Securities borrowing and lending is growing globally and in the Hong Kong market. It is an institutional business, requiring sophisticated systems and expertise. Some overseas clearing houses provide centralised securities lending services, but in Hong Kong there is less room for a centralised service.
There has been renewed discussion in the Hong Kong market recently on the possibility of expanding the securities borrowing and lending (SBL) facility provided by Hong Kong Securities Clearing Company (HKSCC), a subsidiary of HKEx. However, commentators have differing perceptions of the value of such service, and indeed different understandings of what SBL entails. This article seeks to clarify some of these perceptions.
The article firstly describes SBL, as practiced in international markets and in Hong Kong. It summarises the experience of HKEx in operating a stock borrowing programme for settlement coverage. The article also considers the experience of overseas clearing houses and other institutions in providing centralised SBL services. Finally, the relevance of international experience to Hong Kong is discussed.
1. What is securities borrowing and lending2 ?
Securities lending is the temporary transfer of securities on a collateralised basis. In many markets it is an important activity, contributing to greater liquidity, narrower spreads and improved risk management. Most SBL activity takes place on the over-the-counter (OTC) market, hence statistics on volumes are not readily available. However, it is believed that the balance of securities on loan globally exceeds US$1.7 trillion, representing 10 to 12 per cent of lendable assets, and that lending activities generate an annual US$3.2 billion of revenue for lenders and agents3 .
Most SBL activity is between large sophisticated institutions. The institutions follow conventions of practice that have developed over the years and are now embodied in codes such as the Stock Borrowing and Lending Code, developed by the UK Securities Lending and Repo Committee. The International Securities Lending Association has developed standard market agreements, such as the Global Master Securities Lending Agreement, or GMSLA.
"Securities lending" is a misleading term because in legal terms the securities are not actually lent. In fact, the securities are sold to the "borrower" under an agreement for subsequent reacquisition of equivalent securities. The original securities may be sold onward by the borrower to third parties. Hence, absolute title passes over both the securities lent and the collateral received. The economic benefits associated with ownership such as dividends belong in the first place to the borrower (who is the legal owner), but are "manufactured" back to the lender by the borrower making equivalent payments to him. The lender surrenders the rights of ownership such as voting rights. However, if the lender wishes to vote on securities on loan, he has the contractual right to recall equivalent securities from the borrower to do so.
In jurisdictions with stamp duty, such as Hong Kong and the UK, there are provisions in the legislation to exempt SBL transactions from such duty.
Most SBL transactions are against collateral, which can be in the form of cash, securities or other assets. The eligible collateral will be agreed between the parties at the outset, including the initial margin, the maintenance margin, and concentration limits (ie to ensure that the collateral can be liquidated in need). The collateral is often held by a Tri Party Agent, to whom the borrower pays a fee. This agent, usually a large custodian bank or international central securities depository, will receive the eligible collateral from the borrower and hold it to the account of the lender. The Tri Party Agent will mark the collateral to market, distributing the information to lender and borrower.
SBL fees paid by the borrower to the lender vary according to the nature of the securities lent. For example, typical fees in the UK market in December 2003 ranged from 6 to 100 basis points on a per annum basis for UK FTSE 100 equities, 10 to 400 basis points for UK FTSE 250 equities, and 3 to 13 basis points for non-index-linked gilts (government securities), with most transactions being concluded at the lower end of these ranges. Other factors such as the creditworthiness of the borrower, the duration of the loan, and the type of collateral will also affect the fee. Loan transactions are normally larger than US$250,000, although specialist agencies can pool smaller holdings together.
Where the lender receives cash collateral, he will reinvest it, earning the spread between the reinvestment rate and the agreed rebate rate which he pays to the borrower.
Repos and buy-backs
In addition to securities lending transactions, described above, there are also the somewhat similar sale and repurchase agreements and buy/sell backs.
Sale and repurchase agreements, or repos, involve one party agreeing to sell securities to another against a transfer of cash, with a simultaneous agreement to repurchase the same or equivalent securities at a specific price on an agreed date in the future. The resale price will reflect the original sale price together with accrued interest at the repo rate. Most repos are governed by a master agreement, the ISMA/TPMA43 Global Master Repurchase Agreement, or GMRA.
