An Introduction to

Securities Lending
Fourth Edition

Mark C. Faulkner, Managing Director

Spitalfields Advisors
 An Introduction to
Securities Lending
Fourth Edition
Mark C. Faulkner, Managing Director
Spitalfields Advisors

About the Author

Mark Faulkner is Managing Director and co-founder of Spitalfields Advisors Limited. The
company is an independent specialist consultancy firm and its focus is upon the provision of
consultancy services to institutions active, or considering becoming active in the securities
finance markets, particularly beneficial owners. Spitalfields Advisors assists institutions
embarking on securities lending reviews and also analyses existing programmes and suggests
opportunities for improvement.

Mark is also the Chief Executive Officer of Data Explorers Limited. The company provides clients
with insights into comparative risk and performance measurement using proprietary Risk
Explorer and Performance Explorer services. Data Explorers also conducts a wide range of
quantitative research projects and benchmarking exercises on behalf of customers. The Index
Explorer service highlights the potential impact of securities lending upon market prices and
corporate governance.

After graduating from the London School of Economics, Mark Faulkner spent the majority of his
career specialising in International Securities Finance. Since 1987, he has held management
responsibility at L.M. (Moneybrokers) Ltd., Goldman Sachs, Lehman Brothers and more recently
at Securities Finance International Limited.

Whilst occupying these different posts he has gained experience as a lender, borrower, conduit
borrower and prime broker. During his career he has worked closely with the UK Inland Revenue
and has represented firms at the Securities Lending and Repo Committee and the London Stock
Exchange's securities lending committees. Being an independent advisor since 1995 has
provided Mark with a unique insight into the operation of the securities financing market.

To download a free copy of this book or contact Mark about it please visit:

www.spitalfieldsadvisors.com

Disclaimer
The views expressed in this publication are those of the author. Every care has been taken to
ensure that the contents are accurate. However, neither the author, nor the commissioning
bodies nor the publishers can accept any responsibility for any errors or omissions. The
publishers or author can accept no responsibility for loss occasioned to any person acting or
refraining from action as a result of any material in this publication.

1
 Spitalfields Advisors Limited
155 Commercial Street
Table of contents
London E1 6BJ
United Kingdom

Published in the United Kingdom

By Spitalfields Advisors Limited, London
Acknowledgements 7
First published, 2004
© Mark C. Faulkner, 2007 Executive Summary 9
Fourth Edition, 2007
All rights reserved. No part of this publication may be reproduced, stored in a retrieval system,
or transmitted, in any form or by any means, without the prior permission in writing of Chapter 1 What is securities lending? 15
Spitalfields Advisors Limited, or as expressly permitted by law. Enquiries concerning
reproduction outside the scope of the above should be sent to the Publications Department,
Spitalfields Advisors Limited, at the address above. This book may not be circulated in any Chapter 2 Lenders and intermediaries 23
other binding or cover and this condition must be imposed on any acquirer.
Telephone: +44 (0)20 7247 8393 Chapter 3 The borrowing motivation 29
Fax: +44 (0)20 7392 4004
Email: [email protected]
Web: www.spitalfieldsadvisors.com Chapter 4 Market mechanics 35

Design: Radford Wallis

Printing: Linkway CCP Chapter 5 Risks, regulation and market oversight 41

Chapter 6 Securities Lending & Corporate Governance 47

Chapter 7 Frequently asked questions 55

Appendix 1 A Short History of Securities Lending 63

Appendix 2 Terms of Reference of the SLRC 67

Glossary 69

Reference Sources 75

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 Foreword
Securities lending is a long-established practice which plays an important role in today's capital
markets by providing liquidity that reduces the cost of trading and promotes price discovery in
rising as well as falling markets. The resultant increase in efficiency benefits the market as a
whole - from the securities dealers and end investors through to the corporate issuers which
depend on efficient, liquid markets to raise additional capital.

Securities lending markets allow market participants to sell securities that they do not own in
the confidence that they can be borrowed prior to settlement. They are also used for financing,
through the lending of securities against cash, forming an important part of the money markets.
The ability to lend and borrow securities freely underpins the services that securities dealers
offer their customers and the trading strategies of dealers, hedge funds and other asset
managers. On the lending side, securities lending forms a growing part of the revenue of
institutional investors, custodian banks and the prime brokerage arms of investment banks.

This publication aims to describe these markets, with an emphasis towards the United Kingdom,
although UK markets are highly international in terms of both participation and securities
traded. The intended audience is not market practitioners but others with some interest in
securities lending, including trustees of pension or other funds that already lend their securities
or might consider doing so, managers of companies whose securities are lent, financial
journalists, the authorities and other interested parties.

The genesis of the idea to produce this publication goes back to 2003 and discussions in the
Securities Lending and Repo Committee. This committee brings together market practitioners,
the UK authorities and infrastructure providers, with the Bank of England chairing and providing
administrative support. At that time because of falling share prices, some commentators were
drawing links with securities lending and short selling, often revealing some misunderstanding
of how the markets actually worked. This was hardly surprising. Securities lending markets are
complex, with multiple layers of intermediaries, transaction terms and pricing that can be
opaque to those not directly involved in it. Confusing terminology and market jargon does not
help (one reason for the glossary). There seemed to be no authoritative publication, written by
market practitioners, which described and explained the modern markets for a non-expert.

In response to this information gap the original sponsoring organisations, representing the
different players in the market, selected Mark Faulkner to author “An Introduction to Securities
Lending”. The objective was and still remains, to produce an accurate and accessible
description of the markets and how they work, who is involved and why.

“An Introduction to Securities Lending” was originally commissioned by the Securities Lending
and Repo Committee, the International Securities Lending Association, the London Stock
Exchange, the London Investment Banking Association, the British Bankers’ Association and the
Association of Corporate Treasurers and was first published in 2004. It was welcomed by the
National Association of Pension Funds and the Association of British Insurers.

The section on 'Corporate Governance' highlighted the importance of ensuring that beneficial
owners are made aware that when shares are lent the right to vote is also transferred. The
publication also emphasised that a balance needs to be struck between the importance of
voting and the benefits derived from securities lending, and went on to recommend that
beneficial owners should have a clear policy in place to address this.

Recognising that the debate had moved on in many ways since the original publication,
sponsoring organisations felt it would be a useful and timely exercise to produce an update,

4 5
 taking current market practice into account and, in particular, exploring how the different
stakeholders can arrange their securities lending and corporate governance requirements in
Acknowledgements
order to minimise any possible conflict between the two. The result was a paper, entitled
“Securities Lending and Corporate Governance”, first published in June 2005. The publication of the Third Edition of An Introduction to Securities Lending is made possible
by the generous support of the following organisations:
This Fourth Edition of An Introduction to Securities Lending incorporates the corporate
governance publication.

Richard Steele
Chairman
International Securities Lending Association

Whilst researching and writing this book the author received assistance from the following
individuals and organisations:

The Original Authorship Committee

David Rule, Consultant, International Securities Lending Association
Simon Hills, British Bankers’ Association
Dagmar Banton, London Stock Exchange
John Serocold, London Investment Banking Association
Andrew Clayton, International Securities Lending Association

Other contributors
Joyce Martindale, Head of Performance and Risk, Railway Pension Investments Ltd
Susan Adeane, Company Secretary, Railway Pension Investments Ltd
Habib Motani, Partner, Clifford Chance
Niki Natarajan, Editor, InvestHedge
Andrew Barrie, Director, Barrie & Hibbert
Jackie Davis, Publications Manager, British Bankers' Association
Dr. Bill Cuthbert, Chairman, Spitalfields Advisors
Mark Hutchings, Chairman, International Securities Lending Association

An Introduction to Securities Lending, 2003

Commissioned by
Association of Corporate Treasurers
British Bankers’ Association
International Securities Lending Association
London Investment Banking Association
London Stock Exchange
Securities Lending and Repo Committee
Welcomed by
National Association of Pension Funds
Association of British Insurers

Securities Lending & Corporate Governance, 2005

Commissioned by
International Securities Lending Association

6 7
 Endorsed by
Association of Corporate Treasurers
Executive Summary
British Bankers’ Association
London Stock Exchange Securities lending – the temporary transfer of securities on a collateralised basis – is a major
National Association of Pension Funds and growing activity providing significant benefits for issuers, investors and traders alike. These
Securities Lending and Repo Committee are likely to include improved market liquidity, more efficient settlement, tighter dealer prices
and perhaps a reduction in the cost of capital.
He would like to express his gratitude for their assistance, encouragement and support.
The scale of securities lending globally is difficult to estimate, as it is an “over the counter”
rather than an exchange-traded market. However, it is safe to say that the balance of securities
on loan globally exceeds £3 trillion.

What is securities lending?

Securities lending is now an important and significant business that describes the market
practice whereby securities are temporarily transferred by one party (the lender) to another (the
borrower). The borrower is obliged to return the securities to the lender, either on demand or
at the end of any agreed term.

However, the word ‘lending’ is in some ways misleading. In law the transaction is in fact an
absolute transfer of title (sale) against an undertaking to return equivalent securities. Usually
the borrower will collateralise the transaction with cash or other securities of equal or greater
value than the lent securities in order to protect the lender against counterpart credit risk.

Some important consequences arise from the nature of securities lending transactions:

• Absolute title over both lent and collateral securities passes between the parties,
therefore these securities can be sold outright and “on lent”. Both practices are
commonplace and an intrinsic part of the functioning of the market.
• Once securities have been acquired, the new owner of them has certain rights. For
example, it has the right to sell or lend them on to another buyer and vote in AGMs.
• The borrower is entitled to the economic benefits of owning the lent securities (e.g.
dividends) but the agreement with the lender will oblige it to make (“manufacture”)
equivalent payments back to the lender.
• A lender of equities no longer owns them and has no entitlement to vote. But it is
still exposed to price movements on them since the borrower can return them at a
pre-agreed price. Lenders typically reserve the right to recall equivalent securities from
the borrower and will exercise this option if they wish to vote. However, borrowing
securities for the specific purpose of influencing a shareholder vote is not regarded as
acceptable market practice.

Different types of securities lending transactions

Most securities loans are collateralised, either with other securities or with cash deposits. Where
lenders take securities as collateral, they are paid a fee by the borrower. By contrast, where they
are given cash as collateral, they pay the borrower interest but at a rate (the rebate rate) that
is lower than market rates, so that they can reinvest the cash and make a return. Pricing is
negotiated between the parties and would typically take into account factors such as supply
and demand for the particular securities, collateral flexibility, the size of any manufactured
dividend and the likelihood of the lender recalling the securities early. For example, fees for
borrowing UK FTSE 100 equities against securities collateral ranged from 10 – 50 basis points
per annum and fees for borrowing conventional UK government bonds from 3 – 13 basis points
per annum towards the beginning of 2007.

8 9
 As well as securities lending, sale and repurchase (repo) and buy-sell back transactions are used apparently overvalued security is sold short.
for the temporary transfer of securities against cash. In general, securities lending is more likely • Merger arbitrage: for example, selling short the equities of a company making a
to be motivated by the desire to borrow specific securities, repo, and buy-sell backs by the takeover bid against a long position in those of the potential acquisition company.
desire to borrow cash – but this boundary is fuzzy. For example, reinvestment of cash collateral • Index arbitrage: selling short the constituent securities of an equity price index (e.g.
has been an integral part of the securities lending business for many years, particularly in the FTSE 100) against a long position in the index future (e.g. FTSE 100 contract on LIFFE).
United States, with reinvestment opportunities often driving the underlying securities lending
transactions. Short positions also arise as a result of failed settlement (with some securities settlement
systems arranging for automatic lending of securities to prevent chains of failed trades) and
Lenders and intermediaries where dealers need to borrow securities in order to fill customer buy orders in securities where
they quote two-way prices.
The supply of securities into the lending market comes mainly from the portfolios of beneficial
owners, such as pension and other funds, and insurance companies. Underlying demand to Not all securities lending is motivated by short selling. Financing drives many transactions – the
borrow securities begins largely with the trading activities of dealers and hedge funds. lender is seeking to borrow cash against the lent securities, whether using repo, buy/sell backs
or cash-collateralised securities lending.
In the middle are a number of intermediaries. The importance of intermediaries in the market
partly reflects the fact that securities lending is a secondary activity for many of the beneficial Another large class of transactions not involving a short comprises those motivated by lending
owners and underlying borrowers. Intermediaries provide valuable services, such as credit in order to transfer ownership temporarily, an arrangement which can work to the advantage of
enhancement and the provision of liquidity, by being willing to borrow securities at call while both lender and borrower. For example:
lending them for term. They also benefit from economies of scale, including the significant
investment in technology required to run a modern operation. • Where a lender would be subject to withholding tax on dividends or interest but some
potential borrowers are not. The borrower receives the dividend free of tax, and shares
Intermediaries include custodian banks and asset managers lending securities as agents on some of the benefit with the lender in the form of a larger fee or larger manufactured
behalf of beneficial owners, alongside the other services provided to these clients. Some dividend.
specialist securities lending agents have also emerged. Agents agree to split securities lending • Where an issuer offers shareholders the choice of receiving a dividend in cash or
revenues with lenders and may offer indemnities against certain risks, such as borrower default. reinvesting it in additional securities (scrip) at a discount to the market price, but some
funds (e.g. index trackers) are unable to take the more attractive scrip alternative
Another category of intermediary is dealers trading as principals. Dealers intermediate between because their holdings would become larger than permitted under investment
lenders and borrowers, but they also use the market to finance their own wider securities guidelines. The borrower chooses the scrip dividend alternative and sells the securities
trading activities. They may seek returns by taking collateral, counterpart credit or liquidity risk, in the market. Again, the return is shared with the lender through a larger fee or larger
for example, by lending securities to a client for a period while borrowing them on an open manufactured dividend.
basis with a risk of early recall by the lender. Through their prime brokerage operations, they
also meet the needs of hedge funds and the borrowing of securities to finance their positions Trading and settlement
has grown rapidly.
The securities lending market is a hybrid between a relationship-based market and an open,
For beneficial owners, there are a number of different possible routes into the market. These traded market. Historically, transactions were negotiated by telephone but increasingly securities
include using an agent (custodian bank, asset manager or specialist) to manage a lending are broadcast as available at particular rates using email or other electronic platforms.
programme, auctioning a portfolio to borrowers directly, selecting one principal borrower,
establishing an ‘in-house’ operation and lending directly or some combination of these Loans may be either for a specified term, or more commonly, open to recall, because lenders
strategies. typically wish to preserve the flexibility for fund managers to be able to sell at any time.

The borrowing motivation Settlement occurs on a shorter time frame than outright transactions, so that securities can be
borrowed to cover a sale.
The most common reason to borrow securities is to cover a short position – using the borrowed
securities to settle an outright sale. But this is rarely a simple speculative bet that the value of In most settlement systems securities loans are settled as “free of payment” deliveries and the
a security will fall so that the borrower can buy it more cheaply at the maturity of the loan. collateral taken is settled quite separately, possibly in a different payment or settlement system
More commonly, the short position is part of a larger trading strategy, typically designed to and maybe a different country and time zone. This can give rise to “daylight exposure”, a period
profit from perceived pricing discrepancies between related securities. For example: in which the lent securities have been delivered but the collateral securities have not yet been
received. To avoid this exposure some lenders insist on pre-collateralisation, so transferring the
• Convertible bond arbitrage: buying a convertible bond and simultaneously selling the exposure to the borrower.
underlying equity short.
• “Pairs” trading: seeking to identify two companies, with similar characteristics, whose In the United Kingdom, CREST has specific settlement arrangements for stock lending
equity securities are currently trading at a price relationship that is out of line with the transactions.
historical trading range. The apparently undervalued security is bought, while the

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 UK Stamp Duty UK regulation
London Stock Exchange rules require lending arrangements in securities on which UK Stamp Any person conducting stock borrowing or lending business in the United Kingdom would
Duty/Stamp Duty Reserve Tax (SDRT) is chargeable to be reported to the Exchange. This enables generally be carrying on a regulated activity according to the terms of the Financial Services and
firms to bring their borrowing and lending activity ‘on Exchange’ making them exempt from Markets Act 2000 (Regulated Activities) Order 2001, and would therefore have to be authorised
Stamp Duty/SDRT under Inland Revenue regulations. Non-Exchange member firms that conduct and supervised under that Act. The stock borrower or lender would, as an authorised person,
borrowing and lending activity through a member firm are also eligible for stock lending relief be subject to the provisions of the Financial Services Authority (FSA) Handbook, in particular
from Stamp Duty/SDRT. the Inter-Professional Conduct chapter; and they would also have to have regard to the market
abuse provisions of the Financial Services and Markets Act 2000 and the related Code of Market
Companies Act 1985 Conduct issued by the FSA. The FSA Handbook contains rules, guidance, and evidential
provisions relevant to the conduct of the firm in relation to the FSA’s High Level Standards.
Firms that are engaged in equity stock borrowing or lending in the United Kingdom will need
to comply, where appropriate, with the notification requirements applying to notifiable interest Stock Borrowing and Lending Code
in shares as set out in Part VI of the Companies Act 1985.
In addition to the prudential standards set by the FSA, market participants have drawn up a
Stock Borrowing and Lending Code, which UK-based market participants observe as a matter of
Transparency in the UK market good practice. The Code does not in any way replace the FSA’s or other authorities’ regulatory
requirements, nor is it intended to override the internal rules of settlement systems as regards
CREST provides some time-delayed information on the values of securities financing borrowing or lending transactions.
transactions in the FTSE 100, FTSE 250 and Small Cap. This information was first published in
September 2003 and excludes intermediary activity andcollaterall trading where possible. Securities Lending and Repo Committee

Risks and risk management The Securities Lending and Repo Committee (SLRC) produced the Code. The SLRC provides a
forum in which structural developments in the stock lending and repo markets can be discussed
When taking cash as collateral. A lender taking cash as collateral pays rebate interest to the and recommendations made by practitioners, infrastructure providers and authorities. Its terms
securities borrower, so the cash must be reinvested at a higher rate in order to make any net of reference are shown in Appendix 2.
return on the collateral aspect of the transaction. Expected returns can be increased by
reinvesting in assets with more credit risk or longer maturity in relation to the likely term of the Many questions are asked about the securities lending industry and Chapter 7 (Frequently asked
loan, with a risk of loss if market interest rates rise. Many of the large securities lending losses questions) responds to many of these. They have been grouped into legal, dividends and
over the years have been associated with reinvestment of cash collateral. coupons, collateral and risk management, operational and logistical, corporate governance and
lending options for beneficial owners.
Transaction collateralised with other securities. Added to the risk of errors, systems failures and
fraud that are always present in any market, problems can arise from the default of a borrower. Finally, every market has its own jargon and securities lending is no exception. Appendix 3 is a
Following a default the lender must sell its collateral in the market in order to raise the funds glossary of terms.
to replace the lent securities. It will lose money if the value of the collateral securities falls
relative to that of the lent securities. Generally, the risk of loss is greater if it takes longer to Securities lending is too significant to ignore. It touches the interests of securities investors,
close out these positions, if the collateral or lent securities are wrongly valued, if the markets companies that issue securities, market intermediaries and the authorities. It is also too central
for these securities are illiquid or if the market prices of the lent and collateral securities do not to the efficient running of the modern financial markets to be misunderstood. This book is
tend to move together. intended to provide an authoritative introduction to the modern industry.

