SECURITIES LENDING & REPO MARKETS

Overview of the securities financing market

Definition, characteristics and comparison of main instruments used Brief history Standard agreements Securities lending & repo market size and features in geographical regions

Securities Lending & Repo markets

Main players and arrangements

Main players and arrangements in securities lending Main users of repos and arrangements Electronic trading platforms and Central Clearing Counterparts (CCPs)

A practical guide

Challenges & opportunities

Disparate regulation, a challenge for the business Heterogeneous tax frameworks but an on-going harmonisation in Europe Operational efficiency and transparency Mastering collateral management in an evolving environment

Risk versus return

Profile

A top-ranking banking Group specialised in asset servicing

CACEIS is a global player committed to designing reliable, cutting-edge services and building long- lasting relationships with clients. A member of the Crédit Agricole Group, CACEIS is rated AA-/A-1+ by S&P, which reflects the financial support of its principal shareholder. Through offices across Europe, North America and Asia, CACEIS delivers a comprehensive set of high quality core services covering depositary/ trustee and custody, clearing, transfer agency, fund administration and issuer services. CACEIS also provides a broad range of additional high-value services, notably forex, treasury and securities lending operated from CACEIS’s own independent dealing desk. Other high- value services include collateral management, OTC derivatives administration, middle-office outsourcing, private equity fund administration and cross-border fund distribution support. As at December 2009, CACEIS ranked 1st among fund administrators in Europe with €1,060bn in assets under administration and 9th among custodians worldwide with €2,330bn assets under custody. The 3,500 highly experienced employees of CACEIS are committed to upholding quality of service in terms of responsiveness, accuracy and expertise.

DEPOSITARY/TRUSTEE No.1 in Europe No.1 in France No.4 in Germany €665bn

CUSTODY No.9 Worldwide €2,330bn

FUND ADMINISTRATION No.1 in Europe No.1 in France No.4 in Luxembourg No.5 worldwide €1,060bn 8,370 funds

AA-/A-1 +

figures as at 31 December, 2009

Our clients Asset managers Mutual funds Insurance Companies Pension funds Central banks & Sovereign institutions

Hedge funds Distributors Broker-dealers Banks Corporates

Germany Netherlands

Ireland Belgium France Switzerland

Canada United States

Luxembourg

Hong Kong

Generating value in a risk-controlled environment

Our integrated forex, treasury (including repo) and securities lending services simplify your liquidity management and minimise risk as CACEIS remains the legal counterpart. It also replies to your securities financing needs. Dedicated experts & robust capabilities to serve you Liquidity management & securities financing Equipped with state- of-the-art trading technology, our dealers are highly-trained and experienced experts, financial markets and different instruments used. As they trade for CACEIS clients only, they aim to offer the most competitive rates, working in their best interests. Our liquidity activities are supported by solid and integrated back office capabilities to manage all operational aspects, as well as by sophisticated IT systems. management and securities financing with deep-seated knowledge of the

Solid rating S&P AA-/A-1+

Optimised portfolio performance

Flexibility with fully-customised programs

Special emphasis on risk control

Integrated front-to-end process

Integrated & complementary liquidity management, the best way to manage your liquidity

SECURITIES LENDING & REPO

COLLATERAL MANAGEMENT

GLOBAL CUSTODY

CASH REINVESTMENT

ON-LINE REPORTING

CACEIS provides direct access to financial markets for a broad range of instruments, combined with integrated post-execution processing

Foreign Exchange

Money Market & Fixed Income

Structured products

Securities Lending

At CACEIS, we strive for the highest level of risk-adjusted return and work hard to provide you with new opportunities in a smooth manner

2. Securities Lending & Repo

1. Securities Lent

FINANCIAL INSTITUTIONS

CACEIS

FIRST-RATE COUNTERPARTS

LENDERS

AGENT OR PRINCIPAL

BORROWERS

4. Enhanced Returns

3. Diversified Collateral

FULLY INTEGRATED & SECURED FRONT-TO-END PROCESSING

Acting as Principal or Agent, CACEIS provides a full securities lending offer, from dealing to operational processing

Our services cover: • Transaction dealing with first-rate borrowers

• Trade settlement within our global custody network • Collateral management with daily mark-to-market • Automatic initiation and handling of margin calls • Daily follow-up of dividend payments and corporate events • Recall of securities • Calculation and payment of commissions

Key benefits of CACEIS Principal program

O P T I M I S E D R E T U R N S A T M I N I M U M R I S K S P E C I A L I S A T I O N S E E M L E S S I M P L E M E N T A T I O N C A C E I S , A S I N G L E C O U N T E R P A R T Y

• Lending for European domiciled funds • Dedicated front and back-office teams with longstanding experience

• No impact on availability of securities • No additional notification requirements from the asset manager • CACEIS manages the whole operational process from trade dealing to trade settlement

A CACEIS PRODUCT DEVELOPMENT PUBLICATION - 2010

FOREWORD

Continuing our series of academic guides * , we are pleased to present you our latest publica- tion dedicated to the securities lending and repo markets.

