence from the inter-
solid borrowers. Sufficient diversification and proper ests of the proprietary trading positions of the institu-
reporting of counterparties, if needed, should be provid- tion, be it a bank, securities house or broker, or from any
ed to help determine where exposures lie. Borrowers proprietary borrowing flow, requires a separate structure,
should receive the necessary information for counterpar- with independent desks and performance directly linked
ty disclosure requirements, while at the same time, pro- to the revenues paid to clients. Additionally, market
tecting the lending activity. Furthermore, agent lenders access is more effective when dealing with direct end
can provide indemnifications in case of borrower default user interests, such as short covering. Finally, for large
and when the pledged collateral has become insufficient portfolios, the lender should provide performance bench-
due to adverse market movements to mitigate the marking for market levels.
remaining risk. Thus, the creditworthiness of the agent Overall, fund managers should be on the lookout for
lender is crucial. flexible securities lending programmes that will enable
Since collateral requirements, indemnification policies them to implement multiple strategies – such as the use
and cash reinvestment policies may vary, it is of the of structured trades and agency negotiated exclusives –
utmost importance to agree on the accepted collateral across different asset classes. A lending agent’s ability to
and their related haircuts, and to understand what insur- maximise revenue, manage risk, automate processing
ance, if any, your agent provides you with. The opera- and deliver seamless integration with the client’s core
tional strength of the agent you choose is paramount to investment management activity are key differentiators,
proper risk control, with regular and stringent risk moni- as is their ability to innovate and partner with clients on
toring and efficient margin calls. Borrower default can be future product development so that new opportunities
indemnified in various ways, but the first protection can be seized when available.
whatsoever remains the level of collateral that is in your At SGSS, our liquidity management experts offer a full
account. It is important to discuss your collateral require- range of flexible securities lending programmes, tailored
ments with your lender and to ensure that they keep individually and built to boost portfolio performance.
within an acceptable risk/reward profile. Your needs as a Backed by strong post-trade sup-
fund manager, performance versus risk terms, should be port and reporting, we offer
agreed with the agent lender and regularly fine tuned. indemnities, closely monitor col-
Cash reinvestment lateral, and rigorously benchmark
Agent lenders can also provide cash reinvestment, which our performance and market
generates further interest but also credit risks that are access, while you remain in full
measured and reported. When direct investment of the control over your assets. SLMG
cash received as collateral is allowed in fixed income
products, such as short term paper, debt, asset backed
securities or funds, beneficial owners bear a primary risk Guy d’Albrand, global head of
on issuers just as they do with their underlying portfolio. Liquidity Management, SGSS
If needed, beneficial owners should be able to reinvest
SECURITIES LENDING MARKET GUIDE 2008 INVESTOR SERVICES JOURNAL 39
SLMG 2007 pp34-49 10/9/07 4:43 pm Page 40
It seems only yesterday that MiFID was a train that had just
left the station. Now this train suddenly appears to be nearing
its destination, and yet it remains to be seen if quite all of the
tracks to a “harmonised Europe” have been laid
the Committee of European Securities Regulators To facilitate cross border business, MiFID is
(CESR) and were the subject of negotiation at the intended to improve the passport regime by allocat-
European level in the European Securities ing responsibility between “home state” versus
Committee (ESC). They were formally adopted by “host state” regulators, including with respect to
the Commission and published in the Official regulation of cross border branches.
Journal of the European Union on 2 September MiFID is intended to facilitate greater harmonisa-
2006. tion across EEA member states by prescribing more
detailed requirements governing the organisation
Who is affected? and conduct of business of investment firms and
MiFID extends the coverage of the current ISD and how regulated markets and MTFs operate. It also
introduces new and more extensive requirements provides for new and consistently applied pre- and
that will apply to investment firms across Europe, post-trade transparency requirements for equity
including investment banks, brokers, exchanges, markets across Europe; the creation of a new
alternative trading systems, ECNs, investment man- regime for ‘systematic internalisers’ of retail order
agers and others. MiFID’s impact on some firms is flow in liquid equities; and more extensive (but con-
not entirely clear at the time of this writing: for sistent) transaction reporting requirements.
example, many banks and depositories/custodians Finally, although most firms covered by MiFID
will be subject to MiFID in respect of some parts of will also have to comply with the new Capital
their business (for example, to the extent they sell Requirements Directive (CRD), it is expected that
securities, or investment products which contain most regulators will (as the UK FSA and other mem-
40 INVESTOR SERVICES JOURNAL SECURITIES LENDING MARKET GUIDE 2008
SLMG 2007 pp34-49 10/9/07 4:44 pm Page 41
have invested approximately USD50 billion in this strategy; in nity by investing even more heavily in technology and capabili-
contrast to USD2 trillion in hedge funds worldwide. The ties, extending the traditional relationship beyond post-trade
Pyramis survey, meanwhile, shows that 63% of US corporate servicing by supporting clients’ portfolio construction strate-
defined benefit pension plans are already deploying or are gies.
considering deploying a 130/30 strategy in place of long only The volume of lendable assets is growing almost by the day
mandates. and the percentage of lendable assets being lent is also grow-
Widespread adoption will have a positive impact on securi- ing, as more markets ease restrictions on short selling, more
ties lending. The convergence between hedge fund strategies fund managers become accustomed to doing it, and more
and traditional asset management strategies is a major ele- institutions grow comfortable with lending their assets. That
ment of change in securities lending that will drive growth for volume will continue to rise as the market adapts to the
several years, probably at an accelerated rate, just as hedge underlying changes that are taking place in investment philos-
funds have done for the past five to 10 years. The benefit for ophy and practice.
the securities lending industry is that it will bring new, incre- There has probably never been a better time to be a securi-
mental demand for the service. A prime broker may be able to ties lender. Beneficial owners are spoilt for choice, both in
offer an exclusive programme to a particular institution, but terms of the range of service providers and the routes to mar-
that is not going to satisfy all its day to day needs, since any ket. There is strong competition for every mandate, leading to
COMIT - TECHNOLOGY
Deep impact effectively and reduce the liquidity risk, a cross product collat-
eral view is essential. Furthermore, the buy side, such as
hedge funds, require an integrated product offering. This is
why some market participants have merged organisations or
Felix Oegerli discusses the have at least implemented cross product processes.
al, including sophisticated analysis of volatility and liquidity vent the overuse of positions or not actively funding or selling
risk. As the current liquidity crisis shows, the application of positions. Counterpart and trading positions must be kept
stress tests not just to market volatility but also with regard to and updated in real time for risk management purposes. Real-
market reaction on the short term funding side, for example time profit and loss figures will provide the required informa-
changes of collateral and margining rules, is key. Most of the tion to optimise the book and close out unprofitable transac-
Most of the securities lending trades are still agreed over the
telephone. Smaller, or from a profitability standpoint less
important, tickets are increasingly done using electronic trad-
ing platforms. Trading using an electronic exchange requires a
minimum degree of standardisation
technology available in the market does not address counter- tions or to replace them with cheaper sources.
party and systemic risk sufficiently. Additionally, the data model of such an application must be
designed for maximum flexibility from the beginning. All exist-
Where do we go in the future? ing, but also new, trade types must be supported. This
Traders tend to have short memories and are therefore suscepti- includes single security, security versus cash, but even security
ble to short term trends. The electronic securities lending plat- versus security transactions. All future flows of financial
forms, which were launched in the midst of the ‘hype’ of e-busi- instruments must be presented as cash flows, which will allow
ness, are focused on increasing distribution and hence making for all types of synthetic securities finance transactions such
more money. However, between 2000 and 2003, the industry as total return swap and OTC options transactions, but also
was, for the first time, faced with decreasing income. This may for other future transaction types.
have changed the focus of these electronic marketplaces almost Additional features, such as ‘pluggable’ classes will allow
entirely to efficiency gains and hence cost cutting. the functionality of the system to be changed without having
This has only happened partially. Therefore I do not believe to change the core architecture. This reduces the overall costs
that we are going to see a very steep increase in business vol- and time to market for changes. Using standards and open
umes traded electronically until the market demand changes. system technology can reduce the total cost of ownership
Market demand changes can, for example, be based on tax or massively and facilitate the integration effort.
regulatory changes that impact the spreads in securities lend-
ing dramatically in a negative way. This will then lead to fur- So, where does that leave us?
ther commoditisation and standardisation of the business, We, as technology vendors, cannot therefore afford to rest on
which will force market participants to manage the business our laurels. We have to respond to the needs of the market
almost entirely over processes and IT because volume insensi- and create inventive and forward looking systems to help sup-
tivity and low unit cost is going to be critical in the future. This port the business models of the future. SLMG
is why electronic trading platforms are gaining in importance.