Securities lending & corporate governance

Securities lending and the pursuit of good corporate governance are not necessarily in conflict.
Both activities can and do co-exist happily within the investment management mainstream.
Today, many of the foremost proponents of good corporate governance successfully combine an
active voting role with a successful securities lending role. The information flow and
communication necessary to ensure that conflict is avoided is already in place but could be
developed further. Those that are concerned about possible conflict need to openly discuss the
issue with their securities lending counterparts and corporate governance colleagues. There is
no need for anyone to feel that securities lending will disenfranchise them. At all times it should
be remembered that the owner of the securities determines whether securities are either lent
or voted.

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 Chapter 1 What is securities lending?
Securities lending began as an informal practice among brokers who had insufficient share
certificates to settle their sold bargains, commonly because their selling clients had mislaid their
certificates or just not provided them to the broker by the settlement date of the transaction.
Once the broker had received the certificates, they would be passed on to the lending broker.
This business arrangement was not subject to any formal agreement and there was no exchange
of collateral.

Securities lending is now an important and significant business that describes the market
practice whereby securities are temporarily transferred by one party (the lender) to another (the
borrower). The borrower is obliged to return the securities to the lender, either on demand or
at the end of any agreed term. For the period of the loan the lender is secured by acceptable
assets delivered by the borrower to the lender as collateral.

Under English law, absolute title to the securities “lent” passes to the “borrower”, who is
obliged to return “equivalent securities.” Similarly the lender receives absolute title to the
assets received as collateral from the borrower, and is obliged to return “equivalent collateral.”

Securities lending today plays a major part in the efficient functioning of the securities markets
worldwide. Yet it remains poorly understood by many of those outside the market.

Definitions
In some ways, the term “securities lending” is misleading and factually incorrect. Under English
law and in many other jurisdictions, the transaction commonly referred to as “securities lending”
is, in fact...

“a disposal (or sale) of securities linked to the subsequent reacquisition of equivalent

securities by means of an agreement.”

Such transactions are collateralised and the “rental fee” charged, along with all other aspects
of the transaction, are dealt with under the terms agreed between the parties. It is entirely
possible and very commonplace that securities are borrowed and then sold or on-lent.

There are some consequences arising from this clarification:

1. Absolute title over both the securities on loan and the collateral received passes
between the parties.
2. The economic benefits associated with ownership – e.g. dividends, coupons etc. – are
“manufactured” back to the lender, meaning that the borrower is entitled to these
benefits as owner of the securities but is under a contractual obligation to make
equivalent payments to the lender.
3. A lender of equities surrenders its rights of ownership, e.g. voting. Should the lender
wish to vote on securities on loan, it has the contractual right to recall equivalent
securities from the borrower.
4. In the United Kingdom appropriately documented securities lending transactions avoid
two taxes:
Stamp Duty Reserve Tax and Capital Gains Tax.

Different types of securities loan transaction

Most securities loans in today’s markets are made against collateral in order to protect the

14 15
 lender against the possible default of the borrower. This collateral can be cash, or other The example in the previous diagram shows collateral being held by a Tri Party Agent. This
securities or other assets. specialist agent (typically a large custodian bank or International Central Securities Depository)
will receive only eligible collateral from the borrower and hold it in a segregated account to the
(a) Transactions collateralised with other securities or assets order of the lender. The Tri Party Agent will mark this collateral to market, with information
distributed to both lender and borrower (in the diagram, dotted “Reporting” lines). Typically the
borrower pays a fee to the Tri Party agent.
Loan Loan
Lender Borrower Lender Borrower There is debate within the industry as to whether lenders that are flexible in the range of non-
cash collateral they are willing to receive are rewarded with correspondingly higher fees. Some
argue that they are, others claim that the fees remain largely static but that borrowers are more
Reporting Reporting Collateral Collateral
prepared to deal with a flexible lender and therefore balances and overall revenue rise.

Tri Party Tri Party Box 1: Cash flows on a securities loan against collateral other than cash
Agent Agent
The return to a lender of securities against collateral other than cash derives from the fee
charged to the borrower. A cash flow of this transaction reads as follows:
Loan Commences Loan Terminates
Transaction date 13th June 2006
Non-cash collateral would typically be drawn from the following collateral types: Settlement date 16th June 2006
Term Open
• Government Bonds Security XYZ Limited
• Issued by G7, G10 or Non-G7 governments Security price £10.00 per share
• Corporate Bonds Quantity 100,000 shares
• Various credit ratings Loan value £1,000,000.00
• Convertible Bonds Lending fee 50 basis points (100ths of 1 per cent)
• Matched or unmatched to the securities being lent Collateral UK FTSE 100 Concentrated DBVs
• Equities Margin required 5%
• Of specified Indices Collateral required £1,050,000.00 in DBVs
• Letters of Credit Daily lending income £1,000,000.00 x 0.005 x (1/365) = £13.70
• From banks of a specified credit quality
• Certificates of Deposit Should the above transaction remain outstanding for one month and be returned on 16th July
• Drawn on institutions of a specified credit quality 2006 there will be two flows of revenue from the borrower to the lender.
• Delivery By Value (“DBVs”)1
• Concentrated or Unconcentrated On 30th June fees of £191.80 (£13.70 x 14 days)
• Of a certain asset class On 31st July fees of £219.20 (£13.70 x 16 days)
• Warrants
• Matched or unmatched to the securities being lent Thus total revenue is £411.00 against which the cost of settling the transaction (loan and
• Other money market instruments collateral) must be offset.
The eligible collateral will be agreed between the parties, as will other key factors including: NB For purposes of clarity, the example assumes that the value of the security on loan has
remained constant, when in reality the price would change daily resulting in a mark to market
• Notional limits event, different fees chargeable per day and changes in the value of the collateral required.
• The absolute value of any asset to be accepted as collateral Open loan transactions can also be re-rated or have their fee changed if market circumstances
• Initial margin alter. It is assumed that this did not happen either.
• The margin required at the outset of a transaction
• Maintenance margin The agreement on a fee is reached between the parties and would typically take into account
• The minimum margin level to be maintained throughout the transaction the following factors:
• Concentration limits
• The maximum percentage of any issue to be acceptable, e.g. less than 5% of daily • Demand and supply
traded volume • The less of a security available, other things being equal, the higher the fee a lender
• The maximum percentage of collateral pool that can be taken against the same issuer, can obtain
i.e. the cumulative effect where collateral in the form of letters of credit, CD, equity, • Collateral flexibility
bond and convertible may be issued by the same firm • See above – the cost to a borrower of giving different types of collateral varies significantly
so that they might be more willing to pay a higher fee if the lender is more flexible
1 See glossary for an explanation of DBVs.
16 17
 • The size of the manufactured dividend required to compensate the lender for the post-
tax dividend payment that it would have received had it not lent the security Loan
Loan
• Different lenders have varying tax liabilities on income from securities; the lower the Lender Borrower Lender Borrower
manufactured dividend required by the lender, the higher the fee it can negotiate2 Cash Cash
• The term of a transaction
Cash Collateral Cash Collateral
• Securities lending transactions can be open to recalls or fixed for a specified term;
there is much debate about whether there should be a premium paid or a discount for
certainty. If a lender can guarantee a recall-free loan then a premium will be Money Money
forthcoming. One of the attractions of repo and swaps is the transactional certainty on Markets Markets
offer from a counterpart
• Certainty
Loan Commences Loan Terminates
• As Chapter 3 explains, there are trading and arbitrage opportunities, the profitability
of which revolves around the making of specific decisions. If a lender can guarantee a
The revenue generated from cash-collateralised securities lending transactions is derived in a
certain course of action, this may mean it can negotiate a higher fee
different manner from that in a non-cash transaction. It is made from the difference or “spread”
between interest rates that are paid and received by the lender (see Box 2).
Taking into account the above factors, the following table shows the range of lending fees
observed for different asset classes in the UK market in February 2007. The majority of
transactions are concluded at the lower end of the ranges quoted. Box 2: Cash flows on a securities loan collateralised with cash

Asset Class Typical Fee Range

Transaction date 13th June 2006
(basis points per annum) Settlement date 16th June 2006
Term Open
UK FTSE 100 equities 8 – 30
Security XYZ Limited
UK FTSE 250 equities 10 – 100 Security price £10.00 per share
Quantity 100,000 shares
Index Linked Gilts 4–8
Loan value £1,000,000.00
Non-index Linked Gilts 3 – 13 Rebate rate 80 basis points
Collateral USD cash
UK Corporate bonds (Investment grade) 9 – 30
Margin required 5%
UK Corporate bonds (Sub-investment grade) 10 – 50 Collateral required $1,718,850.00 (£1,050,000.00 x 1.637)
Reinvestment rate 130 basis points
Source: Performance Explorer Daily lending income $23.87 or £14.58 ($1,718,850.00 x 0.005 x (1/360))

(b) Transactions collateralised with cash FX Rate assumed of £1.00 = $1.637

Cash collateral is, and has been for many years, an integral part of the securities lending If the above transaction remains outstanding for one month and is returned on 16th July 2006,
business, particularly in the United States. The lines between two distinct activities: there will be two flows of cash from the lender to the borrower. These are based upon the cash
collateral, and the profitability of the lender comes from the 50 basis points spread between
• Securities lending and the reinvestment rate and the rebate rate.
• Cash reinvestment
$1,718,850 x 0.008 x (1/360)) = $38.20
have become blurred and to many US investment institutions securities lending is virtually
synonymous with cash reinvestment. This is much less the case outside the United States but Payments to the borrower:
consolidation of the custody business and the important role of US custodian banks in the
market means that this practice is becoming more prevalent. The importance of this point lies On 30th June $534.80 ($38.20 x 14 days)
in the very different risk profiles of these increasingly intertwined activities. On 31st July $611.20 ($38.20 x 16 days)

The lender’s profit will typically be taken as follows:

On 30th June £204.12 (£14.58 x 14 days)

On 31st July £233.28 (£14.58 x 16 days)

Thus total revenue is £437.40 against which the cost of settling the transactions (loan and
collateral) must be offset.

2 See Chapter 3 for an explanation of how securities lending can be motivated by the different tax status of borrowers and lenders.
18 19
 NB For purposes of clarity, this example assumes that the value of the security on loan has Master Repurchase Agreement (GMRA)3.
remained constant for the duration of the above transaction. This is most unlikely; typically the
price would change daily resulting in a mark to market and changes to the value of the collateral Repos occur for two principal reasons – either to transfer ownership of a particular security
required. Open loan transactions can also be re-rated or have their rebate changed if market between the parties or to facilitate collateralised cash loans or funding transactions.
circumstances alter. It is assumed that this did not happen either.
The bulk of bond lending and bond financing is conducted by repo and there is a growing equity
The marginal increase in daily profitability associated with the cash transaction at a 50 bps repo market. An annex can be added to the GMRA to facilitate the conduct of equity repo
spread compared with the non-cash transaction of 50 bps is due to the fact that the cash spread transactions.
is earned on the collateral which has a 5% margin as well as the fact that the USD interest rate
convention is 360 days and not 365 days as in the United Kingdom. Repos are much like securities loans collateralised against cash, in that income is factored into
an interest rate that is implicit in the pricing of the two legs of the transaction.
Reinvestment guidelines are typically communicated in words by the beneficial owner to their
lending agent, and some typical guidelines might be as follows: At the beginning of a transaction, securities are valued and sold at the prevailing “dirty” market
price (i.e. including any coupon that has accrued). At termination, the securities are resold at a
Conservative predetermined price equal to the original sale price together with interest at a previously agreed
• Overnight G7 Government Bond repo fund rate known as the repo rate.
• Maximum effective duration of 1 day
• Floating-rate notes and derivatives are not permissible In securities-driven transactions (i.e. where the motivation is not simply financing) the repo rate
• Restricted to overnight repo agreements is typically set at a lower rate than prevailing money market rates to reward the “lender” who
will invest the funds in the money markets and thereby seek a return. The “lender” often
Quite Conservative receives a margin by pricing the securities above their market level.
• AAA rated Government Bond repo fund
• Maximum average maturity of 90 days In cash-driven transactions, the repurchase price will typically be agreed at a level close to
• Maximum remaining maturity of any instrument is 13 months current money market yields, as this is a financing rather than a security-specific transaction.
The right to substitute repoed securities as collateral is agreed by the parties at the outset. A
Quite Flexible margin is often provided to the cash “lender” by reducing the value of the transferred securities
• Maximum effective duration of 120 days by an agreed “haircut” or discount.
• Maximum remaining effective maturity of 2 years
• Floating-rate notes and eligible derivatives are permissible (b) Buy/sell backs
• Credit quality: Short-term ratings: A1/P1, long-term ratings: A-/A3 or better
Buy/sell backs are similar in economic terms to repos but are structured as a sale and
Flexible simultaneous purchase of securities, with the purchase agreed for a future settlement date. The
• Maximum effective duration of 120 days price of the forward purchase is typically calculated and agreed by reference to market repo
• Maximum remaining effective maturity of 5 years rates.
• Floating-rate notes and eligible derivatives are permissible
• Credit quality: Short-term ratings: A1/P1, long-term ratings: A-/A3 or better The purchaser of the securities receives absolute title to them and retains any accrued interest
and coupon payments during the life of the transaction. However, the price of the forward
Some securities lending agents offer bespoke reinvestment guidelines whilst others offer contract takes account of any coupons received by the purchaser.
reinvestment pools.
Buy/sell back transactions are normally conducted for financing purposes and involve fixed
Other transaction types income securities. In general a cash borrower does not have the right to substitute collateral.
Until 1996, the bulk of buy/sell back transactions took place outside of a formal legal framework
Securities lending is part of a larger set of interlinked securities financing markets. These with contract notes being the only form of record. In 1995, the GMRA was amended to
transactions are often used as alternative ways of achieving similar economic outcomes, incorporate an annex that dealt explicitly with buy/sell backs. Most buy/sell backs are now
although the legal form and accounting and tax treatments can differ. The other transactions governed by this agreement.
include:
The table overleaf compares the three main forms of collateralised securities loan transaction.
(a) Sale and repurchase agreements

Sale and repurchase agreements or repos involve one party agreeing to sell securities to
another against a transfer of cash, with a simultaneous agreement to repurchase the same
securities (or equivalent securities) at a specific price on an agreed date in the future. It is
common for the terms “seller” and “buyer” to replace the securities lending terms “lender” and
“borrower”. Most repos are governed by a master agreement called the TBMA/ISMA Global
3 The Public Securities Association (“PSA”) is now called the Bond Market Association (“BMA”) and is a US trade association.
20 The International Securities Market Association (“ISMA”) is the self-regulatory organisation and trade association for the international 21
securities market.
 Characteristic Securities lending Repo Buy/sell back Chapter 2 Lenders and intermediaries
Cash collateral Securities/other Specific securities General collateral
non-cash collateral (securities-driven) (cash-driven)
The securities lending market involves various specialist intermediaries which take principal
Formal method Sale with agreement Sale with agreement Sale and repurchase Sale and repurchase Sale and repurchase
of exchange to make subsequent to make subsequent under terms of under terms of and/or agency roles. These intermediaries separate the underlying owners of securities –
reacquisition of
equivalent securities
reacquisition of
equivalent securities
master agreement master agreement typically large pension or other funds, and insurance companies – from the eventual borrowers
of securities, whose usual motivations are described in Chapter 4.
Form of exchange Securities vs cash Securities vs collateral Securities vs cash Cash vs securities Cash vs securities
(n.b. often free of (n.b. often delivery (n.b. often delivery (n.b. often delivery
payment but versus payment) versus payment) versus payment)
sometimes delivery Intermediaries
versus delivery)

Collateral type Cash Securities (bonds and Cash General collateral Typically bonds
equities), letters of (bonds) or acceptable
1. Agent intermediaries
Credit, DBVs, CDs collateral as defined
by buyer
Securities lending is increasingly becoming a volume business and the economies of scale
Return is paid Cash collateral Loan securities (not Cash Cash Cash
to the supplier of collateral securities) offered by agents that pool together the securities of different clients enable smaller owners of
Return payable as Rebate interest Fee e.g. standard Quoted as repo rate, Quoted as repo rate, Quoted as repo rate,
assets to participate in the market. The costs associated with running an efficient securities
(i.e. return paid on fees for FTSE 100 paid as interest on paid as interest on paid through the price lending operation are beyond many smaller funds for which this is a peripheral activity. Asset
cash lower than stocks are about 8- the cash collateral the cash differential between
comparable cash 30 basis points (lower than general sale price and managers and custodian banks have added securities lending to the other services they offer
market interest rates) (i.e. 0.08-0.3% pa) collateral repo rate) repurchase price
to owners of securities portfolios, while third-party lenders specialise in providing securities
Initial margin Yes Yes Yes Yes Possible lending services.
Variation margin Yes Yes Yes Yes No (only possible
through close out and
repricing) Owners and agents “split” revenues from securities lending at commercial rates. The split will
Over- Yes (in favour of the Yes (in favour of the No Possible (if any, Possible (if any,
be determined by many factors including the service level and provision by the agent of any
collateralisation securities lender) securities lender) in favour of the in favour of the risk mitigation, such as an indemnity. Securities lending is often part of a much bigger
cash provider) cash provider)
relationship and therefore the split negotiation can become part of a bundled approach to the
Collateral Yes (determined Yes (determined No Yes (determined No (only possible
substitution by borrower) by borrower) by the original seller) through close out
pricing of a wide range of services.
and repricing)

Dividends and Manufactured to Manufactured to Paid to the Paid to the No formal obligation (a) Asset managers
coupons the lender the lender original seller original seller to return income
normally factored into
the buy-back price It can be argued that securities lending is an asset management activity – a point that is easily
Legal set off in Yes Yes Yes Yes No understood considering the reinvestment of cash collateral. Particularly in Europe, where
event of default
custodian banks were perhaps slower to take up the opportunity to lend than in the United
Maturity Open or term Open or term Open or term Open or term Term only
States, many asset managers run significant securities lending operations.
Typical asset type Bonds and equities Bonds and equities Mainly bonds, Mainly bonds, Almost entirely bonds
equities possible equities possible
What was once a low-profile, back-office activity is now a front-office growth area for many asset
Motivation Security specific Security specific Security specific Financing Financing dominant
dominant managers. The relationship that the asset managers have with their underlying clients puts them
Payment Monthly in arrears Monthly in arrears At maturity At maturity At maturity
in a strong position to participate.

