Review of Settlement Practices for Australian Equities Attachment 1: Overview of the Australian Equities Securities Lending Market ^[16]

An active securities lending market has been in place in Australia for at least three decades, covering both equities and fixed-income securities. While no official data exist, market sources suggest that the value of equities loans outstanding was around $60 billion at end-2007. This was relative to a pool of potentially loanable equities of around $200 billion.^[17] More than 70 per cent of the value outstanding was estimated to have been in ASX-50 securities.

In a securities lending arrangement, a holder of securities agrees to provide the securities to the borrower for a period at the end of which equivalent securities must be returned to the lender. In the interim, the lender reserves the right to recall the loaned securities. If recalled, the borrower is obliged to return the securities within three days (to coincide with the prevailing standard settlement period).^[18]

In 1997, the Australian Securities Lending Association (ASLA) launched an initiative to standardise the legal documentation backing securities lending activity. Loans today are typically backed by the Australian Market Securities Lending Agreement (AMSLA), an essential feature of which is the transfer of title from the lender to the borrower.^[19] This allows the borrower to dispose of the securities at will (subject to return of equivalent securities at the agreed date, or earlier if recalled).

The maturity of stock loans is typically two to four months, but can range from overnight to 364 days (tax implications arise if a loan extends beyond 12 months).

Participants in the equities securities lending market

The securities lending market in Australia can be characterised as a decentralised network of bilateral relationships.

The ultimate lenders of securities are typically long-term wholesale investors – superannuation funds, insurance companies and investment managers.

These parties typically lend via securities lending programmes operated by the major custodians.^[20] The lending motivation is to secure an additional return on portfolio assets. Traditionally, this was seen as a way to offset custody fees, but today is regarded as a vehicle for performance enhancement. For a liquid security, the lending fee is typically of the order of 20 basis points (per annum). For stocks in high demand, the fee may be as high as 200 basis points (per annum).

On the borrower side, the main participants are large brokers and investment banks. These institutions may be borrowing on their own account, perhaps in relation to market-making or index arbitrage activities, or on behalf of a hedge fund via their prime brokerage business. These funds may be covering short sales in respect of either outright directional plays, or, more commonly, relative value or arbitrage strategies. Fails-driven borrowing is also important.

Risk management

Securities loans generally allow for over-collateralisation in favour of the securities lender. This reflects the fact that securities loans are typically driven by the borrower's demand for securities.

Collateralisation practices are relatively standardised in the Australian market, with cash-collateralised loans typically collateralised by 105 per cent and non-cash collateralised loans by 110 per cent. Positions are usually marked to market on a daily basis.

Lenders also usually adopt strict criteria in respect of their eligible borrower lists.

Settlement practices

The Bank's liaison suggests that, in general, around half of all transactions to cover short positions are agreed ahead of settlement date, with borrowers careful to locate illiquid or hard-to-borrow securities ahead of time. The remainder are typically agreed during the 2-3 hours ahead of the 10.30 am cut-off for batch settlement in CHESS on T+3. In part, a borrower's relationships and status in the market determine its confidence in obtaining securities as required. In some cases, borrowers also establish (for a fee) pre-committed lines of securities directly from the ultimate lender.

As far as possible, market participants seek to settle cash-collateralised securities loans on a delivery-versus-payment basis in the daily CHESS batch. Where this is not possible, securities are typically transferred free-of-payment (FOP) in CHESS with the cash collateral moving (in advance) via Austraclear. Loans collateralised with securities are also typically settled FOP, again with the collateral settled in advance.

Footnotes

This overview draws on insights gathered from market participants as well as information in ‘Securities Lending of Equity Securities in Australia’, John C King, Mallesons Stephen Jacques, 2005. [16]

Source: Spitalfields Advisors Yearbook 2007. [17]

The lender's motivation to recall might be to sell the securities or to exercise voting rights. Large brokers will maintain a buffer of hard-to-borrow stock to guard against the possibility of recall, but in some cases may need to buy the stock outright in the market. [18]

This is an adaptation of the UK Overseas Securities Lender's Agreement (OSLA), promoted by the International Securities Lending Association. [19]

Depending on the nature of the programme and the preferences of the lenders, a custodian may act either as principal or agent. It is estimated that there is a broadly even split in Australia between principal programmes and agency programmes. If acting as principal, the custodian borrows from the lender in its own name and then on-lends to the ultimate borrower as principal. In this case, the lender's risk is only vis-à-vis the custodian (typically unsecured), with the custodian managing any counterparty risk with the end-borrower. If acting as agent, the custodian simply intermediates between lender and borrower, taking on no counterparty exposure in its own name. The lender in this case manages the counterparty exposure vis-à-vis the end-borrower. Even when acting as agent, some custodians indemnify stock lenders for any losses arising from stock borrowers defaulting on their commitments. [20]