Overview of Securities Lending
Securities lending arrangements arise when a holder of securities agrees to provide them to a borrower for a period of time. At the end of the period, the borrower returns replacement securities, which are either the original securities, or more commonly are equivalent in number and type to the original securities.
The borrower provides the lender with collateral for the term of the loan, and pays the lender a fee for the use of the borrowed securities. The borrower also compensates the lender for rights and distributions accruing on the borrowed securities during the term of the loan. The lender therefore retains the same portfolio as he had at the outset.
Borrowers require securities because of the margin, derivative, and settlement requirements of the securities markets while lenders seek an additional return by way of fees paid by a borrower.
History of Securities Lending
Securities lending first appeared, in the United Kingdom, during the 60’s and later came to prominence in other markets including the United States, Germany and Japan.
Originally appearing in the Operations area’s of Brokers it has expanded rapidly in recent years and is now a “front office” 24-hour global activity. Securities lending activities add liquidity and efficiency to the market place, supporting the trading activities and strategies in all major markets.
History of Securities lending in Australia
Securities Lending first appeared in the 70’s on an informal basis between Stock Brokers. By the middle of the 80’s, Securities Lending in Australia was growing but was still a fairly marginal business. The level of borrowing was stifled by the high costs and consisted mainly of brokers covering failed trade settlements. The major lenders were the nominee arms of the major trading banks, which accessed securities from their domestic and international custody clients.
It was not until the latter stages of the late 1980’s stock market “bull run” that the volume of securities lending grew. This growth, however, was tempered in Australia by the enactment of two pieces of taxation legislation.
In September 1985, the introduction of Capital Gains Tax legislation (CGT) deemed security loans to be effective disposals for CGT purposes. Most taxable lenders therefore discontinued their activities. Only tax exempt superannuation funds continued to supply the market until they themselves became taxable in May 1988.
The 1988 taxation changes fundamentally altered borrowing practices in this country. Failed trade borrowing diminished, while larger arbitrage driven borrowing was necessarily sourced offshore.
Subsequently, as the availability of offshore securities increased, substantial downward pressure on rates was applied. Overseas lenders, accustomed to lower returns in their markets were prepared to undertake Australian lending for lower fees than the domestic lenders had been.
Towards the end of 1989, the Australian Government instituted a package of reforms designed to alleviate the competitive disadvantages being experienced by domestic lenders. Further reforms made during 1991 mostly restored the ability of domestic lenders to compete with their international counterparts.
The Australian Stock Exchange implemented fixed T + 5 settlement in April 1992. T + 5 settlement was the part of the drive to comply with the directives of the Group of Thirty. This process was continued by the implementation of the CHESS clearance system in late 1994.
With the implementation of T + 5 settlement, lending volumes gradually fell as domestic and offshore market participants became familiar with its administration and failed trade volumes decreased. During late 1992 and 1993 lending volumes grew again due to the market’s increasing sophistication and the wider use of derivative instruments. In these cases, stock borrowing is required to facilitate hedging, short-sales and other exchange traded and Over-the-Counter derivative instruments.
The increasing volumes also encourages the entrance of new lenders. Domestic institutions are increasingly viewing securities lending as a new way to increase revenues, while more overseas institutions are expanding their lending portfolios to include Australian securities.
The securities lending and borrowing operations of most market participants were originally part of their administration areas. Since 1993, due to securities lending staff becoming more experienced, and the market more sophisticated, desks have frequently moved into the trading areas, or have become distinct departments of their own, reflecting the fact that they are not only a support function, but also a revenue centre in their own right.
The Reasons for Borrowing
Why Organisations borrow stock can be categorised into four broad groups.
1. Borrowing for Failed Trades
A failed trade may be defined as one where delivery cannot be completed because of insufficient securities available. This is not deliberate policy, but is caused by any number of general administrative problems. Borrowings to cover fails are mostly small and short in duration (one to five days). The borrower keeps the loan open only until he can complete delivery of the underlying trade.