(b) Custodian banks

The history of securities lending is inextricably linked with the custodian banks. Once they
recognised the potential to act as agent intermediaries and began marketing the service to their
customers, they were able to mobilise large pools of securities that were available for lending.
This in turn spurred the growth of the market.

Most large custodians have added securities lending to their core custody businesses. Their
advantages include: the existing banking relationship with their customers; their investment in
technology and global coverage of markets, arising from their custody businesses; the ability
to pool assets from many smaller underlying funds, insulating borrowers from the administrative
inconvenience of dealing with many small funds and providing borrowers with protection from
recalls; and experience in developing as well as developed markets.

Being banks, they also have the capability to provide indemnities and manage cash collateral
efficiently – two critical factors for many underlying clients.

22 23
 Custody is so competitive a business that for many providers it is a loss-making activity. in-house inventory where available. For example, proprietary trading positions can be a stable
However, it enables the custodians to provide a range of additional services to their client base. source of lending supply if the long position is associated with a long-term derivatives
These include foreign exchange, trade execution, securities lending and fund accounting. transaction. Efficient inventory management is seen as critical and many securities lending
desks act as central clearers of inventory within their organisations, only borrowing externally
(c) Third-party agents when netting of in-house positions is complete. This can require a significant technological
investment. Other ways of mitigating ‘recall risk’ include arrangements to borrow securities from
Advances in technology and operational efficiency have made it possible to separate the affiliated investment management firms, where regulations permit, and bidding for exclusive
administration of securities lending from the provision of basic custody services, and a number (and certain) access to securities from other lenders.
of specialist third-party agency lenders have established themselves as an alternative to
custodian banks. On the demand side, intermediaries have historically been dependent upon hedge funds or
proprietary traders that make trading decisions. But a growing number of securities lending
Their market share is currently growing from a relatively small base. Their focus on securities businesses within investment banks have either developed “trading” capabilities within their
lending and their ability to deploy new technology without reference to legacy systems can give lending or financing departments, or entered into joint ventures with other departments or even
them flexibility. in some cases their hedge fund customers. The rationale behind this trend is that the financing
component of certain trading strategies is so significant that without the loan there is no trade.
2. Principal intermediaries
(a) Broker dealers
There are three broad categories of principal intermediary:
Broker dealers borrow securities for a wide range of reasons:
• Broker dealers
• Specialist intermediaries • Market making
• Prime brokers • To support proprietary trading
• On behalf of clients
In contrast to the agent intermediaries, they can assume principal risk, offer credit
intermediation and take positions in the securities that they borrow. Distinctions between the Many broker dealers combine their securities lending activities with their prime brokerage
three categories are blurred. Many firms would be in all three. operation (the business of servicing the broad requirements of hedge funds and other
alternative investment managers). This can bring significant efficiency and cost benefits.
In recent years securities lending markets have been liberalised to a significant extent so that Typically within broker dealers the fixed income and equity divisions duplicate their lending and
there is little general restriction on who can borrow and who can lend securities. financing activities.

Lending can, in principle, take place directly between beneficial owners and the eventual (b) Specialist intermediaries
borrowers. But typically a number of layers of intermediary are involved. What value do the
intermediaries add? Historically, regulatory controls on participation in stock lending markets meant that globally
there were many intermediaries. Some specialised in intermediating between stock lenders and
A beneficial owner may well be an insurance company or a pension scheme while the ultimate market makers in particular, e.g. UK Stock Exchange Money Brokers (“SEMB”). With the
borrower could be a hedge fund. Institutions will often be reluctant to take on credit exposures deregulation of stock lending markets, these niches have almost all disappeared.
to borrowers that are not well recognised, regulated or who do not have a good credit rating.
This would exclude most hedge funds. In these circumstances, the principal intermediary (often Some of the specialists are now part of larger financial organisations. Others have moved to
acting as prime broker) performs a credit intermediation service in taking a principal position parent companies that have allowed them to expand the range of their activities into proprietary
between the lending institution and the hedge fund. trading.

A further role of the intermediaries is to take on liquidity risk. Typically they will borrow from (c) Prime brokers
institutions on an open basis – giving them the option to recall the underlying securities if they
want to sell them or for other reasons – whilst lending to clients on a term basis, giving them Prime brokers serve the needs of hedge funds and other ‘alternative’ investment managers. The
certainty that they will be able to cover their short positions. business was once viewed simply as the provision of six distinct services, although many others
such as capital introduction, risk management, fund accounting and start up assistance have
In many cases, as well as serving the needs of their own propriety traders, principal now been added:
intermediaries provide a service to the market in matching the supply of beneficial owners that
have large stable portfolios with those that have a high borrowing requirement. They also
distribute securities to a wider range of borrowers than underlying lenders, which may not have
the resources to deal with a large number of counterparts.

These activities leave principal intermediaries exposed to liquidity risk if lenders recall securities
that have been on lent to borrowers on a term basis. One way to mitigate this risk is to use

24 25
 Services provided by prime brokers (a) Size

Profitable activities Part of the cost of being in business Other things being equal, borrowers prefer large portfolios.
Securities lending Clearance
(b) Holdings size
Leverage of financing provision Custody
Loan transactions generally exceed $250,000. Lesser holdings are of limited appeal to direct
Trade execution Reporting
borrowers. Holdings of under $250,000 are probably best deployed through an agency
programme, where they can be pooled with other inventories.
Securities lending is one of the central components of a successful prime brokerage operation,
with its scale depending on the strategies of the hedge funds for which the prime broker acts. (c) Investment strategy
Two strategies that are heavily reliant on securities borrowing are long/short equity and
convertible bond arbitrage. Active investment strategies increase the likelihood of recalls, making them less attractive than
passive portfolios.
The cost associated with the establishment of a full service prime broker is steep and
recognised providers have a significant advantage. Some of the newer entrants have been using (d) Diversification
total return swaps, contracts for difference and other derivative transaction types to offer what
has become known as “synthetic prime brokerage”. Again securities lending remains a key Borrowers want portfolios where they need liquidity. A global portfolio offers the greatest chance
component of the service as the prime broker will still need to borrow securities in order to of generating a fit. That said, there are markets that are particularly in demand from time to
hedge the derivatives positions it has entered into with the hedge funds, for example, to cover time and there are certain borrowers that have a geographic or asset class focus.
short positions. But it is internalised within the prime broker and less obvious to the client.
(e) Tax jurisdiction and position
Beneficial owners
Borrowers are responsible for “making good” any benefits of share ownership (excluding voting
Those beneficial owners with securities portfolios of sufficient size to make securities lending rights) as if the securities had not been lent. They must “manufacture” (i.e. pay) the economic
worthwhile include: value of dividends to the lender. An institution’s tax position compared to that of other possible
lenders is therefore an important consideration. If the cost of manufacturing dividends or
• Pension funds coupons to a lender is low then its assets will be in greater demand.
• Insurance and assurance companies
• Mutual funds/unit trusts (f) Inventory attractiveness
• Endowments
“Hot” securities are those in high demand whilst general collateral or general collateral
When considering whether and how to lend securities, beneficial owners need first to consider securities are those that are commonly available. Needless to say, the “hotter” the portfolio, the
the characteristics of their organisations and portfolio. higher the returns from lending it.

1. Organisation characteristics Having examined the organisation and portfolio characteristics of the beneficial owner, we must
now consider the various possible routes to market.
(a) Management motivation
The possible routes to the securities lending market
Some owners lend securities solely to offset custody and administrative costs. Others are
seeking more significant revenue. (a) Using an asset manager as agent

(b) Technology investment A beneficial owner may find that the asset manager they have chosen, already operates a
securities lending programme. This route poses few barriers to getting started quickly.
Lenders vary in their willingness to invest in technological infrastructure to support securities
lending. (b) Using a custodian as agent

(c) Credit risk appetite This is the least demanding option for a beneficial owner, especially a new one. They will
already have made a major decision in selecting an appropriate custodian. This route also poses
The securities lending market consists of organisations with a wide range of credit quality and few barriers to getting started quickly.
collateral capabilities. A cautious approach to counterpart selection (AAA only) and restrictive
collateral guidelines (G7 Bonds) will limit lending volumes. (c) Appointing a third-party specialist as agent

2. Portfolio characteristics A beneficial owner who has decided to outsource may decide it does not want to use the

26 27
 supplier’s asset manager(s) or custodian(s), and instead appoint a third-party specialist. This
route may mean getting to know and understand a new provider prior to getting started. The
Chapter 3 The borrowing motivation
opportunity cost of any delay needs to be factored into the decision.
One of the central questions commonly asked by issuers and investors alike is “Why does
(d) Auctioning a portfolio to borrowers the borrower borrow my securities?”. Before considering this point let us examine why issuers
might care.
Borrowers bid for a lender’s portfolio by offering guaranteed returns in exchange for gaining
exclusive access. There are several different permutations of this auctioning route: Issuers
• Do-it-yourself auctions If securities were not issued, they could not be lent. Behind this simple tautology lies an
• Assisted auctions important point. When Initial Public Offerings are frequent and corporate merger and acquisition
• Agent assistance activity is high, the securities lending business benefits. In the early 2000s, the fall in the level
• Consultancy assistance of such activity depressed the demand to borrow securities leading to:
• Specialist “auctioneer” assistance
• A depressed equity securities lending market meaning:
This is not a new phenomenon but one that has gained a higher profile in recent years. A key • Fewer trading opportunities
issue for the beneficial owner considering this option is the level of operational support that • Less demand
the auctioned portfolio will require and who will provide it. • Fewer “specials”
• Issuer concern about the role of securities lending, such as
e) Selecting one principal borrower • Whether it is linked in any way to the decline in the value of a company’s shares?
• Whether securities lending should be discouraged?
Many borrowers effectively act as wholesale intermediaries and have developed global
franchises using their expertise and capital to generate spreads between two principals that How many times does an issuer discussing a specific corporate event stop to consider the
remain unknown to one another. These principal intermediaries are sometimes separately impact that the issuance of a convertible bond or the adoption of a dividend reinvestment plan
incorporated organisations, but, more frequently, are parts of larger banks, broker-dealers or might have upon lending of their shares?
investment banking groups. Acting as principal allows these intermediaries to deal with
organisations that the typical beneficial owner may choose to avoid for credit reasons e.g. There is a significant amount of information available on the “long” side of the market and
hedge funds. correspondingly little on the “short” side. Securities lending activity is not synonymous with
short selling. But it is often, although not always, used to finance short sales (see below) and
(f) Lending directly to proprietary principals might be a reasonable and practical proxy for the scale of short selling activity in the absence
of full short sale disclosure. It is therefore natural that issuers would want to understand how
Sometimes after a period of activity in the lending market using one of the above options, a and why their securities are traded.
beneficial owner that is large enough in its own right, may wish to explore the possibility of
establishing a business “in house”, lending directly to a selection of principal borrowers that Reasons to borrow
are the end-users of their securities. The proprietary borrowers include broker-dealers, market
makers and hedge funds. Some have global borrowing needs while others are more regionally
Borrowers, when acting as principals, have no obligation to tell lenders or their agents why they
focused.
are borrowing securities. In fact they may well not know themselves as they may be on-lending
the securities to proprietary traders or hedge funds that do not share their trading strategies
(g) Choosing some combination of the above
openly. Some prime brokers are deliberately vague when borrowing securities as they wish to
protect their underlying hedge fund customer’s trading strategy and motivation.
Just as there is no single or correct lending method, so the options outlined above are not
mutually exclusive. Deciding not to lend one portfolio does not preclude lending to another;
This chapter explains some of the more common reasons behind the borrowing of securities. In
similarly, lending in one country does not necessitate lending in all. Choosing a wholesale
general, these can be grouped into: (1) borrowing to cover a short position (settlement
intermediary that happens to be a custodian in the United States and Canada does not mean
coverage, naked shorting, market making, arbitrage trading); (2) borrowing as part of a
that a lender cannot lend Asian assets through a third-party specialist and European assets
financing transaction motivated by the desire to lend cash; and (3) borrowing to transfer
directly to a panel of proprietary borrowers.
ownership temporarily to the advantage of both lender and borrower (tax arbitrage, dividend
reinvestment plan arbitrage).

Borrowing to cover short positions

(a) Settlement coverage

Historically, settlement coverage has played a significant part in the development of the

28 29
 securities lending market. Going back a decade or so, most securities lending businesses were • Execution of the convertible bond
located in the back offices of their organisations and were not properly recognised as • Execution of the equity
businesses in their own right. Particularly for less liquid securities – such as corporate bonds
and equities with a limit free float – settlement coverage remains a large part of the demand Box 3: Worked example of convertible bond arbitrage
to borrow.
Long side
The ability to borrow to avoid settlement failure is vital to ensure efficient settlement and has • 5% XYZ Limited convertible bond
encouraged many securities depositories into the automated lending business. This means that • Maturing in one year at US$1,000
they remunerate customers for making their securities available to be lent by the depository • Exchangeable into 100 non-dividend-paying shares
automatically in order to avert any settlement failures. • Stock currently trading at US$10 per share

(b) Naked shorting Short side

• A short position of 50 underlying shares at $10 per share
Naked shorting can be defined as borrowing securities in order to sell them in the expectation
that they can be bought back at a lower price in order to return them to the lender. Naked Pricing inefficiencies between these two related securities can create arbitrage opportunities
shorting is a directional strategy, speculating that prices will fall, rather than a part of a wider whether the underlying share price rises or falls. In general, however, the trade will be more
trading strategy, usually involving a corresponding long position in a related security. profitable if the implied volatility of the share price rises, increasing the value of the call option
embedded in the convertible bond.
Naked shorting is a high-risk strategy. Although some funds specialise in taking short positions
in the shares of companies they judge to be overvalued, the number of funds relying on naked Unless the issuer defaults, convertible bonds can only fall in value as low as their “investment
shorting is relatively small and probably declining. value” – what the same company bond would be worth if it were not convertible. In this case,
the investment value is assumed to be US$920.
(c) Market making
Bondholders can purchase protection against issuer default using credit default swaps but this
Market makers play a central role in the provision of two-way price liquidity in many securities element of the transaction is not covered in this example. To keep the example simple, it is also
markets around the world. They need to be able to borrow securities in order to settle “buy assumed that the convertible trades with a “delta” of one to the stock (i.e. that the prices of
orders” from customers and to make tight, two-way prices. the convertible bond and the share change at the same rate.)

The ability to make markets in illiquid small-capitalisation securities is sometimes hampered by A transaction such as the one outlined above would have the following return dynamics:
a lack of access to borrowing and some of the specialists in these less liquid securities have
put in place special arrangements to enable them to gain access to securities. These include No change in share price:
guaranteed exclusive bids with securities lenders. Interest payments on $1,000 convertible bond (5%) $50.00
Interest earned on $500 short sale proceeds (1.5%) $7.50
The character of borrowing is typically short term for an unknown period of time. The need to Fees paid to lender of shares (0.25% per annum) ($1.50)
know that a loan is available tends to mean that the level of communication between market Net cash flow $56.00
makers and the securities lending business has to be highly automated. A market maker that Annual return 5.60%
goes short and then finds that there is no loan available would have to buy that security back
to flatten its book. 25% rise in share price:
Gain on convertible bond $250.00
(d) Arbitrage trading Loss on shorted stock (50 shares @ $2.50/share) ($125.00)
Interest from convertible bond $50.00
Securities are often borrowed to cover a short position in one security that has been taken to Interest earned on short sale proceeds $7.50
hedge a long position in another as part of an “arbitrage” strategy. Some of the more common Fees paid to lender of shares ($1.50)
arbitrage transactions that involve securities lending are described below. Net trading gains and cash flow $181.00
Annual return 18.10%
(i) Convertible bond arbitrage
Convertible bond arbitrage involves buying a convertible bond and simultaneously selling the 25% fall in share price:
underlying equity short and borrowing the shares to cover the short position (see Box 3). Loss on convertible bond (only falling as low as “investment value”) ($80.00)
Leverage can be deployed to increase the return in this type of transaction. Prime brokers are Gain on shorted stock (50 shares @ $2.50/share) $125.00
particularly keen on hedge funds that engage in convertible bond arbitrage as they offer scope Interest from convertible bond $50.00
for several revenue sources: Interest earned on short sale proceeds $7.50
Fees paid to lender of shares ($1.50)
• Securities lending revenues Net cash flow $101.00
• Provision of leverage Annual return 10.10%

30 31
 Components of Return Stock index arbitrage involves buying or selling a basket of stocks and, conversely, selling or
buying futures when mispricing appears to be taking place.

