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March 19, 2008

Out of the Dark Ages

Upstart firms crusade for modernized securities lending

By Gregory Bresiger

Securities lending must escape the Dark Ages and follow the same path of electronic change once undertaken in the world of over-the-counter equity trading. That's what advocates of various electronic lending platforms argue.

Their complaint is that securities lending is an opaque business that doesn't allow participants to accurately gauge supply and demand for a security. Consequently, they say, lenders and borrowers stumble around in the dark because the system is dealer-dominated and inefficient.

"It's unfortunate that in the greatest country in the world, we havea system in which investors can not get transparent information in real time," says John Tabacco, who is CEO of LocateStock and is the founder of Lendex LLC, a securities lending exchange. Most players, or potential players, will never be sure that they are getting fair value without more electronic trading. That's what critics like Tabacco say of the current system. And, without modernization, securities lending will never realize its potential as a $16 trillion global business. The lack of an exchange and modern electronic platforms, critics say, are why brokerages offering securities lending now have low utilization rates.

A New Model

Call it a central credit counterparty (CCP) for securities lending as a consultant did in a recent report. Call it an ECN for securities lending. Call it a securities lending exchange, as do officials of the Jersey City. N.J.-based Lendex, which is tentatively scheduled to begin on April 2.

It all amounts to the same thing: Players say they need a new electronic model that aims to reduce the opacity that plagues many borrowers and lenders.

Lendex officials claim they are going to bring electronic trading techniques to securities lending. They have been working on this for some five years. Tabacco says that, "It's a disgrace there are so many problems with this market, and now regulation is forcing innovation."

Securities lending pricing, critics contend, is often unfair. Some lenders run their operations like cable television. They don't permit a la carte pricing. So, if a borrower is trying to obtain a lightly traded stock, he'll have to buy it along with an easy-to-get stock that he doesn't need. Those venturing into the dark of securities lending, critics say, often don't know what they're getting. Therefore, firms offering securities lending often loan as little as 30 percent of their stock.

"I'd say the utilization of the average overall portfolio is even less than that," says Roy Zimmerhansl, head of securities lending at ICAP. He adds that utilization rates aren't the only measure of a securities lending platform's success. The biggest issue in securities lending, he adds, is how to find the maximum number of potential counterparties and the best prices.

Many players and observers compare the securities lenders business to the OTC equities business in the 1980s and 1990s. It was a fragmented Wild West market. It was one in which buyers and sellers feared they would be cheated. And, as a government investigation later discovered in a bid-rigging scheme, they often were.

Retarding Growth

"Those are perfect analogies of what securities lending is today" according to Harvey Pitt, former chairman of the Securities and Exchange Commission and a consultant to Lendex through his Kalorama Partners consulting firm. He is working on the Lendex plan with Tabacco.

Pitt and others complain that the structure of the securities lending business retards growth. That's because would-be clients like hedge funds can't find objective or sufficient information to make informed choices. Therefore, whether looking for hard-to-get stock or lending out their own securities, they are fearful they will be overcharged or will not get the best rates.

Lendex officials will make the case that returns from special, or hard-to-borrow, securities offered through single-stock auctions will be improved because of their exchange (see sidebar with Lendex official). They also argue that utilization ratios will increase as many securities lending operations tap more stock because information is easier to obtain.

But while everyone agrees that securities lending is often illiquid, the issue of whether an exchange or some new electronic platform will work is this: Will custodians, agents, pension funds and others such as prime brokers, some of whom have a stake in things continuing as they are now, use a new system, be it Lendex or another?

Lendex will charge borrowers a transaction fee to use the platform. Those who upload their inventory themselves, who don't use the Lendex staff, will pay a smaller fee. Will it work?

"Their proposal," says the head of a large securities lending firm of the Lendex plan, "is based on the idea that beneficial owners can generate more money from lending their special, hard-to-get, stocks through Lendex than they would get out of their existing lending agent programs." But, he adds, since the exchange doesn't exist, how can one know if it can work? Some say the Lendex plan will fail because there won't be enough inventory. Some critics charge that Lendex is playing tough guy, implicitly threatening players to use the model or else.

A Closed Community

A broker-dealer, who says he is neither for nor against the Lendex plan, warns that "securities lending is a fairly closed community." To have success, "one must have the support of major holders of liquidity," says the official, who declined to be quoted by name.

