Securities lending plays an essential role in the modern capital markets by providing liquidity, which allows to reduce operational costs and to determine prices both in the growing and declining markets. Effectiveness increase achieved has a beneficial effect on the overall market – from securities dealers and investors to corporate issuers, whose activities depend on efficient, liquid markets enabling them to mobilize additional capital. Securities lending markets let their participants sell securities not owned by them with certainty that they can be borrowed for settlements. Besides, the securities can be used for financing in cash-driven transactions, thus being an important component of the money markets. Free securities lending and borrowing opportunities define a range of services, which dealers provide in this market segment to their clients, as well as a commercial strategy of dealers, hedge funds and other assets managers. Securities lending yields a considerable return to institutional investors, depositary banks and brokerage departments of investment banks. Some times ago due to fall down of prices for equities some observers have seen interconnection between securities lending and short sales that was frequently demonstrating their unawareness of the working mechanisms of these markets. And it is not surprising, because these markets comprise a complex system, including different intermediaries for several levels, corresponding trading terms and conditions and pricing. Total volume of these operations in the international market is more than ₤ 3 trillions per annum. For solving the abovementioned and other issues Great Britain has established a special Securities Lending Committee, which unites market participants, regulators and infrastructure providers. The Committee is headed by the representative of the Bank of England. The Committee’s partners are International Securities Lending Association (ISLA), London Stock Exchange, London Association of Investment Banks, British Banks Association, Association of Corporate Financial Directors, National Association of Pension funds and Association of British Insurers.
For investors who have a static portfolio, i.e. the securities are acquired for a long-term period, securities lending lets earn an additional income with minimum risks. Securities lending pattern is rather simple: an investor transfers securities to the borrower for relevant commission charges. Lender receives a right to use the preliminary approved collateral, while borrower receives a title for loaned securities. According to the agreement, signed by two parties lender reserves his right to the securities to be lent, including, the right to receive dividends. In case of borrower’s default the collateral is transferred to the lender. Acting as holders of financial assets of the clients, custodians play a central role in securities lending arrangements. Considering that securities lending is a complicated and tedious process, mediatory activities of the depositary can be very helpful. Investors independently decide which types of securities are to be lent. The securities can be joined by depositary into a single pool, that allows to reduce considerably a number of operations in the process of loan delivery and return and due to that to make credit resources be more attractive for borrowers. Lender, sometimes jointly with a custodian seeks to make a credit analyses and to assess risks in order to select an eligible borrower and sets credit limits per each borrower and overall limit per each type of securities that can be provided on loan. Alternatively, some custodians offer services and take all credit-related risks. If custodian acts as an agent (intermediate) between lender and custodian, or between lender and custodian, they sign an agreement to specify types of eligible collateral. As a rule, it can be cash means, government bonds, treasury notes, deposit certificates and bank letter of credit. Usually lender requires that the cost of the collateral would be 2-5% more than the cost of the borrowed securities so that it would enable him to cover costs caused by price fluctuation during loan term, as well as costs arisen from collateral sale in case of borrower’s default. As soon as the agreement is signed, the custodian should offer lender’s securities to potential borrowers, agree upon the price and maturity with counterparty and transfer the securities to the borrower in exchange for collateral. Collateral management is a key function of the custodian: collateral should meet the eligible criteria specified in the agreement and be a subject to mark-to-marketing to set a margin rate by the lender. Custodian should also ensure that the borrower would pay the lender the dividend on securities. The borrower should also pay the commission charges through custodian. For these services depositaries usually take a commission in the form of an interest rate of the income derived from securities lending operations.
Securities loan market (USA experience)
Securities lending is extensively used by American investment companies to provide an expansion on the global markets and as an integral part of schemes to close short positions. According to experts, total securities lending volume is $ 500 billion. With growth of proposals for such loans a loan rate usually is 0,12-0,15% per annum, in the meantime, considering the fact that currently major suppliers of securities are bank-custodians and standard level of yield on operations is about 0,05%, the cost of loans will continue further to be going down. One cannot but worth noting that securities lending market began growing very dynamically because of the fact that private pension funds in the USA were allowed that the securities being of their assets would be lent.