I estimate that in 10 years, well over 50% of the market value Felix Oegerli, member of the executive committee, COMIT
volume will be traded electronically. Oegerli is member of the executive committee of COMIT, a
consulting, IT solutions and
Technology requirements integration partner of the finance
The technology requirements to support an integrated, front industry. He was the founder and
to back collateral trading model are substantially higher than CEO of IFBS, an IT application
for just a product silo or transaction processing system. First, solutions and consulting firm spe-
the architecture must be scalable as to the distribution of cialising in securities lending, repo
functionality across servers. This is typically achieved with and collateral management. IFBS
service-based architectures, which allow multiple instances of was recently sold to COMIT. Prior
the same services in order to achieve high performance and to launching IFBS, Oegerli held a
availability. Service-based architectures are also the way to number of business leadership
integrate systems across the net, mainly by using web servic- roles at UBS in Zurich, New York,
es. Transaction processing services for settlement, audit trail, and London for over 20 years in
and accounting should be loosely coupled using message ori- different functions. Between 1990
ented middleware as separation layer. and 1999, he was responsible for
Secondly, real-time information has become a necessity. In the creation and expansion of the Securities Lending, Repo
cross product systems, multiple users with different business and Prime Brokerage business at UBS Zurich, was deputy
intentions may use the same positions. Only real-time global head of Securities Lending and Repo, global head of
updates on positions, preferably on a ‘push’ basis (meaning Prime Brokerage and head of global product management
the user does not have to actively query the system) will pre- Collateral Trading and Management.
SECURITIES LENDING MARKET GUIDE 2008 INVESTOR SERVICES JOURNAL 45
SLMG 2007 pp34-49 10/9/07 4:44 pm Page 46
PANEL - TECHNOLOGY
Daniel Fowler is chief information officer and managing director of eSecLending. Fowler’s
primary responsibilities within eSecLending are for systems and information technology and
application. Prior to joining the firm in 2006, Fowler held several jobs that gave him broad
exposure to both technology and financial markets. Most recently, he was employed by
Brown Brothers Harriman as vice president of Systems, Private Account and Securities
Lending. Prior to that, he worked at Boston Global Advisors as vice president, head of
Technology. Fowler holds a BS in Computer Science from the University of Massachusetts.
There has been a significant increase in automated capability for securities lending
over the last few years, how has this
affected the market in general?
Glicher: Automation enables a firm to scale its business in a more cost efficient manner. EquiLend’s platform
offers the ability to automate the entire lifecycle of a trade. Trades are delivered machine to machine, allowing
potentially an infinite amount of trades to be processed, so that individuals can focus on the more complex
and relationship oriented transactions. Once the trade is initiated, all of EquiLend’s post-trade services are
46 INVESTOR SERVICES JOURNAL SECURITIES LENDING MARKET GUIDE 2007
SLMG 2007 pp34-49 10/9/07 4:44 pm Page 47
available to complete the lifecycle of the contract. regard to securities lending technology would be
Contract, marks, and billing can be reconciled daily, slightly exaggerated. Technology has helped the busi-
mitigating risk. ness to become more efficient for trading general
Oegerli: It is important to highlight that the market collateral tickets and on the post-trade reconciliation
demand transformation drives the business model and trade reporting side. Technology is available to
transformation and not vice versa. Technology will further increase the level of automation on the trad-
never drive a business model but will enable it. In ing side. However, the business requires further
the past, technology mainly had an impact on standardisation in order to fully automate the trad-
process automation and therefore cost. The electron- ing process and this may take well over 10 years.
ic securities lending platforms, which were launched
in the midst of the e-business ‘hype’, were focused Fowler: The greatest technology innovations for the
on widening the distribution network and increasing securities lending industry are taking place in the
profits. However, between 2000 and 2003, the indus- areas of automation and volume processing to cre-
try was for the first time faced with slower growth or, ate greater operational processing efficiencies. A cur-
in some cases, falling revenues. This may have rent important initiative taking shape within the
changed the focus of these electronic marketplaces market is the Automated Recall Management
mainly to efficiency gains in the securities lending Software (ARMS) project. This initiative will allow
trading area and to the post-trade processes. These recalls to be processed via automated systems, in
Where are the greatest innovations Which platforms are dominating the mar-
in technology being seen for securities ket and why?
lending?
Glicher: EquiLend has a strong presence in the mar-
Glicher: The move to a real-time messaging para- ketplace, as it is the most innovative technology
digm and the use of the web browser as the ubiqui- platform. EquiLend was the first securities finance
tous user interface. platform to introduce real-time messaging, the first
platform to handle the complete lifecycle of a con-
Oegerli: To speak about great innovations with tract (trade and post-trade) and the first firm to cre-
PANEL - TECHNOLOGY
ate a standard XML taxonomy, Securities Lending Fowler: There are a number of key factors to consid-
Market Language (SLML). EquiLend created this pro- er when choosing a new technology platform: full
tocol to facilitate the exchange of securities financ- functionality for various business areas; open archi-
ing information. There is SLML representation for all tecture that can be supported internally; and con-
of the business functionality that our users employ. nectivity to allow for communications with legacy
systems and other downstream systems within the
Fowler: In terms of core securities lending systems, organisation. For eSecLending, it is imperative that
SunGard’s Global One is the dominant platform in our core securities lending system be able to feed
the marketplace. There are various reasons for information downstream into other reporting and
Global One’s dominance, but the primary reasons transaction processing systems. We would not
for SunGard’s success with this product is that choose a platform that could not adequately com-
Global One has been around the longest, it has a municate and upload/download information to the
robust suite of functionality and it is not prohibitive- supporting or secondary systems used for transac-
ly expensive. 4Sight, which is the securities lending tion processing. In addition, ongoing support from
system that eSecLending uses, is still a relatively a vendor is crucial, as is their willingness to work
small player in the market but the platform is gain- with you and improve and enhance the system’s
ing greater market share and momentum. 4Sight’s functionality.
architecture is a bit more open and sits on an Oracle
database, which allows for ease of integration and What effect are requirements for greater
support. Anvil is another player in the market. transparency having on the technology
What are the key factors to consider when landscape in securities lending?
choosing a new technology platform? Glicher: Increased automation results in data, which
can, conceptually, be provided on demand, based on
Glicher: Ease of use, cost, and penetration in the the appropriate request.
marketplace.
Fowler: Lenders are looking to increase transparen- What is the future for technology in this
cy in their securities lending activities to ensure an area – where next?
objective, regulatory friendly and highly auditable
programme that can be easily presented to their Glicher: Web services - offering the ability to trans-
management team, board, auditors and regulators mit messaging through web technologies, Web 2.0,
lender and allows for objective decision making on and service oriented architecture (SOA). Securities
how to best allocate portfolios for lending. The auc- lending has matured to the point where it can move
tion process also provides price transparency and away from monolithic, complex, stand alone systems
price discovery, thereby giving clients the opportuni- into more manageable components working within a
ty to definitively identify where the greatest demand distributed systems architecture. The services, both
exists for various pieces of their portfolios. trading and reconciliation, can be self contained and
The desire for greater transparency has also created do not need to depend on the context or state of the
the need for comprehensive benchmarking services. other services. This will lead us to an SOA or a col-
There are multiple providers in the industry offering lection of services or functionalities that communi-
solutions to help lenders better evaluate their secu- cate with each other.
rities lending performance and compare their
cial owners and the eventual borrowers. But typically a number Many broker dealers combine their securities lending activi-
of layers of intermediary are involved. What value do the inter- ties with their prime brokerage operation (the business of serv-
mediaries add? icing the broad requirements of hedge funds and other alterna-
A beneficial owner may well be an insurance company or a tive investment managers). This can bring significant efficiency
pension scheme while the ultimate borrower could be a hedge and cost benefits. Typically within broker dealers the fixed
fund. Institutions will often be reluctant to take on credit expo- income and equity divisions duplicate their lending and financ-
sures to borrowers that are not well recognised, regulated, or ing activities.
who do not have a good credit rating, which would exclude
most hedge funds. (b) Specialist intermediaries
In these circumstances, the principal intermediary (often act- Historically, regulatory controls on participation in stock
ing as prime broker) performs a credit intermediation service lending markets meant that globally there were many interme-
in taking a principal position between the lending institution diaries. Some specialised in intermediating between stock
and the hedge fund.
