1.9 Prime Brokerage/ Equity Finance Flashcards
Name and describe the 6 typical services provided by a Prime Broker…
The typical services that are provided by a prime broker include the following:
- Securities lending and borrowing – eg, to cover short positions in a long/short strategy.
- Leveraged trade execution – undertaking trades on the fund’s behalf that are partly financed by
borrowed funds. - Cash management – maximising the return that is generated from cash held by the fund.
- Core settlement – taking the necessary steps to make sure that any securities purchased become the property of the fund, and the appropriate cash is received for any sales made of the fund’s securities in a timely manner.
- Custody – keeping safe the securities held by the fund, and processing any corporate actions promptly and in accordance with its targets.
- Rehypothecation – in addition to holding collateral and having a charge over the fund’s portfolio, the prime broker might also require a right to re-charge, dispose of or otherwise use the customer’s assets which are subject to the security, including disposing of them to a third party. This is commonly described as a right of rehypothecation. When assets have been rehypothecated, they become the property of the prime broker, as and when the prime broker uses them in this way, for instance by depositing rehypothecated securities with a third-party financier to obtain cheaper funding, or by lending the securities to another client.
Define Prime Brokerage
Prime brokerage is the term given to a collection of services provided by investment banks to their hedge fund clients. Hedge funds are investment funds that are typically only open to a limited range of investors. They tend to follow complex investment strategies, often involving derivatives. However, among the more straightforward strategies adopted is the equity long/short strategy. This involves taking both long positions in equities (in other words, buying shares) and, at the same time, committing to sell equities that are not held by the fund (described as selling short). The hope is that the gain in one half of the strategy (the long or the short) will more than cover the loss on the other half of the strategy (the short or the long). Selling short inevitably means that the fund will need to borrow the securities it has sold until the position is unwound.
What are main sources of equity/fixed income financing?
In order to finance and create positions in equities and bonds required by their hedge fund clients, prime brokers have a number of possibilities:
- Stock borrowing and lending – prime brokers can arrange for the appropriate securities to be borrowed to cover the hedge fund’s short positions and also use the fund’s long positions to lend to others and provide additional returns to the fund as a result.
- Repurchase agreements – repurchase agreements (repos) are essentially when the prime broker arranges the sale of securities owned by the fund for cash, while agreeing to buy back the equivalent securities later for a slightly inflated price. The increase in price is effectively the borrowing cost of the cash, and is often referred to as the repo rate.
- Collateralised borrowing – prime brokers advance cash to the customer against the security of a first fixed charge over the customer’s portfolio. In the event of the customer’s default, this gives the prime broker a right of recourse against the charged assets for the amounts owing to it. The availability of the portfolio as collateral in this way should enable the bank to provide loans at more competitive rates than would be the case with an unsecured loan.
- Tri-Party repos – in the case of a tri-party repo, a custodian bank or clearing organisation acts as an intermediary between the two parties to the repurchase or repo agreement outlined above. The tri-party agent is responsible for the administration of the transaction including collateral allocation, the marking to market, and, when required, the substitution of collateral. The lender and the borrower of cash both enter into tri-party transactions in order to avoid the administrative burden of the simpler form of bilateral repos. Moreover, there is an added element of security in a tri-party repo because the collateral is being held by an agent and the counterparty risk is reduced.
- Synthetic financing – this is when the prime broker will create exposure to particular securities by using derivatives, like swaps, rather than directly buying and holding the securities themselves. This route is generally substantially cheaper than outright purchases.
What is Stock Lending?
Stock lending is the temporary transfer of securities, by a lender to a borrower, with agreement by the borrower to return equivalent securities to the lender at a pre-agreed time.
What is the motivation behind Stock Lending?
There are two main motivations for stock lending: securities-driven, and cash-driven. In securities-driven transactions, borrowing firms seek specific securities (equities or bonds), perhaps to facilitate their trading operations. In the cash-driven trades, the lender is able to increase the returns on an underlying portfolio, by receiving a fee for making its investments available to the borrower. Such transactions may boost overall income returns, enhancing, for example, returns on a pension fund.
Securities Lending Agreement
The terms of the securities loan will be governed by a securities lending agreement, which requires that the borrower provide the lender with collateral, in the form of cash, government securities, or a letter of credit of value equal to or greater than the loaned securities. As payment for the loan, the parties negotiate a fee, quoted as an annualised percentage of the value of the loaned securities. If the agreed form of collateral is cash, then the fee may be quoted as a rebate, meaning that the lender will earn all of the interest that accrues on the cash collateral, and will rebate an agreed rate of interest to the borrower.