(iv) When is an arbitrage possible?

Where the current index futures price (FC) is not equal to the index value (IC) plus the difference
between the risk free interest (RF) and dividends (D) obtainable over the life of the contract.
Total
Short Return
Interest Or whenever the following is not true FC = IC + (RF-D).
Rate

+ Current
+ Leverage
Related
Returns
= Whenever the actual futures price moves away from the above calculated value, i.e. when
Yield FC > IC + (RF-D) or F < IC + (RF-D), arbitrage opportunities exist. The difference between the
0 Dividend Interest current theoretical actual cost and the futures price is called the basis. It is this difference that
Exposure Exposure
- creates an arbitrage opportunity.

(ii) Pairs trading or relative value “arbitrage” When FC > IC + (RF-D) a trader can profit by taking the following action:
This in an investment strategy that seeks to identify two companies with similar characteristics
whose equity securities are currently trading at a price relationship that is out of line with their • Buying a portfolio which is identical to the index value
historical trading range. The strategy entails buying the apparently undervalued security while • Selling index futures
selling the apparently overvalued security short, borrowing the latter security to cover the short
position. When FC < IC + (RF-D) a trader can profit by taking the following action:

Focusing on securities in the same sector or industry should normally reduce the risks in this • Going short (selling) a portfolio which is identical to the index value
strategy. The following chart shows how Sainsbury and Tesco have traded since 1991. At times • Buying index futures
it would have been possible to buy one share and sell the other awaiting price realignment.
It is here that securities lending plays its role. The ability of a borrower to source a complete
portfolio of all the stocks in an index, properly weighted, that will accurately track the
700
performance of the index is a big advantage. Incomplete indices or unbalanced indices open up
600
the possibility of tracking errors occurring whereby the performance of the short cash portfolio
500
deviates from that of the index.
Price

400
300
The ability to borrow securities that have a cheaper manufactured dividend obligation is an
200
advantage too. One of the problem areas is when a component (or components) of the index
100
is in high demand (“trading special”) and the cost of borrowing rises, thereby reducing the
0
De Au Ma Oc Ma Ja Au Ma Oc Ma Ja Au Ma Oc Ju Ja Au Ma Oc Ju Ja Au Ma No Ju Ja
profitability of the transaction. The ability to borrow for a fixed term is also an advantage.
91 921 93 93 94 95 95 96 96 97 98 98 99 99 00 01 01 02 02 03 04 04 05 05 05 07
Tesco plc Sainsbury J plc
The best sources of securities to support this type of transaction are passive index tracking
funds incorporated in countries that have high rates of withholding tax.
Source: Data Explorers Limited
Once established, the stock index arbitrage can generate profits should the price of the index
(iii) Index arbitrage and the underlying securities move up or down. The arbitrage opportunity is often short-lived
In this context, arbitrage refers to the simultaneous purchase and sale of the same commodity as positions are taken and the price adjusts. As these transactions normally have thin margins,
or stock in two different markets in order to profit from price discrepancies between the they are often executed in large sizes.
markets.
(e) Financing
In the stock market, an arbitrage opportunity arises when the same security trades at different
prices in different markets. In such a situation, investors buy the security in one market at a As broker dealers build derivative prime brokerage and customer margin business, they hold an
lower price and sell it in another for more, capitalising on the difference. However, such an increasing inventory of securities that requires financing.
opportunity vanishes quickly as investors rush in to take advantage of the price difference.
This type of activity is high volume and takes place between two counterparts that have the
The same principle can be applied to index futures. Being a derivative product, index futures following coincidence of wants:
derive their value from the securities that constitute the index. At the same time, the value of
index futures is linked to the stock index value through the opportunity cost of funds • One has cash that they would like to invest on a secured basis and pick up yield
(borrowing/lending cost) required to play the market. • The other has inventory that needs to be financed

32 33
 In the case of bonds, the typical financing transaction is a repo or buy/sell back. But for
equities, securities lending and equity repo transactions are used.
Chapter 4 Market mechanics
Tri Party agents are often involved in this type of financing transaction as they can reduce This section outlines the detailed processes in the life of a securities loan including:
operational costs for the cash lender and they have the settlement capabilities the cash
borrower needs to substitute securities collateral as their inventory changes. • Negotiation of loan deals
• Confirmations
(f) Temporary transfers of ownership • Term of loan
• Term trades
(i) Tax arbitrage • Putting securities “on hold”
Tax driven trading is an example of securities lending as a means of exchange. • Settlements, including how loans are settled and settlement concerns
• Termination of loans
Markets that have historically provided the largest opportunities for tax arbitrage include those • Redelivery, failed trades and legal remedies
with significant tax credits that are not available to all investors – examples include Italy, • Corporate actions and voting
Germany and France. • UK tax arrangements and reporting of transactions to the London Stock Exchange

The different tax positions of investors around the world have opened up opportunities for Loan negotiation
borrowers to use securities lending transactions, in effect, to exchange assets temporarily for
the mutual benefit of purchaser, borrower and lender. The lender’s reward comes in one of two Traditionally securities loans have been negotiated between counterparts (whose credit
ways: either a higher fee for lending if they require a lower manufactured dividend, or a higher departments have approved one another) on the phone and followed up with written or
manufactured dividend than the post-tax dividend they would normally receive (quoted as an electronic confirmations. Normally the borrower initiates the call to the lender with a borrowing
“all-in rate”). requirement. However, pro-active lenders may also offer out in-demand securities to their
approved counterparts. This would happen particularly where one borrower returns a security
For example, an offshore lender that would normally receive 75% of a German dividend and and the lender is still lending it to others in the market, they will contact them to see if they
incur 25% withholding tax (with no possibility to reclaim) could lend the security to a borrower wish to borrow additional securities.
that, in turn, could sell it to a German investor who was able to obtain a tax credit rather than
incur withholding tax. If the offshore lender claimed the 95% of the dividend that it would Today, there is an increasing amount of bilateral and multilateral automated lending whereby
otherwise have received, it would be making a significant pick-up (20% of the dividend yield), securities are broadcast as available at particular rates by email or other electronic means.
whilst the borrower might make a spread of between 95% and whatever the German investor Where lending terms are agreeable, automatic matching can take place.
was bidding. The terms of these trades vary widely and rates are calculated accordingly.
An example of an electronic platform for negotiating equity securities loan transactions is
(ii) Dividend reinvestment plan arbitrage EquiLend, which began operations in 2002 and is backed by a consortium of financial
Many issuers of securities create an arbitrage opportunity when they offer shareholders the institutions. EquiLend’s stated objective is to: “Provide the securities lending industry with the
choice of taking a dividend or reinvesting in additional securities at a discounted level. technology to streamline and automate transactions between borrowing and lending institutions
and … introduce a set of common protocols. EquiLend will connect borrowers and lenders
Income or index tracking funds that cannot deviate from recognised securities weightings may through a common, standards-based global equity lending platform enabling them to transact
have to choose to take the cash option and forgo the opportunity to take the discounted with increased efficiency and speed, and reduced cost and risk.” EquiLend is not alone in this
reinvestment opportunity. market; for example, SecFinex offers similar services in Europe.

One way that they can share in the potential profitability of this opportunity is to lend securities Confirmations
to borrowers that then take the following action:
Written or electronic confirmations are issued, whenever possible, on the day of the trade so
• Borrow as many guaranteed cash shares as possible, as cheaply as possible
that any queries by the other party can be raised as quickly as possible. Material changes during
• Tender the borrowed securities to receive the new discounted shares
the life of the transaction are agreed between the parties as they occur and may also be
• Sell the new shares to realise the “profit” between the discounted share price and the
confirmed if either party wishes it. Examples of material changes are collateral adjustments or
market price
collateral substitutions. The parties agree who will take responsibility for issuing loan
• Return the shares and manufacture the cash dividend to the lender
confirmations.

Confirmations would normally include the following information:

• Contract and settlement dates

• Details of loaned securities
• Identities of lender and borrower (and any underlying principal)
• Acceptable collateral and margin percentages

34 35
 • Term and rates How are loans settled?
• Bank and settlement account details of the lender and borrower
Securities lenders need to settle transactions on a shorter timeframe than the customary
Term of loan and selling securities while on loan settlement period for that market. Settlement will normally be through the lender’s custodian
bank and this is likely to apply irrespective of whether the lender is conducting the operation
Loans may either be for a specified term or open. Open loans are trades with no fixed maturity or delegating to an agent. The lender will usually have agreed a schedule of guaranteed
date. It is more usual for securities loans to be open or “at call”, especially for equities, because settlement times for its securities lending activity with its custodians. Prompt settlement
lenders typically wish to preserve the flexibility for fund managers to be able to sell at any time. information is crucial to the efficient monitoring and control of a lending programme, with
Lenders are able to sell securities despite their being on open loan because they can usually reports needed for both loans and collateral.
be recalled from the borrower within the settlement period of the market concerned.
Nevertheless open loans can remain on loan for a long period. In most settlement systems securities loans are settled as “free-of-payment” deliveries and the
collateral is taken quite separately, possibly in a different payment or settlement system and
Term trades – fixed or indicative? maybe a different country and time zone. For example, UK equities might be lent against
collateral provided in a European International Central Securities Depository or US dollar cash
The general description “term trade” is used to describe differing arrangements in the securities collateral paid in New York. This can give rise to what is known in the market as “daylight
lending market. The parties have to agree whether the term of a loan is “fixed” for a definite exposure”, a period during which the loan is not covered as the lent securities have been
period or whether the duration is merely “indicative” and therefore the securities are callable. delivered but the collateral securities have not yet been received. To avoid this exposure some
If fixed, the lender is not obliged to accept the earlier return of the securities; nor does the lenders insist on pre-collateralisation, so transferring the exposure to the borrower.
borrower need to return the securities early if the lender requests it. Accordingly, securities
subject to a fixed loan should not be sold while on loan. The CREST system for settling UK and Irish securities is an exception to the normal practice as
collateral is available within the system. This enables loans to be settled against cash intra-day
Where the term discussed is intended to be “indicative”, it usually means that the borrower has and for the cash to be exchanged, if desired, at the end of the settlement day for a package of
a long-term need for the securities but the lender is unable to fix for term and retains the right DBV securities overnight. The process can be reversed and repeated the next day.
to recall the securities if necessary.
CREST settlement facility for stock lending
Putting securities “on hold” (also known as “icing”)
CREST also has specific settlement arrangements for stock loans, requiring the independent
Putting securities “on hold” (referred to in the market as “icing” securities) is the practice input of instructions by both parties, who must complete a number of matching fields, including
whereby the lender will reserve securities at the request of a borrower on the borrower’s the amount and currency of any cash collateral, together with the percentage value of applicable
expected need to borrow those securities at a future date. This occurs where the borrower must loan margin. Loans may be effected against sterling, euro or dollar consideration or made free-
be sure that the securities will be available before committing to a trade that will require them. of-payment.

While some details can be agreed between the parties, it is normal for any price quoted to be Immediately after the settlement of the loan, CREST automatically creates a pre-matched stock
purely indicative and for securities to be held to the following business day. The borrower can loan return transaction with an intended settlement date of the next business day. The return
“roll over” the arrangement (i.e. continue to ice the securities) by contacting the holder before is prevented from settling until the borrower intervenes to raise the settlement priority of the
9am, otherwise it terminates. transaction. The stock lender may freeze the transaction in order to prevent the stock from
returning.
Key aspects of icing are that the lender does not receive a fee for reserving the securities and
they are generally open to challenge by another borrower making a firm bid. In this case the CREST provides full revaluation facilities for all securities out on loan. On the original creation
first borrower would have 30 minutes to decide whether to take the securities at that time or of the return and every night that the loan is open thereafter, it is marked to market against
to release them. the prevailing CREST offer price. Any deficit or surplus of cash collateral of a stock loan return
arising from price fluctuations is corrected by CREST which automatically generates payment
instructions between the parties and simultaneously alters the value of the return consideration.
“Pay-to-hold” arrangements Users may opt out of the revaluation process by completing the relevant field of the loan
transaction, or by settling loans on a free-of-payment basis.
A variation of icing is “pay-to-hold” where the lender does receive a fee for putting the securities
on hold. As such, they constitute a contractual agreement and are not open to challenge by
other borrowers.
Termination of the loan
Open loans may be terminated by the borrower returning securities or by the lender recalling
them. The borrower will normally return borrowed securities when it has filled its short position.
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 original
lender the opportunity to reduce the rate being charged on the loan before borrowing elsewhere.

36 37
 Redelivery, failed trades and legal remedies • TBMA/ISMA Global Master Repurchase Agreement as extended by supplemental terms
and conditions for equity repo forming Part 2 of Annex 1 of the agreement
When deciding which markets and what size to lend in, securities lenders will consider how
certain they can be of having their securities returned in a timely manner when called and what Where an authorised agreement does not cover the circumstances in which a member firm
remedies are available under the legal agreement (see below) in the event of a failed return. wishes to enter into a lending arrangement, the firm must ensure that the agreement includes
provisions equivalent to those contained within the Exchange’s rules on lending arrangements
Procedures to be followed in the event of a failed redelivery are usually covered in legal in relation to member firm default.
agreements or otherwise agreed between the parties at the outset of the relationship. Financial
redress may be available to the lender if the borrower fails to redeliver loaned securities or UK Companies Act 1985
collateral on the intended settlement date. Costs that would typically be covered include:
Firms that are engaged in equity stock borrowing or lending in the United Kingdom will need
• Direct interest and/or overdraft incurred to comply, where appropriate, with the notification requirements applying to notifiable interest
• Costs reasonably and properly incurred as a result of the borrower’s failure to meet its in shares as set out in Part VI of the Companies Act 1985. Firms that are uncertain about the
sale or delivery obligations application of Part VI should seek legal advice.
• Total costs and expenses reasonably incurred by the lender as a result of a “buy-in”
(i.e. where the lender is forced to purchase securities in the open market following the Transparency in the UK market
borrower’s failure to return them)
CREST provides time-delayed information on the value of securities financing transactions in the
Costs that would usually be excluded are those arising from the transferee’s negligence or wilful top 750 UK equities. This is a subscription service begun in September 2003 following extensive
default and any indirect or consequential losses. An example of that would be when the non- discussion with market participants and the Financial Services Authority. The information it
return of loaned securities causes an onward trade for a larger amount to fail. The norm is for provides pertains to total Stamp Duty Reserve Tax-exempt transactions taking place in each
only that proportion of the total costs which relates to the unreturned securities or collateral to security on a given day and excludes intermediary activity where possible. CREST has provided
be claimed. It is good practice, where possible, to consider “shaping” or “partialling” larger answers to many frequently asked questions on its website, www.crestco.co.uk.
transactions (i.e. breaking them down into a number of smaller amounts for settlement
purposes) so as to avoid the possibility of the whole transaction failing if the transferor cannot The launch of its securities financing data service coincided with its publication of settlement
redeliver the loaned securities or collateral on the intended settlement date. failure statistics The London Stock Exchange monitors both and makes public announcements
on stock lending activity when it feels it is appropriate.
Corporate actions and votes
UK Takeover Panel
The basic premise underlying securities lending is to make the lender “whole” for any corporate
action event – such as a dividend, rights or bonus issue – by putting the borrower under a If it is proposed that any securities lending should take place during an offer period for a UK
contractual obligation to make equivalent payments to the lender, for instance by company, the Takeover Panel should be consulted to establish whether any disclosure is
“manufacturing” dividends. However a shareholder’s right to vote as part owner of a company required and whether there are any other consequences.
cannot be manufactured. When securities are lent, legal ownership and the right to vote in
shareholder meetings passes to the borrower, who will often sell the securities on. Where
lenders have the right to recall securities, they can use this option to restore their holdings and
voting rights. This subject is covered in greater detail in Chapter 6.

UK tax arrangements and London Stock Exchange reporting by member firms

London Stock Exchange rules require lending arrangements in securities on which UK Stamp
Duty/Stamp Duty Reserve Tax (SDRT)4 is chargeable to be reported to the Exchange. This enables
firms to bring their borrowing and lending activity ‘on Exchange’ and to allow them to be exempt
from Stamp Duty/SDRT. Firms which are not members of the Exchange but which conduct
borrowing and lending through a member firm are also eligible for relief from stock lending
Stamp Duty/SDRT. On Exchange lending arrangements are evidenced by regulatory reports that
are transmitted to the Exchange by close of business on the day the lending arrangement is
agreed.
Prior to entering into a lending arrangement, member firms are required to sign a written
agreement with the other party. The Exchange has authorised the following agreements:

• Global Master Securities Lending Agreement

• Master Equity & Fixed Interest Stock Lending Agreement (1996)

4 As defined in Section 99 of the Finance Act 1986 and including stock as defined in the Stamp Act 1891.
38 39
 Chapter 5 Risks, regulation and market oversight
This chapter describes the main financial risks in securities lending, and how lenders usually
manage them. It is not a comprehensive description of the various operational, legal, market
and credit risks to which market participants can be exposed. Readers seeking a fuller analysis
are referred to the relevant sections of “Securities Lending Transactions: Market Development
and Implications”5. The chapter then briefly summarises the UK regulatory framework for
securities lending market participants and the role of the UK Stock Lending and Repo
Committee.

