The securities lending market has grown up around bilateral dealing and sealed bids. Frances Maguire asks if a new electronic trading platform will convince the industry to change.

There is little doubt that the securities lending market is set to grow. With $16,000bn worth of lendable assets available and $3,600bn being lent at present, market consultancy Celent predicts a growth of 5% in the US and 10% in Europe in the next year. Celent also estimates 20% of deals will be struck electronically by 2009, up from the current levels of 10%-15%.

Although the largest players in the market joined together to set up Equilend in 2002 to improve automation in the securities finance industry, the levels of electronic trading are still relatively low. While two other platforms, SecFinex and Eurex SecLend, have built bid/offer models, they have both seen greater take-up of their systems that seek to replicate how the industry currently operates.

General collateral, the more liquid stocks, is increasingly being automated, but allocations of the less liquid stocks, or specials, are still being allocated in private auctions or on a bilateral basis. While specials make up roughly 20% of the securities lending market, it is these sought-after stocks that really drive the profits, and they tend to be allocated to the biggest borrowers of general collateral rather than being bid for in an open market.

Electronic demand

Mayiz Habbal, managing director of the securities and investments group at Celent, says: “Even though the percentage of electronic securities lending is set to grow, it is still a small percentage of total volume because this business still relies heavily on relationships, especially when it comes to special deals.” But he believes that demand for electronic securities lending will come from lenders as they look to capitalise the profit potential of the assets they hold.

In April this year, ICAP launched I-Sec in a bid to convince the securities lenders that the bid/offer exchange-type model provides a more efficient distribution model and that price transparency in a more open market will boost lending prices.

Roy Zimmerhansl, head of electronic securities lending at ICAP, says that after just two months of i-Sec going live, five users are active, and another two are in the process of signing up. All five are Equilend users and three of them are Equilend part owners. “Our product is a complementary one. It is isn’t about taking business or transactions flow away from one Equilend counterparty to another Equilend counterparty, it is about reaching out to a wider universe,” says Mr Zimmerhansl.

ICAP aims to build a core of investment banks first so it is able to go out to the lending community with a top-tier list of borrowers.

Mr Zimmerhansl believes the Equilend model is limited to the largest players with high volumes of general collateral to process and is more of an order routing process for a borrower’s list of stocks, rather than an open market. ICAP’s pre-launch research found that there was no demand for another reconciliation system or auction platform but there was interest in a trading community, with bids and offers, and the ability to negotiate for the best price or transaction terms.

Field wide open

Mr Zimmerhansl firmly believes there is room in the market for i-Sec as no one model for trading has penetrated and that more choice of distribution models is still needed.

He says of i-Sec: “It is about bringing a level playing field. All users on the system will see all the bids, all the offers, and all of the sizes from all of the users, even if they can’t deal with them because they may not have an existing counterparty relationship in place. This will be the first time when everyone gets to see the whole market activity.

“Each executed trade, although it won’t reveal the counterparty, will show last traded size and range, and total base volume on an intra-day basis, so that flow of securities can be tracked.”

Vanilla instruments tend to move to automation faster, however, ICAP believes that an element of customisation is key. But specials have been traded on i-Sec. In theory, anything that trades at 50 basis points (bp) per year or more is broadly considered special, rather than general collateral.

“Some of our biggest trades have traded at more than 50bp. There is no reason why these two markets cannot come together. Users will always grab a special. If they don’t need it, or their customers don’t want it, they could distribute that out to the wider market and see what they could make on it,” says Mr Zimmerhansl.

Lenders keep aside a proportion of specials to allocate to their key relationships, and borrowers take specials they do not need and lend them on. It is this market that i-Sec hopes to capture for it is the borrowers that do not get access to specials that are most likely to pay a higher price for them.

I-Sec has a credit matrix that filters bids and offers and colour codes them so firms know whether they are able to trade on these prices or not. This gives users the ability to take the live trading data into their own systems and track, benchmark or use the data electronically for their own purposes – a feature already available to BrokerTec clients of ICAP. It is possible, even likely, in future that a borrower with many relationships will be able to borrow on screen and lend on screen and get a locked-in price.

Allen Postlethwaite, chief operating officer of SecFinex, believes ICAP’s launch validates the SecFinex model. He says: “We welcome competition and we always encourage our users to use at least one other system to compare where levels are but if there are too many systems we will end up with too many pools of liquidity, which defeats the object of electronic trading hubs.”

SecFinex has developed three models to cover what users may want from a platform – from simple order routing of bulk general collateral trades, or auctioning off the whole portfolio, to a full bid/offer trading system.

SecFinex’s Order Market is anonymous pre-trade and is based on price only so the hit trade will close, so long as credit between the two counterparties is sufficient, and then trading partners are disclosed. SecFinex was the first to publish anonymous executed trades; bringing a level of price transparency that did not exist in the securities lending market.

Centralised trading

Mr Postlethwaite believes that the centralised trading model is being adopted by a growing number of borrowers and lenders, who bring with them their counterparties. It is here he expects to see the greatest growth in the future.

He says: “Everyone would benefit from knowing where stocks really trade and what the price is to the end-user, but it is not all about price transparency as there are other things to be considered, such as the collateral involved and the type of counterparty. Securities finance cannot remain such an opaque market with incoming regulations, such as MiFID [the Markets in Financial Instruments Directive] and Basel II, which address trade reporting,best execution and full transparency.”

Last December, NYSE Euronext bought a 51% stake in SecFinex, which will enable the securities lending platform to be integrated onto the exchange’s network and ultimately be rolled out to exchange members. Mr Postlethwaite adds that it also means SecFinex is looking at the feasibility of moving to an exchange model and it is exploring how this would work for securities lending and whether there is a demand for a Central Counterparty Clearing House (CCP) model.

He says: “Whether the clearing model would work for securities lending remains to be seen, as a lending institution is used to taking margins for lending securities, rather than providing margins to a clearing house.”

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Rob Coxon, head of international securities lending at ABN AMRO Mellon, believes a catalyst, such as the introduction of a central counterparty or further transparency rules from the regulators, is needed to make the bid/offer model really take off. He adds: “Under Basel II, we are coming to terms with the fact that there is margin applied on both sides of the transaction but there are some other issues that would still need to be resolved for a CCP to be able to involved in securities lending.”

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