Securities Lending Today

Securities lending's many functions - indeed

2012-02-07T06:56:38+00:00

The title of the recent FT article "Securities lending and its many functions" nicely captures the essence of modern securities lending. The article focuses on the on-going debate between physical and synthetic ETFs (hilariously and accurately described as a "playground squabble"), but also mentions short selling, fee spits, collateral and regulations. All in less than 1,000 words. Impressive and very well done. The FT isn't always so well balanced in its coverage of securities lending issues.

I have written before that insofar as counterparty risk and collateral market risk, both synthetic and physical ETFs carry similar risk, although they are not exactly the same and at the moment synthetics as a group are setting the pace for disclosure standards.

Short selling is currently in the midst of regulatory rule-making discussions in the EU. The ESMA regulation on short selling is due to enter into force on 1 November 2012, and this has hastened the pace for development of the operational infrastructure required to support the regulation. Next week sees the deadline for comments on the consultation process for the production of technical standards and advice. That consultation period will have been only three weeks which is unbelievably short considering that this is to set the day to day operating standards under which the regulation will be operated. There is far from a consistent set of views across market participants and interested parties, so it will be a challenge for ESMA to sift the commentary.

The article also looks at fee splits, and the variety of arrangements in place. To my mind, moving directly to the question of "What is the fee split?" skips the most crucial question - "How is the program operated?" Kevin McNulty, CEO of ISLA sums up the issue well with his comment "Securities lending is an expensive business to run." and his subsequent explanation. The first and most important issue is the investment that the provider has made in building and operating the business, with the fee split a follow-on. A fund that receives 100% of the fees from a provider that underinvests in the business will inevitably discover it is a false economy. By all means negotiate hard for a reasonable fee split, but don't start there.

I first used the descrption the "Decade of Collateral" just over three years ago and the article closes on the topic. Despite only a brief mention, this is possibly the largest issue we have at the moment and the increasing range of business drivers impacting the need to obtain or transform collateral is exactly the essence of the title of the article - "Securities lending and its many functions". All types of trading products require increasing amounts of collateral. Securities lending is at the centre of this collateral evolution/revolution.

At the end of November 2011, I launched a new course to cover these and other major current issues in more depth. The feedback from the course was excellent with comments from attendees saying:

"Excellent course content and teaching, insightful debate about industry issues and direction"
"Excellent course with structure conducive to open discussion"
"Guest speakers was a very good ideas. Discussion and format of the course was perfect"
"Rather than just a theoretical approach, the course uses real case studies and examples which are very useful"

I am teaching this course again on 28 & 29 February. I hope you can join me and my guest speakers for discussion and debate on these and other issues that shape the future of our industry. The video below will give you some more information on the course. You can register for the course by clicking here.

"An old world for Securities Lending" - I beg to differ

2012-01-31T21:03:33+00:00

I read a blog post tonight and was going to just comment on the blog, but instead I thought I would turn it into a post of my own. The author of "An old world for Stock Borrowing and Lending", Gary Wright is a securities industry veteran and I usually find his views interesting and thoughtful. This time however, I have to disagree with him.

In Gary's article he suggests that the ESMA regulations and short selling and securities lending "appear to me [Gary] to be an admission that the stock borrowing and lending structure in the UK circa 1985 actually worked extraordinarily well"

I draw a different conclusion from the ESMA short selling regulations. They don’t harken back to the circa 1985 stock lending market, far from it.

I set up my first borrowing desk in London in 1987. I think it is fair to describe the activity in the market at that time as a small but profitable hobby for some with the regulations driven by the Bank of England’s desire to be able to monitor activity in gilts. The fact that equities were equally restricted was a by-product, which if not accidental, certainly wasn’t a priority and while they could have chosen to view which companies had the largest short positions as Gary suggests, typically they were more concerned with gilts and the money markets.

