China and others enter securities lending; agents and prime brokers face changing market structure

The news today that China will set up a centralized securities lending exchange (see the FT’s article here) is the latest in a series of moves by individual countries to have an active role in the securities lending market. These actions have significant ramifications for prime brokers, agent lenders, and financial markets as a whole.

Centralized securities lending facilities owned by state actors or by exchanges are significantly disruptive to the current bilateral markets set up by major securities lending agents and prime brokers worldwide. In Brazil, the largest and most successful of these state owned securities lending facilities, agent lenders have struggled to successfully engage in the market. Only now are a few beginning to have success by partnering locally or by engaging in complicated swap transactions. The transparency in pricing that centralized markets provide is also difficult for prime brokers, who may earn additional returns by marking up the hardest to borrow securities to their hedge fund clients. Finadium has reported on the opportunities and challenges faced by agent lenders, prime brokers and securities lending exchanges themselves on several occasions through the years.

Along with China, Russia, Poland and several emerging market countries have announced plans to launch securities lending exchanges in their markets (a tip of the hat to Nigeria Stock Exchange CEO Oscar Onyema, formerly of the Amex). Agent lenders still control supply and will set pricing, and prime brokers still control demand, but now a middleman will enforce rules and may keep control of collateral, possibly the worst part of the set up for existing market players. The middleman will also collect a fee. The markets may become more efficient for this centralization but they will also be a bit more expensive.

In the US, the fee charged by Quadriserv for trading on their securities lending exchange has been easy to swallow but the margin requirements of using the OCC as a CCP have not, and this has significantly hampered Quadiserv’s development. It remains to be seen whether the new securities lending exchanges will operate with a CCP model or whether they will simply pool inventory and provide it out to the higher bidder. If they follow the CCP model, they may want to have a conversation with Eurex about the right way to get things done.

For the markets in general, the move towards securities lending exchanges and the transparency they provide should be a net benefit. Transparent pricing will aid in developing liquidity for equity, bond and derivatives markets and will assist in risk management efforts. Hedge funds and their investors will also benefit as investors will have the comfort of knowing that there is some greater structure to the whole financing business beyond the interaction between the hedge fund and their prime broker; this may also help the retail alternative UCITS and hedged mutual fund businesses.

The evolution of centralized securities lending exchanges at the national level is emblematic of how important securities lending has become for modern and efficient market functioning. It also represents yet another challenge for current market participants in figuring out how they will thrive in the new market structure.

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