Today securities lending and repo markets are a vital component of domestic and interna- tional financial markets, providing liquidity and greater flexibility to securities, cash and deriva- tives markets. They notably improve the functioning of securities markets by allowing sellers immediate access to securities needed to settle transactions where those securities are not available, by offering an efficient means of financing securities portfolios and by support- ing participants’ investment and trading strategies. As such, they play a core role for asset managers, pension funds, insurance companies, investment banks, central banks, sovereign funds, broker-dealers and hedge funds. The past 3 years have been challenging for the securities lending and repo markets on a global scale, as the industry experienced unprecedented events in financial markets world- wide: A credit crunch, impaired liquidity in cash collateral vehicles, the bankruptcy of a major global investment bank, increasing scrutiny from regulators and politicians, the introduction of temporary short-selling bans, and more recently sovereign risk concerns. These events ob- viously created uncertainty and many beneficial owners allocated a significant amount of time reflecting on the lessons learn t from the crisis, reviewing their securities lending programs and looking for greater transparency and control of risks. Meanwhile, the financial turmoil further enhanced the importance of the repo market and secured funding. As the worst of the economic downturn appears now to have abated, we can assert that the securities lending and repo business has proved resilient. We are confident in the future of the industry, which is likely to remain an important element of modern financial markets. Besides, the latest industry statistics available confirm a rebound of the market from a low point in 2008. Since clients are eager to capture the opportunities the securities lending and repo markets can bring to the table, but they need guidance so that they can do so in an environment that they are comfortable with, this publication aims to act as a reference handbook. CACEIS is an experienced player, providing asset managers, other institutional investors, broker-dealers, central banks and sovereign funds with full securities lending/borrowing and repo services from dealing to operational processing on main international markets. It is this experience, expertise and know-how gained through supporting various clients over the years that we share once again in this brochure. You will find hereafter a comprehensive overview of the securities financing market (main instruments and standard agreements used, history, securities lending and repo market size and features), a description of the various market participants and their motivations, as well as of the main arrangements set up. The guide also discusses a number of significant challenges for the market players: Regulation and taxation, operational efficiency and trans- parency, collateral management, risk versus return. Finally it reminds the importance of ap- pointing a proven specialist to conduct this business.

We trust this publication will reply to the numerous questions you may have and that you will find it both relevant and informative.

* Cross-border distribution of UCITS, A thorough understanding of private equity

A CACEIS PRODUCT DEVELOPMENT PUBLICATION - OCTOBER 2010

EXECUTIVE SUMMARY

SECTION I – OVERVIEW OF THE SECURITIES FINANCING MARKET The securities financingmarket encompasses twomain types of instruments: Repo and securities loan transactions. • Repos are a key product for market participants in search of liquidity or specific securities. As a fund-raising tool, they are an alternative to unsecured loans and the issuance of short-term securities. They are also an essential instrument used by central banks to manage their open-market operations in the implementation of monetary policies. • Securities lending provides lenders of securities with a low risk yield enhancement to their investment portfolios, while enabling borrowers to cover failed trades or short positions. Although these instruments may have their own specific legal, accounting and regulatory characteristics, as well as different tax treatment, economic considerations are similar. We can distinguish securities-driven transactions, in which parties seek to gain temporary access to specific securities against collateral, fromcash-driven transactions, in which parties seek to post securities as collateral to obtain secured cash financing. Two main standard agreements govern the international securities lending and repo industry: The Global Master Securities Lending Agreement (GMSLA) and the Global Master Repurchase Agreement (GMRA). In order to mini- mise legal risks, it is highly recommended to sign such standard agreements, which clearly set out the rights and obligations of the counterparties during the life of the transaction. In recent years, new financial structures (total return swaps, contracts for difference, equity swaps) have emerged as alternative securities financing instruments. These substitutes are especially useful in emerging markets where securities lending/repo is limited to a few selected participants and where a local securities lending/repo infrastruc- ture has not been fully developed. The repo and securities lending business, which really developed in the United States in the 1960s before spreading into Europe in the 1980s, has expanded rapidly in the last two decades, being now a 24-hour global activity. The fi- nancial market turmoil that began in August 2007 with the subprime crisis and led to the collapse of Lehman Brothers in mid-September 2008, affected the repo and securities lending markets in several ways. The importance of col- lateral management as an as an essential tool for managing counterparty risk, in particular, was highlighted, as well as the need for much more transparency. In the context of the crisis, regulators began looking at securities lending and repos with greater scrutiny and short selling restrictions were put in place by a number of them worldwide. In terms of geographical market size and features, the US global lending market is a large mature market. The US equity lending market was until recently the largest in the world, comfortably exceeding the European and the Asian Pacificmarkets. The treasuries/bonds US lendingmarket is also very significant. In Europe, France and Germany are the most active equities lending markets. Furthermore, the German sovereign bonds are particularly desirable as they are considered high quality and liquid collateral. In Asia Pacific, the Japanese equities lending market is the larger, in front of the Hong Kong and Australian markets. The European repo market is much bigger in size than the European securities lending market, since repo has be- come the main refinancing product in Europe. Despite its late start, the European repo market is now larger than its US equivalent. SECTION II – MAIN PLAYERS AND ARRANGEMENTS Lenders are primarily institutional investors owning on a long-term basis securities portfolios of sufficient size. They are typically asset managers, mutual funds/unit trusts, pension funds, insurance companies, endowments, etc. Their main motivation is to get additional revenue obtained at relatively low risk on assets that would otherwise have re- mained dormant in the securities accounts. They have various possible routes to enter the securities lending busi- ness, direct or intermediated. The most active borrowers of specific securities are typically major securities dealers, broker-dealers, hedge funds, prime brokers and investment banks. They seek to borrow securities in circumstances where they do not currently have possession of those securities. Other motivations include trading strategies requiring short posi- tions or financing. If theorically securities lending can take place directly between beneficial owners (lenders) and borrowers, in prac-