I also have to adamantly challenge the assertion that stock borrowing has “opened the floodgates for market abuse”. Market abuse regulations have been in existence for many years and are continually tightened by regulators. Market abuse can be perpetrated in many forms, but other than the Maxwell fraud – and I do say fraud rather than securities lending - I am unaware that the ability to freely borrow securities as having been the cause of any market abuse. I should also mention that today's day-traders that flatten positions by the end of the day would have loved the market environment Gary refers to - fortnightly settlement gave rise to all kinds of interesting intra-settlement-period trading Gary doesn't discuss.

As Gary correctly points out, the ability to borrow securities was restricted to jobbers and was gifted in order to support the liquidity of markets. This remains a key driver of borrowing demand today. Numerous academic studies point to the negative impact on liquidity that short selling restrictions imposed by regulators in 2008/2009 and again by a tiny handful of regulators last year caused in the marketplace.

Unfortunately what Gary doesn’t point out is that beyond market making activity, investors and traders require the ability to short sell to hedge, take advantage of arbitrage opportunities and yes, even take negative directional views on securities. Restrictions from the mid-80's would reduce the ability to manage risk for some (which probably isn’t Gary's intention) as well as reducing the ability for others to increase risk positions (which appears to be his preference). A market with the borrowing controls of the pre-Big Bang era would mean smaller markets for equities and fixed income as well as derivatives. Securities borrowing is never done for it's own sake, it is virtually always the result of another transaction in cash or derivative instrument.

ESMA recognises the valuable contribution that short selling makes to the marketplace. Their work questions how to ensure that short selling does not disrupt the market process. By enhancing the certainty with which short sellers can obtain and deliver securities – without the draconian controls of the 1985 era Gary refers to – ESMA rightly concentrates on the issues that could otherwise increase systemic risk.

Unfortunately I won’t be able to attend the short selling debate on 22 February as I will be teaching a securities lending course. Will Gary (or whomever) challenge Frank Field on his unsubstantiated comments from a few years ago regarding unauthorised securities lending allegedly being conducted by a custodian in the UK. I was editor at Global Securities Lending Magazine at the time and despite pestering from our end, Mr Field failed to add any more detail and the allegations withered in the wind.

"An old world for Stock Borrowing and Lending" - most certainly not.

Guest Author on the Financial Transaction Tax

2012-01-25T11:45:17+00:00

The debate continues on the Financial Transaction Tax. The guest author today examines the comments from "Mr Financial Transaction Tax" at the EU. Philip Martin is the former co-head of global tax at Nomura and is now providing investment banking tax services via his company Henleydown Consulting Limited. You can reach Philip at henleydown@btinternet.com

Last week Manfred Bergman the director of indirect taxation and administration at the European Commission released a video to explain the Commission’s proposal for a financial transaction tax “FTT” (Video is below). Mr. Bergman confirms the purpose of an FTT is to raise money from the financial sector and to limit undesirable market behaviour to stabilise markets. Mr. Bergman believes a widely applied charge at a low rate will be easily absorbed, but demonstrates this with reference to the marginal increase in the cost of share purchases rather than the marginal income earned by broker dealers.

He is therefore guilty of proving his point on affordability by reference to the wrong target audience. Mr. Bergman also accepts that certain activities will significantly reduce, by which we assume he refers to the 70 to 90% reduction in activities such as derivatives highlighted within the European Commissions impact assessment. However, he does not address the dichotomy here which is that an effective tax needs a stable and continuing tax base, and preferably to apply to economic rents, whereas the stated intention is to reduce the number of transactions and hence the underlying tax base. As a result the estimate revenues of € 57bn must be highly questionable.

Mr. Bergman also does not make clear how the proposal will be limited to intra-bank market transactions. In a simple transfer of stock from one counterpart to another via a single broker-dealer there would appear to be four charges unless an intermediary exemption is introduced. There is no logical reason for an intermediary to bear the cost of an agency bargain and therefore investors will inevitably bear the cost and, with the multiplication of charges, a rather higher cost than advertised. It is important that there is an open and transparent debate about new forms of revenue, but at present the real issues and difficulties with an FTT remain unclear.