An Introduction to Securities LendingEre CCC ‘an Introduction to Secures Lending’ was commissioned by the Secuties Lending and Repo Commie, the Intemational Secures Lending Association, the London Stock Exchange, the London Investment Banking ‘esocatlon, the Britsh Bankers Assocation and the Associaton of Corporate Treasures and was fst pub lshed in 2004, The author is Mark C. Faulkner, Managing Directo of Spitalfields Advisors Limited It isthe intention ofthe commissioning parties andthe author thatthe publication be ely avaliable and as Widely cstrbuted as possible. With ths objective in mind the copyright holder (Mark. Faulk!) gives his permission for all or pats of the publication to be reproduce, stored in a retrieval sytem, tansmited In lary form oF by any means (electronic, mechanical, photocopying, recording oF othenvise) without hs por permission. The grating ofthis permission is only forthe Enlish language and s conditional upon the insertion of the folowing accrediation. Source: An Introduction to Secutles Lending’ © Mark C Faulkne, The copyright holder reserves the ight to pursue any organisation not accreting as above, No one requiring a translation ofall or pats ofthe publication can do so without the prior permission of the copyright holder. pects ‘The views expressed in ths Booklet are those ofthe author. Every care has been taken to ensure thatthe Contents of the booklet are accurate. However, either the author, nor the commissioning bodies nor the pub lshers can acept any responsibilty for any erfors or omissions. The publishes or author can accept no responsiblity for loss occasioned to any person acting or rerainng from action as a result of any material in this pubtcaton. About the Author ‘Mark Faulkner fs Managing Diecor and cofounder of Spitalfields Advisors Limited. The company is fan independent specialist consultancy frm andi focus is upon the provision of consultancy sev ices to institutions active, or considering becoming act inthe secures nance markets, part Lary beneical owners. Spitalfields Advisors assists Institutions embarking an secures lending Teens of EP proses. The eompary ao fv ish PANS and SHEE poate rites for improvement. SPITALFLELDS qian algo the Chet cxecutive Ofcer of Securities Finance System Limited. The company pr: ADVISORS vides clients with insights inta comparative rsk and performance measurement using proprietary Fskexplorer and perfomanceexplorer serdces. Secures. Aranee Systems aso condutts 2 wide range of quantitative research projets and benchmarking exercises on behalf of custome. ‘ker sraduating fom the London Sehool of Economics, Mak Faulkner spent the majority of his carer spe Galsing in Intemational Secures Finance. Since 1987, he has held management responsiiliy at UM, (Wtoneyorokers) Utd, Goldman Sachs, Lhman Brothers and more recently at Securities Fnance Intemational mite Wis occupying these diferent posts he has gained experience as a lender, borrower, conduit borower and prime broker During his career he has worked closely wit the U Ilana Revenue and has represented fms Bt the Secrties Lending and Repo Committee and the London Stock Exchange's secures lending commit tees. Being an independent advisor since 3995 has provided Nark with a unique insight nko the operation of the secures nancing market. ‘Mat lives with lade and their son Archie in Spitalfields, London. Ta dowmload 2 fee copy ofthis book or contact Mark about t plese vst: winuspiafldsacvisors.comer Ty Foreword .. Acknowledgements . . Executive Summary... Chapter 1 What is securities lending? . . Chapter 2 Lenders and intermediaries ........esesseeseeereseeeee Chapter 3 The borrowing motivation .. . Chapter 5 Risks, regulation and market oversight Chapter 6 Frequently asked questions .. 6.0.1... 0s eeeeeeeeee eee Appendix 1 A short history of securities lending Appendix 2 Terms of Reference of the SLRC . . Appendix 3 Glossary .. e e ° ® ® ® Chapter 4 Market mechanics .. 0... 200s eee ee eee erence renee QD ® ® ®@ ®@ ® ® Reference sources ..a) Secures lending provides taut tothe equity bond and money markets placing it atthe heart of today's financial system. The increase in iqudty reduces the cost of trading, thereby increasing market eiciency and benefiting al Securities lending markets alow market partipans to sell secures that they do nat own in the confidence that they can be Borowed prior to settlement. They are also used fr nancing, though the lending of securties against cash, forming an important part ofthe money markets. The abllty to lend and borrow secures freely underpin the services that securities dealers offer their customers and the acing strategies of dealers, hedge funds and other asset managers. On the lending side, secules lending forms & rowing part of the reverue of institutional investors, custodan banks and the prime brokerage arms of Investment banks This publication aims to describe hese markets, with an emphasis towards the United Kingdom, although UK markets are highly interatonal in tems of both participation and secures traded. The intended audtence IS not market practioners but others with some interest in secures lending, Including tustes of pension (other funds that already lend their Securties or might consider doing so, managers of companies whose Secrtes are lent, franca journalists the authorities and other interested partes, ‘The idea ofa publication arose a year ago in cscussions inthe Secures Lending and Repo Commit, which brings together market practitioners, the UK authors and infiastructure providers, withthe Bank of England haitng and providing acmiistrtive suppor. Ata time of fling share prices, some commentators Were drawing tnks with secures lending and short seling, often reveaing some misunderstanding of how the markets actually worked, This is hardly surprising. Secures lending markets ae complex, with multiple lay 5 of intermedtaries, transaction terms and pricing that can be opaque te those not rectly Involve Ia. Confusing terminology and market jargon does not help (one reason forthe glossay). Thee seemed ta be no authorative publication, written by market practitioners, which described and explained the modern mar kets for a non-expert. The sponsoring organisation, representing the diferent players inthe market, worked together to fil this gop. They set out fo produce an accurate and accessible description of the mates and how they wor, who f involved and why The Securities Lending and Repo Commitee welcome this publication. The National Associaton of Pension Funds and the Assocation of Bish Insurers, as wel as te sponsoring organisations nave also welcomed I, | would keto thank al those involved in is production. David te Chairman, Secures Lending and Repo CommiteePec Cy his researching and writing this book the author received asitance from te following ingiiduals: ‘Authorship Commitee: David Rule, Bonk of Enalané Simon til, Bish Bankers Association Dagmar Benton, London Stock Exchange John Serocold, London investment Banking Association ‘andrew Clayton, Intemational Secures Lending Association ther contibutors: Joyce Martindale, Head of Performance and Risk, Railway Pension Investments Led Susan Adeane, Company Secetan,Rallvay Pension Investments td Habib Motan, Paes, cliford chance Niki Natron Er, vestedge Andrew Banie, Director, Bare & Hibbert Jackie avis, Publications Manages, Bish Bankes Association Bil Cuthbert, Managing Directo, Spitalfields Advisors He would like to express his gratitude for ther assistance, encouragement and suppor.Executive Summary Seeutties lending ~ the temporary transfer of secuites on a collateralsed bass ~ is a major and growing sctvty providing significant benefit for isuer, investre and trader alee, Tese ste likely to include Improved market quit, more efcient settlement, tighter dealer prices and perhaps a reduction in te cost of capa The scale of securities lending globally is dificult to estimate, a5 it s an “ver the counter rather than an exchange-traded marke However it safe to say that the balance of secutes on loan globally exceeds Eston, Censors Seeuities lending desebes the market practice by which, fo a fee, seuss ave wansfered temporarily fom ‘one party, the lender, to anothe the borrower, the borower Is obliged to return them ether on demand or at the end of any agreed term. Howeves the word ‘ending’ is in some ways misleading. In law the transaction isin fact an absolute trans: fer of title (sale) against an undertaking to retur equivalent securities. Usually the borower wil eolatralise the transaction with cash or other secuties of equal or greater vale than the lent secutitesInorde to pro teat the lender agaist counterpart credit sk, Some important consequences tse from the nature of secures lending transactions: ‘+ Absolute ttle over both ent and collateral secures passes between the paris, therefore these ‘ecules can be sold outight and ‘on len. Both practices are commonplace and aninsinsic pat ofthe functioning ofthe market. + Once secures have been acquied, the new owner of them has certain fights Fr example, it has {he tight fo seo lend them onto another buyer and, vote in AGM. ‘+The borower is ented tothe economic benefits of awning the lent secuities (eg. dvidends) but the agreement with the lender wil oblige it to make Cmanufacture) equivalent payments back to the lender ‘+ Alener af equities no longer owns them and has no entitlement to vot. Buti is stil exposed to fice mavements on them since the borawer can return them ate pre-agreed pie. Lenders fyplaly reserve the right to recall equivalent secures from the borrower an wl exercise this ‘option If they wish to vote. Howeve, borrowing secures forthe specie purpose of infuencing 2 Shareholder vote isnot regarded as acceptable market practice. of securities lending transactions ‘Most securities loans ae cllateralse, either with other secures or with cash deposi. Where lenders take secrtes 35 collateral they are paid a fe by the borrower, By contrast, where they ate given cash as colt feral they pay the borrower interest but ata rate (the rebate rae) that lower than market rats, so that they can invest the cash and make a return. Pricing Is negatiated between the pares and would typically take inte account factors such ae supply and demand forthe particular secure, ellatra Reni, the sie of any manufactured dividend and the ikethond of the lender recalling the secures eat, For example, fees for borowing UK FTSE t00 eautes against secures colateral ranged from 6-200 basis points pet annum and fees for borrowing conventional UX government bonds fom 6:0 basis points per armum towards the fend of 2003. As well as securities lending, sale and repurchase (repo) and buysll back transactions are used forthe tom: Dorey transfer of secuties against cast In general, secures lending is more likely to be mativated bythe Gesire to borow specie securities and repo, and buysell backs by the desire to borrow cash ~ but this boundary is fuzzy. For example, reinvestment of cash collateral has been an integral part of the securities lend ing business for many years, partcuanly in the United States, with reinvestment opportunites often driving the underlying secures lending transactions. ee ‘The supply of secuties ito the lending market comes mainly from the portfolios of benefial owner, such 235 pension and other funds, and insurance companles. Undeing demand to borrow Secures begins large Iy with he trading actvties of dealers and hedge funds In the midele are a number of intermediaries. The importance of intermediaries in the market partly reflects the fat that secures lending isa secondary activity for many ofthe beneficial owners and underyng bor rowers. Intermediaries provide vluable services, such as credit enhancement and the provision of iui, by being wiling to borow secures at call while lending them fr tem. They also benef from economies of scale, Including the significant Investment in technology required to un a modem operation,Incermediales Include custodian banks and asset manager lending secutties as agents on behalf of benef Gal overs, alongsice the other