"Taking the Business Global "
By John J. Piccitto
ISF Magazine
September 2003
In the 1980s, the US investment banks exported Stock Lending to Europe and Asia, forcing regulatory changes and sparking a feverish hunt for lenders. In the second of our series of articles tracing the development of the industry, John Piccitto of eSecLending Europe , remembers what happened when the Americans came
to town.
Stock lending may have begun the 1980s with a whimper, but the decade was punctuated by a series of crashes and bangs that closed with the infamous Maxwell affair. When I came to London in 1981, few people knew about stock lending as it was practiced in the US , or realised its potential for profit. A European managing director put it bluntly: Why lend stocks? he snorted. "I thought our job was to sell them! But slowly, the arrival of Salomon Brothers, Morgan Stanley, Prudential Bache, Goldman Sachs, Merrill Lynch, and Lehman Brothers began to shake up the world of the jobbers and the money brokers on the London Stock Exchange (LSE).
During those early days, the UK Inland Revenue (IR) wrestled with the issue of whether or not a security could be loaned to a borrower and still belong to the original owner, who retained every right to the dividend.
At first, the IR threatened to charge Capital Gains Tax (CGT) on every transaction, arguing that the security was sold, as evidenced by the fact that the registered holder was always changed when a security changed hands. Neither a borrower nor a lender be intoned one of my jolly supervisors as we sweated out the IR's final decision.
After many months and many, many meetings, the IR relented and agreed that the loan of a security would not attract CGT. This was the first of many victories for securities lending during the early l98O's. Eventually, Germany and then Switzerland agreed with the UK IR.
BOXING CLEVER
Until the early 1980's, jobbers and money brokers controlled the flow of securities lending and borrowing on the floor of the LSE. Buying and selling of securities was done on a 14-day account basis.
A firm could do all its transactions throughout the two-week period and settle up on the last day. If securities had to be borrowed, the firm in question would go to a money broker to arrange for the borrow, for a fee, and versus collateral. The cycle would begin all over again after the settlement date had passed and the net position was closed via the settlement process.
The US broker dealers brought with them many structural changes that allowed the market to expand. Securities lending functioned in the US through the use of massive box positions maintained by the broker dealers. Each had its own proprietary trading desk that bought and positions for same-day execution turn-around, thus increasing the number and value of the positions held in house (the box). These positions provided a pool of resources to lend to other broker dealers. As these techniques were introduced into the international market, the business became more competitive, and more profitable.
Early in the decade, Viv Thomas of the UK lR issued the famous Extra Statutory Concession B-15. This moved the treatment of securities lending outside the UK money broker system, breaking the stranglehold in that the six UK money brokers had over the borrowing and lending of securities in the UK market. New players, like the US broker dealers, could now borrow securities without going to the fee-collecting middleman, the money broker.
Japan , Hong Kong , and Singapore soon joined Western Europe and the UK in the securities lending business. The book could now be open for 24 hours, from time zone to time zone. Suddenly, the whole financial world wanted access to every type of security on offer to support new types of transactions, and bigger profits came to those companies who made the supply available. The business of securities lending had left the back office where it managed fails and covered deliveries; it was now a money-making, profit
centre business.
LOOKING FOR LENDERS
That triggered the feverish hunt for new lenders. Broker dealers had large supplies of securities, and soon found more. But on occasion they needed that elusive second tier Japanese issue or OTC stock that wasn't in their inventory. So the marketing teams were sent far and wide to sign up the elusive holders of small cap stocks, which could be used by the in-house desks for settlement purposes or other strategies. Travel became a constant feature of the business - I spent 60% of my time on the road for a couple of years, and saw several of my competitors coming out of offices in Singapore, Sydney and Tokyo as I went in - but the increased cost of finding these holders was far exceeded by the increased revenues.
This globalisation of the business prompted the introduction of the standard OSLA agreement in 1986 by the International Securities Lenders' Association (ISLA). The document in its present GMSLA format is still in use today. This period also saw the development of the securities lending conference. The perceived need to network with other marketing people and to educate and cultivate potential lenders was considerable. If you played your cards right you could attend a conference a month, and you might even speak at a conference or two.
Sponsorship of the huge conference bashes reflected the success of the major player and at smaller dinners clients were persuaded to make available to lenders even larger pools of otherwise non-productive securities. Such occasions were touted as learning opportunities about the dynamic industry we all find ourselves working in. One US bank lender was rumoured to employ a managing director to do nothing but go to conferences.
CURRENCY KINGS AND SAMURAI BONDS At the start of the decade, the US broker dealers brought to London their own unique way of doing business. Collateral was the shape of Letters of Credit because no-one wanted to have to handle foreign securities. Cash was always accepted, however in the shape of US dollars. Whilst US dollars cash is still King of the collaterals, today's firms now accept not only euros, sterling, or Swiss francs, but also Swedish, Danish and Norwegian kronor. Japanese yen is still used in the Far East as it was 20 years ago, albeit mostly in the form of Samurai bonds or Nikkei 225 equities. In addition to currency, non-cash collateral gradually became accepted by a few of the more adventurous players.