Financial risks in securities lending are primarily managed through the use of collateral and
netting. As described in Chapter 1, collateral can be in the form of securities or cash. The market
value of the collateral is typically greater than that of the lent portfolio. This margin is intended
to protect the lender from loss, reflect the practical costs of collateral liquidation and repurchase
of the lent portfolio in the event of default. Any profits made in the repurchase of the lent
portfolio are normally returned to the borrower’s liquidator. Losses incurred are borne by the
lender with recourse to the borrower’s liquidator along with other creditors.

Risks and risk management

When taking cash as collateral

Because of its wide acceptability and ease of management, cash can be highly appropriate
collateral. However, the lender needs to decide how best to utilise this form of collateral. As
described in Chapter 1, a lender taking cash as collateral pays rebate interest to the securities
borrower, so the cash must be reinvested at a higher rate to make any net return on the
collateral. This means the lender needs to decide on an appropriate risk-return trade-off. In
simple terms, reinvesting in assets that carry one of the following risks can increase expected
returns:

• a higher credit risk: a risk of loss in the event of defaults or

• a longer maturity in relation to the likely term of the loan

Many of the large securities lending losses over the years have been associated with
reinvestment of cash collateral.

Typically, lenders delegate reinvestment to their agents, (e.g. custodian banks). They specify
reinvestment guidelines, such as those set out in Chapter 1. There is a move towards more
quantitative, risk-based approaches; often specifying the “value-at-risk” in relation to the
different expected returns earned from alternative reinvestment profiles. Agents do not usually
offer an indemnity against losses on reinvestment activity so that the lender retains all of the
risk while their agent is paid part of the return.

When taking other securities as collateral

Compared with cash collateral, taking other securities as collateral is a way of avoiding
reinvestment risk. In addition to the risks of error, systems failure and fraud always present in
any market, problems then arise on the default of a borrower. In such cases the lender will seek
to sell the collateral securities in order to raise the funds to replace the lent securities.
Transactions collateralised with securities are exposed to a number of different risks:

Reaction and legal risk. If a lender experiences delays in either selling the collateral securities
or repurchasing the lent securities, it runs a greater risk that the value of the collateral will fall

5 (BIS/IOSCO, 1999)
40 41
 below that of the loan in the interim. Typically, the longer the delay, the larger the risk. Table 1: Summary of ABC’s lent and collateral position with Borrower 1

Mispricing risk. The lender will be exposed if either collateral securities have been over-valued Asset Class Loan Inventory (£m) No. of Loan Collateral No. of Collateral Gross Margin (£m)
or lent securities under-valued because the prices used to mark-to-market differ from prices that Positions Inventory (£m) Positions

can actually be traded in the secondary market. One example of mispricing is using mid rather Total 550.0 43 575.0 10 25.0
than bid prices for collateral. For illiquid securities, obtaining a reliable price source is FTSE 100 100.0 5 75.0 2 -25
particularly difficult because of the lack of trading activity.
FTSE 250 200.0 10 -200

UK 20-Year Bonds 300.0 5 300

Liquidity risk. Illiquid securities are more likely to be realised at a lower price than the valuation
used. Valuation “haircuts” are used to mitigate this risk (i.e. collateral is valued at, for example, UK Cash 100.0 100

98% or 95% of the current market value). The haircuts might depend upon: US Equities 100.0 15 -100

Japanese Equities 50.0 3 -50

• The proportion of the total security issue held in the portfolio – the larger the position, Malaysian Equities 100.0 10 -100
the greater the haircut
US Long Bonds 100.0 3 100
• The average daily traded volume of the security – the lower the volume, the greater the
haircut Source: Barrie & Hibbert
• The volatility of the security – the higher the volatility, the greater the haircut
Assume that lender ABC has loaned Borrower 1 a range of equities in the UK, US, Japanese and
Congruency of collateral and lent portfolios (mismatch risk). If the lent and collateral portfolios Malaysian markets. Collateral is mainly in the form of UK gilts at various maturities, sterling cash
were identical then there would be no market risk. In practice, of course, the lent and collateral deposits and US long-dated Treasury bonds. The gross margin is £25m or 4.5% of loan
portfolios are often very different. The lender’s risk is that the market value of the lent securities inventory.
increases but that of the collateral securities falls before rebalancing can be effected. Provided
the counterpart has not defaulted, the lender will be able to call for additional collateral on any Table 2: Data used to drive the analysis
adverse collateral/loan price movements. However, following default, it will be exposed until it
has been able sell the collateral and replace the lent securities. Currency Base: GBP Correlation Assumptions

s
tie
s r

ui ian
nd Yea
0

ui se
0

nd g
sh

US s
25

ui

s
10

Bo Lon
tie
Eq ane

Eq ys
tie

s
Bo 0-
Asset Class Average Daily Asset Risk Average Stock

Eq
Ca
SE

SE

a
2
The size of mismatch risk depends on the expected co-variance of the value of the collateral

al
p
UK

US
UK
FT

FT
Liq (£m) Residual Risk (% p.a.)

Ja

M
and lent securities. The risk will be greater if the value of the collateral is more volatile, the FTSE 100 5.80 18% 20% 1.00 0.93 0.38 -0.01 0.70 0.31 0.64 0.26
value of the lent securities is more volatile, or if their values do not tend to move together, so FTSE 250 1.00 20% 30% 0.93 1.00 0.30 -0.09 0.65 0.37 0.61 0.23
that the expected correlation between changes in their value is low. For example, in deciding
UK 20-Year Bonds 20.00 9% 3% 0.38 0.30 1.00 -0.02 0.09 0.12 0.08 0.12
whether to hold UK government securities or UK equities to collateralise a loan of BP shares, a
UK Cash 1% 3% -0.01 -0.09 -0.02 1.00 -0.04 -0.09 -0.07 -0.02
lender would have to judge whether the greater expected correlation between the value of the
UK equities and the BP shares reduced mismatch risk by more than the lower expected volatility US Equities 9.40 20% 24% 0.70 0.65 0.09 -0.04 1.00 0.26 0.64 0.68

in the value of the government securities. Japanese Equities 1.40 25% 22% 0.31 0.37 0.12 -0.09 0.26 1.00 0.30 0.13

Malaysian Equities 0.90 34% 29% 0.64 0.61 0.08 -0.07 0.64 0.30 1.00 0.39
Many agent intermediaries will offer beneficial owners protection against these risks by agreeing US Long Bonds 20.00 14% 5% 0.26 0.23 0.12 -0.02 0.68 0.13 0.39 1.00
to return (buy-in) lent securities immediately for their clients following a fail, taking on the risk
that the value of the collateral on liquidation is lower. Source: Barrie & Hibbert

Securities lending using other securities as collateral: a worked example Table 2 shows the type of data on which a detailed analysis of mismatch risk might be based:
the average daily liquidity in each asset class, the volatility of each asset class, the average
The example opposite illustrates one approach to estimating the risk exposure to a lender residual risk on particular securities within each asset class and a matrix of correlations between
taking securities as collateral. various asset classes.

Realistic valuations
The first consideration is whether the valuation prices are fair. Assuming the portfolios have
been conservatively valued at bid and offer (not mid) prices, then the lender might require some
adjustment (haircut) to reflect concentration and price volatility of the different assets. For
example, in the case of the sterling cash collateral, the haircut might be negligible. But for the
Malaysian equity portfolio, a high adjustment might be sought on the assumption that it would
probably cost more than £100m to buy back this part of the lent portfolio. Required haircuts
might be based on the average daily liquidity for the asset class, the price volatility of the asset
class and the residual risk on individual securities, taken from Table 2.

42 43
 Table 3: Adjusted collateral and lent portfolio values Table 5: Risk analysis for Borrower 1 under different lending policies

Asset Class Adjusted Loan Adjusted Collateral Net Margin (£m) Policy Probability of Loss Expected Loss
Inventory (£m) Inventory (£m) on Default on Default (£m)

Total 557.1 573.3 16.2 Base Case Portfolios 26% 4.0

FTSE 100 100.7 73.8 -26.9 Reaction Time = 10 days 19% 1.8

FTSE 250 203.8 -203.8 Reaction Time = 3 days 5% 0.2

UK 20-Year Bonds 299.7 299.7 Halve the Concentration 20% 2.7

(i.e. double the number of
UK Cash 100.0 100.0 securities lent and collateral)

US Equities 100.2 -100.2 £10m more in Cash Collateral 15% 1.9

Japanese Equities 51.0 -51.0 No Malaysian Lending +

Reduction in Cash Collateral 17% 1.7
Malaysian Equities 101.4 -101.4
Matched Collateral/Lent
US Long Bonds 99.8 99.8 Exposure & Concentration
+ Residual Collateral in Cash 14% 0.7

Source: Barrie & Hibbert

Source: Barrie & Hibbert
Table 3 shows how necessary haircuts could affect the valuation. For example, the lent
Malaysian equities have been revised upwards to £101.4m. This reflects the lower liquidity and Netting
higher volatility of the Malaysian equities, which outweigh the risk reduction brought by
diversifying the risk on the lent portfolio. The lender’s margin has thus effectively been reduced Netting (set off – see below) is an important element of risk management given that market
from £25m to £16.2m or 2.9%. participants will often have many outstanding trades with a counterpart. If there is a default the
various standard industry master agreements for securities lending should provide for the
Risk calculation (post-default) parties’ various obligations under different securities lending transactions governed by a master
agreement to be accelerated, i.e. payments become due at current market values. So instead
Using the adjusted portfolios, the lender can then calculate the risk of a collateral shortfall in of requiring the parties to deliver securities or collateral on each of their outstanding
the event of the borrower defaulting. Broadly, this will need to assess the volatility of each asset transactions gross, their respective obligations are valued (i.e. given a cash value) and the value
class, the correlation between them and the residual risk of securities within them to derive a of the obligations owed by one party are set off against the value of the obligations owed by
range of possible scenarios from which probabilities of loss and the most likely size of losses the other. It is the net balance that is then due in cash.
on default can be estimated. Working on the assumption that the lender can realise its collateral
and replace its lent securities in a reaction time of twenty days, Table 4 shows the results for This netting mechanism is a crucial part of the agreement. That is why there is so much legal
the portfolio, together with some sensitivity analysis in case market volatility and liquidity that focus on it. For example, participants need to obtain legal opinions about the effectiveness of
has been significantly changed. By increasing the volatility assumption or reducing the liquidity netting provisions in jurisdictions of overseas counterparts, particularly in the event of a
assumption, the probability and scale of expected losses increase. counterpart’s insolvency.

Table 4: Risk analysis for Borrower 1 under different assumptions That is also why regulators of financial firms typically expect legal opinions on the robustness
of netting arrangements before they will recognise the value of collateral in reducing counterpart
Scenario Probability of Loss Expected Loss
credit exposures for capital adequacy purposes. In the United Kingdom, SLRC has a netting sub-
on Default on Default (£m) group, which, on behalf of subscribing banks, is monitoring an exercise to gather opinions on
Base Case 26% 4.0 the legal bases for netting in different jurisdictions.
Asset Risk Increased by 50% 33% 8.0

Reduce Liquidity by 50% 31% 5.1 UK regulation

Source: Barrie & Hibbert Any person who conducts stock borrowing or lending business in the United Kingdom would
generally be carrying on a regulated activity under the terms of the Financial Services and
The final sensitivity is reaction time and Table 5 shows how the probability and expected size Markets Act 2000 (Regulated Activities) Order 2001, and would therefore have to be authorised
of losses decrease if the lender can realise the collateral and replace the lent securities more and supervised under that Act. The stock borrower or lender would, as an authorised person,
quickly. be subject to the provisions of the FSA Handbook, including the Inter-Professional chapter of
the Market Conduct Sourcebook. They would also need to have regard to the market abuse
This framework can be used to understand how possible changes in ABC’s programme with provisions of the Financial Services and Markets Act 2000, and the related Code of Market
Borrower 1 might affect the risks. Table 5 summarises some of the possible changes that could Conduct issued by the Financial Services Authority (FSA). The Conduct of Business Sourcebook
be made, in each case leaving the base case portfolio unchanged in other respects. requires a beneficial owner’s consent to carry on stock lending on its account. The FSA
Handbook contains rules, guidance, and evidential provisions relevant to the conduct of the firm

44 45
 in relation to the FSA’s High Level Standards.
Chapter 6 Securities lending & corporate governance
Stock Borrowing and Lending Code
The purpose of this chapter is to consider the central issues and to explore how securities
lending and good corporate governance can be arranged so as to minimise conflict to the
In addition to the essentially prudential standards set by the FSA, market participants have
overall benefit of the institutions involved, the corporations and the market. Various reviews of
drawn up a code, the Stock Borrowing and Lending Code. This is a code that UK-based
this important topic are underway, including those by Paul Myners, The International Corporate
participants in the stock borrowing and lending markets of both UK domestic and overseas
Governance Network (ICGN) and the EU Commission.
securities observe as a matter of good practice. The Code covers matters such as agents,
brokers, legal agreements, custody, margins, defaults, close-outs and confirmations. It is based
It is our contention that securities lending and the pursuit of good corporate governance are
on the current working practices of leading market practitioners and is kept under regular
not necessarily in conflict. Both activities can, and do, co-exist happily within the investment
review. The Code does not in any way replace the FSA’s or other authorities’ regulatory
management mainstream. We hope that the arguments and information put forward in this
requirements; nor is it intended to override the internal rules of settlement systems on
paper substantiate this position. It is our intention that this chapter, which draws examples from
borrowing or lending transactions. Work is currently in progress to produce a UK Annex to the
the UK lending market place but is applicable to the broader marketplace, will add substance
Code that will consider specific aspects of UK law and practices in the equity stock lending
to the ongoing debate in this area.
market. The Code is available on the Bank of England’s website at www.bankofengland.co.uk
What is corporate governance?
Securities Lending and Repo Committee
Corporate governance has increased in importance over recent years. This high profile has been
The Stock Borrowing and Lending Code was produced by the Securities Lending and Repo
supported by investors, their associations and increasingly by regulators. As the Organisation
Committee (SLRC), a UK-based committee consisting of market practitioners, members of bodies
for Economic Co-operation and Development writes in response to the following frequently
such as CREST, the United Kingdom Debt Management Office, the Inland Revenue, the London
asked question “What is corporate governance and why is it important?”:
Clearing House, the London Stock Exchange and the FSA. It provides a forum in which structural
(including legal, regulatory, trading, clearing and settlement infrastructure, tax, market practice
Corporate governance deals with the rights and responsibilities of a company’s
and disclosure) developments in the stock lending and repo markets can be discussed and
management, its board, shareholders and various stakeholders. How well companies are run
recommendations made. It also co-ordinates the development of gilt repo and equity repo
affects market confidence as well as company performance. Good corporate governance is
codes; produces and updates the Gilts Annex to the TBMA/ISMA Global Master Repurchase
therefore essential for companies that want access to capital and for countries that want to
Agreement (GMRA); keeps under review the other legal agreements used in the stock lending
stimulate private sector investment. If companies are well run, they will prosper. This, in
and repo markets; and maintains a sub-group on legal netting. It liaises with similar market
turn, will enable them to attract investors whose support can help to finance faster growth.
bodies and trade organisations covering the repo, securities and other financial markets, both
Poor corporate governance, on the other hand, weakens a company’s potential and, at
in London and internationally. Minutes of SLRC meetings are available on the Bank of England’s
worst, can pave the way for financial difficulties and even fraud6.
website, at www.bankofengland.co.uk/markets/slrc/htm. The SLRC’s terms of reference are shown
in Appendix 2.
Exercising the right to vote is therefore an integral and important aspect of good corporate
governance for institutional investors. To be more precise the exercising of a right to vote
The work of the SLRC complements the work of the various market associations, including, in
against management is the ultimate sanction that a shareholder has and can be seen as a major
the securities lending field, the International Securities Lending Association (ISLA). The
step in meaningful engagement with the company.
objectives of ISLA include representing the common interests of securities lenders and assisting
in the orderly, efficient and competitive development of the securities lending market. ISLA has
helped to produce standard market agreements, including the Overseas Securities Lending Avoiding conflict
Agreement (OSLA 1995 version), the Master Equity and Fixed Interest Securities Lending
Agreement (MEFISLA 1999 version) and the Global Master Securities Lending Agreement (GMSLA There has been widespread discussion regarding the possible conflict between the exercising of
May 2000). good corporate governance on behalf of investors and the lending of securities. This discussion
focuses upon the ability of investors, either directly or by instructing their agents, to vote when
they have securities on loan.

We will draw upon specific examples, where appropriate, and highlight best practice.

