Financial Markets Operations Management (47 page)
Read Financial Markets Operations Management Online
Authors: Keith Dickinson
It is highly unlikely that a beneficial owner of securities will lend directly to the ultimate borrower of securities. There could be a “chain” or “conduit” of borrowings starting with the lender, who lends to the first borrower, who, in turn, lends to the second borrower. In this scenario, the lender could not know who the second borrower was.
There are two types of intermediary: agent intermediaries and principal intermediaries.
Agent intermediaries will, in all probability, be offering other services to their clients wishing to lend their securities. Take the example of a pension fund. A pension fund will appoint a fund manager to manage its assets. The pension fund (or its fund manager) will appoint a custodian to look after its assets including clearing and settlement, safekeeping and asset servicing.
The pension fund is the beneficial owner and might wish to take advantage of securities lending activities. It would be unlikely that the pension fund would have the resources and expertise to directly manage its own securities lending programme, and so it might appoint either its fund manager or its custodian to manage a programme on a discretionary basis.
In addition to fund managers and custodian banks, there are third-party agents that specialise in the management of securities lending programmes. These three types of intermediary act as agents on behalf of their clients; they will deal with the borrowers, manage the programme and share in the fees earned. Whilst they have a duty of care towards their clients, agent intermediaries do not take principal risk.
Principal intermediaries can act either on their own behalf as borrowers or on behalf of their clients. The main differences between a principal and an agent intermediary are that a principal intermediary can perform the following roles:
- Providing a credit-based intermediary service; for example, the lender might be happy to lend to the principal from a credit point of view but might not be willing to lend directly to the borrower.
- Assuming liquidity risk by borrowing from a lender on an “open” basis and lending on a “term” basis to a borrower.
- Establishing a “one-to-many” type of relationship between lender and borrower; for example, the principal intermediary might be able to satisfy a single borrower's request from many lenders (and also vice versa).
Examples of principal intermediaries include:
- Broker/dealers in order to support proprietary trading, market making and on behalf of clients such as prime brokers.
- Specialist intermediaries, who might only provide a service between the lenders and, for example, market makers.
- Prime brokers servicing the needs of hedge funds and managers of alternative investment funds.
We have, on the one hand, institutions that are willing to lend their securities and, on the other hand, institutions that wish to borrow the securities. The question arises as to what would be the best way for a borrower to obtain the securities it requires.
Before we can answer this, we need to know what makes a good lender â a “good lender” from the point of view of the borrower. Which of the portfolio types in
Table 12.4
do you think would be of more interest to a potential
borrower?
TABLE 12.4
Lenders' portfolio characteristics
| Portfolio Characteristics | Portfolio “A” | Portfolio “B” | Portfolio “C” |
| Size | USD 10 million | USD 1 billion | USD 20 billion |
| Average size of each holding | USD 250,000 | USD 5,000,000 | USD 10,000,000 |
| Average number of holdings | 40 | 200 | 2,000 |
| Investment strategy | Passively managed | Actively managed | Passively managed |
| Diversification | Domestic equities and bonds | Global equities | Global equities and bonds |
| Attitude to risk | Risk averse â high quality collateral required | Medium risk â wider range of acceptable collateral | Risk flexible â wide range of acceptable collateral across most asset classes |
A potential borrower might be attracted to all three portfolios as they could contain many of the securities it requires. However, the borrower should consider the following possible hurdles:
- Portfolio “A”:
This portfolio is somewhat limited in terms of geographical reach (domestic securities), has relatively few holdings, each with an average size of USD 250,000 and is somewhat cautious in terms of risk (will only accept high quality collateral). On the positive side, this is a passively managed portfolio, suggesting that the holdings do not change frequently. - Portfolio “B”:
This is a larger portfolio than “A” with a greater number of holdings and a somewhat more flexible approach to collateral requirements. The portfolio is reasonably diversified albeit in one asset class only. A possible disadvantage is that the portfolio is actively managed, suggesting that any securities that the borrower takes could be recalled at any moment. - Portfolio “C”:
This portfolio would appear to be the more attractive proposition. It has a large number of holdings, each of a good size, it is passively managed and well diversified. In addition to this, the portfolio has a flexible approach to collateral.
