Securities Finance: Securities Lending and Repurchase Agreements / Edition 1 available in Hardcover
Securities Finance: Securities Lending and Repurchase Agreements / Edition 1
- ISBN-10:
- 0471678910
- ISBN-13:
- 9780471678915
- Pub. Date:
- 08/08/2005
- Publisher:
- Wiley
Securities Finance: Securities Lending and Repurchase Agreements / Edition 1
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Product Details
| ISBN-13: | 9780471678915 |
|---|---|
| Publisher: | Wiley |
| Publication date: | 08/08/2005 |
| Series: | Frank J. Fabozzi Series , #142 |
| Pages: | 368 |
| Product dimensions: | 6.42(w) x 9.06(h) x 1.06(d) |
About the Author
STEVEN V. MANN, PhD, is Professor of Finance at the Moore School of Business, University of South Carolina. He has coauthored four previous books and numerous articles in the area of investments, primarily fixed-income securities and derivatives. Mann also works as a consultant to investment/commercial banks and has conducted training programs for financial institutions throughout the United States.
Read an Excerpt
Securities Finance
By Frank J. Fabozzi
John Wiley & Sons
ISBN: 0-471-67891-0Chapter One
An Introduction to Securities Lending Mark C. Faulkner Managing Director Spitalfields Advisors
Securities lending-the temporary transfer of securities on a collateralized basis-is a major and growing activity providing significant benefits for issuers, investors, and traders alike. These are likely to include improved market liquidity, more efficient settlement, tighter dealer prices and, perhaps, a reduction in the cost of capital. This chapter describes securities lending, the motivation for lenders and borrowers to participate, the role of intermediaries, market mechanics, and the risks faced by the lenders of securities.
WHAT IS SECURITIES LENDING
Securities lending is an important and significant business that describes the market practice whereby securities are temporarily transferred by one party (the lender) to another (the borrower). The borrower is obliged to return the securities to the lender, either on demand, or at the end of any agreed term. For the period of the loan the lender is secured by acceptable assets delivered by the borrower to the lender as collateral.
Securities lending today plays a major part in the efficient functioning of the securities markets worldwide. Yet it remains poorly understood by many of those outside the market.
In some ways, the term "securities lending" is misleading and factually incorrect. Under English law and inmany other jurisdictions, the transaction commonly referred to as "securities lending" is, in fact ...
a disposal (or sale) of securities linked to the subsequent reacquisition of equivalent securities by means of an agreement.
Such transactions are collateralized and the "rental fee" charged, along with all other aspects of the transaction, is dealt with under the terms agreed between the parties. It is entirely possible and very commonplace that securities are borrowed and then sold or on-lent.
There are some consequences arising from this clarification:
1. Absolute title over both the securities on loan and the collateral received passes between the parties.
2. The economic benefits associated with ownership-e.g., dividends, coupons, etc.-are "manufactured" back to the lender, meaning that the borrower is entitled to these benefits as owner of the securities but is under a contractual obligation to make equivalent payments to the lender.
3. A lender of equities surrenders its rights of ownership, e.g., voting. Should the lender wish to vote on securities on loan, it has the contractual right to recall equivalent securities from the borrower.
Appropriately documented securities lending transactions avoid taxes associated with the sale of a transaction or transference fees.
Different Types of Securities Loan Transaction
Most securities loans in today's markets are made against collateral in order to protect the lender against the possible default of the borrower. This collateral can be cash or other securities or other assets.