A further role of the intermediaries is to take on liquidity risk.
Typically they will borrow from institutions on an open basis –
Historically, regulatory controls
giving them the option to recall the underlying securities if they on participation in stock lending
want to sell them or for other reasons – whilst lending to
clients on a term basis, giving them certainty that they will be
markets meant that globally
able to cover their short positions. there were many intermediaries
In many cases, as well as serving the needs of their own pro-
priety traders, principal intermediaries provide a service to the lenders and market makers in particular, e.g. UK Stock
market in matching the supply of beneficial owners that have Exchange Money Brokers (SEMB). With the deregulation of
large stable portfolios with those that have a high borrowing stock lending markets, these niches have almost all disap-
requirement. They also distribute securities to a wider range of peared.
borrowers than underlying lenders, which may not have the Some of the specialists are now part of larger financial organ-
resources to deal with a large number of counterparts. isations. Others have moved to parent companies that have
These activities leave principal intermediaries exposed to liq- allowed them to expand the range of their activities into propri-
uidity risk if lenders recall securities that have been on lent to etary trading.
borrowers on a term basis. One way to mitigate this risk is to
use in-house inventory where available. For example, propri- (c) Prime brokers
etary trading positions can be a stable source of lending supply Prime brokers serve the needs of hedge funds and other ‘alter-
if the long position is associated with a long-term derivatives native’ investment managers. The business was once viewed,
transaction. simply, as the provision of six distinct services, although many
Efficient inventory management is seen as critical and many others such as capital introduction, risk management, fund
securities lending desks act as central clearers of inventory accounting and start up assistance have now been added:
within their organisations, only borrowing externally when net-
ting of in-house positions is complete. Services provided by prime brokers
This can require a significant technological investment. Other Securities lending is one of the central components of a suc-
ways of mitigating ‘recall risk’ include arrangements to borrow cessful prime brokerage operation, with its scale depending on
securities from affiliated investment management firms, where the strategies of the hedge funds for which the prime broker
regulations permit, and bidding for exclusive (and certain) acts. Two strategies that are heavily reliant on securities bor-
access to securities from other lenders. rowing are long/short equity and convertible bond arbitrage.
On the demand side, intermediaries have historically been The cost associated with the establishment of a full service
dependent upon hedge funds or proprietary traders that make prime broker is steep, and recognised providers have a signifi-
trading decisions. But a growing number of securities lending cant advantage. Some of the newer entrants have been using
businesses within investment banks have either developed total return swaps, contracts for difference and other derivative
“trading” capabilities within their lending or financing depart- transaction types to offer what has become known as “synthet-
ments, or entered into joint ventures with other departments ic prime brokerage”.
or even in some cases their hedge fund customers. The ration- Again securities lending remains a key component of the
ale behind this trend is that the financing component of certain service as the prime broker will still need to borrow securities
trading strategies is so significant that without the loan there is in order to hedge the derivatives positions it has entered into
no trade. with the hedge funds, for example, to cover short positions.
But it is internalised within the prime broker and less obvious
(a) Broker dealers to the client.
Broker dealers borrow securities for a wide range of reasons:
- Market making Beneficial owners
- To support proprietary trading on behalf of clients Those beneficial owners with securities portfolios of sufficient
size to make securities lending worthwhile include:
(c) Credit risk appetite The possible routes to the securities lending market:
The securities lending market consists of organisations with a (a) Using an asset manager as agent
wide range of credit quality and collateral capabilities. A beneficial owner may find that the asset manager they have
A cautious approach to counterpart selection (AAA only) and chosen, already operates a securities lending programme. This
restrictive collateral guidelines (G7 Bonds) will limit lending route poses few barriers to getting started quickly.
volumes.
(b) Using a custodian as agent
2. Portfolio characteristics This is the least demanding option for a beneficial owner, espe-
cially a new one. They will already have made a major decision
(a) Size in selecting an appropriate custodian. This route also poses
Other things being equal, borrowers prefer large portfolios. few barriers to getting started quickly.
unknown to one another. These principal intermediaries are would want to understand how and why their securities are
sometimes separately incorporated organisations, but more traded.
frequently, parts of larger banks, broker-dealers or investment
banking groups. Acting as principal allows these intermediaries Reasons to borrow
to deal with organisations that the typical beneficial owner may Borrowers, when acting as principals, have no obligation to tell
choose to avoid for credit reasons, for example, hedge funds. lenders or their agents why they are borrowing securities. In
fact they may well not know themselves as they may be on-
(f) Lending directly to proprietary principals lending the securities to proprietary traders or hedge funds
Normally after a period of activity in the lending market using that do not share their trading strategies openly. Some prime
one of the above options, a beneficial owner that is large brokers are deliberately vague when borrowing securities as
enough in its own right, may wish to explore the possibility of they wish to protect their underlying hedge fund customer’s
establishing a business “in house”, lending directly to a selec- trading strategy and motivation.
tion of principal borrowers that are the end-users of their secu- This chapter explains some of the more common reasons
rities. The proprietary borrowers include broker-dealers, market behind the borrowing of securities. In general, these can be
makers and hedge funds. Some have global borrowing needs grouped into: (1) borrowing to cover a short position (settle-
while others are more regionally focused.
Naked shorting is a high risk strategy. Although some funds their historical trading range.
specialise in taking short positions in the shares of companies The strategy entails buying the apparently undervalued secu-
they judge to be overvalued, the number of funds relying on rity while selling the apparently overvalued security short, bor-
naked shorting is relatively small and probably declining. rowing the latter security to cover the short position.
Focusing on securities in the same sector or industry should
(c) Market making normally reduce the risks in this strategy.
Market makers play a central role in the provision of two-way
price liquidity in many securities markets around the world. (iii) Index arbitrage
They need to be able to borrow securities in order to settle buy In this context, arbitrage refers to the simultaneous purchase
and sale of the same commodity or stock in two different mar-
kets in order to profit from price discrepancies between the
Stock index arbitrage involves markets.
buying or selling a basket of In the stock market, an arbitrage opportunity arises when the
same security trades at different prices in different markets. In
stocks and, conversely, selling or such a situation, investors buy the security in one market at a
buying futures when mispricing lower price and sell it in another for more, capitalising on the
difference. However, such an opportunity vanishes quickly as
appears to be taking place investors rush in to take advantage of the price difference.
The same principle can be applied to index futures. Being a
orders from customers and to make tight, two-way prices. derivative product, index futures derive their value from the
The ability to make markets in illiquid small capitalisation securities that constitute the index. At the same time, the value
securities is sometimes hampered by a lack of access to bor- of index futures is linked to the stock index value through the
rowing, and some of the specialists in these less liquid securi- opportunity cost of funds (borrowing/lending cost) required to
ties have put in place special arrangements to enable them to play the market.
gain access to securities. These include guaranteed exclusive Stock index arbitrage involves buying or selling a basket of
bids with securities lenders. stocks and, conversely, selling or buying futures when mispric-
The character of borrowing is typically short term for an ing appears to be taking place.
unknown period of time. The need to know that a loan is avail-
able tends to mean that the level of communication between (2) Financing
market makers and the securities lending business has to be As broker dealers build derivative prime brokerage and cus-
highly automated. A market maker that goes short and then tomer margin business, they hold an increasing inventory of
finds that there is no loan available would have to buy that securities that requires financing.
security back to flatten its book. This type of activity is high volume and takes place between
two counterparts that have the following coincidence of wants:
(d) Arbitrage trading - One has cash that they would like to invest on a secured basis
Securities are often borrowed to cover a short position in one and pick up yield.
security that has been taken to hedge a long position in anoth- - The other has inventory that needs to be financed.
er as part of an “arbitrage” strategy. Some of the more com- - In the case of bonds, the typical financing transaction is a
mon arbitrage transactions that involve securities lending are repo or buy/sell back. But for equities, securities lending and
described below. equity, repo transactions are used.