Taking these factors into account and with all things being equal, you might expect most borrowers would want to approach Portfolio “C” in the first instance. It might well be the case that the other two portfolios might only ever be approached occasionally, if at all.
If Portfolios “A” and “B” wish to lend securities, their only choice might be to use an agent intermediary such as their custodian and participate in its managed lending programme on a pooled basis. On the other hand, Portfolio “C” might be attractive enough that principal intermediaries would wish to deal directly with that portfolio.
You will recall that the definitions of securities financing imply from a legal standpoint that the lender is, in fact, disposing of its securities and the borrower is acquiring them. One of the purposes of a legal agreement is to turn the disposal/re-acquisition concept into an economically temporary and short-term collateralised lending transaction. For this to occur, securities financing is supported using legally accepted agreements. These agreements were traditionally negotiated bilaterally between lender and borrower/agent. Over time, these agreements have become globally standardised.
Copies of these agreements can be found on the appropriate website and are free to download. Please note that there might be two or more versions of an agreement as these are updated periodically.
The master agreements for the securities lending business can be found on the International Securities Lending Association's website at
www.isla.co.uk/index.php/master-agreements
where you will find the documents shown in
Table 12.5
.
TABLE 12.5
ISLA documentation
| Documentation | Version | Date |
| Global Master Securities Lending Agreement (GMSLA) | GMSLA 2010 | July 2012 with minor changes to the 2010 version |
| Â | GMSLA (US Tax Addendum 2013) | November 2013 |
| Â | GMSLA (UK Tax Addendum 2014) | December 2013 |
| Â | Freshfields' Guidance Notes | April 2010 |
|  | â¦together with previous versions and an archive. | |
| Netting opinions | Available on subscription only | |
| Securities Lending Set-Off Protocol |
| |
| Industry documentation | Key aspects of working practice, including the Bank of England's “Securities Lending and Repo Committee â Stock Borrowing and Lending Code of Guidance â July 2009”. |
You can also find a list of current best practice papers on the website (
www.isla.co. uk/index.php/bestpractices
) which includes the titles in
Table 12.6
.
TABLE 12.6
Best practice papers
| Title | Date |
| ISLA Agency Lending Disclosure Approval of Principals â Best Practice Paper | October 2013 |
| Statement of Market Guidance: Securities Lending (Fixed Income) Contract Compare | April 2013 |
| Fixed Income Loan Redemptions and Coupon Collection | February 2010 |
| Billing Statement Report Format for Equity Loans | July 2009 |
| Mark to Market for Equity Loans | June 2009 |
| Contract Compare | April 2009 |
| Mark to Market Report Formats for Equity Loans | March 2009 |
| Billing Compare | December 2008 |
| Returns and Recalls | December 2008 |
| Manufactured Income Collection | January 2008 |
If you have not already done so, please download the GMSLA 2010 and familiarise yourself with the main topics noted therein. We will refer to this agreement when we go through the lifecycle in Section 12.6 below.
The International Capital Market Association (ICMA), together with what is now the Securities Industry and Financial Markets Association (SIFMA), introduced the first version of the Global
Master Repurchase Agreement (GMRA) in 1992. The agreement has been updated three times, with the current version being the GMRA 2011.
Three versions (1995, 2000 and 2011) are available on the ICMA website (
www.icmagr oup.org/Regulatory-Policy-and-Market-Practice/short-term-markets/Repo-Markets/global-m aster-repurchase-agreement-gmra/#list
). For the 2011 version, you can also find the following documents:
- Revised version of the GMRA Protocol;
- GMRA 2011 black-lined to show changes from GMRA 2000;
- Guidance Notes to the GMRA 2011;
- Buy/Sell-Back Annex to the GMRA 2011;
- Bills Annex to the GMRA 2011;
- Agency Annex to the GMRA 2011;
- Equities Annex to the GMRA 2011;
- Russian Annex to the GMRA 2011;
- Russian Translation of the GMRA 2011.
In order to cover the validity of the GMRA and the enforceability of the netting provisions contained within the agreement, ICMA has obtained legal opinions covering 62 countries (plus a supplement for Switzerland). These are referred to as the 2013 GMRA Legal Opinions and they consist of a Core Opinion of the GMRA and various SLAs plus specific appendices covering each of the agreements.
