In February the securities lending exchange Quadriserv announced the latest members of its AQS marketplace, a centralised market for securities lending transactions. The list included some impressive names, such as hedge funds DE Shaw and Renaissance Technologies. Also on the list was BNY Mellon, the first big agent lender to commit publicly to conducting securities lending business on-exchange. These latest additions bring the number of AQS participants to nearly 60. Crucially, a significant number of prime brokers have already signed as clearing members of the exchange.
Quadriserv said around a dozen hedge funds have signed to use the platform through their prime brokers. A spokesperson declined to name the funds but said they were all large players with average assets under management of over US$10bn.
On the supply side three agent banks are currently trading on AQS with a fourth in the on-boarding phase.
In Europe, SecFinex, the securities lending exchange which is majority-owned by NYSE Euronext, is “actively bringing on new participants,” said Robert Reynolds, the company’s global head of sales. He declined to provide names due to the anonymous nature of the platform.
The advent of electronic exchanges for securities lending should result in lower costs and greater liquidity for short sellers. Hedge funds currently rely on their prime brokers to secure access to short stock. They in turn borrow those securities from custodian banks hired by large institutional investors to shop their lendable assets to the market.
The business is a profitable one for the intermediaries, but costly and inefficient for every-one else. For instance, custodians often try to get more of their stock out on loan by obliging prime brokers to borrow easy-to-borrow general collateral stock at inflated prices in order to gain access to hard-to-borrow ‘specials’. The costs are passed to hedge funds and there is little in the way of price transparency. At the same time institutional investors complain of the low utilisation rates in their securities lending programmes.
Securities lending exchanges promise to change all that by connecting lenders and borrowers in an open and transparent electronic marketplace.
The sudden surge in securities lending exchanges among prime brokers follows a move by Quadriserv and SecFinex to adapt their business model to appeal to intermediaries.
An old idea
The concept of a centralised marketplace for securities lending is nothing new itself. Quadriserv and SecFinex among others have been in the market in various guises for almost a decade. SecFinex was established in 2000. The company has developed three separate mechanisms for conducting securities lending transactions over a screen-based, electronic platform. Launched in 2003, the SecFinex Order Market allows participants to view best bids and offers and trade on live prices. SecFinex also has a ‘private market’ where participants can negotiate bilateral securities lending and borrowing deals and an ‘auction market’ where borrowers bid competitively to access attractive supply.
The concept of a securities lending exchange backed by a central counterparty (CCP) came to the fore in 2007, when Euronext acquired a stake in SecFinex just prior to its merger with the New York Stock Exchange. Following the deal, SecFinex adopted an exchange model and started working on the design and development of a CCP for its Order Market.
Around the same time Quadriserv linked with the Options Clearing Corporation (OCC) to develop a similar platform for the US. Under this model AQS matches lenders and borrowers using either a continuous price discovery mechanism or a bilateral negotiation facility. The matched loans are then processed by the OCC, which provides CCP guarantees for transactions. Cleared transactions are settled by the Depository Trust Company (DTC).
Quadriserv processed its first centrally cleared, matched and settled securities lending transaction in January 2009. Following a testing period, the exchange officially went live in May 2009. SecFinex concluded CCP agreements in 2009 with LCH.Clearnet and SIX x-clear to introduce a central clearing service in the Euronext markets and seven other European markets.
SecFinex and SIX x-clear plan to introduce a CCP service in the UK soon. Quadriserv is working with Eurex to develop a clearing service for European equities. A launch is expected towards the end of 2010.
Central clearing is increasingly seen as an important benefit for prime brokers, said Quadriserv founder and chief investment officer Greg DePetris. “The CCP model reduces risk for intermediaries and allows them to use capital more efficiently. It can make securities lending, and prime brokerage generally, a much more cost-effective business for broker/dealers,” he said.
One of the main benefits is regulatory capital reduction. Under Basel II a bank does not have to apply capital against securities lending transactions if they are cleared through a CCP. The CCP model also appeals to beneficial owners and the custodian banks that act as their agents in the securities lending business. Their main focus is on collateral management and reinvestment risk.
In a typical stock loan transaction, the lender receives cash collateral from the borrower which is then reinvested in money market instruments. Collateral reinvestment provides an additional revenue stream for the lender but adds incremental risk to the transaction.
Scores of pension funds were left with significant losses in their securities lending programmes in 2008 when their cash reinvestment portfolios plunged in value and became illiquid following the collapse of Lehman Brothers. The experience prompted many pension funds in 2008 to shut down or scale back temporarily their securities lending programmes. Some pension funds are suing their custodian banks over the losses on the grounds that cash collateral was invested in overly aggressive instruments.
Time for caution
“Risk management and oversight are currently at the forefront of lenders’ minds,” said Data Explorers founder and head of innovation Mark Faulkner, founder and head of innovation at Data Explorers.
“Collateral reinvestment returns were a significant source of revenue for many lenders, but the losses in 2008 have forced people to rethink that part of the business. Pension funds want to know how the market would cope if something like Lehman Brothers happened again,” he added.
The CCP offers one solution to the problem: collateral is posted and managed at the clearinghouse level rather than by individual lenders. However, lenders would also lose the opportunity to generate additional revenue through collateral reinvestment.
“Lenders want to learn more about the risk management aspect of a CCP and how it would work in practice. It is not something that beneficial owners have been exposed to in the past,” noted Faulkner.
DePetris believes institutional lenders are dissatisfied with the collateral reinvestment component of the lending process. “Given the rate environment and changing views on the risk-adjusted return from securities lending, large lenders and their clients are focusing more closely on the ‘intrinsic value lending model’ where they get the best fee for every loan, as opposed to overweighting the collateral reinvestment aspect of their returns,” he said.
He thinks that will lead custodial and agent lenders to move more of their business on-exchange as one of a variety of service offerings to their clients. “An exchange allows lenders to find the best rate on every transaction by connecting them to end-borrowers. That notion of market-based transparency and competitive price discovery is a well-understood principle within the broader fiduciary community,” he added.
For now much of the interest in Quadriserv is coming from prime brokers and hedge funds. Merrill Lynch was one of Quadriserv’s earliest backers. It acquired a stake in the company before the Bank of America takeover and was among the first banks to be up and running on AQS.
Bank of America Merrill Lynch head of Americas financing sales Steve Keller compared the move towards exchange trading of stock loans to the advent of electronic execution a decade ago. The market was at first deeply sceptical about the development, he recalled. “The assumption was that spreads would decline and result in lower revenues across the board. In fact, there was an explosion in volumes and the business became more profitable when electronic trading was incorporated alongside the traditional cash business,” he noted.
Keller believes the securities lending business will follow a similar path. “There is a sense of inevitability kicking in. People have recognised that electronic exchanges are going to be a significant part of the future of this business. Whatever resistance there was in the past is quickly falling away,” he said.
One of the main benefits of a securities lending exchange is the additional price transparency it brings to the market, noted Citigroup head of Americas prime finance Alan Pace.
“People are still trying to figure out how the exchange model will work in practice and whether or not it has the potential to replace other methods of lending and borrowing securities,” said Pace.
“The general response has been very positive, but it is still early days. We believe that electronic exchanges do have a role within the securities business, but the size and scope of that role are yet to be determined,” he said.