From the desk of Roy Zimmerhansl
Practice Lead, Pierpoint Financial Consulting
I have been involved with many markets as they moved towards launching securities lending or during their early days. In this post, I will review the value securities lending can bring to an emerging market, the eight key items that markets need to ensure maximum benefits are captured and some observations. I just did a count and have had securities lending conversations in 34 countries outside of my UK home, meeting with regulators, exchanges and market participants many times, each with their individual motivations, no two alike.
This past week I was one of the presenters at a securities lending webinar put on by the Nigerian Stock Exchange with the support of Stanbic IBTC. It was a great event and started with a comprehensive introduction and scene-setting from Oscar Onyema, CEO of the NSE and ended with closing comments from Jude Chiemeka, Divisional Head: Trading Business at NSE. Their seniority and time spent as part of the webinar was impressive and reflected the commitment of the NSE to securities lending. It is still early days for Nigeria, but with this level of support, it is likely to achieve its target goals.
The team I have been working with in preparation for the event has impressed me with their interest and enthusiasm for securities lending since I started speaking with them. I’m a confessed securities lending geek so I can’t get enough of it. Still, I suspect I have found kindred spirits with Oluwatoyin Alake, the moderator for the event and Adedotun Ogunbiyi (my two primary contacts at NSE). On a personal note, it’s a real treat when I’m working with people this engaged, and I’d like to thank them for their ongoing efforts.
What value can securities lending bring to an emerging or frontier market?
Index classification
Index providers classify equity markets based on multiple criteria with short selling and securities lending being two of the considerations they look at. There are of course numerous index providers, but for ease of reference for readers I have included the MSCI and FTSE Russell methodologies here:
Each index provider assesses the standing of a market against key criteria they test for and determines a classification for each market. This classification can have a significant impact on a given market as the breadth of investors – and therefore inward investment and trading activity – will in many cases be impacted by the ranking of a country. It goes without saying that the universe of investors that can invest in developed markets is vastly more extensive than those that can invest in frontier markets, with emerging markets in between the two. So, a country moving from ‘frontier’ to ‘emerging’ or ‘emerging’ to ‘developed’ can be the beneficiary of a large wall of inward investment. Of course, nothing is ever quite that clear-cut, so it is possible for some odd outcomes when a country is ’promoted‘ to the next category.
I have extracted information from the two documents above and produced this table with the figures:
Interestingly, MSCI has rated 16 of its 27 Emerging Markets as having ‘no issues’ or ‘no major issues’ with stock lending. Almost all of FTSE Russell’s 10 Advanced Emerging Markets have securities lending as part of their standard operating infrastructure, and several of its Secondary Emerging Markets also have lending as normal. All of this demonstrates just how well-recognised the practice is as well as being widespread.
Increased liquidity
Securities lending supports market makers and enables traders to execute many trading strategies that employ short selling, driving the need for securities lending. Market making is beneficial for smooth market trading and the provision of liquidity to buyers and sellers. Intuitively it is also evident that the extra volume that short sellers bring also increases turnover. More traders = more trades.
Decreased spreads
Higher turnover and active market makers provide conditions for more efficient trading with lower bid-offer spreads, reducing the frictional cost of investing – good for all market participants. Boaz Yaari of Sharegain in a Securities Finance TV interview with Bill Foley advised that in countries implementing short-selling bans during the recent market chaos, spreads became 8% wider, negatively impacting buyers and sellers.
The less obvious turnover from Short Selling
I mentioned above the enhanced liquidity that results from short sales and facilitating the market-making function. While it may be obvious, it is worth noting that in addition to the initial short sale, traders need to buy the securities back at some future date adding volume again, often being the sole buyers at times of distress where long sellers continue to offload securities.
But that is not what the subtitle refers to, and this is particularly relevant to less developed markets. If an exchange takes the plunge and permits short selling, there is a second volume impact. Although it is not unheard of, it is uncommon for a hedge fund only to have short positions in a market. Often, they will have a mix of long and short positions with the net position skewing it for a bullish or bearish view on the market. So, no short selling, no new long buying either. Aside from the skew, effectively it is a 2X impact per short seller on both the opening trades and the close-out.
Optics
Unfortunately, I have also seen situations where securities lending is being investigated or introduced with little intention of ensuring that it is actively practised. The usual impetus for this is the potential for a positive tick mark from index providers as described above. These markets publish rules, regulations and procedures, get feedback from market participants and interested parties but never quite get around to making the changes.
A couple of quick stories. I recall one situation where a colleague and I provided nine pages of comments and suggestions to a regulator’s consultation on securities lending. Several meetings and many years later, the gaps remain the same, and if 10 trades have been done in that time, I’d be surprised. Then there was the time I was invited to make a presentation on how international bond lending operates as a country wanted to encourage liquidity growth in government bond trading. This was a big deal to my employer, so it was well attended from our firm both from local offices as well as several people including me, flying in for the 3-hour session. I kid you not, 8 minutes into my presentation they stopped me and said they weren’t really interested in how it worked elsewhere, they were going to tell me how it was going to work in their country. I was to relay the information to the broader securities lending community. Not the outcome we expected. And guess what … not a lot has happened to improve their turnover.
Eight Issues For Maximum Success
Now, let me say that markets must satisfy their domestic needs, goals and objectives, and non-resident activity is secondary by definition. I won’t argue the pros and cons of open markets in this post. However, I have included a brief framework that if wholly implemented, provides conditions that will most likely lead to a liquidity-enhancing, spread-reducing, efficient price discovery market.
Legal recognition of securities lending as a temporary loan transaction and not a sale/repurchase.
Clean netting opinion that allows for netting of positions in the event of insolvency of one of the parties.
Clarification of tax treatment – addressing capital gains, substitute dividends, stamp duties and income tax.
Open to both foreign and domestic lenders and borrowers. Some markets discriminate against international participation or foreign short selling. Oddly, Spain discriminates against Spanish institutional investors who have never been permitted to lend their domestic assets.
Permission for both conventional lending as well as financing transactions. A prime broker needs the ability to finance long positions through financing transactions; otherwise, it will discourage or prevent clients from trading in a market.
Cash and synthetic transactions. The ability for investors to get long and short positions via physical trading or using derivatives will provide more trading opportunities.
Ability to transfer securities free-of-payment. Most collateralisation by non-residents will not be done with local market instruments so a DVP transaction will severely impact trading.
Mechanism for dealing with any foreign ownership constraints. Without the confidence of being able to reacquire approved foreign holdings, foreign investors will shy away from lending.
Securities lending can bring many benefits to markets with new introducers being able to stand on the shoulders of those who came before them, enabling them to adapt established market practices to their domestic requirements. There is still a sizeable potential universe of markets and investors that have yet to implement securities at all or have limited volumes, so the future is bright.
The future is bright IF a given market makes the most of the opportunities that lay in front of them. In addition to Nigeria, I have also personally experienced a positive and progressive attitude from stakeholders in Saudi Arabia, Malaysia, the Philippines and Poland.
For the team at Pierpoint, consulting to new markets or helping existing markets improve their infrastructure is part of building a legacy so, despite a few less-than-satisfying experiences, I always relish the opportunity to make a contribution. A dream assignment for a securities lending geek.