Securities Lending Market Guide 2008

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SECURITIES LENDING MARKET GUIDE

£10 - UK, ROW $20 - Americas €15 - EMEA

SECURITIES LENDING

MARKET GUIDE

2008

SHOWCASING SECURITIES LENDING

INVESTOR SERVICES JOURNAL

2008 INVESTOR S ERVICES JOURNAL

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INTRODUCTION

SECURITIES LENDING

MARKET GUIDE 2008

Fast times It has been a year of great change for the securities lending market Welcome to the 2008 edition of ISJ’s annual Securities Lending Market Guide. It has been a busy year for securities lending and borrowing, and there has been no shortage of press coverage surrounding the market and its potential in the future. This guide aims to bring you up to speed with the latest market developments and act as a reference handbook to the particularities of this rapidly evolving business. Our special feature examines the last 12 months in the market and what we can expect from the next year in terms of progress. The impact of hedge funds and 130/30 funds is of particular interest, as they are the underlying cause of a large part of the growth that is happening in the securities lending market at the moment. Securities financing is the bridge between hedge funds, one of the main borrowers of stocks, and institutional investors such as insurance companies, mutual funds and pension funds, the dominant lenders of securities. Furthermore, if you believe the hype, the growth of traditional long only funds’ investment in 130/30 strategies could overtake the growth of hedge funds and become the largest single driver of securities lending over the next five years. The growth of the market is set to continue, according to reports by a number of financial services analyst firms. For example, Celent expects growth in the US securities lending market alone to increase at a rate of 5% per year. However, it has not been smooth sailing for the market over the last year, as industry practices sur-

rounding proxy voting’s relationship to securities lending and the potentially negative influence of hedge funds have gained notoriety in the press. Hedge funds in particular, have faced increased scrutiny for allegedly borrowing to buy votes. The International Corporate Governance Network (ICGN), whose members include some of the world’s largest pension funds, has publicly urged regulators to force funds to make detailed disclosures of sale and repurchase agreements. The ICGN has accordingly drawn up a code of best practice on stock lending in all jurisdictions and is campaigning for the authorities to support it. Dr Andrew Clearfield, member of the ICGN board of governors, spoke to ISJ about his perspective on the matter for our special feature. The Markets in Financial Instruments Directive (MiFID), due to be implemented on 1 November this year, could also mean more scrutiny of lending programmes. It could potentially result in loans being made based on price and best execution, rather than relationships, thus increasing the transparency of the market as a whole. With these opportunities and challenges in mind, we have gathered together the leading lights of the securities lending industry to provide you with a comprehensive insight into the market as it stands today. Virginie O’Shea Group Editor

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Foreword Pan Asia Securities Lending Association

Asian perspective The Pan Asia Securities Lending Association (PASLA) has witnessed a year of great change in the Asian markets, says Sunil Daswani

Securities borrowing and lending activity continues to expand in Asia and spans a range of levels of maturity, from Japan, which represents the second largest securities borrowing and lending market globally, through to Vietnam and Pakistan, in which it is still not permitted. Testament to the degree to which lending volumes have increased in Asia (ex Japan) is that five to seven years ago, securities borrowing and lending flows through Japan accounted for, on average, about 90% of participants' securities borrowing and lending activity throughout the region. As

Australia and Hong Kong have both seen lending flows expand dramatically over the last 12 months; and the South Korean market has grown rapidly during the five years in which securities borrowing and lending has been permitted. Several other markets have made big strides forwards during the last 12 months in setting in place an efficient regulatory and infrastructure framework to support securities borrowing and lending activity. The Philippines has made important advances in this area - and the Philippines Stock Exchange recently invited comment from

Japan was one of the first to establish a market in the region and this remains substantially the largest market in terms of transaction flow these flows in other markets have grown relative to Japan, this figure has now fallen to roughly 50%. To reflect this, a growing number of hedge funds have established offices in Asia - particularly in Hong Kong, Singapore and Australia - and leading global prime brokers have extended their presence in the region to support this activity. Three years ago, the hedge fund market in Asia represented approximately USD250 billion out of a total USD1 trillion hedge fund market globally. These ratios have remained broadly consistent during the subsequent period, with total hedge fund assets in Asia doubling to approximately USD500 billion, balanced against total global hedge fund assets of USD2 trillion. Looking at the development of Asia's securities borrowing and lending markets more closely, Japan was one of the first to establish a market in the region and this remains substantially the largest market in terms of transaction flow.

PASLA members on its proposed regulations on short selling, upon which it soft launched a securities borrowing and lending model in February of this year. Malaysia has set securities borrowing and lending arrangements in place and is progressively refining its operational procedures in close consultation with market participants. In India, the Securities and Exchange Board of India has put out discussion papers and it is hoped that it will bring proposed laws on short selling and securities borrowing and lending into line with international standards. PASLA has been working closely with regulators and with market participants in highlighting the benefits of an active securities borrowing and lending market that is compliant with international best practice. This can serve as an important route to international investment: foreign institutional investors may be willing to allocate a larger percentage of assets to more liquid markets that offer

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efficient price discovery mechanisms - and securities borrowing and lending facilities can be key to delivering this liquidity. To facilitate the extension of a seamless and transparent market, PASLA has been working with regulators and market participants to identify and address areas where a market's securities borrowing and lending procedures differ from international best practice. We recognise that these changes

Sunil Daswani is a director and the regional manager for Securities Lending, Asia, at Northern Trust Global Investments. His primary responsibility revolves around addressing and evaluating securities lending initiatives for lenders and borrowers where Northern Trust acts as an agent lender. Additionally he focuses on building the supply of Asian assets for Northern Trust global securities lending programme, ensuring that the

PASLA has been working closely with regulators and with market participants in highlighting the benefits of an active securities borrowing and lending market that is compliant with international best practice will not be achieved overnight - but our goal is to make securities borrowing and lending functions more streamlined and convenient for participants to use, thereby meeting the preconditions for lending volumes to increase. As a culture of securities borrowing and lending evolves in Asia, we note a tangible shift in levels of educational awareness on both sides of the relationship. In the past, lender clients would be asking us to explain why it would make sense to lend in a new market and to confirm that this would generate acceptable revenues to cover the risks involved. Now the tables have been reversed, with lenders asking why they cannot lend securities in certain markets - and to inquire when necessary regulatory amendments will be passed to make this possible.

due diligence is carried out when lending its clients assets in each jurisdiction. Daswani is responsible for maintaining updated market information and knowledge through relationships with regional contacts that may influence or shape the markets in which Northern Trust lend securities. He has 14 years of experience in the securities industry, of which the last five have been at Northern Trust. In May 2005, Daswani accepted the position of chairman for PASLA for one year. He was re-elected in 2006 and 2007. In this role he ensures that the fellow members are kept updated on key industry events, coordinating as an industry where necessary responses to various international regulatory bodies on topical issues, discussion papers and general market issues that feedback may be required or further clarification is sought.

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Foreword International Securities Lending Association

Broadening horizons Laurence Marshall of the International Securities Lending Association (ISLA) highlights the growth the association has seen over the last 12 months

Since the admission of borrowers to the association in 2004, membership has almost doubled and it will not be long before the numbers reach 100. It was becoming increasingly obvious that we could no longer rely solely on the goodwill of individuals, each with primary responsibility to their firms, to carry out the ever increasing workload. I am delighted therefore that the AGM unanimously approved the board's proposals to expand the association's activities to provide full time support to the membership. We have been very fortunate to recruit

controversy over the last year. Our operational group is producing a steady stream of best practice papers, covering all aspects of the back office. In response to members’ demands, we have created a New Markets group to help open up new markets and work with local exchanges and regulators to establish best practice from the outset. We will also be establishing closer contact and dialogue with the regulators in established markets, as well as the European Commission and CESR. I would encourage all firms who are involved in the

Our new constitution will allow us to take a much more proactive role in representing our industry, not only in Europe and the Middle East, but globally David Rule from the Bank of England as our first chief executive officer. His first priority will be to recruit support staff and secure office premises in the City. We expect the new infrastructure to be in place by autumn. Our new constitution will allow us to take a much more proactive role in representing our industry, not only in Europe and the Middle East, but globally. Our major initiatives to date have included creating a new class of membership, associates, to cater for those who support our industry, for example lawyers, accountants and software houses. I am pleased therefore to report that we are receiving a steady flow of applications. We are working more closely with our equivalents in Asia (PASLA) and the United States (RMA) and we are conducting a review of the market standard legal agreement (the GMSLA). We will continue to rely heavily on our specialist sub-groups for which the contribution of time and expertise by our members remains invaluable. Our regulatory group has been spending a considerable amount of time focusing on the large number of new directives, which will culminate with the implementation of MiFID in November. Our governance group is determined to achieve a universally accepted code of practice for voting, a topic which has produced much

industry to join ISLA, whether as full members or associates. Full details of our aims and objectives, as well as application forms, can be found at www.isla.co.uk.

Laurence Marshall is a managing director in Prime Brokerage Services with UBS Investment Bank, London. He joined UBS in 1993 where he established and managed the Securities Borrowing and Lending desk. Marshall’s current area of responsibility is the management of the international supply business, and is responsible for managing client relationships. He has represented UBS on various industry bodies and is currently chairman of the European Equilend Board. Marshall was appointed ISLA chairman in May 2007. The views and opinions expressed in this material are those of the author and are not those of UBS AG, its subsidiaries or affiliate companies. Accordingly, UBS does not accept any liability over the content of this material or any claims, losses or damages arising from the use or reliance of all or any part thereof.

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Foreword Risk Management Association

Right here, right now There seems no better place to be right now than the securities lending industry, says William Tredick McIntire of the Risk Management Association (RMA)

From a volume perspective, in the first half of this year, we’ve seen broad based growth in on-loan balances, with some lenders’ balances up more than 40% versus the year earlier period. I think this reflects continued growth in demand from hedge funds as well as 130/30 and other alternative investment structures. Some industry watchers speculate that 130/30 could grow to be a USD1 trillion asset class over the next five years, from its current USD60-70 billion. That may be a bit optimistic; however, there is no doubt that this is an area that will experience significant growth. Away from the equity markets, some short demand for corporate bonds previously covered through a traditional securities lending structure is now being satisfied through the use of credit default swaps. In addition, we continue to see the use of equity swap structures in markets that have not yet developed a traditional stock loan structure. There is also a growing list of new markets in which the borrowing and lending of stocks is beginning to take hold. We’ve seen interest in Taiwan, Malaysia, the Czech Republic, Hungary, Turkey, Greece and Israel, all at different stages of development. I believe we’ll see revenue growth in these markets, where the spreads are wider and where hedge funds are looking for exposure. We’re also seeing a contraction in the development cycle for these markets, as countries work diligently and quickly to put in place the necessary tax, legal and regulatory frameworks for securities lending. Another important theme in the lending markets has been the ongoing move toward greater transparency, although certain market participants have not embraced products such as Lending Pit and Performance Explorer. These products have improved the price discovery process and provided objective benchmarking information to beneficial owners. In addition, with the implementation of the Agency Lending Disclosure initiative, borrowers’ credit departments have gained daily visibility into their balance with lenders. The application of technology also continues to play a role in the development of the securities finance market. With continued margin compression, industry participants are looking to apply technology to streamline processes. Applications such as auto-

borrow, EquiLend Dividend Compare and ARMS are tools that allow participants to increase volumes and reduce spreads. The industry is not without its challenges, however. I believe one of the major challenges we face is the ongoing discussion surrounding corporate governance, proxy voting and securities lending. RMA, the International Securities Lending Association (ISLA) and the Securities Industry and Financial Markets Association (SIFMA) have been vocal in responding to misinformation in the press and taking steps to set the record straight. A number of industry representatives have spoken at RMA conferences and have directly engaged those who have criticised the industry. I believe the RMA Committee on Securities Lending has done an excellent job of disseminating information about existing regulations and safeguards that protect securities lending clients. However, there is still more that needs to be done and we are pursuing several agenda items. For one, RMA and SIFMA are providing seed money for a planned academic study of ASTEC Consulting lending data. We hope the results of this study will serve to substantiate our contention that securities lending has had no discernible impact on the outcome of important proxy vote situations. In addition to the proxy voting and corporate governance issue, the committee is also tackling some other issues affecting the securities lending industry. Among other initiatives planned is a salary survey for member organisations, which we believe will be particularly useful as a benchmarking tool. We are also in the very early planning stages of a Latin American lending conference to be jointly sponsored with SIFMA. We’re excited about the prospects for this conference, as we believe there are many beneficial owners in these markets who may be interested in learning more about lending.

William Tredick McIntire is president, Boston Global Advisors, and chairman of the RMA Committee on Securities Lending. He oversees the agent securities lending business of Goldman Sachs in the US and Europe. He joined the business in 1998, after spending the previous two years as chief financial officer of the Equities Division of Goldman Sachs.

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Contents

1

Introduction

Securities Lending Market Guide 2008

2

PASLA Foreword

The Asian perspective

4

ISLA Foreword

Broadening horizons

6

RMA Foreword

Right here, right now

10 Main Attraction

Securities lending in the limelight

16 Statistics

RMA data dissected

20 Panel Debate

A panel of industry experts debate the issues

28 Ask the experts

Practitioner perspectives

34 JPMorgan

Now and the future

36 eSecLending

An investment decision

38 SGSS

If the shoe fits…

40 BBH

MiFID and the market

42 RBC Dexia

A new era beckons

44 COMIT

Deep impact

46 Technology Panel

How has the securities lending market been affected by the advances in technology?

50 Guide

A guide to the sec. lending of the market

66 FAQs

Your questions answered

68 Fintuition

Learning about securities lending

70 A-Z

Those key terms in full

72 Profiles

The details of securities lending service providers

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YEAR IN REVIEW

Main Attraction

Securities lending is no longer loitering in the back office, spurred on by an active hedge fund community, it has now stepped into the custodial limelight. Virginie O’Shea reflects on the last 12 months in the market It has been another year of flux for the securities lending market. Increased activity by hedge funds and the search for alpha by the more traditional players in the market has caused securities lending volumes to rise at a significant rate. The high level of mergers and acquisitions has also acted as a catalyst to this growth. When there is a lot of M&A activity, there is generally a high level of borrowing for arbitrage going on behind the scenes. Since the end of 2003, the value of securities available for loan in the global market has grown at an estimated compound annual rate

of 15-20% to USD13.2 trillion. This year’s figures by Data Explorers indicate that the value on loan in the spring was USD3.5 million. Analyst firm Aite Group has estimated that the global lendable asset market is USD16 trillion and the actual lending market is nearly USD4 trillion. On an institutional level, the California Public Employees’ Retirement System (Calpers), for example, indicated that it made USD150 million from securities lending for the year ended 31 March 2007, an increase of 16%, from the year before. Moreover, according to figures by rival analyst firm Celent, the market as a whole is expected to increase annually at a rate of 5% in the US and 10% in Europe over the next two years. Good news, it seems, for all those involved in the market. Rob Coxon, head of International Securities Lending at ABN AMRO Mellon Global Securities Services, adds: “The bottom line is the business has become much more commoditised, there is spread compression but a lot more volume is being done.” Coxon believes that demand for exclusive supply shows no sign of slowing down, although borrowers are being selective in how they bid. Emerging market

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lending is on increase, he adds, with the demand for assets in esoteric markets –such as Russia and India – growing. There is also an increased appetite by traditional long side investors for short exposure, as demonstrated by the deployment of 130/30 strategies and short extension funds. Andy Clayton, head of securities lending for Europe Middle East, Africa and Asia Pacific, Northern Trust Global Investment, has also witnessed an increase in new market activity. “There is huge interest from clients who now

the pursuit of more complex investment strategies, have increased the demand for securities lending. Hedge funds and their appetite for securities driven through their prime brokers represent the biggest single source of demand in the market, says Coxon. This has been positive for the growth of securities lending, but the secrecy surrounding the activities of these firms has led to some observers questioning their motivations. “They are perceived to be driven by short term opportunism, and this has been particularly evi-

The hedge funds’ active trading styles have increased the demand for securities lending have more exposure to emerging market mandates and from borrowers who see more hedge fund activity in these markets. Also, active extension is the new buzzword in the industry as long/short strategies take hold, this has led to all players analysing how they can leverage this trend to best effect.” There has been some very successful liaison with market infrastructure providers and regulators in Asia in respect of opening markets for securities lending, says Clayton. He expects that the market will see the benefits of this period of consultation over the next few months. Also, he adds, the industry associations have led the way with discussions with regulators regarding forthcoming regulatory changes such as Basel II and MiFID. “At this moment, it looks like the industry will reach a position where it can successfully work within the new regulations without incurring huge additional cost to support wholesale changes to practice,” he says. Despite the recent decision by some investment banks to impose tougher lending terms on hedge funds, their investment strategies are continuing to drive forward the growth of securities lending. The decision to raise margin requirements is a response to rising credit concerns about the impact of the funds on the wider financial market. Prime brokerage departments at several investment banks are thus attempting to insure themselves against the possibility of new hedge fund collapses in the vein of the Bear Stearns’ funds last month. However, regardless of these restrictions, the hedge funds’ active trading styles, including the use of shorting and

dent in the sphere of corporate governance,” he adds. Although there has been a lot of growth, there has also been a number of firms that have decided to exit the securities lending market. Andrew Clearfield, president, Investment Initiatives and chairman of the International Corporate Governance Network (ICGN) Securities Lending Committee, explains: “It seems like the market is expanding strongly; my impression is that it has continued to grow. There have been a few major exceptions to that in that there have been a couple of public pension funds in the last 12 months, most notably Ontario Teachers’, that have decided that lending wasn’t worth it because they were having such problems recalling in order to vote. They decided that as a result of this, that the income they were getting from the lending wasn’t worth it. It was announced loudly and publicly all over Canada.” Clearfield continues: “I have had conversations with some consultants and fund managers in the industry that have said that unless investors get a larger cut of lending, they will exit the market. The brokers currently get the lion’s share of the fees and the custodians and intermediaries get another significant share, although it is much smaller than that of the brokers. The share that goes to the funds is so laughable that it is hardly worth it for what they get. They are essentially selling their votes for a few basis points.” It is not just the hedge funds that are proving to be influential in this area. A large number of traditional fund managers are engaged in devel-

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YEAR IN REVIEW oping absolute return strategies that require them to go short and this is having a significant impact on the growth of the securities lending market. The recent popularity of 130/30 funds, which effectively involve borrowing for short selling purposes, is testament to this trend. As part of a 130/30 fund strategy, fund managers run short positions but remain 100% net invested by being 130% long of the over-performing stocks and 30% short of the underperforming stocks. These funds need stock loan accounts to receive the proceeds of the short sales and then augment the long positions without the need to borrow cash. In order to go short, these market participants must borrow securities. The 130/30 funds are seen as an attractive alternative to going long only as you are no longer so tied to the ups and downs of the market and they thus provide the ability to more consistently beat the market. In fact, the funds are so popular at the moment that market commentators have speculated that their growth may supersede the growth in hedge funds over the next few years. This could, in turn, become one of the largest drivers of securities lending over the next five to 10 years. There is a slight difference between the American and European model of borrowing for 130/30 funds. The US model involves borrowing and shorting in order to execute leverage, whereas in Europe, the leverage is obtained through derivatives. This divergence in practice has come about due to the fact that European regulators do not support the shorting of physical securities to obtain leverage. Despite the discrepancy

between the markets, both are experiencing a high level of growth in securities lending. Denise Valentine, senior analyst at rival analyst firm Aite Group, explains: “The US market is a very mature market with a vast inventory of securities, and is growing at about 5%. However the European market is growing at double this rate.” The 130/30 funds are not just driving forward the growth of the securities lending market; they are also altering the participants’ service requirements. Fund managers that invest in these funds require fully integrated securities lending, borrowing and collateral management, as well as the execution services to affect the initial short sale and subsequent buy back. Servicing therefore goes way beyond custody and fund accounting. This requirement for execution services can prove an onerous task for those engaged in providing securities lending and custodian banks are accordingly obliged to invest in systems to further integrate their processes. Valentine highlights the recent trends that she believes have influenced the securities lending market: “The last 12 months have been about increased participation on electronic platforms to some degree, the increasing use of securities lending as the capital markets continue to globalise, and, finally, hedge funds and large institutional money managers engaging in short selling. In the case of the latter, 130/30 funds, which short securities, have been increasing significantly as traditional money managers seek higher investment returns and compete with hedge funds for institutional money.” Rather than a purely operational activity, securities lending is now considered to be an investment management discipline in its own right. Furthermore, rather than automatically opting to pass the activity to an institution’s custodian, these traditionally dominant players are having to compete for business with third party lenders and electronic auction platforms. Institutions are also increasingly using multiple providers across different parts of their asset base, as beneficial owners have unbundled the securities lending function from the custody business. Valentine adds: “There’s no shortage of participants, including principal owners, custodian banks, third party agents, broker-dealers, prime brokers, investment banks, and hedge funds. Big banks use securities lending for market making, hedge funds often short the security for a strategy play. Owners and lenders participate for profits on the loan.”

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In the rush to gain market share, borrowers have sought alternative sources of supply, lenders have developed new routes to market and exchanges and brokers have developed electronic trading platforms. These trends have put downward pressure on pricing and have forced custodians to seriously rethink their business models. The rise of short selling has also raised the profile of issues around fee transparency. The fee paid by investors to borrow shares they want to sell short has been notoriously difficult to forecast. Borrow supply is a key determinant to the level of fee paid but the exact calculation is more often than not opaque. Fees for a 130/30 strategy

the borrower side of the business, as hedge funds demand more information on where their true borrowing costs reside,” he explains. Northern Trust’s Clayton agrees: “Transparency will not go away so we need to get used to living in the new environment. Market participants will develop their game to play better under the new rules and increased competition will result. It is critical that people considering the data create a level playing field though – with more information available there is increased responsibility on the users to ensure they know what they are doing with the data otherwise they may make erroneous assumptions and decisions.”

The 130/30 funds are not just driving forward the growth of the securities lending market; they are also altering the participants’ service requirements are higher than long only mandate fees in part because the manager must go to a prime broker to borrow securities to short. Hedge funds may be naturally more lenient with regards to transparency, but the traditional asset managers now engaged in 130/30 funds are likely to demand increased fee transparency, which will then put pressure on managers to reduce their fees. Valentine explains: “Improving transparency has been one of the drivers of changes in recent months and that is an ongoing process. Given the level of entrenched interests in this market, it will not be an easy process to continue to build on some of the automation and transparency initiatives.” ABN AMRO Mellon’s Coxon adds: “Accountability and automation are big themes – there is much greater transparency today due to the rise of industry consultants and independent benchmarking services like Astec and Data Explorers. The market has traditionally been fairly opaque, with a strong emphasis on relationships. While this still holds true, it is also the case that price and efficiency are becoming determining factors on where business is transacted.” Transparency brings challenges, as beneficial owners today are much more engaged and the degree of scrutiny has increased significantly, and that additional scrutiny leads to greater competition, adds Coxon. “Only those firms that run accountable programmes can hope to survive in the new environment. The same holds true on

Transparency has obviously had a direct impact on technology spend, as has the increasing complexity of customer requirements. Firms have to spend more on their systems in order to keep up with demand. The focus of securities lending technology has shifted from the back office to the front office, says Valentine. “Technology has advanced with electronic platforms. By 2008, about 15-18% of securities lending will be done over an electronic platform. Examples of trading platforms include EquiLend, eSecLending and SecFinex. Bloomberg instant messaging continues to be a key method of communication for securities lending, and certainly old manual methods of phone and fax are well entrenched, at least for initial order placement,” she elaborates. Overall, Valentine believes that the market is fragmented in its use of technology: “General collateral and highly liquid security securities lending is as old as the hills and these types of securities lending are well suited for automation. This has prompted more technology firms to enter the market, around 2000. Specials, or hard to borrow securities lending, are complex: they’re more profitable and still negotiated by phone.” The influence of technology has largely been negative, says ICGN’s Clearfield. For example, commingled accounts from the point of the view of the custodian save a lot of money, but they have made it difficult to track any kind of accountability with respect to individual positions. “It is hard to tell if you have had a problem

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YEAR IN REVIEW

with over-voting if you don’t know whose shares went where – which shares in an omnibus account were actually lent out. That is a practice that I predict is going to have to end. Technology can have a strongly positive effect of course, but so far, it hasn’t been used that way; instead it’s all been about lowering costs and getting more paper out there,” he adds. Coxon is much more positive about the impact of technology on the market: “Auctions, and by extension auction platforms, have certainly enjoyed a high profile recently. The emergence of players such as eSecLending has created more competition, particularly in respect of agency lending. That has shaken any complacency there may have been out of the industry. Certainly it is a great time to be a beneficial owner – there is a good choice of suppliers, they enjoy pricing leverage and also have more options in terms of selecting the most appropri-

Securities lending and its impact on proxy voting policies and practices has long been the concern of the corporate governance industry, since, potentially, market participants can acquire voting rights in a company without an accompanying financial stake. This separation of economic from voting interest in a company bends one of the basic assumptions behind the one share, one vote principle, and places investors who retain the economic interest in a challenging position. However, it seems that share lending has become a lucrative practice for many institutions. This year’s International Securities Lending Association (ISLA) and Pan Asia Securities Lending Association (PASLA) annual conferences both covered the subject of proxy voting and share lending. Speakers stressed that recent press coverage about the practice of hedge funds obtaining more votes than their

Auction platforms have enjoyed a high profile recently ate route to market for any given portfolio. It is critical in this environment that agent lenders be able to offer a flexible platform that can offer a variety of entry points that reflect the multifaceted nature of securities lending.” Clayton believes that because the whole market has seen a big increase in volumes over the last 12 months, it is important that all participants embrace technological solutions to insulate themselves from the impact of this increase. SecFinex, EquiLend, ICap and Eurex are all illustrative of the demand in the market to capitalise on inherent operational weakness and service a growing need to automate and drive down costs as volume explodes, Coxon continues. However, with the exception of Equilend, all of these platforms have enjoyed either limited success or remain in their infancy, he adds. Regulation and industry best practices (or rather the lack of either) have also been important discussion topics in the securities lending industry over the last 12 months. The issue of securities lending and proxy voting has recently garnered headlines, most notably the Securities and Exchange Commission (SEC) has indicated an interest in the area and suggested further research be carried out.

