Securities lending and the question of pricing
15 March 2022
Martin Walker, Broadridge’s head of product, securities finance and collateral management, looks at securities lending price models in the context of SEC proposed rule 10c-1, reflecting on how this will impact market operations and data vendors’ business models
Image: stock.adobe.com/kmaglara
While pricing models in most areas of capital markets have grown incredibly sophisticated and transparent, at least superficially, one area with a lot of catching up to do is securities lending. When securities are lent for purposes such as covering short sales or settlement failures, there are two main ways in which the lender receives a return, notably fees and rebates. If the borrower provides cash as collateral for the loan of the stock, profit is made on the difference between the interest received by the borrower on those funds and the interest paid to the borrower (the rebate). If securities are provided as collateral instead, the lender’s return comes in the form of a fee paid by the borrower. Fees and rebates vary for different securities depending on market demand. Stocks that are more in demand to facilitate shorting will typically have higher fees, or lower rebates, than securities that are less in demand.
Understanding what the current market price is for borrowing securities is problematic for multiple reasons. There are multiple vendors of pricing data (i.e. rebate and fee rates) for securities lending, but there are a number of potential issues with that data. These issues are very clearly highlighted in the consultation paper issued by the Securities and Exchange Commission (SEC) in relation to their proposed rules on the reporting of securities lending transactions (Rule 10c/a).
The SEC says: "The securities lending market is characterised by asymmetric information between market participants and a general lack of information on current market conditions, which can lead to inefficient prices for securities loans, including equity lending and fixed income lending."
The SEC explanation for unequal access to market information is based on the current model for collecting and distributing market data, the “Give-to-Get” model. Market participants provide trade data to data vendors who aggregate the data and provide back market prices for all securities. The SEC highlight multiple problems with the model, from the perspective of market efficiency and fairness:
• The pricing data is incomplete because not all participants contribute data
• There are very strong incentives for those that have gained control of a large proportion of the supply of in-demand stocks (“specials”, also known as “hot stocks”) not to submit information
• Not all market participants can access the data, even if they are willing to pay for it
• There are significant time delays in getting the data. While cash equity markets see prices move in fractions of a second, receiving a feed of market prices on the next business day is common in securities lending
If the SEC's proposed Rule 10c-1 goes forward in its current form, US securities lending trades will be reported within 15 minutes and pricing data reported in the following business days — but potentially sooner. This is sure to have a major impact on the operations of the market and the business models of the market data vendors that will need to demonstrate the value of analytics, in addition to the value of basic pricing data. It could also have a truly transformative effect on how trading is done.
However, there is more to achieving transparency in the stock lending market than collecting and aggregating all the data for each security. Different types of collateral and different haircuts also ultimately affect the true price of a loan. A lender demanding higher quality collateral or deeper haircuts on the valuation of collateral is ultimately demanding a higher economic price. The credit rating of each party, as well as the management of collateral (is it delivered to the borrower or to a tri-party agent?), also materially impact the economics of trades.
Another pricing factor arises from the nature of trading securities lending itself. Most securities lending trades are done on an “open” basis. This means there is no fixed term on the duration of the trade. Lenders can request the securities back at any point by issuing a "recall" notice. This, of course, has economic consequences for the borrower. If a borrower has obtained stock to cover a short position and then has to unexpectedly return the stock, they need to find an alternative lender of the stock.
In the worst case, where stock is not available for loan, they may have to buy stock and close out their position prematurely. Recalls are typically considered a relationship issue. Firms that excessively recall borrowers or recall too soon after the start of the trade are likely to damage relations and risk future business. Fundamentally, though, there is a value that can be put on the likelihood of being recalled. Doing a trade on an open basis in many ways is equivalent to giving the borrower a free option, but one where the value of the option is seldom explicitly calculated let alone charged for.
