GOVERNMENT SECURITIES LENDING AND

BORROWING INTRODUCTION IN INDIA

Pradeep Naik*

Securities borrowers and lenders

perform one very important economic
function - they provide better liquidity
in the markets.
Introduction
Securities lending involves the temporary
exchange of securities, usually for other
securities or cash of an equivalent value (or
occasionally a mixture of cash and
securities), with an obligation to redeliver a
like quantity of the same securities at a future
date. Most securities lending is structured to
give the borrower legal title to the securities
for the life of the transaction, even though,
economically, the terms are more akin to a
loan. The borrow fee is generally agreed in
advance and the lender has contractual
rights similar to beneficial ownership of the
securities, with rights to receive the
equivalent of all interest payments or
dividends and to have equivalent securities
returned. The importance of the transfer of
legal title is twofold. First, it allows the
borrower to deliver the securities onward, for
example in another securities loan or to
settle an outright trade. Second, it means
that the lender usually receives value in
exchange for the disposition of legal title
(whether in cash or securities), which ensures

that the loan is collateralized.

History
Securities lending has existed since at least
the 19th century with limited activity in a
few countries and these markets were
typically highly regulated to ensure that
stocks were only borrowed by specific
institutions, for specific purposes and often
through specialist intermediaries.
The first moves towards todays modern
market took place in North America in the
1960s and then developed in most other
domestic markets in the 1980s and 1990s.
The US market in the 1960s developed an
active inter-dealer market in loans of stock,
which was associated with increased short
selling activity and a rising incidence of
settlement fails. In the 1970s, US custodian
banks first began lending specific stocks to
broker-dealers on behalf of their clients such
as insurance companies, university
endowment funds and corporate investment
portfolios.
Meanwhile, the 1980s saw a dramatic
increase in the size of government securities
markets in many jurisdictions. This
prompted the development of repo markets
in many of the major government securities

*Shri Pradeep Naik, is Vice-President, Securities Settlement & Margins Department,

The Clearing Corporation of India Limited.

markets as traders looked to finance

inventories, cover short positions and use
repo to take and hedge interest rate
positions. The increasing use of repo by
central banks as a means of providing
secured liquidity in open market operations
was an important stimulus. The
development of an efficient settlement
infrastructure was also significant for
instance, the development of book-entry
settlement, and specific procedures for repos
allowing the delivery of general collateral.
By the end of the 1980s, US global custodian
banks, US securities firms and UK money
lenders started to develop todays offshore
securities lending markets. These firms were
able to effect securities lending transaction
outside the local market through settlement
on the books of foreign sub custodians. The
large US custodian banks began to run their
securities lending businesses on a global
basis in Europe, Japan and North America.
The 1990s have seen an intensification of
these trends. The globalisation of securities
lending markets has continued and
expanded to include new emerging markets.
An increasing number of market
participants have sought to borrow
securities in order to take leveraged positions
for example, taking a long position in one
instrument and a short position in another
in the expectation that the yield spread
between them will alter as a result of
anticipated economic or financial market
developments. Growth in derivatives
markets and the use of information and

execution technology (including access to

real-time information) have enabled
investors to build financial structures that
take on the exact exposures they wish to hold
while largely neutralising the associated
general market risks. Equally, they have
increased the scope for index and other
arbitrage trades to maintain the relationship
between derivatives markets and the
underlying cash markets. Securities lending
markets have provided the liquidity needed
to hold these positions. Meanwhile, market
authorities in many jurisdictions have
sought to address many of the legal,
regulatory and tax impediments to securities
lending. As authorities have taken action to
reduce the scope for activities such as tax
arbitrage, position taking to minimise
market risks has become the main driver
behind demand for securities borrowing.
Some key events have also shaped the
evolution of the market. For instance, in
1994, the increase in US short-term interest
rates led some securities lenders to
experience losses on their reinvested cash
collateral. In many cases, custodian banks
compensated customers for their losses even
where they were not legally obligated to do
so. This experience made lenders more aware
of the investment management side to their
securities lending activities. Many have
introduced risk/return analysis and industry
benchmarking.
The development of active repo market in
various countries from 1993 onwards has a
number of specific implications for market

participants, for securities market

infrastructure, and for market authorities,
including central banks and securities
regulators. The common theme connecting
all of these various implications is the need
for a clear understanding and identification
of the risks and risk management approaches
associated with securities lending.

