Securities Lending – An Overview

An NSE Presentation By

Segun Sanni Head, Client Services

Stanbic IBTC

September 2012

1 • Introduction

2 • Key Players

3 • Benefits of Securities Lending

4 • Types of Loans & Recalls

5 • Collateral Management

6 • Risk Management

7 • SL Life Cycle

8 • Q & A

Outline

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

• 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

Parties to Securities Lending:

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

• Term loan – Borrower is required to return the security at an agreed date in the future

By Collateral Type

• Cash – The loan is collateralized with cash deposit subject to applicable haircut

• 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

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;

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

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 on-

going 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 non-

diversified 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:

• 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)

Mitigation:

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 SLA establish

relationship with beneficial owner

(BO)

Agree terms of engagement &

execute relevant documents

SLA run PMM through its

internal credit processes

Collateral shortage or excess

Start

PMM contact SLA to establish SLB relationship or

vice versa

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

Collateral top up or excess

collateral return

Loan security & collateral are returned to

source

SLA regularly review PMM’s

credit standing to determine credit

status

Recall or loan tenor expiration

End

SLA publish information on

lendable securities

SLA daily mark to market both loan

security & collateral

PMM pay monthly lending

fee to SLA

SLA share lending fee with BO

Life Cycle of An SL Transaction – High level

Lender Agent Model BO publish

information on lendable securities

Agree terms of engagement &

execute relevant documents

BO run PMM through its

internal credit processes

Collateral shortage or excess

Start PMM contact BO to establish SLB

relationship

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

Loan security & collateral

exchange hands

Collateral top up or excess

collateral return

Loan security & collateral are returned to

source

BO regularly review PMM’s

credit standing to determine credit

status

Recall or loan tenor

expiration

End

SLA publish information on

lendable securities

Agent daily mark to market both loan security &

collateral

BO appoint an agent to manage

collateral

PMM pay monthly lending

fee to BO

BO share lending fee

with SLA

QUESTIONS?

Stock Exchange House

2 - 4 Customs Street

P.O. Box 2457, Marina

Lagos Island, Lagos, Nigeria

olala@nse.com.ng

Thank You