Buy/sell backs are similar in economic terms to repos, but structured as a sale and simultaneous purchase of securities, with the purchase agreed for a future settlement date. The price of the forward purchase is typically agreed with reference to repo rates.
Lenders and intermediaries
Because of the complexity of SBL transactions and the narrow margins that users expect, SBL has become a volume business. Specialised agents invest in the systems and knowhow needed to conduct SBL operations, and then leverage their investment by pooling the securities of a number of owners. Agents and owners then split the revenues arising from SBL transactions. Agents include asset managers, particularly in Europe, and custodian banks (who can leverage their custody business and have the advantage of being able to manage cash collateral efficiently). There are also specialist third party agents.
There are principal intermediaries who assume principal risk, offer credit intermediation, and take positions in the securities they borrow. These are broker dealers, specialist intermediaries and prime brokers. Broker dealers need to borrow securities for market-making, to support proprietory trading, and on behalf of clients. Prime brokers serve the needs of hedge funds and other alternative investment vehicles, to which they provide SBL services alongside financing, execution, custody and reporting.
The value added by such intermediaries is to bridge the gap in cases where the lender does not wish to take on credit exposure to the borrower (eg a pension fund owner and a hedge fund borrower). Principal intermediaries also take on liquidity risk, borrowing from lenders on an open basis - ie allowing the lender to recall the securities - and lending to borrowers on a term basis.
Beneficial owners who have securities portfolios of sufficient size to make securities lending worthwhile include pension funds, insurance companies, mutual funds and endowments.
Borrowers generally borrow securities in order (a) to cover a short position (settlement coverage, naked shorting, market making, arbitrage), (b) to support a financing transaction motivated by the desire to lend cash, and to transfer ownership temporarily to the advantage of both lender and borrower (tax arbitrage, dividend reinvestment plan arbitrage).
Settlement coverage was historically the origin of securities lending activity. For less liquid securities such as corporate bonds and equities with limited free float, settlement coverage remains today a large part of borrowing demand. Borrowing to cover settlement is vital to the settlement process. This has led some securities depositories into the automated securities lending business whereby customers make their securities available to be lent by the depository automatically.
Naked shorting is the short selling of securities without any corresponding long position. Commentators suggest that it is a comparatively rare strategy.
Market-makers need to be able to borrow securities in order to execute buy orders and to make tight two-way prices. They need automated communication channels with securities lenders in order to operate. In less liquid securities, market-makers may need special arrangements with lenders such as guaranteed exclusive bids.
Arbitrage involves hedged long and short positions, and often involves securities lending. For example, convertible bond arbitrage involves buying a convertible bond and simultaneously selling the underlying equities short and borrowing to cover the short sale.
Securities loan negotiation takes place between two parties whose credit departments have approved one another. Traditionally, negotiation took place on the phone, but nowadays the negotiation process may be automated, either bilaterally or multilaterally via an electronic platform such as EquiLend (see below), or SecFinex which offers electronic SBL services in Europe.
Following negotiation, the transaction must be confirmed by written or electronic means if possible on the day of the trade. The details include, contract and settlement dates, detail of loaned securities, identities of lender and borrower, acceptable collateral and margin percentage, term and rates, bank and settlement account details of lender and borrower. Material changes during the period of the transaction, such as collateral substitution, are agreed between the parties as they occur. The loan may be for a fixed term or, more usually, open or "at call". Lenders can sell securities which are on open loan because they can usually recall the securities from the borrower within the market settlement period.
Where the borrower expects to need securities at a future date, the lender may put the securities on hold for him ("icing" the securities). The lender receives no fee for icing, but if another borrower makes a firm bid for the securities, the first borrower has 30 minutes to decide whether to take the securities at that time or release them.
Securities lenders need to settle in a shorter time than the settlement period of the market concerned. Settlement is normally through the lender's custodian bank, with which the lender will have agreed a schedule of settlement times. In most settlement systems, securities loans are settled free of payment, with collateral taken separately, often through another system and even in another country or time zone. This gives rise to "daylight exposure" during the period when the lent securities have been delivered but the collateral has not yet been received. To avoid this, lenders will often ask for collateral to be delivered in advance, ie before they release the lent securities.
