22 May 2013

Nigeria: NSE and Stakeholders' Unending Wait for Securities Lending

The plan by the Nigerian Stock Exchange (NSE) to introduce securities lending to the nation's capital market was hailed by stakeholders in the capital market. But the Exchange appears to have abandoned the initiative following market recovery, writes Eromosele Abiodun

Following the global financial crisis that led to stock market crashes around the world, the Nigerian equities market suffered a great deal and every effort by the Nigerian Stock Exchange (NSE) and the Securities and Exchange Commission (SEC) to revive investors' confidence appeared futile.

The NSE had promised to diversify the market from mainly equity based to a market where investors will have several products to buy and sell and in doing so deepen the market through these products.

This, the Exchange management said, was one of its priorities, stressing however, that the Nigerian market was still rudimentary. "There are so many things we can do to bring the equity market to the next level. We can introduce transactions analysis, do statistical arbitrage. But we have to take one step before we run. But if you never take that first step, you will never run," said the Chief Executive Officer of the NSE, Mr. Oscar Onyema.

Some of the market structure reforms embarked upon by the NSE supported by the SEC were fashioned new products/platforms such as market making, securities lending, short selling amongst others. These market structure reforms were intended to boost market activity level and liquidity, restore vibrancy and stimulate the recovery of the market as well as to improve transparency, efficiency as well as depth and product range.

Meanwhile, the market has since rebounded and the NSE seemed to have jettisoned most of its plans, a situation stakeholders said is worrisome. It is not only the NSE that has abandoned its plan for securities lending; the Chartered Institutes of Stockbrokers (CIS), which is the umbrella body of stockbrokers, has failed on its promise to train its member so as to take advantage of the initiative.

Training Stockbrokers

The CIS had last year told THISDAY that it will soon begin the training of its members on securities lending so as take full advantage of the new policy when it hit the market. THISDAY had exclusively reported December last year that the rules and regulations for securities lending would be issued to operators early this year.

The Chief Executive Officer of Asset Management Corporation of Nigeria (AMCON), Mr. Mustapha Chike-Obi, who was involved in developing the rules, had made the disclosure in an interview with newsmen.

According to Chike-Obi, the rules and regulations that would guide securities lending in Nigeria were already concluded and were being forwarded to the Securities and Exchange Commission for approval.

THISDAY checks revealed that in order to be well prepared and take advantage of securities lending, CIS was making arrangement to train stockbrokers.

The CIS President, Mr. Mike Itegboje, had confirmed the development to THISDAY, saying, "We are concluding arrangements and very soon training will commence. Stockbrokers should not miss the training so that when the securities lending becomes operational in the market, they will be actively involved."

Chike-Obi had said that he was actively involved in developing the rules and regulations for securities lending in Nigeria.

"It has been concluded and it will go to the regulators - the NSE and SEC. I believe very soon we are going to have the module for securities lending in Nigeria and that rule will spell out active secondary trading, not just in AMCON bonds, but all other securities. So we are doing everything to develop the securities market and we believe that the Nigeria stock market is going to be much more viable again," he said.

Securities Lending

Meanwhile, the subject matter as simple as it may sound is still very new to many operators and investors in the Nigerian capital market. As a matter of fact, until the start of 2009, securities lending was only an over-the-counter market in developed capital markets. Therefore, the need for adequate training for traders and investors in the Nigerian capital market cannot be over emphasised.

Securities lenders are institutions, which have access to 'lendable' securities. This can be asset managers, who have many securities under management, custodian banks holding securities for third parties or third party lenders who access securities automatically via the asset holder's custodian.

Also, securities lending or stock lending refers to the lending of securities by one party to another. The terms of the loan is governed by a "Securities Lending Agreement", which requires that the borrower provides the lender with collateral, in the form of cash, government securities, or a Letter of Credit of value equal to or greater than the loaned securities. The agreement is a contract enforceable under relevant law, which is often specified in the agreement.

As payment for the loan, the parties negotiate a fee, quoted as an annualised percentage of the value of the loaned securities. If the agreed form of collateral is cash, then the fee may be quoted as a "rebate", meaning that the lender will earn all of the interest, which accrues on the cash collateral, and will "rebate" an agreed rate of interest to the borrower.


Experts also told THISDAY that securities lending is legal and clearly regulated in most of the world's major securities markets.

"Borrowing of securities could be conducted only for specifically permitted purposes, which generally include; facilitating settlement of a trade, to facilitate delivery of a short sale, to finance the security, or to facilitate a loan to another borrower who is motivated by one of these permitted purposes. When a security is loaned, the title of the security is transferred to the borrower. This means that the borrower has the advantages of holding the security, as they become the full legal and beneficial owner of it.

"Specifically, the borrower will receive all coupon and/or dividend payments, and any other rights such as voting rights. In most cases, these dividends or coupons must be passed back to the lender in the form of what is referred to as a manufactured dividend," said Managing Director and Chief Executive Officer of Cowry Assets Limited, Mr. Johnson Chukwu.

He added that "the initial driver for the securities lending business was to cover settlement failure stressing that if one party fails to deliver stock to you it can mean that you are unable to deliver stock that you have already sold to another party."

Chukwu stated that in order to avoid the costs and penalties that can arise from settlement failure, stock could be borrowed at a fee, and delivered to the second party. He disclosed that the principal reason for borrowing a security is to cover a short position.

"As you are obliged to deliver the security, you will have to borrow it. At the end of the agreement you will have to return an equivalent security to the lender. Equivalent in this context means fungible, i.e. the securities have to be completely interchangeable," he said.

Chukwu further stated that securities lending and borrowing is often required, by matter of law, to engage in short selling.

He disclosed that recent regulation in the United States required that, before short sales were executed for 19 specific financial stocks, the sellers first pre-borrow shares in those issues.