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A CACEIS PRODUCT DEVELOPMENT PUBLICATION - OCTOBER 2010

tice a number of layers of intermediaries, whether acting as agent or principal, are often involved. This can be ex- plained by the fact that securities lending involves a variety of complex administrative, operational, accounting and risk management activities, including credit evaluation and cash management, which may be better handled by specialists in that field. The relationship that custodian banks have with their clients puts them in a strong position to participate as principal or agent lender. With regard to repo, the bilateral market must be distinguished from the tri-party market. In the bilateral market, ac- tive repo users fall into three main categories (banks and broker-dealers, investors, central banks), all of them oper- ating on both the cash-taking and the cash-providing sides of the market. In the tri-party arrangement, buyers and sellers outsource the management of the collateral to a tri-party agent and there tends to be a clearer segmentation between cash-takers and cash providers. Cash-takers are traditionally institutions such as investment banks, bro- ker-dealers, hedge funds or prime brokers who have a constant thirst for the cheapest and most reliable sources of liquidity in order to finance their trading activities or their investment portfolios, whereas cash-providers are typi- cally central banks, supra-nationals, commercial banks, asset managers and other institutional investors or agent lenders, who are looking to re-invest their cash in exchange for acceptable collateral. In the repo market as in the securities lending market, the business is heavily relationship-driven and the majority of transactions are still performed out of electronic trading platforms, on a voice-brokered and bilateral trading basis. Moreover, central clearing counterparties are far from enjoying a significant market share and are the hottest point of debate in the industry. SECTION III – CHALLENGES & OPPORTUNITIES In the current environment, where regulators are looking at securities lending and repos with greater scrutiny, one of the biggest challenges facing the industry is regulation. Short-selling in particular remains a concern. Further- more, disparate regulation and taxation among various jurisdictions is a key issue when conducting cross-border transactions. These aspects obviously need to be taken into account as they may create restrictions of investment. Some strategies focus on these taxation gaps to enhance yields. However, as tax harmonisation spreads, opportuni- ties decrease. Other challenges include operational complexity in terms of clearing and settlement for cross-border transactions due to the fragmentation of infrastructures and the lack of automation, but also in terms of collateral valuation and management, corporate actions and income collection processing, etc., as well as the need for highly sophisticated collateral management and risk management infrastructures. The risks involved in repo and securities lending should neither be under- nor over-estimated. However, they are quantifiable and, if properly understood and monitored, manageable through a broad range of mitigation techniques. Collateral is an essential component of securities lending and repo transactions and is the key factor which makes them attractive secured financing instruments, compared to other products. However, one should keep in mind the importance of selecting high-quality and liquid collateral. The United States continue to be predominantly a cash collateral market whereas overall in Europe, non-cash collateral has historically been the collateral of choice. Post-crisis, many beneficial owners are looking for greater transparency, control and customised lending solutions built around their risk/return parameters and objectives. They have put greater restrictions on their programs, limit- ing how much they will lend, what type and quality of collateral are acceptable, as well as being more selective in who they do business with. They are increasingly requiring more information from their lending agents so that they can better understand and evaluate the risk, returns and exposures in their programs. Among the beneficial owners, we also witness the re-emergence of the intrinsic value model of securities lend- ing which produces returns based upon the securities loan itself, with little incremental benefit from collateral reinvestments. As a conclusion, securities lending and repo are complex markets where business expertise and the right capa- bilities are of paramount importance to succeed. Additionally, securities financing and liquidity management re- quire a professional approach and scale capabilities.

A glossary is provided in appendix, as well as a copy of the GMSLA and GMRA standard agreements respectively used for securities lending and repo transactions in international markets.

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1.