An example of this type of transaction occurs when a broker’s client sells stock, but fails to deliver the securities to his broker. The broker borrows the stock, settles the trade and places the resultant settlement funds on deposit. He thereby earns interest on this cash and avoids fail fines. He then unwinds the loan once the client has delivered his securities.
2. Borrowing for Margin Requirements.
To meet margin requirements, for example at the Exchange Traded Options Market. Securities can be borrowed cheaply and lodged as margin, rather than depositing cash.
3. Borrowing for Market Making and Proprietary Trading.
Market Makers and Proprietary Traders are by far the largest borrowers of stock in Australia and are responsible for the majority of securities lending transactions in this country.
These traders sell stock for a variety of reasons, most of which are hedging related. Activities under this category include short selling, equity/share price index arbitrage, equity/ derivative arbitrage, and equity option hedging.
Stock loans drawn down by market makers and traders are typified as being large in volume and long in duration. For lenders, these loans represent the greatest opportunity to maximise profit.
4. Intermediary Brokers.
Intermediaries act between lenders and borrowers. For their services, the intermediary takes a spread. Many institutions find it convenient to lend stock to one or two intermediaries who then on-lend to many more counterparties. This saves administration and limits credit risks.
Depending on the type of collateral lodged, a lender can earn fees on securities loans in two ways. Where a lender receives cash collateral, the lender is expected to invest this cash and to earn at least the “overnight cash” interest rate. From the interest received, the lender deducts his fee and “rebates” the balance to the borrower at the end of each month. Alternatively, where non-cash collateral is lodged, a fee rate is used to calculate fees payable. The Borrower forwards fees, to the Lender, monthly in arrears.
The Lender’s fee is negotiated with the Borrower are depends on loan size, duration, availability and “special” situations.
Risks in Security Lending
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 can arise when a counterparty defaults on its obligations. A thorough credit assessment of all counterparties should initially be undertaken to determine their financial status. Reviews should then be undertaken regularly. In this context, it is important to keep in mind that the fortunes of many potential counterparties can rapidly change.
Other factors to take into account – the quality of the counterparty’s management and financial controls.
2. Collateral Adequacy
The margin above market value must cover market fluctuations, particularly in a rising market. This risk can be minimised by continually monitoring collateral levels and making timely margin calls.
Current market practice in Australia dictates collateral to be at least 105% 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 borrower’s 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 in the Master Securities Lending Agreement.
4. Delivery Risk
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 but at this time only cash transactions are covered.
Some other risks are – Will cheques lodged as collateral be honoured? Will the Share Registry accept the security transfers on loan repayments? The integrity of counterparties is important.
Although not common in Australia some Lenders insist on prepayment of collateral one day in advance of delivering the loan securities, and on repayment of the loaned securities, collateral is returned one day later.
5. Regulatory Risk
Participants should always be aware of any regulatory constraints, for example, in Australia a loan of securities may not be outstanding for a term longer than 12 months or it is classed as a sale and the return would be classed as a purchase. Subsequently capital gains tax would apply.
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.
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 due date. The lender must also ensure that where securities were on loan over ex-entitlement dates, but returned prior to the payable date, that the benefit due is secured.
Legal Title of Securities Owned
Legal title of securities lent passes from the lender to the borrower and back to the lender 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.
Participants should never transact in the Securites Lending Market without relevant legal agreements. The most recognised agreements in the market are the OSLA, the ISDA, and the PSMA/ISMA. The Australian market uses a modified OSLA known as the Australian Master Securities Lending Agreement (AMSLA).
The above agreements outline the relationship and responsibilities of each counterparty and can be amended to cover securities lending in any market. Amendments are usually through riders or addendums attached to the original agreement.
The AMSLA is used for both agency and principle transactions. An Agent lends securities on behalf of the beneficial owner and does not take on any risk for the transaction, subsequently the counterparty risk lies with the beneficial owner and the borrower. In a principle transaction, although the lender may not be the beneficial owner, he takes on the risk associated with the loan to the borrower.
There is also a second type of agreement used in the market usually between custodians and their portfolio clients. This agreement authorises the custodian to lend the clients portfolio and may also outline counterparty and collateral policies.