- Tri Party agents are often involved in this type of financing
(i) Convertible bond arbitrage transaction as they can reduce operational costs for the cash
Convertible bond arbitrage involves buying a convertible bond lender and they have the settlement capabilities the cash bor-
and simultaneously selling the underlying equity short and bor- rower needs to substitute securities collateral as their inventory
rowing the shares to cover the short position. Leverage can be changes.
deployed to increase the return in this type of transaction.
Prime brokers are particularly keen on hedge funds that engage (3) Temporary transfers of ownership
in convertible bond arbitrage as they offer scope for several rev- (a) Tax arbitrage
enue sources: Tax driven trading is an example of securities lending as a
- Securities lending revenues means of exchange.
- Provision of leverage Markets that have historically provided the largest opportuni-
- Execution of the convertible bond ties for tax arbitrage include those with significant tax credits
- Execution of the equity that are not available to all investors – examples include Italy,
Germany and France.
(ii) Pairs trading or relative value “arbitrage” The different tax positions of investors around the world have
This in an investment strategy that seeks to identify two com- opened up opportunities for borrowers to use securities lend-
panies with similar characteristics whose equity securities are ing transactions, in effect, to exchange assets temporarily for
currently trading at a price relationship that is out of line with the mutual benefit of purchaser, borrower and lender. The
lender’s reward comes in one of two ways: either a higher fee tions in 2002 and is backed by a consortium of financial insti-
for lending if they require a lower manufactured dividend, or a tutions. EquiLend’s stated objective is to: “Provide the securi-
higher manufactured dividend than the post-tax dividend they ties lending industry with the technology to streamline and
would normally receive (quoted as an “all-in rate”). automate transactions between borrowing and lending institu-
For example, an offshore lender that would normally receive tions and … introduce a set of common protocols. EquiLend
75% of a German dividend and incur 25% withholding tax (with will connect borrowers and lenders through a common, stan-
no possibility to reclaim) could lend the security to a borrower dards-based global equity lending platform enabling them to
that, in turn, could sell it to a German investor who was able to transact with increased efficiency and speed, and reduced cost
obtain a tax credit rather than incur withholding tax. If the off- and risk.” EquiLend is not alone in this market; for example,
shore lender claimed the 95% of the dividend that it would oth- SecFinex offers similar services in Europe.
erwise have received, it would be making a significant pick-up
(20% of the dividend yield), whilst the borrower might make a Connfirmations
spread of between 95% and whatever the German investor was Written or electronic confirmations are issued,
bidding. The terms of these trades vary widely and rates are whenever possible, on the day of the trade so that any queries
calculated accordingly. by the other party can be raised as quickly as possible.
Material changes during the life of the transaction are agreed
(b) Dividend reinvestment plan arbitrage between the parties as they occur and may also be
Many issuers of securities create an arbitrage opportunity
when they offer shareholders the choice of taking a dividend or Traditionally securities loans
reinvesting in additional securities at a discounted level.
Income or index tracking funds that cannot deviate from have been negotiated between
recognised securities weightings may have to choose to take counterparts on the phone, and
the cash option and forgo the opportunity to take the discount-
ed reinvestment opportunity. followed up with written or
One way that they can share in the potential profitability of electronic confirmations
this opportunity is to lend securities to borrowers that then
take the following action: confirmed if either party wishes it. Examples of material
- Borrow as many guaranteed cash shares as possible, as changes are collateral adjustments or collateral substitutions.
cheaply as possible. The parties agree who will take responsibility for issuing loan
- Tender the borrowed securities to receive the new dis- confirmations.
counted share. Confirmations would normally include the following
- Sell the new shares to realise the “profit” between the dis- information:
counted share price and the market price. - Contract and settlement dates.
- Return the shares and manufacture the cash dividend to - Details of loaned securities.
the lender. - Identities of lender and borrower (+ any underlying principal)
- Acceptable collateral and margin percentages.
Market mechanics - Term and rates.
This section outlines the detailed processes in the life of a - Bank and settlement account details of the lender and
securities loan including: borrower.
the borrower need to return the securities early if the lender separately, possibly in a different payment or settlement system
requests it. Accordingly, securities subject to a fixed loan and maybe a different country and time zone. For example, UK
should not be sold while on loan. equities might be lent against collateral provided in a European
Where the term discussed is intended to be “indicative”, it International Central Securities Depository or US dollar cash
usually means that the borrower has a long term need for the collateral paid in New York. This can give rise to what is known
securities but the lender is unable to fix for term and retains in the market as “daylight exposure”, a period during which the
the right to recall the securities if necessary. loan is not covered as the lent securities have been delivered
but the collateral securities have not yet been received. To
Putting securities “on hold” (also known as “icing”) avoid this exposure some lenders insist on pre-collateralisa-
Putting securities “on hold” (referred to in the market as tion, so transferring the exposure to the borrower.
“icing” securities) is the practice whereby the lender will The CREST system for settling UK and Irish securities is an
reserve securities at the request of a borrower on the borrow- exception to the normal practice as collateral is available within
er’s expected need to borrow those securities at a future date. the system. This enables loans to be settled against cash intra-
This occurs where the borrower must be sure that the securi- day and for the cash to be exchanged, if desired, at the end of
ties will be available before committing to a trade that will the settlement day for a package of DBV securities overnight.
require them. The process can be reversed and repeated the next day.
While some details can be agreed between the parties, it is CREST settlement facility for stock lending
normal for any price quoted to be purely indicative, and for CREST also has specific settlement arrangements for stock
securities to be held to the following business day. The borrow- loans, requiring the independent input of instructions by both
er can “roll over” the arrangement (continue to ice the securi- parties, who must complete a number of matching fields,
ties) by contacting the holder before 9am, otherwise it termi- including the amount and currency of any cash collateral,
nates. together with the percentage value of applicable loan margin.
Key aspects of icing are that the lender does not receive a fee Loans may be effected against sterling, euro or dollar consider-
for reserving the securities and they are generally open to chal- ation or made free-of-payment.
lenge by another borrower making a firm bid. In this case the Immediately after the settlement of the loan, CREST auto-
first borrower would have 30 minutes to decide whether to take matically creates a pre-matched stock loan return transaction
the securities at that time or to release them. with an intended settlement date of the next business day. The
return is prevented from settling until the borrower intervenes
to raise the settlement priority of the transaction. The stock
Settlement will normally be lender may freeze the transaction in order to prevent the stock
through the lender’s custodian from returning.
bank and this is likely to apply Termination of the loan
irrespective of whether the Open loans may be terminated by the borrower returning secu-
rities or by the lender recalling them. The borrower will normal-
lender is conducting the opera- ly return borrowed securities when it has filled its short posi-
tion or delegating to an agent tion. A borrower will sometimes refinance its loan positions by
borrowing more cheaply elsewhere and returning securities to
the original lender. The borrower may, however, give the origi-
“Pay-to-hold” arrangements nal lender the opportunity to reduce the rate being charged on
A variation of icing is “pay-to-hold” where the lender does the loan before borrowing elsewhere.
receive a fee for putting the securities on hold. As such, they
constitute a contractual agreement and are not open to chal- Redelivery, failed trades and legal remedies
lenge by other borrowers. When deciding which markets and what size to lend in, securi-
ties lenders will consider how certain they can be of having
How are loans settled? their securities returned in a timely manner when called, and
Securities lenders need to settle transactions on a shorter time- what remedies are available under the legal agreement (see
frame than the customary settlement period for that market. below) in the event of a failed return.
