Securities lending transactions: market development and implications

July 1999

Foreword

This report has been produced by the Technical Committee of the International Organization of Securities Commissions (IOSCO) and the Committee on Payment and Settlement Systems of the central banks of the Group of Ten countries (CPSS). It is the second report jointly produced by the two committees. The first, Disclosure framework for securities settlement systems, was published in 1997.

The growth in securities lending transactions, such as securities loans and repurchase agreements, has been such in recent years that they now represent a substantial part of the daily settlement value in many settlement systems and play an important role in facilitating market liquidity. Past work by IOSCO and the CPSS has highlighted the expanding use of securities lending transactions and how these market transactions have increased the pressure on settlement agents to permit receipt and delivery of securities on the same day. However, none of these reports has provided a comprehensive survey and analysis of the use of securities lending transactions, the current dynamics of the market and the principal areas of risk. The two Committees therefore set up a Joint Working Group on Securities Lending to fill this gap. The Working Group was mandated to "develop a clearer understanding of the development of securities lending and its implications for securities regulators and central banks, in particular its implications for securities clearance and settlement systems".

As a key part of the project, central banks and securities regulators in each jurisdiction conducted a survey amongst market participants of the size and structure of their lending activities, and the factors that they felt were driving the market's growth. These market participants included broker-dealers, custodian banks, institutional lenders, banks, securities settlement systems, clearing houses, providers of market services and industry consultants. In total, the members of the working group interviewed more than 60 institutions in over a dozen countries worldwide. The Technical Committee of IOSCO and the CPSS express their thanks to the many firms, institutions and individuals who assisted with the survey or who provided other assistance in the preparation of this report.

It is expected that securities lending activity will continue to increase as an integral part of contemporary securities markets. The report provides an overview of the transaction structure, market development and risk issues of securities lending transactions, and discusses a number of implications for market participants, infrastructures providers and market authorities, in particular securities regulators and central banks.

Executive summary

Securities lending transactions have become, and are likely to remain, an important element of modern financial markets. This report, prepared by a joint working group (the "Working Group") of the Technical Committee of IOSCO and the CPSS, presents an overview of securities lending markets and discusses the implications of securities lending activities for market participants, securities clearance and settlement systems, and securities regulators and central banks.

Section 1 of the report provides a general overview of securities lending markets. Securities lending involves the temporary exchange of securities, generally for cash or other securities of at least an equivalent value, with an obligation to redeliver a like quantity of the same securities on a future date. The report begins by distinguishing "securities-driven" from "cash-driven" securities lending transactions. Broadly, in "securities-driven" transactions, institutions seek to lend/borrow specific securities against collateral, while in "cash-driven" transactions, institutions seek to lend/borrow securities as collateralin cash financing arrangements. The report then distinguishes and describes the main transaction structures used to lend securities: securities loans, repurchase agreements (repos), and sell-buybacks. While the legal structure of the transactions differs, the economics are similar.

There follows a description of how securities lending has evolved to fill market needs. While securities lending is fairly new to most jurisdictions, there has been a rapid increase in these activities in recent years and globalisation of the market. Some information is provided about the size and growth of these markets. Section 1 concludes by highlighting some recent trends that are currently shaping securities lending markets.

Section 2describes the participants in securities lending markets and the structure of typical transactions. Participants include securities borrowers and lenders, cash investors and borrowers, intermediaries, and providers of clearing and settlement services. This section describes the underlying motivations for borrowing and lending securities and describes a number of trading strategies that involve the borrowing of specific securities. It also discusses the role of intermediaries such as custodian banks, which lend securities on behalf of institutional investors whose portfolios they hold, and prime brokers, which provide clients with access to lendable securities, including leveraged institutions such as hedge funds. There are also intermediaries which provide automated trade matching, and confirmation services. The basic clearing and settlement of securities lending transactions is similar to the process for settlement of ordinary market transactions. However, entities such as central securities depositories (CSDs) and clearing houses have developed specific services for securities lending transactions, such as automated identification and tracking mechanisms, and central counterparty clearing facilities.

Section 3discusses legal, regulatory, tax and accounting issues that arise in securities lending transactions, which vary significantly from market to market. In recent years, national authorities have made changes to these frameworks in order to facilitate the development of securities lending markets. Among other things, these changes have provided market participants with more certainty that the legal agreements used to govern securities lending activities will be enforceable. Regulatory or tax impediments to the development of securities lending markets in certain jurisdictions have progressively been removed, which has encouraged growth. There are, however, remaining regulatory impediments to market development, which are discussed.