Attempts to organize the securities lending market on the Russian market have been taken since rather long, but so far this potentially prospecting market segment has not yet developed to the extent enough to meet a potential demand at least partly. It happens due to a number of reasons. One of them is that securities lending mechanism is not legitimized. In order to evaluate, how much important it is to use a legitimate mechanism of securities lending, suffice it to say that in the western markets brokerage community is divided into two camps - “buffalos” and “bears”. The first group makes its earning due to increase of market value of the securities, the second one – due to its decrease. Their interaction gives a secondary securities market in general such an enviable stability, which lacks in the Russian market. With minor exaggeration it is possible to say that securities lending is a main instrument of brokers, “speculating for a fall”. Here it is worth mentioning that a game for a fall in case of unprovoked market decline turns into a game of survival of that part of the market, in which such fall has not been foreseen and promptly used. It seems that consequences of financial crisis of August 1998 would have been not so sad for many participants of secondary securities market, provided they had a mechanism and possibility of receiving securities loans. Until now the Russian securities legislation doesn’t specify a legal relationship, the essence of which is loan relations that de facto at a moment are built on another legal basis and are some sort of combination of purchase-sale relations. As a rule, these deals are stipulated by Repo contracts, i.e. a purchase-sale contract, including a provision that obligates to buyback the securities on appropriate date and at a preliminary fixed price. The problem is to apply a legal model of the loan or a commercial credit to such asset as securities. Profit generating technology in the falling market is rather simple. Usually the securities borrowed or those purchased with an obligation of the owner to buy them back, and not sensitive to short-term fluctuations of the market demand or undependable of strategic investors will be sold immediately after their delivery. After some period of time, on date of execution of obligations under loan or on a buyback date, in order to meet the obligation an appropriate amount of securities to be returned is purchased at the price (optimistic variant) lower than the price of the sale and returned to the beneficiary-owner. The price gap is a profit of the market participant who has speculated for a fall. Since the operation is accounted for a short-term fluctuation of the value of the securities and after some time the purchase of the securities takes place, that creates preconditions for a market growth, then in ideal variant such operations produce no threaten to the market. However, if the same example were to be considered with a number of securities vs. a volume of market of a relevant security, or a group of securities of total value vs. daily volume of this market, then the consequences of such operation would be more dramatic. Nevertheless, there exist at least two constraining factors that make such big operations very risky for market participants, speculating for a fall, namely: they have to provide a collateral in the form of liquid assets (other securities or cash) or buyout an appropriate quantity of securities for loan settlement. A transaction of purchase in the market of a significant amount of securities is rather complicated, because in case of big purchase or in case the seller knows that the securities are purchased to meet an urgent obligation, their price can increase to the extent that it could be and should be more than the purchase price of securities. Purchase of small securities baskets can lead to undesirable growth of prices so that total price of the portfolio bought out would be more than that it had been sold out. In addition, it is not worth to forget that value of the collateral given to the lender rather has changed inconsiderably. So, as it implies from the above, there are natural regulators of the market, enabling one to rely on its stability. It would be logical to assume that the market of securities loans is a market of owners of securities holdings and small borrowers. Basing on that, it is necessary to develop standards that would regulate a model of relationships in the securities lending deals. It is clear that the standards should ensure that the risks of the lender and the borrower would be minimized as much as possible. Another, not less important problem, is a settlement policy of the Russian depositaries.
