SECURITIES LENDING & REPO MARKETS

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.

page 4 | Securities Lending & Repo markets