The Bank of England's Securities Lending and Repo Committee published the
Securities Borrowing and Lending Code of Guidance
in 2009 and the
Gilt Repo Code of Guidance
in 2008. These are currently under review
4
and are available on request.
5
The 2009 Code of Guidance can also be found on the ISLA website (
www.isla.co.uk/index.php/master-agree ments/industrydoc
).
In this section we will look at the lifecycle of a securities loan. There are three phases that we will look at in more detail:
- Phase 1: Loan initiation;
- Phase 2: Loan maintenance;
- Phase 3: Loan closure.
Securities lending is another example of a collateralised activity; you will recall that we previously looked at collateral for non-centrally cleared derivatives in Chapter 9.
Remember that there are several ways in which the beneficial owner is able to lend securities through the appointment of:
- A local/global custodian as agent;
- A third-party specialist as agent;
- A principal as an intermediary;
- A proprietary principal;
- A combination of the above.
Whilst these approaches will differ in detail, the concepts will remain fairly similar.
Loans can be initiated in several ways that range from an
ad hoc
approach, to automatic lending and borrowing, and to the use of electronic trading platforms specifically set up for this purpose.
It is more usual for the borrower to make the initial approach; however, the more proactive lenders (or their agents) may offer securities that are “in demand” to potential borrowers.
In addition, a borrower acting as principal might be free to deal with a lender depending on the relationship and the size and constitution of the lender's lendable portfolios. Conversely, an agent might very well have to allocate loans to its lenders' accounts in proportion to the available balances.
A borrower acting in a principal capacity is more likely to approach a lender with whom it has a good working relationship in terms of securities availability, a diverse range of securities and contractual arrangements. It is less likely to deal with a smaller lender that lacks the size of the previous lender, has fewer attractive securities and is more restrictive in terms of loan initiation and loan recalls (see
Table 12.7
).
Although all four lenders have positions in the shares, the borrower has chosen to take one delivery from Lender A. If this situation was to be repeated, then Lenders B, C and D may not benefit very much.
TABLE 12.7
Lending example 1
| Size of Loan: 100,000 Shares | |||
| Client | Available Position | Loan Debited | Remaining Position |
| Lender A | 250,000 | 100,000 | 150,000 |
| Lender B | 20,000 | 0 | 20,000 |
| Lender C | 15,000 | 0 | 15,000 |
| Lender D | 40,000 | 0 | 40,000 |
| Total: | 325,000 | 100,000 | 225,000 |
A borrower approaches an agent such as a global custodian and is able to borrow the full amount of securities it has requested. The global custodian has a number of lendable clients from which it will apportion the loan, as noted in
Table 12.8
.
In this scenario no one client is able to satisfy the borrowing requirement. In any event, the global custodian will satisfy the borrowing by making one delivery but will debit the clients' positions in proportion to their available positions. The global custodian can be seen to be treating its clients in a fair and equitable manner.
TABLE 12.8
Lending example 2
| Size of Loan: 100,000 Shares | |||
| Client | Available Position | Loan Debited | Remaining Position |
| Client A | 50,000 | 40,000 | 10,000 |
| Client B | 20,000 | 16,000 | 4,000 |
| Client C | 15,000 | 12,000 | 3,000 |
| Client D | 40,000 | 32,000 | 8,000 |
| Total: | 125,000 | 100,000 | 25,000 |
Whether acting in a principal or intermediary role, a borrower might experience difficulties in obtaining the quantity of securities it requires. The particular security might be
on demand
(also referred to as being
special
) and perhaps rather illiquid.
A borrower approaches each of the four potential lenders in turn, finding that none of them is able to satisfy the borrowing in one amount. In fact, the requirement can only be satisfied by taking shares from all four lenders (see
Table 12.9
).
