Transparency in the Securities Lending Market IntroFinal Jan2010

S&P INDICES| January 2010

Transparency in the Securities Lending Market

Craig Feldman (212) 438 3296 [email protected]

Dave Guarino Media Contact (212) 438 1471 [email protected]

Summary S&P Indices has introduced a new index series designed to track the average cost of borrowing U.S. equities. This is the first public index series to provide insight into the costs associated with the securities lending market, as measured by the weighted average rebate rates of the equity constituents in the S&P 500, S&P MidCap 400, S&P SmallCap 600 Indices and their underlying Global Industry Classification Standard (GICS) sector sub-indices.

Securities lending is an over-the-counter market that involves the borrowing and lending of securities. Participants include pension funds, mutual funds, and foundations, who lend their security holdings in an effort to generate additional returns; and option traders, hedge funds, and other asset managers, who borrow securities predominantly for the purpose of covering short-sale positions. These parties rely on their respective intermediaries (custodians for the lenders and prime brokers for the borrowers) to broker their transactions and manage counter-party risk.

Source: Standard & Poor’s

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As with many over-the-counter markets, data quality in the securities lending space is improving. Over the past few years, market transparency has increased due to the emergence of data aggregators who collect transaction data from intermediaries and provide the aggregate-level data back to their contributors. With the launch of the S&P Securities Lending Indices, Standard & Poor’s seeks to bring additional transparency to this market.

About the Securities Lending Market On the borrow-side, securities loans are predominantly used to cover short-selling activities. In this case, when short sellers make a trade, they are obligated to deliver the stock sold to the buyer and must therefore borrow the security from another party. To mitigate the risk of the loan, the borrower gives the lender cash collateral that is generally higher than the market value of the securities. The borrowed security and related collateral are then returned to their respective owners once the short seller buys back the stock in the open market, thus unwinding the loan. Securities loans can also be used for derivative hedges, and, to a lesser degree, dividend arbitrage across tax jurisdictions. From the lender’s perspective, securities loans create an opportunity to generate additional income from their holdings outside the return of the individual equities. Moreover, these transactions are frequently managed by the agents responsible for custody of their equity holdings although some lenders prefer to involve a third-party lender. During each securities loan transaction, in addition to the exchange of collateral, a fee called a rebate rate is assessed. The cost is expressed as an interest rate paid on the value of the cash collateral and is based on a spread to a benchmark funding rate like LIBOR or Federal Funds. The proximity of the rebate rate to the benchmark funding rate is often an indication of how hard the security is to borrow. If there is no significant demand to borrow a given equity, the rebate rate will be closer to the benchmark funding rate. Given this low demand and/or ample supply, the lender agrees to keep only a small portion of the interest that would be received if it invested the collateral at the benchmark funding rate. In general, the further a security’s rebate rate falls below the benchmark rate, the more the security is in demand, and consequently, the more invested interest the lender will retain. Other factors that influence rebate rates are the duration and re-pricing frequency of the loan. Open loans are marked-to-market daily to allow rates to move as the benchmark funding rate moves, or as the supply and demand of the security changes. Term loans rates are fixed at the beginning of the loan and are established for a set period of time. Rebate rates may be positive or negative, indicating which participant is responsible for paying interest on the cash collateral outstanding. When the rebate rate is positive, the borrower will receive an interest payment from the lender. When the rate is negative, in addition to providing the necessary cash collateral, the borrower also agrees to pay the lender an interest rate on that collateral.

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The following illustration indicates a simplified example of a securities loan transaction:

Source: Standard & Poor’s Spreads can vary substantially between lenders and borrowers depending on a variety of factors including market supply and demand for the security, credit quality of the counterparties to a trade, and size of balances held. Since September 2008, spreads have also been indicative of broader market dynamics. In some instances, borrowers were paid rebate rates above the benchmark funding rates in order to encourage them to maintain loans and reduce the amount of cash collateral recalled from the lender. Size of Market The size of the securities lending market has increased significantly in recent years due to the growth of hedge funds and other short sellers. At its peak in 2007, the equity securities lending market represented nearly US$ 850 billion with over US$ 400 billion in U.S. equities alone. However, due to market dynamics and short-selling restrictions imposed in the latter half of 2008, the value of equities on loan fell substantially. By June of 2009, the value of U.S. equities on loan was reduced by nearly 40% to US$ 250 billion, similar to the market size three years prior.