Receive payments (known as corporate

actions) equivalent to any coupons,
interest or other rights that have arisen
on the securities in the interim;.

Receive a fee for lending the security.

The fee is normally calculated at an
annual rate based on the value of
securities borrowed. The fee amount will
also depend on the demand/supply
equations for the specific securities at
the material time;

Require collateral from the borrower,

either in the form of cash or other
securities. The amount of collateral
requirement may vary during the course
of the loan to accommodate changes in
the value of the securities lent. Generally
the value of the collateral will be higher
than the value of the securities loaned
towards haircut. Collateral is marked to
market, (usually daily) when the current
value of collateral held is compared with
current value of the loaned stock. Based
on the outcome of such valuation, some
of the collateral held may be returned in
surplus situations, or margin calls made
in deficit situations. Interest and other
income arising on the collateral will
generally be returned to the borrower.

Relevance
The relevance of such an arrangement arises
from its ability to generate market liquidity
when required to cover short positions that
arise in securities settlement.
Simultaneously, it is an avenue through
which dormant securities in an investors
portfolio can be utilized for short tenor
lending to generate fee based income,
especially in a volatile market. It constitutes
a collateralized loan of securities for a
limited period of time in a transparent
structured institutional framework.
At the micro level, securities lending, as a
practice has evolved to assist market makers
and other security dealers to obtain
securities on loan for a temporary period to
meet deliveries on sales that they have made
of those securities, when the dealer has
insufficient stock of its own to meet the
delivery. It is an essential mechanism to
ensure liquidity and efficient operations of
the Securities market.
Together with retaining the right to have the
borrowed security replaced at a future date
with securities of the same kind and amount,
the lender will normally:

Institutional investors are increasingly

joining securities lending programmes to
generate returns on assets that would
otherwise remain idle. Various securities
lending programmes allow clients to retain
full beneficial ownership of loaned
securities throughout the term of a loan.

Clients can also recall the loan at any time if

they wish to sell the securities, exercise
voting rights or participate in corporate
actions. Investors also use income from
securities lending to offset their custody
costs. Institutional investors participate in
securities borrowing programs mainly to
pursue portfolio strategies such as arbitrage
and short selling.
Objectives
To improve settlement efficiency by
reducing settlement failures
To enhance the liquidity of instruments
through the market making process
To increase the attractiveness of
instruments by enhancing yields for
lenders
Legal Position
Legal title of securities lent passes from
lender to borrower at the time of lending and
back to lender from borrower when the
securities are returned.
The lender still retains risk and exposure to
the market place for the lent securities as well
as all the benefits including corporate
actions or dividends. The lender does lose
the voting rights to the securities over the
loan period.
The lender has the right to recall securities
on loan at any time, unless otherwise agreed
with the borrower.

Risks
The risks inherent in lending securities are
not always readily apparent, but must be
recognised as an important consideration
when operating a Securities Lending
programme.
1. Counterparty Risk
Many complications could arise when
counterparty defaults on its obligations. A
thorough credit assessment and quality of
the management of all counterparties is
usually undertaken to determine their
financial status. Reviews are then
undertaken regularly.
2. Collateral Adequacy
The haircut which represents the margin
above market value must adequately cover
market fluctuations, particularly in a rising
market. This risk is minimised by
continually monitoring collateral levels and
making timely margin calls.
Current market practice dictates collateral to
be around 105 110% of the market value of
the loaned securities.
3. Collateral Title Risk
A lender should always ensure there is clear
title to the collateral he holds. This is
especially so with cash. An existing charge
over the borrowers assets may give a
liquidator the right to recall cash collateral
without necessarily returning the underlying

stock because of imperfect set-off. To a large

extent, these problems are addressed through
proper documentation in the form of a
Master Securities Lending Agreement.

due date. The lender must also ensure that

where securities were on loan over exentitlement dates, but returned prior to the
payable date, that the benefit due is secured.

