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March 19, 2008

Out of the Dark Ages

By Gregory Bresiger

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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