Section 4 addresses the types and sources of risk present in securities lending, and the practices and procedures used by market participants to manage and reduce these risks. Because securities lending transactions are typically collateralised, counterparty credit risk is reduced and these are often considered to be relatively low-risk markets. Nonetheless, the types and sources of risk are similar to those encountered by participants in other market transactions. As such, the analyses of risks presented in the previous reports on Delivery versus payment in securities settlement systems (1992) and Cross-border securities settlements(1995) are applicable in the present context. In addition, market participants may be exposed to risks that are specific to securities lending. In particular, the relative operational complexity of securities lending transactions may expose market participants to legal, operational and settlement risks. The report also notes that market participants may be subject to risks arising from changes in the market value of collateral securing the lending transaction, where a decline in the value of collateral results in an under-collateralisation of the transaction.

The Working Group's interviews with market participants suggest that market practices and procedures used to manage and reduce the risks associated with securities lending are broadly similar. Market participants typically conduct formal credit evaluations and impose counterparty credit limits vis-à-vis counterparties. Standard legal agreements are typically used to govern transactions, as are increasingly, standard master agreements. Collateral is used to minimise credit exposures. Operational risk is being addressed by automating as far as possible the processing of transactions. Yet it is clear that risk management practices vary across jurisdictions, and amongst participants within jurisdictions. In describing the risk management practices employed by market participants, the report intends to draw out these differences.

Finally, Section 5discusses the role of securities lending in the context of other financial markets, and the implications of securities lending for market participants, market infrastructure and market authorities. The report first concludes that while securities lending transactions have been important for some time in several national markets, their overall significance within the global financial system has increased notably in the last decade. Today, securities lending markets are a vital component of domestic and international financial markets, providing liquidity and greater flexibility to securities, cash and derivatives markets. The Working Group expects that securities lending activity will continue to increase and become an even more integral component of financial markets in the future.

The report suggests that as the scale and importance of securities lending continue to increase, market participantsshould continue to develop sound practices that identify and control risks, and ensure that these approaches keep pace with the market. In particular, market participants are encouraged to employ sound collateral management practices. This includes ensuring that appropriate collateral is received in exchange for loaned securities, that the value of all loaned securities and collateral is marked to market on a daily basis, and that firms provide for excess collateral to protect against adverse movements in market prices. The report also stresses the importance of undertaking a thorough credit review of all counterparties, of stress testing positions to assess the potential impact of extreme price movements, and of clarifying business relationships, such as principal and agent relationships and indemnification provisions, so that the associated risks are appropriately disclosed. Additionally, the report emphasises that market participants should ensure that appropriate systems are in place for managing and processing securities lending transactions. Participants should also become familiar with and implement the terms and conditions of documentation evidencing securities lending transactions, and consider the risk management challenges associated with cross-border transactions.

The Working Group notes that while securities lending has flourished within existing securities settlement systems, features unique to securities lending transactions have implications for the market infrastructure. In order to further promote liquid securities lending markets, the report suggests that market infrastructure providers consider automating trade processing functions, such as trade comparison, to reduce operational risks existent in manually intensive procedures, consider developing centralised facilities that provide for services such as central counterparty clearing, multilateral netting and tri-party lending and consider developing automated systems that identify and track securities lending transactions separately from ordinary market transactions, where such facilities have not been implemented already. To minimise settlement risk, market infrastructure organisations should continue to encourage the use of delivery versus payment (DVP) mechanisms and consider the introduction of delivery versus delivery (DVD) mechanisms in markets where securities lending is often collateralised by other securities. In the cross-border context, those responsible for market infrastructure should continue to develop the options available for more secure and efficient settlement such as linkages between CSDs, including international central securities depositories ("ICSDs"), and use of tri-party custodians. Market infrastructure organisations are also encouraged to continue their efforts to provide information (i.e. statistics) on the overall state of the securities lending market.

The final section concludes by emphasising that securities regulators and central banksshare a common goal in encouraging sound practices in the securities lending markets, and should ensure that their own regulatory approaches support these practices. The report notes that market authorities should have a sound understanding of how the regulatory environment in their jurisdiction shapes the markets for securities lending and should develop policies that support and encourage safe and efficient market practices. This includes taking steps to reduce any legal uncertainties in securities lending transactions, providing for clarity and comparability of accounting and capital treatment, and promoting market infrastructure improvements such as DVP or other relevant settlement mechanisms (such as DVD). Market authorities should also support efforts by market participants to improve market practices and risk management methods, while reducing the potential for market manipulation. Finally, as is the case with most financial activity conducted on a significant scale, market authorities should assess the potential for securities lending transactions to affect market stability or contribute to systemic risk.

The report has five annexes. A glossary is provided in Annex 1. Annex 2 is the questionnaire used in the market survey mentioned above. Annex 3 provides some information on the current size and features of securities lending markets in the respective Working Group members' jurisdictions. Annex 4 summarises the framework of securities lending markets, in particular legal, regulatory, tax and accounting aspects in the respective Working Group members' jurisdictions. Annex 5 captures features of securities settlement systems related to securities lending transactions.