holdings in order to influence voting was vastly exaggerated. Earlier in the year and in response to such an article in the Wall Street Journal, ISLA issued a statement that declared: “Securities are rarely borrowed for the purpose of influencing votes, and the cases in which borrowed shares can be shown to have influenced a shareholder vote are rarer still.” In the UK, borrowing shares solely for the purpose of voting is contrary to the Securities Lending and Borrowing Code of Guidance, which was drawn up by ISLA to highlight good practices for lenders and their agents. The securities lending contract has been designed to allow lenders to continue to exercise their voting rights if they wish by giving them the right to recall equivalent securities from the borrower at any time, says ISLA. Conversely, ICGN’s Clearfield feels that the issue of vote selling is something that should be dealt with immediately. One of the issues that the ICGN is focusing on is making trustees aware of the fact that they are selling their votes cheaply, he explains. “The point of the 2005 code is insisting that trustees have guidelines down to make it clear to all their beneficiaries that they are sacrificing voting under certain circumstances, and what those circumstances are,

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as well as when they will not sacrifice their votes for this reason,” he says. “This is an ongoing engagement and we are also talking to the issuers, who are also very concerned about the discrepancies in voting (usually manifested by over-votes) and the fact that a few funds have visibly shown up with empty votes and tried to influence meetings. This is enough of a problem for these issuers to get concerned. I am told that it has also come to the attention of the SEC. I know that it is a concern of the World Federation of Exchanges,

greater in Europe due to the complexity of the collateral that lenders exchange, the higher number of disclosed lending programmes and the decentralised infrastructure. ISLA has formed a working group to tackle the issue of agent lending disclosure with the long term objective of Europe achieving a level of disclosure comparable to the US. The association’s proposals for disclosure include the monthly provision of details regarding the underlying counterparty, loaned securities and collateral. ISLA has indicated that it will be

We will see increased focus on the use of regulatory capital over the next few months as well as of the European Commission. They are all looking at the copies of our code and, in particular, two aspects that call upon issuers to separate the record dates for voting from the record dates for entitlement to dividends, essentially eliminating the tax arbitrage, and also to make sure that the agenda is made known before any kind of deadline for recall. These are two things that issuers can do themselves that will possibly reduce the amount of shares out on loan before a crucial vote,” he elaborates. Regardless of which party is right, the fact of the matter is that the profile of the issue has been sufficiently raised for the regulators to take notice. The UK Financial Services Authority and the regulator in Hong Kong have indicated that they are looking into issues regarding disclosure and SEC chairman Christopher Cox has ordered an internal study on the practices surrounding proxy voting in the US. Moreover, according to a global survey on securities lending by Institutional Shareholder Services (ISS) earlier this year, most institutions do not have explicit policies on securities lending relative to proxy voting, leaving them wide open for the regulatory community to suggest appropriate legislative action. Agent lender disclosure has also been a focus for regulators over the last year. In the US this has been driven directly by requirements issued by the SEC and the New York Stock Exchange (NYSE), whereas in Europe, the driver has been the agency lending disclosure specifications under Basel II. The scale of the problem is far

working with the industry over the next year to further develop best practices in this area. Regulation in general has been an issue for the market over the last year. Clayton says: “I think regulation is having more of an impact across all of our businesses and securities lending is no exception. All elements of securities lending have been affected, whether it be increased levels of information concerning our business to allow counterparties to make the right risk decisions, or ensuring that we have comprehensive policies and procedures to prove best execution. Finally, all businesses should treat customers consistently, but the new Treating Customers Fairly directive has required a full examination of the business.” The focus on regulation is also likely to continue for the next 12 months at least, Clayton adds. “I think we will see increased focus on the use of regulatory capital over the next few months as the impact of Basel II will ensure that participants pick the right products for the use of their capital. The counterparties that are used, indemnification required and the collateral provided will all come under the microscope in the next few months,” he explains. Despite these compliance concerns, the future of securities lending remains rosy. However, the key to maintaining and growing demand is to be flexible in your business and listen to what clients and borrowers want and communicate well with both, says Clayton. “This should ensure that you can continue to match supply to demand by developing complimentary capabilities,” he concludes. SLMG

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S TATISTICS

Data Dissected ISJ examines the RMA’s securities lending market data for 2007 The Risk Management Association’s securities lending data covers the first quarter of 2007. Survey data is presented for primary lending markets worldwide, with cash collateral reinvestment data aggregated to reflect reinvestment return, interest rate sensitivity, liquidity,

credit tiering and instrument types for both US dollar and euro currency collateral. The data has been collected by the RMA frominstitutions including AIG, Barclays Global Investors, Brown Brothers Harriman and JPMorgan.

Instrument types on loan in the first quarter 2007 As we can see from the chart, floating rate instruments represented the largest percentage of instrument types on loan in the first quarter of 2007. This is closely followed by fixed rate asset backed securities and corporate collateral at investment grade A or higher. Also popular are US Treasuries repo agreements, although these have declined since last year’s survey. Floating rate asset backed securities have also declined to some extent.

According to RMA figures, the total amount of assets on loan has increased significantly over the last six years. Moreover, the spread of instruments available for borrowing and lending indicates that the market is mature and stable. All asset backed paper is included in the Asset Backed Securities category and Other Vehicles includes all other instruments that could not be categorised.

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RISK MANAGEMENT ASSOCIATION SECURITIES LENDING COMPOSITE - Averages for the period of Quarter 1 2007 Below is a table showing a year on year snapshot of the industry worldwide. Lendable assets refer to the value of loanable securities. On loan versus cash collateral refers to the value of securities on loan in return for cash. On loan versus non-cash collateral refers to the value of securities on loan in return for non-cash collateral. US dollar $

LENDABLE ASSET ($m)

ON LOAN vs CASH COLLATERAL ($m)

ON LOAN vs NON-CASH COLLATERAL ($m)

TOTAL ON LOAN ($m)

TOTAL ON LOAN (%)

North American Treasuries/Bonds US Treasuries/UST Strips US Agencies US Mortgage Backed Securities US Corporate Bonds Canadian Bonds (Gov't & Corporates)

$1,753,274 $471,880 $202,088 $212,175 $844,225 $22,906

$548,952 $340,178 $82,009 $48,884 $74,714 $3,167

$65,178 $56,777 $6,726 $412 $922 $341

$614,130 $396,955 $88,735 $49,296 $75,636 $3,508

35% 84% 44% 23% 9% 15%

North American Equities US Equities (includes ADR’s) Canadian Equities

$3,613,708 $3,558,676 $55,032

$314,011 $309,364 $4,647

$12,826 $10,981 $1,845

$326,837 $320,345 $6,492

9% 9% 12%

European Equities French Equities German Equities Italian Equities UK Equities Scandinavian Equities All Other European Equities

$1,274,195 $186,949 $158,512 $72,794 $427,543 $108,280 $320,117

$88,106 $30,132 $13,672 $9,120 $3,354 $10,974 $20,854

$39,401 $5,480 $4,678 $2,841 $11,816 $4,673 $9,913

$127,507 $35,612 $18,350 $11,961 $15,170 $15,647 $30,767

10% 19% 12% 16% 4% 14% 10%

$616,818 $353,467 $60,881 $113,914 $88,556

$44,093 $20,416 $6,398 $14,305 $2,974

$19,269 $10,734 $1,599 $4,874 $2,062

$63,362 $31,150 $7,997 $19,179 $5,036

10% 9% 13% 17% 6%

$57,068 $5,561,789

$4,115 $450,325

$273 $71,769

$4,388 $522,094

8% 9%

$222,667 $51,958 $79,984 $39,924 $11,628 $39,173

$14,689 $4,328 $6,301 $1,563 $791 $1,706

$25,734 $6,309 $10,995 $6,928 $577 $925

$40,423 $10,637 $17,296 $8,491 $1,368 $2,631

18% 20% 22% 21% 12% 7%

UK Gilts Emerging Market Eurobonds** Eurobonds All Other Sovereign Bonds † Total Bonds (Aggregate Total, incl US)

$145,667 $38,198 $281,105 $89,577 $2,530,488

$8,946 $8,441 $24,352 $5,515 $610,895

$41,719 $5,878 $4,096 $81 $142,686

$50,665 $14,319 $28,448 $5,596 $753,581

35% 37% 10% 6% 30%

TOTALS

$8,092,277

$1,061,220

$214,455

$1,275,675

16%

Pacific Rim Equities (Includes Australia) Japanese Equities Hong Kong Equities Australia All Other Pac-Rim Equities All Other Equities (Not Previously Listed) Total Equities (Aggregate Total) Euro Denominated Sovereign Bonds French Sovereign Bonds German Sovereign Bonds Italian Sovereign Bonds Spanish Sovereign Bonds All Other Euro Denominated Sovereign Bonds

Average Number of Lending Markets

The Survey reflects data provided by the following institutions: AIG Global Investment Corp Barclays Global Investors Boston Global Advisors Brown Brothers Harriman & Co.

19

*(Reported in Aggregate) **(Latin America & E Europe) †(Not Listed Above)

Citibank Frost National Bank Investors Bank & Trust Company JP Morgan Chase & Co. M & I Global Securities Lending Mellon Financial Corp. MetLife Insurance Company

The Northern Trust Company PFPC Trust Company US Bank Union Bank of California The Vanguard Group, Inc. Wells Fargo Institutional Investments Wachovia Global Securities Lending

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Securities Lending PANEL DEBATE

THE SECURITIES LENDING

PANEL DEBATE Guy d’Albrand had been global head of liquidity management at Société Générale since the autumn of 2004. He began his career as a futures broker and then spent several years as an auditor at Société Générale He joined Fimat to run the Tokyo office and was then appointed executive vice president of Société Générale Securities, North Pacific. He then headed up the online brokerage operations in Japan. In 2002, d’Albrand moved back to Société Générale’s head office to become global head of audit for the Corporate and Investment Banking Division of the bank.

Mark Fieldhouse serves as head, Technical Sales, Americas at RBC Dexia. His team is responsible for overall growth and development of the Global Products client base, as well as the product level management of its strategic clients in North America. Global products include securities lending, foreign exchange, cash management and portfolio management services. Fieldhouse brings to his role 12 years experience in the Global Products environment. Prior to heading up Technical Sales for the Americas, Fieldhouse served as director, Technical Sales, Securities Lending. He has previously held a number of progressive positions within the securities lending business, with a focus on client management and business development. Paul Wilson is senior vice president and global head of Sales and Client Management for Securities Lending and Execution Products (SLEP) for JPMorgan Worldwide Securities Services (WSS). He is based in London. Wilson is responsible for new business development and initiation as well as client management across the entire SLEP product range, which includes securities lending, foreign exchange, transition management, futures and options clearing and commission recapture within JPMorgan WSS. Additionally, Wilson is the SLEP regional business executive for the Europe, Middle East and Africa region. He joined Chase in 1984 and has carried out a number of roles within JPMorgan WSS including product development, client services and operations.

Elizabeth Seidel is senior vice president, co-manager of Brown Brothers Harriman Global Securities Lending. Seidel joined BBH in 1999 and was recently appointed department co-manager for Global Securities Lending. In her new role, Seidel has management responsibility for Relationship Management, Risk Management, Sales, and Marketing groups. Seidel has over 15 years experience in the industry, 11 of which involve securities lending. Prior to joining BBH, she worked at Boston Global Advisors and was in charge of Client Service and at State Street Bank in their Securities Lending Division in both Trading and Operations.

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What are the main issues affecting the securities lending market this year? d’Albrand: Supported by a strong overall global economy and high investor confidence, the securities lending market continues to thrive, as it demonstrates an increase in liquidity and market efficiency. As the practice gets more popular among beneficial owners, their demands are on the rise and they expect higher performance and instantaneous churning out of detailed reporting. Although considered generally low risk transactions, a key issue has been

parency. Wilson: New sources of supply continue to come into the market via investors making their securities available for lending for the first time. While this is positive, it does tend to put downward pressure on fees in conjunction with the ever increasing competitiveness of the market. As a separate matter, there is continued debate and discussion regarding corporate governance and the impact of securities lending. Best practice remains where lenders and investors view each event and determine whether to keep securities on loan and benefit from the fee or to

Supported by a strong overall global economy and high investor confidence, the lending market continues to thrive, as it demonstrates an increase in liquidity and market efficiency risk management, which is resulting in a push for technological improvements to better manage associated market, operational and credit risks. Change within the compliance and regulatory arena has also been a main focus, aiming to better manage capital, as we can see with such initiatives as Basel II, which is beneficial to securities lending, as it will enable more precise assessment of collateral quality and suitability. Fieldhouse: We see several major issues that could have a significant impact on the securities lending industry this year. The first would be Basel II, arguably the most important regulatory initiative to have impacted securities lending in the recent past. Basel II will mandate a very structured risk management process. However, as long as beneficial owners have the right risk framework and work with lending partners who have built a comprehensive risk model, there will be opportunities to benefit from higher utilisation and increased lending revenues. Institutional investors are also actively searching for better returns through the execution of alpha-based strategies and seem willing to be much more aggressive with their investment styles. The rise in popularity of hedge funds has galvanised the securities lending industry, with service providers and beneficial owners developing new techniques to satisfy their exacting needs. Providers have been challenged to deliver an integrated service offering, which not only maximises revenues but also simultaneously manages risk and maintains operational trans-

recall the loan in time to vote the proxy. On the tax front, we continue to see new cases come before the European Courts of Justice (ECJ), which point toward greater tax harmonisation across Europe. These cases should be followed closely as they may have significant implications for lenders and borrowers. And the buzz phrase of 2007 has been the 130/30 funds, which are seeing traditional long only managers launch funds that short up to 30% of the value of the fund and then invest the 30% short proceeds to obtain a 130% total long position and a 30% short position. This should increase demand for securities borrowing and create new opportunities for service providers across the securities financing business. Seidel: Over the past year, one of the issues that we have seen heightened client awareness of is corporate governance and the need to vote proxies. This has made invaluable the efficiencies BBH has created through our securities lending system infrastructure and recall process. We are not only able to recall securities in a timely manner for voting purposes, but can actually flag those securities in advance of corporate events to ensure no opportunity is missed. Our clients seem to take great comfort in our streamlined approach. The down side of this trend in the industry, of course, is the impact of recalls on income derived from lending, but our goal is to support our clients' priorities and broader investment objectives and to make lending as seamless to them as possible.

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Securities Lending PANEL DEBATE works and more.

What impact is industry consolidation having on the market? d’Albrand: Industry consolidation, especially with the recent large American mergers, is bringing all participants, large and small, to examine and redefine their business models and service offerings. Consolidation brings complementary companies together, integrating traditional functions, such as fixed income and equity lending. Securities lending desks are

Wilson: In the short term, this should be minimal. There are plenty of providers operating across all spectrums of the industry. Bank mergers are, of course, just one reason for consolidation, but others factors such as the potential for greater tax harmonisation in Europe, possibly resulting in the erosion of the yield enhancement transaction, could affect the profitability of some providers and cause them to either merge or reconsider their position in the business. But

New sources of supply continue to come into the market via investors making their securities available for lending for the first time. While this is positive, it does tend to put downward pressure on fees in conjunction with the ever increasing competitiveness of the market becoming one stop shops and we shall see how these new global entities will do in terms of customer satisfaction. In this highly competitive market, beneficial owners want to maximise their portfolios, but it may not always be in their best interest to be part of a pool, with longer queues and possible lower utilisation rates. Credit issues also arise, since an increase in lendable securities does not necessarily mean an increased credit limit for each counterparty, potentially reducing market liquidity. In this tight market, barriers to entry are tough, however, small players have their own niche, focused on their specific expertise, performance, technology, risk management and client relationships. Fieldhouse: While consolidation is reducing the total number of players in the market, we contend that under the right circumstances, it can help contribute to a higher overall quality of securities lending providers. What you’re seeing as a result of ongoing consolidation is a reduction in the number of regional players, but an increase in the number of truly global operations. The implications of this trend are quite positive for the client organisations, as they are positioned to benefit from everything those global shops have to provide, including new markets, new sources of demand, increased investment in the infrastructure driving the business, top notch risk management frame-

at this time, for investors and beneficial owners, there is plenty of choice in providers and routes to market, and that is healthy for the industry. Seidel: Strategically, we are encouraged with this further consolidation in our industry and believe that there is ample space for BBH and much larger asset service firms to coexist in the current industry environment and pursue their respective strategies. In the securities lending industry, beneficial owners who are clients of an acquired financial institution may find themselves part of a new lending program with a different profile than the one they originally chose, triggering an evaluation of whether the new programme aligns with their objectives. In some cases, consolidation may be the catalyst for new opportunities for both beneficial owners and lenders depending on the results of those evaluations. We distinguish BBH through continuity, high quality service, integrity, and relationship excellence. We operate as a flat, agile organisation providing comprehensive solutions for our clients that help them meet their business objectives. BBH remains uniquely client-centric and committed to continuing to grow organically by pursuing a select group of clients that value our focused strategy and client service excellence. We believe that a firm which understands and capitalises on its unique competitive strengths can pursue a differentiated strategy that delivers success in the form of client and

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Securities Lending PANEL DEBATE employee satisfaction.

Following Electronic Trading Group’s lawsuit last year, how have the attempts at achieving greater price transparency in the securities lending market been received? What progress has been made? d’Albrand: The so-called lack of price transparency of lending fees due to the power of the prime brokers over the industry is quite disputable. The securities lending industry is an OTC market and fees are based on various fac-

How have moves towards introducing greater EU tax harmonisation affected the market? Have any particular recent decisions of the European Courts of Justice had a significant impact on this? d’Albrand: The tax and regulatory environment is complex and challenging. The Focusbank and Denkavit cases have definitely reminded the industry that nothing should be taken for granted. It is evident that tax treaties could be reconsidered, with a potential to reduce the cross border flows. We understand that a number of

Industry consolidation, especially with the recent large American mergers, is bringing all participants to examine and redefine their business models and service offerings tors, such as creditworthiness, whether the stock is callable and ease of location. Increased market transparency, agent borrowing and lending offers, benchmarking tools and trading platforms are giving beneficial owners and short sellers a better view on market prices. In any case, independent intermediaries offering transparent pricing are emerging as competitors to prime brokers. Wilson: Transparency means many things to many people. At JPMorgan, we have seen a large increase in requests from our clients for more detailed information and understanding of their securities lending activities. Gone are the days of a single monthly or quarterly report. Clients are looking for daily, and sometimes real time, information relating to loan activity, revenues, risk and exposures. We are seeing a shift to a more front office asset management approach to lending by many of our clients, and so detailed performance reviews are now commonplace. This focuses on where the return is coming from, where and why superior performance was generated and what risks were taken in the process. There is also more information available today regarding industry wide activity. This is useful in benchmarking or understanding the size of the overall market, as well as prices for a given asset class, and in given markets and for specific securities.

principal market participants – both lenders and borrowers – have for a long time started diversifying their activity to adjust and/or compensate for any changes in the industry’s business models. Fieldhouse: While tax harmonisation will certainly have an impact on the market, it’s only one factor in a constantly evolving marketplace. It could be inferred that tax harmonisation could potentially negatively impact revenue streams from certain markets. At the same time, however, it’s important to keep in mind that major players are constantly investing in new sources of demand and new markets in order to capture additional revenue opportunities as they arise. Wilson: Various decisions by the ECJ have suggested a degree of tax harmonisation among European Union member states. However, most recent decisions issued by the ECJ, combined with the action currently underway by the European Commission, have all hinged on the comparability between the entities claiming the relief. To date, this point has not been fully proven and therefore the direct impact on securities lending has been limited. Rather than the cases having a dramatic and immediate impact on tax rates, it is more likely that the actions of the ECJ and the European Commission will lead to individual member states amending their

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Securities Lending PANEL DEBATE domestic tax legislation to create a more level playing field for cross border, intra-EU investors. For example, early in 2007, the Netherlands reduced its standard tax withholding rate, providing exemption for EU resident pension funds and tax exempt entities (such as charities).

In 2004, the SEC proposed changes in regulation to relax short-sale constraints and the pilot programme began on 2 May 2005, what impact has this had on the market? d’Albrand: The SEC Regulation (SHO in January 2004), where short sellers of equities are required to locate securities to borrow before selling, has given a greater role for securities lending desks. Hedge funds are putting increased pressure on prime broker services. More than ever, finding the right stock at the right moment is an important part of the service a prime broker must give to their clients. All sources of information, electronic or personal relationships, must be used to their full extent.

will have to make significant investments in technology and infrastructure to better dynamically manage associated market, operational and credit risk. The ability to have dynamic risk and collateral management capabilities will position firms to be more responsive than ever to a client’s changing strategies. Wilson: The changes enacted by the SEC (Rule 10a-1(a)) were intended to expand liquidity in the marketplace while implementing strict compliance on fails and appear to have succeeded. Broker-dealers have adopted additional technical controls on locating ‘intent to sell’, which includes client logs for approvals, archiving of data, and pre-borrows of short sales on trade date ahead of settlement date. Borrowing securities for failed deliveries is preferred to effecting a buy-in. Buy-ins have become more efficient, with the introduction of netting through the continuous net settlement system (CNS) doing away with fails after buy-ins, as sometimes happened in the past. In summary, the SEC changes have had a positive affect in the marketplace, but with some added overhead costs for compliance monitoring.

The so-called lack of price transparency of lending fees due to the power of the prime brokers over the industry is quite disputable. The securities lending industry is an OTC market and fees are based on various factors, such as creditworthiness, whether the stock is callable, and ease of location Fieldhouse: Overall, the impact has been a positive one for the securities financing and hedge fund industries. Typically, hedge funds like to take short positions and therefore need constant access to inventory to finance those positions. One of the main drivers has been the growing number of institutional investors pursuing alpha generating strategies such as the 130/30. This important new source of market demand was expected to have a significant impact on pricing, as suppliers capitalised on the growing institutional interest in alternative investments. As a result, there has been a strong emphasis and focus on credit and risk, as well as compliance by regulatory agencies and internal risk departments to ensure a proper risk management framework is in place. The changing regulatory environment and increased focus on risk, credit, compliance and capital usage is now the norm in the industry, and has forced firms into a very structured risk management process. Firms

What will the securities lending market look like in the next five years? Are electronic FX markets foreshadowing the evolution of securities lending? d’Albrand: The securities lending market will be that much more streamlined in five years, and the future success will to some extent be linked to technology. However, I believe that the evolution of the securities lending industry will follow a different path than that of FX. The two activities are simply governed differently. FX is highly regulated but flexible, while securities lending is much less regulated but more constricted. Take for example the fact that each securities lending arrangement is bound by a specific contract, inhibiting the type of transparency found in FX transactions. Amongst the several routes to market, automation is a strong trend, with different platforms such as the auction model. However, many participants still prefer to adhere

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to traditional methods, believing that a relationship-based business may attain better results. Fieldhouse: It’s clear that the future of the securities lending market will be inextricably tied to advances in technology. Technology will continue to serve as the backbone of the industry and those firms who invest wisely and strategically in their technology will be the ones who win out in the end. Going forward, we will continue to see customers demanding more integrated service offerings that will enable them to maximise their revenues and enhance risk management capabilities, while maintaining operational transparency. As with all other electronic trading environments, innovation coupled with robust risk management and the ability to integrate internally and externally, will be

industry-wide platforms such as EquiLend, so that a common standard can be used by industry participants. Within five years, those participants that can embrace technology, have a large well capitalised balance sheet and who can also innovate in areas such as 130/30 funds will be the dominant and successful organisations. Seidel: Transparency and “attention” will be the major factors influencing lending in the next five years. As we have seen for the past decade, lending continues to move towards a more mainstream financial product. With that migration will come greater attention from all involved. Beneficial owners, agents, broker-dealers, regulators, vendors, media folks, you name it, will all have heightened focus on lending. Clients in particular will be looking for the optimal provider – one that can deliver strong returns in a risk miti-

It is likely that the actions of the ECJ and the European Commission will lead to individual member states amending their domestic tax legislation to create a more level playing field for cross border, intra-EU investors the drivers and differentiators in this market. And as the traditionally long only investors continue to migrate to the alternative sphere of investment activity, there will be opportunities for providers who can provide a complete set of services to this client base, as their needs and expectations become more sophisticated and complex. And while technology is certainly going to play an integral role in the future of the industry, what’s going to ultimately make or break the individual players is their ability to integrate into their operations the flexibility that tomorrow’s clients (and their increasingly diverse investment strategies) are going to require. Wilson: Technology and balance sheet are going to become increasingly important factors over the next five years. Balance sheet and capital are going to be essential in delivering to lenders the risk protection they look for via indemnifications from their service providers. As the business continues to grow at a rapid pace, this may start to put a strain on all but the largest and most extensive balance sheets. As volumes increase, not having the necessary technology to achieve straight through processing for a high proportion of transactions and downstream processes will make it very difficult for providers to sustain growth. This also relates to connectivity with

gated environment and deliver this in multiple ways. Customisation, once thought of as a privilege for the largest, will be demanded by a greater segment of the market. Clients all have different objectives in lending and soon all will be able to achieve those and will be pushed to find a partner who can provide it. This attention, focus, and push to the front lines by lending will lead to increased transparency. It will come in the form of price discovery (fees, rates) but more importantly, in total lending transparency. While fees are important, beneficial owners will need to ask the broader question about overall program performance. Could my lending program be done better? More safely? More efficiently? Can I have multiple programs? Until beneficial owners can answer questions like these in the affirmative, only then are we really getting toward transparency. I feel this will be a big change in the next three years. Lastly, on electronic trading – there’s no question that it’s coming. While an important part of the maturation and evolution of transparency in lending, I do think that unlike other products – like foreign exchange – price discovery in lending will be slower to take full hold. As noted above, all clients have a different desire and risk profile in lending and price discovery, while an indicator of success, will not be the sole evaluator in the next few years. SLMG