Settlement will normally be through the lender’s custodian Procedures to be followed in the event of a failed redelivery
bank and this is likely to apply irrespective of whether the are usually covered in legal agreements or otherwise agreed
lender is conducting the operation or delegating to an agent. between the parties at the outset of the relationship. Financial
The lender will usually have agreed a schedule of guaranteed redress may be available to the lender if the borrower fails to
settlement times for its securities lending activity with its cus- redeliver loaned securities or collateral on the intended settle-
todians. Prompt settlement information is crucial to the effi- ment date. Costs that would typically be covered include:
cient monitoring and control of a lending programme, with
reports needed for both loans and collateral. Direct interest and/or overdraft incurred
In most settlement systems securities loans are settled as Costs reasonably and properly incurred as a result of the bor-
“free-of-payment” deliveries and the collateral is taken quite rower’s failure to meet its sale or delivery obligations
extended by supplemental terms and conditions for equity borrower’s liquidator along with other creditors.
repo forming Part 2 of Annex 1 of the agreement
Risks and risk management
Where an authorised agreement does not cover the circum- When taking cash as collateral
stances in which a member firm wishes to enter into a lend- Because of its wide acceptability and ease of management,
ing arrangement, the firm must ensure that the agreement cash can be highly appropriate collateral. However, the
includes provisions equivalent to those contained within the lender needs to decide how best to utilise this form of collat-
Exchange’s rules on lending arrangements in relation to eral. As described in Chapter 1, a lender taking cash as col-
member firm default. lateral pays rebate interest to the securities borrower, so the
cash must be reinvested at a higher rate to make any net
Transparency in the UK market return on the collateral. This means the lender needs to
decide on an appropriate risk-return trade-off. In simple
Today, there is an increasing terms, reinvesting in assets that carry one of the following
risks can increase expected returns:
amount of bilateral and a higher credit risk: a risk of loss in the event of defaults or a
multilateral automated lending longer maturity in relation to the likely term of the loan
Many of the large securities lending losses over the years
CREST provides time-delayed information on the value of have been associated with reinvestment of cash collateral.
securities financing transactions in the top 350 UK equities. Typically, lenders delegate reinvestment to their agents,
This is a subscription service begun in September 2003 (for example, custodian banks). They specify reinvestment
following extensive discussion with market participants and guidelines, such as those set out in Chapter 1. There is a
the Financial Services Authority. move towards more quantitative, risk-based approaches;
The information it provides pertains to total Stamp Duty often specifying the ”value-at-risk” in relation to the different
Reserve Tax-exempt transactions taking place in each securi- expected returns earned from alternative reinvestment pro-
ty on a given day and excludes intermediary activity where files. Agents do not usually offer an indemnity against loss-
possible. CREST has provided answers to many frequently es on reinvestment activity so that the lender retains all of
asked questions on its website, www.crest.co.uk. the risk while their agent is paid part of the return.
The launch of its securities financing data service coincid-
ed with its publication of settlement failure statistics The When taking other securities ass collateral
London Stock Exchange monitors both and makes public Compared with cash collateral, taking other securities as col-
announcements on stock lending activity when it feels it is lateral is a way of avoiding reinvestment risk. In addition to
appropriate. the risks of error, systems failure and fraud always present in
any market, problems then arise on the default of a borrow-
UK Takeover Panel er. In such cases the lender will seek to sell the collateral
If it is proposed that any securities lending should take securities in order to raise the funds to replace the lent secu-
place during an offer period for a UK company, the Takeover rities. Transactions collateralised with securities are exposed
Panel should be consulted to establish whether any disclo- to a number of different risks:
sure is required and whether there are any other conse- Reaction and legal risk. If a lender experiences delays in
quences. either selling the collateral securities or repurchasing the
lent securities, it runs a greater risk that the value of the col-
Risks, regulation and market oversighht lateral will fall below that of the loan in the interim.
This chapter describes the main financial risks in securities Typically, the longer the delay, the larger the risk.
lending, and how lenders usually manage them. It is not a Mispricing risk. The lender will be exposed if either collateral
comprehensive description of the various operational, legal, securities have been over-valued or lent securities under-val-
market and credit risks to which market participants can be ued because the prices used to mark-to-market differ from
exposed. The chapter then briefly summarises the UK regula- prices that can actually be traded in the secondary market.
tory framework for securities lending market participants and One example of mispricing is using mid rather than bid
the role of the UK Stock Lending and Repo Committee. prices for collateral. For illiquid securities, obtaining a reli-
Financial risks in securities lending are primarily managed able price source is particularly difficult because of the lack
through the use of collateral and netting. As described in of trading activity.
Chapter 1, collateral can be in the form of securities or cash. Liquidity risk. Illiquid securities are more likely to be
The market value of the collateral is typically greater than that realised at a lower price than the valuation used. Valuation
of the lent portfolio. This margin is intended to protect the “haircuts” are used to mitigate this risk (i.e. collateral is val-
lender from loss and reflect the practical costs of collateral ued at, for example, 98% or 95% of the current market
liquidation and repurchase of the lent portfolio in the event value). The haircuts might depend upon:
of default. Any profits made in the repurchase of the lent - The proportion of the total security issue held in the portfo-
portfolio are normally returned to the borrower’s liquidator. lio – the larger the position, the greater the haircut.
Losses incurred are borne by the lender with recourse to the - The average daily traded volume of the security: the lower
In addition to the essentially prudential standards set by the of securities lenders and assisting in the orderly, efficient and
FSA, market participants have drawn up a code, the Stock competitive development of the securities lending market.
Borrowing and Lending Code. This is a code that UK-based ISLA has helped to produce standard market agreements,
participants in the stock borrowing and lending markets of including the Overseas Securities Lending Agreement (OSLA
both UK domestic and overseas securities observe as a matter 1995 version), the Master Equity and Fixed Interest Securities
Lending Agreement (MEFISLA 1999 version) and the Global
Master Securities Lending Agreement (GMSLA May 2000).
Corporate governance deals with
the rights and responsibilities of Securities Lending and Corporate governance
What is Corporate Governance?
a company’s management, its Corporate governance has increased in importance over
board, shareholders and various recent years. This high profile has been supported by investors,
their associations and increasingly by regulators. As the
stakeholders. How well compa- Organisation for Economic Co-operation and Development
nies are run affects market confi- writes in response to the following frequently asked question
“What is corporate governance and why is it important?”
dence as well as company Corporate governance deals with the rights and responsibili-
performance ties of a company’s management, its board, shareholders and
various stakeholders. How well companies are run affects mar-
of good practice. The Code covers matters such as agents, bro- ket confidence as well as company performance. Good corpo-
kers, legal agreements, custody, margins, defaults and close- rate governance is therefore essential for companies that want
outs, and confirmations. It is based on the current working access to capital and for countries that want to stimulate pri-
practices of leading market practitioners and is kept under reg- vate sector investment. If companies are well run, they will
ular review. The Code does not in any way replace the FSA’s or prosper. This, in turn, will enable them to attract investors
other authorities’ regulatory requirements; nor is it intended to whose support can help to finance faster growth. Poor corpo-
override the internal rules of settlement systems on borrowing rate governance, on the other hand, weakens a company’s
or lending transactions. Work is currently in progress to pro- potential and, at worst, can pave the way for financial difficul-
duce a UK Annex to the Code that will consider specific aspects ties and even fraud.
of UK law and practices in the equity stock lending market. Exercising the right to vote is therefore an integral and
The Code is available on the Bank of England’s website at important aspect of good corporate governance for institution-
www.bankofengland.co.uk/markets/stockborrowing.pdf. al investors. To be more precise the exercising of a right to vote
against management is the ultimate sanction that a sharehold-
Securities Lending and Repo Committee er has and can be seen as a major step in meaningful engage-
The Stock Borrowing and Lending Code was produced by the ment with the company.
