Finadium Research Report

The Mountain Moves:
Electronic Bid/Offer Markets in Securities Lending

Finadium
November 2007

The growth of electronic bid/offer markets, also called screen-based trading, in securities lending is predicted by almost every professional in the business, although few expect this to happen soon. Most participants ultimately accept the ascendancy of electronic bid/ask markets but few custodians or brokers want to be the first to embrace them. Today, however, the momentum is beginning to build: key drivers of change are pushing for developed, transparent and accessible markets. ICAP has launched their I-Sec stock lending platform and SecFinex has been majority purchased by NYSE Euronext. There is reason to think that the age of electronic bid/offer markets may not be so far off after all.

The major participants in the securities lending market have been used to driving their own dynamics of change. However, the success of bid/offer markets will be motivated by a new mixture of hedge funds, second tier banks and prime brokers, and central credit counterparties. A portion of the hedge fund market is looking for a combination of electronic access, transparency and data from securities lending providers. Bid/offer markets offer all three characteristics. Second tier banks and prime brokers may see bid/offer markets as a way to gain access to greater liquidity and distribution. Central credit counterparties have the potential to level the playing field by removing relationship-driven aspects of the market, particularly in regards to account balances, credit quality and counterparty risk. Central credit counterparties could also allow hedge funds a form of direct access to electronic markets. While all three of these factors together are likely to create success, it may only take one or two for a noticeable impact to occur.

In many ways, electronic bid/offer markets are custom made for small lenders and borrowers. Smaller banks and custodians, excluding overlapping firms with significant prime brokerage operations, hold $5.3 trillion split over 28 firms. Each firm holds an average of US$190 billion in assets under custody with 54% of this in equities. In comparison to the top four firms with average assets of US$14.3 trillion, smaller custodians are small fish indeed (see Exhibit 1). However, a concerted marketing effort could generate substantial inventory for a new trading platform.

Based on dozens of interviews and surveys with market participants, we project that brokers will open up electronic markets to a range of hedge funds very shortly. A hedge fund need not have direct access to a trading system; rather, the model will support a mark-up from the screen price to reflect the broker’s role in providing credit. The smaller and quantitative funds will be logical users. Allowing a test account to reach electronic markets can produce important lessons about credit access and marking up inventory to protect margins. For larger hedge funds, the price on the screen may be worse than what they can get from the broker itself; this will keep the traditional lending industry alive and well with no meaningful impact on pricing. Our overall conclusion on electronic bid/offer markets: slowly, the mountain is starting to move.

The following firms were reviewed for this report:

• EquiLend
• SunGard Loanet
• ICAP I-Sec
• SecFinex
This report is 30 pages with 12 exhibits and figures.

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TABLE OF CONTENTS
■ Executive Summary
■ Key Point Summary
■ The Evolution of Securities Lending Markets
– Dividend Opinions
■ Brokers, Agents and Custodians
– Smaller Banks and Prime Brokers
■ Hedge Funds and “Direct” Borrowing
– Scenarios for Hedge Fund Access
■ The Rise of Central Credit Counterparties
– Counterparty Mechanics
■ Actual and Potential Market Operators
– EquiLend: The Major Player Utility
– SunGard Loanet Centralized Order Routing (LCOR):
The Broad-Based Solution
– Icap I-Sec: The Independent
– SecFinex: The Exchange
■ Getting From Here to There
■ About the Author
■ About Finadium

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