Securities Lending An Overview An NSE Presentation By Segun Sanni Head, Client Services Stanbic IBTC September 2012
Outline 1 2 3 4 Introduction Key Players Benefits of Securities Lending Types of Loans & Recalls Collateral Management 5 Risk Management 6 SL Life Cycle 7 8 Q & A
Introduction What is Securities Lending? The word lending is in some ways misleading. Legally, an SL transaction is an absolute transfer of title (sale) against an undertaking to return equivalent securities. Usually the borrower will collateralize the transaction with cash or other acceptable securities of equal or greater value than the lent securities in order to protect the lender against counterpart credit risk Securities lending describes the market practice by which, for a fee, securities are transferred temporarily from one party, the lender, to another, the borrower who collateralizes the loan and is obliged to return them either on demand or at the end of any agreed term
Introduction Legal title versus economic benefits Absolute legal title over both lent and collateral securities passes between the parties Once securities have been acquired, the new owner (the borrower) has certain rights e.g. to sell or vote at general meetings The borrower is legally entitled to the economic benefits of owning the lent securities e.g. cash and stock dividends
Introduction Supply & Demand The supply of securities into the lending market comes mainly from the portfolios of beneficial owners, such as mutual funds, global pension funds, insurance companies, investment funds, exchange traded funds and sovereign wealth funds and pension* funds Underlying demand to borrow securities begins largely with the trading activities of hedge funds, prime brokers or broker-dealers (market makers)
Introduction Lending Agents/Intermediaries These are custodian banks and asset managers who lend securities on behalf of beneficial owners Their services include credit enhancement, provision of liquidity, collaterals management etc. They split lending fees with lenders in return for their services and risks.
Key Players Parties to Securities Lending: Borrowers: Market Makers, Broker-Dealer firms, Investment Banks, Hedge Funds and Intermediaries usually comprise this group Direct Lenders: These tend to be large institutional investors such as Pension Plans, Insurance Companies, Mutual Funds, Sovereign Wealth Funds, Investment Companies and some High Net-worth Individuals Lending Agents: Custodians, Broker-Dealer firms and Asset Managers tend to play this role
Benefits of Securities Lending To Lenders: Additional income from investment portfolios Market liquidity by increasing the number of potential sellers & buyers in the market To Borrowers: Market making Failed trade protection (short selling) Additional income Market liquidity by increasing the number of potential sellers & buyers in the market To Lending Agents / Intermediaries: Additional income Increased business volumes
Benefits of Securities Lending To The Market: Market liquidity by increasing the number of potential sellers & buyers in the market Efficient pricing and market depth More competitiveness More attractiveness To Issuers: Efficient pricing Market liquidity by increasing the number of potential sellers & buyers in the market To Depository Additional income Increased assets in depository
Benefits of Securities Lending To The Regulators: More efficient market More attraction for FPI Increased liquidity Increased revenue
Types of Sec Lending Loans & Recalls By Tenor Open/callable loan Borrower is required to return the security on demand By Collateral Type Cash The loan is collateralized with cash deposit subject to applicable haircut Term loan Borrower is required to return the security at an agreed date in the future Other securities Loan collateralized by other forms of securities e.g. listed equities, fixed income securities and debt instruments subject to applicable haircuts
Types of Sec Lending Loans & Recalls Reasons for recalls 1. Need to vote 2. Worry about the borrower s credit worthiness 3. Concern over market volatility Recall of securities is subject to the standard settlement time that applies to the securities on the exchange through which they were initially delivered, or as agreed in the original agreement
2. Concentration limits, i.e. the maximum percentage of any issue to be acceptable, for example less than 5% of daily traded volume, or the maximum percentage of collateral pool that can be taken against the same issuer, or a percentage of total market cap. Collateral Management Collateral received by the lender is a kind of insurance against the borrower default. The eligible collateral (taking into account criteria such as credit rating, market, type of security, country, etc.) is agreed between the parties, as well as other parameters linked to collateral: 1. Notional limits, i.e. the absolute value of any asset to be accepted as collateral;
Collateral Management 3. Margin or haircut, i.e. the amount of over-collateralisation required by the securities lender to protect itself from the price volatility of the underlying securities and the counterparty risk. This amount varies with the size and term of the transaction, the securities type and maturity, as well as with the counterparty creditworthiness 4. Initial margin, i.e. the margin required at the outset of a transaction; 5. Maintenance margin, i.e. the minimum margin level to be maintained throughout the transaction; It involves the regular and frequent revaluation of collateral.
Collateral Management Throughout the term of the transaction, the market value of securities and collateral may fluctuate. That is why a regular marking-to-market (daily or even intraday) is carried out to monitor the margin calls that the parties exchange between themselves in order to maintain sufficient levels of collateralization and mitigate market and credit risk.
