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Cairneagle Associates LLP50 Regent Street, London W1B 5RDTelephone: +44 ( 0 ) 20 7432 4525Facsimile: +44 ( 0 ) 20 7432 4526

www.cairneagle.com

SecFinex Limited60 Cannon Street, London EC4N 6NPTelephone: +44 (0) 20 7002 1003Facsimile: +44 (0) 20 700 1123

Stock Borrowing & Lending Seminar

Securities InstituteWednesday 15th April 2009

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Contents

Part 1 Equity Finance – Stock Borrowing & Lending - Myths & Reality : Joseph Hine

Part 2 Changing the Industry – The introduction of an Exchange Platform for Stock Borrowing & Lending : Peter Fenichel

Topics:

Stock borrowing & lending (SBL) has received a lot of attention recently, both as the mechanism that underpins stock shorting, and as a key enabler of the financial markets, but remains poorly understood. This seminar will seek to describe the workings of the SBL market, debunk a number of the myths which surround it, identify its problems, and discuss approaches to addressing them. 

•             What is SBL; where did start; why does it exist today?

•             Who are the participants?• What are the motivations of participants?

•             Does SBL create downward price movements or volatility in the markets?

•             What are the risks of SBL?

•             Why change the SBL model?

•             The Central Counterparty proposal (Is it a solution?)

•             The future for SBL markets/The future of short sales

“Stock Prices may go down as well as up”[Why should Investors only make money when a stock goes up?]

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Part 1Equity Finance – Stock Borrowing & Lending -Myths and Reality

Myth SBL is a small backwater

of the Securities Industry SBL is the prime tool for

downside investment Most SBL is undertaken

for tax avoidance SBL is a highly profitable

business for banks SBL brought down the

UK banking sector SBL should be made

illegal as it de-stabilises markets

Reality Globally SBL is comparable in size to the worlds equity

markets. The value of outstanding loans is around $6trillion at any time.

SBL is only one tool for bear investment: CFDs and derivatives (OTC and on-exchange) are more significant worldwide.

‘Dividend plays’ are increasingly difficult as authorities tighten their net. Tax evasion through SBL has largely disappeared

SBL has traditionally been a facilitation business often only marginally profitable at the desk level– but it supports profit elsewhere.

There is no evidence that SBL positions were the major driver in reducing the value of banks stock

Without SBL the UK equity market (and many others) would become less liquid or cease to function altogether

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Why SBL

Administrative Shorts The complexity of markets and the lingering inefficiency of internal systems means that many firms find themselves short in settlement. SBL with its T0 or T+1 settlement provides a safety valve

Dividend Plays Transferring title from firms with a higher tax liability to ones with a lower tax liability at the payment point of divided. – Not relevant in the UK and increasingly rare in other jurisdictions.

Market Short Direct use of SBL to produce bear positions is, we believe, less than 10% of the business (by number of trades) in the UK

Special Situations Gaining control of stock through borrowing for elective events and in take over- situations is more difficult now

Funding Use of SBL structures by lenders to generate funds (used as an alternative to Repo) a major driver in the USA.

Hedging derivative positions Increasing driver for derivative market MMs and OTC trading firms

Hedging CFDs Major driver of the market in UK and Europe.

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Models for Shorting (SBL and CFD)

Collateral

Borrowed Stock

CashSell

Stock

Collateral

Borrowed Stock

CashmarginCFD

SHORTING VIA SBL SHORTING VIA CFD

Hedge fund shorting market

Prime Broker

Hedge fund shorting market

Lender Lender

Market

In the UK and Europe the CFD route is much more popular as it allows gearing and avoids SDRT – The SBL trade is used as a hedge as it is usually more cost effective and flexible than using derivatives

Market

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Participants and Motivations

The effect on the term curve of different participants using SBL in different ways

Fail Management

Tactical shorts & CFD hedges

Special Situations Strategic

Positions

The SBL market is used by many different participants for many different reasons. This results in a multi-modal term distribution.The curve differs markedly between different countries where motivations can be different.

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Effect on the Equity Markets

Equity market Liquidity• Availability of shares• Increasing trading• Confidence to trade

Use of SBL for fails management• Administrative fails• ‘Held Away’ fails• Fail chains

Use of SBL for profit enhancement by lenders• Size of revenue opportunity• Specials• Trends in profitability

Ensuring Exchange traded derivative liquidity• Specialists’ position management• Keeping markets ‘honest’

CFD and other OTC derivative market hedging• CFDs as a proxy for equity• Equity liquidity issues

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Inherent Risks

Counterparty risk• Credit issues

Market risk• Margining• Squeezes

Default resolution• Unwinding fails

Structures to reduce risk• Collateral and Margin• Triparty Structures

Systemic risk – the length of the lending chain• Speed of unwinding

Operation risk – what is being guaranteed.• Agent Guarantees

Capital application• Who should apply capital

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Summary

SBL is here to stay SBL is integral to the current market but inefficient – especially as regards risk and

capital SBL needs to restructure SBL needs to re-think its facilitation model and perhaps re-price itself.

