A securities lending transaction is transparent when all important aspects of a securities lending trade are fully known to all parties to the deal. In general, transparency is desirable because it minimizes risk, facilitates control and maximizes profit. Fund Managers seek transparency; Boards of Directors demand it; and legislators try to insure that it is an integral part of doing business. SEC Chairman Mary Schapiro recently held a round table on securities landing and related matters in order to “…shine a light on the opaque market…and consider ways to enhance investor-oriented oversight” (WSJ, Sept 29, 2009).
Transparencies, actually. There are several kinds of transparency, each with several aspects, in a securities lending operation. Price transparency is perhaps the most compelling issue right now, after the problems of 2007, 2008 and 2009, closely followed by market transparency. And following those, way behind, is the transparency that reveals whether or not a stock was voted when it was out on loan, once the key issue of the corporate governance movement. Right now, players of all sizes are concerned with what their shares are really worth on the market, and whether or not, once lent, they’ll ever see the shares again, what happens to the collateral in case of default, and so on. The issue of voting for board members, for example, will have to await a post mortem that considers who – if anyone – is responsible for recent market debacles.
Unfortunately, transparency is not always in the perceived economic interest of everybody involved in lending and borrowing securities, and until that perception changes, achieving transparency may be an uphill fight. To beneficial owners, to fund managers of pools of securities, and to people who are considering entering (or re-entering) the securities lending market, the particulars of that fight should be of special interest. If transparency is such a good idea, surely it should be available to all players. Smaller beneficial owners who do not have their own in-house desks, who operate through custodians, third party lenders or ePlatforms should be particularly wary.
Lenders clearly benefit from complete transparency: in order to get the best price for lending equities, the lender needs to know the going price in the marketplace for the shares that he may wish to lend. Also, the lender needs to know exactly what fees will be incurred on a particular route to market, who will be the counterparty to the trade, the mechanics of the trade – what a recall would cost, for example – in order to choose effectively among a widening variety of lending options. The greater the lender’s knowledge, the greater (and safer) the profit potential.
Borrowers too, for instance those borrowing to cover their own in-house deliveries, have an interest in securities lending transparency: they want to know the going price for borrowing shares, so they don’t pay over the odds, and the amount of shares available on the market, which helps evaluate pricing, for example.
However, the general enthusiasm for transparency wanes when a borrower is covering short sales, or (as Prime Broker) onlending to hedge fund clients who are selling short. At that point, discretion – not to say opacity – becomes useful. Hedge funds fear that competitors will infer trading strategies from borrowing patterns. So a hedge fund resists signalling to its competitors any intention to short a stock for fear of attracting others to put on the same short positions. The more stock you can borrow to cover your own delivery, the more stock you can short. And the more stock Trader A borrows to cover shorts, the less available for Trader B to apply to the same purpose. Also, when the market turns, the first investor to short a stock can best afford to be the first investor out.
In addition to covering short positions, securities may be borrowed to facilitate other trading strategies such as implementing convertible arbitrage positions. Every convertible bond has a number of common shares that it will convert into at any given time; this is called the convertible ratio. Convertible arbitrage looks at the number of convertible bonds of an issue versus the amount of common shares of that particular issue available to be borrowed to cover the ratio. In other words, if one bond converts into 100 shares of its underlying stock, and there are 1 million common shares available in the marketplace to be borrowed, the hedge fund could buy 10,000 bonds and sell 1 million shares of stock. The final position on settlement date is: long 10,000 bonds, short 1 million shares. The hedge fund borrows 1 million shares to deliver against the short position and receives the sale proceeds of the 1 million share stock sale to offset the bond purchase price.
Daylight can seriously cramp either of these two strategies, because both strategies offer the greatest profit to the person who can quietly borrow the greatest number of shares first. No sharing. Competition is not welcome. As one broker put it, “I’m as transparent as I can be without revealing my overall trading positions.”
In this connection, the recent announcement by the London Stock Exchange that “hidden orders” will be allowed in the stock market may be of concern to the securities lending market. Systems could be adapted from selling equities to lending and borrowing them; the technology is already up and running in the equity market. In the projected LSE version, hidden orders will allow the seller of equities to place on an exchange all the shares he wants to sell, and a buyer to purchase as many shares as he wishes to buy. However, using hidden orders, the equities exchange shows not the entire amount for sale, but only smaller amounts. When those smaller amounts are taken, a similar tranche comes out of hiding, automatically replaces the block just sold, and moves through the transaction process. This obscures the total amount of shares available for sale, protecting the price for the seller, and obscuring availability to the buyer. Doubtless the technology already in place for equities could be adopted for securities lending purposes, making it more difficult for borrowers and lenders to asses the amount of shares available for borrowing. Deutsche Börse has permitted this practice in equity trading since September, 2009 according to the Financial Times of 9 Nov, 2009.
So, how can a smaller lender find transparency in the larger securities lending market? One way is to join forces with a larger entity, using a route to market such as a custodian, a third party lender or an ePlatform lender. Each of these services lends out shares for its clients, sometimes (as in the case of custodians) as part of a large pool of securities, and each party takes a cut of the profits of trading (custodians on average take 15% and give the borrower 85%, calculated after expenses are deducted). The ePlatforms usually charge monthly and/or yearly membership fees plus a fee per transaction. In the past, the formulae according to which these expenses are calculated have been the subject of legends, so the beneficial owner should compare costs v. profits of the lending program not just initially, but regularly. Reports are frequent but variable – not to say confusing – in specific content. One fund manager reported developing a sort of catechism for all present and potential service providers to insure that apples were available to be compared to apples, and likewise, oranges.
Subscribing to a data service that shows what prices were paid to lend/borrow stock at any given point can be expensive, although additional useful analytical tools are included in the packages most data services offer.
For portfolios of a specific character, above a certain value, building an in house securities lending desk from which traders with market experience can operate a lending program may be a reasonable option, and possibly more cost effective.
Larger custodians belong to larger, more exclusive exchanges that, through pooled resources, supply and support the complex trading strategies mentioned above. For the smaller lender, working through a custodian or third party lender offers several advantages, among them a track record in securities lending, a robust capacity for risk management; and a global market reach, for which the lender may pay considerable fees. In this context, the smaller lender can feel a rather insignificant part of a much larger operation. At the other end of the scale, a bilateral negotiation (picking up the telephone and phoning potential borrowers) can be an occasion for frightening opacity. Less experienced traders who may have only a general idea of current prices or of which issues may have gone special can hardly deal at arm’s length.
The most transparent transaction is available through those electronic exchanges (SecFinex and Equilend, for example) on which a lender places specific amounts of stock to be loaned at stated prices, and borrowers can see (as can other lenders) the transaction in an open market environment. Only after the transaction is completed, is the name of the (pre-qualified, by the exchange) bidder revealed. The ePlatforms have the great virtue of listing all prices for specific shares on that exchange, and participants can see issues rise in price, fall, or go special. Depending on the supply of lendable shares and the volume of trades on that exchange, however, this information might be somewhat localized.
It will be interesting to see what measures the SEC proposes to make securities lending more transparent for all participants. The – admittedly underused – smaller electronic exchanges already provide a route to market that level the playing field for smaller players. While more powerful players send larger volumes through large trading venues, sometimes open to selected members only, the smaller players also can lend shares on an electronic platform, negotiating with full knowledge of current market prices on that exchange, achieving transparency.