TABLE 12.9
Lending example 3
| Size of Loan: 100,000 Shares | |||
| Client | Available Position | Loan Debited | Remaining Position |
| Lender A | 25,000 | 25,000 | 0 |
| Lender B | 20,000 | 20,000 | 0 |
| Lender C | 15,000 | 15,000 | 0 |
| Lender D | 40,000 | 40,000 | 0 |
| Total: | 100,000 | 100,000 | 0 |
There is a means by which a borrower who has unsuccessfully approached a lender is able to temporarily place a “hold” on some of the securities that he needs. We refer to this “hold” as
icing
and in the example above, the borrower would request Lender A to ice 25,000 shares.
The icing might only last for a short period of time, but it enables the borrower to go elsewhere in the certain knowledge that it has at least some of the shares it needs. The borrower repeats this process with Lenders B and C (60,000 shares iced) before finally finding the remaining 40,000 shares with Lender D. The icing should only be used for this purpose and not to prevent other borrowers from being able to get hold of the shares. Icing is a short-term facility which usually expires after a few hours or by close of business on that same day.
This process can be speeded up through the use of electronic platforms that enable lender (or agent) and borrower to communicate available positions and borrowing requests in a timely manner.
Once the borrower has found the securities it needs, it then needs to agree to the terms of the borrowing.
These terms include those listed in
Table 12.10
.
TABLE 12.10
Borrowing terms
| Terms | Comments | |
| Duration of loan | Term | The securities are required for a specific period, e.g. one week, 30 days, etc. |
| Acceptable collateral | Open | The securities can be recalled by the lender or returned by the borrower at any time. |
| Cash | Currency acceptable to both parties. | |
| Fees | Non-cash | Eligible assets, e.g. government securities, letters of credit, etc. |
| Rebate rate | Cash collateral. | |
| Delivery instructions | Premium or fee rate | Non-cash collateral. |
| Loaned securities and collateral | Bank account and settlement details. |
The loan transaction should be confirmed as soon as possible, in a similar way to any other type of transaction, and details should include the contract date, the settlement date and the terms noted in
Table 12.10
.
In
Table 12.11
we have an example of a securities lending transaction.
TABLE 12.11
Loan transaction
| Transaction Date | Mon, July 7, 2014 | Date loan is negotiated | |
| Settlement Date | Mon, July 7, 2014 | Â | Date loan commences |
| Term | Open | Â | Open = At call |
| Security | Marks & Spencer | Ordinary shares | |
| Ticker | MKS:LSE | Stock exchange ticker symbol | |
| Security Price (GBX) | 441.40 | Pence per share | |
| Quantity | 5,000,000 | Shares | |
| Loan Value | GBP 22,070,000.00 | Quantity à Price | |
| Delivery | DVP | From lender's account | |
| Lending Fee | 25 | Basis points | per annum |
| Collateral | DBVs | Type of collateral | |
| Margin | 5.00% | Typical margin rate for non-US securities | |
| Collateral Required | GBP 23,173,500.00 | Based on the margined value of the loaned securities | |
| Lending Income | GBP 151.16 | Per day | Value of loan at the lending fee per day |
Ideally, collateral should be received at the same time as the securities are delivered. This is achievable where cash is provided as collateral (on a delivery versus payment basis). There are difficulties, however, when non-cash is delivered as collateral, as simultaneous delivery versus delivery may not be possible. Assuming the securities and non-cash collateral are exchanged on the same day, at the very least there will be daylight exposure, as both securities and collateral will be delivered at different times of the day.
Depending on the relationship between the lender and borrower, it might be possible for the collateral to be delivered before the securities (i.e. pre-collateralisation), in which case the exposure risk is transferred to the borrower. There is an alternative to pre-collateralisation known as
delivery by value
(DBV) and we will cover this in Section 12.8.5.
Ideally, the securities lent and non-cash collateral given should both be settled as soon as possible, certainly within the normal market convention for the assets concerned. For example, the market convention for regular settlement is T+3, with delivery of loans and returns/recalls on T+0. Having shorter delivery periods enables the lending and borrowing process to be more efficient, especially in terms of accuracy and timeliness.
The loan commencement, i.e. the delivery of securities to the borrower, is shown in
Figure 12.2
.
FIGURE 12.2
Loan commencement
This is the end of the first phase in which the loan has been initiated. Until such time as the securities are returned by the borrower or recalled by the lender, the loan has to be maintained and the collateral managed.