services provided to these clint. Some specials secures lending agents have also emerge. Agents agree to spit securities lending revenues with lenders and may ofeinderniies against certain risks, such as borrower default ‘Another category of intermediary is dealers trading as principals. Dealers intermediate between lenders and borrowers, but they also use the market to nance thelr own wider Secures trading actives. They may Seek retums by taking colteral, counterpart credit or quit sk, for example, by lending securities to 2 client for a petiod while borrowing them on an open basis witha risk of early recall By the lende. Through their prime brokerage operations, they also meet the needs of hedge funds and the boring of secures to France their postions as grown raph For benefclal owners, thete are a numberof diferent possible routes into the market. These include using an agent (custodian bank, asset manager or spedais) to manage a lencng programme, auctioning 2 port folie to borowers direct, selecting one principal Borowe, establishing an “iv house’ operation and lending iret, oF some combination of these strategies ‘The most common reson to borraw secutes to cover a shot psition- using the borrowed secures to Settle an outright sale. Bu this is rarely a simple speculative bet thatthe value of a secuty wil al so that the borrower an buy it more cheaply atthe matutty ofthe loan. Mote commonly, the short poston is part ofa lager trading strategy, typically designed to profit from perceived pricing discrepancies between related Secures, For example: + Converibie bond arbitrage: buying a converble bond and simuitaneously seling the undetying euity shor. ‘+ "airs trading: Seeking to identity two companies, with similar characteristics, whose equity Securities are curenty trading ata price reatonship that is out of line with the historical trading range. The apparenty undervalued secunty fs Bought, whlle the apparently overvalued Secuty Is fl shor ‘+ Nerger arbitrage: for example, seling short the equtles of 2 company making a takeover bid against 8 long poston in those ofthe potential acquisition company. 4+ Inder storage: caling shor the constituent secures of an equity price index (.,FTSE too) against a long position in the index future (eg FISE 100 contract on LFF Shor postions also arise as 2 result of fled settlement (wth some secures setlement systems arranging for automat lending of secuties to prevent chains of fled trades) and where dealers need to borrow secu rites inorder to fl customer buy orders in securities where they quote two-way prices. Not all secures lending is motivated by shor seling, Financing dives many transactions ~ the Lender is Seeking to borow cash against the lent Secures, whether using repo, bulsell backs or cash-colateralsed secures lending. “Another large cass of transactions not involving 2 short comprises those motivated by lending in order to transfer ovnership temporary, an arrangement which can work athe advantage of both lender ans boone For example + Where a lender would be subject to witinlding tax on dividends or interest but some potential borrowers are not. The borower receives the dividend free of tx, and shares some ofthe benefit withthe lender in the frm of a larger fee or lager manufactured dividend ‘+ Where an issuer offers shareholders the choles ef receiving a dividend in cash or einvestng i in ‘ditional secattes (rp) ata discount tothe market price, But some funds (eg index trackers) fae unable to take the more attractive scrip alteratve because thle holdings would become larger than permitted under investment guidelines. The borower chooses the scrip dividend alternative and sells the secures in the markt. Again, the return is shared withthe lender through a larger fee ot larger manufactured dividen. Doreen ‘The secures lending market is @ hybrid between a relationship-based market and an open traded market Historically transactions were negotiated by telephone but increasingly secures ae broadcast as avalable st particular rates using email or ther electronic platforms. Loans may be either fora specified term, ot more commonly, open to recall, because lenders typically wish to preserve the Rexilty for fund managers to be able to sell at any tne. Setement occurs on a shorter time frame than outight transactions, so that secutes can be borrowed to over 2 sale.In mas settlement systems secutties loans ar settled as “ee of payment” deliveries and the collateral taken 'S sated quite separately, possibly ina ciferent payment of settlement system, and maybe a different cour tty and time zone. This can give rise to ‘daylight exposure’, a period in which the lent securities have been delvered but the collateral secures have not yet been received, To avo this exposure some lenders sist (on precoliteralisation, so transfering the exposure to the Borowet. In the United Kingdom, CREST has specie settlement arrangements fr stock lending transactions ray London Stock Exchange rules requite lending arangements insecurities on which UK Stamp Dury/Stamp Duty Reserve Tax SORT) is chargeable to be reported tothe Exchange, This enables fms fo bring thelr Borrowing and lending activity ‘on Exchange’ making them exempt from Stamp OutySORT under inland Revenue regula tions. Non Exchange member fms that conduct borowing and lending actvty through a member fm ae also eligible for stock lending rele trom Stamp DutySORT. ‘Companies Act 1985, Firms that are engaged in equity stock borowing or lening inthe Unite Kingdom il ned to comply, where appropriate, withthe notification requirements applying to notable interest in shares as set out in Part VL ofthe Companies Act 3985, perenne ar CREST provides some time-delayed information on the values of secures financing transactions in the top 350 UK equities. Ths Information was fst published In September 2003 and excludes Intermediary actvty where possible, Cee ‘When taking cash as collaterol. A lender taking cash as collateral pays rebate interest to the securities bor rower, so the cash must be rlnvested a a higher rate inorder to make any net tum onthe collateral aspect Of the transaction. Expected retums can be increased by rinvesting in asets with more ced rik or longer ‘maturity in elation tothe tkely term ofthe loan, with a risk of loss if market interest ates ise. Many of the lange secures lending losses over the years have been associated with relavestment of cash collateral Transaction colloterlised with other securities. Added to the risk of enor, systems failures and fraud that are lays present in any market, problems can arise fom the default of @ boroner Following a default the lender must sells collateral in the martet in ore to raise the funds to replace the lent secures. wil lose money if the value ofthe collateral secures falls relative to that of the lent secutes, Generali, the sk of loss Is greater ii takes longer to close out these positions, ifthe callteralo¢ lent secures ae ‘wrongly value, ifthe markets fr these secures are liquid or ithe market prices ofthe lent and callater a secures do not tend to move together Cas ‘ny person conducting stock borrowing oF lending business in the United Kingdom would generally be cary ing on a regulated activity according to 8he terms ofthe Financial Serces and Markets Act 2000 Regulates ‘eiites) Order 200%, and would therefore have to be authorised and supervised under tht At. The stock borrower or lender would, 35 an authorised person, be subject to the provisions of the Fnancll Services Authority (FSA) Handbook, in arieular the Inter Professional Conduct chapter, and they would aleo have to have regard to the market abuse provisions of the Financat Services and Markets Act 2000 and the relates Code of Market Conduct isued by the FSA The FSA Handbook contains rules, guidance, nd evidential pro visions relevant tothe conduct ofthe frm in elation to the FSA's High Level Standard, Stock Borrowing and Lending Code In adition to the prudential standards set by the FSA, market participants have drawn up a Stock Borowing and Lending Code, which Ut-based market participants observe as a matter of good pratce. The Code does notin any way replace the FA's of other authoes regulatory requirements, nor ist itended to overide the intemal rules of setement systems as regards borowing o lending Wancactions.Bee ere ke ‘The Secutties Lending and Repo Commitee (SLRQ produce the Code. The SLRC provides a forum in which structural developments nthe stock ending and rep markets can be discussed, and recommendations made, by practitioners, inastucture providers and authorities ts terme of reference ae shown In Appendhs 2, Many questions ae asked about the securities lending industy and Chapter 6 Frequently asked questions) responds to many of tese. They have been grouped into legal, vidends and coupons, claterl and risk management, operational and logistical, corporate govemance and lending options for beneficial owners. Finally, every market has its own jargon, and secuties lending i no exception. Appendix 3 is a glossary of terms, Secures lening is too signifiant to fgnre. touches the interests of secures investors, companies that issue secuies, market intermediavies and the authors. Wis aso 0 cental tothe eflent runing ofthe rmodem financial markets to be misunderstood, This book ls Intended to provide an authorative introduc tion fo the modern industy,Chapter 1 What is securities lend Secures lending began as an informal practice among brokers who had insufficient shave cetcates to set te their sold bargains, commonly because their seling cents had mislaither certificates or jst not pro vided them to the broker by the setiement date ofthe transaction. Once the broker had received the cet Cates, they would be passed on o the lending broke. This business arrangement nas subject to no format fsgteement and there nas no exchange of cole Seeuites lending is now an important and significant business that describes the mkt practice whereby Secuites are temporary transfered by one party (he lender) to another (the borower). The bortower is obliged to return the secures tothe ender, either on demand, or atthe end of any agred term. For the evod ofthe loan the lenders secured by acceptable asses delivered by the borrower tothe ender as cot lateral, Under English law, absolute tte to the secures “lent passes to the ‘borrower, who Is obliged to return “equivalent securtis. Silay the lender receives absolut tte tothe assets received as olateral fom the botrower, and i obiged to return “equivalent colateat Securities lending today plays a major part Inthe efficient functioning ofthe secures markets worldwide, ‘ett remains poorly understood by many of those outside the market. In some ways, the trm ‘securities lending’ i misleading and factually Incoret. Under English law and in ‘many othe uisictions, the transaction commonly referred to as ‘securtis lending” infact ‘a disposal (or sale) of secures linked tothe subsequent reacquisiton of equivalent secures by means of an agreement Such transactions are collateralised and the ‘ental fe" charged, along with al other aspects ofthe transac tion are dealt with under the tems agreed between the parties. I's entirely possible and very commonplace that secures ave borowed and then sold or onent. There are some consequences arising fom this clarification: 1 Absolute ttle over both the secutes on loan andthe collateral received passes between the 2 The economic benefits associated wth ownership ~ eg. dividends, coupons ete. ~ are ‘manutacturee back tothe lender, meaning thatthe borower is ened to these benefits as owner ofthe secures but i under a contractual obligation to make equivalent payments to the lende 43. Alender of equlies surenders is rights of ounership, eg. voting. Should the lender wish to vote fn secuities on laa, it has the contractual right to recall equivalent secuites from the borower 14 Inthe United Kingdom appropriately documented secures lending transactions avoid two tas: ‘Stamp Duty Reserve Tax and Capital Gains Ta fa ee eet Most securities loans in today’s markets are made