OVERVIEW OF THE SECURITIES FINANCING MARKET....................................................................... 9 1.1 Definition, characteristics and comparison of main instruments used ............................. 9 1.1.1 Repurchase agreements (repos).............................................................................................. 9 1.1.2 Securities loans.............................................................................................................................. 13 1.1.3 Comparison of both instruments........................................................................................... 16 1.1.4 Alternative securities financing instruments.................................................................... 17 1.2 Brief history ................................................................................................................................................ 18 1.2.1 Early stages of securities lending and repo markets .................................................. 18 1.2.2 The 1960s and 1970s: The development of securities lending and repo markets.......................................................................................................................... 19 1.2.3 The 1980s and 1990s: The globalisation of securities lending and repo markets ......................................................................................................................... 19 1.2.4 The 2000s before the financial crisis: Growth of emerging markets, development of new transaction types and arrangements ..................................... 20 1.2.5 2007-2010: The credit crunch and the Lehman collapse ...................................... 20 1.3 Standard agreements.............................................................................................................................. 21 1.3.1 The GMSLA....................................................................................................................................... 21 1.3.2 The GMRA......................................................................................................................................... 22 1.3.3 The EMA............................................................................................................................................. 23 1.4 Securities lending & repo market size and features in geographical regions ............. 24 1.4.1 Analysis of RMA data (global lending market)................................................................. 24 1.4.2 Analysis of ICMA data (European repo market).............................................................. 27 MAIN PLAYERS AND ARRANGEMENTS................................................................................................. 31 2.1 Main players and arrangement in securities lending .............................................................. 31 2.1.1 Lenders (Beneficial owners)..................................................................................................... 31 2.1.2 Borrowers......................................................................................................................................... 33 2.1.3 Intermediaries................................................................................................................................. 34 2.2 Main users of repos and arrangements......................................................................................... 38 2.2.1 Bilateral repo market................................................................................................................... 38 2.2.2 Tri-party repo market................................................................................................................... 39 2.3 Electronic trading platforms and Central Clearing Counterparts (CCPs) ...................... 40 2.3.1 Electronic trading platforms..................................................................................................... 40 2.3.2 Central Clearing Counterparties (CCPs)............................................................................. 41 CHALLENGES & OPPORTUNITIES.............................................................................................................. 43 3.1 Disparate regulation, a challenge for the business................................................................... 43 3.1.1 General points................................................................................................................................. 43 3.1.2 Recent developments.................................................................................................................. 43 3.2 Heterogeneous tax frameworks but an on-going harmonisation in Europe.................. 44 3.2.1 Current tax framework in main countries......................................................................... 44 3.2.2 Recent developments.................................................................................................................. 49 3.3 Operational efficiency and transparency......................................................................................... 50 3.3.1 Clearing and settlement challenges..................................................................................... 50 3.3.2 Other operational challenges................................................................................................... 50 3.3.3 Investors’ focus on transparency........................................................................................... 51 3.4 Mastering collateral management in an evolving environment........................................... 52 3.4.1 Reminder of basic collateral principles............................................................................... 52 3.4.2 Marking collateral to market and collateral optimisation, 2 key challenges..... 52 3.4.3 The importance of high-quality and liquid collateral....................................................... 53 3.4.4 An overview of assets used as collateral in securities lending and major trends........................................................................................................................... 54 3.4.5 Cash collateral reinvestment in securities lending programs................................. 55

2.

3.

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3.5 Risk versus return..................................................................................................................................... 55 3.5.1 Risk management considerations......................................................................................... 55 3.5.2 Securities lending returns mechanisms............................................................................. 57 3.5.3 New model of returns towards intrinsic value................................................................. 57

CONCLUSION........................................................................................................................................................ 59

BIBLIOGRAPHY................................................................................................................................................................ 60

GLOSSARY............................................................................................................................................................. 61

APPENDIX – GMSLA AND GMRA STANDARD AGREEMENTS.................................................... 71

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INDEX OF FIGURES

FIGURE

TITLE

PAGE

1 2 3 4 5 6 7 8 9

Illustration of a standard repo transaction Valuated example of a repo transaction

10 11 11 13 14 15 16 16 17 18 24 24 25 26 26 27 28 28 29 31 32 33 34 35 36 39

Repo transaction lifecycle

Illustration of a standard securities lending transaction

Valuated example of a securities loan transaction

Securities lending transaction lifecycle

Comparison of repo and securities loan instruments

Illustration of a financing arrangement combining securities lending and repo

How total return swaps (TRS) work

10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28

Evolution of securities lending and repo markets across time Aggregate total of lendable assets and total on loan worldwide (Q2 2010) Total on loan, breakdown by geographical region in USDMM and in % (Q2 2010)

Lendable assets and total on loan, North America (Q2 2010) Lendable assets and total on loan, Europe (Q2 2010) European equities on loan, breakdown by country (Q2 2010) Lendable assets and total on loan, Asia Pacific (Q2 2010)

