Out of the Dark Ages
Upstart firms crusade for modernized securities lending
Clearing Quarterly and Directory, March 19, 2008
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.
"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.
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