Securities finance securities lending and repurchase agreements

Securities
Finance
Securities Lending and
Repurchase Agreements

FRANK J. FABOZZI
STEVEN V. MANN
EDITORS

John Wiley & Sons, Inc.



Securities
Finance


THE FRANK J. FABOZZI SERIES
Fixed Income Securities, Second Edition by Frank J. Fabozzi
Focus on Value: A Corporate and Investor Guide to Wealth Creation by James L.
Grant and James A. Abate
Handbook of Global Fixed Income Calculations by Dragomir Krgin
Managing a Corporate Bond Portfolio by Leland E. Crabbe and Frank J. Fabozzi
Real Options and Option-Embedded Securities by William T. Moore
Capital Budgeting: Theory and Practice by Pamela P. Peterson and Frank J. Fabozzi
The Exchange-Traded Funds Manual by Gary L. Gastineau
Professional Perspectives on Fixed Income Portfolio Management, Volume 3 edited
by Frank J. Fabozzi
Investing in Emerging Fixed Income Markets edited by Frank J. Fabozzi and
Efstathia Pilarinu
Handbook of Alternative Assets by Mark J. P. Anson

The Exchange-Traded Funds Manual by Gary L. Gastineau
The Global Money Markets by Frank J. Fabozzi, Steven V. Mann, and
Moorad Choudhry
The Handbook of Financial Instruments edited by Frank J. Fabozzi
Collateralized Debt Obligations: Structures and Analysis by Laurie S. Goodman
and Frank J. Fabozzi
Interest Rate, Term Structure, and Valuation Modeling edited by Frank J. Fabozzi
Investment Performance Measurement by Bruce J. Feibel
The Handbook of Equity Style Management edited by T. Daniel Coggin and
Frank J. Fabozzi
The Theory and Practice of Investment Management edited by Frank J. Fabozzi and
Harry M. Markowitz
Foundations of Economic Value Added: Second Edition by James L. Grant
Financial Management and Analysis: Second Edition by Frank J. Fabozzi and
Pamela P. Peterson
Measuring and Controlling Interest Rate and Credit Risk: Second Edition by
Frank J. Fabozzi, Steven V. Mann, and Moorad Choudhry
Professional Perspectives on Fixed Income Portfolio Management, Volume 4 edited
by Frank J. Fabozzi
The Handbook of European Fixed Income Securities edited by Frank J. Fabozzi and
Moorad Choudhry
The Handbook of European Structured Financial Products edited by Frank J.
Fabozzi and Moorad Choudhry
The Mathematics of Financial Modeling and Investment Management by Sergio M.
Focardi and Frank J. Fabozzi
Short Selling: Strategies, Risks, and Rewards edited by Frank J. Fabozzi
The Real Estate Investment Handbook by G. Timothy Haight and Daniel Singer
Market Neutral Strategies edited by Bruce I Jacobs and Kenneth N. Levy
Securities Finance edited by Frank J. Fabozzi and Steven V. Mann

Securities
Finance
Securities Lending and
Repurchase Agreements

FRANK J. FABOZZI
STEVEN V. MANN
EDITORS

John Wiley & Sons, Inc.


Copyright © 2005 by John Wiley & Sons, Inc. All rights reserved
Published by John Wiley & Sons, Inc., Hoboken, New Jersey
Published simultaneously in Canada
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ISBN-13 978-0-471-67891-5
ISBN-10 0-471-67891-0

Printed in the United States of America
10 9 8 7 6 5 4 3 2 1


Contents

Preface
About the Editors
Contributing Authors

ix
xiii
xv

PART ONE
Securities Lending
CHAPTER 1
An Introduction to Securities Lending
Mark C. Faulkner
CHAPTER 2
Securities Lending, Liquidity, and Capital Market-Based Finance

State Street
CHAPTER 3
Finding a Route to Market: An Institutional Guide to the
Securities Lending Labyrinth
Mark C. Faulkner