Where redelivery fails, lenders would normally recover costs such as interest arising or the expense of buying the securities in on the open market. To minimise the impact of fails, consideration can be given to breaking a large transaction into smaller parts so that a partial failure does not impact the whole transaction.
Under securities lending, the lender is to be "made whole" for any corporate event, such as dividend or bonus issue - by the borrower making equivalent payments to the lender, eg by manufacture of dividends. However, the right to vote cannot be manufactured.
Lenders manage risk primarily through the use of collateral and netting. Many of the large losses related to securities lending over the years have been related to the reinvestment of cash collateral. Taking securities as collateral avoids reinvestment risk, however the lender is exposed to the risk of incorrect pricing of the securities, and to liquidity risk when he seeks to realise his collateral. There is also the risk of incongruency of collateral and lent portfolios, ie the lent securities may rise in price while the collateral falls.
Given that participants will often have numerous transactions outstanding with a counterpart, netting is important. The master agreement will provide for netting of obligations in case of default, thus saving participants from the need to settle each of their transactions gross. However, care is needed to ensure the efficacy of netting provisions in the jurisdictions in which the SBL transactions take place.
2. Securities borrowing and lending in Hong Kong
Since the introduction of the exemption from stamp duty for properly executed SBL transactions, Hong Kong has emerged as a regional SBL centre. The Pan-Asian Securities Lending Association (PASLA) was founded in Hong Kong in 1995, and now has 33 members, 16 of whom are represented in Hong Kong. Although Japan is the largest regional SBL market and the oldest-established, since Hong Kong is the regional headquarters for many financial firms, it is easy for borrowers and lenders to meet there and resolve any issues; moreover, the credibility of counterparties in Hong Kong is high.
The SBL business in Hong Kong has a similar profile to the business globally, as described in the preceding section. The major Hong Kong-based agent lenders operate their SBL business through a 24-hour global booking system via their offices in different time zones. They pool securities from investors such as US or European pension funds, and insurance companies, and lend to borrowers who are mainly the major brokers and investment banks. These parties in turn may be borrowing for their own account, or more often on behalf of their clients, such as hedge funds or smaller brokers, on whose behalf they accept counterparty risk. Thus smaller borrowers, to whom the lenders' fund clients would not want to be exposed, can nonetheless participate in SBL transactions. Some lenders take collateral only in US dollars.
Fees for a large deal are typically around 25 basis points, the agent lender and the client (stock owner) sharing the fee in perhaps a 7:3 ratio. Deals are rarely below US$100,000, but sometimes smaller deals will be done in less liquid stock (ie for which there is little available for lending) at higher margins.
The Hong Kong regulatory regime, which includes restrictions on short selling (including criminal sanctions), and stamp duty for which exemption has to be claimed by filing the stock lending agreement with the Inland Revenue Department, is not particularly convenient for the industry, but the players have generally adapted to it.
3. HKSCC's Stock Borrowing Programme for Settlement
In 1999, HKSCC introduced a facility whereby it can borrow stock from participants to fulfil HKSCC's settlement obligation to participants with long continuous net settlement (CNS) positions. However, this facility is not much used. It is understood that this is because the settlement efficiency of the Central Clearing and Settlement System (CCASS) on T+2 is already over 99 per cent, hence demand for stock loans to cover unsettled long positions is low. The loan period is also very short, one to two days, hence the related lending fee would be negligible in relation to the administrative work involved. A fixed borrowing fee of 4 per cent on a per annum basis is paid by HKSCC to the lender. HKSCC does not pass through the collateral to the lender. These latter arrangements may not be very attractive to some Participants.
In accordance with CCASS Rule 3503, HKSCC may at any time effect a compulsory stock borrowing transaction in order to (i) meet the aggregate of HKSCC's delivery obligations to participants which have not been satisfied as a result of a participant's failure to deliver eligible securities to HKSCC on T+2, or (ii) replace HKSCC's stock borrowing under any transaction under (i). Such transactions are governed by the Compulsory Stock Borrowing and Lending Regulations which comprise Appendix 6 of the CCASS Operational Procedures.