Latent securities lending forms and illegal use of securities by depositaries
“Transfer of securities by the client to depositary and conclusion of an agreement with the depositary doesn’t entail that the depositary receives a title for securities of the client. Depositary is not entitled to manage the securities of the client, as well as to exercise the securities-related rights of the client until otherwise is provided by written instruction of the client or his authorized person, as set forth in the depositary agreement”. This term stipulated by Provision on depositary activities in the Russian Federation, approved by Regulation ¹ 36 of the Federal Commission on securities market, as of 16th of October 1997, gives the client a protection against unsanctioned use of the securities owned. If, nevertheless, the depositary uses the securities accounted in holders registers for earning an additional income, then such actions would be qualified as unsustainable and be a subject to provisions stipulated by Article 107 of the Civil Code of RF, i.e. the securities and all incomes that have been or could be received by the depositary should be returned. In the meantime, any client also has the right to recall the securities from depositary. It is worth indicating that under Repo agreements the ownership right for securities is transferred to purchaser and such deals are regulated by Article 1102 of the Civil Code of RF, according to which the depositary should return the securities irrespective of the fact, whether it was inappropriate behaviour of the purchaser, the defaulting party, third party or it happened beyond their will. This provision regulates all cases of defaults and failures resulted from settlement, accounting and other operational procedures. Despite numerous attempts to implement in practice a segregation of securities of depositary’s customers from own assets of the company providing appropriate services and to avoid unsanctioned use of the assets (it especially concerns the depositaries who combine their primary activities with brokerage ones), an effective mechanism that would allow to eliminate this problem completely has not been developed yet. In turn, in case of possibility of using the securities of the deponent, for example, for closing short positions, the participants of stock market have no motivations for getting a securities loan. What is the use of paying money for loan, if it is possible to develop a depositary? For the purpose of preventing the cases of illegal or irrelevant use of securities one can presume to substitute a non-positive norm described in RF Provision on depositary activities ("4.12 Depositary should ensure that a client will receive a report on all operations with the securities held or the title for which is accounted in the depositary. Reports and other documentation should be submitted in regular periods set forth in the depositary agreement”) for an imperative one by setting a minimal time to furnish reports and determining procedure of submitting the relevant information and actions of regulators in case of discrepancies found out between depositary reports and holders registers. Meanwhile, main difficulty of controlling the securities use is due to lack of real verification of data of analytical and synthetic depositary accounts with data in the holders registers. Even the procedure practiced by the Bank of Russia in regard of bank depositaries, namely a passive verification of data of synthetic reports for the end of the period, added by real data provided by depositary is not enough to get desirable guarantees. In fact the matter is about closing of short positions and about a term of less than a month. Even though an acting central depositary is available, and moreover, if there is a broad network of registrators, costs related to effective controlling for use of customers assets can be so considerable that the required mechanism is likely to have not been developed for a while. Besides, a mechanism of distribution of responsibility so disliked by the Russian regulators is developed so that it enables to use securities without knowledge of top staff of the depositary that performs depositary and other types of activities. At least, such responsibility has never been a penal action (versus USA). The policy of the Bank of Russia, which insists on a separate department to be introduced in the depositary to provide settlement services, though partially personifies the responsibility, yet doesn’t determine, how it should be done by the legislator.
Risks arising from securities lending
Currently the securities lending is associated with the following types of risks:
- Non-return risk
- Risk related to non-exercising rights: voting right, right for dividends or
other incomes. Recognition of these lender’s rights legally proves to be rather
difficult, since it would lead to a number of unfavourable consequences or to a
conflict with normative acts, for example, non-voting equities would appear.
- Risk arisen from borrower’s default and price fluctuations. After receiving a
loan the borrower can disappear, securities price can increase and the given
collateral will be not enough to buyout appropriate amount of securities.
Nevertheless, those who received securities from defaulting borrower are fair
purchasers. Thus, in case of unavailability of normative acts on manipulation of
prices in the securities market, such scenario would be completely possible and
would essentially reduce the potential market volume.
