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September 17, 2008

In the Crosshairs: The stock loan market braces for change

By Nina Mehta

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Is a screen-based market in the securities lending industry's future? That sounds like crazy talk to some, but it is one of the ideas floating around the stock loan industry these days as broker-dealers nervously await new rule proposals coming out of the Securities and Exchange Commission. The regulator has promised to introduce regulations in the coming months to reduce certain short-selling behavior it considers harmful.

The Commission is under considerable pressure from Congress and the editorial pages of newspapers to do something about what many are calling abusive and manipulative short-selling. A proposal would follow the SEC's unprecedented Emergency Order this past summer. For 23 days starting on July 21, the SEC banned naked short-selling in 19 stocks, requiring traders to have in place bona fide agreements to borrow shares from their brokers before they could sell the stocks short. The SEC did this, it told the world, to prevent rumor-mongerers from trashing the stocks of Fannie Mae, Freddie Mac and another 17 financial companies.

What this means for large swaths of the $8 trillion stock loan industry, most likely, is a fistful of tighter requirements around parts of the trading and settlement process for short sales. That could transform the industry, temporarily at least, by crimping the revenues of prime brokers, the market's major intermediaries. It could also push the industry toward greater automation.

"The foundation of prime brokerage is lending money and lending securities to hedge fund clients," says Paul Busby, Americas head of securities lending at Deutsche Bank. "Any new rules could affect prime brokers." However, he adds, securities lending, a traditionally opaque bilateral market, should become more transparent to customers. The dissemination and availability of more pricing information, he says, is good for the market and should increase overall volume by injecting more efficiency into the industry.

Specifically, the SEC might do a number of things. In a move that would be considered drastic, the SEC could extend the Emergency "pre-borrow" to all stocks or impose it under certain market conditions. It could install tighter rules around the settlement process, or shrink the close-out provisions for broker-dealers whose customers fail to deliver securities for stocks they've sold short.

Bilateral Market

The securities lending industry is dominated by a tight, relationship-based network of lenders and borrowers. That "wholesale" market includes pension funds, mutual funds and other large buyside institutions that loan portions of their portfolios to prime brokers and broker-dealers. Brokers then lend securities needed for short sales to hedge funds and other clients.

The buyside institutions with the loan supply do their lending through behemoth custodian banks or third-party agent lenders. The brokers borrowing stock have bilateral relationships with the lending firms, buttressed by counterparty credit arrangements. All securities lending transactions are collateralized by cash or other securities, with the lending firm investing the collateral and paying a market-based rebate to the borrower. Loans are made on an overnight basis, with the rebate rate (which could be negative for hard-to-borrow names) reflecting the market price of the loan.

At the end of June, the global market of securities available for loan was $14 trillion, with $8 trillion in equities, according to Data Explorers, a London-based global data aggregation company focused on securities lending. This past June, there were $1.4 trillion of global equities on loan, with $586 billion of that in U.S. equities.