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Ask the EXPERTS

ABP Investments Is securities lending a back office or front office function? At pension fund ABP with assets totalling EUR215 billion, we view securities lending as an investment management function. Securities lending is considered an independent investment strategy. We apply all of the same investment disciplines and rigor to securities lending that would be applied to any investment strategy. Asset allocation, vendor selection, investment guidelines, benchmarking, and performance measurement are all part of the ABP programme. We take an active approach to securities lending and aim to optimise providers and counterparties based upon their specialties or ability to pay guaranteed premiums via the auction process for our various portfolios. This approach has been the key to the success of our program which will top EUR105 million this year, up from ¤43.5 million in 2003 prior to the implementation of this strategy. Applying investment management discipline to the inefficient, bundled, securities lending industry has allowed us to maximise performance and create a significant source of alpha. We use three primary vendors for securities lending services with a best of breed approach, eSecLending, State Street and JPMorgan. The eSecLending auction model has been a key tool in the management of the programme. The auction provides price discovery, benchmarking and transparency and has been employed across all asset classes improving both lending fees and utilisation rates. At ABP we have built a robust oversight infrastructure, which has allowed us to maintain control over the programme and make better strategic investment decisions. We have used this infrastructure to employ a variety of collateral management strategies. Key to this has been the unbundling of collateral management services and lending. The programme now uses five distinct, lowly correlated strategies. All managers must comply with ABP’s investment guidelines, but different managers have been hired for different strategies. Our programme is large enough and our auctions are

timed so that we can divide our volatile cash from cash that is considered core and we can commit to a manager for a year or longer. Risk management is a key part of our oversight function. We look at guideline compliance through a variety of reporting tools and analytics that standardise program data across providers. We also measure total exposure across all of our borrowers taking into account exposure in our collateral reinvestment portfolio. Value at risk (VaR) is measured programme wide to ensure that programme risks are appropriate for the fund’s risk tolerance. We have found that our programme VaR is relatively small when compared to the alpha that it delivers. Through our quality management function, we are also constantly working to increase the programme’s operational efficiency to reduce operational risk. While ABP would never underestimate the importance of operational support in the smooth administration of our programme, we primarily view securities lending as an investment strategy that generates considerable amounts of money. Thus, we manage our programme as we would any of our investment functions. Finally, of course, the coin of securities lending also has another side: corporate governance. ABP has a policy in place to strike a balance between the returns from securities lending and the retention of voting rights in cases ‘in which it makes a difference’. A minimum of 10% of the shares will always be available for voting at AGMs. In case a company is on ABP’s full voting list, ABP will in principle vote with all of its shares. Shares lent will be recalled for that purpose, unless there are no controversial issues on the AGM agenda. Mark Linklater, head of Securities Lending, ABP Investments

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Ask the EXPERTS

International Corporate Governance Network What are the implications of stock lending for corporate governance? The growth in stock lending has been one of the most spectacular success stories of the capital market liberalisation of the past 20 years. By providing the markets with greatly enhanced liquidity and greater potential to hedge positions, facilitating two way bets in equities, and providing long term holders of equity positions with a means of enhancing revenue, the expanded lending of today’s markets has contributed significantly to the strong performance of equity markets over the period. However, as beneficial as it has been, this greatly expanded lending activity has not been without its price. As some of the less fortunate side effects come to the fore, the danger increases that regulators will impose rules which have the effect of dramatically inhibiting lending in order to curb some of those side effects. Better that the industry address these issues itself first, than that they be addressed by unsympathetic legislators responding to pressures from outside the investment industry. Lending has always been predicated upon the assumption that most share owners will not want to vote. Since the vote is the one thing that borrowers and their agents cannot indemnify through their lending contracts, this aspect of lending is usually glossed over in the sales pitches made to senior managers and boards of trustees. Prospective lenders are of course assured that the have the right to recall shares (be bought back in) for any reason. The assumption is that they will not have to do this very often. In the event of a bid, rights offering, or other transaction, the broker can often ‘assent the shares’ and be on the hook for the substitute equity instead. Dividends and special distributions are provided for in the contract for difference that the broker has with the hedge fund on the other side of the trade, and everything is just fine. Except, of course, for voting, which requires that similar shares be delivered to the

customer before a date that is seldom far off when the recall order is given. As it now stands, lending has the effect of inuring lenders to their stewardship responsibilities. Fortunately, most shareholders’ votes are non-controversial, because until and unless some mechanism is developed to reduce this conflict between voting and the continuance of a borrowed position, lending will continue to provide a powerful disincentive to voting. The threshold problem is that both the administrators of a lending programme and their counterparts on the borrowing broker’s side have a vested interest that the share not be recalled and the loan terminated. They are apt to point out that the loan will bring in real cash (however little) and that exercising the shareholder’s franchise has only intangible value. The threat that more than very occasional recall may cause the borrower to stop doing business with the lender is invoked to stifle debate. It may also be more difficult than advertised for the borrower to find the needed shares when a recall is demanded; in the case of voting, failure to recall in time seldom results in any penalty clause being invoked by the lender. The net result of this situation, in which proxy voting is made subordinate to lending, is that lenders rarely recall for voting, unless a bid is in prospect. Proxy voting teams, and the few portfolio managers who are interested in corporate governance issues, rapidly become discouraged at this display of corporate priorities. Often controversial voting issues are not even reported to higher levels of management because of the conflict with revenue generation, no matter how small. A further problem is that both investing institutions and their portfolio companies are frequently uncertain as to the size of their actual holdings. An investor soon loses credibility when claiming to represent 3,000,000 shares in an engagement with a company, if only 50,000

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are eventually voted. I have seen senior managers of major funds confidently promise they would vote millions of shares in a certain way, only to see them turn up at an AGM, red faced, with one third that number. The rest were out on loan. Of course, no one else knows why the broker wants to borrow stock, but the assumption is that on the other side is a hedge fund or other client who wants to be short. The shares will be sold in the market, whoever buys them will be another legitimate investor, and that is that. However, the number of cases where it has been revealed that a client was in fact borrowing shares for the sole or primary purpose of voting them, while small, has been rising. There is every reason to believe that there are other instances where this occurs which are not widely known because it is never disclosed who initiates a stock borrowing transaction, let alone what the motivation was for doing so. Borrowing votes is extremely difficult to prove, and while generally condemned as bad practice, in many jurisdictions it is neither illegal nor likely to give rise to sanctions if detected. But even suspicion of the practice is sufficient to compromise the integrity of the shareholders’ meeting. It also encourages management to take more defensive measures at the expense of shareholder value, and plays havoc with our notions of liberal capitalism. ‘Empty voting,’ to use the term applied to it by Henry Hu of the University of Texas, runs directly counter to the concept of collective responsibility for decision making which is at the core of the theory of the corporation. When the shareholder’s voting interest may be detached from his economic interest in the prosperity of the corporation, as is the case with the voting of borrowed shares (as well as the use of certain derivative positions) all sorts of mischief may result. The assumption that the vote is cast in order to protect the owner’s perceived economic interest is no longer valid, and the vote may be cast in such a way as to actually attempt to destroy the value of the corporation. For anyone attempting to wreak mischief upon the company, borrowing shares for the purpose of voting may be a relatively cheap and easy way to do it. There have been cases recently where a shareholder attempted to change the outcome of an AGM by voting almost 5% of the company’s equity when his actual stake in the company

was less than 0.05%. There was the case where a group of borrowers voted to derail a friendly transaction, reaping a huge profit on their short position. There have been instances where shareowners, barred from voting because of a conflict of interest, could lend some of their votes to another, friendly shareholder who was not similarly prohibited. There have been cases where substantial votes were cast by shareholders who had a negative economic interest in a company. While it is true that this is always possible through the use of derivatives, at least the investor’s long position in the shares is a matter of record. The problem with lent and borrowed positions is that they never have to be reported. A party can show up with 5% or even 25% of the votes without ever having to disclose his existence, can vote in a manner contrary to the other shareholders’ interest, and disappear without ever having to transact in an open market. The ICGN Securities Lending Code of Best Practice was drafted with these issues in mind. It was conceived to be relatively unobtrusive, with the goal of reducing lending activity as little as possible. Given that many institutions have decided to absent themselves or withdraw from lending activity because of the problems described above, alleviating these problems could actually result in greater activity, with more entrants returning to this market. The primary objective of the code is to ensure that lenders know what they are doing, and that they keep their beneficiaries or clients apprised of it as well, not that lending activity be reduced indiscriminately. Above all, the ICGN Code calls for greater transparency. Participants in this market need to have greater confidence that they are not lending shares to would be abusers of the system. Issuers, which are in a sense involuntary participants, need to have confidence that rights delegated to shareholders are not going to be usurped by those whose interest is in no way allied to the survival and prosperity of the enterprise. Andrew Clearfield, chairman of the ICGN Committee on Securities Lending

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Ask the EXPERTS

CalPERS

How can an organisation benefit from securities lending and corporate governance at the same time? “To be or not to be; that is the question.” Hamlet considered the most basic of questions: suffer with “outrageous fortune” or fight against a “sea of troubles.” Four hundred years after Shakespeare’s eponymous play was first written, the question remains the same for securities lending. It is also important to consider: to vote or not to vote; that is the question. Establishing a balance between revenue and corporate governance mirrors Hamlet’s struggle to balance fortune and troubles. At the California Public Employees’ Retirement System (CalPERS), the equilibrium is established and well proven that it is possible, if not necessary, to harmonise stock loan earnings with a sound proxy voting policy. CalPERS’ securities lending group works closely with the corporate governance unit to maintain a policy that accentuates CalPERS’ fiduciary responsibility to the pensioners, along with the responsibility of a long term investor. In the fiscal year ending June 2007, CalPERS’ securities lending contributed USD162 million in income to the overall fund performance. CalPERS recognises that maximising returns is not mutually exclusive from voting proxies. This well coordinated dance balances communication, transparency, and consistency. The beginning steps of the dance involve establishing an open line of communication and good working relationships with the fund’s corporate governance decisions. Creating policies and procedures that are formally documented helps minimise conflicts. At CalPERS, there are three policies which address lending and proxy voting. The first two involve exclud-

ing approximately 50 securities from lending during the year. The third policy recalls, around the expected record date, the 300 largest US equity positions to participate in the proxy vote. The next dance step involves ensuring that the policies and procedures are transparent to all stakeholders – lending agents, borrowers, custodians, and other administrative agents. Establishing the proxy guidelines as a part of the contract ensures that all parties understand the rules. Additionally, CalPERS has a procedure to determine what happens if a stakeholder wishes to keep the security on loan. If a borrower wishes to borrow a stock over record date, the securities lending group writes a proposal that details the economic value of keeping the security on loan and presents it to the corporate governance unit. The corporate governance unit reviews the proposal and then accepts or denies it, based upon correlating the earnings received from the loan and the value of the vote. Before the dance ends, a record of consistency must be established. This includes following the mandate, goals and mission of the organisation; staffing resources to support the initiative and monitoring processes properly; and enforcing the policy. At CalPERS, this well rehearsed dance has resulted in maximising lending revenue and following a first rate corporate governance policy. CalPERS has balanced fortunes and troubles and determined the answer to the question to vote or not to vote. Do both. Daniel Kiefer, opportunistic portfolio manager, CalPERS

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JPMorgan - FUTURE OF THE MARKET

Now and the future Paul Wilson looks ahead at the potential of the securities lending market Asset managers or pension funds would hardly have considered the relative merits of different securities lending structures five years ago. Any return was a good return and the front office was not concerned as long as securities lending was not affecting their ability to manage the assets and generate alpha. Typically, the big custodian agent lenders called on their clients and educated them on the risks, returns and operational implications of securities lending. It was a single route to market, and although somewhat one dimensional, it could be sufficiently tailored (for example, markets, borrowers, collateral guidelines) to suit most clients’ risk/reward requirements. Consequently, many institutional investors participated, so that lending books grew, borrower demand increased, trading desks expanded and revenues grew. A view from today shows that the custodian lenders, plus a few new market entrants are still doing good business. Lending volumes, driven by an expanded pool of lendable assets, have been matched by increased demand from the prime brokers and an economic environment

ences without hearing extensive debates on tax harmonisation, hedge fund activity, proxy voting, indemnification, transparency, disintermediation, electronic trading and emerging markets, to name but a few. It would be easy to dismiss some of these as minor threats to revenues requiring minimal product enhancement from the agent lenders to address the issues; however, that could be a mistake. Tax harmonisation is already affecting revenue streams. Europe has already seen many changes over the last few years. Fortunately, the general strength of securities lending revenues has, so far, cushioned the blow. However, reliance on one revenue stream is creating significant concentration risk for some industry participants and the consequences will be evident as additional tax treaties are signed and/or more harmonisation occurs. Beneficial owners have for a long time selected risk management as the single most important consideration when participating in securities lending. Risk management is never far from the top of any beneficial owner’s agenda. Make no mistake, the level of lending returns enjoyed are significantly influenced by the level of risk that lenders are prepared to take. As risk/return analysis improves within the industry, beneficial owners will increasingly ask questions about their programmes, the level of indemnification afforded by the agent and the ability of their agent to meet its indemnification obligations should an event occur. The result is that

Multi-tasking by agent lenders is the future; the one dimensional securities lending model with a captive client base has disappeared that has pushed up returns for most beneficial owners and lenders. But does that mean that the environment is an easy one for agent lenders, and that education, not competition, still drives new beneficial owners into our respective programs? Not at all. Growth in the industry has created new lending structures, alternative providers and intense competition. Lending clients are no longer satisfied in knowing that their assets are being lent but want to be assured that they are maximising revenues and controlling risk. Furthermore, environmental factors are creating both threats and opportunities to the industry. You can’t attend many securities lending confer-

enhanced reporting, greater transparency and better informed relationship managers will provide granular details for the beneficial owners to satisfy their need for information. Just as significantly, agent lenders will be quizzed on their financial ability to meet the promises they make within their contracts. Just how reliable is that indemnification after all? Other points of debate in the industry are with us now and have been for a few years. Proxy voting, for example, requires close coordination between the agent and their beneficial owners to ensure that corporate governance obligations are fulfilled. The fact that beneficial owners cannot vote shares that are on loan is the fundamental

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point that drives the concern. This leads to much misunderstanding, rumour and speculation. Recalling stock before the record date where voting is viewed as important in a given case is a ready made solution, especially when the majority of positions are lent on an overnight basis. Securities lending can certainly sit comfortably with an active corporate governance programme. Best practice dictates that each beneficial owner develops a policy with regard to how it will handle voting in situations where securities are on loan, weighing the value of revenues being achieved versus the loss of voting rights.

So, if you have a diverse source of revenue, great risk management, provide top level information to your clients and maximise revenues across the range of securities lending routes to market mentioned above then you have it all? Well no, actually. The securities lending industry is not immune from the changes taking place across the asset management world. It has been well documented that the lines that separate long managers from hedge funds look increasingly blurred. The more sophisticated institutional investors and 130/30 fund strategies are generating an

The securities lending industry is not immune from the changes taking place across the asset management world. It has been well documented that the lines that separate long managers from hedge funds look increasingly blurred Tax harmonisation, risk analysis and indemnification quality will influence the industry in coming years, and proxy voting will continue to cause debate. Directed lending – Clients have their own lending desk, negotiate loans themselves, and work in partnership with their custodian to administer the programme operationally. Exclusive lending – Lending to one borrower, typically after an auction, often conducted by the agent, where the highest bidder wins the right to exclusive access to one or more portfolios. Third party (non-custody) lending – Lending programmes for those beneficial owners where the lending agent is not the custodian bank. Synthetic lending – The use of financial instruments to replicate lending structures. This is used for those markets where an established securities lending structure does not exist. Depository lending linkage – Links to lending programmes of certain depositories, such as Euroclear. Combinations – Mix and matching of all of the above. All of these structures come with their own challenges. Technology must be in place and legal and regulatory due diligence handled. It’s a challenge to offer the whole suite of products, but clients expect it and often like to consolidate their lending services with one provider and also want to get maximum value across the whole product set.

increase in shorting from the more traditional managers. These managers, who have worked for many years with their agent lenders are, for the first time, looking for borrowing as well as lending services. Borrowing a position from an internally or externally managed account of the same client and having other sources to capture good value borrows from your agent can be an attractive proposition. Add that to the same agent that can manage your collateral delivery against positions borrowed and overlay the range of securities lending programmes mentioned above across the same securities and you have a powerful business model. This multi-tasking by agent lenders is the future; the one dimensional securities lending model with a captive client base has disappeared. By working closely with beneficial owners so that they can, without multiple contracts and multiple vendor relationships, also gain significant economies of scale will see the end game winners being those banks with the broadest products, the most healthy balance sheets, the most diverse sources of revenues and the best technologies to maximise returns, quantify risk and provide true performance measurement. SLMG Paul Wilson, senior vice president and global head of Sales and Client Management for Securities Lending and Execution Products (SLEP), JPMorgan Worldwide Securities Services

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eSecLending - SECURITIES LENDING IN 2007

An investment decision Chris Jaynes explores the current position of securities lending in the market Securities lending is a well established practice and a mature market, but it has experienced a significant evolution over the past decade. The industry has changed from being viewed primarily as a back office, operational function, to a front office investment management discipline. Beneficial owners are now increasingly viewing securities lending as an alpha generating tool capable of producing a meaningful and predictable revenue stream across a wide range of portfolios and asset classes. Where it was Historically, securities lending was treated as a back office, operational tool that was used to facilitate settlements and cover shorts in the market. Demand arose from the banks and broker-dealers and supply originated at large pension funds, insurance companies and asset managers. The significant growth in both the trading volume and sophistication of the equity and fixed income markets, along with the creation of a wide range of derivative products has created increased demand to borrow securities. This increased demand has led to the need for more supply, leading to more discriminatory pricing, and more creative means of managing and packaging the product. From a beneficial owner’s perspective, securities lending was historically viewed as a bundled service provided by custodian banks and mandates were linked with custody from both a contractual and pricing standpoint. There was limited transparency and few alternatives to the traditional custodial agent pooled lending programmes. However, over the past decade securities lending has received a new level of attention and focus from beneficial owners. Securities lending decisions began to be viewed as an investment decision, causing a change of expectations from clients and a new level of service and competition from third party and custodial agents.

Today’s market Beneficial owners are now increasingly viewing securities lending as a predictable alpha generating process, capable of producing consistent incremental returns across a broad array of asset classes. They are looking beyond the traditional stock by stock pooled agency lending programmes and incorporating specialised lending programmes tailored to fit their specific risk/return parameters. Beneficial owners are also taking advantage of the fact that there are more choices in the marketplace today allowing them to evaluate securities lending and its providers in a new light – and to select more than a single route to market. Many long accepted investment management disciplines are now being applied to the securities lending market, including transparency, use of specialists, multiple managers and competition. Transparency There is a clear trend by beneficial owners to unbundle their securities lending and custody mandates in order to increase transparency and returns and gain greater control over their securities lending programmes. Greater transparency is important to beneficial owners in three key areas: performance measurement to determine if they are earning competitive returns; risk management to gain better understanding and control over the risks they are taking to generate returns; and fees they are paying to service providers. The industry has adopted better benchmarking tools to improve performance measurement and analysis. There are now viable database systems to assist market participants in determining whether their returns are in line with industry averages. Transparency is also increasingly important for senior management and boards to ensure that their fund assets are earning the full and appropriate returns for any risks taken and to ensure that objective criteria were used to award asset mandates. Many beneficial owners have also recently unbundled their custody and lending contracts to gain a better understanding and control of their fees, and to better align the interests of their service providers. Multiple providers and use of specialists Beneficial owners have been utilising multiple providers for many years for investment management, brokerage execution and foreign exchange, even though these are all services typically provided by custodian banks or their affiliates. The same is now becoming true for securities lend-

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ing. Many beneficial owners, especially in the US, UK and Europe, have successfully implemented securities lending programmes utilising both third party and custodial agents. These beneficial owners are also increasingly using auctions and third party specialists to enhance returns on their most attractive assets while continuing to utilise their custodian to lend their general collateral assets via the agency queue. As many beneficial owners are now understanding that securities lending is primarily a trading and investment management function, they are choosing to optimise results by utilising specialists. They are now implementing more sophisticated provider selection processes and demanding more sophisticated risk management and reporting tools. The traditional custodial stock by stock, queue or pool driven, lending programme has been

lender to achieve premium, market driven results, in a manner that provides unbiased, measurable results, which they can then produce for their boards and management. Definition of an exclusive principal arrangement: An exclusive principal arrangement makes a portfolio, or portion of a portfolio, available to a specific borrower for a fixed period of time, in exchange for a guaranteed return. For this exclusive right, the borrower pays a guaranteed fixed return to the lender either as a fixed basis point based on the value of the lendable assets in the portfolio, or via a fixed sum payable monthly over the term. Where it is going As Lenders and investment managers come to more fully understand the securities lending mar-

Transparency is increasingly important for senior management and boards to ensure that their fund assets are earning the full and appropriate returns for any risks taken and to ensure that objective criteria were used to award asset mandates joined by a number of new, innovative and customisable lending processes. These include: - The growth of the third party agent lender, including non-custodial agency lending done via a custodial bank. - The rise of exclusive principal programmes – going direct to the borrower or broker. - The use of auctions to distribute information and determine the market price for a portfolio of securities, or even a single security. Auctions and competition The rise of auctions in the securities lending market is a trend that is also gaining popularity. Beneficial owners have the opportunity to auction off a portfolio, a portion of a portfolio, or even single stocks, to a selected pool of borrowers in a competitive environment. Most auctions award portfolios to the winning bidder(s) on an exclusive principal basis. The objective is to capture the most attractive price for the assets, while providing the lender with a high degree of transparency and control throughout the process. This route to market has proven to be successful for a broad range of asset classes when compared to traditional pooled lending programmes for many large pension funds, mutual funds and investment management groups. It enables the

ket and its underlying structures, the trend towards managing the product as an alpha-generating instrument will continue. Beneficial Owners are, now more than ever, actively managing their securities lending programmes. They are more carefully considering the options and tools available to them and are therefore making better informed lending decisions. They are also actively seeking to introduce competition and utilise various routes to market, allowing them to safely increase returns, mitigate risk and achieve greater control over their programmes. We expect to see more sophisticated and innovative methods of lending continue to evolve, as new assets become available for lending, as new markets around the world develop and as improved risk management and trading tools are developed. SLMG

Chris Jaynes, president of eSecLending

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SGSS - SELECTION CRITERIA

If the shoe fits… Guy d’Albrand writes about the important factors fund managers need to consider when instigating a lucrative securities lending programme The world of securities lending is complex and often misunderstood. However, this is changing – it’s an industry currently in midstream of formalisation. Securities lending represents a significant growth area for fund managers, and is a vital tool in generating additional returns to enhance performance. Many have already come aboard, reaping an additional income stream from their assets. To launch a securities lending programme, it is essential that fund managers first fully understand their own investing strategy and portfolio size before being able to properly determine their securities lending criteria, taking into account their trading, risk and operational comfort levels. Choice of an agent lender Few funds can ignore the yield enhancement effects of a well managed securities lending programme. It is true with any class of assets and, taking into account the cash reinvestment additional return, it can be significant. There is an array of lending options to choose from. Pricing, risk management and operational support are important, but so is the client-agent link itself. Securities lending is a people business. The quality of the agent lender, that is to say the dedication towards the fund’s assets, is one of the key considerations when analysing a securities lending programme. A healthy relationship is a fundamental prerequisite to productive long term collaboration. The main challenge in choosing the right agent stems not only from the fact that securities lending transactions are complicated to carry out because they are OTC transactions, but also because they require a specific expertise to ensure safe settlement, relevant collateral adjustment and exact billing. Moreover, the actual asset’s utilisation rate and lending performance is highly dependent on the agent reach and team dedication in lending those assets, whatever algorithm is in place to ensure fairness of treatment across customers. When a full range of services, from custody to securities lending, can be delivered, transactions can be processed seamlessly. A comprehensive service provider has a better grasp of the overall process and is able to

integrate different services efficiently and cost effectively. Additionally, an agent lender that offers the entire value chain can suggest further enhancements to the programme on an individual basis. Certainly, the idea of trading directly with borrowers rather than going through an agent can be tempting. Although not impossible, this would entail a higher level of engagement in becoming a direct participant in the lending market. Front and back office functions, operational costs, financial capabilities, risk management and the complicated regulatory framework that exist in many countries combined could make it difficult for smaller lenders to run a direct lending business profitably. Importantly, ensuring that borrowing conditions from principal borrowers or through exclusive arrangements are attractive requires specific (and expensive) skills and teams. Through outsourcing their securities lending activity to an agent lender, fund managers can better focus on their core business. Does size matter? Is the lender you intend to choose a wholesale participant distributing large portfolios in a mass product fashion and thus leaving a substantial spread to other players, or does this lender make the most of each portfolio line by reaching end users directly? The answer depends on the size and market position of the lender and also on the service level the lender is committed to provide. Although large lending agents certainly bring some advantages, they may not be the most suitable for some fund managers, since the opportunity for lending is a matter of the market reach possible through an agent and the team’s ability to be proactive in lending inventories. Beneficial owners might thus be better served in smaller programmes, where they are catered to with more dedication than in large factories. Moreover, if the lender requires local or regional expertise, another route may be more appropriate, especially to maximise utilisation rates and/or the returns achieved from participating in those markets. Operational efficiency? Operational efficiency is an increasingly important contributor to overall fund performance and operational risk assessment is under more scrutiny with Basel II requirements. Awareness of the operational aspects of securities lending transactions is crucial. Responsibilities encompass several components, such as continually keeping users up to date about the portfolio, processing and checking the lending transactions, monitoring and allocating the collateral, and processing recalls and reallocation, coupon payment and corporate actions, allocation of the lending revenues, and measuring exposures and risks. Beneficial owners have a large set of constraints to be taken into account, such as acceptable types of trades