SBL is an little understood minority area of the securities industry and like any minority it has been a convenient scapegoat - blamed for recent market dislocation. In fact SBL is no more to blame than any other part of the industry. However this does not mean that SBL should continue unchanged.

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Part 2Changing the Industry – The introduction of an Exchange Platform

for Stock Borrowing & Lending

SBL is now too important to be done on a ‘Best Endeavours’ basis• Certainty of price• Certainty of terms• Certainty of returns• Certainty of credit

Exchange Platform without CCP

is half of the solution• Current Exchange Platform model

CCP without Exchange Platform is too clumsyMTF

CCP

Trading serviceTrade validationMember ValidationBillingCommunications

Risk ManagementMargin and CollateralFailure Management

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Why Change?

Counterparty Risk• The industry is becoming paralysed due to counterparty risk issues outside SBL

Administrative Overheads• Disproportionate to the business profitability.• Act as a brake on new business

Agent Lender Disclosure• Not acceptable to some• Expense for all

Collateral Issues• Collateral excess rising 110%+• Excess collateral used to cover concern over counterparty risk• Acceptability rules are various and complex• Collateral security issues

Capital• Frequent confusion and contradiction regarding capital allocations• Bi-lateral model gives limited scope for netting• Counterparty risk requires capital allocation under Basel II

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The Critical Importance of Capital and Credit

Collateral only reduces risk – it does not eliminate it. Counterparty risk must be assessed for Basel II Agent guarantees (lending agent or Tri-party agent) help but risk of agent failure must

be accounted for. Capital allocated to SBL desks has been reduced Credit lines which stretch over many businesses are being withdrawn or reduced in

investment banks Small trading firms and hedge funds can not get credit lines without depositing cash or

near-cash instruments with bank. For many firms the only way to continue in the SBL business is by using a CCP to

eliminate counterparty risk and credit issues.

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Alternative Structures

Tripartite(Use of central agent to reduce risk)

Patron Bank(Netting on the balance sheet of large bank/ prime broker)

Liquidity location & Post-trade admin(Centralised checking, settlement routing, registration, etc)

OTC Bilateral(Traditional phone market or using bilateral communications e.g. via Bloomberg)

Benefits Benefits

Value added Drawbacks Drawbacks

•Flexibility•Choice of Counterparties•Confidentiality

•Costs•Credit problems•Risk

•Reduced administrative Overheads

•Reduced operational Risk

•Credit problems•Counterparty risk

•Potential for netting•Operational guarantee

•Limited pool•Capital impact on bank•Risk

•Collateral management•Access to counterparties•Operational guarantee

•Credit risk still exists•Still uses capital•Pool is limited

•Risk elimination•Capital relief under Basel II•Large pool of counterparties

•Increased cost

CCP

JP MorganEuroclearMorgan

StanleyGoldman Sachs

E Seclendin

gBloomber

g

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Features of CCP

Capital Reductions For firms facing CCPs

Credit Enhancement Overcomes counterparty credit issues

Anonymity Through SecFinex matching system• Name Give-up Anonymous trading not compulsory• ALD Reduces administrative load• Returns No singling out of counterparty for early returns• Strategic Prime Broker need not see positions of Hedge fund clients

Operational Benefits Reduced Contracts, credit agreements, position monitoring etc

Collateral & Margin Central point for collateral and margin• Reduced Collateral In some cases may be as low as 100%• Margin Netting Net position with CCP can be margined• Two sides margined Margin from Lender and borrower

Regulation Improves regulator’s vision of the market

Reduces systemic risk

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The SecFinex Solution - 1

OUTLINE SCHEMATIC OF GENERIC STRUCTURE POST CCP

Lender

Borrower

Settlement System

Tra

din

g

Sys

tem

Nova

tion

Post

tra

de

man

ag

em

en

t

Bi-lateral trade given up to CCP via SecFinex

Exchange Trade

Exchange

Trade

Ris

k

Man

ag

em

en

t

CCP

Exchange Platform

CCP becomes Counterparty

Margin

Collateral Accounts

Borrower

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The SecFinex Solution - 2

CCPs appropriate to individual markets. Slightly different models of clearing dependant on different market traditions,

regulations and abilities Issues of tax resolved Issues of Basel II counterparty relief when trading member is using Clearing

Member are resolved

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Incremental Change

The move to CCP will be gradual and will never be 100% On-market anonymous trading will grow but will not eliminate bi-materal trading novated

to the CCP As CCPs become more comfortable with the market changes in collateral rules will make

the proposition even more compelling Most firms will retain bi-lateral ability in their back offices but some will move to a ‘CCP

only’ model MTF/CCP model is likely to increase SBL activity due to reduced overheads and capital

requirements Extension of MTF/CCP model outside Europe is being considered