Risk Management Types of Risks Seven types of risks are associated with Securities Lending Transactions: Counterparty Risk Market Risk Collateral Re-investment Risk Liquidity Risk Delivery Risk Operational Risk Legal Risk
Market Related Risks & Mitigants Counterparty or Credit Risk Risk that can arise when a counterpart defaults on its obligations (e.g. in a securities lending transaction, the borrower does not return the loaned securities and there is insufficient collateral to buy in the securities) Mitigation: 1. Credit evaluation: Careful analysis, selection and ongoing monitoring of participating borrowers/buyers 2. Indemnification insurance for borrower default 3. Comprehensive legal documentation including collateral schedule, re-pricing and default processes
Market Related Risks & Mitigants Market Risk - Mismatch risk between the securities lent and the collateral received Risk that can arise in case of price volatility, market liquidity and exchange rate fluctuations if the market price of the underlying securities or the collateral move adversely in a short period of time, so that the value of collateral accounts for less than the value of the securities lent Mitigation: 1. Maintenance of sufficient margin levels and collateral types depending on the assets on loan, with continuous monitoring of collateral levels (daily mark-to-market and timely margin calls)
Market Related Risks & Mitigants Collateral Reinvestment Risk Risk that can occur in securities lending when the collateral received is reinvested into assets of lower quality or in instruments of nondiversified issuers Mitigation: 1. Credit quality, maturity, liquidity and diversification of eligible collateral 2. Collateral reinvestment guidelines reflecting the beneficial owner s risk and reward objectives 3. Strong procedures and control systems
Market Related Risks & Mitigants Liquidity Risk: Mitigation: Risk that the counterparty cannot settle an obligation for the full value when it is due, for any reason (e.g. demand for large quantities of securities or funds that renders the counterparty unable to meet its obligations when due, counterparty s inability to unwind its short outright position) 1. Use of buffer securities (e.g. a higher buffer for less liquid issues) or reserve cash 2. Over-collateralization to cover market fluctuations
Operation Related Risks & Mitigants Delivery Risk: Risk that can occur when A) securities have been lent and collateral has not been received at the same time or prior to the loan or B) collateral is being returned but the loan return has not been received or C) settlement fails Mitigation: 1. Delivery Versus Payment (DVP) or Delivery Versus Delivery (DVD) processes 2. Straight Through Processing (STP) 3. Pre-collateralization (collateral received in advance of delivering the loan securities) 4. Use of tri-party collateral agents
Operation Related Risks & Mitigants Operational Risk: Risk that deficiencies in information systems, manual processes or internal controls could result in an unexpected loss or in penalties imposed by a counterparty. Risks that can arise when the securities lending players have not the adequate infrastructure (e.g. manual interventions) and processes in place to cope with the business rules (e.g. recall in time to enable a sale of the securities lent) Mitigation: 1. Use of intermediaries having the right infrastructure, high levels of automation and efficient processes (e.g. corporate actions, recalls) 2. Data granularity and quality to cope with the business rules
Legal Related Risks & Mitigants Legal and Regulatory Risk: Risk of loss because of the unexpected application of a law or regulation, or because a contract cannot be enforced Mitigation: 1. Written contract in the form of a robust standard master agreement, addressing the various legal aspects of securities lending and clarifying the roles and responsibilities of the participants, as well as the legal framework in a particular jurisdiction (e.g. GMSLA)
Life Cycle of An SL Transaction High level Principal Borrower Model Start SLA establish relationship with beneficial owner (BO) SLA publish information on lendable securities Agree terms of engagement & execute relevant documents PMM contact SLA to establish SLB relationship or vice versa SLA run PMM through its internal credit processes SLA obtain approval to set credit limit for PMM PMM contact SLA to negotiate & agree the terms of an SL transaction Transaction details signed off by both parties Loan security & collateral exchange hands PMM pay monthly lending fee to SLA SLA share lending fee with BO SLA daily mark to market both loan security & collateral Collateral shortage or excess Collateral top up or excess collateral return SLA regularly review PMM s credit standing to determine credit status Recall or loan tenor expiration Loan security & collateral are returned to source End
Life Cycle of An SL Transaction High level Lender Agent Model Start BO publish information on lendable securities SLA publish information on lendable securities PMM contact BO to establish SLB relationship Agree terms of engagement & execute relevant documents BO run PMM through its internal credit processes BO approves credit limit for PMM PMM contact BO to negotiate & agree the terms of an SL transaction Transaction details signed off by both parties BO appoint an agent to manage collateral Loan security & collateral exchange hands Agent daily mark to market both loan security & collateral Collateral shortage or excess Collateral top up or excess collateral return BO regularly review PMM s credit standing to determine credit status PMM pay monthly lending fee to BO BO share lending fee with SLA Recall or loan tenor expiration Loan security & collateral are returned to source End
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