against collateral in order to protect the lender against the possible detaut ofthe borrower This collateral canbe cash, ater Secutis of other asets. (@ Transactions collatralised with other secutes or assets , Reporing Sepang #/ cotter Colter Loan Commences Loan TerminatesNoncash collateral would typcaly be drawn fom the following colateral types: + "Government Bonds issued by 67, Gio oF Hon-G7 governments + Corporate Bonds Various credit ratings + Convertible Bands Hatched or unmatched tothe secutes belng lent + Equtes OF specified indices + Letters of Gest «From banks of a specified credit quality + Certicates of Deposit. ‘Drawn on institutions ofa specified ced qualty + Deivery By Value (O8VS) = Concentrated of Unconcentated * ofa contain aset cass + Warrants * Matched or unmatched to the secuttes being ent ‘Other money market instruments The eligible collateral will be agreed between the partes, as wl ther key factors including: + Notional Limi ‘The absolute value of any asset to be acepted as collateral + iat mario ‘The maigin requled at the outset of @ transaction + Maintenance margin * The minimum margin level to be rainained throughout the transaction + Concentration tmits ‘The maximum percentage of any issue tobe acceptable, eg. less than 5% of dll traded volume * The maximum percentage of collateral pool that can be taken against the same ister, he. the ‘umlative effect where collateral inthe form of lters of ced, CD, eau, bond and convertbte may be issued by the same firm The example in the above clagram shows colateral being held by a Th Party Agent This specialist agent (yp ically arg custocan bank or Intemational Central Secrties Deposton) wil receive only eligible cllater al from the borrower and hold it in sepregated account tothe order ofthe lendet. The TH Paty Agent wil mate this callatral to market, with information dstibuted to bath lender and bovower (in the diagram, dot ted Reporting’ ines. Typically the Borrower pays fee tothe Tel Party get. There is debate within the industry 35 to whether lenders that are exible inthe range of nan IC + (RFD) or Fic « (RFD), aritage opportunities exist. The ilerence between the cutest theoretical aetul cost and the futures pie is called the basis. ths diference that cents an aoitage opportunity. Wen FC» IC + (RF) a trader can profit by taking the follwing action + Buying a portfolio which i identical to the index value + Seling index futures When FC «IC + (RF-D) a trader can profit by taking the following action: + Going short (ling) a portfolio which is Buying index futures idemical tothe index value cis hee that secures lending plays its tle. The ably ofa borower to source a complete portfolio of all the stocks in an index. propery weighted, that will accurately trac the performance ofthe Index = 2 big advantage. Incomplete indices or unbalanced Indices open up the possibilty of tacking errors occuring ‘wnereby the performance of the short cash portfolio devates from that ofthe nex. The ability to bortow secures that have a cheaper manufetred avidend obligation isan advantage to, (ne ofthe problem aeas Is when a component (or components af the Index in high demand (trading spe- tia) and the cost of borrowing res, thereby reducing the profitability ofthe transaction. The ability to bor row fora fiaed term i also an advantage. ‘Te best sources of securities to suppor this typeof transaction are passive index tracking funds incorp- rated In counties that have high ates of withholding tax ‘nce established, the stock index arbitrage can generate profits should the price ofthe index and the under. Iving secures move up ar down, The stbittage opportunity is often shortved as postions re taken end the price adjusts. As these transactions normally Rave thin margins, they are ofen executed in lage ies. (9 Financing As broker dealers buld derivative prime brokerage and customer margin business, they hold an inceasing Inventory of secuties that requies nancing ‘This type of activity is high volume and takes place between two counterparts that have the following cin idence of wants + One has cash that they would tke to invest ona secured basis and pick up yield +The other has inventaty that needs to be frances In the case of bonds, the typical fnancing transaction isa repo or buysell back, But for equities, securities lenging and equity. repo transactions are sed, Ti Paty Agents a1 often involved inthis type of Francing transaction as they can reduce operational costs, forthe cash lender and they have the settlement capabliies the cash borrower needs to substitute secur ties collateral a their inventory changes (@ Temporary transfers of ownership Tax arbitrage Tax driven trading is an example of secures lending as a means of exchange.Markets that hae historically provided the largest opportunites for tax abivage include those with sign cant tax credits that ae not avalable to al investors ~ examples include lly, Germany and France The ferent tax postions of investors atound the world have opened Up opportunities for borowers 19 Use securities lending transactions, In ef, to exchange assets temporarily forthe mutual bene of purchase, botrawer and lender The lender’ renard comes In ane of two ways ether a higher fee for lending i they require a lower manufactured dlidend, o a higher manufactured dividend than the post-tax dvdend they would normaly receive (quoted as an ‘alln rate), For example, an offshore lender that would normally receive 78% of @ Geman dividend and incut 25% with holding tax (with no possibilty to reclaim) coud lend the securty to‘ borrower tat n tur, could sell I 8 German investor who was able to obtain a tax creat rather thn cat withhalaing tx If the offshore lender {lames the 95% ofthe dividend that would otheralse have received, it would be making 2 signlcant pick up Go af the cvidend yield, whilst the borower might make 2 spread of between 95% and whatever the German investor was bidding. The tems of these trades vary widely and rates are calcuated accordingly () Dividend reinvestment plan arbitrage Many issuers of secutles create an arbitrage opportunity when they offer shareholders the choice of taking 2 dvidend or reivestng In addtional seuntis a 2 discounted level Income or inex tracking funds that cannot deviate fam recognised securities welghtings may have to choose to take the cash option and frgo the opportunity to take the discounted reinvestment opportunity. ‘One way that they can share Inthe potential proftabllty ofthis opportunity is to lend securities to boron fers that then take te following ation: ‘+ Borrow as many guaranteed cash shares as possible, as cheaply as possible {Tender the borrowed secures to receive the new discounted shares + sell the new shares to realise the “prof between the discounted shate price and the market price ‘+ Retumn the shores and manufacture the cash dividend tothe lenderPela MULL Clm Cer Cy Tis section outines the dealed processes inthe lie of @secuties loan including: Negotiation of loan deals Confemations ‘erm of loan Term trades Palting securities “on hol Setlments, including how loans are settled and settlement concerns Termination of loans Redelvery fled trades and lgal remedies Comporate actions and voting Lc tax arrangements and reporting of transactions to the London Stock Exchange Tradtionaly secures loans have been negotiated between counterparts (whose credit departments have approved one another on the phone and followed up with witten or electronic confirmations. Normally the borrower itiats the call to the lender witha bortowing requirement. Howevet, pro-active lenders may also offer ou in-demand secures to thelr approved counterparts. This would happen particularly where one bor rower retums 2 secutty and the lender i tl lending Itt other In the market, they will contact them to See I they wish to borrow addtional secures. Today, there is an increasing amount of bilateral and multilateral automate lending whereby secures are brosdeast as available at particular rates by email or other electronic means. Where lending fers are agree able, automatic matching can take place ‘An example of an election platform for negotiating equlty secures loan transactions fs EqulLend, which began operations In 2002 and is backed by a consortium of financial institutions. EquLend’s stated objecive isto: "Provide the secures lending industry with the technology to steanine and automate transactions between borrowing and lending institutions and. introduce a set of common protocols. Equitend will cn neet Borowers and lenders through 2 common, standarésased global equty lending platform enabling ther to transact wth increased eficeney and speed, and reduced cost and isk Equitend i not alone inthis mar ket; for example, Secfinex offers sina services in Europe. \Writen or electron confirmations ae issued, whenever possible, on the day of the trade so that any queries bythe other party can be raised as quicly as possible. Material changes during the life ofthe transaction are agreed between the partes as they occur and may also be confi if either party wishes it. Examples of material changes are collateral agjstments or callateral substitutions. The parties agree who wl Ske responsiblity for isuing loan confimations. Confirmations would normally incude the fllowng information: + Contract and settlement cates + pts of loaned secrties identities of lender and borromer (and any undetving principal Acceptable collateral and margin percentages Term and rates ‘Bank and Settlement account details ofthe lender and borrower aoe Teo Loans may ether be fora specifi tem or open. Open loans are trades with no fed maturity date. tis ‘more usual for securities loans to be open oat cal, especially for equtes, Because lenders typically wish to preserve the flexbiity fr fund managers tobe able to sell at anytime. Lenders are abe to sell securities fespite thei being on open loan because they can usualy be realed from the borrower within the settle ‘ment peviod of the market concemed. Nevertheless open loans can remain on loan for 8 long period ee eed ‘The general description term trade is used to describe difering arrangements inthe secuttes lending mar at. The partes have to agree whether the term ofa loan is aed fora finite period or whether the dur tion is merely ‘indicate’ and therefore the secures are callable. I fied, the lender isnot obliged to acceptthe eater retuen of the secuies: nor does the bowrower need to retun the secuttes eal i the lender requests it Accordingly, secures subject to 2 fixed loan should nat be sol while on loan ‘here the term discussed is intended to be ‘indicative’ it usually means thatthe borower has long-term need fr the secures but the lender fs unable to fx for term and retane the right fo Tecll the secant if necessary Putting secures ‘on hold (refered to Inthe market as ‘cng’ securities) i the practice whereby he lender will reserve secures atthe request af a borrower an the borower's expected need to boraw those secur tis at a future date, This occurs where the Borrower must Be sue thatthe secures wil be available before Committing toa trade that wil require them. ‘white some details can be agreed between the partis, it normal for any price quoted to be purely inaca tive, and for secures to be held tothe following business day. The borrower can rol over the arangement (ie continue to ce the secures) by contacting the holder before gam, otherwise it terminates. key aspects of icing are thatthe lender does not receive a fee for reserving the secures and they are gen erally open to challenge by another borrower making fm bid. In this case the fst borrower would Rave 59 minutes to decide whether to take the secrtes at tha ne of to release them. ‘Pay-to-hold’ arrangements ‘A vatiaton on icing is paytoshole" where the lender does receive a fee for puting the secures on hold As Such, they constitute a contractual agreement and are rot open to challenge by other borowers. Secures lenders need to settle vansactons on a shorter timeframe than the customary settlement period for that market. Settlement wll normally be