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(open or term), loan periods, counterparties, collateral, percent on loan limit per issue, overall percent on loan limit per fund, and limits per counterparty that very often make every single lending trade a specific transaction. The agent lender should be able to implement these sets of constraints and ensure their monitoring at the front office level and then by the compliance team. Risks associated with securities lending transactions are now well understood and monitored. Risks should be in line with clients’ investment and general policies. It is the agent lender’s role to point out risks arising from market conditions or regulation, mitigate risks as much as possible and optimise revenues accordingly, as well as continually reassessing the risk/reward ratio, with the aim of achieving maximum performance. Monitoring and guidelines As far as counterparty risk, borrowers need to be duly authorised by beneficial owners and the agent lender. Agent lenders should convey their risk department expertise and help beneficial owners in further securing solid borrowers. Sufficient diversification and proper reporting of counterparties, if needed, should be provided to help determine where exposures lie. Borrowers should receive the necessary information for counterparty disclosure requirements, while at the same time, protecting the lending activity. Furthermore, agent lenders can provide indemnifications in case of borrower default and when the pledged collateral has become insufficient due to adverse market movements to mitigate the remaining risk. Thus, the creditworthiness of the agent lender is crucial. Since collateral requirements, indemnification policies and cash reinvestment policies may vary, it is of the utmost importance to agree on the accepted collateral and their related haircuts, and to understand what insurance, if any, your agent provides you with. The operational strength of the agent you choose is paramount to proper risk control, with regular and stringent risk monitoring and efficient margin calls. Borrower default can be indemnified in various ways, but the first protection whatsoever remains the level of collateral that is in your account. It is important to discuss your collateral requirements with your lender and to ensure that they keep within an acceptable risk/reward profile. Your needs as a fund manager, performance versus risk terms, should be agreed with the agent lender and regularly fine tuned. Cash reinvestment Agent lenders can also provide cash reinvestment, which generates further interest but also credit risks that are measured and reported. When direct investment of the cash received as collateral is allowed in fixed income products, such as short term paper, debt, asset backed securities or funds, beneficial owners bear a primary risk on issuers just as they do with their underlying portfolio. If needed, beneficial owners should be able to reinvest

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their cash collateral in various currencies for various durations and to process FX trades. Since risks related to cash reinvestment are potentially greater than those with securities lending, choosing a hefty structure is advisable: the agent lender should share its expertise while setting cash reinvestment guidelines. Risks and performance are linked, and compliance with beneficial owners’ guidelines should be checked pretrade - to be performed automatically by the front office and post-trade by the risk and compliance department of the lender. Moreover, the agent lender should use its own market knowledge (its own market rating system for instance) to enforce more stringent rules, whenever judged necessary, and watch at all times the issuers/counterparties used. The bottom line Similar to the utilisation rate, performance is linked to market access and reach. To be fully rewarding for the beneficial owner, market access should be independent from any vested interest. Independence from the interests of the proprietary trading positions of the institution, be it a bank, securities house or broker, or from any proprietary borrowing flow, requires a separate structure, with independent desks and performance directly linked to the revenues paid to clients. Additionally, market access is more effective when dealing with direct end user interests, such as short covering. Finally, for large portfolios, the lender should provide performance benchmarking for market levels. Overall, fund managers should be on the lookout for flexible securities lending programmes that will enable them to implement multiple strategies – such as the use of structured trades and agency negotiated exclusives – across different asset classes. A lending agent’s ability to maximise revenue, manage risk, automate processing and deliver seamless integration with the client’s core investment management activity are key differentiators, as is their ability to innovate and partner with clients on future product development so that new opportunities can be seized when available. At SGSS, our liquidity management experts offer a full range of flexible securities lending programmes, tailored individually and built to boost portfolio performance. Backed by strong post-trade support and reporting, we offer indemnities, closely monitor collateral, and rigorously benchmark our performance and market access, while you remain in full control over your assets. SLMG

Guy d’Albrand, global head of Liquidity Management, SGSS

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Brown Brothers Harriman - MiFID

MiFID and the market Elizabeth Seidel discusses the impact of the European directive on the securities lending market The Markets in Financial Instruments Directive (MiFID) comes into effect 1 November 2007, when it will replace the existing Investment Services Directive (ISD). European Economic Area (EEA) member states were required to amend their national legislation and rules to incorporate MiFID requirements by 31 January 2007. MiFID is a major part of the European Union’s Financial Services Action Plan (FSAP), which is designed to help integrate Europe's financial markets. MiFID comprises two levels of European legislation. Level 1, the directive itself, was adopted in April 2004. Level 2, MiFID’s “technical implementing measures”, were developed with the advice of

securities), but not others. To avoid intolerable regulatory complexity, it is expected that regulators will attempt to apply MiFID as consistently as possible to in-scope and out-of-scope firms alike. The UK Financial Services Authority (FSA), for example, signalled early on it would do this “where appropriate”, and it did so later in 2007 by issuing harmonised rules. While other member state regulators are expected to follow suit, some have been slow to provide similar clarity. What is affected? In addition to covering organisational and conduct of business requirements applying to all investment firms, MiFID will make significant changes to the European regulatory framework to cover a broader range of financial instruments, whether traded on or off exchange. It will widen the range of ‘core’ investment services and activities that investment firms can “passport” on a cross border basis into other EEA member states. What benefits will MiFID bring? New services that will be passportable as “core” activities under MiFID (which were not passportable under ISD) will include: Advice that involves a personal recommendation; Operation of a multilateral trading facility (MTF); and Dealing in commodity derivatives, credit derivatives and financial contracts for differences.

It seems only yesterday that MiFID was a train that had just left the station. Now this train suddenly appears to be nearing its destination, and yet it remains to be seen if quite all of the tracks to a “harmonised Europe” have been laid the Committee of European Securities Regulators (CESR) and were the subject of negotiation at the European level in the European Securities Committee (ESC). They were formally adopted by the Commission and published in the Official Journal of the European Union on 2 September 2006. Who is affected? MiFID extends the coverage of the current ISD and introduces new and more extensive requirements that will apply to investment firms across Europe, including investment banks, brokers, exchanges, alternative trading systems, ECNs, investment managers and others. MiFID’s impact on some firms is not entirely clear at the time of this writing: for example, many banks and depositories/custodians will be subject to MiFID in respect of some parts of their business (for example, to the extent they sell securities, or investment products which contain

To facilitate cross border business, MiFID is intended to improve the passport regime by allocating responsibility between “home state” versus “host state” regulators, including with respect to regulation of cross border branches. MiFID is intended to facilitate greater harmonisation across EEA member states by prescribing more detailed requirements governing the organisation and conduct of business of investment firms and how regulated markets and MTFs operate. It also provides for new and consistently applied pre- and post-trade transparency requirements for equity markets across Europe; the creation of a new regime for ‘systematic internalisers’ of retail order flow in liquid equities; and more extensive (but consistent) transaction reporting requirements. Finally, although most firms covered by MiFID will also have to comply with the new Capital Requirements Directive (CRD), it is expected that most regulators will (as the UK FSA and other mem-

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MiFID is intended to facilitate greater harmonisation across EEA member states by prescribing more detailed requirements governing the organisation and conduct of business of investment firms and how regulated markets and MTFs operate ber state regulators have done) permit such firms to implement the new capital requirements on a “common platform” basis. Application to stock lending: Best execution Individual securities lending relationships tend to be highly customised, with trades by lenders often involving different portfolio structures and providing for different reinvestment options. As a result, the concept of comprehensive benchmarking – a necessity if MiFID best execution concepts are to apply – does not lend itself well to the securities lending environment. In addition, MiFID requirements relating to order execution are premised on orders for execution being “purchases” or “sales”, which securities lending transactions most certainly are not. Furthermore, lenders do not deliver “orders” for execution. While securities lending transactions have been excluded from MiFID’s trade and transaction reporting requirements for some time, there remains continued uncertainty as to whether MiFID’s best execution requirements will or can apply to securities lending activity. In its 07/15 Policy Statement, the FSA noted that: “Depending on how a securities lending transaction is structured and depending on the status of the client (as retail, professional or eligible counterparty) it is possible, using the analysis in the Commission’s response to CESR, that best execution requirements could apply. Firms are therefore advised to carefully review the Commission’s response in the context of the particular facts and circumstances of their businesses.” With the 1 November 2007 deadline fast approaching, the industry is running out of time to alter course and there will be continued discussion around this topic especially with the regulators: “intending to facilitate greater use of industry guidance as we move towards a more principles-based approach to regulation”.

It seems only yesterday that MiFID was a train that had just left the station. Now this train suddenly appears to be nearing its destination, and yet it remains to be seen if quite all of the tracks to a “harmonised Europe” have been laid. With only three months to go before MiFID takes effect, regulators, industry associations and regulated firms will be scrambling to implement required changes and digest new clarifications that have yet to emerge. It is hoped that MiFID will bring to Europe the benefits the Commission has promised, and it is possible some firms may be able to take advantage of them. In any case, Brown Brothers Harriman will continue to monitor developments closely. Watch this space. SLMG Elizabeth Seidel, senior vice president, co-manager of BBH Global Securities Lending Elizabeth Seidel joined BBH in 1999 and was recently appointed department co-manager for Global Securities Lending. In her new role, Seidel has management responsibility for Relationship Management, Risk Management, Sales, and Marketing groups. Seidel has over 15 years experience in the industry, 11 of which involve securities lending. Prior to joining BBH, she worked at Boston Global Advisors and was in charge of Client Service and at State Street Bank in their Securities Lending Division in both Trading and Operations. In addition, Seidel has worked at Wellington Management Company, LLP in a client service capacity and prior to that on the trading desk at a global hedge fund; Teton Partners, LLP for two years. Seidel received a Bachelor of Arts in Economics from College of the Holy Cross and is series 7 and series 63 licensed.

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RBC Dexia - TALKING TACTICS

A new era beckons The international securities lending industry stands poised on the verge of an exciting new era, says Mark Fieldhouse The trend for traditional long only investment managers to begin adopting hedge fund style investment tactics will bring about a realignment of existing securities lending business and create new opportunities for incremental business. The outlook for custodians in such a market is clearly optimistic. But while the fund management side of the equation is excited by the rise of 130/30 funds, they must be wary as they enter uncharted waters. The new approach will create risk and compliance requirements, heightening the need for fund managers to tap into the talents and services of established external providers of securities services. Custodians are the obvious providers of those services, aligning the front, middle and back offices to make the transition to a brave new investment world smooth and efficient, helping to meet not just 130/30 needs, but providing additional services such as securities lending. Securities that a long

introduction of the Pension Protection Act (PPA) and new standards for corporate plans from the Financial Accounting Standards Board (FASB). Public plans must now adhere to new rules from the Government Accounting Standards Board (GASB). “The PPA has increased DB plan funding requirements and accelerated the timeframes to fully fund a plan,” noted Pyramis Global Investors, the institutional money management arm of Fidelity Investments, the Canadian mutual fund company, in its fifth annual DB survey, carried out amongst large US corporate and public DB plans. The changes mandated by FASB and GASB require organisations to report their pension plan deficits or surpluses on the income statement. In the face of these new regulatory pressures, many plans have been forced to re-examine their investment approaches. The concerns identified in the survey show a marked shift in attitudes toward any investment strategy that can reduce volatility or improve returns, noted Peter Chiappinelli, senior vice president at Pyramis. The survey also showed that half of all corporate DB plans claimed that they were using (or considering using) liability driven investment. Second, it is becoming increasingly difficult to achieve alpha through traditional long only investment. With efficient and transparent markets, conventional long only active investment will inevitably deliver returns only slightly above beta. This has resulted in pension funds becoming more aggressive in their investment style, moving some of their assets away from benchmark sensitive approaches to make meaningful allocations to alternative assets and absolute return products. In addition, a growing number of pension funds are turning to

The advantage of a 130/30 fund for the institutional investor is that it can take a step in the direction of hedge fund style investment without unduly increasing risk only manager will traditionally have lent to earn a few extra basis points will in future be pledged as collateral for stock being borrowed. Custodians can manage collateral as well as provide liquidity, through a one stop shop that other market participants cannot duplicate. Why is this happening and why now? The underlying reasons for such a significant change are well rehearsed and reassuringly familiar. First, the demand for alpha is ever more apparent to the institutional investor base and, in particular, to pension funds. Low interest rates and poor or negative investment returns in the internet boom and bust years of the early 2000s have left many traditional defined benefit (DB) pension funds with huge deficits. Although those deficits could be reduced by rising markets, rules for funding those deficits have forced many companies to direct large sums of cash to their pension funds. In 2006, for instance, the US pension industry experienced significant regulatory and accounting changes, including the

the bond and derivatives markets to implement liability driven investment (LDI) strategies. The advantage of a 130/30 fund for the institutional investor is that it can take a step in the direction of hedge fund style investment without unduly increasing risk. Active extensions that provide positive alphas can significantly increase a fund’s total return with only a minimal impact on the overall volatility of the portfolio. With appropriate risk control, they can be viewed as an ‘extension’ of traditional equity management, rather than as a quantum leap into full blown alternative assets. In a 130/30 fund, up to 30% of the portfolio can be shorted with the proceeds from the short sales used to purchase 30% additional longs. Hence, the portfolio maintains a 100% net long exposure with gross footings of 130% long and 30% short. The potential for growth is significant. According to Morgan Stanley, US institutions, including pension funds,

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have invested approximately USD50 billion in this strategy; in contrast to USD2 trillion in hedge funds worldwide. The Pyramis survey, meanwhile, shows that 63% of US corporate defined benefit pension plans are already deploying or are considering deploying a 130/30 strategy in place of long only mandates. Widespread adoption will have a positive impact on securities lending. The convergence between hedge fund strategies and traditional asset management strategies is a major element of change in securities lending that will drive growth for several years, probably at an accelerated rate, just as hedge funds have done for the past five to 10 years. The benefit for the securities lending industry is that it will bring new, incremental demand for the service. A prime broker may be able to offer an exclusive programme to a particular institution, but that is not going to satisfy all its day to day needs, since any

nity by investing even more heavily in technology and capabilities, extending the traditional relationship beyond post-trade servicing by supporting clients’ portfolio construction strategies. The volume of lendable assets is growing almost by the day and the percentage of lendable assets being lent is also growing, as more markets ease restrictions on short selling, more fund managers become accustomed to doing it, and more institutions grow comfortable with lending their assets. That volume will continue to rise as the market adapts to the underlying changes that are taking place in investment philosophy and practice. There has probably never been a better time to be a securities lender. Beneficial owners are spoilt for choice, both in terms of the range of service providers and the routes to market. There is strong competition for every mandate, leading to

The potential for growth is significant. According to Morgan Stanley, US institutions, including pension funds, have invested approximately USD50 billion in this strategy; in contrast to USD2 trillion in hedge funds worldwide one prime broker is unlikely to control enough of the required liquidity to have a significant impact. Prime brokers must have access to the liquidity pool – and it is primarily the custodians who provide that pool. Unless institutions decide to handle in-house the additional administration, processing and reporting that will be required, they will need to use the services of established providers. Setting up the necessary infrastructure would be prohibitively expensive. Robust intraday VaR reporting, coupled with dynamic, real time collateral management, will be needed to enable lenders to exercise greater collateral flexibility, while allowing traditionally long only institutional investors to execute alpha-based strategies. Additionally, an advanced, Basel II complaint risk management framework and infrastructure will be an advantage for lenders in mitigating risk. The custodian is the logical choice to provide all these functions in a single, integrated solution. For agent lenders, the change is inevitable. The holistic model of lending means one set of processes, one set of controls and one service. This enhances risk management, because all the client’s activity – exposures, concentrations and diversification – can all be tracked and validated through a single point. Technology and automation will have even more of a key role to play in the future in terms of operational efficiency, risk management and continual transactional cost control. Lenders will want to be confident that the various processes will be seamlessly integrated so that the flow of data is automated and in real time, thus reducing the possibility of error and loss. Part of the strategic focus for providers will be to make available a complete set of services to the alternative commu-

greater market effectiveness and innovation. That competition is very healthy for all sides of the securities lending market. A portfolio manager may invest USD100 in a basket of stocks, such as those in the Russell 3000 Index. A short is then placed on an additional USD30 in stocks from that pool that is believed to be overvalued. The manager borrows USD30 worth of those overvalued stocks, and sells them in the expectation that they can be replaced later with cheaper shares when the price falls. The proceeds from that short sale are then used to purchase stocks which are thought to be undervalued so that the manager ends up with USD130 now invested in traditional long positions. A manager bullish about prospects for the IT sector, but with a more positive view of Apple than of Microsoft, could sell Microsoft short, borrowing stock to enable the sale, and use the proceeds to buy Apple. Custodians have the infrastructure, the staff, the experience and the expertise to help pursue short extensions in a cost effective way. SLMG

Mark Fieldhouse, head, Technical Sales, Americas, RBC Dexia Investor Services Mark Fieldhouse serves as head, Technical Sales, Americas. His team is responsible for overall growth and development of the Global Products client base, as well as the product level management of its strategic clients in North America. Global products include securities lending, foreign exchange, cash

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COMIT - TECHNOLOGY

Deep impact Felix Oegerli discusses the impact of technology on the securities lending market When considering

the impact of technology in the context of securities lending, we should look first at the development of the securities lending industry and how it has been supported by technology.

The history If we look back to the late eighties and early nineties when the international securities finance market started to evolve, we can break the evolution down into three phases. In the first phase, international securities lending systems were trade or transaction focused. Volumes and the degree of standardisation were relatively low. Automation was not that important and the user was happy that the systems could support the key processes. The systems available in the market or newly launched then were not even in real time. In the international marketplace there were very few vendor systems available, most coming from the US domestic market and marketed as multi-currency. The first real international securities lending

effectively and reduce the liquidity risk, a cross product collateral view is essential. Furthermore, the buy side, such as hedge funds, require an integrated product offering. This is why some market participants have merged organisations or have at least implemented cross product processes. Where are we today? Today, visions and strategies are defined together with an understanding of the technology involved. IT follows strategy. However, IT enables new strategy. Depending on the business model and the size of an organisation, the securities lending business is more integrated into other business lines, such as repo, synthetic finance and maybe even OTC derivative collateral management. This is either in the form of integrated processes or even combined organisations. One of the key success factors for a successful integration of the business lines is a horizontal position-focused IT platform. However, typically there is no single IT platform supporting this business model. A variety of vendor systems are being used, mostly for the books and records, very often, in-house functional add-ons or additional data collection facilities are developed to at least partly fulfil the business requirements for a consolidated view of the positions and transactions. Consequently, a large number of heterogeneous systems and interfaces must be supported and reconciled, leading to enormous maintenance costs and the risk of poor data quality. As the IT structure typically mirrors the business structure, there is often no single point of responsibility for changes. Multiple

The technology requirements to support an integrated, front to back collateral trading model are substantially higher than for just a product silo or transaction processing system system that really had an impact in the market was only built in the early nineties. In the second phase, the market started its consolidation phase and extended the number of different trading products. More technology vendors emerged but, again, they were product focused with some degree of additional automation in the post-trade processes. The market reaction was to leverage this technology for efficiency by adding interfaces to internal systems and internal add-ons. Insufficient emphasis was placed on the overall architecture and technologies in place. This has often led to patchwork style results. The third phase started in the late nineties, when businesses did not concentrate on single products but more on positions across many different product lines. Traditionally, the securities lending business was equity focused, the benchmark bond repo business more treasury related, and the corporate and emerging market repo was more of a debt financing business. Many broker-dealers and universal banks were organised accordingly. Over recent years, it has been recognised that collateral is increasingly becoming a currency. In order to finance a financial institution’s balance sheet more

departments have to be coordinated, which is again slow and costly. Most of the securities lending trades are still agreed over the telephone. Smaller, or from a profitability standpoint less important, tickets are increasingly done using electronic trading platforms. Trading using an electronic exchange requires a minimum degree of standardisation. After a rather slow start, the electronic securities lending exchanges such as EquiLend are slowly gaining momentum. EquiLend, which was established in 2001 by a group of major securities lending players, has certainly added value by allowing participants to transact and reconcile through a secure hub. While these efficiency and standardisation gains are important, it has not yet added enough value to the transparency issue. With the increasing volumes and complexity of the securities finance business, risk management has become a key component of an IT solution. Counterparty and operational risks are the most important risks in securities finance. The main risk categories include compliance with regulations such as tax, poor legal documentation, quality of data in general and, last but not least, the valuation of exposures and collater-

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al, including sophisticated analysis of volatility and liquidity risk. As the current liquidity crisis shows, the application of stress tests not just to market volatility but also with regard to market reaction on the short term funding side, for example changes of collateral and margining rules, is key. Most of the

vent the overuse of positions or not actively funding or selling positions. Counterpart and trading positions must be kept and updated in real time for risk management purposes. Realtime profit and loss figures will provide the required information to optimise the book and close out unprofitable transac-

Most of the securities lending trades are still agreed over the telephone. Smaller, or from a profitability standpoint less important, tickets are increasingly done using electronic trading platforms. Trading using an electronic exchange requires a minimum degree of standardisation technology available in the market does not address counterparty and systemic risk sufficiently. Where do we go in the future? Traders tend to have short memories and are therefore susceptible to short term trends. The electronic securities lending platforms, which were launched in the midst of the ‘hype’ of e-business, are focused on increasing distribution and hence making more money. However, between 2000 and 2003, the industry was, for the first time, faced with decreasing income. This may have changed the focus of these electronic marketplaces almost entirely to efficiency gains and hence cost cutting. This has only happened partially. Therefore I do not believe that we are going to see a very steep increase in business volumes traded electronically until the market demand changes. Market demand changes can, for example, be based on tax or regulatory changes that impact the spreads in securities lending dramatically in a negative way. This will then lead to further commoditisation and standardisation of the business, which will force market participants to manage the business almost entirely over processes and IT because volume insensitivity and low unit cost is going to be critical in the future. This is why electronic trading platforms are gaining in importance. I estimate that in 10 years, well over 50% of the market value volume will be traded electronically. Technology requirements The technology requirements to support an integrated, front to back collateral trading model are substantially higher than for just a product silo or transaction processing system. First, the architecture must be scalable as to the distribution of functionality across servers. This is typically achieved with service-based architectures, which allow multiple instances of the same services in order to achieve high performance and availability. Service-based architectures are also the way to integrate systems across the net, mainly by using web services. Transaction processing services for settlement, audit trail, and accounting should be loosely coupled using message oriented middleware as separation layer. Secondly, real-time information has become a necessity. In cross product systems, multiple users with different business intentions may use the same positions. Only real-time updates on positions, preferably on a ‘push’ basis (meaning the user does not have to actively query the system) will pre-

tions or to replace them with cheaper sources. Additionally, the data model of such an application must be designed for maximum flexibility from the beginning. All existing, but also new, trade types must be supported. This includes single security, security versus cash, but even security versus security transactions. All future flows of financial instruments must be presented as cash flows, which will allow for all types of synthetic securities finance transactions such as total return swap and OTC options transactions, but also for other future transaction types. Additional features, such as ‘pluggable’ classes will allow the functionality of the system to be changed without having to change the core architecture. This reduces the overall costs and time to market for changes. Using standards and open system technology can reduce the total cost of ownership massively and facilitate the integration effort. So, where does that leave us? We, as technology vendors, cannot therefore afford to rest on our laurels. We have to respond to the needs of the market and create inventive and forward looking systems to help support the business models of the future. SLMG

Felix Oegerli, member of the executive committee, COMIT Oegerli is member of the executive committee of COMIT, a consulting, IT solutions and integration partner of the finance industry. He was the founder and CEO of IFBS, an IT application solutions and consulting firm specialising in securities lending, repo and collateral management. IFBS was recently sold to COMIT. Prior to launching IFBS, Oegerli held a number of business leadership roles at UBS in Zurich, New York, and London for over 20 years in different functions. Between 1990 and 1999, he was responsible for the creation and expansion of the Securities Lending, Repo and Prime Brokerage business at UBS Zurich, was deputy global head of Securities Lending and Repo, global head of Prime Brokerage and head of global product management Collateral Trading and Management.

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PANEL - TECHNOLOGY

SECURITIES LENDING PANEL

TECHNOLOGY DEBATE Benjamin Glicher is chief technology officer of EquiLend and is charged with the goal of building a scalable, secure, and highly available technology platform. His responsibilities include all aspects of the infrastructure and application development areas of the EquiLend system. Prior to joining EquiLend in January 2002, Glicher was the managing director of Financial Services Technology at PricewaterhouseCoopers. Earlier in his career, he was chief technology officer at Global Market Information, a subsidiary of Track Data Corporation. Glicher received his BS in computer science from Brooklyn College, a member of the City University of New York, in 1982.

Felix Oegerli is member of the executive committee of COMIT, a consulting, IT and integration partner of the finance industry. He was the founder and CEO of IFBS, an IT application solutions and consulting firm specialising in securities lending, repo and collateral management. IFBS was recently sold to COMIT. Prior to launching IFBS, Oegerli held a number of business leadership roles at UBS in Zurich, New York, and London for over 20 years in different functions. Between 1990 and 1999 he was responsible for the creation and expansion of the Securities Lending, Repo and Prime Brokerage business at UBS Zurich, was deputy global head of Securities Lending and Repo, global head of Prime Brokerage and head of global product management, Collateral Trading and Management. Daniel Fowler is chief information officer and managing director of eSecLending. Fowler’s primary responsibilities within eSecLending are for systems and information technology and application. Prior to joining the firm in 2006, Fowler held several jobs that gave him broad exposure to both technology and financial markets. Most recently, he was employed by Brown Brothers Harriman as vice president of Systems, Private Account and Securities Lending. Prior to that, he worked at Boston Global Advisors as vice president, head of Technology. Fowler holds a BS in Computer Science from the University of Massachusetts.