Transactions Collateralized with Other Securities or Assets
Noncash collateral would typically be drawn from the following collateral types:
* Government bonds
* Issued by G7, G10 or Non-G7 governments
* Corporate bonds
* Various credit ratings
* Convertible bonds
* Matched or unmatched to the securities being lent
* Equities
* Of specified indices
* Letters of credit
* From banks of a specified credit quality
* Certificates of deposit
* Drawn on institutions of a specified credit quality
* Delivery by value ("DBVs")
* Concentrated or unconcentrated
* Of a certain asset class
* Warrants
* Matched or unmatched to the securities being lent
* Other money market instruments
The eligible collateral will be agreed upon between the parties, as will other key factors including:
* Notional limits
* The absolute value of any asset to be accepted as collateral
* Initial margin
* The margin required at the outset of a transaction
* Maintenance margin
* The minimum margin level to be maintained throughout the transaction
* Concentration limits
* The maximum percentage of any issue to be acceptable, e.g., less than 5% of daily traded volume
* The maximum percentage of collateral pool that can be taken against the same issuer, that is, the cumulative effect where collateral in the form of letters of credit, CD, equity, bond and convertible may be issued by the same firm
Exhibit 1.1 shows collateral being held by a tri-party agent. This specialist agent (typically a large custodian bank or international central securities depository) receives only eligible collateral from the borrower and hold it in a segregated account to the order of the lender. The triparty agent marks this collateral to market, with information distributed to both lender and borrower (in the diagram, dotted "Reporting" lines). Typically the borrower pays a fee to the tri-party agent.
Exhibit 1.2 provides an illustration of cash flows on a securities against collateral other than cash for a transaction in the United Kingdom.
There is debate within the industry as to whether lenders, which are flexible in the range of noncash collateral that they are willing to receive, are rewarded with correspondingly higher fees. Some argue that they are; others claim that the fees remain largely static, but that borrowers are more prepared to deal with a flexible lender and, therefore, balances and overall revenue rise.
The agreement on a fee is reached between the parties and would typically take into account the following factors:
* Demand and supply
* The less of a security available, other things being equal, the higher the fee a lender can obtain
* Collateral flexibility
* The cost to a borrower of giving different types of collateral varies significantly, so that they might be more willing to pay a higher fee if the lender is more flexible
* The size of the manufactured dividend required to compensate the lender for the posttax dividend payment that it would have received had it not lent the security
* Different lenders have varying tax liabilities on income from securities; the lower the manufactured dividend required by the lender, the higher the fee it can negotiate.
* The term of a transaction
* Securities lending transactions can be open to recalls or fixed for a specified term; there is much debate about whether there should be a premium paid or a discount for certainty. If a lender can guarantee a recall-free loan then a premium will be forthcoming. One of the attractions of repo and swaps is the transactional certainty on offer from a counterpart
* Certainty
* As explained later in this chapter, there are trading and arbitrage opportunities, the profitability of which revolves around the making of specific decisions. If a lender can guarantee a certain course of action, this may mean it can negotiate a higher fee
Transactions Collateralized with Cash
Cash collateral is, and has been for many years, an integral part of the securities lending business, particularly in the United States. The lines between two distinct activities, securities lending and cash reinvestment, have become blurred and to many U.S. investment institutions securities lending is virtually synonymous with cash reinvestment. This is much less the case outside the United States, but consolidation of the custody business and the important role of U.S. custodian banks in the market means that this practice is becoming more prevalent. The importance of this point lies in the very different risk profiles of these increasingly intertwined activities.
The revenue generated from cash-collateralized securities lending transactions is derived in a different manner from that in a noncash transaction (see Exhibit 1.3). It is made from the difference or "spread" between interest rates that are paid and received by the lender (see Exhibit 1.4).
Reinvestment guidelines are typically communicated in words by the beneficial owner to their lending agent, and some typical guidelines might be as follows:
Conservative
* Overnight G7 Government Bond repo fund
* Maximum effective duration of 1 day
* Floating-rate notes and derivatives are not permissible
* Restricted to overnight repo agreements
Quite Conservative
* AAA rated Government Bond repo fund
* Maximum average maturity of 90 days
* Maximum remaining maturity of any instrument is 13 months
Quite Flexible
* Maximum effective duration of 120 days
* Maximum remaining effective maturity of 2 years
* Floating-rate notes and eligible derivatives are permissible
* Credit quality: Short-term ratings: A1/P1, long-term ratings: A-/A3 or better
Flexible
* Maximum effective duration of 120 days
* Maximum remaining effective maturity of 5 years
* Floating-rate notes and eligible derivatives are permissible
* Credit quality: Short-term ratings: A1/P1, long-term ratings: A-/A3 or better
Some securities lending agents offer customized reinvestment guidelines while others offer reinvestment pools.