Securities Lending and Repo Committee (SLRC), that is a UK-
based committee consisting of market practitioners, members Avoiding Conflict
of bodies such as CREST, the United Kingdom Debt There has been widespread discussion regarding the possible
Management Office, the Inland Revenue, the London Clearing conflict between the exercising of good corporate governance
House, the London Stock Exchange and the FSA. It provides a on behalf of investors and the lending of securities. This dis-
forum in which structural (including legal, regulatory, trading, cussion focuses upon the ability of investors, either directly or
clearing and settlement infrastructure, tax, market practice and by instructing their agents, to vote when they have securities
disclosure) developments in the stock lending and repo mar- on loan.
kets can be discussed, and recommendations made. It also co- We will draw upon specific examples, where appropriate, and
ordinates the development of gilt repo and equity repo codes; highlight best practice.
produces and updates the Gilts Annex to the ISMA/TBMA
Global Master Repurchase Agreement (GMRA); keeps under The Legal Position
review the other legal agreements used in the stock lending There are differing views in the market place as to the exact
and repo markets; and maintains a sub-group on legal netting. meaning of the term Securities Lending. “The word ‘lending’ is
It liaises with similar market bodies and trade organisations in some ways misleading. In law the transaction is, in fact, an
covering the repo, securities and other financial markets, both absolute transfer of title against an undertaking to return
in London and internationally. Minutes of SLRC meetings are equivalent securities.”
available on the Bank of England’s website, at www.bankofeng- This results in some important consequences arising from
land.co.uk/markets/slrc/htm. The SLRC’s terms of reference the nature of securities lending transactions:
are shown in Appendix 2. - Absolute title over both lent and collateral securities passes
The work of the SLRC complements the work of the various between parties, meaning that these securities can be sold out-
market associations, including, in the securities lending field, right or “on lent”.
the International Securities Lending Association (ISLA). The - Once securities have been passed, the new owner of them
objectives of ISLA include representing the common interests has certain rights. For example they have the right to sell or
lend them to another buyer and vote in the AGMs/EGMs if books because shares held as collateral or in trading books are
they are the holder at the record date. not normally voted.
- The lender of equities no longer owns them and has no enti- The right to recall any security on loan is enshrined in the
tlement to vote. But they are still exposed to price movements legal agreement underpinning this activity and typically the
on them since the economic exposure to owning those securi- lender recalling securities must provide their agent or borrower
ties is not passed. Typically lenders reserve the right to recall with “standard settlement period notice.” Recalls are part and
equivalent securities from the borrower and must exercise this parcel of the securities lending business.
option if they wish to vote. However, borrowers seek to avoid recalls wherever possible
and frequent recalls may discourage borrowers from accessing
Shares should not be borrowed for the purpose of voting portfolios.
As Paul Myners writes in the March 2005 Report to the In practice the lenders, or their agent, communicate the
Shareholder Voting Working Group, ‘Review of the lender’s position with regards to voting to the borrowers so as
Impediments to voting UK shares’: “Borrowing shares for the to avoid any surprises.
purpose of acquiring the vote is inappropriate, as it gives a pro- It is important for all parties that they understand the impor-
portion of the vote to the borrower which has no relation to tance of this communication and the rights of the underlying
their economic stake in the company. This is particularly the client to recall their securities to vote.
case in takeover situations or where there are shareholder reso- There are several positions that can be taken and these are
lutions involving acquisitions or disposals. The potential to vote driven by the owners of the assets made available for loan.
borrowed shares means that there is a risk that decisions could At all times it is the owner who determines what can and can-
be influenced by those that do not have an economic interest in not be done with their securities.
the business. I believe that this merits the attention of lenders,
fund managers and the ultimate beneficial owners, and their The beneficial owners of these assets include the following
respective trade associations. They should visit existing prac- types of organisations:
tices to see whether practical procedures could be put in place - Pension Funds
to prohibiting the borrowing of stock for the purposes of voting. - Mutual Funds
In this respect, the Securities Borrowing and Lending Code of - Insurance Companies
Guidance states: “there is consensus in the market that securi- - Unit Trusts
ties should not be borrowed solely for the purposes of exercis- - Charities and Religious Institutions
ing the voting rights at, for example, an AGM or EGM. Lenders
should also consider their corporate governance responsibilities The Lenders’ Choices
before lending stock over a period in which an AGM or EGM is The following positions are possible and there are securities
lending programmes constructed to cater for each of them:
Open loans may be terminated Voting (and therefore recalling) securities at every opportuni-
by the borrower returning ty, for example when the owner has a strong culture of voting
and does not wish to miss an opportunity to demonstrate its
securities or by the lender position to the company.
recalling them This is quite a rare position to take and is often only made in
a subset of markets that are very important to the owner e.g. A
expected to be held” . UK pension fund might wish to recall all UK securities to vote.
Similarly collateral held, which can be of equal or greater In his report, Paul Myners accepted that investors might
value than the shares lent, should not be voted. This is a clear have legitimate economic reasons for not recalling all securi-
position and one of which practitioners actively engaged in the ties to vote.
business of securities lending are acutely aware. Voting (and therefore recalling) securities only when the
vote is deemed important enough, for example when a
The Right to Recall takeover is being considered.
It is the case that securities on loan cannot be voted by the This is a more commonplace position and enables the
lender. Should they wish to exercise their right to vote, they owners to enjoy higher securities lending revenues whilst
need to recall these securities by the pre-determined time i.e. voting when they feel it is warranted. It is important to note
record date. that the beneficial owner determines when it is important to
Notwithstanding the above, it is not the case that, in aggre- vote, not their agents or borrowers. Here again the owners
gate, all votes on lent shares are lost. might focus upon their local market where their corporate
Some shares that have been borrowed will be delivered into governance aspirations are understandably higher than they
the market to settle sales and end up with buyers. These buyers might be overseas.
will be oblivious to the fact that these shares have been bor-
rowed and will view them as their property and choose to vote Not voting securities at all
as they see fit. There are still organisations that choose, for their own rea-
It is the case that there may be some loss of votes associated sons, not to vote. This is their decision although increasing
with collateral positions or positions sitting long in trading pressure in the UK from the government and others with
regulatory responsibility may well encourage greater voting Here are some suggestions that are currently being consid-
over time. However, should they change their mind and ered and that will make a difference if implemented:
make an exception, they would have the capability to notify
their agent or borrower and recall the securities in the nor- - Transparency
mal way. All stakeholders, not just securities lending professionals,
for example fund managers and corporate governance pro-
Maintaining a buffer of at least one share in all holdings fessionals, should understand the following:
To ensure that the beneficial owner or asset manager - The established legal framework underpinning the
receives direct advice regarding voting (and all other corpo- lending arrangement.
rate actions) the retention of at least one share in their - Securities must be recalled to vote.
account is advisable. This has the advantage of ensuring the - The exact notice required to recall the shares to
efficient and direct flow of information whilst retaining opti- vote - this may be different to normal market settlement
mal lending returns. It is typical for there to be some reten- periods depending on the lending agent being used.
tion or “buffer” of securities to be made in a lending pro- - Which securities are on loan.
gramme and this level could be as low as one share or could - How to access loan and/or governance information.
be expressed as a percentage of the value of the holding. - The potential effect of dividend record dates.
Furthermore, bringing the payment date closer to the AGM Beneficial owners need to ensure that any agents they
would ensure that the dividend timetable is not unduly have made responsible for their voting and stock lending
lengthened. This would enable lenders that wish to act in a co-ordinated way. This may mean that portfolio
participate in profitable dividend related lending activity to managers need to receive reports regarding securities on
do so with less voting conflict. loan so as to avoid any situation whereby votes that they
It will also ensure that lenders are fully informed and can intend to make are not possible.
vote when it matters to them. This change does not require This should be straightforward as notification of a vote
changes in company law and could be affected by the issuing taking place is given well in advance and securities can
companies. easily be recalled if necessary.
- Guidance
It is clear from the SLRC Code of Guidance and the Myners Conclusion
reports on the subject of securities lending and voting that Securities lending and the pursuit of good corporate gov-
the practice of borrowing shares specifically to vote is unac- ernance are not necessarily in conflict. Both activities can
ceptable. and do co-exist happily within the investment manage-
Many active participants in the securities lending business ment mainstream.
already have the suggested measures outlined above in
place. That should be a source of comfort to those con-
cerned about the activity. Since the demise of the
borrowing purpose test, it is
Lending is only part of the picture
The evidence suggests that lending is not one of the pri- technically possible for someone
mary reasons why voting turnout is low. to borrow securities to vote
The value of a vote is determined by the owner of that
vote – if they do not value it they may choose not to exer-
cise their right, irrespective of their willingness to lend. Today, many of the foremost proponents of good corpo-
As the law currently stands in the UK, borrowing securi- rate governance successfully combine an active voting
ties in order to build up a holding in a company with the role with a successful securities lending role.
deliberate purpose of influencing a shareholder vote is not The information flow and communication necessary to
illegal. However, based on recent headlines and the work ensure that conflict is avoided is already in place but
done by the International Corporate Governance Network, could be developed further. Those that are concerned
institutional lenders have recently become more aware of about possible conflict need to openly discuss the issue
this possibility, and tend not to see it as a legitimate use of with their securities lending counterparts and corporate
securities borrowing. governance colleagues.