- If securities, how it is being currently, are transferred to borrower
according to Repo agreement, then it is not improbable that the agreement would
be invalid, if the borrower’s actions caused damage to his shareholders or
founders in accordance with the order of regress of requirements towards
borrower or that the deal would be recognized fake due to the fact that its
conditions had been initially unprofitable for the borrower, because the
lender’s margin was accounted in the prices of sale of securities and their
buyback. Termination of the agreement by such reasons or any other situation,
connected with borrower’s desire to terminate the deal due to non-appearance of
circumstances, the borrower relied on when signing the agreement and in case of
no legal confirmation that the deal is legitimate can create a significant risk
for potential lender. As a rule, securities loan is used to receive revenue to
be based on the deference of securities prices, when they are falling down (midterm
loan) or to deliver securities under purchase-sale deal (short term loan).
Because of theses operations the borrower is exposed to commercial risks.
In addition, it is worth indicating other risks as follows:
- Risk arisen from prompt delivery of the loan, it is important for short-term
securities lending and can be if the workflow would be standardized.
- Risk arisen from demand of earlier fulfillment of obligation.
- Risk arisen from collateral loss.
- Risk arisen from settlement system due to lack of settlement standards. It is
important that borrower and lender would be duly legitimized.
Thus, thinking about volume of securities lenders’ market to be at least a
little bit essential one it arises a question about providing the rights of
those who would be able to deliver these securities, e.g. holders of big
holdings, which securities are not sensitive to short-term price fluctuation,
namely strategic investors, as well as a question about borrower’s legitimation.
As it implies from the aforesaid, removal of such obstacle as absence of
motivation for securities loan, is not enough to create a developed market. Its
development will be limited by risks, some of them, by the way could be
eliminated by relevant regulation.
Taxation on securities lending transactions
In addition to the above, there are also left unsolved the issues related to taxation of income/loss, derived from securities lending operations and related to them deals. Let’s review most typical examples from practice formed due to unavailability of relevant regulation of such operations. Difference of costs of securities under Repo deal proves to be automatically appeared not in favour of the borrower. The above situation not only gives ground to recognize that the deal is disputable, but it also followed by certain taxes to be paid by the borrower. The borrower can bear losses due to gap between high purchase price of securities and lower buyout price. If the borrower is a bank, then its negative balance under Repo deal is attributed to a prime cost, because it is a loss caused by negative difference between purchase and buyout securities prices according to Article 77 of Provision “On determination of taxation basis for payment of income tax by banks and other credit organizations” approved by RF Government Regulation ¹ 490 of the 16th of May 1994 and Article 26 of the Government Tax Service ¹ ÍÏ-6-01/362 of the 23rd of September 1994, followed by amendments and additions “On application of some articles of Provision “On determination of taxation basis for payment of income tax by banks and other credit organizations”, and prime cost of banking services is not a subject to taxation and doesn’t diminish a taxation base. If the borrower is an enterprise, then such loss is not a subject to taxation under Article 2. 4. of Regulation of the Government Tax Service of RF ¹37 "About procedure of calculation and payment of income tax by enterprises and organizations”. If the borrower is a non-resident, then such operation is a subject to income tax under legislation of the country of origin of the company. At the same time interest rate on loan should decrease the taxation basis. However, since lender’s income is comprised of securities sale-buyback prices difference, appropriate costs of the borrower are not attributed to the prime cost and thus do not diminish a taxation base. As it follows from the above, due to application of the purchase-sale model to relationship, which actually form a loan, efficiency of these operations lowers, whilst the risk of invalidity increases. Nevertheless, Russian participants turn out to be in unequal positions compared to foreigners, particularly, offshore companies. The latter have no profit up to the end of the operation, the deals that could be considered as a single complex transaction are not interrelated between themselves under the legislation in force and none of counterparties of foreign company is entitled during calculations to charge income tax, because without the above relationship the securities lending operations are done by the company-borrower at a loss. All the abovesaid confirms that solution of appropriate problems produced by development of the stock market presumes that it is needed to develop a systematic approach to the issues that somehow are beyond the frame of such problems.