Over the last 20 years the case for fee income has changed drastically. Back in the 1980s it was typical for a lender to charge 250 to 400 basis points to borrow a Japanese equity. Currently, some firms may use their Japanese securities as loss-leaders to attract borrowers to Korean and/or Taiwan issues. To get the hot stocks you have to take the general collateral (GC) issues as well.
The early part of the decade saw the start of Japanese convertible bond and convertible warrant trading mainly through the Zurich stock exchange, which created a need to borrow Japanese securities outside Japan for arbitrage strategies. The borrowing of Japanese securities grew at a fantastic rate from Nikkei 225 securities to Japanese second tier issues, some of which became the hot stocks of their day. When the Nikkei 225 average reached its peak of 37,000, its securities were in great demand. But the bubble was about to burst and hedge funds were so sure that it was going to happen that they swamped their prime brokers to get whatever issues were available at whatever price. The boom had moved from Europe to the Far East .
By the time of the Big Bang in London (1986/1987), money was to be made just by having supply to offer to anyone who came to you for a borrow. Fees were extremely low since it was a borrower's market, acceptable collateral was anything that could be priced on a recognised exchange and deliveries had to be made without fail or the borrowing broker would go elsewhere with his business. In any case, everybody made money. It is difficult not to think of these as the good old days, having lived through them, and after.
I still miss the three-hour lunches and the steak and kidney pudding at the
Old Dr Butler's Head.
The Big Bang simply meant the deregulation of the securities market in the UK . Securities could be bought and sold for commissions that were lower than they had ever been. The liquidity of the market was facilitated by the open acceptance of securities lending and borrowing, while the monopolistic practices of the money broker community were soon to be eliminated.
The growing success of the securities lending business was recognised (belatedly) in 1989, when the Group of 30 announced that ...the practice of securities lending and borrowing should be encouraged. The Group of 3O felt that securities lending facilitated an orderly market and this was good for overall market liquidity. But the coming of age of international securities lending was marked not in Europe or the Far East , but at the 1988 US Securities Lending Conference held in Boca Raton , Florida . For the first time, this US domestic event devoted a large portion of its programme to international issues. Non-US tax laws and new regulations for the governance of international deals
were discussed.
EXPAT EXPERTS
Even in the late 1980s, securities lending staff would come from the US to work in London as UK affiliates of US broker dealers found to their dismay that knowledge of international securities lending was not present in the UK . This produced the first wave of US stock loan experts arriving in London to run the business, both front and back office. Increased staff numbers required more office space to house the new employees as the business expanded. Additionally, cost-of-living allowances were demanded and often received by the US staff for foreign homes equivalent to what they had left behind (and were renting out) in New York, Chicago or San Francisco.
In order to convince US staff that an overseas assignment was a good idea, US broker dealers came up with the expat package. This involved a relocation allowance, a mortgage allowance (or rent subsidies), and perhaps a lump sum settling in payment. Compared to expat packages in the 1990's, these early deals were fairly modest, and yet earlier expats tended to stay abroad longer than their 90's counterparts.
But all good things come to an end. In 1988/89 the London stock market crashed. Jobs were lost, new fortunes evaporated, traders turned in their Porsches and the term negative equity popped up in discussions of the housing market. What more could happen?
Enter Robert Maxwell, whose baneful ghost haunts the business still. The invasion of Kuwait in August of 1990, the Maxwell affair in 1991- it was all just around the corner. The 1980s had seen the introduction of a new product to the international market - the 1990 would mark a fresh stage of development- product differentiation. But there was another important difference, too - the 1980s were more fun.
The Watchman In the mid-1980, broker dealers made money on every transaction in one way or another. At bonus time - usually December traders were called in to discuss their year end bonus number. Once this number was known, the trader returned to his trader position to weep, brag, complain, or fake it. But at one city trading room, everybody returned to their positions to await the arrival of the Watchman.
This very smartly dressed gentleman went to each trading position and opened his notebook. Each page showed a watch Rolex, Omega, Cartier, etc with the price on the reverse of the page. The trader the looked over the watches on offer and selected a' Christmas Gift' to be delivered as soon as the bonus cheque was paid. Of course the cost of the gift reflected the size of the bonus; and everybody could tell the result of the earlier conferences from the purchase.
The equity money broker a very rare beast. In the early 80s, securities (and cash) could only be borrowed from money brokers on the London Stock Exchange. The LSE and the Bank of England allowed only six firms to lend securities and money in the trading community. These were:
But the arrival of the US dealers, and their more open style of trading, something had to give. A group of these broker dealers approached the Inland Revenue as well as the LSE and the Bank of England to talk about it. After many weeks of deliberations and phone calls, the LSE, BoE and IR decided to create a new classification of dealer, the equity only money broker. This was to be a broker entitled to lend equities, but not money, and thus to offer no competition to the most remunerative business of the existing firms, that of lending cash. However since the paper work required to become an equity only money broker was so onerous, only two US houses Lehman Brothers Money Brokers and Prudential Bache Capital Funding (Money Brokers) took up the offer. When Extra Statutory Concession B-15 was enacted, the equity only money broker went the way of the woolly mammoth.