Shares should not be borrowed for the purpose of voting

As Paul Myners wrote in the March 2005 Report to the Shareholder Voting Working Group,
‘Review of the Impediments to voting UK shares’:

Borrowing shares for the purpose of acquiring the vote is inappropriate, as it gives a
proportion of the vote to the borrower which has no relation to their economic stake in

6 www.oecd.org
46 47
 the company. This is particularly the case in takeover situations or where there are The practitioners
shareholder resolutions involving acquisitions or disposals. The potential to vote
borrowed shares means that there is a risk that decisions could be influenced by those They in turn need to ensure that they or their counterparts/agents act in accordance with the
that do not have an economic interest in the business. I believe that this merits the beneficial owner’s requirements. The counterparts or agents will include the following types of
attention of lenders, fund managers and the ultimate beneficial owners, and their organisations:
respective trade associations. They should visit existing practices to see whether
practical procedures could be put in place to prohibit the borrowing of stock for the • Asset Managers
purposes of voting. In this respect, the Securities Borrowing and Lending Code of • Local Custodians
Guidance states: “there is consensus in the market that securities should not be • Global Custodians
borrowed solely for the purposes of exercising the voting rights at, for example, an AGM • Third Party Lending Specialists
or EGM. Lenders should also consider their corporate governance responsibilities before • Proxy Voting Contractors e.g. ISS or ADP
lending stock over a period in which an AGM or EGM is expected to be held”7. • Broker Dealers
Similarly collateral held, which can be of equal or greater value than the shares lent, should
not be voted8.
The lenders’ choices

This is a clear position and one of which practitioners actively engaged in the business of The following positions are possible and there are securities lending programmes constructed
securities lending are acutely aware. to cater for each of them:

1. Voting (and therefore recalling) securities at every opportunity e.g. when the owner has
The right to recall a strong culture of voting and does not wish to miss an opportunity to demonstrate its
position to the company
It is the case that securities on loan cannot be voted by the lender. Should they wish to exercise
their right to vote, they need to recall these securities by the pre-determined time i.e. record This is quite a rare position to take and is often only made in a subset of markets that
date. Notwithstanding the above, it is not the case that, in aggregate, all votes on lent shares are very important to the owner e.g. A UK pension fund might wish to recall all UK
are lost. Some shares that have been borrowed will be delivered into the market to settle sales securities to vote. In his report, Paul Myners accepted that investors might have
and end up with buyers. These buyers will be oblivious to the fact that these shares have been legitimate economic reasons for not recalling all securities to vote.9
borrowed and will view them as their property and choose to vote as they see fit. It is the case
that there may be some loss of votes associated with collateral positions or positions sitting 2. Voting (and therefore recalling) securities only when the vote is deemed important
long in trading books because shares held as collateral or in trading books are not normally enough e.g. when a takeover is being considered
voted.
This is a more commonplace position and enables the owners to enjoy higher securities
The right to recall any security on loan is enshrined in the legal agreement underpinning this lending revenues whilst voting when they feel it is warranted. It is important to note that
activity and typically the lender recalling securities must provide their agent or borrower with the beneficial owner determines when it is important to vote, not their agents or
“standard settlement period notice.” Recalls are part and parcel of the securities lending borrowers. Here again the owners might focus upon their local market where their
business. However, borrowers seek to avoid recalls wherever possible and frequent recalls may corporate governance aspirations are understandably higher than they might be
discourage borrowers from accessing portfolios. In practice the lenders, or their agent, overseas.
communicate the lender’s position with regards to voting to the borrowers so as to avoid any
surprises. It is important for all parties that they understand the importance of this 3. Not voting securities at all
communication and the rights of the underlying client to recall their securities to vote.
There are still organisations that choose, for their own reasons, not to vote. This is their
There are several positions that can be taken and these are driven by the owners of the assets decision although increasing pressure in the UK from the government and others with
made available for loan. At all times it is the owner who determines what can and cannot be regulatory responsibility may well encourage greater voting over time. However, should
done with their securities. they change their mind and make an exception, they would have the capability to notify
their agent or borrower and recall the securities in the normal way.
The beneficial owners
4. Maintaining a buffer of at least one share in all holdings
The beneficial owners of these assets include the following types of organisations:
To ensure that the beneficial owner or asset manager receives direct advice regarding
• Pension Funds voting (and all other corporate actions) the retention of at least one share in their account
• Mutual Funds is advisable. This has the advantage of ensuring the efficient and direct flow of information
• Insurance Companies whilst retaining optimal lending returns. It is typical for there to be some retention or
• Unit Trusts “buffer” of securities to be made in a lending programme and this level could be as low
• Charities and Religious Institutions as one share or could be expressed as a percentage of the value of the holding.

7 SLRC Code of Guidance Clause 7.4 9 ‘Review of the Impediments to voting UK shares’, Report to the Shareholder Voting Working Group, Paul Myners, March 2005
48 49
8 ‘Review of the Impediments to voting UK shares’, Report to the Shareholder Voting Working Group, Paul Myners, March 2005
 Market practice was on loan over the period from January 2005 to January 2007. This peaked at 6% in April
2005. Normal levels of borrowing would seem to be in the 3% to 4% range and the
Currently the majority of lenders of securities do not recall securities for voting except for the extraordinary peaks can be identified as coinciding with the dividend dates.
more contentious votes. This choice is theirs to make and should they wish to alter this position
they are free to do so. The impact of dividend dates on some securities can be demonstrated in the chart below that
shows how borrowing changes over time. HSBC is one of many UK securities that offers its
Typically a lender of securities would let their counterparts know their position regarding shareholders the option of taking the dividend in either stock or cash. The inserted diamonds
corporate governance and propensity to vote before joining a lending programme. Lending are the record date for the dividends.
agents have strong operational procedures in place to ensure recalls are made where
appropriate. 20.00 1,050.00

%Market Cap on Loan

The May 2005 Euromoney survey conducted by the International Securities Finance Magazine 1,000.00
15.00
(“ISF”) of 117 international beneficial owners exhibited the following results: 950.00
10.00
900.00
Do you ever recall securities to vote?
5.00
850.00
Yes 42%
0.0 800.00
No 58% Jan 05 Apr 05 Jul 05 Oct 05 Jan 06 Apr 06 Jul 06 Oct 06 Jan 07 Apr 07

HSBC Holdings (%Market Cap on Loan) HSBC Holdings (Price)

If you do make recalls to vote, what issues are you voting on?

On contentious issues 44% Source: Index Explorer

All proxies 19%
Mergers & Acquisitions 22% It is clear that HSBC and other dividend related borrowing is having a significant impact upon
Board composition and pay 14% the FTSE 100 peaks on a quarterly basis. This is a traditional dividend payment time.

This means that of those responding 8% recall every security to vote, i.e. of the 42% of those The impact of dividends
that recall to vote, 19% do so for all proxies.
Below we show that once the amount of borrowing specifically around dividend dates is
As the results above demonstrate, the majority of lenders of securities (58%) do not recall excluded, the value of the FTSE 100 on loan is much less volatile.
securities in order to vote. A change in this position may result in the lender forgoing some or
all of their securities lending income.
4.50

% Market Cap on Loan

FTSE 100 borrowing 4.00

The scale of lending related disenfranchisement needs putting into context and the following 3.50
charts may assist in this regard:
3.00

2.50
6.00 Jan 05 Apr 05 Jul 05 Oct 05 Jan 06 Apr 06 Jul 06 Oct 06 Jan 07 Apr 07
% Market Cap on Loan

5.50
FTSE 100 (% Market Cap on Loan)
5.00
4.50
4.00
Source: Index Explorer
3.50
3.00 Putting disenfranchisement in context
2.50
Jan 05 Apr 05 Jul 05 Oct 05 Jan 06 Apr 06 Jul 06 Oct 06 Jan 07 Apr 07
We have seen that there is a material amount of borrowing in this blue chip index that peaks
FTSE 100 (% Market Cap on Loan) over dividend dates. What impact does this pattern have upon voting turnout and thereby upon
corporate governance? It is difficult to say in specific terms without going into detailed examples
Source: Index Explorer and space prohibits us from doing so here. However, the following conclusions easily emerge
from the research. The scale of securities lending does not typically exceed the voluntary
The previous chart shows the percentage of the market capitalisation of the FTSE 100 index that disenfranchisement one sees at typical AGMs. In other words more investors choose not to vote

50 51
 (for whatever reason) than choose to lend (and not recall). to assess than the benefit of making a vote. Any policy should be flexible enough to take into
account a wide variety of security specific situations.
The graph below shows measures of voting turnout regarding company remuneration policy in
2006. We have analysed the proportion of shares on loan, shares voted and shares not voted Communication
for the 99 companies of the FTSE 100 for which information is publicly available.
It is imperative that all stakeholders have access to all necessary information in time to make
The Turn Out block shows the percentage of shares that were voted at the meeting. The Shares informed decisions. This requires accurate communication of data throughout the chain of
on Loan block represents the percentage of shares in each company that were on loan at the organisations that are involved in lending, including the stakeholders at the beneficial owners,
time of the meeting. The Unwanted/Unpositioned block shows the percentage of shares that all teams at their providers and also the issuer. The efficient communication of any recalls is a
were neither voted at the meeting or on loan at the time of the meeting. vital part of the process that is normally well documented in the securities lending agreement.
Beneficial Owners should typically expect that securities on loan will be returned upon the
provision of standard settlement period notice.
100%
90% Timing
80%
70%
60% Given the scale of lending activity around the dividend record date it is constructive to maintain
50%
40%
the separation of the record date from the AGM. However, the issuers should ensure that the
30% necessary documentation regarding the shareholders meeting are distributed prior to the record
20% date so that the owners can decide whether they would prefer to vote or make the securities
10%
0% available for loan. Furthermore, bringing the payment date closer to the AGM would ensure that
Turn Out Shares Not Voted Abstain the dividend timetable is not unduly lengthened. This would enable lenders that wish to
participate in profitable dividend related lending activity to do so with less voting conflict. It
will also ensure that lenders are fully informed and can vote when it matters to them. This
Source: Data Explorers, Makinson Cowell amendment does not require changes in company law and could be affected by the issuing
companies. The graph for HSBC shown below, which has been adjusted for dividend impact (i.e.
Suggestions the extraordinary dividend related borrowing has been removed) shows what one could call
“normalised” borrowing levels. The difference in scale between this chart and the one presented
So what should be done to alleviate the perceived problem? Here are some suggestions that earlier is stark and the normal level of borrowing is much less volatile.
are currently being considered and that will make a difference if implemented:
20.00 1,050.00
Transparency

%Market Cap on Loan

1,000.00
15.00
All stakeholders, not just securities lending professionals, e.g. fund managers and corporate 950.00
governance professionals, should understand the following: 10.00
900.00

• The established legal framework underpinning the lending arrangement 5.00

850.00
• Securities must be recalled to vote
0.0 800.00
• The exact notice required to recall the shares to vote – this may be different to normal Feb 05 May 05 Aug 05 Nov 05 Feb 06 May 06 Aug 06 Nov 06 Feb 07 May 07
market settlement periods depending on the lending agent being used
HSBC Holdings (%Market Cap on Loan) HSBC Holdings (Price)
• Securities which are on loan
• How to access loan and/or governance information
• The potential effect of dividend record dates Source: Index Explorer

Some beneficial owners are already in receipt of detailed reporting from their lending agents, Guidance
although it is fair to say that the frequency and distribution of this information varies. Best
practice is to provide daily reports securely on the internet. This enables permissioned users It is clear from the SLRC Code of Guidance and the Myners reports on the subject of securities
throughout the beneficial owners organisation to understand which securities are on loan. lending and voting that the practice of borrowing shares specifically to vote is unacceptable.

Consistency Many active participants in the securities lending business already have the suggested measures
outlined above in place. That should be a source of comfort to those concerned about the
A clear policy is required so that the inherent conflict between the securities lending income activity.
forgone and the “value” of recalling to vote is addressed explicitly. This policy should be
carefully drafted and agreed by stakeholders. In practice, accurately assessing the economic
trade off is challenging – the opportunity cost of making a recall may be known and is easier

52 53
 Lending is only part of the picture Chapter 7 Frequently asked questions
The evidence suggests that lending is not one of the primary reasons why voting turnout is low.
The securities lending business is seen by many non-practitioners as difficult to understand and
The value of a vote is determined by the owner of that vote – if they do not value it they may
there are many questions asked. Here, we provide answers to some of them.
choose not to exercise their right, irrespective of their willingness to lend.

As the law currently stands in the UK, borrowing securities in order to build up a holding in a Legal
company with the deliberate purpose of influencing a shareholder vote is not illegal. However,
based on recent headlines and the work done by the International Corporate Governance 1 What do people mean when they talk about transfer of title?
Network, institutional lenders have recently become more aware of this possibility, and tend not
to see it as a legitimate use of securities borrowing. Contracts provide for ownership of lent securities to pass from the lender to the borrower.

Since the demise of the borrowing purpose test, it is technically possible for someone to borrow A moment’s thought about one of the principal motivations for borrowing and lending securities
securities to vote. However, it has been made very clear that this is not acceptable practice as will make the necessity for this clear. Say the borrower needs to borrow securities to cover a
the UK Annex to the Stock Borrowing and Lending Code, SLRC, 11 May 2004 makes clear. short position, i.e. to fulfil a contract it has entered into to sell on the securities. The buyer is
expecting the borrower to pass it ownership on settlement of that sale, as is normal in a sale.
Should this activity become an issue of concern in the future, it would draw regulatory attention If the borrower cannot do that, the borrower will not be able to fulfil its contract with that
very quickly, with the widespread support of the securities lending industry. purchaser. In order to enable it to fulfil its contract, the borrower obtains title from the lender
and then passes it on to the purchaser, hence “transfer of title”.
It is vital that beneficial owners are aware that when shares are lent the right to vote is also
transferred. The SLRC Code of Guidance states that “agents should make it clear to clients that 2 What does this mean for the lender?
voting rights are transferred.”10
The lender needs to be aware that it will be transferring ownership of the securities and of the
Going forward, a balance needs to be struck between voting securities and the benefits derived various consequences that flow from this.
from lending securities. Quantifying these competing benefits is challenging. The income derived
from securities lending can be explicitly measured but the value of a vote is perhaps less First, any transfer taxes applicable to a purchase of securities will be due unless an exemption
tangible – particularly now that most securities carry a vote and the majority of equity securities applies. This will typically be an issue for the borrower on the initial leg of the transaction. But
in publicly quoted companies rank pari passu (i.e. there are fewer companies that issue both the lender should recognise that the return leg of the transaction (i.e. when the borrower
voting and non voting shares that can be compared with one another). transfers securities back to the lender) may also attract transfer taxes where they are applicable.

Beneficial owners need to ensure that any agents they have made responsible for their voting Second, the transfer of the lent securities is in legal terms a disposal of them, and the lender
and stock lending act in a co-ordinated way. This may mean that portfolio managers need to needs to establish whether such a disposal will have any consequences. Again this is usually a
receive reports regarding securities on loan so as to avoid any situation whereby votes that they tax question e.g. are there tax consequences for the lender in disposing of the lent securities?
intend to make are not possible. This should be straightforward as notification of a vote taking
place is given well in advance and securities can easily be recalled if necessary. Third, and very importantly, the obligation of the borrower on the return leg of the transaction
is to transfer equivalent securities back to the lender, not the original securities. In a securities
lending transaction, the borrower is not “holding” the securities in trust or in custody on behalf
Conclusion
of the lender. The borrower actually owns them, which is to say that the lender has no right to
securities that are in the hands of the borrower. Given that the borrower will often have sold
Securities lending and the pursuit of good corporate governance are not necessarily in conflict.
on the securities, it is unlikely that the securities would be in the borrower’s hands.
Both activities can and do co-exist happily within the investment management mainstream.
Today, many of the foremost proponents of good corporate governance successfully combine an
Fourth, as the lender will cease to be the owner, it will no longer be entitled to income from
active voting role with a successful securities lending role. The information flow and
the securities, will not receive notice or proceeds of corporate actions and will lose all voting
communication necessary to ensure that conflict is avoided is already in place but could be
rights in respect of the securities. The standard documentation sets out contractual mechanisms
developed further. Those that are concerned about possible conflict need to openly discuss the
for putting the owner in a comparable economic position in respect of income and corporate
issue with their securities lending counterparts and corporate governance colleagues. There is
actions. Voting rights are transferred and the lender must recall equivalent securities from the
no need for anyone to feel that securities lending will disenfranchise them. At all times it should
borrower in order to vote.
be remembered that the owner of the securities determines whether securities are either lent
or voted.
3 Why is it called securities “lending” when there is transfer of title?

Because commercially and economically people think of it as lending. Reflecting this, for
accounting and capital requirements it is usually treated as a loan.

4 Does it mean that the lender gets exactly the same securities back?

10 ‘Stock Borrowing & Lending Code of Guidance’, Securities Lending & Repo Committee, December 2000
54 55
 No. The borrower’s obligation is to return “equivalent securities” i.e. from the same securities Dividends and coupons
issue with the same International Securities Identification Number (ISIN). Often it will have sold
the original lent securities and has to borrow or purchase securities in the market to fulfil its 1. What happens if the lender has lent a stock over the dividend period?
obligation to the lender.
The “borrower” of stock makes good to the lender the dividend amount that the lender would
5 Does the lender have a pledge over the collateral? have received had it not lent the stock in the first place. This amount is the gross dividend less
any withholding tax that the lender would usually incur.
No. Under standard market agreements and English law, there is usually a transfer of title to
the collateral. If the collateral is cash, all that means is that there is a cash payment by the 2. Does the lender still receive the dividend or coupon payment?
borrower into the lender’s bank account. If the collateral is securities, there is a transfer of title
of those securities to the lender. No, the lender receives from the borrower a “manufactured” dividend or coupon rather than the
dividend or coupon itself.
Many of questions that arise for borrowers in relation to collateral securities also arise for
lenders in relation to lent securities. 3 Does the lender still receive the (manufactured) dividend or coupon payment on the due date?

Yes, the lender’s account should be credited on the due date by the borrower, even if the
6 Why are there so many different agreements? borrower has not actually received it.
Historically the different tax treatment of securities lending in different jurisdictions has driven 4 What happens if the lender has loaned a stock over a scrip dividend record date – does
the need for different agreements (such as OSLA – the Overseas Securities Lenders’ Agreement, it get the relevant cash or stock on the pay date?
MEFISLA – the Master Equity and Fixed Income Stock Lending Agreement, and so on). Following
tax changes it has generally become possible to use a single document. The GMSLA – the Global The lender should tell the borrower in advance which it would like to receive. Again the
Master Securities Lending Agreement, consolidates the various historical documents. borrower must manufacture the cash or stock for the lender even if it is receiving the other.
7 If the securities lending is carried out under English Law, but a custodian appoints a 5 Who organises that?
sub-custodian in another country, or lends to an entity in another country which does
not recognise English Law, what happens when something goes wrong? It is between the borrower and the lender (or its designated agent or custodian).

