Securities Lending and Borrowing: An Overview
Studies on the state of liquidity in Kenya, including a Services Volunteer Corps report on the same have recommended several measures to improve liquidity, volume and pace of trading within the Kenyan capital markets. Key among the recommendations has been the introduction of Securities Lending and Borrowing (SLB) as well as Short Selling. In line with this recommendation, the National Treasury published the Capital Markets (Securities Lending, Borrowing and Short Selling) Regulations, 2017 (“Regulations”) in November 2017,
The Regulations, define securities lending as the temporary transfer of securities from a lender to a borrower with the concurrent written agreement to return the securities either on demand or at a future date. Full legal title to the securities is transferred from the lender to the borrower so that the securities can be used entirely as the borrower desires, including selling them onward to others. As consideration for the lending, the borrower pays the lender a fee over the duration of the loan.
THE PARTIES TO AN SLB TRANSACTION
The International Securities Lending Association (ISLA) categorizes participants in an Securities Lending and Borrowing transaction into three broad groups. The first group comprises Lenders who supply securities into the market mainly from the portfolios of beneficial owners, such as pension & mutual funds and insurance companies since they hold large, relatively stable asset portfolios. Other common lenders include collective investment schemes, sovereign wealth funds and high net worth individual investors whose interest is to grow the value of their portfolios over the medium to long term. The second group comprises borrowers who identify trading opportunities that will more than make up for the lending fee costs. Borrowers are typically regulated firms such as investment banks, market makers, broker dealers, arbitragers, directional short sellers and players in the derivatives and Exchange Traded Funds markets. The last group comprises intermediaries/lending agents who undertake the securities lending activity on each of the parties’ behalves since securities lending is a secondary activity for many of the beneficial owners and underlying borrowers. The Regulations define a lending agent as a third party who is not a party to a securities lending agreement but who provides support services to securities lenders including the monitoring of loans, the negotiation of lending fees or rebate rates, and the management of collateral.
BENEFITS OF SECURITIES LENDING AND BORROWING
The key benefit of Securities Lending and Borrowing to the market is that it provides liquidity to the broader market, which has been wanting in the Kenyan market. Securities Lending and Borrowing also helps in supporting a number of trading strategies, timely settlement of transactions in the market and hence improvement of market efficiency.
According to ISLA, to the lenders, Securities Lending and Borrowing provides a low risk incremental income for long term investors, such as pension funds, collective investment schemes and insurance companies. These returns (both in the form of loan fee and any return from cash collateral reinvestment) help to reduce the costs of managing their investments & to provide pensions and long term savings to investors. On the other hand, Borrowers may want to own securities for a certain period for a variety of reasons, chief among them being covering a short position (this is the net investment position in a security in which the security has been borrowed and sold but not yet replaced). Borrowers are able to use the borrowed securities to settle an outright sale. Borrowers also use Securities Lending and Borrowing in enhancing settlement efficiency, having the securities to support a trading strategy, or in merely fulfilling a settlement obligation at the Securities Exchange.
RISKS AND OPPORTUNITIES
At the market level, financial experts warn that Securities Lending and Borrowing, if not strongly regulated, carry the risk of opening the danger of stock manipulation by investors keen to benefit from a price fall and aggressive speculation which was partly blamed for aggravating the 2008 global financial crisis. The Capital Markets Authority has however assured the market that the Regulations, which borrow from international best practice, will check this risk through, inter alia, the requirement of collateral to cover the lender’s exposure.
For market participants, J.P Morgan in a recent publication observe that the three primary risks in SLB are borrower /counterparty default risk, operational risk and cash collateral reinvestment risk. The main risk for a lender in SLB is the counterparty default. To mitigate the risk, Deloitte advises that the securities or cash held as collateral must be used to restore loaned securities to the portfolio. Borrowers of securities are exposed to similar risks as the lender and the main risk for them is default by the Lender in returning the borrower’s collateral. In such event, the borrower can exercise their rights under the lending agreement and can seize the borrowed securities to cover amounts due. As such, the risks can be prevented by parties.
In sum, securities lending has potential to offer a countless benefits not only to the broader market in Kenya but also to long term investors and firms that may want to participate in SLBs. The enactment of the Regulations and subsequent commitment by NSE to upgrade their systems to allow the Security Lending and Borrowing framework to work by the second quarter of 2018 are notable milestones towards introduction of this product into the market. A future article will include an exposition of mechanics of the Regulations and the Securities Lending and Borrowing transaction.
Article by: C.G Mbugua