through the lender's custodian bank and ths is kel to apply respective of whether the lander s conducting the operation or delegating to an agent. The lender wil usu- ally have agreed a schedule of guaranteed settlement times forts secures lending activity With its custo- tans, Prompt setiement information fs crucial to the efficent monitoring and conto of lending programme, ‘with reports needed fr ath loans and collateral In most settlement systems secures loans are sated as ‘e-ot payment deliveries and the eallteral is taken quite separately, possibly in a diferent payment or settlement system and maybe diferent country and time zone. For etample, UK equities might be lent against colateral provided in a European Intemational Central Securities Depository or US dollar cash collateral paid in New York. Tis can give ise to what i known in the market a5 "davaht exposure’ pviod during whieh the loan isnot covered asthe lent securities have been delivered but the colateal secures have not yet been received. To void this exposure some lenders Insist on pre-collatralsation, so transfering the exposure to the bower. The CREST system for setting UK and trish secures isan exception to the normal practice as colateal is avaliable within the system. This enables loans tobe settled against cash inta-day an forthe cash to be ‘exchanged, If desired, atthe end of the setlement day fr a package of DBV securities overnight. The process an be reversed and repeated the next day. Cm CREST also has sped settiement arangements fo stock loans, requiring the independent input of rstue tions by both paris, who must complete a number of matching fs, including the amount and currency of any cash collateral, together withthe percentage value of applicable loan main. Loans may be effected ‘against sting, euto oF dolar consieration of made fte-of payment, Immediately after the settement ofthe loan, CREST automatically cates a presmatched stock loan retum transaction with an intended settlement date ofthe next business dy. The retum Is prevented from setting Lunt the bortowe ltevenes to aise the settlement priotiy of the transaction. The stock lender may freeze the transaction in order to prevent the stock fom retuing. CREST provides full evaluation faclitis forall secures out on loan. On the original creation ofthe retum and everynight that the lean is open thereafter, itis marked to market against the prevailing CREST ofer Price, Any deficit or surplus of cash callateral of stock loan ret arising fom price Mutuations is corect 4 by CREST which automaticaly generates payment Instructions between the partis and simultaneously alters the value ofthe retum consideration. Users may opt out ofthe revaluation process by completing the relevant fed of the loan transaction, or by setting loans on a fee-oF payment bass.ino ‘pen loans may be terminated by the borrower tetuming secures or bythe lender realng ther. The bor rower wil normally retun bortoned secures when it has filed is short position, & bortoner wil sometimes refinance its loan positions by boring more cheaply elsewhere and returning secures to the original lender. The borrower may, however. give the original lender the opportunity to reduce the rate being charged ‘an the loan before borrowing elsewhere. failed trades and legal remedies When deciding which markets and what size to lend in, securities lenders wil consider how certain they can be of having their secures retuned in a timely manner when calle, and what remedies are avaiable under the legal agreement (se below) inthe event of 2 failed retum, Procedures tobe followed in the event ofa falled reéelivery ae usually covered in legal agreements oF oth tnvise agreed between the partes atthe outset of the velatlonehip. Financial redress may be avalale tothe lender if the bortoner fils to redever loaned secures or collateral onthe intended settlement date. Costs that would typically be covered incude: 4 Direct interest and/or overdat incurred Costs reasonably and properly Incured as a esut ofthe borrowers failure to me its sale or elvery obligations ‘+ Tota costs and expenses reasonably incured bythe lender as a result ofa “buy (Le. where the ete foc pars seats he oan met owing he Bono ar ot them) Costs that would usualy be excluded are those aisng from the transferees negligence or wilful default and any nec or consequential losses. An example ofthat would be when the non-etun of loaned securities Causes an onward trade fora larger amount to fl The nom is for only that proportion of te total costs which relates tothe unretured secures or collateral to be claimed, i go0d practice, where possible, ¢0 Consider ‘shaping’ or ‘paraling’ larger transactions (ie. breaking them down into a number of smaller amounts or settlement purposes) sas to avoid the possiblity of the whole transaction fling f the trans feror cannot redeliver the loaned secures or colatealon the intended settlement date, The basi premise undeying securities lending is to make the lender ‘whale for any corporat action event suchas a dviden, rights or bonus issue ~ by puting the borrower under a contractual obligation to make equivalent payments tothe lender, fr instance by ‘manufacturing’ lvdends. However a shareholders right to vote as part owner of a company cannot be manufactured, When secures are lent, legal ownership and the right to vote in shareholder meetings passes tothe bortowe, who wil often sel the securities on, Where lenders have the right to recall secures, they can use this opti to estore thee holdings and voting ight The onus is on the borrower to find the secures, by bortoning or purchasing them in the market if neces say Ths can damage market liquidity, wich Is sk that inermediaies manage. It is important that beneficial owners are aware that when shares are let the right to vot sao transfered, The SURC' code of guidance (ee Chapters) sates in section 2.4 that lenders should make it eat to clients that voting vights ate transfered, A balance needs to be struck between the importance of voting and the benefits derived from lending the secures. Beneficial owners need to ensure tha any agents they have made responsible for thelr ving and stock lending act n a co-ordinated way. Borrowing securities in order to build up a holding in 2 company withthe deliberate pupose of inflwencing 8 shareholder vote isnot necessarily ileal in the United Kingdom. Howeve, institutional lenders have reent Iy become more aware ofthe possibilty, and tend not to see it 2 a legitimate use of securities borowing. ‘A numberof market bodls, In the United Kingdom and internationally, have been addressing the relationship between secuties lending and voting. For example, a recent report by Paul Myners to the UK Shareholder Voting Working Group made the following recommendation: ‘Stocklending is important in maintaining markt Uquidity but borowing of shares forthe purpose of voting 's ot appropiate... important that bonefidalovners ae fully aware of the implications for voting if they agree to thelr shares belng lent. In particular, when a resolution 5 contentious | star om the pasion that the lender should automatically recall the related stock, unless there are good economic reasons for not doing 50" {even o he npeiens ong Sar, alae waminesmetncIntemational a working group of the Intemational Corprate Governance Network is currently examining best practices for long-term investors In elation to seeuites lending and voting. The SLRC is also considering ad Hons tote code in this area, Ce ee London Stock Exchange rules require lending arrangements in securities on which UK Stamp Duty/Stamp Duty Reserve Tax (SDR) fs chargeable to be reported to the Exchange. This enables fms to bing thelr boron ing an¢ lending activity ‘on Exchange’ and to allow them to be exempt from Stamp Duty/SORT Firms which ie not members ofthe Exchange but which conduct Bovowing and lending tough a member fir ae also eligible for relief om stock lending Stamp Duy/SDRT. On Exchange lending arangements are evidenced by regulatory reports that ae transmitted to the Exchange by close of business on the day the lending arange- ment is agreed Prior to entering into lending arangement, member fms ae required to signa writen agreement with the ther party. The Exchange has authorsed te following agreements: + Global Master Secures Lending Agreement 1+ Master Equlty & Fined Interest Stock Lending Agreement (196) ‘+ PSNISMA Global Master Repurchase Agreement as extended by supplemental terms and conditions for equity repo forming Pat 2 of Annex 1 ofthe agreement ‘where an authorised agreement does not cover the circumstances In which a member frm wishes to enter Inco lending arrangement, the fm must ensure thatthe agreement Includes provisions equivalent to those fortained within the Exchanges rules on lending arangements in relation to rember fm deFault. gece Firms that ae engaged in equity stock borrowing or lending inthe United Kingdom il need to comply, where appropriate, with the notification requirements applying to notifiable interest in shares as set out in Part VI Df the Companies Act 1985, Firms that are uncertain about the application of Pat VI should seek legal advice, ‘Transparency in the UK market CREST provides timedelayed information onthe value of secures financing transactions inthe top 350 UK aus. This a subscription service begun in September 2003 folowing extensive discussion with make Patcipants and the Financial Sevices Authotty. The information it provides pertains to total Stamp Duty Reserve Tax-exempt transactions taking place In each securty on a glven day and excludes intermediay activ ity were possible, CREST as provided answers to many frequently asked questions on its webs, somcrest 0. ‘The launch of ts securities financing data service coincided with ts publication of settlement flue statis- tes. The London Stock Exchange monitors both and makes public announcements on stack lending actiy when fees IIs approprate (at lit s proposed that any securities lending should take place during an offer perio fora UK company, the Takeover Panel shouldbe consulted to establish whether any dscosure i required and whether there are any ier consequences '5 5 Gein Sein 9 oft Fc 96 and ch lok ete nee Sm A |Chapter 5 Risks, regulation and market oversight Tis chapter desribes the main nancial sks in secures lending, and how lenders usally manage them, Itis not a comprehensive description ofthe various operational, legal, market and credit sks to which mar ket parcpants can be exposed. Readers seeking a fuller analysis ae refered to the relevant sections of for trample, Secures Lending Transactions: Market Development ana Implctions". The cnapter then briely Summaries the UK regulatory framework for secures landing market participants and the role of the UK Stock Lending and Repo Commitee Financial risks in secures lending ae primaly managed through the use of collateral and netting. As escibed in chapter 1, collateral canbe inthe form of secures or cash, The market value of the collateral 's typically greater than that af the lent portfolio. This margin is intended to protect the lender from loss and refleetthe practical costs of collateral quiation and repurchase ofthe lent porto inthe event of default ‘Any profits made in the repurchase of the lent portlio are normally retuned to the borrowers liquidator Losses incurred are borne By the lender with recourse tothe barower’s liquidator along with other credors, Coren cas When taking cash a5 collateral Because of ts wide aceptablty and ease of management, cash can be highly appropiate collateral. However, the lender needs to decide how best toute his form of collateral As destribed in Chapter, ender tle Ing cash as colatral pays rebate interest to the secures borrower, o the cash must be reinvested at a hgh trate to make any net return on the collateral. This means the lender needs ta decide on an appropriate Fiskretum trade of. In simple terms, reinvesing in assets that cary one ofthe following risk can Increase expected retuns: 4+ aigher cit rik: 2 sk of oss in the event of dtauits oF ‘a Longer matty in elation to te Hkely term ofthe loan Many ofthe large securities lending losses over the years have been associated with reinvestment of cash collate, ‘Typically, lenders delegate reinvestment 10 their agents, (eg. custodian banks). They specty reinvestment guidlines, such as those Set aut In Chapters. There Is a move towards more quantitate, risk-based Spproaches; often speciving te Value-t- in relation tothe diferent expected returns eamed fom ater ratve reinvestment profes. Agents do not usually offer an indemnity agaist losses on reinvestment activi, Uy so thatthe lender retains all ofthe rk while their agent Is paid part ofthe rlur, When taking other secures as collateral Compared with cash cliatera, taking other secures as cllaterl isa way ofavoingrenvestment lk. In addition to the risks of er, systems faire and aud always present in any market, problems then aise on the default of a Borrower. In such cases the lender wil seek to sel the collateral secures In order to rake the funds to replace the lent securities. Transactions colateralised with secur are exposed to 2 number of liflerent risks Reaction and legalvsk Ifa lender experiences delays in either sling the collateral secures o repurchasing the lent securities, it runs a greater risk thatthe value of the cllatral wil fal Below that ofthe lean inthe Interim, Typical, the longer the delay, the larger the risk Mispricing isk. Te lender wil be exposed if ether collateral secures have been overvalued oF lent secur ties undervalued because the prices used to mark to market cf from prices that ean actualy be traded hn the secondary market. One example of mispricing is using mi rather than bid pics fr collateral For ili uid secures, obtaining arelabe price source is particulary dificult because ofthe lack of trading actvty Lui isk. Wiquid secures are more tkely to be realised at a lower price than the valuation used, \aluation haircuts are used to mitigate this rik (ie. collateral is valued at, fr example, 98% oF 95% of the ‘atent matket value). Te hateuts might depend upoa: The proportion ofthe total security issue held inthe portfolio - the larger the position, the greater the haircut ‘The average daly traded volume ofthe secury: the lower the volume, the greater the haircut +The voltity ofthe securiy the higher the volatility, the greater the haircut © 50059)Ccongruency of colateral and let portfolios (mismatch ist. the lent and collateral portfolios were identical then there weuld be no market sk In practice, of course, the lent and collateral portfolios are often very a ferent, The lender’ rik is thatthe market value of the let securities increases but that of the eolateal secu es fs before rebalancing can be effected, Provided the counterpart has not defaulted, the ender wil be le to call for addtional colateral on any adverse callteraViaan pice movements. However, folowing default, twill be exposed uni ithas been abe ell the ealateral and replace the lent secu, The sizeof mismatch isk depends on the expected co-variance ofthe value ofthe collateral and lent sec: Fite. Te risk wil be greater ifthe value ofthe collateral more volatile, the value ofthe lent securities i ‘more volatile, oF 1 their values do not tend to move together, so that the expected covelation between {hanges in their value i aw. For example, in decicng whether to hold UK goverment secures o: UK eau ties to colateralise a loan of BP shares, a lender would have to judge whether the greater expected corel tion between the value ofthe UK equities and the BP shares reduced mismatch sk by more than the lower fexpected volt in the value ofthe goverment secures. Many agent intermediaries wil offer beneficial owners protection against these risks by agreeing to retum (buyin) let secures immeciately fr thet clients following a fa, taking on the risk that the vale ofthe Eollateral on liquidation slower This example Hustrates one approach to estimating the sk exposure to a lender taking secures as calisteral. “Tables: Summary of ABCS lent and collateral postion with Borower + roetcns — | san iventory tim | otter | Gott etc | rss Mae em) Nee Ser iemy | Pine Tress ces [oo 3 = Source: Bane & Hibbert ‘Assume that lender ABC has loaned Borrower 1 a range of equities inthe UK, US, panese and Malaysian markets Collateral is mainly inthe form of UK gis at vious matures, string cash depos and US tong: fated Treasury bonds. The gross magn Is £25m or 45% of loan Inventor. Table 2: Data used to drive the analysis a caching eet se Towson | i? i? . Le tans Fo? 0 Es Teme ee ne ear aan aaa ode aah mame fmf fe ee ‘anata [oe eno pacts ea aor omy op tory Sinrtea [awe lus be tse en ane oat on ey Source: Bane & HibbertTable 2 shows the type of data on which a dtaied analysis of mismatch sk might be based: the average daly Ligudty in each asset class, the voltlty of each aset class, the average residual rik on particular ‘secstes within each asset class and a mats of corelatons between various asset castes, The fst consideration Is whether the valuation prices are fac. Assuming the polis have been consera- tively valued at bid and offer (not mid) prices, then the lender might require some adjustment (hair) to reflec concentvation and price volatity ofthe diferent assets. For example in the case ofthe steing «ash Collateral, the hareut might be negligible. Gut forthe Malaysian equlty porto, a high adjustment might be Sought on the assumption that it would probably cast more than £ioom to buy back this part of the lent port. foo. Required talrcuts might be based on the average day liquily forthe asset cass, the price volatility ofthe asset class and the residual rsk on inalidual secures, taken Fram Table 2. “Table 9: Adjusted collateral and lent portfolio values ose cass | ase oan | Aste cota | et Mem ‘remy es) | tent co ea Tearoeteaes [ne = tetoran utes ee me Souree: Bane & Hibbert Table 3 shows how necessary haicuts could affect the valuation. For example, the lent Nolayslan equities have Been revised upwatds 1 £10: 4m. This reflects the lower lquity and higher volatility of the Malaysian quits, which outweigh the risk reduction brought by diversifying the risk on the lent portflio. The lenders rman has thus effectively been reduced from £25m to £x6.2m oF 2.9% Ta Using the adjusted portfolio, the lender can then calculate the risk ofa collateral shortfall in the event of the Boriower delauling, Broadly this wil need to assess the voatity ofeach asset cass, the coreation between them and the residual rik of secures within them to deve a range of possible scenarios fom which probabilities of loss and the most likely sizeof losses on default can be estimated. Working on the assumption thatthe lender can realise ls collateral and replace its lent secutes ina reaction time of twen ty days, Table g shows the results forthe portfolio, together with some sensitivity analysis incase market voasiity and tuidty that has been signifcartly changed. By increasing the volatility assumption or redue ing the liquidity assumption, the probability ana sale of expected losses increase, “Table 4: Risk analysis for Borrower & under diferent assumptions seen rte ce as. ‘metal rb em) Tse sk eso ae | te Teter aati orsee [a = Source: Bane & Hibbert The final sensitivity is reaction time and Table 5 shows how the probabilty and expected sizeof losses decrease ithe lender can realise the collateral and veplace the lent secutles more quity, This framework canbe used to understand how possible changes in ABCs programme with Borrower 1 might affect the risks, Tables summarises some ofthe posible changes that could be made, in each case leaving the base case pontoio unchanged in other resp o“Table 5: Risk analysis for Borrower s under diferent lending polices ee) nay te ocd as ‘ta tt Tescon nes aye [iv = Peace Tne = pao [s ce (ede nb of Sens tod coe to Mayon eng + etc eck Cte for ‘ed Caan ree en Source: Bane & Hibbert Netting (et off - see below) is an important element af risk management given that market participants wil often Rave many outstanding trades with 2 counterpart. If there Is a defaut the various standard industry Inaster agreements for secures lending should provide forthe parties various obligations under diferent secur lending transactions governed by a master agreement to be accelerated, ie. payments become due Bt caren market values. So instead of requiring the parties to dever securities or collateral on ach oftheir futstanding vansactons gross, thelr respecive obligations are valued (.e. gven a cash valu) andthe value Of the obligations owed by one party ate set off against the value of the obligations owed by the othe, and itis the net Balance that is then due in cash. “This neting mechanism is a crucial part ofthe agreement. Tat is why there is so much legal focus ont for texan, artiipans need to oblain legal opinions abaut the electveness of netting provisions in jurisdic tions of overseas counterparts, partulaly inthe event of a counterparts Insolvency ‘That is also why regulator of financial Firms typically expect legal opinions on the robustness of netting arrangements before they wil recognise the value of callteral in redicng counterpart credit exposures for ‘apital adequacy purposes. In the United Kingdom, SLRC has a netting sub-graup, whic, on behalf of sub- Scrbing banks, Is monitoring an exercise to gather opinions onthe legal bases for netting in diferent juris “tions Ce ‘Any person who conducts stock borrowing or lending business inthe United Kingdom would generally be cr Ing on a regulated activity under the terms ofthe Financial Services and Markets Act 2000 Regulated ‘Aatvties) Order 2001, and would therefore have tobe authorised and supervised under that Act. The stock borrower or lender would, as an authorised person, be subject othe provisions ofthe FSA Handbook, includ ing the Inter Professiona chapter of the Marke Conduct Sourebook. They would aso need to have regard to the market abuse provisions ofthe Finandal Services and Muakets Act 2000, and the related Code of Market Conduct issued by the nancial Services Authority (FSA). The Conduct of Business Sourcebook requires 2 ben efial owner’ consent to carry on stock lending on ifs account. The FSA Handbook contains ules, guldance, {nd evidential provisions relevant te the candutt ofthe fm in relation tothe FSA High Level Standards Be eens ke In ation tothe essentially prudential standard set by the FSA, matket participants have drawn up 2 code, the Stock Boring and Lending Code. This Is code that UK-based partelpants inthe stock borowing and lending markets ofboth Uk domestic and overseas secures observe as a mater of good practice. The Code overs matters such a8 agents, brokers, legal agreements, custody, margins, deals and close-out, and con Firmations. ls based the cutent working practices of leading market practiloners and s Kept under re: lar review. The Code does net In any way replace the FSA'S or other authorities regulatory requrement: nor is itintended to overide the intemal rules of settlement syters on borrowing or lending transactions. Work is curently in progress to produce a UK Annex to the Code that wil consider specie aspects of UK aw and practices in the equiy stock lending market. The Code is available on the Bank of Englands website at ‘wen bankotenglnd.coukjmarketsstockborrowing palee eek) The Stock Borrowing and Lending Code was produced by the Secures Lending and Repo Committee (SURO), thats a Uicbased committee consisting of market practitioners, members of bodes such as CREST, the Unted Kingdom Debt Management Offce, the Inland Revenue, the London Clearing House. the London Stock Exchange and the FSA. It provides 2 forum in which structural eluding legal, regulatory, trading, dlearing and settlement inastrctre tax, market practice and dsclosure) development in the stock lending nd repo markets can be discussed, and recommendations made. I aso co-ordinates the development of git repo and ‘uly repo codess prodices and updstes the Gis Annex to the ISMATBNA Global Master Repurchase ‘Agreement (GIA); Keeps under revlew the other egal agreements