1

3

39

57

CHAPTER 4
Evaluating Lending Options
Anthony A. Nazzaro

79

CHAPTER 5
The Auction Process and Its Role in the Securities Lending Markets
Daniel E. Kiefer and Judith G. Mabry

87

CHAPTER 6
The Fundamentals of Fixed Income Securities
Frank J. Fabozzi

107

v


vi

Contents

CHAPTER 7
Managing Liquidity Risks in Cash-Based Lending Programs
Ed Blount and Aaron J. Gerdeman

127

CHAPTER 8
Quantifying Risks in Securities Lending Transactions
Mark C. Faulkner

141

CHAPTER 9
Risk, Return, and Performance Measurement in Securities Lending
Peter Economou

151

CHAPTER 10
Developing Effective Guidelines for Managing Legal Risks—U.S. Guidelines
Charles E. Dropkin

167

CHAPTER 11
Tax Issues Associated with Securities Lending
Richard J. Shapiro

179

CHAPTER 12
Accounting Treatment of Loans of Securities
Susan C. Peters

205

PART TWO
Bond Financing via the Repo Market

219

CHAPTER 13
Repurchase and Reverse Repurchase Agreements
Frank J. Fabozzi and Steven V. Mann

221

CHAPTER 14
The European Repo Market
Richard Comotto

241

CHAPTER 15
Overview of U.S. Agency Mortgage-Backed Securities
Frank J. Fabozzi

255


Contents

vii

CHAPTER 16
Dollar Rolls
Frank J. Fabozzi and Steven V. Mann

283

CHAPTER 17
Evaluating the Interaction of Dollar Rolls and MBS Investments
Anand K. Bhattacharya, Paul Jacob, and William S. Berliner

299

PART THREE
Equity Financing Alternatives to Securities Lending

315

CHAPTER 18
Equity Financing Alternatives to Securites Lending
Frank J. Fabozzi and Steven V. Mann

317

INDEX

333



Preface

ecurities finance involves secured borrowing and lending transactions
that are motivated for various reasons such as obtaining securities for settlement, financing inventory positions, and generating incremental income
by lending securities. At one time, securities finance consisted of securities
lending arrangements for equities and bonds and repurchase agreements
(repos) for bonds. While these two forms of securities finance still dominate
today, other methods commonly used include contracts for differences,
equity swaps, and single stock futures as well as equity repos.
The purpose of this book is to provide investors and traders with an
enhanced understanding of the various arrangements in the securities
finance market. It is our hope that the knowledge gained will enable
readers to make a more informed choice about their participation in this
expanding market.
The book is divided in three parts. The 12 chapters in Part One
cover securities lending, also commonly referred to as stock lending.
Chapter 1 by Mark Faulkner describes securities lending as well as benefits for lenders and borrowers of securities participating in the market,
the different types of securities lending transactions, mechanics of the

transaction, the role of intermediaries, and the risks faced by the lenders
of securities. The critical role of securities finance in capital markets is
discussed by the staff of State Street in Chapter 2. Finding the most suitable route to participate in the securities lending market and the issue of
selecting a suitable counterparty are the subjects of Chapter 3 by Mark
Faulkner, focusing on the lending of international equities with regard
to both lending and nonlending institutions.
The traditional programs available to institutional investors seeking
to enter the securities lending market are also reviewed by Anthony
Nazzaro in Chapter 4. An innovative program offering an alternative
route to the market is the auction process developed by eSecLending. In
Chapter 5, Daniel Kiefer of CalPERS and Judith Mabry of eSecLending
describe this new option available to principal lenders. At one time, simply computing the revenues produced by a securities lending program
was adequate in assessing the potential benefits for market participants

S

ix


x

Preface

and for managing a program. Today, this is not adequate. Rather, market participants evaluate the decision to participate and manage the process based on the risk-adjusted expected return.
To help understand the risks in a securities lending transaction
involving bonds, Chapter 6, prepared by one of the editors, provides
background information about the characteristics of these securities and
their risks. In the United States, programs involving lending against cash
collateral are the most common form of collateral management model
and recently cash-based lending has become more popular outside the