Securities-Collateralised Lending

The Cowry Assets boss however, noted that the term "securities lending" is sometimes used erroneously in the same context as a "stock loan" or individual "securities-collateralised loan".

He said the former refers to the actual lending typically of banks or brokerages to other institutions to cover short sales or for other temporary purposes, stressing that the latter is used in private or institutional securities-backed loan arrangements across a wide spectrum of securities.

"In recent years, consumers have been warned to avoid non-recourse transfer-of-title stock loans. Today, it is widely accepted that the only legally valid consumer lending programmes involving stocks or other securities are those in which the stocks remain in the client's title and account without sale through a fully licensed and regulated institution," he said.

Speaking on the impact securities lending will have on the Nigerian capital market, he stressed that securities lending will provides liquidity to equities, bond and money markets, placing it at the heart of today's financial system. This increase in liquidity, he pointed out, will reduce the cost of trading, increasing market efficiency and benefiting all investors.

Specifically, he said, "Securities lending markets allow market participants to sell securities that they do not own in the confidence that they can be borrowed prior to settlement. They are also used for financing, through lending of securities against cash, forming an important part of the money markets.

"The ability to lend and borrow securities freely underpins the services that securities dealers offer their customers and the trading strategies of dealers, hedge funds and other asset managers. On the lending side, securities lending forms a growing part of the revenue of institutional investors, custodian banks and the prime brokerage arms of investment banks."


On his part, Managing Director and Chief Executive of Huntingfield Capital Limited, Mr. Onye Onwuka, disclosed that some important consequences arise from the nature of securities lending transactions.

"In some countries, absolute title over both lent and collateral securities passes between the parties. Therefore, all these securities can be sold outright or on-lent, which are commonplace and an intrinsic part of the functioning of the market. The borrower is entitled to the economic benefits of owning the lent securities (e.g. dividends), but the agreement with the lender will oblige it to make ('manufacture') equivalent payments back to the lender.

"Another point to note is that a lender of equities no longer owns them and has no entitlement to vote. But it is still exposed to price movements on them, since effectively the borrower can return them at a pre-agreed price. Lenders typically reserve the right to recall equivalent securities from the borrower, and will exercise this option if they wish to vote. Borrowing securities for the specific purpose of influencing a shareholder vote is not regarded as acceptable market practice in some countries," he said.

Securities Lending Transactions

The Huntingfield Capital boss further stated that most securities loans are collateralised, either with other securities or with cash deposits. He noted that where lenders take securities as collateral, they are paid a specific fee by the borrower.

"By contrast, where they are given cash as collateral, they pay the borrower interest but at a rate (the rebate rate) that is lower than market rates, so that the lender can reinvest the cash and make a return (i.e. the spread).

"Pricing is negotiated between the parties and would typically take into account factors such as supply and demand for the particular securities, collateral flexibility, the size of any manufactured dividend, and the likelihood of the lender recalling the securities early, "he said.

Onwuka stressed that as well as securities lending, sale and repurchase and buy-back transactions are used for the temporary transfer of securities against cash. He said securities lending in general is more likely to be motivated by the desire to borrow specific securities.

"For example, reinvestment of cash collateral has been an integral part of the securities lending business for many years, particularly in the United States, with reinvestment opportunities often driving the underlying securities lending transactions," he said.

Lenders and Intermediaries

He said the supply of securities into the lending market comes mainly from the portfolios of beneficial owners, such as pension and other funds and insurance companies, adding that the underlying demand to borrow securities begins largely with the trading activities of dealers and hedge funds.

"In the middle are a number of intermediaries. The importance of intermediaries in the market partly reflects the fact that securities lending is a secondary activity for many of the beneficial owners and underlying borrowers. But intermediaries provide valuable services, such as credit enhancement and the provision of liquidity, by being willing to borrow securities at call while lending them for term. They also benefit from economies of scale, including the significant investment in technology required to run a modern operation," he said.

Intermediaries, he noted, include custodian banks and asset managers lending securities as agents on behalf of beneficial owners, alongside the other services provided to these clients.

The Borrowing Motivation

Onwuka disclosed that the most common reason to borrow securities is to cover a short position-using the borrowed securities to settle an outright sale. "But this is rarely a simple speculative bet that the value of a security will fall, so that the borrower can buy it more cheaply at the maturity of the loan. More commonly, the short position is part of a larger trading strategy, typically designed to profit from perceived pricing discrepancies between related securities.

"The securities lending market is a hybrid between a relationship-based market and an open, traded market. Historically, transactions were negotiated by telephone but increasingly securities are broadcast as available at particular rates using email or other electronic platforms. Loans may be either for a specified term or, more commonly, open to recall, because lenders typically wish to preserve the flexibility for fund managers to be able to sell at any time," he said.

Risks and Risk Management

Onwuka disclosed that, "When taking cash as collateral a lender taking cash as collateral pays rebate interest to the securities borrower. So the cash must be reinvested by the lender at a higher rate in order to make any net return on the collateral aspect of the transaction." Expected returns, he stated, can be increased by reinvesting in assets with more credit risk or longer maturity in relation to the likely term of the loan, with a risk of loss if market interest rates rise.

He added that many of the large securities lending losses over the years have been associated with re-investment of cash collateral.

"Transaction collateralised with other securities Apart from the risk of errors, systems failures and frauds always present in any market, problems arise on the default of a borrower. The lender must then sell its collateral in the market in order to raise the funds to replace the lent securities. It will lose money if the value of the collateral securities falls relative to that of the lent securities. Generally, the risk of loss is greater: if it takes longer to close out these positions, the collateral or lent securities are wrongly valued, the markets for these securities are illiquid, and if the market prices of the lent and collateral securities do not tend to move together," he said.

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