Financial Markets Operations Management (46 page)
Read Financial Markets Operations Management Online
Authors: Keith Dickinson
A corporate action is any situation or event that is initiated by the issuing company and which has an impact on the issuer itself and/or the issuer's shareholders or bondholders.
Corporate actions can be either benefits (e.g. a cash dividend paid to shareholders) or “situations” that impact the issuer's balance sheet (e.g. a capitalisation issue).
Some types of corporate action are known as mandatory events. These occur without any beneficial owner choice (e.g. a stock split). Other types are optional or voluntary, where the beneficial owner has a choice to make (e.g. a rights issue).
There is a large number of corporate action types, ranging in complexity from reasonably straightforward (e.g. a share consolidation) to complicated and time-consuming (e.g. a hostile, contested takeover bid).
All corporate actions are time-sensitive and care must be taken especially when handling optional events, as failure to execute a required action by a specified date can result in substantial financial losses.
Corporate actions can be grouped into nine key event-type categories with numerous sub-types:
- Capital changes:
Bonus issue, consolidation, enfranchisement, distribution, forward stock split, par value change, recapitalisation, redenomination, renominalisation, reverse stock split, rights offering, unit split, spin off, scheme of arrangement. - Dividends:
Cash dividend, disbursement, dividend waived, return of capital, scrip dividend, stock dividend, dividend reinvestment plan. - Earnings:
Actual earnings, forecasted earnings, adjusted earnings. - Payments:
Cash payment, interest payment, payment waived, return of debt, scrip payment. - Mergers:
Merger, merger election, offer to buy, takeover, demerger. - Redemptions:
Call, escrow to maturity, fixed redemption, full call, partial call, partial pre-refunded, pre-refunded, repayment, sinking fund redemption. - Repurchases:
Buy-back, consent, consent tender, conversion, exchange, exercise, odd lot tender, partial put/retainment option, put mandatory, put optional, relinquishment option, retainment option, tender offer. - Shareholder meetings:
Shareholder meeting, Annual General Meeting, Extraordinary General Meeting. - Information announcements:
Bankruptcy, default, information, liquidation, name change, new offer, poison pill.
Here you will find a list of voluntary and mandatory events for both equities and bonds. This list is an extract from the Securities Market Practice Group's “SMPG CA Global Market Practice â Part 2 for Standards Release 2014” released 12 February 2014.
The EIG+ tab contains the following information:
- Corporate action event name;
- A definition plus any comments made by the SMPG;
- Short name code for the event (CAEV);
- Mandatory/voluntary/choice indicator code (CAMV);
- Other technical information.
The SMPG Corporate Actions Global Market Practice Part 1 document, together with the Part 2 spreadsheet, is updated fairly often. It is, therefore, a good idea to visit the website frequently.
The full list is available to guest visitors and can be obtained from
http://smpg.webexone.com
.
Click through to Documents>Public Documents>2. Corporate Actions>A. Final Global Documents>2. CA Global Market Practice â Part 2 â SR2014 V1.1.xlsm (last updated 1Â August 2014).
Securities Financing
In Chapter 7: Securities Clearing, we saw that forecasting was an important part of the clearing process. We require sufficient cash to pay for our purchases and securities availability to ensure delivery of our sales.
Recall our choices in
Table 12.1
.
TABLE 12.1
Financing choices
| Transaction | Comments | Financing Choices |
| Our purchases | Our funding costs increase if we are unable to pay for our purchases. The trades might settle (incurring overdraft charges) or might be blocked by the clearing house (resulting in interest charges from our counterparties). |
|
| Our sales | We will not receive the cash proceeds as expected. We will lose re-investment opportunities and the lack of cash might also result in failed purchases. |
|
We can conclude that securities financing allows us to borrow cash for our purchases (and other funding requirements) and borrow securities to facilitate our sales (and other securities deliveries).
There are three types of securities financing:
- Securities lending and borrowing;
- Repurchase agreements;
- Sell/buy-backs.
By the end of this chapter, you will be able to:
- Understand the different types of securities financing;
- Follow the lifecycle of a securities financing transaction;
- Appreciate the risks involved and how they can be mitigated;
- Understand the roles of the participants and intermediaries.
Securities financing is the temporary lending of assets to a borrower in exchange for a fee. Asset types include:
- Cash
- Securities
- Equities
- Bonds
- Equities
We will see that cash is lent and borrowed predominantly through repurchase agreements and, to a much lesser extent, sell/buy-backs and securities through securities lending and borrowing.
Securities lending and borrowing (“securities lending”) involves a transfer of securities (such as shares or bonds) from a “lender” to a third party (the “borrower”), who provides the lender with collateral in the form of shares, bonds or cash.