United States. In cash-based lending programs, it is critical that liquidity
risks be controlled. In Chapter 7, Ed Blount and Aaron Gerdeman
explain how to manage liquidity risks.
An analytical framework for aiding lenders in making decisions on
the appropriateness of any type of collateral program (cash or securities) and understanding how they could amend proposed programs to
reflect their particular risk/reward tolerance is described in Chapter 8 by
Mark Faulkner. In Chapter 9, Peter Economou explains how reporting
performance on a risk-adjusted basis can provide lenders with the information for proactively managing the securities lending process.
The participants in a securities lending transaction must consider
legal, regulatory, tax, and accounting issues. The last three chapters in
Section One deal with these issues. In Chapter 10, Charles Dropkin
explains how to develop effective guidelines for managing legal risks for
U.S.-based participants. He identifies certain key legal and regulatory
issues that market participants must understand and follow in order to
have an effective compliance program and describes mechanisms that
can be included in programs for reducing insolvency risk. The Federal
income tax consequences of securities lending transactions are detailed
in Chapter 11 by Richard Shapiro. Statement of Financial Accounting
Standard 140 is the primary accounting literature on securities lending
transactions. In determining the accounting treatment, the basic concept
is control. In Chapter 12, Susan Peters offers guidance regarding the
recording and financial treatment of loaned securities.
Part Two covers bond financing by means of repurchase agreements
(repos). The first chapter in this section, Chapter 13, prepared by the
editors, explains a repo transaction, the types of repo transactions, and
the mechanics of the transaction. The focus of the chapter then turns to
the analysis of a repo transaction from the investor’s perspective and
illustrates the calculations with Bloomberg screens. While the focus of
Chapter 13 is the U.S. repo market, Richard Comotto covers the European repo market in Chapter 14. Because of the unique characteristics
of agency mortgage-backed securities (MBS), a special form of repo has

developed, dollar rolls. Before the editors describe dollar rolls in Chap-


xi

Preface

ter 16, one of the editors provides an overview of agency MBS in Chapter 15. A historical and analytical framework for assessing the effect of
dollar rolls on the MBS market and strategies employed by asset managers (including valuation dynamics) is explained in Chapter 17 by Anand
Bhattacharya, Paul Jacob, and William Berliner.
Part Three contains only one chapter (Chapter 18) coauthored by
the editors and describes alternative vehicles to securities lending for
equity financing. These alternatives are equity repo and linear derivative
contracts (i.e., nonoptions) which include contracts for differences and
single stock futures, and equity swaps.
We would like to extend our profound appreciation to the contributing authors and Jim Daraio Capital Markets Management for permission to use some of the exhibits in Chapter 16.
Frank J. Fabozzi
Steven V. Mann



About the Editors

Frank J. Fabozzi, Ph.D., CFA, CPA is the Frederick Frank Adjunct Professor of Finance in the School of Management at Yale University. Prior to
joining the Yale faculty, he was a Visiting Professor of Finance in the
Sloan School at MIT. Professor Fabozzi is a Fellow of the International
Center for Finance at Yale University and the editor of the Journal of
Portfolio Management. He earned a doctorate in economics from the City
University of New York in 1972. In 1994 he received an honorary doctorate of Humane Letters from Nova Southeastern University and in 2002
was inducted into the Fixed Income Analysts Society’s Hall of Fame. He is

the honorary advisor to the Chinese Asset Securitization Web site.
Steven V. Mann, Ph.D., is Professor of Finance at the Moore School of
Business, University of South Carolina. He has coauthored four previous
books and numerous articles in the area of investments, primarily fixedincome securities and derivatives. Professor Mann is an accomplished
teacher, winning 20 awards for excellence in teaching and has received
two awards for outstanding research. He also works as a consultant to
investment/commercial banks and has conducted training programs for
financial institutions throughout the United States.

