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Cairneagle Associates LLP50 Regent Street, London W1B 5RDTelephone: +44 ( 0 ) 20 7432 4525Facsimile: +44 ( 0 ) 20 7432 4526
www.cairneagle.com
SecFinex Limited60 Cannon Street, London EC4N 6NPTelephone: +44 (0) 20 7002 1003Facsimile: +44 (0) 20 700 1123
Stock Borrowing & Lending Seminar
Securities InstituteWednesday 15th April 2009
Page 2
Contents
Part 1 Equity Finance – Stock Borrowing & Lending - Myths & Reality : Joseph Hine
Part 2 Changing the Industry – The introduction of an Exchange Platform for Stock Borrowing & Lending : Peter Fenichel
Topics:
Stock borrowing & lending (SBL) has received a lot of attention recently, both as the mechanism that underpins stock shorting, and as a key enabler of the financial markets, but remains poorly understood. This seminar will seek to describe the workings of the SBL market, debunk a number of the myths which surround it, identify its problems, and discuss approaches to addressing them.
• What is SBL; where did start; why does it exist today?
• Who are the participants?• What are the motivations of participants?
• Does SBL create downward price movements or volatility in the markets?
• What are the risks of SBL?
• Why change the SBL model?
• The Central Counterparty proposal (Is it a solution?)
• The future for SBL markets/The future of short sales
“Stock Prices may go down as well as up”[Why should Investors only make money when a stock goes up?]
Page 3
Part 1Equity Finance – Stock Borrowing & Lending -Myths and Reality
Myth SBL is a small backwater
of the Securities Industry SBL is the prime tool for
downside investment Most SBL is undertaken
for tax avoidance SBL is a highly profitable
business for banks SBL brought down the
UK banking sector SBL should be made
illegal as it de-stabilises markets
Reality Globally SBL is comparable in size to the worlds equity
markets. The value of outstanding loans is around $6trillion at any time.
SBL is only one tool for bear investment: CFDs and derivatives (OTC and on-exchange) are more significant worldwide.
‘Dividend plays’ are increasingly difficult as authorities tighten their net. Tax evasion through SBL has largely disappeared
SBL has traditionally been a facilitation business often only marginally profitable at the desk level– but it supports profit elsewhere.
There is no evidence that SBL positions were the major driver in reducing the value of banks stock
Without SBL the UK equity market (and many others) would become less liquid or cease to function altogether
Page 4
Why SBL
Administrative Shorts The complexity of markets and the lingering inefficiency of internal systems means that many firms find themselves short in settlement. SBL with its T0 or T+1 settlement provides a safety valve
Dividend Plays Transferring title from firms with a higher tax liability to ones with a lower tax liability at the payment point of divided. – Not relevant in the UK and increasingly rare in other jurisdictions.
Market Short Direct use of SBL to produce bear positions is, we believe, less than 10% of the business (by number of trades) in the UK
Special Situations Gaining control of stock through borrowing for elective events and in take over- situations is more difficult now
Funding Use of SBL structures by lenders to generate funds (used as an alternative to Repo) a major driver in the USA.
Hedging derivative positions Increasing driver for derivative market MMs and OTC trading firms
Hedging CFDs Major driver of the market in UK and Europe.
Page 5
Models for Shorting (SBL and CFD)
Collateral
Borrowed Stock
CashSell
Stock
Collateral
Borrowed Stock
CashmarginCFD
SHORTING VIA SBL SHORTING VIA CFD
Hedge fund shorting market
Prime Broker
Hedge fund shorting market
Lender Lender
Market
In the UK and Europe the CFD route is much more popular as it allows gearing and avoids SDRT – The SBL trade is used as a hedge as it is usually more cost effective and flexible than using derivatives
Market
Page 6
Participants and Motivations
The effect on the term curve of different participants using SBL in different ways
Fail Management
Tactical shorts & CFD hedges
Special Situations Strategic
Positions
The SBL market is used by many different participants for many different reasons. This results in a multi-modal term distribution.The curve differs markedly between different countries where motivations can be different.
Page 7
Effect on the Equity Markets
Equity market Liquidity• Availability of shares• Increasing trading• Confidence to trade
Use of SBL for fails management• Administrative fails• ‘Held Away’ fails• Fail chains
Use of SBL for profit enhancement by lenders• Size of revenue opportunity• Specials• Trends in profitability
Ensuring Exchange traded derivative liquidity• Specialists’ position management• Keeping markets ‘honest’
CFD and other OTC derivative market hedging• CFDs as a proxy for equity• Equity liquidity issues
Page 8
Inherent Risks
Counterparty risk• Credit issues
Market risk• Margining• Squeezes
Default resolution• Unwinding fails
Structures to reduce risk• Collateral and Margin• Triparty Structures
Systemic risk – the length of the lending chain• Speed of unwinding
Operation risk – what is being guaranteed.• Agent Guarantees
Capital application• Who should apply capital
Page 9
Summary
SBL is here to stay SBL is integral to the current market but inefficient – especially as regards risk and
capital SBL needs to restructure SBL needs to re-think its facilitation model and perhaps re-price itself.