Since the demise of the borrowing purpose test, it is There is no need for anyone to feel that securities lend-
technically possible for someone to borrow securities to ing will disenfranchise them. At all times it should be
vote. remembered that the owner of the securities determines
However, it has been made very clear that this is not whether securities are either lent or voted. SLMG
acceptable practice as the UK Annex to the Stock
Borrowing and Lending Code, SLRC, 11 May 2004 makes
clear. Mark Faulkner, Spitalfields Advisors
Should this activity become an issue of concern in the The previous section is an edited extract from 'An
future, it would draw regulatory attention very quickly, with Introduction to Securities Lending' and 'Securities Lending &
the widespread support of the securities lending industry. Corporate Governance' by Mark Faulkner, Spitalfields Advisors.
It is vital that beneficial owners are aware that when It has been prepared with Faulkner's permission. The original
shares are lent the right to vote is also transferred. The publication of 'An Introduction to Securities Lending' was com-
SLRC Code of Guidance states that “agents should make it missioned by the International Securities Lending Association,
clear to clients that voting rights are transferred.” the Association of Corporate Treasurers, the British Bankers
Going forward, a balance needs to be struck between vot- Association, the London Investment Banking Association, the
ing securities and the benefits derived from lending securi- London Stock Exchange and the Securities Lending and Repo
ties. Quantifying these competing benefits is challenging. Committeee. It was welcomed by the National Association of
The income derived from securities lending can be Pension Funds and the Association of British Insurers. The
explicitly measured but the value of a vote is perhaps less original publication of 'Securities Lending & Corporate
tangible - particularly now that most securities carry a vote Governance' was commissioned by the International Securities
and the majority of equity securities in publicly quoted Lending Association and endorsed by the Association of
companies rank pari passu (i.e. there are fewer companies Corporate Treasurers, the British Bankers Association, the
that issue both voting and non voting shares that can be London Stock Exchange, the National Association of Pension
compared with one another). Funds and the Securities Lending and Repo Committeee.
Guide - FAQs
What do people mean when they talk about transfer of title? Voting rights are transferred and the lender must recall equiv-
Contracts provide for ownership of lent securities to pass from alent securities from the borrower in order to vote.
the lender to the borrower.
A moment's thought about one of the principal motivations Why is it called securities “lending” when there is
for borrowing and lending securities will make the necessity for transfer of title?
this clear. Because commercially and economically people think of it as
Say the borrower needs to borrow securities to cover a short lending. Reflecting this, for accounting and capital require-
position, i.e. to fulfil a contract it has entered into to sell on the ments it is usually treated as a loan.
securities. The buyer is expecting the borrower to pass it own-
ership on settlement of that sale, as is normal in a sale. If the Does it meean that the lender gets exactly the same
borrower cannot do that, the borrower will not be able to fulfil securities back?
its contract with that purchaser. In order to enable it to fulfil its No. The borrower’s obligation is to return “equivalent securi-
contract, the borrower obtains title from the lender and then ties” i.e. from the same securities issue with the same
passes it on to the purchaser, hence “transfer of title”. International Securities Identification Number (ISIN).
Often it will have sold the original lent securities and has to
What does this mean for the lenderr? borrow or purchase securities in the market to fulfil its obliga-
The lender needs to be aware that it will be transferring owner- tion to the lender.
ship of the securities and of the various consequences that
flow from this. Does the lender have a pledge over the collateral?
First, any transfer taxes applicable to a purchase of No. Under standard market agreements and English law, there
securities will be due unless an exemption applies. This will is usually a transfer of title to the collateral. If the collateral is
typically be an issue for the borrower on the initial leg of the cash, all that means is that there is a cash payment by the bor-
transaction. But the lender should recognise that the return rower into the lender’s bank account. If the collateral is securi-
leg of the transaction (when the borrower transfers securities ties, there is a transfer of title of those securities to the lender.
back to the lender) may also attract transfer taxes where they Many of questions that arise for borrowers in relation to
are applicable. collateral securities also arise for lenders in relation to lent
Second, the transfer of the lent securities is in legal terms a securities.
disposal of them, and the lender needs to establish whether
such a disposal will have any consequences. Again this is usu- Why are there so many different agreements?
ally a tax question e.g. are there tax consequences for the Historically the different tax treatment of securities lending in
lender in disposing of the lent securities? different jurisdictions has driven the need for different agree-
Third, and very importantly, the obligation of the borrower on ments (such as OSLA – the Overseas Securities Lenders'
the return leg of the transaction is to transfer equivalent s Agreement, MEFISLA – the Master Equity and Fixed Income
ecurities back to the lender, not the original securities. In a Stock Lending Agreement, and so on). Following tax changes it
securities lending transaction, the borrower is not “holding” has generally become possible to use a single document and
the securities in trust or in custody on behalf of the lender. The the GMSLA – the Global Master Securities Lending Agreement,
borrower actually owns them, which is to say that the lender consolidates the various historical documents.
has no right to securities that are in the hands of the borrower.
Given that the borrower will often have sold on the securities, If the securities lending is carried out under English Law, but a
it is unlikely that the securities would be in the borrower's custodian appoints a sub-custodian in another country, or
hands). lends to an enntity in another country which does not recognise
Fourth, as the lender will cease to be the owner, it will no English Law, what happens when something goes wrongg?
longer be entitled to income from the securities, will not Simplifying a bit, there are three elements in the application of
receive notice or proceeds of corporate actions, and will lose all law to a securities lending transaction. The first is the contrac-
voting rights in respect of the securities. tual law, the second are the home country laws applying to
The standard documentation sets out contractual mecha- each party, and the third is the law applying to the place where
nisms for putting the owner in a comparable economic posi- the securities are held.
tion in respect of income and corporate actions. The contractual law is that which applies to the legal
66 INVESTOR SERVICES JOURNAL SECURITIES LENDING MARKET GUIDE 2008
SLMG 2007 pp50-69 10/9/07 5:07 pm Page 67
Securities Finance & Hedge Fund Training - Public & In-House Courses
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Buy-in
The practice whereby a lender of
registered holder (as of the ex-
coupon date) of that security.
Income Security Act, a U.S. law
governing private U.S. pension I cing/putting stock on hold
The practice whereby a lender
securities enters the open market Coupons may be paid (in most plan activity, introduced in 1974
to buy securities in order to cases) annually, semi-annually or and amended in 1981 to permit holds securities at a borrower's
replace those that have not been quarterly. plans to lend securities in accor- request in anticipation of that
returned by a borrower. Strict dance with specific guidelines. borrower taking delivery.
market practices govern the buy-
in process. D aylight exposure
The period in the day when one
Equivalent
A term denoting that the securi-
Indemnity
A form of guarantee or insur-
ties or collateral returned must ance, frequently offered by
C arry
The difference between interest
party to a trade has a temporary
credit exposure to the other due
to one side of the trade having
be of an identical type, nominal
value, description and amount to
Agents. Terms vary significantly
and the value of the indemnity
return on securities held and those originally provided. If, dur- does also.
settled before the other. It would
financing costs. See Negative normally mean that the loan had ing the term of a loan, there is a
carry and Positive carry. corporate action in relation to ISLA
settled but the delivery of collat- The International Securities
Negative carry: Net cost incurred eral would settle at a later time, loaned securities, the lender is
when financing cost exceeds normally entitled to specify at Lenders Association, the trade
although there would also be association for securities lenders.
yield on securities that are being exposure if settlement happened that time the form in which he
financed. in reverse order. The period wishes to receive equivalent
Positive carry: Net gain earned securities or collateral on termi- ISMA
extends from the point of settle- The International Securities
when financing cost is less than ment of the first side of the trade nation of the loan. The legal
yield on financed securities. agreement will also specify the Market Association, an organisa-
to the time of settlement of the tion of international securities
other. It occurs because the two form in which equivalent securi-
Cash trade ties or collateral are to be dealers, maintains offices in
sides of the trade are not linked Zurich. ISMA is an industry
Where an outright purchase or in many settlement systems or returned in the case of other cor-
sale of securities is made for a porate events. group that sets standards of
settlement of loan and collateral business conduct in the global
purpose other than financing. take place in different settlement securities markets, advises regu-
Close-out (and) netting
An arrangement to settle all
systems, possibly in different
time zones. F ail
The failure to deliver cash or col-
lators on market practices and
provides educational opportuni-
ties for industry participants. ing maturities, rates, currencies, acts on its own behalf or substi- cial"/in high demand for any of
or margins, the repo trader gen- tutes its own risk for that of its several reasons, are sought after
L IBA
London Investment Banking
erates a P&L.