xiii



Contributing Authors

William S. Berliner
Anand K. Bhattacharya
Ed Blount
Richard Comotto
Charles E. Dropkin
Peter Economou
Frank J. Fabozzi
Mark C. Faulkner
Aaron J. Gerdeman
Paul Jacob
Daniel E. Kiefer
Judith G. Mabry
Steven V. Mann
Anthony A. Nazzaro
Susan C. Peters

Richard J. Shapiro
State Street

Countrywide Securities Corporation
Countrywide Securities Corporation
The ASTEC Consulting Group
University of Reading, England
Proskauer Rose LLP
State Street
Yale University
Spitalfields Advisors
The ASTEC Consulting Group
Countrywide Securities Corporation
CalPERS
eSecLending
University of South Carolina
A. A. Nazzaro Associates
eSecLending
Ernst & Young LLP

xv



PART

One
Securities Lending

CHAPTER

1

An Introduction to Securities
Lending
Mark C. Faulkner
Managing Director
Spitalfields Advisors

ecurities lending—the temporary transfer of securities on a collateralized basis—is a major and growing activity providing significant
benefits for issuers, investors, and traders alike. These are likely to
include improved market liquidity, more efficient settlement, tighter
dealer prices and, perhaps, a reduction in the cost of capital. This chapter describes securities lending, the motivation for lenders and borrowers to participate, the role of intermediaries, market mechanics, and the
risks faced by the lenders of securities.

S

WHAT IS SECURITIES LENDING
Securities lending is an important and significant business that describes
the market practice whereby securities are temporarily transferred by
one party (the lender) to another (the borrower). The borrower is
obliged to return the securities to the lender, either on demand, or at the

The author is grateful for the assistance provided by David Rule, Simon Hills, Dagmar Banton, John Serocold, Andrew Clayton, Joyce Martindale, Susan Adeane,
Habib Motani, Niki Natarajan, Andrew Barrie, Jackie Davis, and Bill Cuthbert.

3

4

SECURITIES LENDING

end of any agreed term. For the period of the loan the lender is secured
by acceptable assets delivered by the borrower to the lender as collateral.
Securities lending today plays a major part in the efficient functioning of the securities markets worldwide. Yet it remains poorly understood by many of those outside the market.
In some ways, the term “securities lending” is misleading and factually incorrect. Under English law and in many other jurisdictions, the
transaction commonly referred to as “securities lending” is, in fact ...
a disposal (or sale) of securities linked to the subsequent
reacquisition of equivalent securities by means of an agreement.
Such transactions are collateralized and the “rental fee” charged, along
with all other aspects of the transaction, is dealt with under the terms
agreed between the parties. It is entirely possible and very commonplace
that securities are borrowed and then sold or on-lent.
There are some consequences arising from this clarification:
1. Absolute title over both the securities on loan and the collateral
received passes between the parties.
2. The economic benefits associated with ownership—e.g., dividends,
coupons, etc.—are “manufactured” back to the lender, meaning that
the borrower is entitled to these benefits as owner of the securities but
is under a contractual obligation to make equivalent payments to the
lender.
3. A lender of equities surrenders its rights of ownership, e.g., voting.
Should the lender wish to vote on securities on loan, it has the contractual right to recall equivalent securities from the borrower.
Appropriately documented securities lending transactions avoid taxes
associated with the sale of a transaction or transference fees.

Different Types of Securities Loan Transaction

Most securities loans in today’s markets are made against collateral in
order to protect the lender against the possible default of the borrower.
This collateral can be cash or other securities or other assets.

Transactions Collateralized with Other Securities or Assets
Noncash collateral would typically be drawn from the following collateral types:


An Introduction to Securities Lending

5

■ Government bonds
■

Issued by G7, G10 or Non-G7 governments

■ Corporate bonds

Various credit ratings
Convertible bonds
■ Matched or unmatched to the securities being lent
Equities
■ Of specified indices
Letters of credit
■ From banks of a specified credit quality
Certificates of deposit
■ Drawn on institutions of a specified credit quality
■

■
■
■
■

■ Delivery by value (“DBVs”)1

Concentrated or unconcentrated
Of a certain asset class
■ Warrants
■ Matched or unmatched to the securities being lent
■ Other money market instruments
■