In accordance with the Compulsory Stock Borrowing and Lending Regulations, CCASS Participants which wish to lend their securities in return for income deposit the securities into their stock lending account, whereupon they become available for lending to HKSCC. Once a borrowing request is matched with the eligible securities in the stock lending account, the relevant securities are debited from that Participant's stock lending account and credited to HKSCC's account in CCASS. The loan has no fixed term, but can be recalled by the lender at any time with five business days' notice.
4. Overseas experience of centralised securities borrowing & lending services
A number of overseas central securities depositories have introduced securities borrowing and lending services, not only to cover settlement failure, as in Hong Kong, but in some cases also for strategic purposes.
In some less mature markets, such as Korea, the depository has managed to capture a major share of the local SBL market. However, in more mature markets, such as Singapore, the larger industry players are already catered for. These players mostly have global operations and seek counterparties who have a global offering; moreover, they have global integrated systems and standard practices. The local depository, which only has local stocks to offer and cannot necessarily conform with global practice, may not be an attractive counterparty. Hence in mature markets the depository may obtain at best only a marginal segment of smaller players. Nonetheless, in some very large markets, depositories with a sophisticated offering such as Crestco or Euroclear appear to have developed a successful SBL business.
Selected examples of centralised SBL services are described below5 .
Singapore Exchange (SGX)
The main objective of SGX's SBL programme is to improve liquidity of the stocks traded on the SGX. The programme was launched in January 2002 by SGX's subsidiary, Central Depository (CDP). The account structure of CDP is the foundation of the SBL programme. The stocks from a large number of direct securities accounts provide a steady supply to the lending pool.
CDP acts as the principal to both borrowers and lenders. The borrowers and lenders remain mutually anonymous. CDP collects collateral from the borrowers but does not pass it on the lenders. For cash collateral provided by the borrowers, CDP will pass back the interest to them at a lower rate.
The direct securities account holders are the major lenders. Currently, about 6,000 direct securities account holders have signed up to lend out their stocks. They can specify to lend out (1) all stocks, (2) specific stocks only, or (3) specific stocks with maximum quantities only. The stocks remain in the accounts of the potential lenders. CDP uses a separate system to keep track of the lending pool. Stock movements are only required for executed SBL loans and recalls.
SGX brokers are the major borrowers. A majority of them have participated in the programme. Most of their loans are on second- and third-liners for retail trades. The loan sizes are usually small with average of 60,000 to 70,000 shares per transaction. The custodians seldom participate because they have their own lending desks and are not interested in the small deals.
The 200 stocks with the highest transaction volumes are eligible for the programme, and the minimum borrowing size is 1,000 units. Fees are fixed - borrowers pay 6 per cent and lenders get 4 per cent. CDP has implemented various risks management measures on the price risks and concentration risks for the outstanding loans and the collateral. However, it is up to the borrowing brokers to monitor the risks of their clients.
The transaction volume of the SBL programme has been low. It is difficult to attract investors to participate. Borrowers see the programme as a complement to the OTC market. They will usually obtain large loans for blue chips through the OTC market and small loans or loans for second- or third-liners from CDP. It is difficult for CDP to compete with the OTC market on the pricing and services. Short-selling activity is not robust in Singapore, which is a further reason for the low demand for SBL loans.
Crestco is the central securities depository for the UK securities market and Irish equities. Through the CREST system, Crestco provides electronic real-time settlement for corporate and government securities, particularly those traded on the London Stock Exchange (LSE), Irish Stock Exchange and virt-x. In 2002, Crestco was merged with Euroclear.
CREST provides stock lending and collateral transfer functions through three services - Stock Loan, Delivery By Value (DBV) and, since 2001, Repo. The functionality allows two parties to transact with each other as principal or agent; CREST itself is never a counterparty to any loan or repo transaction. Crestco does not mandate that stock loan transactions be used for any particular purpose. Stock loans may be used for the following activities, among others: fails management, short selling, dividend arbitrage and equity financing. One advantage of the CREST system is that since collateral is available within the system, loans can be settled against cash intra-day and the cash can be exchanged if desired for a package of DBV securities overnight. During April 2004, CREST had a daily average of GBP65 billion of open lending equities, and GBP76 billion of open lending gilts (UK Government securities).