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Source: SunGard Astec Analytics

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Similar trends can be observed in the market value outstanding of loans (pro-forma) in the S&P Securities Lending Indices, most notably in the S&P 500 Securities Lending Index.

Source: Standard & Poor’s Please see additional disclosures concerning index performance and index levels at the end of this document. The inception date for the S&P Securities Lending Indices (“Indices”) is September 11, 2009 at the market’s close. The Indices were not in existence before that date. The backtest period shown for the Indices is June 30, 2006 at the market’s close through September 10, 2009. The actual performance period shown for the Indices is September 11, 2009 at the market’s close through December 31, 2009.

While loan volumes over the last year have been down comparatively with the peak levels seen in 2007 and 2008, current research indicates that associated revenues have not declined at as high of a rate over the same period. Borrowing costs have been selectively increasing for so-called “hard to borrow” securities. This is partially due to increased demand from the greater diversity of market participants who are now actively involved in the securities lending market. For example, traditional asset managers are now looking more at long/short and market neutral investment offerings which has increased their borrow activity. In addition, the new regulatory changes aimed to eliminate “naked” short selling (those transactions enacted without having to borrow the security sold) have obligated market makers and other hedgers to borrow securities before shorting.

S&P Securities Lending Index Series The S&P Securities Lending Index Series is designed to measure the average cost of borrowing U.S. equities. The series seeks to reflect the average securities lending rate for the constituents of the underlying U.S. equity indices: S&P 500, S&P MidCap 400, S&P SmallCap 600, and the underlying Global Industry Classification Standard (GICS®) sector sub-indices. Index constituents must have a consistently available rebate rate and are then weighted based on their respective float-adjusted weightings in the related equity index. The index undergoes daily rebalancing

Market Value of Loans Outstanding (in millions of USD)

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S&P 500 SecuritiesLending Index



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to adjust for all constituent and weighting changes that occur in the related equity index. More information on index weightings is included in the S&P Securities Lending Indices Index Methodology available at www.indices.standardandpoors.com. Rebate rates, particularly with regard to so-called “easier-to-borrow” securities, tend to be highly correlated to a benchmark funding rate. Therefore, movement in the indices can be largely influenced by the movement of the funding rate. For this reason, S&P Indices has also created a “Spread” version of each index which isolates the movement of the benchmark funding rate (Federal Funds Open) and reflects the “spread” between the funding rate and the average securities lending rate for the reference equity index. By excluding the movement of the funding rate, the S&P Securities Lending Spread Indices seek to reflect the “spreads” to which the securities lending market participants may be subject; which many consider to be the true cost to borrow.

Source: Standard & Poor’s, Data from May 1, 2006 through December 31, 2009 Please see additional disclosures concerning index performance and index levels at the end of this document. The inception date for the S&P Securities Lending Indices (“Indices”) is September 11, 2009 at the market’s close. The Indices were not in existence before that date. The backtest period shown for the Indices is May 1, 2006 at the market’s close through September 10, 2009. The actual performance period shown for the Indices September 11, 2009 at the market’s close through December 31, 2009. The Indices are unmanaged, statistical composites and their returns do not reflect payment of any sales charges or fees an investor would pay to purchase the securities they represent. Such costs would lower performance. It is not possible to invest directly in an index. Securities lending rates will change over time, and past securities lending rates are not necessarily indicative of future securities lending rates. The Federal Funds Open Rate is a benchmark funding rate and is used to calculate the spread indices.