1
Legally, a securities loan is the transfer of title against an irrevocable undertaking to return equivalent securities. This means that registered securities such as shares will be transferred out of the lender's name into that of the borrower and registered back in the lender's name when they are returned.
When we look at the motivations for securities lending, we will see that the borrower will sell, lend-on or otherwise dispose of the securities. In order to do this, the borrower must have legal ownership of the securities. The lender therefore surrenders legal ownership, implying a disposal rather than a temporary loan of the securities.
A securities lending agreement will bridge the gap between the legal and economic nuances of this business. For securities lending, the Global Master Securities Lending Agreement (GMSLA), published by the International Securities Lending Association (ISLA), is used.
A repurchase agreement (
repo
) is the sale of securities together with an agreement for the seller to buy back the securities at a later date. The primary purpose of a repo is to enable the seller to borrow cash using the securities as collateral.
If the above definition of a repo is stated from the seller's point of view, what is the buyer's?
For the buyer, there is an agreement to purchase securities together with an agreement to sell them back to the seller. The primary purpose is to enable the buyer to lend cash, taking the securities as collateral. We refer to this agreement as a
reverse repo
.
In any particular transaction, there will be a repo (seller) and a reverse repo (buyer).
A repo is generally used to raise cash, i.e. for financing purposes. A repo can also be securities-driven, i.e. the “buyer” is borrowing securities and using cash as collateral.
The legal agreement is the Global Master Repurchase Agreement (GMRA), published jointly by the Securities Industry and Financial Markets Association (SIFMA) and the International Capital Market Association (ICMA).
In contrast to securities lending and repo activities, which are covered by the various editions of the GMSLA and GMRA respectively, sell/buy-back transactions were traditionally a sale of and a subsequent re-purchase of securities. These were undocumented and treated as two separate transactions. Today, sell/buy-backs are documented and covered by the GMRA supported by a sell/buy-back annex.
Apart from some operational differences, a documented sell/buy-back is similar to a repo and a buy/sell-back to a reverse repo.
Undocumented sell/buy-back transactions are riskier than those covered by the appropriate documentation.
The three types of securities financing transaction are summarised in
Figure 12.1
.
FIGURE 12.1
Summary of securities financing transactions
| Characteristic | Securities Lending | Repo Agreements & Documented Sell/Buy-Back | Undocumented Sell/Buy-Back |
| Motivation | Security specific | Financing or Security specific | Financing |
| Maturity | Open (Call) or Term | Open (Call) or Term | Open (Call) or Term |
| Method of exchange | Sale with agreement to purchase equivalent securities | Sale with agreement to purchase equivalent securities | Sale and repurchase |
| How exchanged |
|
| Cash vs. Securities |
| Collateral type |
|
| Usually bonds |
| Collateral substitution | Borrower's choice |
| No |
| Return paid to giver of: |
| Cash | Cash |
| Form of return |
| Interest rate quoted as a repo rate (paid as interest on the cash) | Interest rate quoted as a repo rate (paid through the difference between sale price and buy-back price) |
| Income (coupons & dividends) | Manufactured and paid to the lender | Paid to original seller | Normally factored into the buy-back price |
| ( * ) The cash giver receives interest on the cash (rebate rate) and the cash taker reinvests the cash (reinvestment rate) at a higher interest rate. The difference between the reinvestment and rebate rates represents the return to the securities lender. |
We have seen that securities financing is driven by the need for either cash or securities and that the transactions are collateralised by appropriate securities and cash. In this section, we will consider the players from the perspective of the buy side and the sell side. Buy-side motivation is basic; sell-side motivation is more complex.
These characteristics can be attractive to potential borrowers requiring access to cash and/or securities.
There is only one reason why any of the above buy-side institutions would want to lend its securities and cash: to earn a return. This return can be explicit in terms of earning fees or interest on cash balances or implied in terms of reduced custody fees incurred by the institution. It is also true that securities lending and securities-specific repo and sell/buy-back transactions increase securities liquidity in the market.
There are several reasons why any institution might require access to securities and cash. These include:
- To cover a short position (securities);
- To finance an inventory position (cash);
- To benefit from a temporary transfer of ownership (securities).
Let us take a look at some examples of the reasons for borrowing securities and cash.
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You purchase USD 5,000,000 of a bond from one counterparty and sell USD 4,000,000 of the same bond to another counterparty, both for the same settlement date. On the settlement date the purchase fails; this leaves you short of bonds for the sale, which results in a second settlement fail. By borrowing USD 4,000,000 of the bond you will be able to settle the sale. This situation gives you two benefits:
- As you have not had to pay for the purchase, you have “use of funds”;
2
and - You have the sale proceeds which you can make use of.
On settlement of the purchase, you will be able to repay the loan of USD 4 million of the bond. The funding benefit of your positive cash flow should outweigh the cost of borrowing the bonds.