Throughout the life of a loan, it is necessary to ensure that the value of collateral always exceeds the value of the loan. This is to ensure that there will always be sufficient collateral to liquidate and with the cash proceeds replace the securities lent.
The example shown in
Table 12.12
will illustrate the situation outlined in the Q&A section above.
TABLE 12.12
Correlation between loaned securities and collateral
| Â | Value of Loan | Value of Collateral | Difference | Result |
| Start of business | 100,000 | 105,000 | 5.00% | Acceptable |
| Close of business §1 | 95,000 | 106,000 | 11.58% | Over-collateralised |
| Close of business §2 | 105,000 | 107,000 | 1.90% | Under-collateralised |
At the start of business, the difference between the values of the loan and collateral is 5%.
By the close of business in scenario §1, the loan value has dropped and the collateral value increased. The resulting difference has widened to 11.58% and the loan is over-collateralised. In this case, the borrower would expect to recall sufficient collateral to return the difference to 5%.
By the close of business in scenario §2, the values of both the loan and the collateral have increased (albeit not by the same percentage). The difference has narrowed so that the loan is under-collateralised. If the borrower were to default at this stage, then there would be only just sufficient collateral to cover the replacement of the loan, placing the lender at risk.
So, one element of our loan maintenance is to ensure that there is sufficient collateral at all times and furthermore that the difference between the valuations is at a pre-agreed level. We refer to this difference as the loan
margin
and in the example above, the margin is 5%. Whilst there are no specific rules in this regard, market convention tends to follow the values shown in
Table 12.13
.
TABLE 12.13
Margin percentages
| Market(s) | Margin |
| USA securities | 2% |
| Rest of the world securities | 5% |
Please note that these margin levels are negotiable, and in markets where the operations are more problematic (e.g. settlements and custody), the margin could be higher.
A daily revaluation (also known as a
mark-to-market
) is usually sufficient under normal market conditions. Lenders, or their agents, do have the right under the SLA to call for extra margin during a day (an
intra-day margin call
).
Margin calls can be settled as soon as they are requested or, if there is an agreed threshold in place, as soon as the threshold has been exceeded (see
Table 12.14
).
TABLE 12.14
Margin calls and thresholds
| Â | Loan Value | Collateral Value | Threshold | Action Required | New Collateral Balance |
| A | 110,000 | 105,000 | None | Borrower pays extra 10,500 margin | 115,500 |
| Â | Â | 25,000 | Extra margin accounted for but not paid | Â | |
| B | 95,000 | 105,000 | None | Lender repays 5,250 margin to borrower | 99,750 |
| Â | Â | 25,000 | Reduced margin accounted for but not paid | Â |
In example A in
Table 12.14
, the loan value has exceeded the collateral value and the lender calls for extra margin/collateral from the borrower. If there is no threshold then a delivery is made; if the threshold is, say, 25,000, then no actual deliveries are made but the extra amount is accounted for in the books and records.
In example B in the table, we have the opposite situation, where the loan value has dropped and the borrower requests a repayment of margin/collateral from the lender. Again, if there is no threshold, then a delivery is made; with a threshold, no deliveries are made and entries are passed in the books and records.
Every day, using the previous day's closing prices, you should revalue the securities that are “on loan” and the collateral that has been taken, ensuring that the correct margin level is maintained. Subject to any threshold, the lender will call for more margin if the margin level has decreased below the required level, or the borrower will request a
return of some collateral if the margin level has increased. An example, using a small portfolio of European equities, is shown in
Table 12.15
.
TABLE 12.15
Portfolio of European securities
| Equities Lent | Quantity | Price (EUR) | Value (EUR) |
| Aegon, shares | 170,000 | 6.91 | 1,174,700.00 |
| BASF, shares | 15,000 | 76.59 | 1,148,850.00 |
| Lafarge, shares | 25,000 | 54.08 | 1,352,000.00 |
| Repsol, shares | 75,000 | 18.13 | 1,359,750.00 |
| Value of loan portfolio: | 5,035,300.00 | ||
| Margin level @ | 5% | 251,765.00 | |
| Collateral required: | 5,287,065.00 |
We can see that the amount of collateral required to cover a loan portfolio worth approximately EUR 5 million can be calculated to be just under EUR 5.3 million.