Equilend was established in the US in 2001 by a group of major financial services firms to develop a centralised system for securities lending. The system was launched in June 2002, and has seen daily volumes of US$2.5 billion per day with US$1 trillion of securities available for lending. Equilend's sole purpose is SBL facilitation. In 2003, Equilend established a subsidiary in London, Equilend Europe, which is authorised by the Financial Services Authority to operate as an alternative trading system in the UK.
The Equilend platform is an open, global, standards-based system that enables lenders and borrowers of securities to transact with one another via a secure hub. This removes the need for participants to maintain point-to-point connections with one another, and replaces manual processes with automation. The platform is a web-based using XML standards for communication (Equilend's Securities Lending Markup Language, SLML, a new open-standards protocol created for the securities industry).
The Options Clearing Corporation
The Options Clearing Corporation (OCC) is the clearing house for listed equity options in the US. In 1993, the OCC introduced the Hedge System which allows its clearing members to borrow and loan securities with listed options contracts and selected exchange traded funds. The stock loan programme aims to reduce OCC margin requirements by reflecting the real risks of their inter-market hedged positions.
In the Hedge System, OCC clearing members can create hedge stock loan/borrow positions. The terms and rebate of the stock loan are negotiated between borrowers and lenders. Details of loans are sent to the Depository Trust Company (DTC) using special OCC codes. Cash and securities are transferred through DTC. Members can also instruct OCC to automatically allocate hedge positions against either equity or index stock positions for margin offset. Each business evening, OCC marks to market each outstanding stock loan/borrow position and reports the information to participants daily. The transactions are guaranteed by OCC.
Clearstream, part of the Deutsche Boerse Group, offers settlement and custody services on over 150,000 bonds and equities to the German, Luxembourg and international markets. As one service of the custody business, global securities financing service is provided via its Central Securities Depository and International Securities Depository.
Clearstream offers securities lending services - including automated securities lending and borrowing service which automatically detects the loan requirement of a borrower and the loan supply from the lender. Collateral of the borrower will be blocked and pledged directly in favour of Clearstream as the guarantor. The loan securities will then be transferred to the borrower. The strategic securities lending (SSL) service is a pro-active service supporting the longer-term trading strategies of borrowers. SSL lenders and borrowers are required to open an account in and sign agreed terms with Clearstream Banking for SSL transactions. Borrowers have to send an enquiry to the SSL Service Desk in London to check the availability of the securities. Once initiated, the proposed transaction details are agreed and confirmed by the SSL Operations Unit in Luxembourg which will transfer the securities and collateral to the appropriate accounts. Clearstream also provides a case-by-case lending service. It provides collateral management services - including tripartite repo service and tripartite securities lending service.
Clearstream is the second largest provider of tri-party securities financing in the world. According to the tri-party securities financing industry survey by Global Custodian, Clearstream processed US$104 billion of assets daily in 2004.
Euroclear, established in 1968, is an International Central Securities Depository based in Europe and also provides Central Securities Depository services to a number of domestic markets in Europe. Euroclear offers securities lending and borrowing services through the Euroclear Bank and also through its wholly-owned subsidiary Crestco (see above).
Euroclear Bank's securities lending service targets loan demand to avoid settlement failures. Securities are generally eligible for lending if regulations in the jurisdiction of issue permit the lending and borrowing of securities. Currently, the securities available include 32 currencies, debt in 26 markets and equities in 15 markets.
The service is an integrated component of the settlement process. Clients must explicitly subscribe to the service by completing various enrolment forms. Borrowers must complete credit documentation with Euroclear Bank. There are three types of SBL transactions: automatic instructions, opportunity borrowing and requested recall. Lenders' positions are aggregated into an anonymous lending pool from which securities are allocated to borrowers on a pro rata basis. Euroclear Bank acts as the counterparty of borrowers and lenders. Furthermore, Euroclear Bank monitors and guarantees the return of lent securities, related entitlements paid by issuers and payment of lending fees.