SBL is an little understood minority area of the securities industry and like any minority it has been a convenient scapegoat - blamed for recent market dislocation. In fact SBL is no more to blame than any other part of the industry. However this does not mean that SBL should continue unchanged.
Page 10
Part 2Changing the Industry – The introduction of an Exchange Platform
for Stock Borrowing & Lending
SBL is now too important to be done on a ‘Best Endeavours’ basis• Certainty of price• Certainty of terms• Certainty of returns• Certainty of credit
Exchange Platform without CCP
is half of the solution• Current Exchange Platform model
CCP without Exchange Platform is too clumsyMTF
CCP
Trading serviceTrade validationMember ValidationBillingCommunications
Risk ManagementMargin and CollateralFailure Management
Page 11
Why Change?
Counterparty Risk• The industry is becoming paralysed due to counterparty risk issues outside SBL
Administrative Overheads• Disproportionate to the business profitability.• Act as a brake on new business
Agent Lender Disclosure• Not acceptable to some• Expense for all
Collateral Issues• Collateral excess rising 110%+• Excess collateral used to cover concern over counterparty risk• Acceptability rules are various and complex• Collateral security issues
Capital• Frequent confusion and contradiction regarding capital allocations• Bi-lateral model gives limited scope for netting• Counterparty risk requires capital allocation under Basel II
Page 12
The Critical Importance of Capital and Credit
Collateral only reduces risk – it does not eliminate it. Counterparty risk must be assessed for Basel II Agent guarantees (lending agent or Tri-party agent) help but risk of agent failure must
be accounted for. Capital allocated to SBL desks has been reduced Credit lines which stretch over many businesses are being withdrawn or reduced in
investment banks Small trading firms and hedge funds can not get credit lines without depositing cash or
near-cash instruments with bank. For many firms the only way to continue in the SBL business is by using a CCP to
eliminate counterparty risk and credit issues.
Page 13
Alternative Structures
Tripartite(Use of central agent to reduce risk)
Patron Bank(Netting on the balance sheet of large bank/ prime broker)
Liquidity location & Post-trade admin(Centralised checking, settlement routing, registration, etc)
OTC Bilateral(Traditional phone market or using bilateral communications e.g. via Bloomberg)
Benefits Benefits
Value added Drawbacks Drawbacks
•Flexibility•Choice of Counterparties•Confidentiality
•Costs•Credit problems•Risk
•Reduced administrative Overheads
•Reduced operational Risk
•Credit problems•Counterparty risk
•Potential for netting•Operational guarantee
•Limited pool•Capital impact on bank•Risk
•Collateral management•Access to counterparties•Operational guarantee
•Credit risk still exists•Still uses capital•Pool is limited
•Risk elimination•Capital relief under Basel II•Large pool of counterparties
•Increased cost
CCP
JP MorganEuroclearMorgan
StanleyGoldman Sachs
E Seclendin
gBloomber
g
Page 14
Features of CCP
Capital Reductions For firms facing CCPs
Credit Enhancement Overcomes counterparty credit issues
Anonymity Through SecFinex matching system• Name Give-up Anonymous trading not compulsory• ALD Reduces administrative load• Returns No singling out of counterparty for early returns• Strategic Prime Broker need not see positions of Hedge fund clients
Operational Benefits Reduced Contracts, credit agreements, position monitoring etc
Collateral & Margin Central point for collateral and margin• Reduced Collateral In some cases may be as low as 100%• Margin Netting Net position with CCP can be margined• Two sides margined Margin from Lender and borrower
Regulation Improves regulator’s vision of the market
Reduces systemic risk
Page 15
The SecFinex Solution - 1
OUTLINE SCHEMATIC OF GENERIC STRUCTURE POST CCP
Lender
Borrower
Settlement System
Tra
din
g
Sys
tem
Nova
tion
Post
tra
de
man
ag
em
en
t
Bi-lateral trade given up to CCP via SecFinex
Exchange Trade
Exchange
Trade
Ris
k
Man
ag
em
en
t
CCP
Exchange Platform
CCP becomes Counterparty
Margin
Collateral Accounts
Borrower
Page 16
The SecFinex Solution - 2
CCPs appropriate to individual markets. Slightly different models of clearing dependant on different market traditions,
regulations and abilities Issues of tax resolved Issues of Basel II counterparty relief when trading member is using Clearing
Member are resolved
Page 17
Incremental Change
The move to CCP will be gradual and will never be 100% On-market anonymous trading will grow but will not eliminate bi-materal trading novated
to the CCP As CCPs become more comfortable with the market changes in collateral rules will make
the proposition even more compelling Most firms will retain bi-lateral ability in their back offices but some will move to a ‘CCP
only’ model MTF/CCP model is likely to increase SBL activity due to reduced overheads and capital
requirements Extension of MTF/CCP model outside Europe is being considered
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