The growing acceptance of short selling has led to attempts to automate the bilateral, voice-based securities lending business, but as Frances Maguire finds, an alternative trading system has appeared that could bring greater transparency to securities lending.
There is an old adage among securities lending players that if you hold a stock it is “general collateral” but if you are desperately seeking to borrow a stock, it becomes a “special”. Like over-the-counter deals, securities lending grew out of a demand for stocks for shorting the market and started with bi-lateral agreements between custodial banks holding shares on behalf of large funds and prime brokers working on behalf of hedge funds.
While this is still very much the case, lenders need to know that they are getting the best revenue for the loan of their stocks and borrowers need to ensure they are not paying over the odds.
E-solutions
The earliest proponents of e-lending platforms have largely focused upon simply replacing telephone dealing with electronic bi-lateral trading. EquiLend is a global platform developed to automate point-to-point securities financing transactions between lenders and borrowers of stock. It negates the need for EquiLend’s founding firms to maintain back office systems to support business and enables them to deal with their counterparties over the electronic system rather than the telephone. EquiLend is aimed at large volume players in need of greater processing efficiencies.
Dirk Pruis, president and CEO of EquiLend, says: “Our volume is dominated by the general collateral business. We accept that participants will always want to negotiate specials. Our goal is simply to make the market as efficient as possible. As the market grows and becomes more commoditised, firms will need to automate and scale up in order to continue to be profitable as spreads tighten and margins shrink.”
Best price
While EquiLend is aiming at the high volume general collateral end of the market, eSecLending is focused upon enabling lenders to get the best price for the hottest stocks. The electronic hub enables borrowers to bid to win the exclusive rights to whole portfolios for a certain period of time, usually a year.
To date, 17 auctions have been held. Auctions are held for either multiple portfolios or larger portfolios that are divided into smaller segments. For example, an auction of $15bn of European equities could have as many as 15 “lot segments” that borrowers can bid on in the auction, most likely by country or region. The purpose of the segmentation is to allow borrowers to identify and bid upon assets where they have the greatest demand. Some large borrowers could have interest and demand for a large, broad portfolio, but smaller, niche players may just have strong demand for specific markets or sectors. This can often lead to award decisions where the sum of the portfolio segments is greater than awarding the entire portfolio to just one borrower.
Major players
The high stakes involved has restricted the action to the larger players. Winning borrowers of the largest auctions, such as the California Public Employee Retirement Scheme (CalPERS) included Abbey National, Barclays Capital, BNP Paribas Securities, Deutsche Bank, and Morgan Stanley. eSecLending was established to enable the lenders of large portfolios to ensure they were getting the best price, where they traditionally relied upon custodial banks to negotiate deals.
Chris Jaynes, chief operating officer of eSecLending, says: “The eSecLending model is best suited for large portfolios, which in traditional agency lending pools often subsidise less attractive supply. Where small, specialised portfolios can be auctioned, it is the larger high margin portfolios which typically benefit the most.”
Confidentiality
However, the market remained just as opaque as ever as the actual cost of borrowing securities still remained confidential. The Risk Management Association’s securities lending committee publishes quarterly statistics of what has been loaned, aggregated from 22 firms, but securities lending consultancy Securities Finance International (SFI), has gone one step further. The consultancy publishes the fees of more than 200,000 transactions to enable greater benchmarking of what is being paid to borrow securities. It is strictly a closed “members club”: lenders and borrowers report the fees paid and the size of transactions, and in return, SFI publishes the statistics to them alone.
Other outfits have tried to better chart the cost of lending for hard-to-borrow stock. Quadriserv, for example, charts the last price paid for stock for the ultimate end users of stock lending – the hedge funds. This year, SFI will move from monthly to weekly publication to its members of more timely price-information. It expects to grow the share of the securities lending market it is benchmarking – currently $2,100bn of underlying deals, which it estimates is one third of the total market.
New model
SecFinex started life in Europe as an electronic marketplace for bi-lateral deals. Then last year, it developed a wholly new model that could completely change how securities lending is conducted. The launch of its Order Market in October 2003 brought both anonymity and a price discovery mechanism to the sector for the first time. Similar to the exchange model, SecFinex’s Order Market seeks to match borrowers and lenders, and by posting bids it is finally bringing a measure of transparency to an extremely opaque and private market place.
The system includes live orders and credit monitoring allowing equity finance traders to trade on a live price-driven market. Initially, the new screen will cover individual stocks in the major European equity indices, with additional securities and indices to be added later. Two markets operate – an overnight market and a longer, fixed-term market, both trading on a fee basis, standardising securities trading into 1000 share lots. A pre-market matching engine matches bids and offers every morning.
Chris Fay, chief operating officer at SecFinex, says: “We believe that this is the next logical step in the development of the international securities lending marketplace. The first step was to move traders from the telephone to the trading screen, now they are moving from conditional trading to unconditional trading with true price transparency and one-click trading.”
Taking on the sceptics
There was, and still is, some scepticism of the model, which SecFinex is working upon overcoming. Mr Fay says: “Many said no-one would ever trade specials on an electronic anonymous market, and yet a trade has gone through at a rate of a 65% fee – that’s 6500 basis points – which is pretty special.”
Furthermore, in a comparison of data SecFinex carried out with SFI, there was further evidence of the SecFinex anonymous trading platform being used to access hard-to-borrow stock. And users show that they are prepared to pay a premium to do so. For the day where the comparison was made, like-for-like stock (with the same tax treatments) was borrowed in the market for between 10-20 basis points – the cost of general collateral – according to SFI, yet the same stock changed hands at 50 and 70 basis points on the SecFinex platform.
Regardless of whether one borrower paid over the odds or whether one lender earned less than it could have for that stock, the fact still remains that specials are not being reserved for bi-lateral deals. If the demand and availability is there, borrowers will trade electronically, and more to the point, anonymously.
Added transparency
If specials are simply the hot stocks of the moment, using an electronic market to auction them off publicly brings a measure of price discovery to securities lending, even for the bilateral privately traded market where deals will most likely continue to be done for hard-to-borrow stock.
Ian Maynard, executive director and head of European equity finance trading at Lehman Brothers International (Europe) – one of 17 firms now live on SecFinex’s Order Market – is upbeat about the launch. He says: “The introduction of price-driven trading is a significant step forward for the equity finance market, helping it catch up with the developments in the cash equity and equity derivatives markets, which have long benefited from greater transparency and automation available from truly electronic systems.”
But for Mr Maynard, specials will always exist. “So long as there is corporate activity, there will always be a market for specials,” he adds. And for the moment, until there is greater liquidity, SecFinex represents a small proportion of Lehman’s total securities lending business.
All three models expect increased uptake in the coming year as more lenders turn to stock lending and the need for greater automation increases. For SecFinex’s Order Market, perhaps with the most still to prove, this means aiming to become the reference price for European securities lending. This drive will start in April, when the new regulations for alternative trading systems from the UK’s Financial Services Authority come into effect, and the SecFinex Order Market will move from being an authorised representative of its majority shareholder, to an alternative trading system for securities lending.