S&P Securities Lending Indices compared to the Federal Funds Open Rate

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S&P 500 SecuritiesLending Index(SPSL5U)



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S&P Securities Lending Spread Indices

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S&P 500 Securities Lending Spread Index (SPSL5US)

Source: Standard & Poor’s; Data from May 1, 2006 through December 31, 2009 Please see additional disclosures concerning index performance and index levels at the end of this document. The inception date for the S&P Securities Lending Indices (“Indices”) is September 11, 2009 at the market’s close. The Indices were not in existence before that date. The backtest period shown for the Indices is May 1, 2006 at the market’s close through September 10, 2009. The actual performance period shown for the Indices September 11, 2009 at the market’s close through December 31, 2009. The Indices are unmanaged, statistical composites and their returns do not reflect payment of any sales charges or fees an investor would pay to purchase the securities they represent. Such costs would lower performance. It is not possible to invest directly in an index. Securities lending spreads change over time, and past securities lending spreads are not indicative of future securities lending spreads. The Federal Funds Open Rate is a benchmark funding rate and is used to calculate the spread indices.

The S&P 500, S&P 400 and S&P 600 Securities Lending Indices are further divided into sub-indices which show constituents within their respective GICS sectors. These sub-indices seek to demonstrate how rate movements may vary among sectors. The chart below compares the movement of selected sub-indices (Consumer Discretionary, Consumer Staples and Financials) within the S&P 500, S&P 400, and S&P 600 Securities Lending indices for the second quarter of 2009. One can observe variance not only between the indices, but among the sectors within those indices. For instance, the financials indices for the S&P 400 and S&P 600 move closely in line with each other, hovering around the Federal Funds target of 0-25 basis points, while the S&P 500 financials sector was consistently priced at a negative rebate rate, indicating the continued increased demand for many of the securities within the sector.



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Source: Standard & Poor’s, Data from April 1, 2009 through June 30, 2009 Please see additional disclosures concerning index performance and index levels at the end of this document. The inception date for the S&P Securities Lending Indices (“Indices”) is September 11, 2009 at the market’s close. The Indices were not in existence before that date. The chart only shows backtest periods. The Indices are unmanaged, statistical composites and their returns do not reflect payment of any sales charges or fees an investor would pay to purchase the securities they represent. Such costs would lower performance. It is not possible to invest directly in an index. Securities lending rates will change over time, and past securities lending rates are not necessarily indicative of future securities lending rates.

Understanding Securities Lending Data As illustrated earlier, securities lending rebate rates are provided at two intervals in the loan process: 1) When a loan moves from a custodian to a prime broker (the “wholesale” rate);

2) When the loan moves from a prime broker to the end-borrower (the “retail” rate). Retail rates are more diverse and can differ from one another depending on a wide range of factors that include the credit quality of the borrower, the value of the client to the overall firm, and other non-securities lending related issues. As such, retail rate variance may be significantly higher than that of wholesale rates. Standard & Poor’s uses wholesale weighted average rebate rate data, as aggregated by SunGard Astec Analytics, in the calculation of this index series. For these indices, S&P only uses the rates reported to SunGard as being associated with loans which: 1) are open; 2) involve U.S. dollar cash collateral; 3) are not part of any exclusive agreement; and 4) are not part of any dividend tax trade. Moreover, to prevent data outliers from improperly distorting the calculation of each constituent’s weighted average rebate rate, and consequently, the index level, a smoothing algorithm is employed to

Comparison of Selected S&P Securities Lending GICS Sub-IndicesQ2 2009

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S&P 600 Securities Lending Consumer Discretionary Index S&P 500 Securities Lending Consumer Discretionary Index S&P 400 Securities Lending Consumer Discretionary Index

S&P 600 Securities Lending Consumer Staples Index S&P 500 Securities Lending Consumer Staples Index S&P 400 Securities Lending Consumer Staples Index

S&P 600 Securities Lending Financials Index S&P 500 Securities Lending Financials Index S&P 400 Securities Lending Financials Index

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remove outliers. Details on the smoothing algorithm employed are available in the S&P Securities Lending Indices Index Methodology available at www.indices.standardandpoors.com.