used in the stock lending and tepo mar kets; and maintains @sub-gtoup on legal netting I laises with sila market bodies and trede organisations covering the repo secures and other mancal markets, both In London and intemaionally Minutes of SLRC meetings ae avaiable on the Bank of England's website, at wewbankofengiand.co.ukmarketssirhtm, The SLRS terms of teference are shown in Append 2, ‘The work ofthe SLRC complements the work of the various market association, Including, inthe secures lending il, the International Securities Lending Assocation (SLA). The objectives of ISLA include repre senting the common interest of secures lenders and assisting in the order efcent and competitive devel. ‘opment ofthe secures lending market. ILA has helped to produce standard market agreements, Icing the Overseas Securities Lending Agreement (OSLA 1995 version), the Master Equity and Fixed Interest Secures Lending Agreement (MEFISLA 1999 version) and the Global Master Secures Lending Agreement (GIVSLA tay 2000)COE Cm Maem Cte The secuttes lending business fs seen by many non practitioners as difett to understand and there are many questions asked. Here, we provide answers to some of them, 1 What do people mean when they talk about transfer of tile? Contracts provide for ownership of lent securities to pass from the lender to the borrower, ‘Amoments thought about one of the principal motivations for borowing and lending secures will make the necessity forthe clear. Say the borower needs to bortow secrties to cover short postion, i, to full 3 ontrac it has entered into to sell onthe securities. The buyer Is expecting the borower to pass It owner Ship on setement of that sale, as 's normal Ina sale. If the borower cannot do that, the borower wll not be able to ful its contact with that purchaser. In order to enable it to fulfil its contrac, the borrower obtains tite from the lender and then pases it on to the purchase, hence transfer of tte 12 What does this mean forthe lender? The lender needs to be aware that it wil be transfering ownership of the secures and ofthe valous con sequences that flow frm this Fist, any transter taxes applicable to a purchase of secures wll be due unless an exemption applies. This wil ypcally be an issue for the borower onthe inital leg ofthe transaction. But the lener should recog. rise thatthe return leg of the transaction Ge. when the borower transfers securities back to the tender) may flso attract transfer faxes where they are applicable, Second, the transfer ofthe lent secures sin legal terms a dlsposal of them, and the lender needs to estab lsh whether such disposal will have any consequences. Agan this s usually a tax question eg. are there tax consequences fr the lender in disposing of the lent secures? ire, and very importantly, the obligstion ofthe borower on the return leg ofthe transaction isto transfer uivalentsecues back to the lender, not the orginal secures. In secuites lending transaction, the borrower ls not ‘holding the secuties In tust or mcustody on behalf ofthe lender. The borrower actully ‘wns them, which fs to say thatthe lender has no right to secures that are In the hands ofthe borower. Given thatthe borrower wll often have sold on the secures it unlikely that the secures would be Fy the borrowers hands), Fourth, asthe lender wil cease to be the owner, it wil no longer be entitled to income from the secures, wil not receive neice or proceeds of corporate actions, and wil lose al volng rights in respect af the sec ftes. The standard documentation sets out contractual mechanisms fr putting the aver in a compareble feconomie poston in respect of income and corporate actions. Voting rights are transfered and the lender ‘must recall equivalent secuites from the borrower inorder to vote. 23 Why tsi called securities tending® when there fs transfer of tle? Because commetilly and economically people think oft as lending. Reflecting thi, for accounting and cap ital requirements it is wsualy treated as a loa. 4 Does it mean thatthe lender gets exactly the same secures back? No. The borrowers obligation is to rerum ‘equivalent secutles’ Le. fom the same secufties [sue withthe same Intemational Secures dentifcation Number (SIN). Often it will have sold the original lent securities and has to borrow of purchase secures In the market to full ts obligation to the lende, 5 Does the loner have a pledge over the collateral? No. Under standard market agreements and English aw, thee Is usualy a vansfr of ttle to the collateral. f the colaterals cash, all that means is that there fsa cash payment bythe borrower into the lenders bank account I the colateral Is secutites, there I a tansferof te of those secures tothe lender. ‘Many of questions that arise for borrowers in relation to collateral securities also arse for lenders in elation to lent securities 6 Why are there so many diferent agreements? Historically the diferent tax treatment of securities lending in diferent jurisdictions has driven the need forferent agreements (such as OSLA ~ the Overseas Secutes Lenders’ Agreement, MEFISLA ~ the Master Equity and Fixed Income Stock Lending Agreement, and soon) Following tax changes It has generally become possible to use a single document and the GNSLA ~ the Global Master Securties Lending Agreement, con folidates the various Mistral documents 7 the securities lending Is cared out under Engish Law, but a custodian appoints a sub-custodian Im another county, or lends to an entity in another country whlch does not recrgnise English Law, what happens when something goes wrong? Simplifying a bit there are thee elements in the application of law to secuties lending transaction. The Fists the contractual lan, the second ae the home country laws applying to each party, and the thirds the law applying tothe place were the securities ae held The contractual aw is that which apple to the legal agreement between the pates, which sets out the con tractua terms relating tothe lending transaction. Most ending agreements are in practice subject to English Taw, so that any disputes canbe seed in the courts of England ‘where a party incorporated in England proposes to conduc a secures lending transaction with a party incor porated in another county, the UkIncororated party will need to check, notally by obtaling a legal epi Ton, thatthe home country tw ofthe other party will allow the contrat to be given eect in accordance with its terms. This opinion wil normaly focus in paiculr on the cose out and netting (st-of) provisions of the legal agreement that apply in the insolvency of ether party (see section on netting In Chapter). This togeth er with the colateatsation and margin arangements shoulé keep the sks in conducting such business to acceptable levels ‘As regards the law relating o where the secures ar held, secures borowers need tobe cartin that they have good ttle to the secures since thee is a potenti for conflicts of laws or legal uncertainty in this respect. The treitonal rule for determining the vali ofa espostion of securities isto look tothe law of the place where the secures are located (the “ex sae’ of lex situs principe). This, however, effet to apply i secures are hela trough 2 numberof intemediaies. The genealy prefered approach now isto Took tothe locaton ofthe intermedary mainaining the account lato which the secures ate credited (he "PRIMA principle. The EU Collateral Directive as implemented in EU member states apples the PRIMA prin ple, and there ae plans to extend it further through the so-called Hague Convention. rd 1 What happens ifthe lender has lent a stock over the dividend petiod? The “borrower of stock makes good tothe lender the dividend amount thatthe lender would have received had it not lent the stock in the fst place. This amount the gross dividend less any withholding tax that the lender would usualy incu 2 Does the lender stil receive the dividend or coupon payment? No, The fender receives from the borrower a manufacture" dvidend or coupon rather than the dividend or upon isl 3 Does the lender sil recelve the (manufactured) dividend or coupon payment on the due date? Yes, the ende’'s account should be credited on the due date bythe borrower, even ifthe borrower has not actualy received i 44 What happens ifthe lender has loaned a stock over a stip dividend record date ~ does it get the televant cash or stock on the pay date? The lender should tell the borrower In advance which it would lke to receve Agaln the borower must man. Uufacture the cash oF stock for the lender even is recelvng the other. 5 Who organises that? itis bebween the borer andthe lnder (or its designated agent o custodian. {6 Why do lenders get higher Loan ates i they take cash fora scrp dividend? Usually there is anda incentive offered by 0 company to shareholders that take srip rather than cash Therefore the Borower can take scp, sell It ta give addtional income over the cash amount of the dividend, and may share this with the lenderCollateral and risk management 4 What is collateral? Financial instruments given by borowers to lenders to protect them against default over the tem ofthe loa, Colateal secures ae usually marked to market everyday. Borrowers are required to maintain collateral with ‘a market vale at least equal tothe market value ofthe loaned secures plus some agreed margin ‘halcut (Gee below, 2 What Is 2 haleut? “Walrcut or margin isthe extra colatral that a borrower provides inorder to mitigate any adverse movernents In the value ofthe loan and value of collateral between the mark-to-market date, and the value of Vqudat 4 callatral ané repurchase loan securities on the default date. 1 How often is the collateral valued? LUsualy every day, as with the loaned secures, but it can be more frequent in exceptional crcumstances. 416 the collateral held inthe lenders name or ts agent's name? It shouldbe held Inthe lender's name, but canbe held by an agent fo the lender's order iso desired, 51s cllteral valued atthe indvidual cient level or does the custodian value it ata summed level {and then allocate the collateral amongst he clients? ‘Again this can be done either way 3s desired by lenders and agents, {6 What happens ifthe borrower defaults? The lender iquidates the collateral and repurchases the loaned (lst) secures. Any excess shoul be retuned to the borower or liquidator. Any shortfall should be claimed from the boroner or Uquidator 7 How do lenders get ther secures back? How long does it tke? Within the usual settlement cycle forthe secures in question (ee Chapter 4), after they have been repur case. 8 Who ligudates the collateral? Lenders other agents they use ther. 9 How do tenders ensure thatthe liquidation of the colteral is done at market rates? Ina similar manner as they mit check on any sles made inthe usual curse of busines. Some agents will indemnify lenders against borrower deta, in which case they wil return the loaned assets and deat with li Uiating the collteral themselves. 10 What happens if market prices rie between the borower defaulting and cath being made available following the liquidation ofthe collateral? Any shortfall shoul be daimed from the borrower or its Uquidator in insolvency. N.B. Upto 2 48-hour wi ‘ow is avaliable under the OSLA, NEFISLA and GESLA (see the glossary for definitions) depending on whether ‘etal takes place within or outsde nonmal Business hous. Ths is extended to days Inthe new GMSLA, 14 What happens ifthe markets move such thatthe collateral held I less than the required cllaterat amount?” ‘ay shortfall should be clsimed from the borrower oF ts lauidator in insolvency, oterwise more collateral should be sought. if markets ate pacully volatile then inr-day marking to market may be appropiate 12 How often i the collateral topped up (Le. marked to market and margin called? Usually every day oF a8 recule. 