India edges closer to stock lending
India is finally closer to implementing a market-friendly stock borrowing and lending programme that should have a big effect on the development of the country’s capital markets. Having a functional securities lending market is a key component of efficient and liquid securities markets. The ability to borrow a stock enables market participants to sell short, and smoothes the settlement process in the cash market. It also enhances arbitrage activity between the derivatives and cash markets, aiding the liquidity of both.
The latest development is not India’s first attempt at developing a securities lending market. It has tried previously and failed, but the current strategy appears to be gaining sufficient support to ensure eventual success.
The structure of securities lending varies significantly around the world and in Asia. The most common structure globally is through over-the-counter (OTC) transactions: an intermediary takes on counterparty risk in exchange for collateral from the borrower.
However, the Securities and Exchange Board of India (SEBI) has promoted a screen-based, exchange-traded system; the exchange’s clearing corporation collects the collateral and acts as a central counterparty.
South Korea is often seen as a role model. India’s new structure does have some similarities with Korea, but it also reflects India’s particular historical experience of stock markets. For India’s equity market participants, what matters is not what model has been adopted, but the fact that stock lending has commenced in earnest.
In India, the clearing house plays a central role as in South Korea, but in contrast, the clearing house in India does not guarantee trades but operates on a best-efforts basis.
If a borrower does not return stock for whatever reason, there is a financial close-off, by selling the collateral and buying stock, or the return of collateral plus any adjustments in valuations.
“Globally, the collateral goes to the lender, here, collateral is left with the clearing house,” says Ashish Chauhan, the deputy chief executive of the Bombay Stock Exchange (BSE).
“But post the financial crisis, many firms prefer to leave collateral with a clearing house rather than with a counterparty.”
It is important to realise that stock lending is a banking transaction, not a trading one. “There are various initiatives under way in the US and in Europe to develop anonymous, order-driven, stock lending and borrowing platforms,” says the BSE’s head of product strategy, Sayee Srinivasan.
“But these are very early days and the market remains OTC in the sense that the terms are negotiated in private and if necessary, reported, settled and cleared through a clearing house.
“But unless clearing houses are in a position to guarantee return of the stock, anonymous stock lending will remain a challenge.”
Without a guarantee, knowing who the counterparties are remains a key issue for both lenders and borrowers. Lenders will want to know who the borrower is, so they can be confident that the borrower can return the stock. The borrower would also like to be confident that recalls will not happen too quickly.
Usually stock lending fees are accrued daily and are paid regularly in arrears. In India, they are paid up-front. However, if there is a recall, then the borrower has to be able to replace the transaction at current rates, so if annual fees rose from 10% to 20%, the lender would have to pay the difference.
Stock lending and borrowing is not new to India. “It has always been around in the form of badla trading,” Srinivasan says. But badla was banned in 2001 prior to the introduction of single-stock futures contracts. However, the market had been made comfortable with the concept of stock lending and borrowing, albeit with cash and futures trading all embedded within the badla structure.
Prior to the introduction of electronic trading, transactions required two weeks for settlement. Armies of clerks moved vast amounts of paper to transfer shares. A trader could buy and sell equities from Monday onwards and would only have to deliver or receive delivery of a net position on the close of Friday at the end of the following week. If the net position was zero, he would either receive trading profits or have to pay for losses.
Badla allowed traders to carry forward long or short net positions to the next settlement period. Large positions could be built up without delivery for months at a time. Like a traditional futures contract, badla gave leveraged exposure to the market, but unlike a futures contract, the responsibility for the maintenance of marked-to-market margins lay with the broker rather than the buyer or seller or a clearing house.
The initial attempt to introduce more formal stock lending was in 1997 when when SEBI launched the Securities Lending Scheme. Both the BSE and the National Stock Exchange (NSE) used it to introduce badla-like products combined with the settlement process of the respective exchanges. Whilst this made the schemes immediately attractive as traders were familiar with the structure, the products were banned because of the inherent instabilities in the process.
The next attempt to create a stock borrowing and lending market was in 2008 when SEBI introduced a new set of regulations: The Stock Lending and Borrowing Scheme.
“When SEBI introduced the new regulations, it was possible only to lend or borrow for less than seven days with a window of an hour per day for trading,” the BSE’s Srinivasan explains. “This failed as there was no demand with these restrictions in place. A year later, SEBI relaxed the regulations to allow lending for up to 30 days, but nothing much happened.”
What has caused the stock lending and borrowing marketplace to finally start gaining traction was the decision by SEBI last year to allow lending to be extended for up to a year, and to allow both recalls and returns of stock.
Srinivasan says market participants are willing to live with this current set of regulations and are in the process of getting the systems into place, arranging agreements with custodians and so on.
“Firms such as Goldman Sachs and Morgan Stanley need to have agreements with the exchange and with their clients to form a tripartite structure of some sort,” he says.
The BSE went live in November following the NSE, who had launched their facility a couple of months earlier. “People are testing systems, etc. Because the market as such never existed in this form in the past, the infrastructure has to be put into place. So hopefully, by the end of this year, we will start seeing decent volumes,” Srinivasan says.
Settlement of single stock futures and options has so far been by cash. But this does disconnect futures prices from that of the underlying stock, so that arbitragers cannot be 100% sure that prices will converge.
The success of the derivatives marketplace and the development of its infrastructure have led to recent moves in India to introduce physical settlement. This would align derivatives better with their underlying stocks; hedgers and arbitragers would benefit if they operate in both the derivative market and the underlying cash markets to close out trades.
For this to succeed would also require the development of liquid stock lending and borrowing facilities. Many argue that without liquid stock borrowing, physical delivery become difficult. But Srinivasan sees that the introduction of physical delivery should in itself, encourage a more liquid stock-borrowing market.
“Physical settlement will reduce the risk for market making,” he says. Traders can undertake strategies such as protected puts and covered calls. So if a market maker could set up a borrowing programme with, say, an insurance company, then it would be willing to make markets.
“Proprietary trading desks and market-makers are interested, if they can find people willing to lend, they can quote on a number of single stock options.”
The BSE chief executive, Chauhan, thinks potential stock lenders include the main institutional holders of equities who are looking to generate extra return by lending stock in this way. “We have been talking to large and small insurance companies who are all interested in the product. What we are now doing from the exchange perspective is to systematically go and educate the domestic players.
“The global players all understand this already. A lot of the supply will come from local guys. They tend to buy and hold, so lending stock would provide an additional source of return for them,” Chauhan says.
In addition, as Srinivasan points out, there is a large retail market in India, with many who are long-term buy-and-hold investors: “They would be interested in stock lending if it did not cost too much. Physical settlement will give a reason to borrow and lend.”
Stock lending is still in its early stages in India. Volumes are low at less than $10m traded a day, with most of this representing proprietary trading undertaken by a few firms, according to Srinivasan. And as Chauhan says, there is a lot of scope for improvement. But he is optimistic: “By late 2011, stock lending in India will have achieved the momentum required to take off.”