4. Delivery Risk

The Indian Position

Delivery risks occur both when Securities

have been lent and collateral has not been
received at the same time or prior to the loan,
and when collateral is being returned but the
loan return has not been received. In todays
electronic society delivery risk can be
reduced with Delivery Versus Payment (DVP)
transactions. At this time only cash
transactions are covered under DVP..

In India, the government securities market

has witnessed drastic changes since 1994 i.e.
inception of Primary Dealers (PD) system.
Till that time banking sector was investing
only for the purpose of statutory
requirements and Funds and Insurance
companies as final investors. Introduction
of PDs in India has helped move towards
achieving the objective of increase in market
depth and liquidity as well. Moreover, PDs,
while acting as market makers, have made
the market more vibrant along with existing
market players and new players like Foreign
Institutions, Mutual Funds and Insurance
Companies. The daily turnover in outright
transactions has increased manifolds from a
few hundred crores in 1990-93 to well over
two/three thousand croes today. Indeed, it
has even gone beyond ten thousand crores a
day in 2004. Further, at the instance of RBI,
CCIL became operational from Feb. 2002
extending guaranteed settlement of
government securities trades with netting
benefits which has improved manifold
efficiencies in the settlement system
facilitating the introduction of DVP III
settlement system on 01 April 2004.

5. Regulatory Risk
Participants should always be aware of any
regulatory constraints, for example, in some
countries a loan of securities can not be
outstanding for a term longer than 12
months else it is classed as a sale and the
return would be classed as a purchase.
6. Market Risk
Although maintaining margins through
Mark to Market alleviates market risk, the
risk can be made up of many components
including price volatility, market liquidity
and exchange rate fluctuations. Strong
procedures and control systems are essential
in managing this risk.

st

7. Accrued Benefits
The lender must be able to accurately
determine which benefits he is due, and the
borrower must be able to remit them on the

To ensure timely and efficient securities

settlement in the Government Securities
Market as also to achieve reductions in

attendant systemic and operational risks, a

s e c u r i t i e s b o r ro w i n g a n d l e n d i n g
arrangement in government securities was
considered necessary to effectively meet
instances of securities shortages in the
settlement processes. Accordingly, in terms
of the authority vested with RBI in the
Finance Bill 2002-2003, a Securities Lending
and Borrowing Scheme for government
securities was approved by RBI on 3 April
2003. The transactions under the scheme
stands exempted from capital gains tax. The
key guidelines of the Scheme are
rd

The scheme is a limited purpose one

with its scope and purpose restricted to
assist CCIL in ensuring timely
settlement of government securities
transactions in the secondary market
Only CCIL is authorized to borrow
securities under the scheme;
RBI proposes to keep membership to the
scheme restricted to the bare minimum;
Specific RBI approval is necessary to
admit market participants into the
scheme;
The Scheme has been operationalised by
CCIL with effect from 25 October 2004.
Currently two large market players
participate as approved members of the
Scheme. The arrangement entails transfer of
ear-marked securities to a dedicated SGL
Account with RBI by the participating
members which can be accessed by CCIL to
handle shortages.
th

The above Securities Lending & Borrowing

Scheme strengthens CCILs ability to meet
instances of securities shortages. However,
there is still scope for shortage allocations
due to the variety of instruments available
for trading in the secondary market some of
which have very little liquidity, for instance
most of the State Government Development
Loans. The probability of default on any of
such instruments in a day can not be
estimated with any degree of preciseness.
Further keeping all such securities readily
available at all times is impracticable. This
has a limitation in CCILs ability to meet all
instances of securities shortages under the
current T+0 settlement system especially in
the light of relative settlements taking place
towards late evening well after market hours.
Once the market moves to T+1 settlement
system and subject to requisite regulatory
approval wider participation as also
alternate methodologies such as automatic
electronic access to concerned SGL Accounts
through a deemed repo arrangement;
introduction of real time Market Auction
System etc. could be considered.
The existence of an efficient Securities
Lending and Borrowing Program capable of
meeting the twin objective of injecting
market liquidity and meeting all instances of
securities shortages on a cost-effective basis
is imperative before ushering in important
market reforms such as short-selling in
government securities.
(Source BIS and RBI guidelines.)