13 Are the cllateralsecutles and the secures on loan valued atthe same tie/pricesfequency? Not always. The collateral and oan secures might be locate in diferent markets and tine zones. Otherwise both valuations should be made atleast daily.14 15 accrued ierest included Inthe calculations of market value for collateral, loans and fes? The GHSLA provides fr the valuation of both secures and collateral to include + acer income ‘dividend or interest payments decared but not yet due by the issuer + dividends paid inthe form of securities but not other rights or assets dering fom ownership ofthe securities or collateral 15 What happens if borower does retum a stock when called or at maturity? The ender may decide to expedite a“buyitt, whereby it purchases the unretumed stock inthe market end Involes the borrower for any eos 16 Who would pay the overdraft foes if lender's fund manager had sold stock and the lender had fled to sete the ade Because the borrower hadnt returned the stock? The lender may claim against the borower for ay direct costs incurred. However it shoulé be noted that con Sequential O56 might not be covered. Where the borower’s flue to redeliver sects tthe lender caus- 2 larger onward transaction to fl the nam is forthe lender ta claim only that proportion of the costs that relate directly tothe loaned secu. 57, What i cash reinvestment? In many cases, particulaly Inthe Unted States, stock Is loaned agalnst cash collateral. Rather than the Bor rower paying 2 fee, Ie eceves a rebate (e.g. 0.4%) being the interest rate payable onthe cash (eg) leas the fee eg. 0) In such situations the lender, or ther agent, has cash and an obligation To ay tis bate to the borrower. Te lender therefore reinvess the cash fo recelve an interest rte (@. 11%) so thatthe lender recives the fee plus ary reinvestment pickup (eg. 0.1%) or less any reinvestment shortal The reinvestment matket Inthe US Is aptly descrived as te tll that wags the dog’ The pursuit of income ina fay mature lending market fr US secures mean that reinvestment opportunities equenty dive loan Transactions that are tle more than a method of ralsing cash, 1 What are the risks attached to cash reinvestment? There f the chance thatthe reinvestment rate achieved sles than the rebate rate This usualy happens in rising interest rate environments Ifthe interest rate paid tothe borrower isthe overnight rate fied dally and reivestments ae for aired period (eg. one month). So if short-term ats ise during te time that the rei vestment is faed, the lender can lose ‘Also, reinvestment ate sometimes made into investments of lower cet quality to achieve returns. Hf this instrument defaults on interest payments or is downsraded by rating agencies, tis Uikely to fll in value. Most reinvestment is made inlo US Treasury or US Agency mortgage-backed sectes, in wih cases cstodl ‘an/oanks wil usualy Indemnlfy lenders inthe case of default, 19, What happens ifthe assets being held as collateral become worthless? So long as the borower has not defaulted too, they wil substitute, or top-up cliateral to the agreed level in the course ofthe markto-market process 20 What happens ifthe assets on loan become worthless? The borrower wil ask for collateral back tothe agreed level nthe couse ofthe marktomaket process 24 What i an indemnity? It is 2 kind of insurance poliy offered to lenders to mitigate risks associated with lending. One ofthe mast Commonly offered indernities is against borawer default. usualy ke insurance policies, they cover speci Ic-events and are nota catchall so, a5 with insurance polices, read te small prin 22 Who offers them? \Usualy custodian banks offer inderitis to their lending customers. Third Paty Agents obtain them fom insurance companies on behalf of tender cents, 25 What stings are attached? Lenders may be asked to split revenue to ge the custodian a lager share, reflecting the value ofthe indemnity,24 How important I to create a set of lending/colaterl gudeties before starting to lend rather th accepting the standard tems/guidelines? Fora new lender, an agents standard termsfguideines ave probably @ good place to start. The nest ste is to cansidr what Is and is not appropriate to accept om the standard terms/guidelines in terms of a isk. t isthe cients prerogative to alter these guidelines as they se ft Operational and logistical 4 What Is the difference between overnight and term loans? ost tans are transacted on an ‘oper’ or overnight basis. Sometimes landers are prepared to guarantee that they wil maintain the loan over a longer period, but tis i fay rare. In such cases the boroner has cet tainty that ent secures wl ot get recaled inside the term ofthe lan, it fs more usual tat a hedge fund borrower will obtain tem loans fom an investment bank, which wil have multiple lenders so that if one Should reall they can borrow fom anathec. 2 How long are term loans usually on loan fr? ‘Amonth would be a typical period, bu t depends on the nature ofthe trade underlying the need to borrow 3 How long does it take to recall a stack? Recalling should be exactly tke buying I a ender gives an insruction by a specie deadline, then it souls receive the stock back within the usual settlement cycle of the market in question, ies 4 Can lenders vote in am AGMYEGM whilst stock is on loan? No. Stock lening sin ae sense a misnomer: i involves the transfer of title, and with that, all voting rights associated with the secures; indeed secures are ote borrowed in order to sete an outight sae, so that the secures pass onto another outright owner. ut borowers havea contractual obligation to return equ lent secures to lenders on demand, Lenders therefore treat securities loans as temporay transactions that do not afect ther desired holding in a stock. Inthe case of votes, lenders have the choice whether to recall ‘equivalent securities in order to vate ther entre ‘desired olin ort leave stock on lan, forgoing the right to vote (though, this does not mean that votes are necessarily ost’ in aggregate, asthe new owner May ‘choose f0 vote) If they opt to Teave the stock on toa they have no means of contoling of knowing how the carent owner might vote. Thelr decision on realing the stack bos down to whether the benefits of vot ing are greater than those of lending. Investors make thelr own choices. iis worth noting that retus to lenders often increase around key corporate action. 2 Can lenders recal stock to vote and does this affect their reputation as lenders? It is quite common for lenders to retln@ buffer when lending stock so they can always goto oF vote In an AGIVEGM whist stock ison loan. However if they wish to vote all their holding, they must recall the lent Secures. Ifa bortawer is stil holding the stock (Le. It has not yet been used to full shortsale obligations) lenders may ask them to vote the stock on their behalf 3. Ist acceptable to borow stock inorder to accumulate a large temporary holding and influence 3 vote? Borrowing stock forthe purpose of accumulating a temporary holding to ilence a vote fs nota practice that most market patipants regard as acceptable. Canes 4 an lenders loan more stocks from a porto that has very litle radingtumover rather than a very actively traded porta? Yes as greater certainty about the stabity ofthe loa i a enel factor for al borrowers 2 How do custodians decide whose stock they lend If they have many clients that hold a parteular sock? They have allocation algorithms, but no two seem to be the same.3 What i an exclusive Lending retaonship? Wire a lender makes available al, or segments of, its assets to a particular borrower or borowers exclu sively 4 How is this diferent to going via a custodian? te an indeed be done via a eastodian, whieh wil do all the necessary administration, ete. Unie in an exc sive relationship the custoian wil usualy parcel ou loans to boromers ona stockbystck basis, wih the ‘algorit? making the allecations between lenders 5 How long do exclusive arrangements normally last? There is no standard tmetrame but many last one yest. {6 How does the custodian make money from secures lending? Mostly they split the income between lenders and themselves. 17 What fees do they normaly charge? ‘Usual te lender gets between 6o% and 90%, but percentages van.PN Uae MCR me Co CC Lig Secuities lending began with the development of securities trading markets. For example, inthe UK market from the pth centun, specialist intermediaries sourced gis forthe jobbers or market makers. Colateral, typ Tally noncas passed between the parties at the end of the trading day and offered protection forthe lenders. Mich of the borrowing facitted a practice called "bond washing, whereby Tax advantages were feichanged between parties around record and exdividend dates. Tis was the precusorto tax arbiage. A twortier market quickly emerged: a seeutyspecfi or ‘speci market, and a more generic Francing oF ‘ge ral market ed As the UK and US secuities trading markets developed, so did the securities Lending markets. Here ae Some ofthe key developments that took place inthe 2960s: ‘+The fist formal equity lending transactions took place in the Cty of London ‘An active intrdeaer market developed in the US (back office to back offce) “The increase in general, but particulaly bloc, trading volume Inthe US equity markets. The settlement system continued to be paper-based and this led to larg backlogs of settlement fis {and back ofces borrowing secures for settlement cover “+ US Treasury bond fhancing expanded - before thatthe US market had focused on equities eed In the 19708 the US market developed and assumed much of the shape that would be recognised today. The Uk market would not develop to is present frm unt deregulation following Big Sang in the 3980s. Here are Some ofthe key developments that took place in the 3570s: ‘+The estabishment ofthe US Depostor Trust Company (DTO reduced settiement related demand but facitated an increase in trading activity ‘+ Taging demand from arbivageurs increased, Srategies included + Convertible bond arbitrage + Tac artrage « Initial Publi Ofering (PO) related trading ‘+ The US custodian banks began to len secures on behalf oftheir lens: + Endowments «Insurance Companies + Pension Funds (amendments to ERISA legislation In 1981 permitted lending n accordance with suletines) ‘+ Teasury dealers bogan matched book’ repo trading ~ thereby generating borowing demand ‘+The US Treasury bond repo market became a key part ofthe money matkets +The US non-cash ‘bonds borrow market promoted brokerto-bank Business: «Cash collateral was a problem for banks wishing to avoid capital charges + Using long inventory saved the borowers money * Using non-cash ealateral reduced their balance sheet when compared to cash ‘©The use of derivatives and leverage in transactions expanded because retums could be inreased and banks ner willing to extend the necessary fhance ‘+The creation of inders~ specialists that lacked captal but had significant relationships and could Jind the securities that borowers needed ~ emerged ‘+The fist oss border or Interational secures lending transactions took place «Typically offshore tom the US or the UK + Inaly involving experienced waders using trading techniques that had been proven over tine in their local markets «Several key advantages suchas time zone, and a high concentation of international fund ‘management experts, pu the United Kingdom a the cente of international secures lending The 19805, Key developments included: '+ Coss border secures lending grew rap, driven party by the itematonal expansion ofthe US broker dealer: and custocian banks ‘+ Institutional lending of overseas secures increased because US and UK lenders were willing #2 {expand ther programmes from being domestic oly ‘+ Increases in the debt of most Gio goverments encouraged the growth of government bond lending and repo markets ‘+ Tading demand continued to stow, driven by a varety of strategies: +The Intemational derivatives matkets expanded with many derivatives hedging strategiesrequiring shor coverage eg index arbitrage ‘Tae arbitrage ~ the tax anomalles avalabe to expot internationally were numerous * Hedge funds were established insignificant numbers + Some institutional lenders began to enter into exclusive lending relationships with borrowers 4 Secures settlement systems induced book entry setiement and were able to