SECURITIES LENDING & REPO MARKETS

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-

Securities Lending & Repo markets | page 3