It might surprise non-specialists to learn that the turmoil experienced in Far Eastern markets over the past two years or so can be viewed as a positive selling point for the securities lending product. Anecdotal evidence suggests that any losses taken during this period were suffered not by lenders, as positions were recalled by agent banks from borrowers almost immediately, but by borrowers who were caught off guard.
If anything, the problems arising in the Far East can be said to serve as an example of how securities lending is a risk mitigation factor rather than a risk element. The nub of this argument is that the collateral required in securities lending is traditionally high quality, high grade paper, denominated in US dollars or some other stable currency. Therefore, a lender lending in a volatile market will in effect be able to convert low grade country risk into higher grade country risk. While the value of a loan can drop drastically, the collateral will hold its value.
Securities lending, in essence, is still largely misunderstood. From a lender's perspective, it remains a low-risk, low-return business, the bulk of the risk being absorbed by the borrowers. Fred Francis, Vice President, Global Securities Lending and Finance at Royal Trust in Toronto, is on something of a one-man mission to open the eyes of the world to its manifest attractions.
"In markets where securities lending is not tacitly encouraged, such as in most of the Far East, price volatility and lack of liquidity is endemic. Markets should encourage lending. We are seeing numerous markets taking action in supporting and regulating securities lending in such a way that it becomes a much more established business. In South Korea, for example, lending will probably grow quite rapidly."
Others are also bullish about securities lending in the region. Michelle Phillips, a vice president in global securities lending at Chase Manhattan Bank in London, notes that participants are less numerous and activity less substantial than before."Nevertheless, there has been a steady increase in confidence, and a modest rise in activity as a result. Although it has been a slow process, we are optimistic about the future. Short selling and stock lending/borrowing are still prohibited in Malaysia. However, we are hopeful that some of the restrictions will be eased in the near future; were the government to relax some of the market and tax regulations, activity would invariably resume, under the prescribed guidelines."
Says Cindy Tang, Manager Product Development at Custody and Clearing at HSBC in Hong Kong. "With greater education and a higher profile, more and more lenders in this region are finding out that lending or repo-ing out stocks can make attractive commercial sense, and that the activity itself is playing a key part in creating depth and liquidity in the securities market."
"With recovery expected or taking place across the region, demand for stocks by borrowers is anticipated and lenders are expected to make good steady returns, especially in larger economies such as Japan and the Hong Kong SAR. We are therefore projecting high growth in securities lending and borrowing for the region from next year onwards, with local regulators needing to react to the surge in offshore activity, and looking to introduce a version of onshore securities lending in their respective markets. Not surprisingly, the Overseas Securities Lending Agreement, the market standard document used for securities lending, is being revised, to include new force majeure and other precautionary clauses."
Notwithstanding these positive views, some market practices have inevitably changed, with an increase in stock buffers pinpointed as a favourite defence mechanism. If a lender lends out one hundred per cent of stock, and a client wants to sell, that necessitates a recall. Borrowers who have to settle on a liquidation basis will inevitably be hurt. To avoid failure, lenders routinely maintain higher buffers than previously to satisfy sales. Royal Trust, for instance, has reassessed its buffers and increased them in certain markets. Today they vary between a floor or 10% and 25%-plus, depending on the markets in question and their depth.
"A growing trend in securities lending is the preference
by major institutional borrowers to secure exclusive contracts
with large lenders to ensure a consistent supply of stocks,"
comments Cindy Tang. "The importance placed by borrowers
for guaranteed stock supply is becoming paramount, even at the
expense of having to pay a higher fixed lending fee."
In some markets, notes Fred Francis, lenders have taken to insisting
upon shorter recall periods for stock lent. Where a market operates
T+3 settlement, a lender might insist on recall in a shorter period,
on T+1 or T+2 to avoid penalties on failures. Such shorter settlement
periods have not necessarily been universally accepted by borrowers.
As with all areas of banking, though, the first line of defence is picking the right counterparts with which to transact business. There is little substitute for blue chip creditworthiness.
A version of this article appeared in Financial News, the London-based weekly newspaper covering the securities and investment banking markets.