Benefits of Stock Lending
The initial driver for the securities lending business was to cover settlement failure. If one party fails to deliver stock to you, it can mean that you are unable to deliver stock that you have already sold to another party. In order to avoid the costs and penalties that can arise from settlement failure, stock can be borrowed at a fee, and delivered to the second party. When your initial stock finally arrives (or is obtained from another source) the lender will receive back the same number of shares in the security they lent.
The principal reason for borrowing a security, therefore, is to cover a short position. As you are obliged to deliver the security, you will have to borrow it. At the end of the agreement you will have to return an equivalent security to the lender. Equivalent in this context means fungible, ie, the securities have to be completely interchangeable. Compare this with lending a ten euro note. You do not expect exactly the same note back, as any ten euro note will do.
Securities lending and borrowing is often required, by matter of law, in order to engage in short selling. In fact, regulations enacted in 2008 in the US, Australia and the UK, among other jurisdictions, required that, before short sales were executed for specific stocks, especially banks and financial services companies, the sellers first pre-borrowed shares in those issues.
There is an ongoing debate among global policymakers and regulators about how to impose new restrictions on short selling and in June 2010, during a period of turbulence for the eurozone, Germany took a unilateral step in banning the naked short selling of credit default swaps (CDSs) (ie, when the short seller had no interest in the underlying security for the credit default swap).
Benefits of Stock Lending according to the FCA
The FCA lists the following positive aspects of stock lending in its guidance to the investment community:
• It can increase the liquidity of the securities market by allowing securities to be borrowed temporarily, thus reducing the potential for failed settlements and the penalties this may incur.
• It can provide extra security to lenders through the collateralisation of a loan.
• It can support many trading and investment strategies that otherwise would be extremely difficult
to execute.
• It allows investors to earn income by lending their securities on to third parties.
• It facilitates the hedging and arbitraging of price differentials.
Risks of Stock Lending
Many feel that securities lending can aid market manipulation through short selling, which can potentially influence market prices. Short selling itself is not wrong, but market manipulation certainly is.
The debate about the merits and validity of short selling is sometimes emotion-charged, and features in the rhetoric of politicians in populist attacks on the financial services industry. It is probably fair to say that for most investment professionals, who actually work in the financial markets, the notion that short selling in itself is an abusive practice is not palatable. There may be times when the activity can be disruptive, but markets have a tendency to over-react in either direction and the periodic focus given to short selling when a market is moving down should be counterbalanced by the tendency for markets to become too frothy and for long investors to become exuberant when markets are going up.
At the time of writing, the Financial Conduct Authority (FCA) is conducting a thematic review of the investment management industry that includes assessing whether or not stock lending is undertaken in the best interests of customers. For example, is the lending of assets by a fund manager done for a pension fund client in the best interests of that fund and its existing and potential pensioners? In particular, the FCA is looking at whether there is a danger that the profits generated from stock lending are not appropriately shared with the managers’ customers, and whether the risk that loaned assets are not returned is placing unnecessary risk on the fund.
Who are the Stock Borrowing and Lending Intermediaries (SBLIs)?
Securities lending has increasingly become a volume business which has encouraged the proliferation of various specialist intermediaries to undertake principal and/or agency roles in this field. These SBLIs provide a service in separating out the underlying owners of securities – which are typically large pension funds or insurance companies – from those who would be borrowers of those securities, typically hedge funds and other asset managers, and liaising with both sides. The economy of scale offered by SBLIs in pooling together securities of different clients has also enabled smaller asset-holders to participate in this market.
Asset managers and custodian banks have added securities lending to the other services they offer. Owners and SBLIs will often split revenues from securities lending at commercial rates. The split will be determined by many factors, including the service level and provision by the agent of any risk mitigation, such as an indemnity. Securities lending is often part of a much bigger relationship and therefore the split negotiation can become part of a bundled approach to the pricing of a wide range of services.
Custodian Banks (SBLI)
Since custody is a highly competitive business, for many providers it is often run as a loss-making activity. Supplementing their custodian role by acting as an SBLI can add a new level of revenue- generation for custodian banks. Many large custodian banks have therefore added securities lending to their core custody businesses.
From the perspective of the custodian, the advantages of acting as an SBLI are that they already have:
• an existing banking relationship with their customers;
• investment in technology and global coverage of markets arising from their custody businesses;
• the ability to pool assets from many smaller underlying funds, insulating borrowers from the
administrative inconvenience of dealing with many small funds;
• experience in local operations in developing as well as developed markets;
• the capability to provide indemnities and manage cash collateral efficiently.