European repo market size from 2001 to 2009

Cash currency analysis in the European repo market as at December 2009 Collateral analysis in the European repo market as at December 2009

Main players involved in securities lending transactions

Illustration of a typical “Principal borrower” model offered by a custodian bank Illustration of trading strategies relying on securities borrowing Illustration of a typical “lender agent” model offered by a custodian bank Benefits for beneficial owners when employing an agent lender

Tri-party collateral management arrangement Illustration of a typical tri-party arrangement

Automatic trading systems market share in the European repo market as at December 2009 41

Illustration of an arrangement with a CCP

41

29

Tax framework in North America (based on information current as at 01/01/2010)

45

30

Tax framework in Europe (based on information current as at 01/01/2010)

46

31

Tax framework in Asia Pacific (based on information current as at 01/01/2010)

48

32

An overview of the most important changes related to new FATCA Act in the US

49

33

IIllustration of a typical arrangement to optimise collateral management

53

34

% of collateral taken as cash in securities lending transactions

54

35

Illustration of the cash collateral reinvestment process

55

36

Identification of risks in repo & securities lending and means of mitigation

56

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A CACEIS PRODUCT DEVELOPMENT PUBLICATION - OCTOBER 2010

OVERVIEW OF THE SECURITIES FINANCING MARKETS

1.

OVERVIEW OF THE SECURITIES FINANCING MARKET

1.1

1.1

Definition, characteristics and comparison of main instruments used

The securities financing market encompasses two main types of instruments: Repo and securities loan transactions. Although these instruments may have their own specific le- gal, accounting and regulatory characteristics, as well as different tax treatment, economic considerations are similar. We can distinguish securities-driven transactions, in which parties seek to gain temporary access to specific securities against collateral, from cash-driven transactions, in which parties seek to post securities as collateral to obtain secured cash financing. In general securities loan is more likely to be securities-driven whereas repo is rather cash-driven.

1.1.1

Repurchase agreements (repos)

Repo is the generic term for repurchase agreement.

It is one of the most widely used securities financing instruments and has become a key source of capital market liquidity, through the lending of securities against cash. Repos are integral components of the banking industry’s treasury, liquidity and assets/liabilities management disciplines. They are also an essential transaction used by central banks for the management of open market operations. A repo transaction involves a short-term sale of securities by a seller (cash-taker) versus a transfer of cash by a buyer (cash-provider), with a simultaneous agreement for the seller to repurchase the same or similar securities at a future date or on demand at an agreed upon price (equal to the original sale price plus a return on the use of the sale proceeds during the term of the repo transaction). The assets temporarily sold in a repo on the purchase date are held as collateral by the counterpart. Thus, the seller is also called collateral-provider, while the buyer is called collateral-taker. These assets held as collateral are a form of protection in the event the seller is not able to return the borrowed cash at the end of the repo agreement. Indeed, if the seller defaults, the buyer can liquidate the collateral in order to recover its cash. In addition, if the issuer of the collateral defaults, the buyer can secure fresh collateral from the seller by making a margin call. Both events of default are possible but are unlikely to occur at the same time, provided the issuer of the collateral and the counterparty are sufficiently independent entities and their credit risks have a low correlation. Settlement of a repo transaction involves the delivery of the securities and the transfer of funds between the buyer and seller. In a classic repo, both legs of trade settle delivery versus payment (DVP). The maturity of a repo can be one day (overnight repo) or a longer term (typically from 2 days to 3 months).

1 Source: Euroclear, “Understanding repo and the repo market”, March 2009

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OVERVIEW OF THE SECURITIES FINANCING MARKETS

At the beginning of a transaction, securities are valued and sold at the prevailing “dirty” market price (including any coupon that has accrued), also called “all in price”. Between the sale and the repurchase:

> The seller gets the use of the cash proceeds of the sale of the assets.

> The buyer gets legal title to the assets received in exchange for the cash it has paid. If the seller defaults on the repurchase, the buyer can liquidate the assets to recover some or all of its cash. In addition, as the buyer owns the collateral assets, he can re-use them during the term of the repo by selling the assets outright, “repoing” them or pledging them to a third party. The buyer must buy back the assets by the end of the repo in order to be able to sell them back to the seller. > Any coupon or dividend paid to the buyer during the term of the transaction is immediate- ly passed through to the original owner of the securities (i.e. the seller). This equivalent payment made by the buyer to the seller is called manufactured payment or manufac- tured dividend. Upon termination of the repo, the securities are returned to the initial seller and the cash investor receives back the original sale price plus a previously agreed upon interest rate (the repo rate), as illustrated by figure 1. The repo rate can be fixed or floating (e.g. indexed to EONIA).