The Value of an Index in Securities Lending The S&P Securities Lending Indices seek to bring a level of transparency into the wholesale rate market by providing a neutral, third-party view of the securities lending marketplace. The indices may be licensed by market participants who want to develop products that could be used in hedging, trading and other investment strategies. For instance, the indices could be used as a reference in financial products which may help prime brokers create term loans at potentially more beneficial levels for their clients. The S&P Securities Lending Indices may also provide valuable information to institutional lenders and short seller borrowers as they seek opportunities in the securities lending market. Lenders may potentially use the information provided by the indices as they execute their own strategies designed to hedge against rate increases that would decrease their revenue streams. Short sellers and other borrowers may also seek to benefit from using the information provided by the indices for the same purposes. While the indices are designed to measure the wholesale rates that are not available to the short seller market, there are still several opportunities for analysis between the wholesale and retail rates. Short sellers may use the indices to evaluate the correlation between their own fees and the indices. They may also use the indices as they seek to hedge their own costs or to speculate on the direction of the markets. The following is an example of how the indices could have been used as a tool to analyze the impact of a hedging product. The chart below depicts the S&P 600 Securities Lending Index pro-forma history for 2008 and the Federal Funds Open Rate. It illustrates that movements in the Federal Funds target affected the Federal Funds Open level and consequently the S&P 600 Securities Lending index level (pro-forma) to which it is highly correlated. However, liquidity and credit concerns began to weigh heavily on the markets in the second half of 2008. Consequently, the extreme interest rate and equity market volatility that resulted contributed to a decreased correlation of the S&P 600 Securities Lending Index to the Federal Funds Open Rate. The


use of an index-based hedging product could have been used as a tool to address the exposure a market participant could have had to these factors.

Source: Standard & Poor’s; Data from January 1, 2008 through December 31, 2008 Please see additional disclosures concerning index performance and index levels at the end of this document. The inception date for the S&P Securities Lending Indices (“Indices”) is September 11, 2009 at the market’s close. The Indices were not in existence before that date. The backtest period shown for the Indices is January 1, 2008 at the market’s close through September 10, 2009. The actual performance period shown for the Indices September 11, 2009 at the market’s close through December 31, 2009. The Indices are unmanaged, statistical composites and their returns do not reflect payment of any sales charges or fees an investor would pay to purchase the securities they represent. Such costs would lower performance. It is not possible to invest directly in an index. Securities lending rates will change over time, and past securities lending rates are not necessarily indicative of future securities lending rates. The Federal Funds Open Rate is a benchmark funding rate and is used to calculate the spread indices. The chart is for illustrative purposed only and does not endorse the use of the Indices as a basis for investment strategies for any investor.

The chart on the next page displays the correlations of the Federal Funds Open Rate to S&P 500, 400, and 600 Securities Lending Rate and Spread indices on a per year and full period basis. The correlations for the Rate indices diminished most notably in 2008 and 2009, when the extreme volatility, as mentioned earlier, had a significant effect on the observed relationships between the two. As expected, the Spread indices, which isolate the movement of the Federal Funds Open Rate, showed lower correlations across the board when compared to the Rate indices.

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Correlations to Federal Funds Open Rate RATE INDICES SPREAD INDICES

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SecLending 400

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SecLending Full period 0.597 0.785 0.047 0.172 0.272 0.183

2009 0.173 0.584 0.037 0.202 0.279 0.312 2008 0.781 0.848 0.893 0.371 0.277 0.171 2007 0.884 0.985 0.989 0.090 0.456 0.570 2006 0.464 0.961 0.979 0.078 0.388 0.479

Please see additional disclosures concerning index performance and index levels at the end of this document. The inception date for the S&P Securities Lending Indices (“Indices”) is September 11, 2009 at the market’s close. The Indices were not in existence before that date. The backtest period shown for the Indices is January 1, 2006 at the market’s close through September 10, 2009. The actual performance period shown for the Indices September 11, 2009 at the market’s close through December 31, 2009.

The chart below details the correlation of individual constituents to their respective sector and broader indices. Note that the individual constituents of the indices are all highly correlated to both the sector and the broader securities lending indices. The implication is that the sector indices may potentially be used as a proxy for tracking the movement of rebate rates on individual securities and, consequently, for the development of hedging tools. (All data from May 1, 2006 thru April 20, 2009).