Whenever non-cash collateral is given, there is the risk that the value of the underlying assets will decline. We therefore have a combination of issuer risk and market risk. The riskier the underlying security, the greater is the chance that the issuer might default or the market value decline.
In addition to margining the securities loan, the collateral taker will reduce the market value of the collateral by a certain percentage (the
haircut
). For the collateral giver, this means that extra collateral must be given, i.e. an
excess
.
Asset types with a low risk will attract a low haircut; the riskier the asset type, the greater the haircut. We can also factor credit ratings and maturities into our risk ranking, as the following exercise will illustrate.
Table 12.16
shows some standard supervisory haircuts. We can draw some conclusions as to the degree of haircut required for the different asset classes.
TABLE 12.16
Standard supervisory haircuts
| Issue Rating for Debt Securities | Residual Maturity | Sovereigns | Other Issuers |
| AAA to AAâ | < 1 year | 0.50% | 1.00% |
| Â | 1 to 5 years | 2.00% | 4.00% |
| Â | > 5 years | 4.00% | 8.00% |
| A+ to BBBâ | < 1 year | 1.00% | 2.00% |
| Â | 1 to 5 years | 3.00% | 6.00% |
| Â | > 5 years | 6.00% | 12.00% |
| BB+ to BBâ | All | 15.00% | Â |
| Â | Main index equities (including convertible bonds) and gold | 15.00% | |
| Â | Other equities listed on an exchange (including convertible bonds) | 25.00% | |
| Â | Cash in the same currency | 0.00% |
We can come to the following conclusions:
- Sovereign borrowers that have good credit ratings and have issued securities with less than 12 months to maturity require a lower haircut compared with borrowers with poorer credit ratings and securities with more than five years to maturity.
- With debt securities, the longer the time to maturity, the greater the risk of default. Longer-term debt securities therefore require greater haircuts.
- Equities in general require greater haircuts than sovereign and non-sovereign issuers, although listed equities that are not on a main index (e.g. DAX, CAC, etc.) attract a greater haircut than equities that are on the main index.
- Cash in the same currency does not attract any haircut; cash foreign currency is exposed to FX risk and might therefore need to be assessed for a haircut.
You will recall that legal title to securities that are lent and collateral that is given changes from giver to taker. Under the terms of the Securities Lending Agreement, the securities borrower and the collateral taker are obliged to “manufacture” any benefits and pass them back to the securities lender and the collateral giver. In effect, the income payer is simply a cash payer, with the cash representing the amount of income; hence, we use the term
manufactured income
. (This makes sense as an issuer is only able to pay a particular dividend or coupon once and manufacturing income overcomes the problem of a multiple income payment.)
The amount of income (dividends and coupons) payable should be the amount that the beneficiary would have received if it had not lent the securities or given the collateral.
Any difference in the amount will be for the account of the payer. For example, ABC announces a dividend of 2.00 per share. A securities lender has lent 100,000 shares to a borrower. ABC pays the dividend to the borrower with a 20% withholding tax deduction. The lender is entitled to receive dividends with a 10% deduction (see
Table 12.17
).
TABLE 12.17
Cost to borrower through WHT differences
| Â | Party | Gross Amount | WHT Rate | Net Amount |
| Dividend paid | Borrower | 200,000.00 | 20% | 160,000.00 |
| Dividend owed to | Lender | 200,000.00 | 10% | 180,000.00 |
| Cost to borrower | Â | Â | Â | â20,000.00 |
In this example, had the lending institution not lent 100,000 ABC shares, then the amount of dividend receivable would have been 180,000.00.
This situation would not arise for gross-paying securities, e.g. Eurobonds.
It is not possible to manufacture voting rights and therefore the securities lender loses the right to vote. The only way the lender (as the beneficial owner of the securities) can vote is to recall the securities in time to exercise the vote and hope that they can re-lend after the vote has taken place.
Securities lenders are entitled to benefit from the many different types of corporate action (e.g. bonus issues, rights issues, takeovers, etc.). In Chapter 11, you saw some examples of these corporate action events, and there will be different ways of approaching them from a securities lending point of view. In general, however, the securities lender is made good by the borrower (and the collateral giver by the collateral taker).