There has been a significant increase in automated capability for securities lending over the last few years, how has this affected the market in general? Glicher: Automation enables a firm to scale its business in a more cost efficient manner. EquiLend’s platform offers the ability to automate the entire lifecycle of a trade. Trades are delivered machine to machine, allowing potentially an infinite amount of trades to be processed, so that individuals can focus on the more complex and relationship oriented transactions. Once the trade is initiated, all of EquiLend’s post-trade services are 46 INVESTOR SERVICES JOURNAL SECURITIES LENDING MARKET GUIDE 2007

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available to complete the lifecycle of the contract. Contract, marks, and billing can be reconciled daily, mitigating risk. Oegerli: It is important to highlight that the market demand transformation drives the business model transformation and not vice versa. Technology will never drive a business model but will enable it. In the past, technology mainly had an impact on process automation and therefore cost. The electronic securities lending platforms, which were launched in the midst of the e-business ‘hype’, were focused on widening the distribution network and increasing profits. However, between 2000 and 2003, the industry was for the first time faced with slower growth or, in some cases, falling revenues. This may have changed the focus of these electronic marketplaces mainly to efficiency gains in the securities lending trading area and to the post-trade processes. These

regard to securities lending technology would be slightly exaggerated. Technology has helped the business to become more efficient for trading general collateral tickets and on the post-trade reconciliation and trade reporting side. Technology is available to further increase the level of automation on the trading side. However, the business requires further standardisation in order to fully automate the trading process and this may take well over 10 years. Fowler: The greatest technology innovations for the securities lending industry are taking place in the areas of automation and volume processing to create greater operational processing efficiencies. A current important initiative taking shape within the market is the Automated Recall Management Software (ARMS) project. This initiative will allow recalls to be processed via automated systems, in

Trades are delivered machine to machine, allowing potentially an infinite amount of trades to be processed, so that individuals can focus on the more complex and relationship oriented transactions processes will become more and more standardised and will eventually be fully automated. So the answer is that technology will facilitate greater efficiency and transparency, but will only be a small factor for further growth in the sense of lower entry barriers to this market. Fowler: In general, the increase in automated capabilities for the securities lending market has resulted in an ability to better manage increased lending volumes and trading activity. Technology has created greater operational processing efficiencies for agent lenders and borrowers, which has helped to reduce operational costs and human resource requirements.

Where are the greatest innovations in technology being seen for securities lending? Glicher: The move to a real-time messaging paradigm and the use of the web browser as the ubiquitous user interface. Oegerli: To speak about great innovations with

which all information would be communicated over the same standard messaging system. This will greatly improve operational processing and reduce fail risk for securities lending activities. In the area of volume processing, securities lending vendors like LoanNet, EquiLend, and Prium are standardising interfaces with counterparties and simplifying the reconciliation of operational processing, as well as billing comparisons and contract comparisons. These initiatives create greater efficiencies, improved processing, and provide for more reliable and scalable operations, which in turn, more easily enables lenders and borrowers to successfully manage increased flows and volume processing.

Which platforms are dominating the market and why? Glicher: EquiLend has a strong presence in the marketplace, as it is the most innovative technology platform. EquiLend was the first securities finance platform to introduce real-time messaging, the first platform to handle the complete lifecycle of a contract (trade and post-trade) and the first firm to cre-

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PANEL - TECHNOLOGY

ate a standard XML taxonomy, Securities Lending Market Language (SLML). EquiLend created this protocol to facilitate the exchange of securities financing information. There is SLML representation for all of the business functionality that our users employ. Fowler: In terms of core securities lending systems, SunGard’s Global One is the dominant platform in the marketplace. There are various reasons for Global One’s dominance, but the primary reasons for SunGard’s success with this product is that Global One has been around the longest, it has a robust suite of functionality and it is not prohibitively expensive. 4Sight, which is the securities lending system that eSecLending uses, is still a relatively small player in the market but the platform is gaining greater market share and momentum. 4Sight’s architecture is a bit more open and sits on an Oracle database, which allows for ease of integration and support. Anvil is another player in the market.

What are the key factors to consider when choosing a new technology platform? Glicher: Ease of use, cost, and penetration in the marketplace.

Fowler: There are a number of key factors to consider when choosing a new technology platform: full functionality for various business areas; open architecture that can be supported internally; and connectivity to allow for communications with legacy systems and other downstream systems within the organisation. For eSecLending, it is imperative that our core securities lending system be able to feed information downstream into other reporting and transaction processing systems. We would not choose a platform that could not adequately communicate and upload/download information to the supporting or secondary systems used for transaction processing. In addition, ongoing support from a vendor is crucial, as is their willingness to work with you and improve and enhance the system’s functionality.

What effect are requirements for greater transparency having on the technology landscape in securities lending? Glicher: Increased automation results in data, which can, conceptually, be provided on demand, based on the appropriate request.

In the area of volume processing, securities lending vendors like LoanNet, EquiLend, and Prium are standardising interfaces with counterparties and simplifying the reconciliation of operational processing, as well as billing comparisons and contract comparisons Oegerli: Selecting a market technology platform should be based on an internal business case that compares the additional income generated through a better distribution system and the cost savings on post-trade processes to the investment required to integrate the platform plus the running cost. Another key consideration is the current and anticipated success in getting market participants to use the service, ensuring a certain market depth and liquidity in case of trading platforms. Experience has shown that only user driven market platforms will succeed.

Oegerli: Technology is available for the reporting and analysis of transactions. However, despite the increased transparency over the last few years, there is still a long way to go. Full transparency on pricing involves a lot of complex benchmarking including, for example, counterparty specific internal trading, risk and funding policies. Furthermore, information about market depth would also be required. I believe that full transparency is only going to be achieved when the market is commoditised and this may take over 10 years.

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Fowler: Lenders are looking to increase transparency in their securities lending activities to ensure an objective, regulatory friendly and highly auditable programme that can be easily presented to their management team, board, auditors and regulators lender and allows for objective decision making on how to best allocate portfolios for lending. The auction process also provides price transparency and price discovery, thereby giving clients the opportunity to definitively identify where the greatest demand exists for various pieces of their portfolios. The desire for greater transparency has also created the need for comprehensive benchmarking services. There are multiple providers in the industry offering solutions to help lenders better evaluate their securities lending performance and compare their

What is the future for technology in this area – where next? Glicher: Web services - offering the ability to transmit messaging through web technologies, Web 2.0, and service oriented architecture (SOA). Securities lending has matured to the point where it can move away from monolithic, complex, stand alone systems into more manageable components working within a distributed systems architecture. The services, both trading and reconciliation, can be self contained and do not need to depend on the context or state of the other services. This will lead us to an SOA or a collection of services or functionalities that communicate with each other.

Another key consideration is the current and anticipated success in getting market participants to use the service, ensuring a certain market depth and liquidity in case of trading platforms returns to other industry participants.

How is risk management affected by these technology platforms? Glicher: Automation mitigates the risk often found with manual input. Automating trade and post-trade processes significantly decreases manual interaction; therefore any issues that occur can be remediated in a more straightforward manner. Oegerli: Counterparty and operational risks are the most important risks in securities finance. The main risk categories include compliance with regulations such as tax, poor legal documentation, quality of data in general and, last but not least, the valuation of exposures and collateral, including sophisticated analysis of volatility and liquidity risk, including the application of stress tests. In order to minimise the risk in securities lending, technology is key. Market technology platforms may reduce some of the operational risk but they do not address counterparty risk. This is a key process for each individual securities finance participant.

Oegerli: Further commoditisation and standardisation of the business will force market participants to manage the business over processes and IT because volume insensitivity and low unit cost is going to be critical in the future. This is why electronic trading platforms are gaining in importance. I estimate that in 10 years, well over 50% of the market value volume will be traded electronically. Fowler: There is significant room in the market for further automation and technological advancements for operational processing and trading. For instance, if the market can get to the point where the dividend claiming process can also be automated along the same lines as recalls, market participants will experience significant improvements in terms of cost and resource reductions. More broadly speaking, I imagine the securities lending market will also one day explore how to better integrate lending activities with the traditional investment management decisions. Using newer web services technology you may find investment managers using their fund’s lending data to calculate whether there is a better economic decision to recalling a security or leaving it on loan. SLMG

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Securities Lending GUIDE

Securities Lending GUIDE A guide to the machinery of the securities lending market Securities lending began as an informal practice among brokers who had insufficient share certificates to settle their sold bargains, commonly because their selling clients had mislaid their certificates or just not provided them to the broker by the settlement date of the transaction. Once the broker had received the certificates, they would be passed on to the lending broker. This business arrangement was subject to no formal agreement and there was no exchange of collateral. Securities lending is now an important and significant business that describes the market practice whereby securities are temporarily transferred by one party (lender) to another (borrower). The borrower is obliged to return the securities to the lender, either on demand, or at the end of any agreed term. For the period of the loan the lender is secured by acceptable assets delivered by the borrower to the lender as collateral. Under English law, absolute title to the securities “lent” passes to the “borrower”, who is obliged to return “equivalent securities.” Similarly the lender receives absolute title to the assets received as collateral from the borrower, and is obliged to return “equivalent collateral.” Securities lending today plays a major part in the efficient functioning of the securities markets worldwide. Yet it remains poorly understood by many of those outside the market. Definitions In some ways, the term “securities lending” is misleading and factually incorrect. Under English law and in many other jurisdictions, the transaction commonly referred to as “securities lending” is, in fact: “a disposal (or sale) of securities linked to the subsequent reacquisition of equivalent securities by means of an agreement.” Such transactions are collateralised and the “rental fee” charged, along with all other aspects of the transaction, are dealt with under the terms agreed between the parties. It is entirely possible and very commonplace that securities are borrowed and then sold or on-lent. There are some consequences arising from this clarification: - Absolute title over both the securities on loan and the collateral received passes between the parties. - The economic benefits associated with ownership – for example, dividends, coupons – are “manufactured” back to the lender, meaning that the borrower is entitled to these benefits as owner of the securities but is under a contractual obligation to make equivalent payments to the lender. - A lender of equities surrenders its rights of ownership, for example, voting. Should the lender wish to vote on securities on loan, it has the contractual right to recall equivalent securities from the borrower. - In the United Kingdom appropriately documented securities lending transactions avoid two taxes: Stamp Duty Reserve Tax and Capital Gains Tax.

Different types of securities loan transaction: Most securities loans in today’s markets are made against collateral in order to protect the lender against the possible default of the borrower. This collateral can be cash, or other securities or other assets. (a) Transactions collatteralised with other securities or assets Non-cash collateral would typically be drawn from the following collateral types: * Government Bonds - Issued by G7, G10 or Non-G7 governments * Corporate Bonds - Various credit ratings * Convertible Bonds - Matched or unmatched to the securities being lent * Equities - Of specified Indices * Letters of Credit - From banks of a specified credit quality * Certificates of Deposit - Drawn on institutions of a specified credit quality * Delivery By Value (“DBVs”)1 - Concentrated or * Unconcentrated - Of a certain asset class * Warrants - Matched or unmatched to the securities being lent *Other money market instruments The eligible collateral will be agreed between the parties, as will other key factors including: * Notional Limits - The absolute value of any asset to be accepted as collateral * Initial margin - The margin required at the outset of a transaction * Maintenance margin - The minimum margin level to be maintained throughout the transaction * Concentration limits - The maximum percentage of any issue to be acceptable, for example less than 5% of daily traded volume - The maximum percentage of collateral pool that can be taken against the same issuer, i.e. the cumulative effect where collateral in the form of letters of credit, CD, equity, bond and convertible may be issued by the same firm

The borrower is obliged to return the securities to the lender, either on demand, or at the end of any agreed term The example in the diagram shows collateral being held by a Tri Party Agent. This specialist agent (typically a large custodian bank or International Central Securities Depository) will receive only eligible collateral from the borrower and hold it in a segre-

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TRANSACTIONS COLLATERALISED WITH OTHER SECURITIES OR ASSETS

Borrower

Lender

Reporting Collateral

Reporting Loan Commences

Tri Party Agent

Borrower

Lender

Collateral

Loan Terminates

Tri Party Agent

gated account to the order of the lender. The Tri Party Agent will mark this collateral to market, with information distributed to both lender and borrower (in the diagram, dotted “Reporting” lines). Typically the borrower pays a fee to the Tri Party agent. There is debate within the industry as to whether lenders that are flexible in the range of non-cash collateral they are willing to receive are rewarded with correspondingly higher fees. Some argue that they are, others claim that the fees remain largely static but that borrowers are more prepared to deal with a flexible lender and therefore balances and overall revenue rise. (b) Transactions collateralised with cash Cash collateral is, and has been for many years, an integral part of the securities lending business, particularly in the United States. The lines between two distinct activities. Securities lending and cash reinvestment have become blurred and to many US investment institutions securities lending is virtually synonymous with cash reinvestment. This is much less the case outside the United States but consolidation of the custody business and the important role of US custodian banks in the market means that this practice is becoming more prevalent. The importance of this point lies in the very different risk profiles of these increasingly intertwined activities. The revenue generated from cash-collateralised securities lending transactions is derived in a different manner from that in a non-cash transaction. It is made from the difference or “spread” between interest rates that are paid and received by the lender. Other transaction types Securities lending is part of a larger set of interlinked securities financing markets. These transactions are often used as alternative ways of achieving similar economic outcomes, although the legal form and accounting and tax treatments can differ.

The other transactions include: (a) Sale and repurchhase agreements Sale and repurchase agreements or repos involve one party agreeing to sell securities to another against a transfer of cash, with a simultaneous agreement to repurchase the same securities (or equivalent securities) at a specific price on an agreed date in the future. It is common for the terms ”seller” and “buyer” to replace the securities lending terms “lender” and ”borrower”. Most repos are governed by a master agreement called the TBMA/ISMA Global Master Repurchase Agreement (GMRA)2. Repos occur for two principal reasons – either to transfer ownership of a particular security between the parties or to facilitate collateralised cash loans or funding transactions. The bulk of bond lending and bond financing is conducted by repo and there is a growing equity repo market. An annex can be added to the GMRA to facilitate the conduct of equity repo transactions. Repos are much like securities loans collateralised against cash, in that income is factored into an interest rate that is implicit in the pricing of the two legs of the transaction. At the beginning of a transaction, securities are valued and sold at the prevailing “dirty” market price (including any coupon that has accrued). At termination, the securities are resold at a predetermined price equal to the original sale price together with interest at a previously agreed rate known as the repo rate. In securities-driven transactions (where the motivation is not simply financing) the repo rate is typically set at a lower rate than prevailing money market rates to reward the “lender” who will invest the funds in the money markets and thereby seek a return. The “lender” often receives a margin by pricing the securities above their market level. In cash-driven transactions, the repurchase price will typically be agreed at a level close to current money market yields, as this is a financing rather than a security specific transaction. The right to substitute repoed securities as collateral is agreed by the parties at the outset. A margin is often provided to the cash “lender” by reducing the value of the transferred securities by an agreed “haircut” or discount. (b) Buy/sell backs Buy/sell backs are similar in economic terms to repos but are structured as a sale and simultaneous purchase of securities, with the purchase agreed for a future settlement date. The price of the forward purchase is typically calculated and agreed by reference to market repo rates. The purchaser of the securities receives absolute title to them and retains any accrued interest and coupon payments during the life of the transaction. However, the price of the forward contract takes account of any coupons received by the purchaser. Buy/sell back transactions are normally conducted for financing purposes and involve fixed income securities. In general a cash borrower does not have the right to substitute collateral. Until 1996, the bulk of buy/sell back transactions took place outside of a formal legal framework with contract notes being

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Securities Lending GUIDE TRANSACTIONS COLLATERALISED WITH CASH Loan

Borrower

Lender Cash

Cash

Loan Commences

Collateral Money Markets

Loan

Borrower

Lender Cash

Cash Loan Terminates

Collateral Money Markets

the only form of record. In 1995, the GMRA was amended to incorporate an annex that dealt explicitly with buy/sell backs. Most buy/sell backs are now governed by this agreement. Lenders and intermediaries The securities lending market involves various types of specialist intermediary which take principal and/or agency roles. These intermediaries separate the underlying owners of securities – typically large pension or other funds, and insurance companies – from the eventual borrowers of securities Intermediaries 1. Agent intermediaries Securities lending is increasingly becoming a volume business and the economies of scale offered by agents that pool together the securities of different clients enable smaller owners of assets to participate in the market. The costs associated with running an efficient securities lending operation are beyond many smaller funds for which this is a peripheral activity. Asset managers and custodian banks have added securities lending to the other services they offer to owners of securities portfolios, while third party lenders specialise in providing securities lending services. Owners and agents “split” revenues from securities lending at commercial rates. The split will be determined by many factors including the service level and provision by the agent of any risk mitigation, such as an indemnity. Securities lending is often part of a much bigger relationship and therefore the split negotiation can become part of a bundled approach to the pricing of a wide range of services. (a) Asset managers It can be argued that securities lending is an asset management activity – a point that is easily understood in considering the reinvestment of cash collateral. Particularly in Europe, where custodian banks were perhaps slower to take up the

opportunity to lend than in the United States, many asset managers run significant securities lending operations. What was once a back office low profile activity is now a front office growth area for many asset managers. The relationship that the asset managers have with their underlying clients puts them in a strong position to participate. (b) Custodian banks The history of securities lending is inextricably linked with the custodian banks. Once they recognised the potential to act as agent intermediaries and began marketing the service to their customers, they were able to mobilise large pools of securities that were available for lending. This in turn spurred the growth of the market. Most large custodians have added securities lending to their core custody businesses. Their advantages include: the existing banking relationship with their customers; their investment in technology and global coverage of markets, arising from their custody businesses; the ability to pool assets from many smaller underlying funds, insulating borrowers from the administrative inconvenience of dealing with many small funds and providing borrowers with protection from recalls; and experience in developing as well as developed markets. Being banks, they also have the capability to provide indemnities and manage cash collateral efficiently – two critical factors for many underlying clients. Custody is so competitive a business that for many providers it is a loss making activity. However, it enables the custodians to provide a range of additional services to their client base. These may include foreign exchange, trade execution, securities lending and fund accounting. (c) Third-party agents Advances in technology and operational efficiency have made it possible to separate the administration of securities lending from the provision of basic custody services, and a number of specialist third-party agency lenders have established themselves as an alternative to the custodian banks. Their market share is currently growing from a relatively small base. Their focus on securities lending and their ability to deploy new technology without reference to legacy systems can give them flexibility. 2. Prrincipal intermediaries There are three broad categories of principal intermediary: - Broker dealers - Specialist intermediaries - Prime brokers In contrast to the agent intermediaries, they can assume principal risk, offer credit intermediation and take positions in the securities that they borrow. Distinctions between the three categories are blurred. Many firms would be in all three. In recent years, securities lending markets have been liberalised to a significant extent so that there is little general restriction on who can borrow and who can lend securities. Lending can, in principle, take place directly between benefi-

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cial owners and the eventual borrowers. But typically a number of layers of intermediary are involved. What value do the intermediaries add? A beneficial owner may well be an insurance company or a pension scheme while the ultimate borrower could be a hedge fund. Institutions will often be reluctant to take on credit exposures to borrowers that are not well recognised, regulated, or who do not have a good credit rating, which would exclude most hedge funds. In these circumstances, the principal intermediary (often acting as prime broker) performs a credit intermediation service in taking a principal position between the lending institution and the hedge fund. A further role of the intermediaries is to take on liquidity risk. Typically they will borrow from institutions on an open basis – giving them the option to recall the underlying securities if they want to sell them or for other reasons – whilst lending to clients on a term basis, giving them certainty that they will be able to cover their short positions. In many cases, as well as serving the needs of their own propriety traders, principal intermediaries provide a service to the market in matching the supply of beneficial owners that have large stable portfolios with those that have a high borrowing requirement. They also distribute securities to a wider range of borrowers than underlying lenders, which may not have the resources to deal with a large number of counterparts. These activities leave principal intermediaries exposed to liquidity risk if lenders recall securities that have been on lent to borrowers on a term basis. One way to mitigate this risk is to use in-house inventory where available. For example, proprietary trading positions can be a stable source of lending supply if the long position is associated with a long-term derivatives transaction. Efficient inventory management is seen as critical and many securities lending desks act as central clearers of inventory within their organisations, only borrowing externally when netting of in-house positions is complete. This can require a significant technological investment. Other ways of mitigating ‘recall risk’ include arrangements to borrow securities from affiliated investment management firms, where regulations permit, and bidding for exclusive (and certain) access to securities from other lenders. On the demand side, intermediaries have historically been dependent upon hedge funds or proprietary traders that make trading decisions. But a growing number of securities lending businesses within investment banks have either developed “trading” capabilities within their lending or financing departments, or entered into joint ventures with other departments or even in some cases their hedge fund customers. The rationale behind this trend is that the financing component of certain trading strategies is so significant that without the loan there is no trade. (a) Broker dealers Broker dealers borrow securities for a wide range of reasons: - Market making - To support proprietary trading on behalf of clients

Many broker dealers combine their securities lending activities with their prime brokerage operation (the business of servicing the broad requirements of hedge funds and other alternative investment managers). This can bring significant efficiency and cost benefits. Typically within broker dealers the fixed income and equity divisions duplicate their lending and financing activities. (b) Specialist intermediaries Historically, regulatory controls on participation in stock lending markets meant that globally there were many intermediaries. Some specialised in intermediating between stock

Historically, regulatory controls on participation in stock lending markets meant that globally there were many intermediaries lenders and market makers in particular, e.g. UK Stock Exchange Money Brokers (SEMB). With the deregulation of stock lending markets, these niches have almost all disappeared. Some of the specialists are now part of larger financial organisations. Others have moved to parent companies that have allowed them to expand the range of their activities into proprietary trading. (c) Prime brokers Prime brokers serve the needs of hedge funds and other ‘alternative’ investment managers. The business was once viewed, simply, as the provision of six distinct services, although many others such as capital introduction, risk management, fund accounting and start up assistance have now been added: Services provided by prime brokers Securities lending is one of the central components of a successful prime brokerage operation, with its scale depending on the strategies of the hedge funds for which the prime broker acts. Two strategies that are heavily reliant on securities borrowing are long/short equity and convertible bond arbitrage. The cost associated with the establishment of a full service prime broker is steep, and recognised providers have a significant advantage. Some of the newer entrants have been using total return swaps, contracts for difference and other derivative transaction types to offer what has become known as “synthetic prime brokerage”. Again securities lending remains a key component of the service as the prime broker will still need to borrow securities in order to hedge the derivatives positions it has entered into with the hedge funds, for example, to cover short positions. But it is internalised within the prime broker and less obvious to the client. Beneficial owners Those beneficial owners with securities portfolios of sufficient size to make securities lending worthwhile include:

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Securities Lending GUIDE - Pension funds - Insurance and assurance companies - Mutual funds/unit trusts - Endowments When considering whether and how to lend securities, beneficial owners need first to consider the characteristics of their organisations and portfolio. 1. Organisation characteristics (a) Management motivation Some owners lend securities solely to offset custody and administrative costs. Others are seeking more significant revenue. (b) Technology investment Lenders vary in their willingness to invest in technological infrastructure to support securities lending. (c) Credit risk appetite The securities lending market consists of organisations with a wide range of credit quality and collateral capabilities. A cautious approach to counterpart selection (AAA only) and restrictive collateral guidelines (G7 Bonds) will limit lending volumes. 2. Portfolio characteristics (a) Size Other things being equal, borrowers prefer large portfolios. (b) Holdings size Loan transactions generally exceed USD250,000. Lesser holdings are of limited appeal to direct borrowers. Holdings of under USD250,000 are probably best deployed through an agency programme, where they can be pooled with other inventories.

The securities lending market consists of organisations with a wide range of credit quality and collateral capabilities (c) Investment strategy Active investment strategies increase the likelihood of recalls, making them less attractive than passive portfolios. (d) Diversification Borrowers want portfolios where they need liquidity. A global portfolio offers the greatest chance of generating a fit. That said, there are markets that are particularly in demand from time to time and there are certain borrowers that have a geographic or asset class focus.