Benchmark against which the individual equity constituents were correlated:

Average Correlation

Median Correlation

Standard Deviation

Correlation All Securities Lending Indices 0.945 0.997 0.141 All GICS Sector Sub-indices 0.935 0.993 0.157 Securities Lending Consumer Discretionary (composite) 0.919 0.986 0.166 Securities Lending Consumer Staples (composite) 0.940 0.995 0.150 Securities Lending Energy (composite) 0.951 0.991 0.124 Securities Lending Financials (composite) 0.906 0.987 0.190 Securities Lending Healthcare (composite) 0.940 0.995 0.151 Securities Lending Industrials (composite) 0.948 0.997 0.152 Securities Lending Information Technology (composite) 0.950 0.997 0.132 Securities Lending Materials (composite) 0.934 0.995 0.162 Securities Lending Telecommunication Services (composite) 0.902 0.992 0.203 Securities Lending Utilities (composite) 0.964 0.998 0.102

Source: Standard & Poor’s Please see additional disclosures concerning index performance and index levels on Page 11. The inception date for the S&P Securities Lending Indices (“Indices”) is September 11, 2009 at the market’s close. The Indices were not in existence before that date. The chart only shows backtest periods.

Conclusion In summary, the securities lending market is becoming an increasingly dynamic landscape. In a market that has been historically opaque, Standard & Poor’s Securities Lending Indices seeks to bring additional transparency and provide valuable information that may be useful as a tool for a variety of analytical purposes including the identification of potential new trading, hedging, and investment opportunities.

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Performance Disclosures The S&P 400 Securities Lending Index, S&P 500 Securities Lending Index, S&P 600 Securities Lending Index, the S&P 400 Securities Lending Spread Index, S&P 500 Securities Lending Spread Index, S&P 600 Securities Lending Spread Index and the underlying GICS sector sub-indices (collectively, the “Indices”) are composite indices. Indices are not collective investment funds and are unmanaged. Securities lending rates and spreads will change over time, and past securities lending rates and spreads are not necessarily indicative of future securities lending rates and spreads. It is not possible to invest directly in an index. The inception date for the Indices is September 11, 2009 at the market’s close. The Indices were not in existence before that date. The backtest periods for the Indices start as indicated in the charts at the market’s close and go through September 10, 2009. The actual performance period shown for the Indices is September 11, 2009 at the market’s close through December 31, 2009. The chart entitled “Comparison of Selected S&P Securities Lending GICS Sub-Indices Q2 2009” shows only a backtest period. History for the Indices is available from May 1, 2006, and the charts do not necessarily correspond to the entire available history of the Indices. The methodology that is currently used to create the Indices was applied from inception of the Indices and retroactively to available information on weighted average rebate rates collected by SunGard Astec Analytics to create the backtest index levels shown in the preceding pages. Prospective application of the methodology used to construct the Indices may not result in performance commensurate with the backtest returns shown. The Indices are not based, use a modified market capitalization weighting scheme and are rebalanced daily. Index levels are calculated using weighted average rebate rates identified with open ended, U.S. dollar denominated cash collateral and non-exclusive and non-dividend tax contracts. If a company is added to the related equity index, but does not have available securities lending data at the time of addition, the security is added at a weight of zero until the rates are available. The Federal Funds Open Rate is a benchmark funding rate and is used to calculate the spread indices. If the S&P Securities Lending Index Committee decides, in its sole discretion, that there are not consistently available securities lending data for a company, then the company is removed from the Indices. The S&P Securities Lending Index Committee reserves the right to reinterpret publicly available information and to make changes to the Index based on a new interpretation of that information at its sole discretion. Please refer to the methodology paper, S&P Securities Index Lending Series Methodology, available at www.standardandpoors.com, for more details about the index constituent eligibility, construction and maintenance. The index performance shown has inherent limitations. The index returns shown do not represent the results of actual trading of investor assets. Standard & Poor’s maintains the indexes and calculates the index levels, spreads and/or performance shown or discussed, but does not manage actual assets. Indices are statistical composites and their returns do not reflect payment of any sales charges or fees an investor would pay to purchase the securities they represent. The imposition of these fees and charges would cause actual and backtested performance to be lower than the performance shown. For example, if an index returned 10 percent on a $100,000 investment for a 12-month period (or $10,000) and an annual asset-based fee of 1.5 percent were imposed at the end of the period (or $1,650), the net return would be 8.35 percent (or $8,350) for the year. Over 3 years, an annual 1.5% fee taken at year end with an assumed 10% return per year would result in a cumulative gross return of 33.1%, a total fee of $5,375 and a cumulative net return of 27.2% (or $27,200).