Korea Securities Depository (KSD)
The KSD introduced SBL services in 1997. It provides intermediary services such as trade intermediation, matching, delivery and return, management of rights deriving from loaned securities and collateral management.
The KSD was the first institution to offer SBL services in Korea and thus had an advantage over other service providers. The market has grown steadily, and in 2003, the KSD captured a record 80 per cent share of the Korean SBL market, with a monthly average volume of KRW538 billion (US$450 million). The main purposes of securities borrowing include supporting trading strategies, avoiding fails in securities delivery and providing inventory for various financial strategies.
The KSD commenced repo agent service for foreign institutional investors from 2000. However, the business is not very successful because foreign investors still have many barriers to participate the domestic repo market such as differences in language, time and telecommunication method.
Taiwan Stock Exchange (TSEC)
The TSEC launched an SBL system on 30 June 2003. As of 15 March 2004 (about nine months after launch), 248 SBL transactions had been conducted with transaction value of NT$27 billion (US$800 million). The SBL system is targeted at qualified institutional investors.
Participants can only borrow securities for strategic trading. According to the TSEC's Operation Rules, permissible trading strategies include hedging, arbitraging and exercising contracts. Before placing an order, a borrower should indicate the purpose of the transaction and prove ownership of the derivatives to the broker.
The TSEC provides three kinds of SBL transactions - fixed-rate transaction, competitive auction transaction and negotiated transaction. The exchange provides a matching system for fixed-rate and competitive auction transactions. After matching, the order details will be passed to the Taiwan Securities Central Depository (TSCD), a subsidiary of the TSEC. Accordingly, TSCD will transfer the securities from the lender account to the borrower account. The borrower returns the securities by notifying its securities dealer which in turn notifies the exchange. The borrower should deposit collateral to the exchange. For negotiated transactions, borrowers and lenders will agree the securities, collateral, related fees and beneficial owners of the securities. The exchange will not provide guarantee to this type of transaction. Details of the negotiated transactions will be sent to the exchange which will inform TSCD to process. The SBL transactions are mainly fixed-rate transactions (57 per cent) and competitive transactions (42 per cent). Only one per cent of transactions are negotiated transactions.
SBL facilitates a variety of transactions in the market, and so is an important support for market liquidity. It is a complex business with an involved transaction process. Before executing a transaction, the borrower has to assess the creditworthiness of the lender, and then negotiate the terms and sign an agreement with him. The borrower then has to take delivery of the securities, deposit collateral, deposit further collateral if called upon to do so by the lender, make the lender whole for any dividends or other benefits arising from the underlying securities, and finally return borrowed securities on the due date while at the same time taking delivery of the returned collateral. Because of its complexity, SBL is typically conducted among large global players who have the systems, the creditworthiness and the specialised skills to conduct such operations. SBL is nowadays a volume business conducted mostly at low margins with a high level of automation. It is dominated by global intermediaries, who aggregate the borrowing and lending demand of their clients.
In Hong Kong, the SBL industry has been established for almost 10 years, and operates along the lines described above. The major global lending agents are represented in Hong Kong and conduct much of their regional lending from the territory. Their clients are the major securities firms, which in turn represent the borrowers such as hedge funds and second-tier securities firms. The major players operate through global transaction systems in accordance with international practice on a highly competitive basis. These players occupy the market space; there would be less room for a centralised service.
1 Article prepared for October 2004 issue of Hong Kong Exchanges and Clearing (HKEx)'s journal Exchange. Matthew Harrison and Ada Choi are in HKEx's Research & Planning Department.
2 This section is largely based upon An Introduction to Securities Lending, a paper commissioned by the UK Securities Lending and Repo Committee and other bodies, © Mark C.Faulkner.
3 Technology Key as Sec Lending Moves Upstream, Securities Industry News, 24 February 2003.
4 The UK-based International Securities Market Association (ISMA) and the US-based Public Markets Association (TPMA).
5 Based mainly on information gathered from the respective institutions' websites, viewed during August and September 2004, supplemented by discussion with personnel of certain institutions.