■

The eligible collateral will be agreed upon between the parties, as will
other key factors including:
■ Notional limits

The absolute value of any asset to be accepted as collateral
■ Initial margin
■ The margin required at the outset of a transaction
■ Maintenance margin
■ The minimum margin level to be maintained throughout the transaction
■ Concentration limits
■ The maximum percentage of any issue to be acceptable, e.g., less
than 5% of daily traded volume
■ The maximum percentage of collateral pool that can be taken against
the same issuer, that is, the cumulative effect where collateral in the

■

1

Delivery by Value is a mechanism in some settlement systems whereby a member
may borrow or lend cash overnight against collateral. The system automatically selects and delivers collateral securities, meeting pre-determined criteria to the value of
the cash (plus a margin) from the account of the cash borrower to the account of the
cash lender and reverses the transaction the following morning.


6

SECURITIES LENDING

form of letters of credit, CD, equity, bond and convertible may be
issued by the same firm
Exhibit 1.1 shows collateral being held by a tri-party agent. This specialist agent (typically a large custodian bank or international central
securities depository) receives only eligible collateral from the borrower
and hold it in a segregated account to the order of the lender. The triparty agent marks this collateral to market, with information distributed
to both lender and borrower (in the diagram, dotted “Reporting” lines).
Typically the borrower pays a fee to the tri-party agent.
Exhibit 1.2 provides an illustration of cash flows on a securities against
collateral other than cash for a transaction in the United Kingdom.
There is debate within the industry as to whether lenders, which are
flexible in the range of noncash collateral that they are willing to
receive, are rewarded with correspondingly higher fees. Some argue that
they are; others claim that the fees remain largely static, but that borrowers are more prepared to deal with a flexible lender and, therefore,
balances and overall revenue rise.
The agreement on a fee is reached between the parties and would
typically take into account the following factors:

■ Demand and supply

The less of a security available, other things being equal, the higher
the fee a lender can obtain
■ Collateral flexibility
■ The cost to a borrower of giving different types of collateral varies
significantly, so that they might be more willing to pay a higher fee if
the lender is more flexible
■

EXHIBIT 1.1

Noncash Collateral Held by a Third-Party Agent
Loan Commences

Loan Terminates


An Introduction to Securities Lending

7

EXHIBIT 1.2

Cash Flows on a Securities Loan Against Collateral Other than Cash
The return to a lender of securities against collateral other than cash derives from the
fee charged to the borrower. A cash flow of this transaction reads as follows:

Transaction date
Settlement date

Term
Security
Security price
Quantity
Loan value
Lending fee
Collateral
Margin required
Collateral required
Daily lending income

13 June 2005
16 June 2005
Open
XYZ Limited
£10.00 per share
100,000 shares
£1,000,000.00
50 basis points (100ths of 1%)
UK FTSE 100 Concentrated DBVs
5%
£1,050,000.00 in DBVs
£1,000,000.00 × 0.005 × (1/365) = £13.70

Should the above transaction remain outstanding for one month and be returned on
16 July 2005 there will be two flows of revenue from the borrower to the lender.
On 30 June fees of £191.80 (£13.70 × 14 days)
On 31 July fees of £219.20 (£13.70 × 16 days)
Thus total revenue is £411.00 against which the cost of settling the transaction (loan
and collateral) must be offset.

Note: For purposes of clarity, the example assumes that the value of the security
on loan has remained constant, when in reality the price would change daily resulting in a mark to market event, different fees chargeable per day and changes
in the value of the collateral required. Open loan transactions can also be re-rated
or have their fee changed if market circumstances alter. It is assumed that this did
not happen either.

■ The size of the manufactured dividend required to compensate the

lender for the posttax dividend payment that it would have received
had it not lent the security
■ Different lenders have varying tax liabilities on income from securities; the lower the manufactured dividend required by the lender, the
higher the fee it can negotiate.2
2

An explanation of how securities lending can be motivated by the different tax status of borrowers and lenders is discussed later in this chapter.