We covered the subject of fails management in more detail in Chapter 8.
You are a dealer and you take the view that shares in a company are about to go down in price. You do not have a position in the shares. In order to benefit, you sell the shares now and plan to buy them back at some unspecified future time when, hopefully, the price has gone down. As you have executed a sale, you have an obligation to deliver shares that you do not have. In order to settle your sale, you will need to borrow the shares until such time as you buy them back.
As a market maker, you have the obligation to make a two-way price under any market conditions. If the market comes to you with more “buy orders” than “sell orders”, you might be going short of securities to deliver. In this case, you will need to borrow some from securities and return them when your inventory goes long.
An arbitrage strategy involves going long in one security and short in another, often related, security. The short position will need to be covered by borrowing the securities.
An example would be a convertible bond arbitrage where the arbitrageur buys a convertible bond and sells the equivalent number of underlying shares. For this strategy to work, the arbitrageur will need to borrow the shares until such time as the arbitrage is closed (i.e. buy the shares, sell the convertible bond and repay the loan of shares).
A derivatives trader writes call options on a single stock in the expectation that he will not be called upon to exercise and deliver the underlying shares.
When a dealer buys one or more securities, it can finance the purchase costs using repo or sell/buy-back transactions. The dealer can either repo the purchased securities straight back to the original selling counterparty or repo other securities using the cash to finance the original transactions.
Arbitrage opportunities can arise when ownership of equities is temporarily transferred. However, securities lending in these situations may not be regarded as acceptable practice. There are three examples to consider:
- Dividend arbitrage;
- Scrip dividend arbitrage;
- Exercising voting rights.
This is a tax-avoidance scheme used by investors based in a country that does not have a double taxation agreement with the country in which the investment is located and taxed (foreign investor). If the tax rate is 25%, then the foreign investor will receive 75% of the dividend.
With a dividend arbitrage, the shares are lent through an intermediary to a local company (borrower) over the dividend period. The borrower receives the dividend with a tax credit of 30%, enabling it to reclaim part of the tax paid by the corporation. Therefore, for every 1.00 of dividend, it is worth 1.43 to the borrower [1.43
*
(100% â 30%) = 1.00].
The shares are then returned to the original lender (the foreign investor) and the increase in dividend shared between the three parties involved, with the lender receiving either an extra lending fee or a manufactured dividend.
Arbitrage opportunities can arise when a company announces a dividend and gives the shareholder the option of receiving either cash or more shares. An arbitrageur will borrow the shares over the dividend period with an agreement that he will pay cash to the lender. The borrower will know how many shares are available based on an average of several days' closing prices following the ex-dividend date.
However, the decision as to whether to take cash or shares does not have to be made for several weeks. Depending on what the share price subsequently does, the borrower will either take cash or shares which can then be sold for a profit as the example in
Tables 12.2
and
12.3
illustrates.
TABLE 12.2
Scrip dividend arbitrage
| Holding | 10,000 | Shares | Â | Â |
| Dividend | 0.50 | per share = | 5,000.00 | Cash |
| Average Closing Price | 25.00 | per share | Â | Â |
| New Shares in lieu of cash dividend | 200 | Shares | i.e. [5,000/25] | Â |
TABLE 12.3
Decision â cash or shares?
| Share Price Movement | Price | Action Taken by Borrower | Result | Cash |
| Increases to | 30.00 | Take shares in lieu, sell them and pay dividend to lender | Sell 200 shares @ 30.00 | 6,000.00 |
| Pay dividend to lender | â5,000.00 | |||
| Profit: | 1,000.00 | |||
| Decreases to | 20.00 | Take cash dividend and pay dividend to lender | Receive dividend | 5,000.00 |
| Pay dividend to lender | â5,000.00 | |||
| Profit: | 0.00 |
On the decision date, the borrower must decide whether to take cash or shares (
Table 12.3
).
An organisation could influence the corporate governance of a company without being a beneficial owner by borrowing shares and voting on them at an AGM or EGM. The UK's Bank of England addressed this point in its 2009 Code of Guidance.
Firstly, it noted that: “⦠securities should not be borrowed solely for the purpose of exercising the voting rights⦔ and secondly, that lenders should: “⦠consider their corporate governance responsibilities before lending stock over a (AGM/EGM) period⦔.
3
We have seen that there are various reasons why companies should want to borrow securities and that some might be questionable in terms of tax avoidance or corporate governance issues. It is for these reasons that the regulators allow securities lending and borrowing to take place for so-called permitted purposes. These permitted purposes can be summarised as follows:
- Facilitating the settlement of a trade;
- Facilitating delivery of a short sale;
- Financing the security;
- Lending to another borrower who is motivated by one of these permitted purposes.