(e) Tax jurisdiction and position Borrowers are responsible for "making good" any benefits of share ownership (excluding voting rights) as if the securities had not been lent. They must "manufacture" (pay) the economic value of dividends to the lender. An institution's tax position compared to that of other possible lenders is therefore an important consideration. If the cost of manufacturing dividends or coupons to a lender is low then its assets will be in greater demand. (f) Inventory attractiveness "Hot" securities are those in high demand whilst general collateral or general collateral securities are those that are commonly available. Needless to say, the "hotter" the portfolio, the higher the returns to lending. Having examined the organisation and portfolio characteristics of the beneficial owner, we must now consider the various possible routes to market. The possible routes to the securities lending market: (a) Using an asset manager as agent A beneficial owner may find that the asset manager they have chosen, already operates a securities lending programme. This route poses few barriers to getting started quickly. (b) Using a custodian as agent This is the least demanding option for a beneficial owner, especially a new one. They will already have made a major decision in selecting an appropriate custodian. This route also poses few barriers to getting started quickly. (c) Appointing a third party specialist as agent A beneficial owner who has decided to outsource may decide it does not want to use the supplier’s asset manager(s) or custodian(s), and instead appoint a third-party specialist. This route may mean getting to know and understand a new provider prior to getting started. The opportunity cost of any delay needs to be factored into the decision. (d) Auctioning a portfolio to borrowers Borrowers demand portfolios for which they bid guaranteed returns in exchange for gaining exclusive access to them. There are several different permutations of this auctioning route: - Do-it-yourself auctions - Assisted auctions - Agent assistance - Consultancy assistance - Specialist “auctioneer” assistance This is not a new phenomenon but one that has gained a higher profile in recent years. A key issue for the beneficial owner considering this option is the level of operational support that the auctioned portfolio will require and who will provide it. e) Selecting one principal borrower Many borrowers effectively act as wholesale intermediaries and have developed global franchises using their expertise and capital to generate spreads between two principals that remain

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unknown to one another. These principal intermediaries are sometimes separately incorporated organisations, but more frequently, parts of larger banks, broker-dealers or investment banking groups. Acting as principal allows these intermediaries to deal with organisations that the typical beneficial owner may choose to avoid for credit reasons, for example, hedge funds. (f) Lending directly to proprietary principals Normally after a period of activity in the lending market using one of the above options, a beneficial owner that is large enough in its own right, may wish to explore the possibility of establishing a business “in house”, lending directly to a selection of principal borrowers that are the end-users of their securities. The proprietary borrowers include broker-dealers, market makers and hedge funds. Some have global borrowing needs while others are more regionally focused. (g) Choosing some combination of the above Just as there is no single or correct lending method, so the options outlined above are not mutually exclusive. Deciding not to lend one portfolio does not preclude lending to another; similarly, lending in one country does not necessitate lending in all. Choosing a wholesale intermediary that happens to be a custodian in the United States and Canada does not mean that a lender cannot lend Asian assets through a third-party specialist, and European assets directly to a panel of proprietary borrowers. The borrowing motivation One of the central questions commonly asked by issuers and investors alike is “Why does the borrower borrow my securities?” Before considering this point let us examine why issuers might care. If securities were not issued, they could not be lent. Behind this simple tautology lies an important point. When Initial Public Offerings are frequent and corporate merger and acquisition activity is high, the securities lending business benefits. In the early 2000s, the fall in the level of such activity depressed the demand to borrow securities leading to: A depressed equity securities lending market meaning: - Fewer trading opportunities - Less demand - Fewer ”specials” Issuer concern about the role of securities lending, such as Whether it is linked in any way to the decline in the value of a company’s shares? Whether securities lending should be discouraged? How many times does an issuer discussing a specific corporate event stop to consider the impact that the issuance of a convertible bond, or the adoption of a dividend reinvestment plan might have upon lending of their shares. There is a significant amount of information available on the long side of the market and correspondingly little on the short side. Securities lending activity is not synonymous with short selling. But it is often, although not always, used to finance short sales (see below) and might be a reasonable and practical proxy for the scale of short selling activity in the absence of full short sale disclosure. It is therefore natural that issuers

would want to understand how and why their securities are traded. Reasons to borrow Borrowers, when acting as principals, have no obligation to tell lenders or their agents why they are borrowing securities. In fact they may well not know themselves as they may be onlending the securities to proprietary traders or hedge funds that do not share their trading strategies openly. Some prime brokers are deliberately vague when borrowing securities as they wish to protect their underlying hedge fund customer’s trading strategy and motivation. This chapter explains some of the more common reasons behind the borrowing of securities. In general, these can be grouped into: (1) borrowing to cover a short position (settle-

In many cases, principal intermediaries provide a service to the market in matching the supply of beneficial owners that have large stable portfolios with those that have a high borrowing requirement ment coverage, naked shorting, market making, arbitrage trading); (2) borrowing as part of a financing transaction motivated by the desire to lend cash; and (3) borrowing to transfer ownership temporarily to the advantage of both lender and borrower (tax arbitrage, dividend reinvestment plan arbitrage). Borrowing to cover short positions (a) Settlement coverage Historically, settlement coverage has played a significant part in the development of the securities lending market. Going back a decade or so, most securities lending businesses were located in the back offices of their organisations and were not properly recognised as businesses in their own right. Particularly for less liquid securities – such as corporate bonds and equities with a limit free float – settlement coverage remains a large part of the demand to borrow. The ability to borrow to avoid settlement failure is vital to ensure efficient settlement and has encouraged many securities depositories into the automated lending business. This means that they remunerate customers for making their securities available to be lent by the depository automatically in order to avert any settlement failures. (b) Naked shorting Naked shorting can be defined as borrowing securities in order to sell them in the expectation that they can be bought back at a lower price in order to return them to the lender. Naked shorting is a directional strategy, speculating that prices will fall, rather than a part of a wider trading strategy, usually involving a corresponding long position in a related security.

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Securities Lending GUIDE Naked shorting is a high risk strategy. Although some funds specialise in taking short positions in the shares of companies they judge to be overvalued, the number of funds relying on naked shorting is relatively small and probably declining. (c) Market making Market makers play a central role in the provision of two-way price liquidity in many securities markets around the world. They need to be able to borrow securities in order to settle buy

Stock index arbitrage involves buying or selling a basket of stocks and, conversely, selling or buying futures when mispricing appears to be taking place orders from customers and to make tight, two-way prices. The ability to make markets in illiquid small capitalisation securities is sometimes hampered by a lack of access to borrowing, and some of the specialists in these less liquid securities have put in place special arrangements to enable them to gain access to securities. These include guaranteed exclusive bids with securities lenders. The character of borrowing is typically short term for an unknown period of time. The need to know that a loan is available tends to mean that the level of communication between market makers and the securities lending business has to be highly automated. A market maker that goes short and then finds that there is no loan available would have to buy that security back to flatten its book. (d) Arbitrage trading Securities are often borrowed to cover a short position in one security that has been taken to hedge a long position in another as part of an “arbitrage” strategy. Some of the more common arbitrage transactions that involve securities lending are described below. (i) Convertible bond arbitrage Convertible bond arbitrage involves buying a convertible bond and simultaneously selling the underlying equity short and borrowing the shares to cover the short position. Leverage can be deployed to increase the return in this type of transaction. Prime brokers are particularly keen on hedge funds that engage in convertible bond arbitrage as they offer scope for several revenue sources: - Securities lending revenues - Provision of leverage - Execution of the convertible bond - Execution of the equity (ii) Pairs trading or relative value “arbitrage” This in an investment strategy that seeks to identify two companies with similar characteristics whose equity securities are currently trading at a price relationship that is out of line with

their historical trading range. The strategy entails buying the apparently undervalued security while selling the apparently overvalued security short, borrowing the latter security to cover the short position. Focusing on securities in the same sector or industry should normally reduce the risks in this strategy. (iii) Index arbitrage In this context, arbitrage refers to the simultaneous purchase and sale of the same commodity or stock in two different markets in order to profit from price discrepancies between the markets. In the stock market, an arbitrage opportunity arises when the same security trades at different prices in different markets. In such a situation, investors buy the security in one market at a lower price and sell it in another for more, capitalising on the difference. However, such an opportunity vanishes quickly as investors rush in to take advantage of the price difference. The same principle can be applied to index futures. Being a derivative product, index futures derive their value from the securities that constitute the index. At the same time, the value of index futures is linked to the stock index value through the opportunity cost of funds (borrowing/lending cost) required to play the market. Stock index arbitrage involves buying or selling a basket of stocks and, conversely, selling or buying futures when mispricing appears to be taking place. (2) Financing As broker dealers build derivative prime brokerage and customer margin business, they hold an increasing inventory of securities that requires financing. This type of activity is high volume and takes place between two counterparts that have the following coincidence of wants: - One has cash that they would like to invest on a secured basis and pick up yield. - The other has inventory that needs to be financed. - In the case of bonds, the typical financing transaction is a repo or buy/sell back. But for equities, securities lending and equity, repo transactions are used. - Tri Party agents are often involved in this type of financing transaction as they can reduce operational costs for the cash lender and they have the settlement capabilities the cash borrower needs to substitute securities collateral as their inventory changes. (3) Temporary transfers of ownership (a) Tax arbitrage Tax driven trading is an example of securities lending as a means of exchange. Markets that have historically provided the largest opportunities for tax arbitrage include those with significant tax credits that are not available to all investors – examples include Italy, Germany and France. The different tax positions of investors around the world have opened up opportunities for borrowers to use securities lending transactions, in effect, to exchange assets temporarily for the mutual benefit of purchaser, borrower and lender. The

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lender’s reward comes in one of two ways: either a higher fee for lending if they require a lower manufactured dividend, or a higher manufactured dividend than the post-tax dividend they would normally receive (quoted as an “all-in rate”). For example, an offshore lender that would normally receive 75% of a German dividend and incur 25% withholding tax (with no possibility to reclaim) could lend the security to a borrower that, in turn, could sell it to a German investor who was able to obtain a tax credit rather than incur withholding tax. If the offshore lender claimed the 95% of the dividend that it would otherwise have received, it would be making a significant pick-up (20% of the dividend yield), whilst the borrower might make a spread of between 95% and whatever the German investor was bidding. The terms of these trades vary widely and rates are calculated accordingly. (b) Dividend reinvestment plan arbitrage Many issuers of securities create an arbitrage opportunity when they offer shareholders the choice of taking a dividend or reinvesting in additional securities at a discounted level. Income or index tracking funds that cannot deviate from recognised securities weightings may have to choose to take the cash option and forgo the opportunity to take the discounted reinvestment opportunity. One way that they can share in the potential profitability of this opportunity is to lend securities to borrowers that then take the following action: - Borrow as many guaranteed cash shares as possible, as cheaply as possible. - Tender the borrowed securities to receive the new discounted share. - Sell the new shares to realise the “profit” between the discounted share price and the market price. - Return the shares and manufacture the cash dividend to the lender. Market mechanics This section outlines the detailed processes in the life of a securities loan including: Loan negotiation Traditionally securities loans have been negotiated between counterparts (whose credit departments have approved one another) on the phone, and followed up with written or electronic confirmations. Normally the borrower initiates the call to the lender with a borrowing requirement. However, pro-active lenders may also offer out in-demand securities to their approved counterparts. This would happen particularly where one borrower returns a security and the lender is still lending it to others in the market, they will contact them to see if they wish to borrow additional securities. Today, there is an increasing amount of bilateral and multilateral automated lending whereby securities are broadcast as available at particular rates by email or other electronic means. Where lending terms are agreeable, automatic matching can take place. An example of an electronic platform for negotiating equity securities loan transactions is EquiLend, which began opera-

tions in 2002 and is backed by a consortium of financial institutions. EquiLend’s stated objective is to: “Provide the securities lending industry with the technology to streamline and automate transactions between borrowing and lending institutions and … introduce a set of common protocols. EquiLend will connect borrowers and lenders through a common, standards-based global equity lending platform enabling them to transact with increased efficiency and speed, and reduced cost and risk.” EquiLend is not alone in this market; for example, SecFinex offers similar services in Europe. Connfirmations Written or electronic confirmations are issued, whenever possible, on the day of the trade so that any queries by the other party can be raised as quickly as possible. Material changes during the life of the transaction are agreed between the parties as they occur and may also be

Traditionally securities loans have been negotiated between counterparts on the phone, and followed up with written or electronic confirmations confirmed if either party wishes it. Examples of material changes are collateral adjustments or collateral substitutions. The parties agree who will take responsibility for issuing loan confirmations. Confirmations would normally include the following information: - Contract and settlement dates. - Details of loaned securities. - Identities of lender and borrower (+ any underlying principal) - Acceptable collateral and margin percentages. - Term and rates. - Bank and settlement account details of the lender and borrower. Term of loan, and selling securities while on loan Loans may either be for a specified term or open. Open loans are trades with no fixed maturity date. It is more usual for securities loans to be open or “at call”, especially for equities, because lenders typically wish to preserve the flexibility for fund managers to be able to sell at any time. Lenders are able to sell securities despite their being on open loan because they can usually be recalled from the borrower within the settlement period of the market concerned. Nevertheless open loans can remain on loan for a long period. Term trades – fixed or indicative? The general description “term trade” is used to describe differing arrangements in the securities lending market. The parties have to agree whether the term of a loan is “fixed” for a definite period or whether the duration is merely “indicative” and therefore the securities are callable. If fixed, the lender is not obliged to accept the earlier return of the securities; nor does

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Securities Lending GUIDE the borrower need to return the securities early if the lender requests it. Accordingly, securities subject to a fixed loan should not be sold while on loan. Where the term discussed is intended to be “indicative”, it usually means that the borrower has a long term need for the securities but the lender is unable to fix for term and retains the right to recall the securities if necessary. Putting securities “on hold” (also known as “icing”) Putting securities “on hold” (referred to in the market as “icing” securities) is the practice whereby the lender will reserve securities at the request of a borrower on the borrower’s expected need to borrow those securities at a future date. This occurs where the borrower must be sure that the securities will be available before committing to a trade that will require them. While some details can be agreed between the parties, it is normal for any price quoted to be purely indicative, and for securities to be held to the following business day. The borrower can “roll over” the arrangement (continue to ice the securities) by contacting the holder before 9am, otherwise it terminates. Key aspects of icing are that the lender does not receive a fee for reserving the securities and they are generally open to challenge by another borrower making a firm bid. In this case the first borrower would have 30 minutes to decide whether to take the securities at that time or to release them.

Settlement will normally be through the lender’s custodian bank and this is likely to apply irrespective of whether the lender is conducting the operation or delegating to an agent “Pay-to-hold” arrangements A variation of icing is “pay-to-hold” where the lender does receive a fee for putting the securities on hold. As such, they constitute a contractual agreement and are not open to challenge by other borrowers. How are loans settled? Securities lenders need to settle transactions on a shorter timeframe than the customary settlement period for that market. Settlement will normally be through the lender’s custodian bank and this is likely to apply irrespective of whether the lender is conducting the operation or delegating to an agent. The lender will usually have agreed a schedule of guaranteed settlement times for its securities lending activity with its custodians. Prompt settlement information is crucial to the efficient monitoring and control of a lending programme, with reports needed for both loans and collateral. In most settlement systems securities loans are settled as “free-of-payment” deliveries and the collateral is taken quite

separately, possibly in a different payment or settlement system and maybe a different country and time zone. For example, UK equities might be lent against collateral provided in a European International Central Securities Depository or US dollar cash collateral paid in New York. This can give rise to what is known in the market as “daylight exposure”, a period during which the loan is not covered as the lent securities have been delivered but the collateral securities have not yet been received. To avoid this exposure some lenders insist on pre-collateralisation, so transferring the exposure to the borrower. The CREST system for settling UK and Irish securities is an exception to the normal practice as collateral is available within the system. This enables loans to be settled against cash intraday and for the cash to be exchanged, if desired, at the end of the settlement day for a package of DBV securities overnight. The process can be reversed and repeated the next day. CREST settlement facility for stock lending CREST also has specific settlement arrangements for stock loans, requiring the independent input of instructions by both parties, who must complete a number of matching fields, including the amount and currency of any cash collateral, together with the percentage value of applicable loan margin. Loans may be effected against sterling, euro or dollar consideration or made free-of-payment. Immediately after the settlement of the loan, CREST automatically creates a pre-matched stock loan return transaction with an intended settlement date of the next business day. The return is prevented from settling until the borrower intervenes to raise the settlement priority of the transaction. The stock lender may freeze the transaction in order to prevent the stock from returning. Termination of the loan Open loans may be terminated by the borrower returning securities or by the lender recalling them. The borrower will normally return borrowed securities when it has filled its short position. A borrower will sometimes refinance its loan positions by borrowing more cheaply elsewhere and returning securities to the original lender. The borrower may, however, give the original lender the opportunity to reduce the rate being charged on the loan before borrowing elsewhere. Redelivery, failed trades and legal remedies When deciding which markets and what size to lend in, securities lenders will consider how certain they can be of having their securities returned in a timely manner when called, and what remedies are available under the legal agreement (see below) in the event of a failed return. Procedures to be followed in the event of a failed redelivery are usually covered in legal agreements or otherwise agreed between the parties at the outset of the relationship. Financial redress may be available to the lender if the borrower fails to redeliver loaned securities or collateral on the intended settlement date. Costs that would typically be covered include: Direct interest and/or overdraft incurred Costs reasonably and properly incurred as a result of the borrower’s failure to meet its sale or delivery obligations

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COMPONENTS OF RETURN

+ 0 -

Short Interest Rate Current Yield Dividend Exposure

+

Leverage Related Returns

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Total Return

=

Interest Exposure

Total costs and expenses reasonably incurred by the lender as a result of a “buy-in” (i.e. where the lender is forced to? purchase securities in the open market following the borrower’s failure to return them) Costs that would usually be excluded are those arising from the transferee’s negligence or wilful default and any indirect or consequential losses. An example of that would be when the non-return of loaned securities causes an onward trade for a larger amount to fail. The norm is for only that proportion of the total costs which relates to the unreturned securities or collateral to be claimed. It is good practice, where possible, to consider “shaping” or “partialling” larger transactions (breaking them down into a number of smaller amounts for settlement purposes) so as to avoid the possibility of the whole transaction failing if the transferor cannot redeliver the loaned securities or collateral on the intended settlement date. Corporate actions and votes The basic premise underlying securities lending is to make the lender “whole” for any corporate action event – such as a dividend, rights or bonus issue – by putting the borrower under a contractual obligation to make equivalent payments to the lender, for instance by “manufacturing” dividends. However a shareholder’s right to vote as part owner of a company cannot be manufactured. When securities are lent, legal ownership and the right to vote in shareholder meetings passes to the borrower, who will often sell the securities on. Where lenders have the right to recall securities, they can use this option to restore their holdings and voting rights. The onus is on the borrower to find the securities, by borrowing or purchasing them in the market if necessary. This can damage market liquidity, which is a risk that intermediaries manage. It is important that beneficial owners are aware that when shares are lent the right to vote is also transferred. The SLRC’s code of guidance states in section 2.5.4 that lenders should make it clear to clients that voting rights are transferred. A balance needs to be struck between the importance of voting and the benefits derived from lending the securities. Beneficial owners need to ensure that any agents they have made responsible for their voting and stock lending act in a co-ordinated way. Borrowing securities in order to build up a holding in a company with the deliberate purpose of influencing a shareholder vote is not necessarily illegal in the United Kingdom. However, institutional lenders have recently become more aware of the possibility, and tend not to see it as a legitimate use of securi-

ties borrowing. A number of market bodies, in the United Kingdom and internationally, have been addressing the relationship between securities lending and voting. For example, a recent report by Paul Myners to the UK Shareholder Voting Working Group3 made the following recommendation: Stocklending is important in maintaining market liquidity but borrowing of shares for the purpose of voting is not appropriate… it is important that beneficial owners are fully aware of the implications for voting if they agree to their shares being lent. In particular, when a resolution is contentious I start from the position that the lender should automatically recall the related stock, unless there are good economic reasons for not doing so.’ Internationally, a working group of the International Corporate Governance Network is currently examining best practices for long-term investors in relation to securities lending and voting. The SLRC is also considering additions to its code in this area. UK tax arrangements and London Stock Exchange reportingg by member firms London Stock Exchange rules require lending arrangements in securities on which UK Stamp Duty/Stamp Duty Reserve Tax (SDRT)4 is chargeable to be reported to the Exchange. This enables firms to bring their borrowing and lending activity ‘on Exchange’ and to allow them to be exempt from Stamp

When securities are lent, legal ownership and the right to vote in shareholder meetings passes to the borrower, who will often sell the securities on. Where lenders have the right to recall securities, they can use this option to restore their holdings and voting rights Duty/SDRT. Firms which are not members of the Exchange but which conduct borrowing and lending through a member firm are also eligible for relief from stock lending Stamp Duty/SDRT. On Exchange lending arrangements are evidenced by regulatory reports that are transmitted to the Exchange by close of business on the day the lending arrangement is agreed. Prior to entering into a lending arrangement, member firms are required to sign a written agreement with the other party. The Exchange has authorised the following agreements: - Global Master Securities Lending Agreement - Master Equity & Fixed Interest Stock Lending Agreement (1996) - PSA/ISMA Global Master Repurchase Agreement as

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Securities Lending GUIDE extended by supplemental terms and conditions for equity repo forming Part 2 of Annex 1 of the agreement Where an authorised agreement does not cover the circumstances in which a member firm wishes to enter into a lending arrangement, the firm must ensure that the agreement includes provisions equivalent to those contained within the Exchange’s rules on lending arrangements in relation to member firm default. Transparency in the UK market

Today, there is an increasing amount of bilateral and multilateral automated lending CREST provides time-delayed information on the value of securities financing transactions in the top 350 UK equities. This is a subscription service begun in September 2003 following extensive discussion with market participants and the Financial Services Authority. The information it provides pertains to total Stamp Duty Reserve Tax-exempt transactions taking place in each security on a given day and excludes intermediary activity where possible. CREST has provided answers to many frequently asked questions on its website, www.crest.co.uk. The launch of its securities financing data service coincided with its publication of settlement failure statistics The London Stock Exchange monitors both and makes public announcements on stock lending activity when it feels it is appropriate. UK Takeover Panel If it is proposed that any securities lending should take place during an offer period for a UK company, the Takeover Panel should be consulted to establish whether any disclosure is required and whether there are any other consequences. Risks, regulation and market oversighht This chapter describes the main financial risks in securities lending, and how lenders usually manage them. It is not a comprehensive description of the various operational, legal, market and credit risks to which market participants can be exposed. The chapter then briefly summarises the UK regulatory framework for securities lending market participants and the role of the UK Stock Lending and Repo Committee. Financial risks in securities lending are primarily managed through the use of collateral and netting. As described in Chapter 1, collateral can be in the form of securities or cash. The market value of the collateral is typically greater than that of the lent portfolio. This margin is intended to protect the lender from loss and reflect the practical costs of collateral liquidation and repurchase of the lent portfolio in the event of default. Any profits made in the repurchase of the lent portfolio are normally returned to the borrower’s liquidator. Losses incurred are borne by the lender with recourse to the

borrower’s liquidator along with other creditors. Risks and risk management When taking cash as collateral Because of its wide acceptability and ease of management, cash can be highly appropriate collateral. However, the lender needs to decide how best to utilise this form of collateral. As described in Chapter 1, a lender taking cash as collateral pays rebate interest to the securities borrower, so the cash must be reinvested at a higher rate to make any net return on the collateral. This means the lender needs to decide on an appropriate risk-return trade-off. In simple terms, reinvesting in assets that carry one of the following risks can increase expected returns: a higher credit risk: a risk of loss in the event of defaults or a longer maturity in relation to the likely term of the loan Many of the large securities lending losses over the years have been associated with reinvestment of cash collateral. Typically, lenders delegate reinvestment to their agents, (for example, custodian banks). They specify reinvestment guidelines, such as those set out in Chapter 1. There is a move towards more quantitative, risk-based approaches; often specifying the ”value-at-risk” in relation to the different expected returns earned from alternative reinvestment profiles. Agents do not usually offer an indemnity against losses on reinvestment activity so that the lender retains all of the risk while their agent is paid part of the return. When taking other securities ass collateral Compared with cash collateral, taking other securities as collateral is a way of avoiding reinvestment risk. In addition to the risks of error, systems failure and fraud always present in any market, problems then arise on the default of a borrower. In such cases the lender will seek to sell the collateral securities in order to raise the funds to replace the lent securities. Transactions collateralised with securities are exposed to a number of different risks: Reaction and legal risk. If a lender experiences delays in either selling the collateral securities or repurchasing the lent securities, it runs a greater risk that the value of the collateral will fall below that of the loan in the interim. Typically, the longer the delay, the larger the risk. Mispricing risk. The lender will be exposed if either collateral securities have been over-valued or lent securities under-valued because the prices used to mark-to-market differ from prices that can actually be traded in the secondary market. One example of mispricing is using mid rather than bid prices for collateral. For illiquid securities, obtaining a reliable price source is particularly difficult because of the lack of trading activity. Liquidity risk. Illiquid securities are more likely to be realised at a lower price than the valuation used. Valuation “haircuts” are used to mitigate this risk (i.e. collateral is valued at, for example, 98% or 95% of the current market value). The haircuts might depend upon: - The proportion of the total security issue held in the portfolio – the larger the position, the greater the haircut. - The average daily traded volume of the security: the lower

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the volume, the greater the haircut. - The volatility of the security; the higher the volatility, the greater the haircut. Congruency of collateral and lent portfolios (mismatch risk). If the lent and collateral portfolios were identical then there would be no market risk. In practice, of course, the lent and collateral portfolios are often very different. The lender’s risk is that the market value of the lent securities increases but that of the collateral securities falls before rebalancing can be effected. Provided the counterpart has not defaulted, the lender will be able to call for additional collateral on any adverse collateral/loan price movements. However, following default, it will be exposed until it has been able sell the collateral and replace the lent securities. The size of mismatch risk depends on the expected covariance of the value of the collateral and lent securities. The risk will be greater if the value of the collateral is more volatile, the value of the lent securities is more volatile, or if their values do not tend to move together, so that the expected correlation between changes in their value is low. For example, in deciding whether to hold UK government securities or UK equities to collateralise a loan of BP shares, a lender would have to judge whether the greater expected correlation between the value of the UK equities and the BP shares reduced mismatch risk by more than the lower expected volatility in the value of the government securities. Many agent intermediaries will offer beneficial owners protection against these risks by agreeing to return (buy-in) lent securities immediately for their clients following a fail, taking on the risk that the value of the collateral on liquidation is lower. Realistic valuations The first consideration is whether the valuation prices are fair. Assuming the portfolios have been conservatively valued at bid and offer (not mid) prices, then the lender might require some adjustment (haircut) to reflect concentration and price volatility of the different assets. For example, in the case of the sterling cash collateral, the haircut might be negligible. But for the Malaysian equity portfolio, a high adjustment might be sought on the assumption that it would probably cost more than GBP100 million to buy back this part of the lent portfolio. Required haircuts might be based on the average daily liquidity for the asset class, the price volatility of the asset class and the residual risk on individual securities, taken from Table 2. Using the adjusted portfolios, the lender can then calculate the risk of a collateral shortfall in the event of the borrower defaulting. Broadly, this will need to assess the volatility of each asset class, the correlation between them and the residual risk of securities within them to derive a range of possible scenarios from which probabilities of loss and the most likely size of losses on default can be estimated. Working on the assumption that the lender can realise its collateral and replace its lent securities in a reaction time of 20 days, Table 4 shows the results for the portfolio, together with some sensitivity analysis in case market volatility and liquidity that has been significantly changed. By increasing the volatility assumption or reducing the liquidity assumption, the probability and scale of

expected losses increase. Netting Netting is an important element of risk management given that market participants will often have many outstanding trades with a counterpart. If there is a default the various standard industry master agreements for securities lending should provide for the parties’ various obligations under different securities lending transactions governed by a master agreement to be accelerated, payments become due at current market values. So instead of requiring the parties to deliver securities or collateral on each of their outstanding transactions

