Number’s up for counterparties

In the past few months, the securities lending market has had to manage its largest counterparty default in its history, with the bankruptcy of Lehman Brothers, and in turn cope with the immediate restrictions on short selling, imposed by regulators in a large number of jurisdictions, most notably the US, UK and Australia.

To a large extent, the fact that stock indices continued to fall, despite the short selling restrictions, vindicated the short sellers as not being the sole cause of plummeting share prices. Furthermore, several lenders of financial stocks are understood to have already restricted lending in these stocks in the days preceding the bans, demonstrating a level of self-regulation in the sector.

As with all markets, consolidation and a shrinking number of counterparties will have an impact on the ease and cost of doing business. Perhaps more importantly however, the collapse of Lehmans, and the controversy surrounding short selling, has forced the securities lending market to reassess the role of counterparty risk, leaving some lenders wondering if the risk is worth the return.

The greatest impact has been on the exclusives market, where a portion of a portfolio is lent to one borrower for a fixed period. It is thought that, in the short term at least, the number of whole portfolio exclusives to a single borrower will be dramatically scaled back.

An exclusive survey carried out in August/September 2008 by independent securities lending consultancy Spitalfield Advisors highlighted that borrowers would also be constrained by capital and will be more selective about the portfolios they bid for.

Lending contraction

Anthony Byrne, global head of securities lending at Deutsche Bank, says that both supply and demand in securities lending has fallen due to market conditions. These include negative hedge fund performance and a large amount of de-leveraging as volatility has increased, as well as the dramatic value of redemptions seen in recent months, which totalled some $43bn by September this year.

Mr Byrne adds that there has been a very significant decrease in the requirement to short across the industry. As a result of short-selling restrictions, many of the crowded trades are materially covered, which has resulted in a sharp upside volatility, and the risk of going short has increased materially.

Additionally, he says, there are two forces at work on the core supply side, from the custodian banks, agents and beneficial owners – the lack of demand for borrowing and the diminished returns on collateral as a result of the downturn. Apart from the lack of demand, when a prime broker borrows stock, they often place cash back with the lender as collateral, which is reinvested against the benchmark, and provides a source of additional revenue.

Faced with enormous notionals, Mr Byrne says the industry lends itself towards automation. Deutsche Bank is always looking for ways to make itself more efficient by using electronic platforms for securities lending, he adds. He believes that the move to greater automation is inevitable and the incentives for the industry to move towards a central counterparty for securities lending have also increased.

In September, SecFinex, an electronic global marketplace for securities lending, joined forces with LCH.Clearnet to build the first central counterparty (CCP) for stock borrowing and lending across the SecFinex Order Market multilateral trading facility for Euronext markets. This will include stock loan transactions in France, Belgium, the Netherlands and Portugal.

Not only will the CCP-directed trades on the SecFinex marketplace eliminate bi-lateral credit risk between lender and borrower, it will also lower the administration costs associated with maintaining multiple credit agreements and significantly reduce the capital required to support stock loan transactions. The introduction of LCH.Clearnet’s CCP services is likely to significantly increase market volumes and will enable market participants, through the general clearing arrangements, to access more markets and new counterparties.

Peter Fenichel, CEO of SecFinex, says: “This is a very important evolutionary move to enhance SBL [stock borrowing and lending] market efficiency, transparency and transaction activity. We believe the introduction of a CCP in Euronext markets will establish the basis for extending this model across all European markets.”

Risk assessment

As an agent lender for beneficial owners, Blair McPherson, director, technical sales, Europe and Middle East at RBC Dexia Investor Services, says that risk has been the dominant feature of current discussions with owners, and this has led to a complete review of where their risks are in terms of counterparties, collateral and transparency.

He says: “Our services have become much more tailored to each individual lender’s risk/return profile. Some lenders are still bullish and want a return as comfortable as any risk that they currently have, whereas others have put restrictions on, either by counterparty or on the amount being lent out. For most beneficial owners, securities lending is not a core activity, but the recent losses are prompting a risk/return review across the board.”

There are many different reasons why securities are borrowed, shorting being just one. Securities are borrowed for settlement coverage as well as market making, arbitrage trading, including tax and dividend reinvestment arbitrage, as well as part of a financing transaction to lend cash.

“There can be much debate about the value of shorting [naked versus covered] and its role in price discovery,” says Mr McPherson. “But while short selling may involve securities lending, securities are borrowed for numerous reasons and securities lending itself is widely acknowledged as being a fundamental component of efficient capital markets, facilitating greater settlement efficiency and providing liquidity to the equity, bond and money markets.”