Other Transaction Types
Securities lending is part of a larger set of interlinked securities financing markets. These transactions are often used as alternative ways of achieving similar economic outcomes, although the legal form and accounting and tax treatments can differ. The other transactions are described in the following subsections.
Sale and Repurchase Agreements
Sale and repurchase agreements or repos involve one party agreeing to sell securities to another against a transfer of cash, with a simultaneous agreement to repurchase the same securities (or equivalent securities) at a specific price on an agreed date in the future. It is common for the terms "seller" and "buyer" to replace the securities lending terms "lender" and "borrower." Most repos are governed by a master agreement called the TBMA/ISMA Global Master Repurchase Agreement (GMRA).
Repos occur for two principal reasons: either to transfer ownership of a particular security between the parties or to facilitate collateralized cash loans or funding transactions.
The bulk of bond lending and bond financing is conducted by repurchase agreements (repos) and there is a growing equity repo market. An annex can be added to the GMRA to facilitate the conduct of equity repo transactions.
Repos are much like securities loans collateralized against cash, in that income is factored into an interest rate that is implicit in the pricing of the two legs of the transaction.
At the beginning of a transaction, securities are valued and sold at the prevailing "dirty" market price (i.e., including any coupon that has accrued). At termination, the securities are resold at a predetermined price equal to the original sale price together with interest at a previously agreed rate known as the repo rate.
In securities-driven transactions (i.e., where the motivation is not simply financing) the repo rate is typically set at a lower rate than prevailing money market rates to reward the "lender" who invests the funds in the money markets and, thereby, seek a return. The "lender" often receives a margin by pricing the securities above their market level.
In cash-driven transactions, the repurchase price typically is agreed at a level close to current money market yields, as this is a financing rather than a security-specific transaction. The right to substitute repoed securities as collateral is agreed by the parties at the outset. A margin is often provided to the cash "lender" by reducing the value of the transferred securities by an agreed "haircut" or discount.
Buy/Sell Backs
Buy/sell backs are similar in economic terms to repos but are structured as a sale and simultaneous purchase of securities, with the purchase agreed for a future settlement date. The price of the forward purchase is typically calculated and agreed by reference to market repo rates.
The purchaser of the securities receives absolute title to them and retains any accrued interest and coupon payments during the life of the transaction. However, the price of the forward contract takes account of any coupons received by the purchaser.
Buy/sell back transactions are normally conducted for financing purposes and involve fixed income securities. In general a cash borrower does not have the right to substitute collateral. Until 1996, the bulk of buy/sell back transactions took place outside of a formal legal framework with contract notes being the only form of record. In 1995, the GMRA was amended to incorporate an annex that dealt explicitly with buy/sell backs. Most buy/sell backs are now governed by this agreement.
Exhibit 1.5 compares the three main forms of collateralized securities loan transaction.
LENDERS AND INTERMEDIARIES
The securities lending market involves various types of specialist intermediary which take principal and/or agency roles. These intermediaries separate the underlying owners of securities-typically large pension or other funds, and insurance companies-from the eventual borrowers of securities, whose usual motivations are described later in this chapter.
Intermediaries
Agent Intermediaries
Securities lending is increasingly becoming a volume business and the economies of scale offered by agents that pool together the securities of different clients enable smaller owners of assets to participate in the market. The costs associated with running an efficient securities lending operation are beyond many smaller funds for which this is a peripheral activity. Asset managers and custodian banks have added securities lending to the other services they offer to owners of securities portfolios, while third party lenders specialize in providing securities lending services.