The dealer doubts that major custodians such as State Street and Northern Trust, both of which declined comment for this story, will use Lendex. He also maintains that Lendex has been taking "a confrontational approach," trying to force asset holders to use its model. And he also questions whether the Lendex exchange will have a relationship with a CCP. At presstime, Lendex officials said they were about to establish such a relationship.

"We're going to sign the papers with a custodian very soon," said Tabacco as CQ&D was going to press (see news section).

Others simply question whether Lendex will work. "By adding Harvey Pitt," says another securities lending dealer who didn't want to be quoted by name, "what exactly are they adding?"

Pitt has legal arguments for critics of the Lendex plan. If custodians, agents and others don't explore the Lendex options, they will be possibly failing in their fiduciary/best- execution obligations to clients, he argues. But Lendex critics say that best execution rules are difficult to apply to securities lending.

The securities lending dealer disputes Pitt's claim. He says, say you are an agent or a custodian lender and you want to lend out a small state's entire portfolio. If a dealer goes to an exchange to loan out some of the hard-to-get securities, it may be true that one is getting the best price on the securities.

"But if they're getting the best price on one-tenth of the securities that they could lend through another model, another model in which they might earn more revenue, then just getting best execution on a small part of the model doesn't really equate to best execution," he says.

Still, Pitt disagrees. He predicts that the regulators will impose new securities lending rules this year. This is based on the belief that "there is a need for higher legal standards in securities lending," Pitt says.

Modernization Needed

A hedge fund manager, who declined to be quoted by name, agrees that an exchange or more electronic trading-like platforms are needed, especially for those using new 130/30 strategies, strategies in which precise shorting is critical in generating alpha. Electronic securities lending will eventually happen, the manager says. But he also concedes that big prime brokers, such as Goldman Sachs, and big custodians, such as State Street, understand that someday there will eventually widespread electronic securities lending.

"But they'll wait until the last possible moment" the manager contends. Both Goldman Sachs, along with the other two biggest prime brokers, Morgan Stanley and Bear Stearns, declined to comment for this story.

An official with securities lender Quadriserv says it's human nature that most firms want to go slow. However, he adds, the "vested interests" of securities lending aren't against progress.

"It's just that they want a voice in the direction and pace of progress," says Gregory DePetris, one of the co-founders of Quadriserv. Operationally and technologically, he says, many firms are behind the times in securities lending. DePetris says he is interested in investigating every new securities lending model. But he believes "no one solution is going to be the right solution for everyone in this market."

Clients will have different needs, he says. For example, he says, for a pension fund with "only hard-to-borrow stock, the idea of centralized price discovery sounds like a really good deal." Others, he explains, will only be interested in widely available stock. They could use a very different model, he adds. So DePetris also says that the notion of best execution' in securities lending means different things to different people.

Looking at Lendex

DePetris adds that he will be watching Lendex and other developing securities lending operations very closely. That's a sentiment echoed by an analyst who has championed the idea of electronic securities lending.

"Lendex potentially could be the strongest market concept yet for creating transparency in securities lending, according to Josh Galper, a securities industry analyst and founder of the consultant Vodia Group and an advocate of electronic securities lending.

In a Vodia Group report entitled "The Mountain Moves: Electronic Bid/Ask Markets in Securities Lending," he names four candidates as a possible CCP, leaving out Lendex. Those firms named in the report-EquiLend, SunGard, ICAP i-Sec and SecFinex-have the financial backing and technology to make a CCP or exchange work, according to the report.

These firms have platforms that might represent an "embryonic" securities lending exchange, the report says. If one of them were to go forward with a CCP, it would "spur tremendous development or liquidity in securities lending," the report says.

SunGard and EquiLend, Galper wrote, have the best built- in trading controls to prevent a borrower from taking positions the lender believes are too large. Which one would be the best model for a securities lending exchange?

"EquiLend is in fact the obvious choice for this type of global market utility," he writes. But Galper also says that SunGard's Loanet Centralized Order Routing (LICOR) utility is similar to EquiLend's product.

"The primary differences are that EquiLend bundles all of its products together at tiered price points while SunGard offers its services on a base rate per ticket basis, and that SunGard can maintain full books and records for clients," according to the Vodia Group report.

