SECURITIES LENDING & REPO MARKETS

A CACEIS PRODUCT DEVELOPMENT PUBLICATION - OCTOBER 2010

OVERVIEW OF THE SECURITIES FINANCING MARKETS

1.1.4

Alternative securities financing instruments

1.1

Although the most common, repo and securities loan are not the only securities finance instruments. In recent years, new financial structures, such as total return swaps (TRSs) – see illustration figure 9 -, contracts for differences (CFDs) and equity swaps, have been de- veloped and increasingly become an alternative to the classic securities lending and repo instruments described in the previous sections. These synthetic or swap transactions have the same economic effect as securities lending/repo but do not involve an actual exchange of securities and are treated as off-balance sheet transactions. They are typically governed by ISDA international standard agreements. 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 infra- structure has not been fully developed. They also gives access to the securities lending/repo markets to additional entities that may not have the infrastructure to monitor fees and rebates or are not permitted to conduct securities lending/repo transactions under regulatory guidelines but can trade options. Furthermore, they can be attractive to counterparties that want to avoid the operational burden of securities settlement or that face tax obstacles to securities lending. In Taiwan for example, where securities lending is complicated by the combined influence of a tax on earnings and different settlement timetables for purchases and sales, offshore synthetic transactions have provided a convenient alternative to the onshore market 4 .

Figure 9: How total return swaps (TRS) work

In theory, each leg can be executed separately with different parties but in reality trade is bundled together and so economically identical to a repo. The bond trader will receive the “total return” on the bonds, which means that: > if bond rises in value, trader pays the difference in value to the counterparty. > if bond falls in value, the trader will receive the difference from the counterparty. As part of the swap, trader pays for example Libor +/- swap on the cash proceeds. The cash investor counterparty has full title and can sell securities in the open market at termination. Dealer has no legal obligation to repurchase the bonds. The trade will take bonds off dealer’s balance sheet, which may be desired if a year-end is approaching.

1 – Institution sells security (e.g. bond) at market price

2 – Institution executes a swap transaction for a fixed term, exchanging the total return on the security for an agreed rate on the relevant cash amount

3 – On maturity of the swap, institution repurchases security at the market price

Copyright CACEIS, 2010

4 Source: JP Morgan, “Securities lending as an asset management technique”, 2010

Securities Lending & Repo markets | page 17