Then and now
In the 1970s, US custodian banks started lending of specific stocks on behalf of clients, to broker dealers. Then came the failure of the Drysdale securities in 1982 which had a profound impact on the securities lending industry. The Drysdale securities failure led to careful scrutiny of counterparties and their balance sheets and collateral requirements; and standardisation of contracts and daily mark-to-market became much more universal.
Since the market then was mainly physical, it used to take 10 to 15 days for the transfer of securities from the lenderÆs to the borrowerÆs name. At the end of the tenure, the borrower used to purchase the shares from the market and deliver street-name shares to the lenders. Again, the lender used to take 10 to 15 days to make this transfer. Transfer time became one of the main reasons why lending and borrowing never truly took flight. Intermediaries used to create the market for lending / borrowing transactions.
Today, securities lending has gained traction in a much more international stock market and the globalised underlying securities market. With the marketÆs transformation from the physical to the electronic inefficiencies in trading, lending and borrowing have been reduced. WhatÆs more, the expansion of the derivatives markets, innovations in derivatives transactions and greater use of short selling trading strategies in the last four to five years have led to an increase in securities lending transactions.
It has not been a significant shift however, largely because of lack of liquidity in the market (lack of lenders and borrowers).
Taking stock û Why have lending and borrowing not picked up?
- Liquidity: There is lack of liquidity in the market (lack of lenders and borrowers). Investors globally favour liquidity - æLiquidity attracts LiquidityÆ as they say. If we could attract liquidity in the lending and borrowing market by providing open position information to investors, attractive commissions to Lenders, guaranteed delivery to borrowers û we are likely to see a major shift in favour of lending and borrowing.
- Transparency in matching: Transparency in matching of lenders and borrowers is another important factor. Intermediaries / market place should communicate the matching logic (LIFO, FIFO, Weighted Average, etc.) to lenders and borrowers û this will help to increase the confidence between lenders and borrowers.
- Regulatory restrictions: In many countries, some entities (foreign institutional investors, mutual funds) are not allowed to short sell and to borrow securities. Because of these restrictions, such entities can only lend shares. The result û more lenders against fewer borrowers in the market.
- Lending & borrowing settlement at depository: In some countries, depositories take T+1 or T+2 days to settle lending and borrowing transactions. Should regulators allow depositories to settle lending and borrowing transactions at T+0, shortened settlement times will likely encourage such transactions.
- Investor awareness: Lack of awareness amongst the players and misconceptions about lending and borrowing transactions is another factor holding back demand for the product.
Micro-exchanges û the future for securities lending and borrowing?
The notion of market places (exchanges) playing a significant role in securities lending and borrowing isnÆt new. There are marketplaces in the US and Europe that provide securities lending and borrowing to industry players.
In spite of several initiatives, however, the idea of exchanges offering securities lending hasnÆt quite taken flight.
Perhaps the answer is not so much in a big bang approach, but in micro-exchanges set up by custody service providers and financial institutions (representing end-investors) for their own customers.
Such micro-exchanges can potentially deliver:
- Economies of scale that reduce the overall costs of transactions
- Improved liquidity in the market (guaranteed matching of lend / borrow transaction).
The technology exists to support such smaller scale initiatives. The Web-services approach û a service oriented software system for instance. It deals with loosely coupled systems and offers standards-based interfaces. Micro-exchanges will use standardized securities lending and borrowing message to interact with each other. The key benefit of the service oriented system in the securities lending market place is discovery of offers in a totally automated manner.
How will the ôMicro-exchangeö work?
Whenever an end-client needs to lend or borrow securities, a request will be made through a variety of channels such as the web or e-mail. This request will be made first to internal customers and if the system is unable to find a response then it will initiate the same to the external world (custodians, broker dealers). The Micro-exchange will receive the response (availability of the lender or borrower for the request) from those systems.
Once the Micro-exchange receives a response then order-matching and contract negotiation can take place between two parties. Needless to say, appropriate security mechanisms including hard authentication based on digital signatures may be implemented.
|Micro lending & borrowing (exchanges) via Web-Services|
Realising the benefits
Securities lending could reduce settlement risk and provide lenders with the opportunity to earn more money on their idle stock. With its inherent advantages, securities lending has potentially a starring role in shaping the future of the securities markets.