process greater volumes: the Group of 30 report by an intemational group of experts stated that secures lending should be encouraged as a means of expecting efficent settlement + On May a7th 1982, Drysdale Secures, a minor bond dealer, collapsed. Drysdale had over $2 bilion in US Treasury loans outstanding when it defaulted. Institutional supply temporal died up folowing the Drysdale ata, particularly via the custodians, dve to legal uncertainties, the US Goverment Secures Act of 3986 flloned. Other changes Included the BMA developing the Standardised secures lending legal agfeement, a specication of claterl margins, colateralsation lof accried interest and disclosure of poroners and lenders by custodian banks. + Inthe autumn of 3988 Robert Manvel authorised secrties lending transactions frm the Mirror Group Newspaper pension fund, was not unt after his death on sth November top) that the consequences ofthese and subsequent transactions became apparent tothe authors, the market fand the pensones. As the Department of Trade and Industy (OTT) puts itn a chronology of vents on wand goxuk “from November 1988, Me Robert Maxwell therefore began to make use of the more marketable blue chip ‘ares held by the pension funds and Fist Tokyo Index Trust as collateral for bank borrowings tothe private ‘side; this was described as ‘stock lending’ to make it appear tobe the legitimate practice of lending secr- ties to market makers as part of ordinary share dealing actives. Cash continued to be borrowed from the pension funds by the paivate side without providing any collateral to the pension funds fr these loans.” Secuites lending volumes again rose sharply in most markets thoughout the decade. Key developments Includes: + Growing demand to borrow secuities to support hedging ané trading sateges «Technological advances, including computer processing power, access to real tne price Information and automated trade execution made possible new trading strategies, suchas statistical, arbitrage Further rapid growth in hedge fund assets under management, despite a pause following the Collapse of Lng Term Capital Management in 3999 ‘investment banks developed global prime brokerage operations to support the actives of hedge fund elets, including securities lending and financing 4+ The removal of many regulatory, tax and structural bares to secutes lending throughout the \wotd. Some ofthe major changes and developments inthe repo markel were driven bythe removal Of spect legal or regulatory bares, eg. 3993 Feneh repo + 1996 Japanese repo 3996 UK repo 1397 lalan buysell back + 3998 Swiss repo + In'3996 the sharp Increase In US short-term Interest rates led to losses for many securities lenders that had taken US doll cash as colateral and were reinvesting it in a varity af money market instruments. In mary cases ther agents, typically custodian banks, compensated thei underying Clients for these losses even though they were not lgaly obliged to do so, Lessons included Improved risk management procedure, better documentation and clear reinvestment guidelines. + uring the Asan crisis i 3997-98, the authorities ina number of counties imposed restrictions on Short selling, craving a Unk with cuteneyspecultlon, «Malaysia and Thalland both in August 1997 on Tends include +The market becoming more segmented * Specialist regional players developing * Outsourcing developing, eg third party secures lending agents + Tex arbitrage opportunites disappearing as tax harmonisation occurs {Continuing deregulation and tax changes making possible the establishment of new secuties lending markets, e.g. In Brazil, Ina, Kore, Taiwan Now transaction types: ‘Equity repo ~ much more accepted and widespread than in 19905, * Contacts for Difeences (CFDS)+ Total return swaps «Prime brokers using CFDs and total return swaps to allow clients to take postions in equity and ‘bond derivatives rather than the undertving secures Csythetic prime brokerage) Fewer Ital Public Offering CPO) and Merges and Acquistion CMA.) opportunities in 2002 and 2003 with fewer ‘ot’ stock. The rate of growth of equty stock lending slowed but the evelopment of traded cet and corporate bond markets encouraged growth Inthe fed income par ofthe businessAppendix 2 Terms of Reference of the SLRC ‘The commit wilt ‘+ Provide a forum in which structural Gncuding legal, eguaton trading, clearing and settlement Infastvcture, tax, market practice and disclosure) developments inthe stock lending and repo mmatkets can be ciscussed, and recommendations made, by pracitone's, Inkastuctute providers and the authorities, + Covrdinate the development ofthe Stock Borrowing and Lending Code of Guidance. This i @ summary of the basic procedures that UXcbased participants in stack borawinglending ofboth UK domestic and overseas securities observe as a matter of good practic, + Co-ordinate the development ofthe it and Equity Repo Codes of Best Practice. These codes set ‘out standards of good praice for repo. Tey are drawn upon the bass of practice in existing repo ‘markets in London observed by practitioners andthe authorities and are kept under review. ‘+ Produce and update the Gis Annex to the ISMAMTBMA Global Mater Repurchase Agreement (GMRN), Liaise, where appropriate, wth similar market bodies and tade organisations covering the repo and secures markets, and other financial markets, In London and ater franca centres. ‘+ Malnzain a Sub-group on legal netting anc, IF equte, create other sub-groups fo research and manage specie topes. Discussions between members dung the couse of meetings willbe held to be configetial though sum mares of these discussions will be published, normally within one month of the mecting, at htpfvebankoengland.co.ukfmarketssichtm Membership ‘+The Committee is caied and administered by the Bank of England, +The Committee comprises market participants representing the main trade associations involved in the UK and intemational repo and stock lending markets, (curentiy Intemational Secures Lending Associaton; Intemational Secures Market Associaton, Bond Market Association; European Repo Counc, London Investment Banking Assocation; London Money Market Association; Bish Bankes! Associaton), infastuctre providers and the UX authoties, ‘+ Membership ‘of tne Commitee isto be decided by the Chairman, The Chairman may invite adtonat ad hoc representatives ftom “knowledgeable paris i thought appropriate.PMT ae Cl Ot LA Every industry has its own business terms. Secures ending is no exception. Here we lst the more esoteric terms mentioned inthis booket and some that might be encountered whilst exploring the market. Note that some tems may have diferent meanings. in contexts other than secures lending. ‘Acrued interest: Coupon interest that is eared on @ bond fram the last coupon date tothe present date Agen: A prty to loan transaction that acts on behalf of cent. The agent typically does nt take in sk ina transaction, See "Inder ‘Alin dividend: the sum ofthe manufactured dividend plus the fee to be pald by the bowower tothe lender, expressed as a percentage ofthe dividend ofthe stock on loan. [Ln pice: Market price ofa bon, plus accrued interest, Generally rounded tothe nearest 0.0. Also known 25 ‘ty price Basis point: One one-hundredth of a percent or 0.01% Bearer secures: Securtis that are not registered to any particular party and hence are payable to the party that I in possession of them, Beneficial owner: A party that i enttled to the rights of ownership of property. Inthe context of secures, the term i usualy used to lstinguish this party rom the registered holder (@ nominee, far example) that holds the secures forthe beneelal onne. Beneft: Ary entitlement due toa stock or shareholder as a result of purchasing or holding securities, includ ing te right to any dividend, rights issue, sep issu, etc. made by the issue Inthe case of leaned secur ties oF ealateral, Benois are passed back tothe lender or bortower las appropiate), usualy by way of & ‘manufactured dlvidend or te fetun of equlvalent secures or collateral BMA: The Bond Market ASSoclation ~ Is a US-based Industy organisation of participants involved in certain sectors af the bond markets. The BMA establishes nor-inging standards of business conduc inthe US The: income securities markets, Formerly known asthe Public Secures Association oF PSA. Buyin: The practice whereby a lender of secures enters the open market to buy secures to replace those that have not been retured by 2 boromer Stict market practices gover buy ins. Guyins may be enforced by market authors in some jursccions Buy/Sel, Se/Buy: Types of bond transactions that, in economic substance, replicate reverse repos, and repos respectively These transactions consst ofa purchase (or sale) ofa secutty versus cash with a forward com mitment to sel back (or buy baci) the secures. Used a5 an altematve to repos/everss. ‘amy: oierence between interest retum on secuttes held and fnancing costs: Negative cary: Net cost ncured when financing cost exceeds yield on secures that are being anced Positive cary: Net gain eamed when financing cost i less than yield on Franced secures Cashavientated repo: Transaction motivated by the need of one pat to invest ash andthe nee ofthe ether to borrow. See alco “Securles-oentated repo’ Cash trade: A non financing purchase or sal of sects. Clear: To complete a trade, ie. when the seller delivers securities and the buyer delivers funds in cored form, ‘trade fais when proper delivery requirements are not satsed Close-out (and) netting: An arangement to sete ail existing obligations to and claims ona counterpart fling under that arrangement by one single net payment, immediately upon the occurence ofa defined event of deta Collateral: Securities 0+ cash delivered by & borrower toa lender to suppor loan of securities or cash Contract for biferences (CD): An OTC derivative transaction that enables one paty to ain economic expo sure tothe price moverent ofa securty bull or bea). Witers of CFDs hedge by taking postions inthe under ving Secures, making ecient secures financing or boring key. Corporate action: A carprate event in relation fo which the holder ofthe secury must or may make an eee tion or take some other action In order to secure its entitlement andior to opt for a partcular form of ent Hement (see also equvalend.Corporate event: An even in elation toa secuty as a result of which the holder wil or may become ent! ted to +a benef (sividend, rights issue etc): or + Secutes other than those which he held prior to that event (akeover offer, scheme of arangement, Conversion, redemption, etc). This type of corporate event i also knowns a stock situation, ‘Condul borower: See Intermedlry Custodian: An entity that holds secuites of any type for investors, effecting receipts and deliveries, and sup piving appropriate reporting Daylight exposure: The period in the day when one pary to a trade has a temporary credit exposure tothe ther due to one party having setied before the other R would normaly mean tat the loan had setied but the dalvery of eallateral would settle at 2 later time (although there would also be exposure i setiement happened in reverse). The period extends from the point of settlement of the fist side ofthe trade tothe time of setiement ofthe other k occurs because the two sides of the trade ae not linkedin many ste: rent systems or settlement of loan and collateral take place in diferent systems, possibly in dierent time Delverout repo: ‘Standard’ two-party repo, where the party receiving cash delivers bonds to the cash provider Detery-by-value (DBV):A mechanism in some settlement systems (uding CREST) whereby a member may borrow or led cash overnight aginst collateral The system automatically selects and delves eollateral secu ties, meeting predetermined crea tothe value ofthe cash (plus 8 magi) frm the account ofthe cash borrower fo the account ofthe cash lander and reverses the transaction the falling maring. Distbutions:Entilerents arising on securities that are loaned out, eg, dividends, interest, and non-

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