Whichever model or models are successful, lenders and borrowers agree that securities lending is a fraction of what it could be if borrowers and lenders had more confidence in the rules of the game. The consultant Celent, in a recent study of securities lending, estimates total global lendable assets are some $16 trillion. But the amount lent is some $3.6 trillion, Celent says.

A Growing Business

Still, Celent projects that securities lending in the United States, despite its problems, will still grow by only about 5 percent a year over the next few years, about half of the projected European growth rate.

Despite its problems in the United States, securities lending has already begun to become a more prominent business at many securities firms, according to industry observers. But more electronic trading platforms and more CCPs would help expedite the growth of the untapped business, just as Nasdaq's growth from a utility to a formal exchange promoted OTC equity trading, say industry observers.

The basic idea of a central credit counterparty (CCP) is that it becomes a buyer to every seller and a seller to every buyer. The CCP is a middleman, taking on the risk in every transaction. It ensures the creditworthiness of all parties. Therefore, an effective CCP would greatly reduce trading costs, generate uniform credit risks and offer anonymous securities lending trading.

Nevertheless, ICAP's Zummerhansl says that while a CCP could reduce dealer-to-dealer concerns about credit worthiness, the bigger issue is ensuring that an electronic platform has the greatest reach of potential trading parties.

Critics of the current securities lending markets say that information now is highly concentrated in the hands of a relatively small number of people. That means few screens on which prices are displayed. It also means fewer places where one can get more than an indicative quote.

Big Profits

Right now the system has some big winners. For example, prime brokers, which often act as middlemen between the owners of a stock and the borrower, now reap huge revenues from this line. Securities lending can be a very profitable if one owns certain kinds of lendable stock or for a middleman who knows how to use the spread.

Securities lending is a kind of derivatives business in which one makes money by borrowing a security at one rate and lending it out at a higher rate. Indeed, a lender will offer the securities at a rebate rate, and then invest the collateral from the loan at a federal funds basis, which can be 10 basis points higher.

Mutual funds usually make 1 to 2 percent a year on their securities lending. However, for the biggest prime brokers it's tall cotton. Prime brokers and custodians are earning between 3.5 and 7 percent a year on their securities lending operations, estimates Vodia Group in a recent report.

In the report, Vodia says securities lending generates some $8 billion in prime brokerage revenues that come from their hedge fund clients.

The prime brokers' rates of securities profits might decline if securities lending became more electronic and information more widely disbursed.

A Rising Tide Lifts All

On the other hand, electronic trading advocates predict there would be a long-term benefit even to the prime brokers if the business modernizes. More inventory would suddenly become available. More transactions would take place. Prime brokers would have lower rates of profit on their securities lending business, but their volumes would rise.

More people would feel confident about using securities lending, according to this scenario. Therefore packaged selling would be less common. Some believe that this would mean that securities lending was coming out of the Dark Ages.


Will Lendex Work?

A Q&A with John Tabacco, Firm Founder

CQ&D: How will Lendex improve things for lenders and borrowers?

JT: Lendex will adda level of transparency that has never been seen before in securitieslending. For the first time, lenders will get real-time, dynamic, securities lending rebate data, accompanied bya refreshing dose ofwhat we thinkthey deserve most, respect. Borrowers will see vast improvementsin their ability to find previously untapped liquidity sources, and Lendex will provide borrowers the opportunity to bid up for more liquidity. The democratization of the securities lending allocation process has begun and borrowers and lenderswill be the direct beneficiaries.

CQ&D: Why have there have been so many complaints about poor pricing in securities lending?

JT: The lack of transparencyin markets always leads to inefficient pricing.It is difficult to secure the best price, or feel secure that you've been paid or charged the best price,when there is no publicly disseminated information relating to the actual market for any product.In securities lending, free markets have been impeded for years by an antiquated system of bundled services and commission- basedhard-to-borrow allocation models.

CQ&D: Some have charged that LocateStock has not been a successful product. How do you respond?

JT: I think that since 2005 when LocateStock introduced our first-to-market electronic securities lending solution, we have been misunderstood. The naysayers are either misinformed or have tried toimitate us andfailed miserably. I also have been accused of being confrontational, but what people don't understand is how hard it is to introduce products thatthe biggest financial institutions in the world think threaten their revenue models. IfI didn't take a confident stance from day one,we would have been eaten up and spit out already.It's difficult to be Mr. Nice Guy, as you bring what are perceived to be anti-establishment products to market. My resolution for 2008is to run a kinder, gentler

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