Figure 1: Illustration of a standard repo transaction

REPO TRADE INITIATION

Both parties agree to a repo rate Party A sells €50M worth of securities to Party B against the transfer of €50M in cash from Party B

Securities (€50M worth)

Party A SELLER/CASH-TAKER

Party B BUYER/CASH-PROVIDER

Cash (€50M)

Repotransaction characteristics Trade date Settlement date

Seller identity Buyer identity Maturity Collateral name and ID Nominal value Repo rate Settlement instructions

REPO TRADE TERMINATION

Party B returns the securities to Party A against the payment of the original €50M in cash + the repo interest earned for the period

Securities

Party A

Party B

Cash (€50M + repo interest)

Copyright CACEIS, 2010

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 “lend- er” 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 transac- tion. 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 trans- ferred securities by an agreed “haircut” or discount.

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A CACEIS PRODUCT DEVELOPMENT PUBLICATION - OCTOBER 2010

OVERVIEW OF THE SECURITIES FINANCING MARKETS

Figure 2 displays a valuated example of a repo transaction

Figure 2: Valuated example of a repo transaction

1.1

Trade date

16/09/2010 20/09/2010 20/10/2010

Settlement date Termination date

Term Seller Buyer

30 days Firm B Firm A

Security

Bund DBR 4% 4/1/18

Nominal amount

€10,000,000.00

Clean price

112.550685

Accrued interest

2.8493

All in price 115.40 Cash payment (purchase price) €11,540,000.00 Repo rate 0.40% per year

On termination, Firm A returns the securities to Firm B on a DVP basis and the Firm B re-pays Firm A the original cash amount of € 11,540,000.00 plus 30 days’ return on that cash at the agreed repo rate of 0.40% per year. The return is calculated as follows: € 11,540,000.00 x 0.40% x 30/360 = € 3,846.67

Copyright CACEIS, 2010

If rights of substitution of collateral have been negotiated up-front between the parties, the seller can get back the securities before the termination of the repo and substitute them with other securities of at least equal quality and value, acceptable to the buyer. Furthermore, a repo transaction can generally be terminated by the parties involved with a 24- or 48-hour advance notice (call). Such rights of substitution and 24- or 48-hours calls give sellers flexibility in managing their securities portfolios. Figure 3 schematises the typical lifecycle of a repo transaction, from its initiation to its termination.

Figure 3: Repo transaction lifecycle

3 - CONFIRMATION OF PURCHASE TRANSACTION Written or electronic confirmation issued on the day of the trade, including contract and settlement dates, details of repoed securities, identities of buyer and seller, haircut, term, rates, bank & settlement a/c details of the buyer & seller

2 - NEGOTIATION OF TERMS BETWEEN THE PARTIES

For clarity, processes have been simplified.

Nature of collateral delivered against cash, duration, rates

4 - SETTLEMENT Delivery of the securities and transfer of funds between the buyer and seller (DVP)

1 - MEETING OF THE FINANCING NEEDS > > Aseller needs cash/ wants to finance its securities available Abuyer wants to remunerate its cash available in a secured manner

REPO INITIATION

REPO TERMINATION

7 - REPURCHASE OF SECURITIES BY SELLER, PAYMENT OF CASH + INTEREST At the end of the repo (pre-defined term or on seller’s recall for open repos), the buyer resells the securities to the seller and deliver them via its custodian bank/sub-custodian network or ICSD). At the same time, the seller returns the funds to the buyer plus an interest calculated according to the repo rate negotiated up-front.

5 - DAILY MARK TO MARKET Daily mark to market to ensure that the cash received matches the daily market value of the securities sold in repo. Margin calls occur between the buyer and the seller

REPO IN PROGRESS

6 - POSSIBLE EVENTS:

Collateral substitution (if right of substitution) Re-pricing Corporate action on the securities sold in repo Prorogation of term