Simplifying a bit, there are three elements in the application of law to a securities lending 6 Why do lenders get higher loan rates if they take cash for a scrip dividend?
transaction. The first is the contractual law, the second are the home country laws applying to
each party and the third is the law applying to the place where the securities are held. Usually there is a financial incentive offered by a company to shareholders that take scrip rather
than cash. Therefore the borrower can take scrip, sell it to receive additional income over the
The contractual law is that which applies to the legal agreement between the parties, which cash amount of the dividend and may share this with the lender.
sets out the contractual terms relating to the lending transaction. Most lending agreements are
in practice subject to English law, so that any disputes can be settled in the courts of England.
Collateral and risk management
Where a party incorporated in England proposes to conduct a securities lending transaction with
a party incorporated in another country, the UK-incorporated party will need to check, normally 1 What is collateral?
by obtaining a legal opinion, that the home country law of the other party will allow the contract
to be given effect in accordance with its terms. This opinion will normally focus in particular on Financial instruments given by borrowers to lenders to protect them against default over the
the close out and netting (set-off ) provisions of the legal agreement that apply in the insolvency term of the loan. Collateral securities are usually marked to market every day. Borrowers are
of either party (see section on netting in Chapter 5). This together with the collateralisation and required to maintain collateral with a market value at least equal to the market value of the
margin arrangements should keep the risks in conducting such business to acceptable levels. loaned securities plus some agreed margin “haircut” (see below).

As regards the law relating to where the securities are held, securities borrowers need to be 2 What is a haircut?
certain that they have good title to the securities since there is a potential for conflicts of laws
or legal uncertainty in this respect. The traditional rule for determining the validity of a “Haircut” or margin is the extra collateral that a borrower provides in order to mitigate any
disposition of securities is to look to the law of the place where the securities are located [the adverse movements in the value of the loan and value of collateral between the mark-to-market
“lex sitae” or “lex situs” principle]. This is, however, difficult to apply if securities are held date, and the value of liquidated collateral and repurchased loan securities on the default date.
through a number of intermediaries. The generally preferred approach now is to look to the
location of the intermediary maintaining the account into which the securities are credited (the 3 How often is the collateral valued?
“PRIMA” principle). The EU Collateral Directive as implemented in EU member states applies the
PRIMA principle and there are plans to extend it further through the so-called Hague Convention. Usually every day, as with the loaned securities, but it can be more frequent in exceptional
circumstances.

56 57
 4 Is the collateral held in the lender’s name or its agent’s name? zones. Otherwise both valuations should be made at least daily.

It should be held in the lender’s name, but can be held by an agent to the lender’s order if so 14 Is accrued interest included in the calculations of market value for collateral, loans and
desired. fees?

5 Is collateral valued at the individual client level or does the custodian value it at a The GMSLA provides for the valuation of both securities and collateral to include
summed level and then allocate the collateral amongst its clients? • accrued income
• dividend or interest payments declared but not yet due by the issuer
Again this can be done either way as desired by lenders and agents. • dividends paid in the form of securities

6 What happens if the borrower defaults? but not other rights or assets deriving from ownership of the securities or collateral.

The lender liquidates the collateral and repurchases the loaned (lost) securities. Any excess 15 What happens if a borrower doesn’t return a stock when called or at maturity?
should be returned to the borrower or liquidator. Any shortfall should be claimed from the
borrower or liquidator. The lender may decide to expedite a “buy-in”, whereby it purchases the unreturned stock in the
market and invoices the borrower for any costs.
7 How do lenders get their securities back? How long does it take?
16 Who would pay the overdraft fees if a lender’s fund manager had sold stock and the
Within the usual settlement cycle for the securities in question (see Chapter 4), after they have lender had failed to settle the trade because the borrower hadn’t returned the stock?
been repurchased.
The lender may claim against the borrower for any direct costs incurred. However it should be
8 Who liquidates the collateral? noted that consequential loss might not be covered. Where the borrower’s failure to redeliver
securities to the lender causes a larger onward transaction to fail, the norm is for the lender to
Lenders or their agents (if they use them). claim only that proportion of the costs that relate directly to the loaned securities.

9 How do lenders ensure that the liquidation of the collateral is done at market rates? 17 What is cash reinvestment?

In a similar manner as they might check on any sales made in the usual course of business. In many cases, particularly in the United States, stock is loaned against cash collateral. Rather
Some agents will indemnify lenders against borrower default, in which case they will return the than the borrower paying a fee, it receives a rebate (e.g. 0.4%) being the interest rate payable
loaned assets and deal with liquidating the collateral themselves. on the cash (e.g. 1%) less the fee (e.g. 0.6%). In such situations the lender, or their agent, has
cash and an obligation to pay this rebate to the borrower. The lender therefore reinvests the
10 What happens if market prices rise between the borrower defaulting and cash being cash to receive an interest rate (e.g. 1.1%) so that the lender receives the fee plus any
made available following the liquidation of the collateral? reinvestment pick-up (e.g. 0.1%) or less any reinvestment shortfall.

Any shortfall should be claimed from the borrower or its liquidator in insolvency. N.B. Up to a The reinvestment market in the US is aptly described as ‘the tail that wags the dog’. The pursuit
48-hour window is available under the OSLA, MEFISLA and GESLA (see the glossary for of income in a fairly mature lending market for US securities means that reinvestment
definitions) depending on whether default takes place within or outside normal business hours. opportunities frequently drive loan transactions that are little more than a method of raising
This is extended to 5 days in the new GMSLA. cash.

11 What happens if the markets move such that the collateral held is less than the required 18 What are the risks attached to cash reinvestment?
collateral amount?
There is the chance that the reinvestment rate achieved is less than the rebate rate. This usually
Any shortfall should be claimed from the borrower or its liquidator in insolvency, otherwise more happens in rising interest rate environments if the interest rate paid to the borrower is the
collateral should be sought. If markets are particularly volatile then intra-day marking–to- overnight rate fixed daily and reinvestments are for a fixed period (e.g. one month). So, if short-
market may be appropriate. term rates rise during the time that the reinvestment is fixed, the lender can lose.

12 How often is the collateral topped up (i.e. marked to market and margin called)? Also, reinvestments are sometimes made into investments of lower credit quality to achieve
returns. If this instrument defaults on interest payments or is downgraded by rating agencies,
Usually every day or as required. it is likely to fall in value. Most reinvestment is made into US Treasury or US Agency mortgage-
backed securities, in which cases custodian/banks will usually indemnify lenders in the case of
13 Are the collateral securities and the securities on loan valued at the same default.
time/prices/frequency?
19 What happens if the assets being held as collateral become worthless?
Not always. The collateral and loan securities might be located in different markets and time-

58 59
 So long as the borrower has not defaulted too, they will substitute, or top-up collateral to the Corporate governance
agreed level in the course of the mark-to-market process.
1 Can lenders vote in an AGM/EGM whilst stock is on loan?
20 What happens if the assets on loan become worthless?
No. Stock lending is in one sense a misnomer: it involves the transfer of title, and with that, all
The borrower will ask for collateral back to the agreed level in the course of the mark-to-market voting rights associated with the securities; indeed securities are often borrowed in order to
process. settle an outright sale, so that the securities pass onto another outright owner. But borrowers
have a contractual obligation to return equivalent securities to lenders on demand. Lenders
21 What is an indemnity? therefore treat securities loans as temporary transactions that do not affect their desired holding
in a stock. In the case of votes, lenders have the choice whether to recall equivalent securities
It is a kind of insurance policy offered to lenders to mitigate risks associated with lending. One in order to vote their entire “desired holding” or to leave stock on loan, forgoing the right to
of the most commonly offered indemnities is against borrower default. Usually, like insurance vote. (Although, this does not mean that votes are necessarily ‘lost’ in aggregate, as the new
policies, they cover specific events and are not a catchall so, as with insurance policies, read owner may choose to vote.) If they opt to leave the stock on loan they have no means of
the small print! controlling or knowing how the current owner might vote. Their decision on recalling the stock
boils down to whether the benefits of voting are greater than those of lending. Investors make
22 Who offers them? their own choices. It is worth noting that returns to lenders often increase around key corporate
actions.
Usually custodian banks offer indemnities to their lending customers. Third Party Agents obtain
them from insurance companies on behalf of lender clients. 2 Can lenders recall stock to vote, and does this affect their reputation as lenders?
23 What strings are attached? It is quite common for lenders to retain a buffer when lending stock so they can always go to
or vote in an AGM/EGM whilst stock is on loan. However if they wish to vote all their holding,
Lenders may be asked to split revenue to give the custodian a larger share, reflecting the value they must recall the lent securities. If a borrower is still holding the stock (i.e. it has not yet
of the indemnity. been used to fulfil short-sale obligations) lenders may ask them to vote the stock on their
behalf.
24 How important is it to create a set of lending/collateral guidelines before starting to lend
rather that accepting the standard terms/guidelines? 3 Is it acceptable to borrow stock in order to accumulate a large temporary holding and
influence a vote?
For a new lender, an agent’s standard terms/guidelines are probably a good place to start. The
next step is to consider what is and is not appropriate to accept from the standard Borrowing stock for the purpose of accumulating a temporary holding to influence a vote is not
terms/guidelines in terms of a risk. It is the client’s prerogative to alter these guidelines as they a practice that most market participants regard as acceptable.
see fit.
The various lending options for beneficial owners
Operational and logistical
1 Can lenders loan more stocks from a portfolio that has very little trading/turnover rather
1 What is the difference between overnight and term loans? than a very actively traded portfolio?

Most loans are transacted on an “open” or overnight basis. Sometimes lenders are prepared to Yes, as greater certainty about the stability of the loan is a critical factor for all borrowers.
guarantee that they will maintain the loan over a longer period, but this is fairly rare. In such
cases the borrower has certainty that lent securities will not get recalled inside the term of the 2 How do custodians decide whose stock they lend if they have many clients that hold a
loan. It is more usual that a hedge fund borrower will obtain term loans from an investment particular stock?
bank, which will have multiple lenders so that if one should recall they can borrow from another.
They have allocation algorithms, but no two seem to be the same.
2 How long are term loans usually on loan for?
3 What is an exclusive lending relationship?
A month would be a typical period, but it depends on the nature of the trade underlying the
need to borrow. Where a lender makes available all, or segments of, its assets to a particular borrower or
borrowers exclusively.
3 How long does it take to recall a stock?
4 How is this different to going via a custodian?
Recalling should be exactly like buying. If a lender gives an instruction by a specific deadline,
then it should receive the stock back within the usual settlement cycle of the market in It can indeed be done via a custodian, which will do all the necessary administration. Unlike in
question. an exclusive relationship custodian will usually parcel out loans to borrowers on a stock-by-

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 stock basis, with the “algorithm” making the allocations between lenders.
Appendix 1 A Short History of Securities Lending
5 How long do exclusive arrangements normally last?
Securities lending began with the development of securities trading markets. For example, in
There is no standard timeframe but many last one year. the UK market from the 19th century, specialist intermediaries sourced gilts for the jobbers or
market makers. Collateral, typically non-cash, passed between the parties at the end of the
6 How does the custodian make money from securities lending? trading day and offered protection for the lenders. Much of the borrowing facilitated a practice
called “bond washing”, whereby tax advantages were exchanged between parties around record
Mostly they split the income between lenders and themselves. and ex-dividend dates. This was the precursor to tax arbitrage. A two-tier market quickly
emerged: a security-specific or “special” market and a more generic financing or “general”
7 What fees do they normally charge? market.

Usually the lender gets between 60% and 90%, but percentages vary. The 1960s
As the UK and US securities trading markets developed, so did the securities lending markets.
Here are some of the key developments that took place in the 1960s:

• The first formal equity lending transactions took place in the City of London
• An active interdealer market developed in the US (back office to back office)
• The increase in general, but particularly block, trading volume in the US equity markets.
The settlement system continued to be paper-based and this led to large backlogs of
settlement fails and back offices borrowing securities for settlement cover
• US Treasury bond financing expanded – before that the US market had focused on
equities

The 1970s
In the 1970s the US market developed and assumed much of the shape that would be
recognised today. The UK market would not develop to its present form until deregulation
following Big Bang in the 1980s. Here are some of the key developments that took place in the
1970s:

• The establishment of the US Depository Trust Company (DTC) reduced settlement related
demand but facilitated an increase in trading activity
• Trading demand from arbitrageurs increased. Strategies included:
• Convertible bond arbitrage
• Tax arbitrage
• Initial Public Offering (IPO)-related trading
• The US custodian banks began to lend securities on behalf of their clients:
• Endowments
• Insurance Companies
• Pension Funds (amendments to ERISA legislation in 1981 permitted lending in
accordance with guidelines)
• Treasury dealers began “matched book” repo trading – thereby generating borrowing
demand
• The US Treasury bond repo market became a key part of the money markets
• The US non-cash “bonds borrow” market promoted broker-to-bank business:
• Cash collateral was a problem for banks wishing to avoid capital charges
• Using long inventory saved the borrowers money
• Using non-cash collateral reduced their balance sheet when compared to cash
• The use of derivatives and leverage in transactions expanded because returns could be
increased and banks were willing to extend the necessary finance
• The creation of “finders” – specialists that lacked capital but had significant relationships
and could find the securities that borrowers needed – emerged

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 • The first cross border or international securities lending transactions took place The 1990s
• Typically offshore from the US or the UK
• Initially involving experienced traders using trading techniques that had been proven Securities lending volumes again rose sharply in most markets throughout the decade. Key
over time in their local markets developments included:
• Several key advantages such as time zone and a high concentration of international
fund management expertise, put the United Kingdom at the centre of international • Growing demand to borrow securities to support hedging and trading strategies
securities lending • Technological advances, including computer processing power, access to real time price
information and automated trade execution made possible new trading strategies such
The 1980s as statistical arbitrage
• Further rapid growth in hedge fund assets under management despite a pause
Key developments included: following the collapse of Long Term Capital Management in 1999
• Investment banks developed global prime brokerage operations to support the
• Cross border securities lending grew rapidly, driven partly by the international expansion activities of hedge fund clients, including securities lending and financing
of the US broker dealers and custodian banks • The removal of many regulatory, tax and structural barriers to securities lending
• Institutional lending of overseas securities increased because US and UK lenders were throughout the world. Some of the major changes and developments in the repo market
willing to expand their programmes from being domestic only were driven by the removal of specific legal or regulatory barriers, e.g.
• Increases in the debt of most G10 governments encouraged the growth of government • 1993 French repo
bond lending and repo markets • 1996 Japanese repo
• Trading demand continued to grow, driven by a variety of strategies: • 1996 UK repo
• The international derivatives markets expanded, with many derivatives hedging • 1997 Italian buy-sell back
strategies requiring short coverage e.g. index arbitrage • 1998 Swiss repo
• Tax arbitrage – the tax anomalies available to exploit internationally were numerous • In 1994 the sharp increase in US short-term interest rates led to losses for many
• Hedge funds were established in significant numbers securities lenders that had taken US dollar cash as collateral and were reinvesting it in
• Some institutional lenders began to enter into exclusive lending relationships with a variety of money market instruments. In many cases their agents, typically custodian
borrowers banks, compensated their underlying clients for these losses even though they were not
• Securities settlement systems introduced book entry settlement and were able to legally obliged to do so. Lessons included improved risk management procedures, better
process greater volumes: documentation and clear reinvestment guidelines.
• The Group of 30 report by an international group of experts stated that securities • During the Asian crisis in 1997-98, the authorities in a number of countries imposed
lending should be encouraged as a means of expediting efficient settlement restrictions on short selling, drawing a link with currency speculation, e.g. Malaysia and
• On May 17th 1982, Drysdale Securities, a minor bond dealer, collapsed. Drysdale had Thailand both in August 1997.
over $2 billion in US Treasury loans outstanding when it defaulted. Institutional supply
temporarily dried up following the Drysdale affair, particularly via the custodians, due to 2000’s and beyond
legal uncertainties, the US Government Securities Act of 1986 followed. Other changes
included the BMA developing the standardised securities lending legal agreement, a Trends include:
specification of collateral margins, collateralisation of accrued interest and disclosure of
borrowers and lenders by custodian banks. • The market becoming more segmented:
• In the autumn of 1988 Robert Maxwell authorised securities lending transactions from • Specialist regional players developing
the Mirror Group Newspaper pension fund. It was not until after his death on 5th • Outsourcing developing e.g. third party securities lending agents
November 1991 that the consequences of these and subsequent transactions became • Tax arbitrage opportunities disappearing as tax harmonisation occurs
apparent to the authorities, the market and the pensioners. As the Department of Trade • Continuing deregulation and tax changes making possible the establishment of new
and Industry (“DTI”) puts it in a chronology of events on www.dti.gov.uk: securities lending markets, e.g. in Brazil, India, Korea, Taiwan
• New transaction types:
“From November 1988, Mr Robert Maxwell therefore began to make use of the more • Equity repo – much more accepted and widespread than in 1990s
marketable blue chip shares held by the pension funds and First Tokyo Index Trust as • Contracts for Differences (“CFDs”)
collateral for bank borrowings to the private side; this was described as ‘stock lending’ • Total return swaps
to make it appear to be the legitimate practice of lending securities to market makers • Prime brokers using CFDs and total return swaps to allow clients to take positions in
as part of ordinary share dealing activities. Cash continued to be borrowed from the equity and bond derivatives rather than the underlying securities (“synthetic prime
pension funds by the private side without providing any collateral to the pension funds brokerage”)
for these loans.” • Initial Public Offering (“IPO”) and Mergers and Acquisition (“M&A”) opportunities
impacting the number of specials in the securities lending market.