Many of the large securities lending losses over the years have been associated with reinvestment of cash collateral gross, their respective obligations are valued (given a cash value) and the value of the obligations owed by one party are set off against the value of the obligations owed by the other, and it is the net balance that is then due in cash. This netting mechanism is a crucial part of the agreement. That is why there is so much legal focus on it: for example, participants need to obtain legal opinions about the effectiveness of netting provisions in jurisdictions of overseas counterparts, particularly in the event of a counterpart’s insolvency. That is also why regulators of financial firms typically expect legal opinions on the robustness of netting arrangements before they will recognise the value of collateral in reducing counterpart credit exposures for capital adequacy purposes. In the United Kingdom, SLRC has a netting subgroup, which, on behalf of subscribing banks, is monitoring an exercise to gather opinions on the legal bases for netting in different jurisdictions. UK regulation Any person who conducts stock borrowing or lending business in the United Kingdom would generally be carrying on a regulated activity under the terms of the Financial Services and Markets Act 2000 (Regulated Activities) Order 2001, and would therefore have to be authorised and supervised under that Act. The stock borrower or lender would, as an authorised person, be subject to the provisions of the FSA Handbook, including the Inter-Professional chapter of the Market Conduct Sourcebook. They would also need to have regard to the market abuse provisions of the Financial Services and Markets Act 2000, and the related Code of Market Conduct issued by the Financial Services Authority (FSA). The Conduct of Business Sourcebook requires a beneficial owner’s consent to carry on stock lending on its account. The FSA Handbook contains rules, guidance, and evidential provisions relevant to the conduct of the firm in relation to the FSA’s High Level Standards. Stock Borrowing and Lending Code

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Securities Lending GUIDE In addition to the essentially prudential standards set by the FSA, market participants have drawn up a code, the Stock Borrowing and Lending Code. This is a code that UK-based participants in the stock borrowing and lending markets of both UK domestic and overseas securities observe as a matter

Corporate governance deals with the rights and responsibilities of a company’s management, its board, shareholders and various stakeholders. How well companies are run affects market confidence as well as company performance of good practice. The Code covers matters such as agents, brokers, legal agreements, custody, margins, defaults and closeouts, and confirmations. It is based on the current working practices of leading market practitioners and is kept under regular review. The Code does not in any way replace the FSA’s or other authorities’ regulatory requirements; nor is it intended to override the internal rules of settlement systems on borrowing or lending transactions. Work is currently in progress to produce a UK Annex to the Code that will consider specific aspects of UK law and practices in the equity stock lending market. The Code is available on the Bank of England’s website at www.bankofengland.co.uk/markets/stockborrowing.pdf. Securities Lending and Repo Committee The Stock Borrowing and Lending Code was produced by the Securities Lending and Repo Committee (SLRC), that is a UKbased committee consisting of market practitioners, members of bodies such as CREST, the United Kingdom Debt Management Office, the Inland Revenue, the London Clearing House, the London Stock Exchange and the FSA. It provides a forum in which structural (including legal, regulatory, trading, clearing and settlement infrastructure, tax, market practice and disclosure) developments in the stock lending and repo markets can be discussed, and recommendations made. It also coordinates the development of gilt repo and equity repo codes; produces and updates the Gilts Annex to the ISMA/TBMA Global Master Repurchase Agreement (GMRA); keeps under review the other legal agreements used in the stock lending and repo markets; and maintains a sub-group on legal netting. It liaises with similar market bodies and trade organisations covering the repo, securities and other financial markets, both in London and internationally. Minutes of SLRC meetings are available on the Bank of England’s website, at www.bankofengland.co.uk/markets/slrc/htm. The SLRC’s terms of reference are shown in Appendix 2. The work of the SLRC complements the work of the various market associations, including, in the securities lending field, the International Securities Lending Association (ISLA). The objectives of ISLA include representing the common interests

of securities lenders and assisting in the orderly, efficient and competitive development of the securities lending market. ISLA has helped to produce standard market agreements, including the Overseas Securities Lending Agreement (OSLA 1995 version), the Master Equity and Fixed Interest Securities Lending Agreement (MEFISLA 1999 version) and the Global Master Securities Lending Agreement (GMSLA May 2000). Securities Lending and Corporate governance What is Corporate Governance? Corporate governance has increased in importance over recent years. This high profile has been supported by investors, their associations and increasingly by regulators. As the Organisation for Economic Co-operation and Development writes in response to the following frequently asked question “What is corporate governance and why is it important?” Corporate governance deals with the rights and responsibilities of a company’s management, its board, shareholders and various stakeholders. How well companies are run affects market confidence as well as company performance. Good corporate governance is therefore essential for companies that want access to capital and for countries that want to stimulate private sector investment. If companies are well run, they will prosper. This, in turn, will enable them to attract investors whose support can help to finance faster growth. Poor corporate governance, on the other hand, weakens a company’s potential and, at worst, can pave the way for financial difficulties and even fraud. Exercising the right to vote is therefore an integral and important aspect of good corporate governance for institutional investors. To be more precise the exercising of a right to vote against management is the ultimate sanction that a shareholder has and can be seen as a major step in meaningful engagement with the company. Avoiding Conflict There has been widespread discussion regarding the possible conflict between the exercising of good corporate governance on behalf of investors and the lending of securities. This discussion focuses upon the ability of investors, either directly or by instructing their agents, to vote when they have securities on loan. We will draw upon specific examples, where appropriate, and highlight best practice. The Legal Position There are differing views in the market place as to the exact meaning of the term Securities Lending. “The word ‘lending’ is in some ways misleading. In law the transaction is, in fact, an absolute transfer of title against an undertaking to return equivalent securities.” This results in some important consequences arising from the nature of securities lending transactions: - Absolute title over both lent and collateral securities passes between parties, meaning that these securities can be sold outright or “on lent”. - Once securities have been passed, the new owner of them has certain rights. For example they have the right to sell or

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lend them to another buyer and vote in the AGMs/EGMs if they are the holder at the record date. - The lender of equities no longer owns them and has no entitlement to vote. But they are still exposed to price movements on them since the economic exposure to owning those securities is not passed. Typically lenders reserve the right to recall equivalent securities from the borrower and must exercise this option if they wish to vote. Shares should not be borrowed for the purpose of voting As Paul Myners writes in the March 2005 Report to the Shareholder Voting Working Group, ‘Review of the Impediments to voting UK shares’: “Borrowing shares for the purpose of acquiring the vote is inappropriate, as it gives a proportion of the vote to the borrower which has no relation to their economic stake in the company. This is particularly the case in takeover situations or where there are shareholder resolutions involving acquisitions or disposals. The potential to vote borrowed shares means that there is a risk that decisions could be influenced by those that do not have an economic interest in the business. I believe that this merits the attention of lenders, fund managers and the ultimate beneficial owners, and their respective trade associations. They should visit existing practices to see whether practical procedures could be put in place to prohibiting the borrowing of stock for the purposes of voting. In this respect, the Securities Borrowing and Lending Code of Guidance states: “there is consensus in the market that securities should not be borrowed solely for the purposes of exercising the voting rights at, for example, an AGM or EGM. Lenders should also consider their corporate governance responsibilities before lending stock over a period in which an AGM or EGM is

Open loans may be terminated by the borrower returning securities or by the lender recalling them expected to be held” . Similarly collateral held, which can be of equal or greater value than the shares lent, should not be voted. This is a clear position and one of which practitioners actively engaged in the business of securities lending are acutely aware. The Right to Recall It is the case that securities on loan cannot be voted by the lender. Should they wish to exercise their right to vote, they need to recall these securities by the pre-determined time i.e. record date. Notwithstanding the above, it is not the case that, in aggregate, all votes on lent shares are lost. Some shares that have been borrowed will be delivered into the market to settle sales and end up with buyers. These buyers will be oblivious to the fact that these shares have been borrowed and will view them as their property and choose to vote as they see fit. It is the case that there may be some loss of votes associated with collateral positions or positions sitting long in trading

books because shares held as collateral or in trading books are not normally voted. The right to recall any security on loan is enshrined in the legal agreement underpinning this activity and typically the lender recalling securities must provide their agent or borrower with “standard settlement period notice.” Recalls are part and parcel of the securities lending business. However, borrowers seek to avoid recalls wherever possible and frequent recalls may discourage borrowers from accessing portfolios. In practice the lenders, or their agent, communicate the lender’s position with regards to voting to the borrowers so as to avoid any surprises. It is important for all parties that they understand the importance of this communication and the rights of the underlying client to recall their securities to vote. There are several positions that can be taken and these are driven by the owners of the assets made available for loan. At all times it is the owner who determines what can and cannot be done with their securities. The beneficial owners of these assets include the following types of organisations: - Pension Funds - Mutual Funds - Insurance Companies - Unit Trusts - Charities and Religious Institutions The Lenders’ Choices The following positions are possible and there are securities lending programmes constructed to cater for each of them: Voting (and therefore recalling) securities at every opportunity, for example when the owner has a strong culture of voting and does not wish to miss an opportunity to demonstrate its position to the company. This is quite a rare position to take and is often only made in a subset of markets that are very important to the owner e.g. A UK pension fund might wish to recall all UK securities to vote. In his report, Paul Myners accepted that investors might have legitimate economic reasons for not recalling all securities to vote. Voting (and therefore recalling) securities only when the vote is deemed important enough, for example when a takeover is being considered. This is a more commonplace position and enables the owners to enjoy higher securities lending revenues whilst voting when they feel it is warranted. It is important to note that the beneficial owner determines when it is important to vote, not their agents or borrowers. Here again the owners might focus upon their local market where their corporate governance aspirations are understandably higher than they might be overseas. Not voting securities at all There are still organisations that choose, for their own reasons, not to vote. This is their decision although increasing pressure in the UK from the government and others with

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Securities Lending GUIDE regulatory responsibility may well encourage greater voting over time. However, should they change their mind and make an exception, they would have the capability to notify their agent or borrower and recall the securities in the normal way. Maintaining a buffer of at least one share in all holdings To ensure that the beneficial owner or asset manager receives direct advice regarding voting (and all other corporate actions) the retention of at least one share in their account is advisable. This has the advantage of ensuring the efficient and direct flow of information whilst retaining optimal lending returns. It is typical for there to be some retention or “buffer” of securities to be made in a lending programme and this level could be as low as one share or could be expressed as a percentage of the value of the holding. Market Practice Currently the majority of lenders of securities do not recall securities for voting except for the more contentious votes. This choice is theirs to make and should they wish to alter this position they are free to do so. Typically a lender of securities would let their counterparts know their position regarding corporate governance and propensity to vote before joining a lending programme. Lending agents have strong operational procedures in

Currently the majority of lenders of securities do not recall securities for voting except for the more contentious votes. This choice is theirs to make and should they wish to alter this position they are free to do so place to ensure recalls are made where appropriate. Putting Disenfrranchisement in Context So there is a material amount of borrowing in this blue chip index that peaks over dividend dates. What impact does this pattern have upon voting turnout and thereby upon corporate governance? It is difficult to say in specific terms without going into detailed examples and space prohibits us from doing so here. However, the following conclusions easily emerge from the research. The scale of securities lending does not typically exceed the voluntary disenfranchisement one sees at typical AGMs. In other words more investors choose not to vote (for whatever reason) than choose to lend (and not recall). Suggestions So what should be done to alleviate the perceived problem?

Here are some suggestions that are currently being considered and that will make a difference if implemented: - Transparency All stakeholders, not just securities lending professionals, for example fund managers and corporate governance professionals, should understand the following: - The established legal framework underpinning the lending arrangement. - Securities must be recalled to vote. - The exact notice required to recall the shares to vote - this may be different to normal market settlement periods depending on the lending agent being used. - Which securities are on loan. - How to access loan and/or governance information. - The potential effect of dividend record dates. Some beneficial owners are already in receipt of detailed reporting from their lending agents, although it is fair to say that the frequency and distribution of this information varies. Best practice is to provide daily reports securely on the internet. This enables permissioned users throughout the beneficial owners organisation to understand which securities are on loan. - Consistency A clear policy is required so that the inherent conflict between the securities lending income forgone and the “value” of recalling to vote is addressed explicitly. This policy should be carefully drafted and agreed by stakeholders. In practice, accurately assessing the economic trade off is challenging – the opportunity cost of making a recall may be known and is easier to assess than the benefit of making a vote. Any policy should be flexible enough to take into account a wide variety of security specific situations. - Communication It is imperative that all stakeholders have access to all necessary information in time to make informed decisions. This requires accurate communication of data throughout the chain of organisations that are involved in lending, including the stakeholders at the beneficial owners, all teams at their providers and also the issuer. The efficient communication of any recalls is a vital part of the process that is normally well documented in the securities lending agreement. Beneficial Owners should typically expect that securities on loan will be returned upon the provision of standard settlement period notice. - Timing Given the scale of lending activity around the dividend record date it is constructive to maintain the separation of the record date from the AGM. However, the issuers should ensure that the necessary documentation regarding the shareholders meeting are distributed prior to the record date so that the owners can decide whether they would prefer to vote or make the securities available for loan.

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Furthermore, bringing the payment date closer to the AGM would ensure that the dividend timetable is not unduly lengthened. This would enable lenders that wish to participate in profitable dividend related lending activity to do so with less voting conflict. It will also ensure that lenders are fully informed and can vote when it matters to them. This change does not require changes in company law and could be affected by the issuing companies. - Guidance It is clear from the SLRC Code of Guidance and the Myners reports on the subject of securities lending and voting that the practice of borrowing shares specifically to vote is unacceptable. Many active participants in the securities lending business already have the suggested measures outlined above in place. That should be a source of comfort to those concerned about the activity. Lending is only part of the picture The evidence suggests that lending is not one of the primary reasons why voting turnout is low. The value of a vote is determined by the owner of that vote – if they do not value it they may choose not to exercise their right, irrespective of their willingness to lend. As the law currently stands in the UK, borrowing securities in order to build up a holding in a company with the deliberate purpose of influencing a shareholder vote is not illegal. However, based on recent headlines and the work done by the International Corporate Governance Network, institutional lenders have recently become more aware of this possibility, and tend not to see it as a legitimate use of securities borrowing. Since the demise of the borrowing purpose test, it is technically possible for someone to borrow securities to vote. However, it has been made very clear that this is not acceptable practice as the UK Annex to the Stock Borrowing and Lending Code, SLRC, 11 May 2004 makes clear. Should this activity become an issue of concern in the future, it would draw regulatory attention very quickly, with the widespread support of the securities lending industry. It is vital that beneficial owners are aware that when shares are lent the right to vote is also transferred. The SLRC Code of Guidance states that “agents should make it clear to clients that voting rights are transferred.” Going forward, a balance needs to be struck between voting securities and the benefits derived from lending securities. Quantifying these competing benefits is challenging. The income derived from securities lending can be explicitly measured but the value of a vote is perhaps less tangible - particularly now that most securities carry a vote and the majority of equity securities in publicly quoted companies rank pari passu (i.e. there are fewer companies that issue both voting and non voting shares that can be compared with one another).

Beneficial owners need to ensure that any agents they have made responsible for their voting and stock lending act in a co-ordinated way. This may mean that portfolio managers need to receive reports regarding securities on loan so as to avoid any situation whereby votes that they intend to make are not possible. This should be straightforward as notification of a vote taking place is given well in advance and securities can easily be recalled if necessary.

Conclusion Securities lending and the pursuit of good corporate governance are not necessarily in conflict. Both activities can and do co-exist happily within the investment management mainstream.

Since the demise of the borrowing purpose test, it is technically possible for someone to borrow securities to vote Today, many of the foremost proponents of good corporate governance successfully combine an active voting role with a successful securities lending role. The information flow and communication necessary to ensure that conflict is avoided is already in place but could be developed further. Those that are concerned about possible conflict need to openly discuss the issue with their securities lending counterparts and corporate governance colleagues. There is no need for anyone to feel that securities lending will disenfranchise them. At all times it should be remembered that the owner of the securities determines SLMG whether securities are either lent or voted.

Mark Faulkner, Spitalfields Advisors The previous section is an edited extract from 'An Introduction to Securities Lending' and 'Securities Lending & Corporate Governance' by Mark Faulkner, Spitalfields Advisors. It has been prepared with Faulkner's permission. The original publication of 'An Introduction to Securities Lending' was commissioned by the International Securities Lending Association, the Association of Corporate Treasurers, the British Bankers Association, the London Investment Banking Association, the London Stock Exchange and the Securities Lending and Repo Committeee. It was welcomed by the National Association of Pension Funds and the Association of British Insurers. The original publication of 'Securities Lending & Corporate Governance' was commissioned by the International Securities Lending Association and endorsed by the Association of Corporate Treasurers, the British Bankers Association, the London Stock Exchange, the National Association of Pension Funds and the Securities Lending and Repo Committeee.

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Guide - FAQs

Frequently Asked Questions Your securities lending queries answered What do people mean when they talk about transfer of title? Contracts provide for ownership of lent securities to pass from the lender to the borrower. A moment's thought about one of the principal motivations for borrowing and lending securities will make the necessity for this clear. Say the borrower needs to borrow securities to cover a short position, i.e. to fulfil a contract it has entered into to sell on the securities. The buyer is expecting the borrower to pass it ownership on settlement of that sale, as is normal in a sale. If the borrower cannot do that, the borrower will not be able to fulfil its contract with that purchaser. In order to enable it to fulfil its contract, the borrower obtains title from the lender and then passes it on to the purchaser, hence “transfer of title”. What does this mean for the lenderr? The lender needs to be aware that it will be transferring ownership of the securities and of the various consequences that flow from this. First, any transfer taxes applicable to a purchase of securities will be due unless an exemption applies. This will typically be an issue for the borrower on the initial leg of the transaction. But the lender should recognise that the return leg of the transaction (when the borrower transfers securities back to the lender) may also attract transfer taxes where they are applicable. Second, the transfer of the lent securities is in legal terms a disposal of them, and the lender needs to establish whether such a disposal will have any consequences. Again this is usually a tax question e.g. are there tax consequences for the lender in disposing of the lent securities? Third, and very importantly, the obligation of the borrower on the return leg of the transaction is to transfer equivalent s ecurities back to the lender, not the original securities. In a securities lending transaction, the borrower is not “holding” the securities in trust or in custody on behalf of the lender. The borrower actually owns them, which is to say that the lender has no right to securities that are in the hands of the borrower. Given that the borrower will often have sold on the securities, it is unlikely that the securities would be in the borrower's hands). Fourth, as the lender will cease to be the owner, it will no longer be entitled to income from the securities, will not receive notice or proceeds of corporate actions, and will lose all voting rights in respect of the securities. The standard documentation sets out contractual mechanisms for putting the owner in a comparable economic position in respect of income and corporate actions.

Voting rights are transferred and the lender must recall equivalent securities from the borrower in order to vote. Why is it called securities “lending” when there is transfer of title? Because commercially and economically people think of it as lending. Reflecting this, for accounting and capital requirements it is usually treated as a loan. Does it meean that the lender gets exactly the same securities back? No. The borrower’s obligation is to return “equivalent securities” i.e. from the same securities issue with the same International Securities Identification Number (ISIN). Often it will have sold the original lent securities and has to borrow or purchase securities in the market to fulfil its obligation to the lender. Does the lender have a pledge over the collateral? No. Under standard market agreements and English law, there is usually a transfer of title to the collateral. If the collateral is cash, all that means is that there is a cash payment by the borrower into the lender’s bank account. If the collateral is securities, there is a transfer of title of those securities to the lender. Many of questions that arise for borrowers in relation to collateral securities also arise for lenders in relation to lent securities. Why are there so many different agreements? Historically the different tax treatment of securities lending in different jurisdictions has driven the need for different agreements (such as OSLA – the Overseas Securities Lenders' Agreement, MEFISLA – the Master Equity and Fixed Income Stock Lending Agreement, and so on). Following tax changes it has generally become possible to use a single document and the GMSLA – the Global Master Securities Lending Agreement, consolidates the various historical documents. If the securities lending is carried out under English Law, but a custodian appoints a sub-custodian in another country, or lends to an enntity in another country which does not recognise English Law, what happens when something goes wrongg? Simplifying a bit, there are three elements in the application of law to a securities lending transaction. The first is the contractual law, the second are the home country laws applying to each party, and the third is the law applying to the place where the securities are held. The contractual law is that which applies to the legal

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agreement between the parties, which sets out the contractual terms relating to the lending transaction. Most lending agreements are in practice subject to English law, so that any disputes can be settled in the courts of England. Where a party incorporated in England proposes to conduct a securities lending transaction with a party incorporated in another country, the UK-incorporated party will need to check, normally by obtaining a legal opinion, that the home country law of the other party will allow the contract to be given effect in accordance with its terms. This opinion will normally focus in particular on the close out and netting (set-off) provisions of the legal agreement that apply in the insolvency of either party (see section on netting in Chapter 5). This together with the collateralisation and margin arrangements should keep the risks in conducting such business to acceptable levels. As regards the law relating to where the securities are held, securities borrowers need to be certain that they have good title to the securities since there is a potential for conflicts of laws or legal uncertainty in this respect. The traditional rule for determining the validity of a disposition of securities is to look to the law of the place where the securities are located [the “lex sitae” or “lex situs” principle]. This is, however, difficult to apply if securities are held through a number of intermediaries. The generally preferred approach now is to look to the location of the intermediary maintaining the account into which the securities are credited (the “PRIMA” principle). The EU Collateral Directive as implemented in EU member states applies the PRIMA principle, and there are plans to extend it further through the so-called Hague Convention.

Who organisees that? It is between the borrower and the lender (or its designated agent or custodian). Why do lenders get higher loan rates if they take cash for a scrip dividend? Usually there is a financial incentive offered by a company to shareholders that take scrip rather than cash. Therefore the borrower can take scrip, sell it to give additional income over the cash amount of the dividend, and may share this with the lender.

What happens if the lender has lent a stock over the dividend period? The “borrower” of stock makes good to the lender the dividend amount that the lender would have received had it not lent the stock in the first place. This amount is the gross dividend less any withholding tax that the lender would usually incur.

What is colllateral? Financial instruments given by borrowers to lenders to protect them against default over the term of the loan. Collateral securities are usually marked to market every day. Borrowers are required to maintain collateral with a market value at least equal to the market value of the loaned securities plus some agreed margin “haircut”.

Does the leender still receive the dividend or coupon payment? No, the lender receives from the borrower a “manufactured” dividend or coupon rather than the dividend or coupon itself.

What is a haircut? “Haircut” or margin is the extra collateral that a borrower provides in order to mitigate any adverse movements in the value of the loan and value of collateral between the mark-to-market date, and the value of liquidated collateral and repurchased loan securities on the default date.

Does the lender still receive the (manufacturedd) dividend or coupon payment on the due date? Yes, the lender’s account should be credited on the due date by the borrower, even if the borrower has not actually received it. What happens if the lender has loaned a stock over a scrip dividend record date – does it get the relevant cash or stock on the pay date? The lender should tell the borrower in advance which it would like to receive. Again the borrower must manufacture the cash or stock for the lender even if it is receiving the other.

How often is the collateral valued? Usually every day, as with the loaned securities, but it can be more frequent in exceptional circumstances. Is the collateral held in thhe lender’s name or its agent’s name? It should be held in the lender’s name, but can be held by an agent to the lender’s order if so desired. (Source SPITALFIELDS ADVISORS)

SLMG

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FinTuition - HEDGE FUND MARKET

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Securities Lending GLOSSARY

Securities Lending A-Z ccrued interest Coupon interest that is earned on a bond from the last coupon date to the present date.

existing obligations to and claims on a counterpart falling under that arrangement by one single net payment, immediately upon the occurrence of a defined event of default.

All-in dividend The sum of the manufactured dividend plus the fee to be paid by the borrower to the lender, expressed as a percentage of the dividend on the stock on loan.

Collateral Securities or cash delivered by a borrower to a lender to support a loan of securities or cash.

A

All-in price The market price of a bond plus accrued interest. Also known as "dirty price".

B

earer securities Securities that are not registered to any particular party on the books of the issuing company and hence are payable to the party that is in possession. Beneficial owner A party that is entitled to the rights of ownership of property. In the context of securities, the term is usually used to distinguish this party from the registered holder (a nominee for example) that holds the securities for the beneficial owner. Buy-in The practice whereby a lender of securities enters the open market to buy securities in order to replace those that have not been returned by a borrower. Strict market practices govern the buyin process.

C

arry The difference between interest return on securities held and financing costs. See Negative carry and Positive carry. Negative carry: Net cost incurred when financing cost exceeds yield on securities that are being financed. Positive carry: Net gain earned when financing cost is less than yield on financed securities. Cash trade Where an outright purchase or sale of securities is made for a purpose other than financing. Close-out (and) netting An arrangement to settle all

Conduit borrower A party that borrows a security in order to on-deliver it to a client, rather than borrowing it for its own in-house needs. Corporate event An event in relation to a security as a result of which the holder will be or may become entitled to: * a benefit (dividend, rights issue etc.); or * securities other than those which he holds prior to that event (takeover offer, scheme of arrangement, conversion, redemption etc). This type of corporate event is also known as a stock situation. Coupon date The date upon which the issuer of an interest paying security makes an interest payment to the registered holder (as of the excoupon date) of that security. Coupons may be paid (in most cases) annually, semi-annually or quarterly.

D

aylight exposure The period in the day when one party to a trade has a temporary credit exposure to the other due to one side of the trade having settled before the other. It would normally mean that the loan had settled but the delivery of collateral would settle at a later time, although there would also be exposure if settlement happened in reverse order. The period extends from the point of settlement of the first side of the trade to the time of settlement of the other. It occurs because the two sides of the trade are not linked in many settlement systems or settlement of loan and collateral take place in different settlement systems, possibly in different time zones.

Days to cover The number of days (in terms of average daily outright buying/selling turnover of the security) that it would take to cover the value on loan as of the date reported.

lateral in time for the settlement of a transaction.

Dividend date The date upon which the issuer of the share pays the dividend to the owner (as at the ex-dividend date) of the security.

eneral Collateral (GC) Securities that are not "special" in the market and may be used, typically, simply to collateralise cash borrowings. Also known as "stock collateral".

Double counting Financing transactions include a proportion of trades executed by intermediaries. These transactions artificially inflate the overall value on loan and are, therefore, automatically removed prior to publication of the data. In brief, the process to exclude double counting removes transaction values where one participant is seen to lend and borrow the same security value from two other participants on the same day. The originating lender and end borrower values are retained to represent the true level of value on loan.

E

RISA The Employee Retirement Income Security Act, a U.S. law governing private U.S. pension plan activity, introduced in 1974 and amended in 1981 to permit plans to lend securities in accordance with specific guidelines. Equivalent A term denoting that the securities or collateral returned must be of an identical type, nominal value, description and amount to those originally provided. If, during the term of a loan, there is a corporate action in relation to loaned securities, the lender is normally entitled to specify at that time the form in which he wishes to receive equivalent securities or collateral on termination of the loan. The legal agreement will also specify the form in which equivalent securities or collateral are to be returned in the case of other corporate events.