Prime Brokers (SBLI)
In contrast to those SBLIs that act as agent intermediaries, principal SBLI intermediaries, such as prime brokers, can assume principal risk, offer credit intermediation and take positions in the securities that they borrow. A beneficial owner may often be reluctant to take on credit exposures to borrowers they are not familiar with, who may not be regulated or who may not have a good credit rating. This could well exclude many hedge funds. In such circumstances, a prime broker, acting as an SBLI, will be providing a credit intermediation service in taking a principal position between the lending institution or beneficial owner of the securities and the hedge fund.
A further role of prime brokers is to take on liquidity risk. Typically they will borrow on an open basis, which gives the beneficial owner the option to recall the underlying securities if they want to sell them or for other reasons. However the SBLI will be lending to clients on a term basis, giving them certainty that they will be able to cover their short positions.
One way to mitigate this risk is to use in-house inventory (stock) if available. For example, proprietary trading positions can be a stable source of lending supply if the long position is associated with a long- term derivatives transaction. Efficient inventory management is seen as critical and many securities lending desks act as central clearers of inventory within their organisations. This can require a significant technological investment.
Securities lending is also one of the central components of a prime brokerage operation in regard to its hedge fund clients. In particular, two hedge fund strategies that are heavily reliant on securities borrowing are long/short equity and convertible bond arbitrage.
Administration (SBLI)
In contrast to those SBLIs that act as agent intermediaries, principal SBLI intermediaries, such as prime brokers, can assume principal risk, offer credit intermediation and take positions in the securities that they borrow. A beneficial owner may often be reluctant to take on credit exposures to borrowers they are not familiar with, who may not be regulated or who may not have a good credit rating. This could well exclude many hedge funds. In such circumstances, a prime broker, acting as an SBLI, will be providing a credit intermediation service in taking a principal position between the lending institution or beneficial owner of the securities and the hedge fund.
A further role of prime brokers is to take on liquidity risk. Typically they will borrow on an open basis, which gives the beneficial owner the option to recall the underlying securities if they want to sell them or for other reasons. However the SBLI will be lending to clients on a term basis, giving them certainty that they will be able to cover their short positions.
One way to mitigate this risk is to use in-house inventory (stock) if available. For example, proprietary trading positions can be a stable source of lending supply if the long position is associated with a long- term derivatives transaction. Efficient inventory management is seen as critical and many securities lending desks act as central clearers of inventory within their organisations. This can require a significant technological investment.
Securities lending is also one of the central components of a prime brokerage operation in regard to its hedge fund clients. In particular, two hedge fund strategies that are heavily reliant on securities borrowing are long/short equity and convertible bond arbitrage.
Cash or assets held in favour of a customer for stock lending activity must be held in accordance with the appropriate custody rules. This includes dividends, stock lending fees and any other payments received in relation to stock lending.
Legalities of Stock Broking
Securities lending is legal and clearly regulated in most of the world’s major securities markets. Most markets mandate that the borrowing of securities be conducted only for specifically permitted purposes, which generally include to:
• facilitate settlement of a trade;
• facilitate delivery of a short sale;
• finance the security; or
• facilitate a loan to another borrower who is motivated by one of these permitted purposes.
In the UK those involved in securities lending will generally be supervised by the FCA. They will be subject to the FCA’s Handbook, including the Inter-Professional Conduct Chapter of the Market Conduct Sourcebook; and also subject to the provisions of the Financial Services and Markets Act (FSMA 2000) on, among other things, market abuse.
They will also have regard to the provisions of the Stock Borrowing and Lending Code, produced by the Stock Lending and Borrowing Committee, a committee of market participants, chaired by the BoE, which includes a representative of the FCA.
Effect on a Lender’s Rights and Corporate Actions
When a security is loaned, the title of the security transfers to the borrower. This means that the borrower has the advantages of holding the security, just as though they owned it. Specifically, the borrower will receive all coupon and/or dividend payments, and any other rights such as voting rights. In most cases, these dividends or coupons must be passed back to the lender in the form of what is referred to as a manufactured dividend.
If the lender wants to exercise its right to vote, it should recall the stock in good time so that a proxy voting form can be completed and returned to the registrar by the required deadline. Similar issues are involved in other corporate actions such as capitalisation issues.
Technically, the consequences arising from any corporate action by the issuer of a security, such as a capitalisation matter or rights issue, when that security has been lent to another would, prima facie, be to the benefit/cost of the borrower. Under the terms of the security agreement it is customary that these costs/benefits flow back to the lender, and the exact manner in which this is implemented should be reflected in the securities lending agreement.
The term securities lending is sometimes used erroneously as a synonym of stock loan. The latter is used in private hedged portfolio stock collateralised loan arrangements, where the underlying securities are hedged so as to convert the variable asset to a relatively stable asset, against which a usually non- recourse or limited-recourse loan can be placed.
