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August 14, 2007

A Securities Lending Exchange?

Researcher Notes Securities Lending's Large Unrealized Potential

By Gregory Bresiger

Also in this article

Securities lending, a sometimes disorderly business with myriad standards, could have a formal exchange within five years, an industry researcher predicts. As far as transparency goes, the equity securities lending business now resembles the credit derivatives market of the 1990s or the Nasdaq prior to order-handling rules, according to a recent report by researcher Vodia Group. An exchange would help the equity securities lending market provide clearer pricing and also give the practice more credibility, the report says.

"The emergence of a viable exchange will push more asset holders into securities lending and will introduce more trading firms to the notion of securities lending as an asset class," says the report, "Securities Lending and Asset Holding: Tracking U.S. Equity Inventory Supply."


The U.S. equities securities lending market is now $717 billion, the report says. This means that stocks represent about 15 percent of the total assets on loan, with bonds and other securities making up the balance of what Vodia estimates is a $5 trillion market.

A clearinghouse or a brokerage might sponsor this exchange, which would have one central electronic trading platform, says Josh Galper, a principal of Vodia Group. "An exchange would create a more true market price for securities loans," Galper adds. So why hasn't it happened already?

A small securities lending player, who declined to be quoted by name, says "it is financially to the benefit of big dealers to delay an exchange as long as possible, because an opaque market will produce bigger margins for them."

Securities lending is a tough business. It is competitive and at times confusing. Prices, and even the nature of the business, can be confusing. For example, the securities lending market can be mixed up with short selling. Short selling often contains transactions involving an unknown number of naked or phantom shares.

By contrast, securities loans are at times used to cover failed positions. These loans can be passed from broker to broker, while a short sale is made by one firm or individual.

In a typical securities lending transaction, the agent lender or the custodian lends the security to a client, the prime broker. The prime broker lends it to a mutual fund or hedge fund, which is often engaging in some kind of hedging strategy.

Show Me the Collateral

At each step, the client must produce collateral, which is usually cash. Who holds these loaned securities? Pension plans, mutual funds, retail investors, hedge funds and the proprietary desks of broker-dealers. A securities lending exchange, if it ever happens, would provide a key advantage, advocates say. Securities lending now operates in ways that can confuse many would-be clients, who fear they are overpaying because inventory is limited and loan standards vary.

Indeed, EquiLend formed a consortorium to bring common standards to a business in which pricing and standards are often a mishmash (See Traders Magazine, June).

So the Vodia report says that securities lending today exists within a set of illiquid, over-the-counter marketplaces, each setting its own prices, enforcing its own rules and usually having too many or too few stocks.