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 Appendix 2 Terms of Reference of the SLRC
The committee will:

• Provide a forum in which structural (including legal, regulatory, trading, clearing and
settlement infrastructure, tax, market practice and disclosure) developments in the stock
lending and repo markets can be discussed, and recommendations made, by
practitioners, infrastructure providers and the authorities.
• Co-ordinate the development of the Stock Borrowing and Lending Code of Guidance.
This is a summary of the basic procedures that UK-based participants in stock
borrowing/lending of both UK domestic and overseas securities observe as a matter of
good practice.
• Co-ordinate the development of the Gilt and Equity Repo Codes of Best Practice. These
codes set out standards of good practice for repo. They are drawn up on the basis of
practice in existing repo markets in London observed by practitioners and the authorities
and are kept under review.
• Produce and update the Gilts Annex to the TBMA/ISMA Global Master Repurchase
Agreement (GMRA).
• Liase, where appropriate, with similar market bodies and trade organisations covering
the repo and securities markets, and other financial markets, in London and other
financial centres.
• Maintain a sub-group on legal netting and, if required, create other sub-groups to
research and manage specific topics.

Discussions between members during the course of meetings will be held to be confidential,
although summaries of these discussions will be published, normally within 1 month of the
meeting, at www.bankofengland.co.uk

Membership

• The Committee is chaired and administered by the Bank of England.

• The Committee comprises market participants representing the main trade associations
involved in the UK and international repo and stock lending markets, (currently
International Securities Lending Association; International Securities Market Association;
Bond Market Association; European Repo Council, London Investment Banking
Association; London Money Market Association; British Bankers’ Association),
infrastructure providers and the UK authorities.
• Membership of the Committee is to be decided by the Chairman. The Chairman may
invite additional ad hoc representatives from “knowledgeable parties” if thought
appropriate.

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 Glossary
Every industry has its own business terms. Securities lending is no exception. Here we list the
more esoteric terms mentioned in this booklet and some that might be encountered whilst
exploring the market. Note that some terms may have different meanings in contexts other than
securities lending.

Accrued interest: Coupon interest that is earned on a bond from the last coupon date to the
present date.

Agent: A party to a loan transaction that acts on behalf of a client. The agent typically does not
take in risk in a transaction. See “Indemnity.”

All-in dividend: The sum of the manufactured dividend plus the fee to be paid by the borrower
to the lender, expressed as a percentage of the dividend of the stock on loan.

All-in price: Market price of a bond, plus accrued interest. Generally rounded to the nearest 0.01.
Also known as “dirty price”.

Basis point: One one-hundredth of a percent or 0.01%.

Bearer securities: Securities that are not registered to any particular party and hence are
payable to the party that is in possession of them.

Beneficial owner: A party that is entitled to the rights of ownership of property. In the context
of securities, the term is usually used to distinguish this party from the registered holder (a
nominee, for example) that holds the securities for the beneficial owner.

Benefit: Any entitlement due to a stock or shareholder as a result of purchasing or holding

securities, including the right to any dividend, rights issue, scrip issue, etc. made by the issuer.
In the case of loaned securities or collateral, benefits are passed back to the lender or borrower
(as appropriate), usually by way of a manufactured dividend or the return of equivalent
securities or collateral.

BMA: The Bond Market Association – is a US-based industry organisation of participants

involved in certain sectors of the bond markets. The BMA establishes non-binding standards of
business conduct in the US fixed-income securities markets. Formerly known as the Public
Securities Association or PSA.

Buy-in: The practice whereby a lender of securities enters the open market to buy securities to
replace those that have not been returned by a borrower. Strict market practices govern buy-
ins. Buy-ins may be enforced by market authorities in some jurisdictions.

Buy/Sell, Sell/Buy: Types of bond transactions that, in economic substance, replicate reverse
repos, and repos respectively. These transactions consist of a purchase (or sale) of a security
versus cash with a forward commitment to sell back (or buy back) the securities. Used as an
alternative to repos/reverses.

Carry: Difference between interest return on securities held and financing costs:
Negative carry: Net cost incurred when financing cost exceeds yield on securities that
are being financed.
Positive carry: Net gain earned when financing cost is less than yield on financed
securities.

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 Cash-orientated repo: Transaction motivated by the need of one party to invest cash and the and non-cash distributions.
need of the other to borrow. See also ‘Securities-orientated repo’.
DVP (Delivery versus payment): The simultaneous delivery of securities against the payment of
Cash trade: A non-financing purchase or sale of securities. funds within a securities settlement system.

Clear: To complete a trade, i.e. when the seller delivers securities and the buyer delivers funds ERISA: The Employee Retirement Income Security Act, a US law governing private US pension
in correct form. A trade fails when proper delivery requirements are not satisfied. plan activity, introduced in 1974 and amended in 1981 to permit plans to lend securities in
accordance with specific guidelines.
Close-out (and) netting: An arrangement to settle all existing obligations to and claims on a
counterpart falling under that arrangement by one single net payment, immediately upon the Equivalent (securities or collateral): A term meaning that the securities or collateral returned
occurrence of a defined event of default. must be of an identical type, nominal value, description and amount to those originally
provided. If, during the term of a loan, there is a corporate action in relation to loaned
Collateral: Securities or cash delivered by a borrower to a lender to support a loan of securities securities, the lender is normally entitled to specify at that time the form in which he wishes to
or cash. receive equivalent securities or collateral on termination of the loan. The legal agreement will
also specify the form in which equivalent securities or collateral are to be returned in the case
Contract for Differences (CFD): An OTC derivative transaction that enables one party to gain of other corporate events.
economic exposure to the price movement of a security (bull or bear). Writers of CFDs hedge
by taking positions in the underlying securities, making efficient securities financing or Escrow: See Tri Party
borrowing key.
Fail: The failure to deliver cash or collateral in time for the settlement of a transaction.
Corporate action: A corporate event in relation to which the holder of the security must or may
make an election or take some other action in order to secure its entitlement and/or to opt for Free-of-payment delivery: Delivery of securities with no corresponding payment of funds.
a particular form of entitlement (see also equivalent).
G7: The Group of Seven, i.e. US, France, Japan, United Kingdom, Germany, Italy and Canada
Corporate event: An event in relation to a security as a result of which the holder will or may
become entitled to: G10: The Group of Ten, i.e. US, France, Japan, United Kingdom, Germany, Italy and Canada, the
• a benefit (dividend, rights issue etc.); or Netherlands, Sweden and Switzerland
• securities other than those which he held prior to that event (takeover offer, scheme of
arrangement, conversion, redemption, etc). This type of corporate event is also known General Collateral (GC): Securities that are not “special” (see below) in the market and may be
as a stock situation. used, typically, to collateralise cash borrowings. Also known as “stock collateral”.

Conduit borrower: See intermediary. Gilt-Edged Securities (Gilts): United Kingdom government bonds.

Custodian: An entity that holds securities of any type for investors, effecting receipts and Gilt-Edged Securities Lending Agreement (GESLA): see Master Gilt Edged Securities Lending
deliveries, and supplying appropriate reporting. Agreement.

Daylight exposure: The period in the day when one party to a trade has a temporary credit Global Master Securities Lending Agreement (GMSLA): The Global Master Securities Lending
exposure to the other due to one party having settled before the other. It would normally mean Agreement has been developed as a market standard for securities lending of bonds and
that the loan had settled but the delivery of collateral would settle at a later time (although equities internationally. It was drafted with a view to compliance with English law.
there would also be exposure if settlement happened in reverse). The period extends from the
point of settlement of the first side of the trade to the time of settlement of the other. It occurs Gross-paying securities: Securities on which interest or other distributions are paid without any
because the two sides of the trade are not linked in many settlement systems or settlement of taxes being withheld.
loan and collateral take place in different systems, possibly in different time zones.
Haircut: Initial margin on a repo transaction. Generally expressed as a percentage of the market
Deliver-out repo: “Standard” two-party repo, where the party receiving cash delivers bonds to price.
the cash provider.
Hedge fund: A leveraged investment fund that engages in trading and hedging strategies,
Delivery-by-value (DBV): A mechanism in some settlement systems (including CREST) whereby frequently using leverage.
a member may borrow or lend cash overnight against collateral. The system automatically
selects and delivers collateral securities, meeting pre-determined criteria to the value of the Hot/hard stock: A particular security that is in high demand in relation to its availability in the
cash (plus a margin) from the account of the cash borrower to the account of the cash lender market and is thus relatively expensive or difficult to borrow.
and reverses the transaction the following morning.
Hold in custody: An arrangement under which securities are not physically delivered to the
Distributions: Entitlements arising on securities that are loaned out, e.g. dividends, interest, borrower (lender) but are simply segregated by the lender in an internal customer account.

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 Icing/putting stock on hold: The practice whereby a lender holds securities at a borrower’s market standard exclusively for lending UK gilt-edged securities. It was drafted with a view to
request in anticipation of that borrower taking delivery. complying with English law and has a legal opinion from Queen’s Counsel.

Indemnity: A form of guarantee or insurance, frequently offered by agents. Terms vary Matched/Mismatched book: Refers to the interest rate arbitrage book that a repo trader may
significantly and the value of the indemnity does also. run. By matching or mismatching maturities, rates, currencies, or margins, the repo trader takes
market risk in search of returns.
Interdealer broker: Agent or intermediary that is paid a commission to bring buyers and sellers
together. The broker’s commission may be paid either by the initiator of the transaction or by Net paying securities: Securities on which interest or other distributions are paid net of
both counterparts. withholding taxes.

Intermediary: A party that borrows a security in order to on-deliver it to a client, rather than Open transactions: Trades done with no fixed maturity date.
borrowing it for its own in-house needs. Also known as a conduit borrower.
Overseas Securities Lenders’ Agreement (OSLA): The Agreement was developed as a market
International Securities Lending Association (ISLA): A trade association for securities lending standard for stock lending prior to the creation of the Global Master Securities Lending
market practitioners. Agreement. It was drafted with a view to complying with English law and has a legal opinion
from Queen’s Counsel. Intended for use by UK-based parties lending overseas securities (i.e.
ISMA: The Zurich-based International Securities Market Association is the self-regulatory excluding UK securities and gilts), it has since become the most widely used global master
organisation and trade association for the international securities market. ISMA sets standards agreement.
of business conduct in the global securities markets, advises regulators on market practices and
provides educational opportunities for market participants. Pair off: The netting of cash and securities in the settlement of two trades in the same security
for the same value date. Pairing off allows for settlement of net differences.
London Investment Banking Association (LIBA): The principal trade association in the UK for
firms active in the investment banking and securities industry. LIBA members are generally Partialling: Market practice or a specific agreement between counterparts that allows a part-
borrowers and intermediaries in the stock lending market. delivery against an obligation to deliver securities.

Manufactured dividends: When securities that have been lent out pay a cash dividend, the Pay-for-hold: The practice of paying a fee to the lender to hold securities for a particular
borrower of the securities is in general contractually required to pass the distribution back to borrower until the borrower is able to take delivery.
the lender of the securities. This payment “pass-through” is known as a manufactured dividend.
Prime brokerage: A service offered to clients – typically hedge funds – by investment banks to
Margin, initial: Refers to the excess of cash over securities or securities over cash in a support their trading, investment and hedging activities. The service consists of clearing,
repo/reverse repo, sell/buy-buy/sell, or securities lending transaction. One party may require an custody, securities lending, and financing arrangements.
initial margin due to the perceived credit risk of the counterpart.
Principal: A party to a loan transaction that acts on its own behalf or substitutes its own risk
Margin, variation: Once a repo or securities lending transaction has settled, the variation margin for that of its client when trading.
refers to the band within which the value of the security used as collateral may fluctuate before
triggering a margin call. Variation margin may be expressed either in percentage or absolute Proprietary trading: Trading activity conducted by an investment bank for its own account rather
currency terms. than for its clients.

Margin call: A request by one party in a transaction for the initial margin to be reinstated or to PSA Public Securities Association: The former name of the BMA.
restore the original cash/securities ratio to parity.
Rebate rate: The interest paid on the cash side of securities lending transactions. A rebate rate
Mark-to-market: The act of revaluing the securities collateral in a repo or securities lending of interest implies a fee for the loan of securities and is therefore regarded as a discounted rate
transaction to current market values. Standard practice is to mark to market daily. of interest.

Market value: The value of loan securities or collateral as determined using the last (or latest Recall: A request by a lender for the return of securities from a borrower.
available) sale price on the principal exchange where the instrument was traded or, if not so
traded, using the most recent bid or offered prices. Repo: Transaction whereby one party sells securities to another party and agrees to repurchase
the securities at a future date at a fixed price.
Master Equity and Fixed Interest Stock Lending Agreement (MEFISLA): This was developed as a
market standard agreement under English law for stock lending prior to the creation of the Repo rate: The interest rate paid on the cash side of a repo/reverse transaction.
Global Master Securities Lending Agreement. It has a legal opinion from Queen’s Counsel and
has been mainly, but not exclusively, used for lending UK securities excluding gilts. Repo (or reverse) to maturity: A repo or reverse repo that matures on the maturity date of the
security being traded.
Master Gilt Edged Stock Lending Agreement (GESLA): The Agreement was developed as a

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 Repricing: Occurs when the market value of a security in a repo or securities lending transaction
changes and the parties to the transaction agree to adjust the amount of securities or cash in
Reference Sources
a transaction to the correct margin level.
The web contains a lot of information on securities lending. A simple Google search on
Return: Occurs when the borrower of securities returns them to the lender. “securities lending” finds 500,000 results.

Revaluation (“reval”): See Repricing. All of the major practitioners have sections of their websites dedicated to securities lending,
repo, prime brokerage, etc.
Reverse Repo: Transaction whereby one party purchases securities from another party and
agrees to resell the securities at a future date at a fixed price. Below, we list in alphabetical order, some of the websites that could prove to be useful
reference sources:
Roll: To renew a trade at its maturity.
ABI www.abi.org.uk
Securities-orientated repo trade: Transaction motivated by the desire of one counterpart to Bank of England www.bankofengland.co.uk
borrow securities and of the other to lend them. See also Cash-orientated repo trade.
Barrie & Hibbert www.barrhibb.com
Shaping: A practice whereby delivery of a large amount of a security may be made in several BIS www.bis.org
smaller blocks so as to reduce the potential consequences of a fail. May be especially useful BMA www.bondmarkets.com
where partialling is not acceptable.
CREST www.crestco.co.uk
Specials: Securities that for several reasons are sought after in the market by borrowers. Holders Data Explorers Limited www.dataexplorers.com
of special securities will be able to earn incremental income on the securities by lending them Deutsche Bank www.db.com
out via repo, sell/buy, or securities lending transactions.
DTI www.dti.gov.uk
Spot: Standard non-dollar repo settlement two business days forward. This is a money market eSecLending www.eseclending.com
convention.
Eurex www.eurexchange.com
Stock situation: See corporate event. Fortis www.fortis.com
FSA www.fsa.gov.uk
Substitution: The practice in which a lender of general collateral recalls securities from a
borrower and replaces them with other securities of the same value. Index Explorer www.indexexplorer.com
IOSCO www.iosco.org
TBMA/ISMA Global Master Repurchase Agreement (GMRA): The market-standard document used ISLA www.isla.co.uk
for repo trading. The GMRA, whose original November 1992 version was based on the PSA
Master Repurchase Agreement, was revised in November 1995 and again in October 2000. ISMA www.isma.org
LSE www.londonstockexchange.com
Term transactions: Trades with a fixed maturity date.
Merrill Lynch www.ml.com
Third-party lending: A system whereby an institution lends directly to a borrower and retains Morgan Stanley www.morganstanley.com
decision-making power, while all administration (settlement, collateral, monitoring and so on) NAPF www.napf.co.uk
is handled by a third party, such as a global custodian.
PASLA www.paslaonline.com
Tri Party: The provision of collateral management services, including marking to market, Performance Explorer www.performanceexplorer.com
repricing and delivery, by a third party. Also known as escrow. RBC Dexia Investor Services www.rbcdexia-is.com

Tri Party Repo: Repo used for funding/investment purposes in which the trading counterparts Report Explorer www.reportexplorer.com
deliver bonds and cash to an independent custodian bank or central securities depository (the Risk Explorer www.riskexplorer.com
“Tri Party Custodian”). The Tri Party Custodian is responsible for ensuring the maintenance of RMA www.rmahq.org
adequate collateral value, both at the outset of a trade and over its term. It also marks the
collateral to market daily and makes margin calls on either counterpart, is required. Tri Party Spitalfields Advisors www.spitalfieldsadvisors.com
repo reduces the operational and systems barriers to participating in the repo markets. State Street www.statestreet.com
Tata Consultancy Group www.tcs.com

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76
An Introduction to
Securities Lending
Securities lending provides liquidity to the equity, bond and
money markets, placing it at the heart of today's financial
system. This increase in liquidity reduces the cost of trading,
thereby increasing market efficiency and benefiting all.
Securities lending markets allow market participants to sell
securities that they do not own in the confidence that they
can be borrowed prior to settlement. They are also used for
financing, through the lending of securities against cash,
forming an important part of the money markets. The ability
to lend and borrow securities freely underpins the services
that securities dealers offer their customers and the trading
strategies of dealers, hedge funds and other asset managers.
On the lending side, securities lending forms a growing part
of the revenue of institutional investors, custodian banks
and the prime brokerage arms of investment banks.

This publication aims to describe these markets, with an

emphasis towards the United Kingdom, although UK markets
are highly international in terms of both participation and
securities traded. The intended audience is not market
practitioners but others with some interest in securities
lending, including trustees of pension or other funds that
already lend their securities or might consider doing so,
managers of companies whose securities are lent, financial
journalists, the authorities and other interested parties.

Spitalfields Advisors Limited

155 Commercial Street
London E1 6BJ
United Kingdom
T +44 (0)20 7247 8393
F +44 (0)20 7392 4004
www.spitalfieldsadvisors.com
[email protected]