> > >

Copyright CACEIS, 2010

>

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A CACEIS PRODUCT DEVELOPMENT PUBLICATION - OCTOBER 2010

OVERVIEW OF THE SECURITIES FINANCING MARKETS

• GC versus Specials The general motivation for repos is financing, i.e. the need to borrow or lend cash. Such repos are called “General Collateral (GC) repos” and constitute the bulk of the repo market. With GC repos, the buyer does not insist on the seller providing a particular securities issue as collateral but will accept any of a range of similar quality issues However, repos can also be used to borrow securities in order to cover short positions. In that case, buyers will seek a specific security as collateral in the repo market. Such repos are called “specials” and are comparable to securities lending. The interest given up by the buyer of a special in the repo market is equivalent to the fee paid by the borrower of the same securities in the securities lending market. The repo rate for a security in demand is generally below the GC repo rate. • Reverse repo A reverse repo is the mirror image of a repo (buyer’s viewpoint). It involves the short-term purchase of securities versus a transfer of cash, with a simultaneous agreement to resell the securities at a future date at an agreed-upon price. Reverse repos may be used to borrow specific securities in order to cover short positions, to finance a new purchase or meet short-term cash needs. • Credit repo The bulk of collateral in most repo markets is comprised of domestic government bonds, gen- erally considered as free of default risk and liquid. An alternative collateral repo market – called “credit repo” and including instruments such as covered bonds, other Mortgage-Backed Securities (MBSs), other Asset-Backed Securities (ABSs), Collateral Debt Obligations (CDOs) or unsecured corporate bonds – also exists but is much smaller and was set back by the recent crisis. • Equity repo In addition to traditional government bonds repos that have been around for many years, it should be noted that there is a growing but still fairly new equity repo market. In the past, equity repowas not popular because fixed income assets were considered themost safe, but with the collapse in the structured products market and as modern markets have expanded, banks and broker-dealers have sought to increase their financing capabilities by using alter- native forms of repo collateral, such as equities. Equity repo has become a strong component of the overall repo market because of the benefits provided by transparent pricing, which is a more dependant book of liquidity, and reduced execution risk. Adding equity repo to a portfo- lio disaggregates risk and makes it more transparent. Simply put, equity repo is a repurchase agreement, which uses various types of equities as collateral 2 . The repo market is currently a key tool for market participants in search of liquidity or specific securities. As a fund-raising tool, repos are an alternative to unsecured loans and the issuance of short-term securities. Originally confined to the back-office, repo has gradually grown in importance and is now considered as an integral liquidity man- agement tool for all financial institutions across the industry. Repo is also an essential tool used by central banks to manage their open-market operations in the implementa- tion of monetary policies. With unsecured financing no longer an option beyond the very short term, the repo market has become increasingly attractive.

2 Source: Investor Services Journal, “Securities Lending Market Guide 2009”, 2009

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A CACEIS PRODUCT DEVELOPMENT PUBLICATION - OCTOBER 2010

OVERVIEW OF THE SECURITIES FINANCING MARKETS

1.1.2

Securities loans

1.1

Securities loan refers to a transaction in which one party (the lender) transfers to another party (the borrower) securities (equities, bonds), often against the transfer of collateral in order to protect the lender against the possible default of the borrower, with the simulta- neous agreement by the borrower to transfer to the lender equivalent securities on a fixed date or on demand (open), against the transfer to the borrower by the lender of assets equivalent to such collateral. Open term loans, which can be recalled at any time with a minimal notice period, are more commonly used than fixed term. Indeed, they provide flexibility as they enable the lender to exit the securities lending transaction on demand and sell at any time the concerned securi- ties. Thus, in a deteriorating credit environment a lender can reduce his exposure to, or even cease trading with, a counterpart in very short order. Throughout the life of the loan, the market value of the lent securities and of the collateral (if securities collateral) will fluctuate. To maintain sufficient levels of collateralisation, a daily (or even intraday) mark to market is typically done and margin calls are exchanged accordingly between the parties. The borrower pays the lender a fee for the use of the borrowed securities, paid monthly or at the termination of the transaction (in fine). This fee takes into account factors such as demand and supply (the more sought-after on the market securities are, the higher the fee a lender can obtain) or collateral flexibility. In case of cash collateral, the securities lender pays the borrower an interest rate calculated on the cash collateral received (rebate rate). A rebate rate of interest implies a fee for the loan of securities and is therefore regarded as a discounted rate of interest.

Figure 4 illustrates the characteristics and the main flows of a standard securities lending transaction, while figure 5 shows a valuated example of securities loan transaction.

Figure 4: Illustration of a standard securities lending transaction

Securitieslendingtransaction characteristics Trade date

Settlement date Lender identity Borrower identity

Securities lending Collateral delivery (Cash/Securities)

Maturity (open/fixed) Security name and ID Dividend entitlement Quantity lent Loan market value Lending fee Nature of collateral

Party A «LENDER»

Party B «BORROWER»

Margin calls

Lending fee Possible interest on cash collateral (rebate)

(cash/securities) Margin required Amount of collateral required Settlement instructions

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Party B

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A CACEIS PRODUCT DEVELOPMENT PUBLICATION - OCTOBER 2010

OVERVIEW OF THE SECURITIES FINANCING MARKETS

Figure 5: Valuated example of a securities loan transaction

Trade date Value date

02/08/2010 03/08/2010 10/08/2010

Termination date

Lender

Firm A Firm B

Borrower

Securities lent

Credit Agricole SA (shares - ISIN FR0000045072)

Quantity of securities lent Market value per share

1,000,000.00 (shares)

€10.90

Total market value

€10,900,000.00

Lending fee

20 bps p.a.