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Disclaimers This document does not constitute an offer of services in jurisdictions where Standard & Poor’s or its affiliates do not have the necessary licenses. Standard & Poor’s receives compensation in connection with licensing its indices to third parties. All information provided by Standard & Poor’s is impersonal and not tailored to the needs of any person, entity or group of persons. Standard & Poor’s and its affiliates do not sponsor, endorse, sell, promote or manage any investment fund or other vehicle that is offered by third parties and that seeks to provide an investment return based on the returns of any Standard & Poor’s index. Standard & Poor’s is not an investment advisor, and Standard & Poor’s and its affiliates make no representation regarding the advisability of investing in any such investment fund or other vehicle. A decision to invest in any such investment fund or other vehicle should not be made in reliance on any of the statements set forth in this presentation. Prospective investors are advised to make an investment in any such fund or other vehicle only after carefully considering the risks associated with investing in such funds, as detailed in an offering memorandum or similar document that is prepared by or on behalf of the issuer of the investment fund or other vehicle. Inclusion of a security within an index is not a recommendation by Standard & Poor’s to buy, sell, or hold such security, nor is it considered to be investment advice. Exposure to an asset class is available through investable instruments based on an index. It is not possible to invest directly in an index. There is no assurance that investment products based on the index will accurately track index performance or provide positive investment returns. Standard & Poor’s does not guarantee the accuracy and/or completeness of any Standard & Poor’s index, any data included therein, or any data from which it is based, and Standard & Poor’s shall have no liability for any errors, omissions, or interruptions therein. Standard & Poor’s makes no warranties, express or implied, as to results to be obtained from use of information provided by Standard & Poor’s and used in this service, and Standard & Poor’s expressly disclaims all warranties of suitability with respect thereto. While Standard & Poor’s has obtained information believed to be reliable, Standard & Poor’s shall not be liable for any claims or losses of any nature in connection with information contained in this document, including but not limited to, lost profits or punitive or consequential damages, even if it is advised of the possibility of same. These materials have been prepared solely for informational purposes from sources believed to be reliable. Standard & Poor’s makes no representation with respect to the accuracy or completeness of these materials, the content of which may change without notice. The methodology involves rebalancings and maintenance of the indices that are made periodically during each year and may not, therefore, reflect real-time information. Standard & Poor’s uses the aggregate weighted average rebate rate data in the form provided to it by SunGard. Transaction data are reported to SunGard by market participants and discrepancies and errors may occur. In the calculation of the indices, S&P only uses the data which SunGard classifies as being associated with open loans which involve U.S. dollar cash collateral, and which are not part of any exclusive agreements or dividend tax trades. SunGard classifies these transactions based on the information that market participants report to SunGard and the results of SunGard’s proprietary screening algorithms. Although SunGard makes a reasonable attempt to screen and clean the data, neither SunGard nor S&P guarantees the quality, accuracy and/or completeness of the data. Analytic services and products provided by Standard & Poor’s are the result of separate activities designed to preserve the independence and objectivity of each analytic process. Standard & Poor’s has established policies and procedures to maintain the confidentiality of non-public information received during each analytic process. Standard & Poor's and its affiliates provide a wide range of services to, or relating to, many organizations, including issuers of securities, investment advisers,


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and financial intermediaries, and accordingly may receive fees or other economic benefits from those organizations, including organizations whose securities or services they may recommend, rate, include in model portfolios, evaluate or otherwise address. Copyright © 2010 by Standard & Poor’s Financial Services LLC. All rights reserved. Redistribution, reproduction and/or photocopying in whole or in part is prohibited without written permission. S&P, S&P 500, GICS, S&P MIDCAP 400, S&P SMALLCAP 600 and STANDARD & POOR’S are registered trademarks of Standard & Poor’s Financial Services LLC.

Documents

Transparency in the Securities Lending Market IntroFinal Jan2010