Owners and agents "split" revenues from securities lending at commercial rates. The split will be determined by many factors including the service level and provision by the agent of any risk mitigation, such as an indemnity. Securities lending is often part of a much bigger relationship and therefore the split negotiation can become part of a bundled approach to the pricing of a wide range of services.
Asset Managers
It can be argued that securities lending is an asset-management activity-a point that is easily understood in considering the reinvestment of cash collateral. Particularly in Europe, where custodian banks were, perhaps, slower to take up the opportunity to lend than in the United States, many asset managers run significant securities lending operations.
What was once a back-office low profile activity is now a front office growth area for many asset managers. The relationship that the asset managers have with their underlying clients puts them in a strong position to participate.
Custodian Banks
The history of securities lending is inextricably linked with the custodian banks. Once they recognized the potential to act as agent intermediaries and began marketing the service to their customers, they were able to mobilize large pools of securities that were available for lending. This in turn spurred the growth of the market.
Most large custodians have added securities lending to their core custody businesses. Their advantages include: the existing banking relationship with their customers; their investment in technology and global coverage of markets, arising from their custody businesses; the ability to pool assets from many smaller underlying funds, insulating borrowers from the administrative inconvenience of dealing with many small funds and providing borrowers with protection from recalls; and experience in developing as well as developed markets.
Being banks, they also have the capability to provide indemnities and manage cash collateral efficiently-two critical factors for many underlying clients.
Custody is so competitive a business that for many providers it is a loss-making activity. However, it enables the custodians to provide a range of additional services to their client base. These may include foreign exchange, trade execution, securities lending, and fund accounting.
(Continues...)
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Table of Contents
Preface ixAbout the Editors xiii
Contributing Authors xv
Part One Securities Lending 1
Chapter 1 An Introduction to Securities Lending 3Mark C. Faulkner
Chapter 2 Securities Lending, Liquidity, and Capital Market-Based Finance 39State Street
Chapter 3 Finding a Route to Market: An Institutional Guide to the Securities Lending Labyrinth 57Mark C. Faulkner
Chapter 4 Evaluating Lending Options 79Anthony A. Nazzaro
Chapter 5 The Auction Process and Its Role in the Securities Lending Markets 87Daniel E. Kiefer and Judith G. Mabry
Chapter 6 The Fundamentals of Fixed Income Securities 107Frank J. Fabozzi
Chapter 7 Managing Liquidity Risks in Cash-Based Lending Programs 127Ed Blount and Aaron J. Gerdeman
Chapter 8 Quantifying Risks in Securities Lending Transactions 141Mark C. Faulkner
Chapter 9 Risk, Return, and Performance Measurement in Securities Lending 151Peter Economou
Chapter 10 Developing Effective Guidelines for Managing Legal Risks—U.S. Guidelines 167Charles E. Dropkin
Chapter 11 Tax Issues Associated with Securities Lending 179Richard J. Shapiro
Chapter 12 Accounting Treatment of Loans of Securities 205Susan C. Peters
Part Two Bond Financing via the Repo Market 219
Chapter 13 Repurchase and Reverse Repurchase Agreements 221Frank J. Fabozzi and Steven V. Mann
Chapter 14 The European Repo Market 241Richard Comotto
Chapter 15 Overview of U.S. Agency Mortgage-Backed Securities 255Frank J. Fabozzi
Chapter 16 Dollar Rolls 283Frank J. Fabozzi and Steven V. Mann
Chapter 17 Evaluating the Interaction of Dollar Rolls and MBS Investments 299Anand K. Bhattacharya, Paul Jacob, and William S. Berliner
Part Three Equity Financing Alternatives to Securities Lending 315
Chapter 18 Equity Financing Alternatives to Securites Lending 317Frank J. Fabozzi and Steven V. Mann
Index 333