Payment of fee

in fine

Securities collateral Collateralisation level

FRANCE OAT FRTR 3 ½ 04/15 (ISIN FR0010163543)

105% 108%

Dirty price of FRANCE OAT (rounded)

Firm A agrees to lend 1,000,000.00 shares of Credit Agricole equities for a period of 7 days to Firm B against French Government bonds as collateral: > The collateralisation level required being 105%, the need in collateral is € 10,900,000.00 x 105% = € 11,445,000.00. > The dirty price of the FRANCE OAT FRTR 3 ½ 04/15 collateral being 108%, the nominal amount of FRANCE OAT FRTR 3 ½ 04/15 required is € 11,445,000 /108% = € 10,597,222.00 (rounded to € 10,600,000.00) On the value date, Firm A delivers to Firm B a quantity of 1,000,000 of Credit Agricole equities and Firm B delivers to Firm A FRANCE OAT FRTR 3 ½ 04/15 collateral for a nominal amount of € 10,600,000.00. For simplification purposes, let’s consider that the market value of the securities lent remain steady during the term of the transaction and that no margin call is operated between both parties. At the termination of the transaction: > On re-delivery of the Credit Agricole equities, Firm B will pay Firm A a lending fee of 20bps on the € 10,900,000.00 securities value borrowed for 7 days, i.e. 0.2% x 10,900,000.00 x 7/360 = € 423.89 > Firm A will re-deliver the securities collateral received to Firm B.

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Securities lending involves the absolute transfer of title to both the securities lent and the collateral taken, from the lender to the borrower 3 :

> The borrower can re-sell the securities borrowed.

> Any voting rights are transferred along with title. Securities must therefore be recalled by the lender, or collateral substituted by the borrower, if they wish to exercise the voting rights attached to equities. > Although the borrower, as owner of the securities, is entitled to the possible economic benefits associated with ownership such as dividends and coupons, he is under a con- tractual obligation to make equivalent payments of all distributions, if any, paid during the term of the trade, to the lender. This payment pass-through by the borrower to the lender is known as a “manufactured” payment or dividend.

Figure 6 illustrates the typical lifecycle of a securities lending transaction, from its initiation until its termination.

3 Source: Source : Bank of England & the Securities Lending and Repo Committee (SLRC), “Securities borrowing and Lending Code of Guidance”, July 2009

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A CACEIS PRODUCT DEVELOPMENT PUBLICATION - OCTOBER 2010

OVERVIEW OF THE SECURITIES FINANCING MARKETS

Figure 6: Securities lending transaction lifecycle

1.1

3 - CONFIRMATION OF TRANSACTION Written or electronic confirmation issued on the day of the trade, including contract and settlement dates, details of lent securities, identities of borrower and lender, acceptable collateral and margin %, term, rates, bank & settlement a/c details of the lender & borrower

2 – NEGOTIATION OF TERMS BETWEEN THE PARTIES > Quantity of securities lent, duration, rates, collateral

For clarity, processes have been simplified. Direct lending model (no intermediary)

4 - COLLATERAL DELIVERY The borrower delivers cash or securities collateral to the lender (e.g. 105% of the loan value). In case of pre-collateralisation, collateral is delivered before securities

LOAN INITIATION

1 - MEETING OF THE SUPPLY & DEMAND > A borrower needs a particular security > A beneficial owner wants to place its securities available for loan

4 bis - SECURITIES DELIVERY Settlement through the lender’s and the borrower’s custodian banks, sub-custodian networks or ICSD (intruction to deliver vs instruction to receive)

8- PAYMENT OF LENDING FEES At the end of the loan, the borrower pays lending fees to the lender

LOAN TERMINATION

7bis - RETURN OF COLLATERAL At the end of the loan, the lender returns the collateral taken to the borrower

5 - DAILY MARK TO MARKET The lender performs daily mark to market to ensure that the collateral is adjusted based on the daily market value of the securities lent. Margin calls occur between the lender and the borrower

7- RETURN OF SECURITIES TO LENDER At the end of the loan (pre-defined term or on lender’s recall for open loans), the borrower returns the securities to the lender via its custodian bank/sub-custodian network or ICSD

LOAN IN PROGRESS

6 - POSSIBLE EVENTS: Collateral substitution Portfolio substitution Re-rate Re-pricing Corporate action on the securities lent Prorogation of term > > > > > >

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It should be noted that constraints such as accepted types of securities, loan periods, coun- terparties, collateral, limits per issue, per fund and per counterparty often make each trade a specific transaction. The reasons why a borrower needs to temporarily borrow securities vary but generally the securities lent are needed to support a trading strategy or a settlement obligation. These motivations are further analysed in section II. • GC versus Specials As for repos, the securities lending market makes the distinction between GC and Specials. > The General Collateral (GC) market is composed of securities that are not in high demand by the market, i.e. commonly and largely available securities. > On the contrary, Specials – also called “hot” securities or “specifics”- refers to securities that are specifically located and highly demanded in the market. The “hotter” the portfolio, the higher the returns to lending. Securities lending provides lenders of securities with a low risk yield enhancement to their investment portfolios, while enabling borrowers to cover failed trades or short positions. Today modern securities lending is a specialised activity, which can significantly con- tribute to the generation of alpha and the overall performance of investment funds.

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