Securities lending: A key missing link in the Indian securities markets

by Rohini Grover.

The importance of securities lending

Securities lending is a temporary exchange of securities between two parties against some collateral with an obligation to return the borrowed securities at a future date. The collateral may be in the form of shares, bonds, or cash. It serves the following objectives:

1. It allows market participants to 'short-sell' by borrowing securities temporarily. A well functioning securities lending and borrowing (SLB) market enables efficient execution of trading strategies based on short selling. For example, in cash and futures arbitrage, an arbitrageur will buy futures and short sell borrowed shares in the spot market if the futures price is lower than the spot price. This ensures that the futures price returns to its fair value and restores market efficiency.
   There is ample research on the gains from short selling. E.g. Boehmer et al, 2008 shows that banning short selling lowers market quality as measured by spreads, price influence, and volatility. Recent research by Rajat Tayal and Susan Thomas suggests important links between short selling constraints and asymmetry in liquidity.
2. Investors with a long term investment horizon earn additional returns in the form of lending fees by lending securities. Portfolio returns go up when securities are lent, but there might be credit risk if there is inadequate collateral.
3. Additionally, in a money market, investors with large inventories of securities can post them as collateral to obtain short term finance.

The features of a well functioning SLB market include: wide market access with large number of borrowers and lenders; transparent regulation to mitigate uncertainty and encourage participation on both sides; and low transaction costs. Several countries like the US, Brazil and South Korea have established successful SLB markets. In India, while the equity market achieved transformative change, securities lending is the last big component which has not fallen into place.

The Indian experience

The SLB market in India was introduced by the National Securities Clearing Corporation Ltd (NSCCL) on April 21, 2008. The market design featured automated screen based trading platform with online matching of trades based on price-time priority; all classes of investors permitted, including FIIs; settlement guarantee; and NSCCL as an Approved Intermediary acting as a Central Counterparty (CCP).

All over the world, securities lending is generally done OTC and generally involves credit risk. The Indian launch was quite novel in two respects: the emphasis on anonymous order matching (so as to remove the infirmities of OTC transacting) and the use of a clearinghouse which eliminated credit risk.

The Indian SLB market has grown through two distinct phases:

1. From 2008 - 2009: After introduction, the initial market volume was negligible. SEBI revised the SLB framework in October 2008 to tackle this. The key changes were: increasing SLB tenure from 7 days to 30 days; increasing trading timings from one hour to a full trading day; accounting for corporate actions such as dividends and stock splits. This phase was largely a failure.
2. From 2010 - present: Starting January 2010, a number of market microstructure changes were introduced to improve the segment's liquidity by easing participation. These steps increased volumes significantly in percentage terms, but in absolute terms it is still a highly inadequate market.

Regulatory changes

Two broad regulatory themes emerged since 2010. Where SEBI amended the framework to improve market microstructure, IRDA widened the market by allowing insurance firms to participate.
The following are the details of the changes introduced by SEBI:

• SEBI circular: Jan 06, 2010 w.e.f June 28, 2010:
  1. The tenure of SLB was extended to 12 months.
  2. Early recall and early repayment facility were introduced.
  3. In case of an early recall by lender, the clearing house will procure securities for the lender on a best effort basis. A fee will be charged to the lender seeking early recall.
  4. In case of early repayment by the borrower, the clearing house will release the margins on the returned securities. It will try to lend these securities onward on best effort basis. If it is unable to do so, the borrower will have to forego the lending fee for the remaining period.
• SEBI circular: Nov 22, 2012 :
  1. Liquid ETFs were introduced with position limits based on their AUM. Trading in these commenced in September, 2013.
  2. A roll-over facility was introduced which provided roll over for 3 months (original + 2).
  3. Netting of counter positions, i.e. netting between the "borrowed" and "lent" positions of a client was not allowed.
• SEBI circular: May 30, 2013:
  1. New stocks (other than F&O stocks) were added to SLB. Trading in these started in July, 2013.
  2. Collateral for margin obligations was made similar to that for cash market.

In addition to the changes introduced by SEBI, IRDA opened up SLB participation to insurance firms via IRDA guidelines: July 12, 2013. It limited lending to a maximum of 10% of the securities in the fund. In February 2014 (after an odd gap of six months) NSE clarified the position limits for insurance firms and other institutional investors via NSE circular: Feb 14, 2014. These were to be the same as that of a participant i.e. lower of 10% of the market wide position limit (MWPL) or Rs.50 crore.

Outcomes

The enhanced flexibility, due to longer contracts and early recall and repayment, considerably improved the liquidity of the market. The four week average number of shares traded increased from 0.0006 million to 0.049 million after the implementation of the changes.
Provision of roll-over facilities and relaxation of collateral requirements had a modest impact. The former increased traded volume by 40% and the latter by only 7%.

The introduction of liquid ETFs and 46 new stocks was expected to increase the trading activity by widening the market. Nevertheless, with the onset of trading in ETFs, the market observed only a meagre 9% increase in the average number of shares traded in the four week period prior vis-a-vis the four week period after the change. Moreover, there was no significant change in these averages after the commencement of trading in new stocks. If anything, the traded volume dropped from 0.41 million to 0.32 million.

