Ronke Ayegbajeje of Stanbic IBTC discusses securities lending as a market catalyst
The concept of securities lending, which involves the transfer of securities from a lender to a borrower, based on agreed terms, is key to the financial sector as the presence and success of a securities lending market is a critical benchmark for measuring market quality and conduciveness for other differentiated products like derivatives.
Dating as far back as 1969, but formally commencing in London around 1999 before gaining popularity in other parts of the world, securities lending is more popular in Europe, some parts of Asia, and North America, with North America doing about 9 percent of world trade. According to the International Securities Lending Association (ISLA) as of 31 December 2018, a total of €2.2 trillion was on loan globally, while €16.6 trillion was available for lending.
Typically, lenders are institutional investors—pension fund administrators, insurance companies, fund managers, hedge funds, and asset managers; or individual investors—high net-worth individuals and retail investors. Additionally, fund managers who engage in securities lending have the potential to improve their fund portfolio performance by reinvesting the income earned in the fund or using it to offset management fees.
Institutional investors may approach a securities lending agent directly to make their securities available for lending while individual investors will do so through an intermediary agent. Parties that play as borrowers include stockbrokers, broker dealers and banks. Most markets have variants of the principal or agency lending models which they align with, depending on the regulations of such markets.
Benefits of securities lending from a participatory standpoint include the opening-up of additional streams of income to both the lender and borrower. Borrowers earn profit from short-selling and taking advantage of arbitrage opportunities while lenders earn income from fees paid by the borrowers. It also brings about market liquidity and drives price discovery. Like most loan agreements, collateral will be involved in the process—hence collaterals are quite critical for securities lending agreements. The collateral is to buy back the securities borrowed in case the borrower defaults, hence protecting the lender and returning them into a state where they were before the securities were borrowed. Collateral types for securities lending include, but are not limited to, cash, bonds, treasury bills, and other money market and debt instruments. Given the importance of securities lending in global markets, the use of the Global Master Securities Lending Agreement has become a standard that most markets adopt.
Curiously, given all its benefits, many regions in the world are yet to embrace the potential of securities lending. Except for South Africa, the rest of Africa is yet to catch-up in the securities lending world. This financial invention is not only a catalyst for more sophisticated financial/capital market transactions like hedging, short selling, arbitrage which ultimately facilitate price discovery and brings about liquidity in the market; it is also the bedrock of many other financial market transactions like derivatives, forwards and so on. A market that is yet to offer securities lending I deem unequal to its securities lending offering counterparts in terms of market development and may not be as forward-looking.
Perhaps one of the reasons that this has not been fully embraced in many African countries and indeed some other parts of the world is that a few people understand the concept. This poor understanding is common to the parties who are supposed to play significant roles in securities lending—holders of securities, government regulators and tax authorities, who may find it challenging to apply tax rules. In some instances, the tax rules do not exist.
One way to remedy the issue of knowledge gap is for fund managers to sensitise security holders in their books and advise them of the opportunities of securities lending and benefits thereto. If this is done at the point of onboarding each client, then a sizeable amount of security holders will be duly informed, and we can expect to start closing the knowledge gap one step at a time.
Another considerable reason is the double taxation of dividend in some jurisdictions. This will happen when a corporate action event such as cash dividends are paid, the holder of the security (that is the borrower) receives the dividend but because the lender must be returned to their original position, the borrower will pay the proceeds from the dividend to the lender. The cash the borrower pays the lender in lieu of dividend received (‘manufactured’ or ‘as is’ dividend). While the original dividend paid to the borrower is subjected to a dividend tax rate. The manufactured dividend is also subjected to tax, nevertheless at a less favourable income tax rate by the government or tax authorities in such regions because they view the manufactured dividend as normal income from the business. This is discouraging to market makers and may even be viewed as punitive by some financial dealers.
The solution to this is for these governments/tax authorities to come up with policies favourable to manufactured dividends. Perhaps if these policies are imbibed worldwide, the global income from securities lending will surge significantly and securities financing will gain more popularity.
Investors have different personalities and appetite for risk, but as with any loan agreement or transaction, securities lending carries default risk. From history, the risk is controlled effectively through collaterisation of the transaction. Plus, some securities lending agents indemnify their lenders to prevent them from suffering losses.
There is also the risk that the borrower’s collateral will be mismanaged by the lender or the securities lending agent, but there have been recent laws to combat this and government regulation in major countries allow lenders to re-invest collateral in sovereign bonds which are relatively risk-free.
To conclude on how effectively securities lending risks and perceived risk are being mitigated, the International Securities Lending Association has come up with a global agreement that governs all securities lending transactions. The agreement addresses defaults, lender and borrower warranties, collateral agreements, taxes and so on. This should encourage savvy investors.
Financial transactions are not usually done in isolation (except they are fraudulent) and will normally involve several parties. Securities lending is not an exception; hence, for it to work, world financial corporations, exchanges and depositories must work together to drive it to its full potential.
Although some parts of the world are yet to fully embrace securities lending, there are organisations that are determined to make it work by pushing, advocating and sensitising. One such organisation is Stanbic IBTC Bank in Nigeria (a member of Standard Bank Group), which is determined to pioneer this development in the Nigerian market and has worked closely with the Nigerian Stock Exchange, the Federal Inland Revenue Service—Nigeria’s tax authority, and the Securities and Exchange Commission to ultimately add value to investors and the greater society.
Stanbic IBTC is technology-driven and has begun the process of driving the securities lending business technologically by engaging with the Nigerian Stock Exchange and the Central Securities Clearing System on processes to make each transaction straight-through. Fortunately, these organisations are very keen on bringing development to our markets and are working together to ensure this is attained.
Just as little drops of water are believed to form an ocean, I believe the efforts of these organisations will eventually pay off and can only hope that the rest of the world come to the table.