Moving average
client when trading.
Proprietary trading
in the market by borrowers.
Holders of special securities will
be able to earn incremental
Association, the principal trade A statistical measure that reports Trading activity conducted by a income on the securities by lend-
association in the UK for firms the average of the previous stat- securities firm for its own account ing them out via repo, sell/buy, or
active in the investment banking ed number of day's data in pref- rather than for its clients. securities lending transactions.
and securities industry. LIBA erence to the actual value for that
members are generally borrowers
and intermediaries in the stock
lending market.
day. This process can improve
trend recognition by smoothing
shorter-term fluctuations.
R ebate rate
The interest paid on the cash
Specials
Securities that for any of several
reasons are sought after in the
side of a securities lending trans- market by borrowers. Holders of
M anufactured dividends
When securities that have been
N egative carry
Net cost incurred when financing
action. A rebate rate of interest
implies a fee for the loan.
special securities will be able to
earn incremental income on the
securities by lending them out
lent out pay a cash dividend, the cost exceeds yield on securities Recall via repo, sell/buy, or securities
borrower of the securities is gen- that are being financed. Request by a lender for the return lending transactions
erally contractually obligated to of securities from a borrower.
pass on the distribution to the Net paying securities Spot
lender of the securities. This pay- Securities on which interest or Repo Standard non-dollar repo settle-
ment "pass-through" is known as other distributions are paid net A transaction whereby one party ment two business days forward.
a manufactured dividend. of withholding taxes. sells securities to another party A money market convention.
and agrees to repurchase the
Margin, initial
Refers to the excess of cash over
securities or securities over cash
O pen transactions
Trades done with no fixed maturi-
securities at a future date at a
fixed price.
Substitution
The ability of a lender of general
collateral to recall securities from
in a repo/reverse repo, sell/buy- ty date. Repricing a borrower and replace them
buy/sell, or securities lending Occurs when the market value of with other securities of the same
transaction. One party may
require an initial margin due to P air off
a security in a repo or securities
lending transaction changes and
value.
the perceived credit risk of the
counterpart. No initial margin is
typically expected in fixed-income
The netting of cash and securi-
ties in the settlement of two
trades in the same security for
the parties to the transaction
agree to adjust the amount of T erm transactions
Trades with a fixed maturity date.
securities or cash in a transaction
transactions, but where it does the same value date. Pairing off to the correct margin level.
occur, it normally ranges from allows for settlement of net dif- Third party lending
1% to 3%. ferences. Reverse repo The system whereby an
A transaction whereby one party institution lends directly to a
Margin, variation Partialling purchases securities from anoth- borrower and retains decision-
Once a repo or securities lending Market practice or a specific er party and agrees to resell the making power, while all
transaction has settled. The vari- agreement between counterparts securities at a future date at a administration (settlement col-
ation margin on a repo or securi- that allows a part-delivery against fixed price. lateral monitoring, and so on) is
ties lending transaction refers to an obligation to deliver securities. handled by a third party, such as
the band within which the value a global custodian.
of the security used as collateral
may fluctuate before triggering a
Pay for hold
The practice of paying a fee to
S ecurities lending
The collateralised (usually) bor- Triparty repo
margin call. Variation margin the lender to hold securities for a rowing and lending of Securities. Repo used for funding/invest-
may be expressed either in %age particular borrower until the bor- This business allows large ment purposes in which bonds
or absolute currency terms. The rower is able to take delivery. investors (for example, Pension and cash are delivered by the
GMRA (See PSA/ISMA Global Funds, Insurance and Assurance trading counterparts to an inde-
Master Repurchase Agreement) Positive carry Companies and Investment pendent custodian bank or clear-
states that all legitimate requests Net gain earned when financing Funds of various types) to gener- ing house (the 'Triparty
for variation margin must be cost is less than yield on financed ate additional income from their Custodian") that is responsible
honoured. securities. investments in securities by lend- for ensuring the maintenance of
ing them. There is no formal adequate collateral value, both at
Margin call Prime brokerage market structure, and no the outset of a trade and over its
A request by one party in a trans- A service offered by both Bank compulsion to use any interme- term. The Triparty Custodian
action for the initial margin to be and Non-Bank financial institu- diary. Lenders and Borrowers can marks the collateral to market
reinstated or to restore the origi- tions (e.g. Investment Banks and thus configure their programs to daily and makes margin calls on
nal cash/securities ratio to parity. Broker/Dealers) to support cus- suit individual needs - using either counterpart, as required.
tomers' proprietary trading, either Agent or Principal Triparty repo reduces the opera-
Mark-to-market investment and hedging activi- Intermediaries as required, or tional/systems barriers to partici-
The act of revaluing the securi- ties. Clients of this service are going direct to the Proprietary pating in the repo markets.
ties collateral in a repo or securi- frequently Hedge Funds, who are Borrowers, including Hedge
ties lending transaction to cur-
rent market values. This maybe
done daily or at a suitable inter-
often long on ideas, short on
capital and the necessary support
infrastructure. Prime Brokerage
Funds. Securities are borrowed
to support hedging and V alue
The value of loan securities or
arbitrage transactions,
val agreed upon by the parties to may therefore include Clearing, market making, as well as settle- collateral as determined using
a transaction. Custody and Reporting, but also ment activities. the last (or latest available) sale
Securities Lending, Financing price on the principal exchange
Matched/mismatched book and Execution. Short squeeze (bear squeeze) where the instrument was traded
Refers to the interest rate arbi- Where one or more market partic- or, if not so traded, using the
trage book that a repo trader may Principal ipants reduce liquidity by with- most recent bid or offered prices.
run. By matching or mismatch- A party to a loan transaction that holding securities that are "spe- © Spitalfields Advisors
Bastian Cohen
Guy d’Albrand
Felix Oegerli
Brian Lamb
Daniel Fowler
Company Brief: 2006, Fowler held several jobs that gave him broad
eSecLending is a global securities lending man- exposure to both technology and financial markets.
ager and a leading provider and administrator of Most recently, he was employed by Brown Brothers
customised securities lending programmes. Its Harriman as vice president of Systems, Private
programmes attract some of the world’s largest Account and Securities Lending. Prior to that, he
and most sophisticated asset gatherers, includ- worked at Boston Global Advisors as vice president,
ing pension funds, mutual funds, investment head of Technology. Fowler holds a BS in Computer
managers and insurance companies. The firm Science from the University of Massachusetts.
awards principal securities lending business
through a competitive auction process that has
provided clients with higher returns compared to Key Services:
traditional programme structures and improved Securities lending management and administra-
transparency and objective criteria upon which to tion
make decisions. The company has auctioned Cash collateral portfolio management
over USD1.3 trillion to date. eSecLending main-
tains offices in Boston, London and Burlington,
Vermont. Securities Finance Trust Company, an
eSecLending company, performs all regulated
business activities.
Sandie O’Connor
Mark Fieldhouse
Time to change?
4sight Securities Finance provides a full front • Software with the flexibility to be tailored to your
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repo, swaps, and collateral management of
• Maximise efficiency through quick and seamless
both Equities and Fixed Income Securities.
integration with your existing systems
4sight Securities Finance is a proven solution
used globally by a wide range of financial • Quick and easy real time access to your data,
institutions, and can be used on an agency with the ability to import and export in any
or principal basis. required format.