The move towards transparency in ­securities lending has already begun, according to Mr McPherson, and there is an increasing amount of information available on what is being borrowed and lent among market participants. “Where people are uncomfortable is how to give transparency to those outside the securities lending market,” he says. There is a need to put metrics around why people borrow securities, and perhaps this is where the electronic trading platforms can bring transparency.

Mr McPherson says: “A move away from telephone trading will bring audited trails, which will improve transparency from a compliance perspective. However, unlike a foreign exchange deal, which is very transactional, lending has more moving parts, so that one price on screen does not apply to all and a conversation is still needed.

“There are lots of things that can be done to make lending more transparent and lenders and borrowers have been more aware of this in the past two years and have attempted to educate the market and provide more information, but recent events will speed this up.”

Withheld information

Currently, borrowers have no obligation to tell lenders or their agents why they are borrowing securities when acting as principals. Often they are borrowing on behalf of a third party and either do not know, or do not want to disclose, their customer’s trading strategy and motivation.

However, Mr McPherson is unconvinced that a CCP will not bring as many problems as it will solve. He says: “Diversification is the key for most lenders, and a central counterparty really moves away from this as it brings more concentration risk. While there is certainly merit in having a central counterparty as an option, a single counterparty may not be an ideal situation.”

According to Mr McPherson, the solution is bound up in the definition of ‘central’. A larger counterparty, with groups of participants, would work but it may not be prudent to put all the business through a single CCP, especially without consideration of the titles of collateral. “In theory, it is not a bad option to have, but the word ‘central’ is troublesome. It could actually end up with less transparency.”

But John Edwards, director of fixed income sales at ICAP Electronic Broking, says ICAP has long advocated the merits of a CCP in the majority of its markets and sees the adoption of a CCP for securities lending as the next significant development in the sector.

The i-sec platform, launched in April 2007, is based on the proven BrokerTec system architecture, and ICAP sees this as a natural next step in the equity lending markets, matching other existing and well-established BrokerTec products.

Differences remain

There are, however, fundamental dif­ferences between the fixed income and equity lending markets in terms of settlement, coupons and dividends, which need to be more fully investigated, and ICAP is ­currently exploring opportunities with LCH.Clearnet.

Mr Edwards says that transparency is a key factor of any electronic trading system as screen trading operates like bulletin boards, enabling improved price discovery as well as providing better historical pricing.

Electronic trading is not yet as well-established in equity lending as it is in fixed-income bond repo, but some of the changes going through the market now should speed this process up, both in terms of a CCP reducing credit risk and also the benefits and efficiencies of straight through processing.

For equities securities lending, i-sec is currently operating an anonymous pre-trade system with a bilateral, ‘name-give-up’ on execution. This is supported with the functionality of a credit module, allowing participants to restrict counterparties with whom they have no credit line in place.

ICAP has seen volumes grow in i-sec, and encouraging levels of new client expansion over the past four months, given the current market conditions, indicate a growing interest in electronic trading and the i-sec product. The number of counterparties live has increased to 17 firms, with a further two firms shortly to join as new participants and four existing firms that have committed to complete the integration work to publish and submit file orders for multiple short and long positions.

According to Mr Edwards, the short selling ban has impacted day-to-day volumes and has undermined some market confidence as financial stocks represent a significant part of day-to-day activity. However, this will almost certainly help drive some changes in this sector.

He says: “Long term, this will encourage increased use of electronic trading and aid the development of a central counterparty, following the bankruptcy of Lehman Brothers, facilitating the reduction of counterparty risk.”

Short-selling restrictions

The CCP services being developed by SecFinex and LCH.Clearnet are expected to launch in the second quarter of next year, slated for June 2009. Whether the securities lending market will shrink as both borrowers and lenders rethink their strategies remains to be seen. In the short-term, while the US emergency short-selling restrictions have been lifted, the restrictions on short selling implemented by the Financial Services Authority in the UK and regulators in Australia are expected to remain in place until January 2009.

Longer term, securities lending provides crucial liquidity to the capital markets and is expected to continue to play a key role. However, while reduced lending activity will mean assets will incur custody fees, there is a danger that demand for borrowing securities will diminish simply because investors will be nervous that the emergency bans could be re-implemented at any time, making it difficult to make long-term strategic investment decisions.