The US Securities and Exchange Commission (SEC) held a round table last week to shed light on securities lending and short sales. This comes in the backdrop of comments by SEC officials that they are concerned about the lack of transparency in the lending market and the possibility of misuse of collateral deposited by stock borrowers.
After the financial crisis, the spotlight has turned on over-the-counter (OTC) markets and many regulators have expressed a preference for the more transparent exchange-traded model. In light of this, the Securities and Exchange Board of India’s (Sebi) exchange-traded securities lending and borrowing (SLB) model with a central counterparty (CCP) seems like the right move.
But one also has to contend with the fact that the Indian SLB market is inactive even 18 months after its launch. So while Sebi may be tempted to feel smug about starting off with the exchange-traded model for SLB, it needs to wake up to the fact that some tweaking would be required in the current model for market participants to use the facility.
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SLB transactions have been done OTC internationally. Securities are borrowed typically by short sellers to meet settlement obligations and loaned temporarily by institutions with idle inventory of these securities. This is done in exchange for adequate collateral.
In markets such as the US, where the collateral is paid in cash, the return for the lender is the interest earned on the collateral minus any rebate payable to the borrower. The terms of the collateral, rebate, tenure of the stock borrow, conditions for recalling stock in case of some corporate action, etc., are fixed at the time of the transaction. Because of these nuances involved in a securities lending transaction, many market participants pointed out in the round table that the preferred route should be the OTC model. The counter argument made was that the exchange model can be used to supplement the OTC market, wherever standardization is possible.
While the norm internationally is the OTC model, there are a few markets such as South Korea, Taiwan and Brazil that operate on an exchange model with a CCP for securities lending transactions. These models have had reasonable success. But as panellists in a recent securities lending conference organized by International Securities Finance magazine pointed out, that’s largely because these markets have adopted a hybrid structure with some features of the OTC market. For instance, market participants can negotiate the terms of a transaction and then strike it on the exchange platform. This works akin to the block deals window permitted by Sebi for equities trading. Malaysia tried a pure exchange traded model, but has realized over the last three years that some changes need to be made. So while it has retained the CCP structure, starting August this year it has allowed negotiation of tenor and fee, and the movement of collateral offshore.
In its attempt to standardize the product to be suitable for exchange-based trading, Sebi has fixed the tenor of the stock borrow at 30 days (raised from seven days initially). This needs to change, as borrowers and lenders both need flexibility on the period of the transaction.
The other major hindrance to SLB in India is that it’s permitted only in stocks on which derivatives trading is permitted. Investors can easily short sell shares using a stock futures contract and the need to go through the convoluted process of selling short in the cash market and then borrowing shares in SLB and reversing these two legs later will obviously be avoided. The benefit of SLB in India lies much more in shares where derivatives trading is not permitted.
Besides, in the above mentioned markets that follow a hybrid structure (except Brazil), the collateral is held by the lender or an agent working on behalf of the lender. Since offshore players are used to this structure, brokers and agents claim that they would be uncomfortable with the practice of the exchange’s clearinghouse holding the collateral, which is the case with the Sebi model. But it must be noted that the Brazilian SLB market has done well despite this guideline and a change in regulation in this regard may not be a prerequisite for the SLB market to take off in India.
In any case, the risk of collateral reinvestment is quite high and during the financial crisis, a number of institutions engaged in SLB were hurt badly as some collateral reinvestment programmes lost money. Besides, with Lehman failing, counterparty risk became apparent.
The events of 2008 have led to the setting up of electronic platforms with central clearing services even in developed markets. A prime example is Quadriserv Inc., which has created a public, centralized marketplace in the US for the borrowing and lending of equity securities through its subsidiary, Automated Equity Finance Markets Inc. (operating as AQS). For transactions matched on AQS, the Options Clearing Corporation acts as a CCP, guaranteeing daily mark-to-market payments, and the return of loaned securities and collateral. With regulators increasingly getting comfortable with the CCP model, such platforms are likely to grow well, although their contribution to overall volumes is small currently.
In sum, Sebi has made a good decision to insist on an exchange model with a CCP despite received wisdom that the SLB market has worked best in an OTC framework globally. Having said that, it needs to be more flexible with product specifications for trading to pick up.
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