Permitting insurance firms to trade in the market was a positive move by IRDA because it added to the shallow lending side ailing the SLB segment. Once again, the step yielded insignificant gains. On Feb 14, 2014, when the position limits for insurance firms and other institutional investors were revised to the participant level, the liquidity improved dramatically clocking a 70% increase in average number of shares traded after revision.

Diagnosing the failure

Since the securities loan is made on the exchange platform and covered by the clearing house, there is no risk to the lender of not receiving the lending fee. However, the risk of not procuring the security lent, on early recall, persists.

In an early recall the lender has to quote the lending fee he is willing to forego for the balance period. However, an early recall request is fulfilled by the clearing house on a best effort basis only – the exchange does not guarantee liquidity so that there is a matching order on the other side offering securities to the recall order. The lender has to wait for a match to his early recall order, failing which, he will have to keep the loan position open till the reverse leg day.

Suvanam and Jalan (2012) find that the SLB market in India has typically been a borrower-driven market with the presence of few lenders. The borrowing side in India is primarily proprietary traders, whereas in other countries the borrowing side is more diversified and includes hedge funds, mutual funds, foreign investors etc. Market diversity and depth on both the sell and the buy side is essential for proper functioning of a market. Suvanam and Jalan (2012) conclude (pp. 27) that "such diversity is currently absent in the Indian SLBM".

Globally, pension funds are large players on the lending side but in India they are not allowed to participate. The investment guidelines under the Investment Management Agreement between the NPS trust and pension funds impose restrictions such as "the assets are not to be encumbered", and further, "the PF shall buy and sell securities on the basis of deliveries and shall in all cases of purchases, take delivery of relative securities and in all cases of sale, deliver the securities and shall in no case put itself in a position whereby it has to make short sale or carry forward transaction or engage in badla finance".

Suvanam and Jalan (2012) find that foreign investors constitute 90% of the buy side and 86.4% of the sell side in the South Korean SLB market – another market that limits the segment to only the exchange. The Indian segment may also benefit from easing FII participation norms. While domestic institutional investors are likely to require time to understand the mechanism and set up processes to participate, FIIs are likely to be rapid entrants into this market.

There are numerous mistakes in regulations which have to be fixed in order to open up the market for FIIs:

1. RBI's rules for FII participation in the SLBM prescribe that shares may be borrowed only for short selling. There is no clarity on what happens if the FII sells short and is unable to procure stock in the SLB market.
2. FIIs must maintain collateral only in the form of cash while domestic institutional investors have a wider range of collateral options such as cash, fixed deposit receipt, bank guarantees and most recently included Gsecs and T-bills.
3. FIIs may need to access the SLB market despite having stock in their portfolio. FIIs may hold an omnibus account while client positions are maintained internally. This warrants participation in SLB for one client while the FII holds stock for another. The regulatory stance on this is unclear.
4. The RBI prohibits NRIs from participating in the SLB market.

The client level position limit of 1% of MWPL is too small especially for institutional investors. The presence of extremely low limits on trading ETFs may be a reason for their failure in improving liquidity. For example, the market wide position limits in NIFTYBEES for June 2014 was 548,557 shares. Hence, the client level position was 5,486 shares (1% of MWPL) which is ridiculously small.

An over the counter (OTC) market provides greater contract flexibility and wider position limits that encourage greater participation. The low volumes in India may, in part, be because the Indian regulator has limited the SLB segment to the exchange – unlike the US which is primarily an OTC market and Brazil which allows trading in SLB on both the exchange and OTC.

The way forward

1. Removing lenders' risk: Absence of a settlement guarantee mechanism in case of early recall by lenders erodes incentives for large lenders to enter the market. The existing SLB framework does not provide such a guarantee (SEBI circular: Jan 06, 2010). In contrast, the CCP in South Korea provides settlement guarantee for a fee. In Hong Kong, the CCP forces borrowers to return the securities to the lender in case of early recall. The Indian regulator should either adopt a model for providing this guarantee or at least provide monetary compensation in lieu of it.
2. Adding pension funds to the list of lenders: It will be useful for PFRDA to invite debate about the costs and the benefits of allowing participation of pension funds in the Indian SLB market. Guidelines similar to those released by IRDA for insurance firms should be issued to allow their participation.
3. Increasing FII participation: The RBI rules: Dec 31, 2007 permit only cash collaterals for FIIs. Given that RBI already allows FIIs to maintain a wide range of collaterals in the equity and F&O segment, this could easily be extended to the SLB segment. Also, there should be clarity on issues such as failure to procure the securities lent and access to SLB market when they already hold stocks in their portfolio.
4. Increasing position limits: SEBI and the exchanges should reconsider the client level positions. They should seek market consultation and set position limits accordingly.
5. Establishing a parallel OTC market: The SEBI circular: Dec 20, 2007 states 'that stock exchanges shall put in place, a full fledged securities lending and borrowing (SLB) scheme, within the overall framework of "Securities Lending Scheme, 1997".' It designates clearing houses/corporations of stock exchanges as the Approved Intermediary under the Securities Lending Scheme, 1997. This prohibits an OTC market in the SLB market. As Suvanam and Jalan (2012) note "a parallel OTC market with a CCP or without a CCP can augment this market." The regulator must invite debate with market participants and researchers to consider this possibility with the objective of improving liquidity.