F

ail The failure to deliver cash or col-

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Free-of-payment delivery Delivery of securities with no corresponding payment of funds.

G

Global Master Securities Lending Agreement (GMSLA) A market standard legal agreement drafted with a view to compliance with English law. An English law opinion has been obtained on the agreement.

H

aircut Initial margin on a repo transaction. Generally expressed as a percentage of the market price. Hold in Custody (HIC) repo Repo whereby the borrower of cash segregates collateral in a specific internal account for the cash lender, rather than delivering out collateral.

I

cing/putting stock on hold The practice whereby a lender holds securities at a borrower's request in anticipation of that borrower taking delivery. Indemnity A form of guarantee or insurance, frequently offered by Agents. Terms vary significantly and the value of the indemnity does also. ISLA The International Securities Lenders Association, the trade association for securities lenders. ISMA The International Securities Market Association, an organisation of international securities dealers, maintains offices in Zurich. ISMA is an industry group that sets standards of business conduct in the global securities markets, advises regulators on market practices and provides educational opportuni-

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ties for industry participants.

L

IBA London Investment Banking Association, the principal trade association in the UK for firms active in the investment banking and securities industry. LIBA members are generally borrowers and intermediaries in the stock lending market.

M

anufactured dividends When securities that have been lent out pay a cash dividend, the borrower of the securities is generally contractually obligated to pass on the distribution to the lender of the securities. This payment "pass-through" is known as a manufactured dividend. Margin, initial Refers to the excess of cash over securities or securities over cash in a repo/reverse repo, sell/buybuy/sell, or securities lending transaction. One party may require an initial margin due to the perceived credit risk of the counterpart. No initial margin is typically expected in fixed-income transactions, but where it does occur, it normally ranges from 1% to 3%.

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ing maturities, rates, currencies, or margins, the repo trader generates a P&L.

acts on its own behalf or substitutes its own risk for that of its client when trading.

Moving average A statistical measure that reports the average of the previous stated number of day's data in preference to the actual value for that day. This process can improve trend recognition by smoothing shorter-term fluctuations.

Proprietary trading Trading activity conducted by a securities firm for its own account rather than for its clients.

N

egative carry Net cost incurred when financing cost exceeds yield on securities that are being financed. Net paying securities Securities on which interest or other distributions are paid net of withholding taxes.

O

pen transactions Trades done with no fixed maturity date.

P

air off The netting of cash and securities in the settlement of two trades in the same security for the same value date. Pairing off allows for settlement of net differences.

Margin, variation Once a repo or securities lending transaction has settled. The variation margin on a repo or securities lending transaction refers to the band within which the value of the security used as collateral may fluctuate before triggering a margin call. Variation margin may be expressed either in %age or absolute currency terms. The GMRA (See PSA/ISMA Global Master Repurchase Agreement) states that all legitimate requests for variation margin must be honoured.

Partialling Market practice or a specific agreement between counterparts that allows a part-delivery against an obligation to deliver securities.

Margin call A request by one party in a transaction for the initial margin to be reinstated or to restore the original cash/securities ratio to parity.

Prime brokerage A service offered by both Bank and Non-Bank financial institutions (e.g. Investment Banks and Broker/Dealers) to support customers' proprietary trading, investment and hedging activities. Clients of this service are frequently Hedge Funds, who are often long on ideas, short on capital and the necessary support infrastructure. Prime Brokerage may therefore include Clearing, Custody and Reporting, but also Securities Lending, Financing and Execution.

Mark-to-market The act of revaluing the securities collateral in a repo or securities lending transaction to current market values. This maybe done daily or at a suitable interval agreed upon by the parties to a transaction. Matched/mismatched book Refers to the interest rate arbitrage book that a repo trader may run. By matching or mismatch-

Pay for hold The practice of paying a fee to the lender to hold securities for a particular borrower until the borrower is able to take delivery. Positive carry Net gain earned when financing cost is less than yield on financed securities.

Principal A party to a loan transaction that

R

ebate rate The interest paid on the cash side of a securities lending transaction. A rebate rate of interest implies a fee for the loan. Recall Request by a lender for the return of securities from a borrower. Repo A transaction whereby one party sells securities to another party and agrees to repurchase the securities at a future date at a fixed price. Repricing Occurs when the market value of a security in a repo or securities lending transaction changes and the parties to the transaction agree to adjust the amount of securities or cash in a transaction to the correct margin level. Reverse repo A transaction whereby one party purchases securities from another party and agrees to resell the securities at a future date at a fixed price.

S

ecurities lending The collateralised (usually) borrowing and lending of Securities. This business allows large investors (for example, Pension Funds, Insurance and Assurance Companies and Investment Funds of various types) to generate additional income from their investments in securities by lending them. There is no formal market structure, and no compulsion to use any intermediary. Lenders and Borrowers can thus configure their programs to suit individual needs - using either Agent or Principal Intermediaries as required, or going direct to the Proprietary Borrowers, including Hedge Funds. Securities are borrowed to support hedging and arbitrage transactions, market making, as well as settlement activities. Short squeeze (bear squeeze) Where one or more market participants reduce liquidity by withholding securities that are "spe-

cial"/in high demand for any of several reasons, are sought after in the market by borrowers. Holders of special securities will be able to earn incremental income on the securities by lending them out via repo, sell/buy, or securities lending transactions. Specials Securities that for any of several reasons are sought after in the market by borrowers. Holders of special securities will be able to earn incremental income on the securities by lending them out via repo, sell/buy, or securities lending transactions Spot Standard non-dollar repo settlement two business days forward. A money market convention. Substitution The ability of a lender of general collateral to recall securities from a borrower and replace them with other securities of the same value.

T

erm transactions Trades with a fixed maturity date. Third party lending The system whereby an institution lends directly to a borrower and retains decisionmaking power, while all administration (settlement collateral monitoring, and so on) is handled by a third party, such as a global custodian. Triparty repo Repo used for funding/investment purposes in which bonds and cash are delivered by the trading counterparts to an independent custodian bank or clearing house (the 'Triparty Custodian") that is responsible for ensuring the maintenance of adequate collateral value, both at the outset of a trade and over its term. The Triparty Custodian marks the collateral to market daily and makes margin calls on either counterpart, as required. Triparty repo reduces the operational/systems barriers to participating in the repo markets.

V

alue The value of loan securities or collateral as determined using the last (or latest available) sale price on the principal exchange where the instrument was traded or, if not so traded, using the most recent bid or offered prices. © Spitalfields Advisors

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Service Provider PROFILES

Bastian Cohen

Company Brief: Fortis Global Securities Financing Group has established itself as an important player within the global securities financing arena. We have a solid track record with the infrastructure to handle large and complex securities financing transactions globally, whereby we combine our equities and fixed income financing capability in an integrated and tailor made, one stop shop client service. We can furthermore customise our client’s securities borrowing and lending programme to meet their specific requirements. Dedicated teams are working in offices around the globe; the Netherlands, Belgium, Cayman, Denmark, Germany, France, Luxembourg, Italy, Spain, the United Kingdom, Hong Kong, Singapore, Turkey and the United States. Fortis is known for its dedication and its proven ability to develop new products, services and technology. As a result we now rank among the most important principal players worldwide in the securities borrowing and lending market. Structured transactions are an interesting alternative to traditional securities borrowing and lend-

ing. Fortis has a dedicated strategy and product development team, enhancing securities financing capabilities by structuring your specific needs. Fortis is a solid, financially strong and internationally oriented company with a stable credit rating (AA-).

Key Locations: Amsterdam: + 31 20 527 1499 London: + 44 20 7444 8511 New York: + 1 212 418 6802 Paris: + 33 1 5567 9084 Hong Kong: + 852 2823 2188

Key Contacts:

Bastian Cohen is global head of the Securities Financing Group at Fortis’ Global Markets, part of Merchant Banking Key Services: - Securities borrowing and lending - Equity financing - REPO, bond and collateral financing - Equity swaps

Wouter van der Ploeg, Managing Director Sales Securities Financing Sander Baauw, Executive Director Sales Equity Financing Francois Nissen, Executive Director Sales Structured Securities Financing Manuel Postigo, Executive Director Sales Bond and Collateral Financing

72 INVESTOR SERVICES JOURNAL SECURITIES LENDING MARKET GUIDE 2008

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Guy d’Albrand

Company Brief: Société Générale Securities Services (SGSS) liquidity management division offers several cash and securities liquidity programmes through its various teams. Our product range includes securities lending and borrowing services, middle and back office securities lending in-sourcing and cash collateral reinvestment services. Our lending and borrowing programmes are entirely customer driven and tailored to clients’ needs. Through our dedicated Global Customer Service Unit, in charge of operational support, we help set a fully customised monitoring and reporting for your lending activity. Our cash reinvestment programmes are diversified yet remain fully compliant within your guidelines. Société Générale’s financial strength and commitment to the securities services field make SGSS a strong agent. Moreover, our safe and flexible technology will help make the most of your assets with flexibility and dedication. Guy d’Albrand, global head of Liquidity Management, SGSS

Key Locations: Paris: Société Générale Securities Services Liquidity Management 52, rue de la Victoire 75009 Paris France T: +33 (0) 1 53 05 48 42 F: +33 (0) 1 53 05 47 54

Guy d’Albrand has been global head of Liquidity Management since fall 2004. He began his career as a futures broker and then spent several years as an auditor at Société Générale. He joined Fimat to run the Tokyo office and was then appointed executive vice president of Société Générale Securities, North Pacific. He then headed up the online brokerage operations in Japan. In 2002, d’Albrand moved back to head office to become global head of audit for the Corporate and Investment Banking Division of the bank. He is a graduate of Ecole Superieure de Commerce de Paris and holds a BA in Mathematics from Paris IV University and a post-graduate degree in Japanese language and civilization from Paris VII University. Key Services: - Securities lending and borrowing services - Securities lending and borrowing middle and back office in-sourcing services - Excess Cash and Cash collateral reinvestment services - SG short term paper programs

Key Contacts: Europe: Denis Tréboit Head of Securities Lending Group T: +33 (0) 1 53 05 48 42 [email protected] www.sg-securities-services.com

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Service Provider PROFILES

Felix Oegerli

Company Brief: COMIT offers the financial industry a wide range of consulting services, individual software development and standard software solutions such as FINACE. FINACE is the leading modular and fully integrated solution in the area of securities lending, repo and collateral management covering front to back processes.

Collateral Trading and Management. Oegerli holds a degree as Swiss federal certified banking expert, and is a frequent conference speaker and industry expert on securities lending, repo and collateral trading and management.

Key Services: Felix Oegerli, member of the executive committee, COMIT Oegerli is member of the executive committee of COMIT, a consulting, IT solutions and integration partner of the finance industry. He was the founder and CEO of IFBS, an IT application solutions and consulting firm specialising in securities lending, repo and collateral management. IFBS was recently sold to COMIT. Prior to launching IFBS, Oegerli held a number of business leadership roles at UBS in Zurich, New York, and London for over 20 years in different functions. Between 1990 and 1999, he was responsible for the creation and expansion of the Securities Lending, Repo and Prime Brokerage business at UBS Zurich, was deputy global head of Securities Lending and Repo, global head of Prime Brokerage and head of global product management Key Locations: IFBS AG, Buckhauserstrasse 11 CH_8048 Zurich, Switzerland

FINACE is the leading modular and fully integrated solution in the area of securities lending, repo and collateral management covering front to back processes.

Key Contacts: Felix Oegerli, CEO, IFBS T: +41 (0)44 218 14 14 F: +41 (0)44 218 14 18 E: [email protected] W: www.ifbs.com

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Brian Lamb

Company Brief: EquiLend is a leading provider of trade and posttrade services for the securities finance industry. Owned by a consortium of 11 of the largest global financial services firms, EquiLend facilitates straight through processing by using a common standards-based protocol and infrastructure, which automates formerly manual business processes. Used by borrowers and lenders throughout the world, the EquiLend platform increases efficiency and enables access to additional liquidity. EquiLend's end to end solutions, which reduce the risk of potential errors and eliminate the need to maintain costly point to point connections, include: Availability, AutoBorrow, AutoBorrow Express, Negotiation, EquiLend AuctionPort, Contract Comparison, Mark-to-Market Comparison, Returns, Recalls, Billing Comparison and Delivery, Dividend Claims Comparison, and Agent Lender Disclosure (ALD). Brian Lamb CEO, Equilend Holdings As CEO, Brian Lamb is responsible for all global operations for EquiLend, its affiliates and subsidiaries. He brings 20 years of hands on experience and a deep knowledge of the global securities finance industry with an emphasis on technology solutions. Prior to

Key Locations: New York: 17 State Street, 9th Floor New York NY 10004 T: +1 212 901 2200 London: 54 Lombard Street London EC3P 3AH +44 20 7743 9510

joining EquiLend, Lamb spent 17 years with Barclays Global Investors (BGI). While at BGI, Lamb held various positions, including head of Global Derivatives Services and Cash Strategist. Lamb spent many years in securities finance while at BGI. His roles in that area ranged from product manager for Fixed Income Securities Lending, as well as program manager and alternate board member of EquiLend. He is one of the thought leaders among the initial ownership group that helped design the EquiLend platform. Lamb is a graduate of the University of Notre Dame, and holds a BS in business administration with a concentration in finance. Key Services: EquiLend is a leading technology provider of trade and post-trade services for the securities finance industry. EquiLend facilitates straight through processing by automating formerly manual business processes. EquiLend's services support the full lifecycle of a trade. In doing so, the EquiLend platform increases efficiency, mitigates risk, allows for scalability, and cost containment. The EquiLend platform also supports the execution of payment and delivery instructions, as well as Agency Lender Disclosure (ALD), through the DTCC.

Key Contacts: Brian Lamb CEO Michelle Lindenberger Vice president, marketing and communications E: [email protected]

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Service Provider PROFILES

Daniel Fowler

Company Brief: eSecLending is a global securities lending manager and a leading provider and administrator of customised securities lending programmes. Its programmes attract some of the world’s largest and most sophisticated asset gatherers, including pension funds, mutual funds, investment managers and insurance companies. The firm awards principal securities lending business through a competitive auction process that has provided clients with higher returns compared to traditional programme structures and improved transparency and objective criteria upon which to make decisions. The company has auctioned over USD1.3 trillion to date. eSecLending maintains offices in Boston, London and Burlington, Vermont. Securities Finance Trust Company, an eSecLending company, performs all regulated business activities.

2006, Fowler held several jobs that gave him broad exposure to both technology and financial markets. Most recently, he was employed by Brown Brothers Harriman as vice president of Systems, Private Account and Securities Lending. Prior to that, he worked at Boston Global Advisors as vice president, head of Technology. Fowler holds a BS in Computer Science from the University of Massachusetts. Key Services: Securities lending management and administration Cash collateral portfolio management

Daniel Fowler, managing director and chief information officer, eSecLending Daniel Fowler’s primary responsibilities within eSecLending are for systems and information technology and application. Prior to joining the firm in Key Locations: Boston: 175 Federal Street, 11th Floor Boston, MA 02110 United States T: +1.617.204.4500 F: +1.617.204.4599

Key Contacts: Christopher Jaynes T: +1.617.204.4500 F: +1.617.204.4599 [email protected]

London: 1st Floor 10 King William Street London EC4N 7TW United Kingdom T: +44 20 7469 6000 F: +44 20 7469 6099 76 INVESTOR SERVICES JOURNAL SECURITIES LENDING MARKET GUIDE 2008

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- Expert industry knowledge - Outstanding responsiveness to our clients - The reliability of a company that has worked with some of the world’s largest financial institutions to deliver many successful projects Visit www.4sight.com for further details Alastair Chisholm, managing director, 4sight Financial Software Alastair Chisholm

Company Brief: 4sight Financial Software is a leading supplier of innovative software solutions to the securities finance, settlement and connectivity markets with offices and clients worldwide. 4sight Securities Finance is a flexible modular solution that empowers financial institutions of all sizes, from the smallest direct lender to the global custodian, broker or intermediary on an agency or principal basis. It supports borrowing, lending, repo, swaps and collateral management across the equity and fixed-income markets and provides 24 hour continuous operation, inter-desk trading, a ‘global book’, realtime value dated position keeping and a powerful web reporting module, allowing full front to back office processing. 4sight Securities Finance also integrates seamlessly with external systems and employs a data model that enables quick and easy real time access to your data, with the ability to import and export data in any required format. As a company 4sight delivers: - Ground breaking securities lending software at the cutting edge of technology Key Locations: 4sight Financial Software Ltd Conference House 152 Morrison Street Edinburgh, EH3 8EB United Kingdom T: +44 (0) 131 557 5522 4sight Financial Software Ltd 11-29 Fashion Street London, E1 6PX United Kingdom T: +44 (0) 207 043 8300

Alastair Chisholm is managing director of 4sight Financial Software. 4sight was formed in 2003 when he led an MBO of the Securities Finance and Settlement business units from OM Technology, where he was general manager. Chisholm has been involved in software development for the financial markets for the last 18 years in a variety of roles, both with software houses and financial organisations. Prior to joining OM in 1999, he was a director at TCAM Systems and held senior positions with Accenture, NatWest Markets and Wood Mackenzie. Key Services: The key features of our company and products include: - Highly configurable software solutions to meet each client’s unique individual requirements. - Quick and easy integration with third party solutions. - A professional implementation, ensuring a minimum of disruption to business during system changeover. - Many years of expertise in our chosen fields. - A strong focus on development and customer service to ensure our products stay at the forefront of market requirements, and our clients continue to remain happy.

Key Contacts: Judith McKelvey, global sales director T: +44 (0) 207 043 8319 [email protected] Jason Hayes, North American sales director T: +1 416 548 7922 [email protected] Peter Sanders, Asia Pacific general manager T: +61 (0) 2 90378416 [email protected] SECURITIES LENDING MARKET GUIDE 2008 INVESTOR SERVICES JOURNAL 77

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Service Provider PROFILES

Sandie O’Connor

Company Brief: JPMorgan's breadth of capability, financial strength, professional expertise and seamless operation make it a strong lending agent to its clients. JPMorgan’s lending program enables investors to access a broad spectrum of lending markets, with a diverse borrower base while achieving very competitive bids for their securities - all of this in an environment designed not to compromise the activities of their fund managers. As one of the founding members of EquiLend, a global automated platform for borrowers and lenders, JPMorgan is at the forefront of technology and is ideally placed given its integrated lending, custody and accounting platforms. JPMorgan also affords clients a broad indemnification against borrower default. Sandie O’Connor, managing director and business executive, Securities Lending and Execution Products, JPMorgan Worldwide Securities Services O’Connor is a managing director and global head of the Securities Lending and Execution Products (SLEP) business of JPMorgan Worldwide Securities Key Locations: New York: T: +1-212-552-8075 London: T: (44-20)7-742-0249 Sydney: T: (61-2)9250 4606 Key Contacts: Europe, Middle East, Africa Paul Wilson, managing director, global head Client Management and Sales

Services, an industry leader in custody and investor services. O'Connor serves on the executive committee for Worldwide Securities Services. In this role, O’Connor is responsible for domestic and international securities lending, foreign exchange, futures and options clearing and transition management. She directs overall strategy for this product set including product development, marketing, investment management and operations worldwide. She is also focused on positioning the SLEP business for growth by delivering innovative, market leading products, services and client facing technology. Key Services: Discretionary (Agency) Securities Lending Services Directed Securities Lending Services Third Party (non custody) Securities Lending Principal Securities Lending Program (via JPMorgan Securities Ltd) Tri-Party collateral management and Escrow services Cash collateral reinvestment services

[email protected] T: (+44-20)7-742-0249 Europe, Middle East, Africa Michael Fox, head of Sales [email protected] T: (+44-20)7-742-0256 Western Hemisphere William Smith, managing director, head of Sales The Americas T: +1-212-552-8075

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Mark Fieldhouse

Company Brief: RBC Dexia Investor Services offers proven expertise in global custody, fund and pension administration and shareholder services to institutions around the world. Established in January 2006, we are a joint venture equally owned by Royal Bank of Canada and Dexia. We rank among the world’s top 10 global custodians, with USD2.4 trillion in client assets under administration. RBC Dexia Investor Services offers clients a complete range of investor services supported by: a worldwide network of offices in 15 countries on four continents; unparalleled European transfer agency capabilities; fund administration services in 14 global markets; strong credit ratings: Aa3 (Moody’s), AA- (S&P); more than 100 years of experience in institutional financial services; products and technology that meet clients’ present and future needs; top ratings for client service in industry client satisfaction surveys. Our innovative products and services help clients maximise operational efficiency, minimise risk and enhance portfolio returns. And our more than 4,320 experienced and enthusias-

tic professionals in 15 markets offer proven expertise to enhance clients’ business performance.

Key Locations: RBC Dexia Investor Services 71 Queen Victoria Street London EC4 V4DE United Kingdom

Key Contacts: Tony Johnson Global Head, Sales & Relationship Management 44 20 7653 4096/[email protected]

RBC Dexia Investor Services 77 King Street West, 35th Floor Toronto, ON M5W 1P9 Canada

Mark Fieldhouse, head, Technical Sales, Americas, RBC Dexia Investor Services Mark Fieldhouse serves as head, Technical Sales, Americas. His team is responsible for overall growth and development of the Global Products client base, as well as the product level management of its strategic clients in North America. Global products include securities lending, foreign exchange, cash management and portfolio management services. Key Services: RBC Dexia Investor Services provides clients an extensive range of solutions including: global custody, fund and pension administration, shareholder services, distribution support, reconciliation services, transition management, investment analytics, compliance monitoring and reporting, securities lending and borrowing, treasury services and commission recapture. rbcdexia-is.com

Mark Fieldhouse Director, Technical Sales, North America 1 416 955 5525/[email protected] Blair McPherson Director, Technical Sales, Europe, Middle East & Asia Pacific 44 20 7653 6365/[email protected] SECURITIES LENDING MARKET GUIDE 2008 INVESTOR SERVICES JOURNAL 79

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Service Provider PROFILES

Elizabeth Seidel

Company Brief: A global leader with nearly 200 years of experience, Brown Brothers Harriman (BBH) helps many of the world's most sophisticated mutual funds, investment managers, banks and insurance companies achieve their international business objectives. With approximately USD2 trillion of assets in safekeeping, BBH provides specialist services and innovative solutions to clients in over 90 markets for custody, accounting, administration, securities lending, foreign exchange, and brokerage services. Combining entrepreneurial thinking, innovative technology, and unmatched client service, BBH is consistently ranked among the world's top global custodians and maintains a presence in each of the principal financial centres around the globe. BBH Global Securities Lending leverages these resources to achieve customised solutions and optimised returns for every client. Delivered through award winning client service and integrated technology, our product expertise with respect to trading, risk management, and seamless product delivery, allows us to customise each securities lending programme based upon

specific portfolio characteristics. This has allowed us to create an attractive programme for some of the world's most sophisticated investors. BBH stands alone as an organisation large enough to compete with behemoth organisations, yet small enough to be innovative, flexible, and responsive at the individual client level. We consistently develop creative solutions in support of new initiatives and growth. We work hard to earn our clients’ trust as a reliable, consultative business partner who does not compete; rather our interests are truly aligned. We possess the experience, depth, and stability of a major custodian bank, yet one with the agility and nimbleness needed to offer clients a “total solution” based on their current securities lending objectives. The BBH programme offers its clients multiple routes to market, compelling economics, full customisation, transparency, comprehensive risk management, and award winning relationship management. For more info please visit www.bbh.com Elizabeth Seidel, senior vice president, co-manager of BBH Global Securities Lending Elizabeth Seidel joined BBH in 1999 and was recently appointed department co-manager for Global Securities Lending. In her new role, Seidel has management responsibility for Relationship Management, Risk Management, Sales, and Marketing groups. Key Services: * Award-winning custodial and third party agency lending * Auction/exclusive platform * In-house cash collateral reinvestment option * Relationship excellence * Critical market intelligence provided through daily trading summaries, specials list, newsletter

Key Locations:

Key Contacts: London: Ciaran McNamee T: +44 (0) 2076 142114

Boston: Brown Brother Harriman & Co 40 Water Street Boston, MA 02109

Boston: Casey Gildea T: +1 617 772 1492

London: Brown Brothers Harriman Ltd Veritas House 125 Finsbury Pavement London EC2A 1PN

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Time to change?

Choose a flexible Securities Finance solution that integrates seamlessly

4sight Securities Finance provides a full front to back office system for lending, borrowing, repo, swaps, and collateral management of both Equities and Fixed Income Securities. 4sight Securities Finance is a proven solution used globally by a wide range of financial institutions, and can be used on an agency or principal basis.

• Software with the flexibility to be tailored to your unique business requirements • Maximise efficiency through quick and seamless integration with your existing systems • Quick and easy real time access to your data, with the ability to import and export in any required format.

email: [email protected] www.4sight.com Financial Markets Solutions

EDINBURGH • LONDON • TORONTO • SYDNEY

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Crowded Pool or Exclusive Access? Crowded

Pool

or

Exclusive

Access? The choice is yours. eSecLending takes an active approach to securities lending by managing customized programs for institutional investors. Unlike the traditional agency approach, where many lenders’ portfolios are grouped together and their securities sit in a pool waiting to

or

be borrowed, eSecLending markets each client’s portfolio individually and awards lending rights to the optimal bidders. Our clients receive more lending revenue compared to traditional programs, because eSecLending introduces objective competition via

an

auction

process.

eSecLending clients achieve all this while maintaining conservative risk parameters, retaining close control over their lending programs and receiving superior, customized client service.

eSecLending provides services only to institutional investors and other persons who have professional investment experience. Neither the services offered by eSecLending nor this advertisement are directed at persons not possessing such experience. Securities Finance Trust Company, an eSecLending company, performs all regulated business activities. Past performance is no guarantee of future results. Our services may not be suitable for all lenders.

United States +1.617.204.4500 Europe +44 (0) 207.469.6000 [email protected] www.eseclending.com