The other peculiarity of stock lending in the US and other markets, though one reflected in common master agreements, is the willingness of participants to allow trades to be cancelled or have key economic attributes changed up to the settlement of the initial leg of the trade (i.e. when loaned stock and collateral are exchanged). These cancellations and amendments have economic consequences, but in the American market they are not charged for.
A more transparent and liquid market for securities lending in the US is sure to increase the pressure on participants to raise the accuracy and efficiency of their pricing models simply to compete. Given that non-US stocks are lent in the US and US stock is lent outside the US, the pressure for better pricing data and better pricing tools is likely to be felt in all the major markets.
Understanding what the current market price is for borrowing securities is problematic for multiple reasons. There are multiple vendors of pricing data (i.e. rebate and fee rates) for securities lending, but there are a number of potential issues with that data. These issues are very clearly highlighted in the consultation paper issued by the Securities and Exchange Commission (SEC) in relation to their proposed rules on the reporting of securities lending transactions (Rule 10c/a).
The SEC says: "The securities lending market is characterised by asymmetric information between market participants and a general lack of information on current market conditions, which can lead to inefficient prices for securities loans, including equity lending and fixed income lending."
The SEC explanation for unequal access to market information is based on the current model for collecting and distributing market data, the “Give-to-Get” model. Market participants provide trade data to data vendors who aggregate the data and provide back market prices for all securities. The SEC highlight multiple problems with the model, from the perspective of market efficiency and fairness:
• The pricing data is incomplete because not all participants contribute data
• There are very strong incentives for those that have gained control of a large proportion of the supply of in-demand stocks (“specials”, also known as “hot stocks”) not to submit information
• Not all market participants can access the data, even if they are willing to pay for it
• There are significant time delays in getting the data. While cash equity markets see prices move in fractions of a second, receiving a feed of market prices on the next business day is common in securities lending
If the SEC's proposed Rule 10c-1 goes forward in its current form, US securities lending trades will be reported within 15 minutes and pricing data reported in the following business days — but potentially sooner. This is sure to have a major impact on the operations of the market and the business models of the market data vendors that will need to demonstrate the value of analytics, in addition to the value of basic pricing data. It could also have a truly transformative effect on how trading is done.
However, there is more to achieving transparency in the stock lending market than collecting and aggregating all the data for each security. Different types of collateral and different haircuts also ultimately affect the true price of a loan. A lender demanding higher quality collateral or deeper haircuts on the valuation of collateral is ultimately demanding a higher economic price. The credit rating of each party, as well as the management of collateral (is it delivered to the borrower or to a tri-party agent?), also materially impact the economics of trades.
Another pricing factor arises from the nature of trading securities lending itself. Most securities lending trades are done on an “open” basis. This means there is no fixed term on the duration of the trade. Lenders can request the securities back at any point by issuing a "recall" notice. This, of course, has economic consequences for the borrower. If a borrower has obtained stock to cover a short position and then has to unexpectedly return the stock, they need to find an alternative lender of the stock.
In the worst case, where stock is not available for loan, they may have to buy stock and close out their position prematurely. Recalls are typically considered a relationship issue. Firms that excessively recall borrowers or recall too soon after the start of the trade are likely to damage relations and risk future business. Fundamentally, though, there is a value that can be put on the likelihood of being recalled. Doing a trade on an open basis in many ways is equivalent to giving the borrower a free option, but one where the value of the option is seldom explicitly calculated let alone charged for.
The other peculiarity of stock lending in the US and other markets, though one reflected in common master agreements, is the willingness of participants to allow trades to be cancelled or have key economic attributes changed up to the settlement of the initial leg of the trade (i.e. when loaned stock and collateral are exchanged). These cancellations and amendments have economic consequences, but in the American market they are not charged for.
A more transparent and liquid market for securities lending in the US is sure to increase the pressure on participants to raise the accuracy and efficiency of their pricing models simply to compete. Given that non-US stocks are lent in the US and US stock is lent outside the US, the pressure for better pricing data and better pricing tools is likely to be felt in all the major markets.
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