GLOBAL FINANCE & MARKETS | GOVERNMENT BOND MARKETS ADVISORY SERVICES Securities Lending and Related Standing Facilities Background Note May 2015 Background Note1 This note is part of a series of background notes produced under the World Bank Group Government Bond Markets (GBM) Advisory Services Program as a by-product of its strategy to support the development of liquid local currency bond markets. Selected topics have been a key focus in the areas of work of the Advisory Services because of their catalytic impact on debt market development. They include primary market organization through primary dealers and liability management, repo markets, securities lending, price dissemination, and clearing and settlement arrangements.2 Securities lending can make significant contributions to bond market development, as it promotes secondary market liquidity by helping market participants avoid delivery fails and conduct market operations. Specifically, securities lending facilities (SLFs) can be particularly useful for primary dealers that must comply with quoting obligations and often engage in short positions as part of their daily market-making activity. This background note provides some guidance on how to design an SLF, reviewing different types of financial instruments and SLF structures that can be used as well as the preconditions. Various elements and procedures related to putting an SLF in place are illustrated with country examples. Production of this background note was led by Olga Akcadag. Baudouin Richard was the primary author, working in collaboration with Anderson Caputo Silva, Olga Akcadag, and Indhu Raghavan, all of the World Bank Group Government Bond Markets Advisory Services Program Team. The authors wish to thank Thordur Jonasson, Senior Financial Sector Expert, MCMDM, IMF, and Mike Williams, Senior Consultant, WBG, for reviewing the note. A special thank you to country questionnaire respondents,3 David Anderson, who edited this background note, and Aichin Lim Jones, who provided the design and layout. 1 TThis background note has been prepared to support World Bank Group technical assistance programs for the development of local capital markets. This note is a work in progress because data intended to show practical examples of country practices are still being collected. Comments to asilva3@worldbank.org, baudouin.richard@live.be, and oakcadag@ifc.org are welcome. 2 Six notes have been produced so far on Primary Dealers, Liability Management, Repo Markets, Securities Lending, Electronic Trading Platforms, and Domestic Syndications. 3 These include the Brazilian National Treasury, Central Bank of Malaysia, Ministry of Finance and Public Credit Mexico, National Treasury of South Africa, and Turkish Treasury.. Contents i Contents Abbreviations and Acronyms...................................................................................III 1. Introduction..........................................................................................................1 2. Securities Lending.................................................................................................3 2.1. Definition and Objectives..................................................................................... 3 2.2. Link between Securities Lending and PDs’ Quoting Obligation........................... 3 2.3. Securities Lending Instruments............................................................................. 4 3. Securities Lending Facility.....................................................................................5 3.1. Securities Lending Procedures............................................................................... 5 3.2. Automatic Securities Lending Facility Provided by a Clearing House to Its Members............................................................................................................ 5 3.3. Special Securities Lending Facility Provided by a DMO to its PDs....................... 6 3.4. Ways for a DMO to Ensure the Availability of Securities for Lending................... 6 3.5. Comparison between Clearing House and DMO-Provided Lending Facilities...... 7 3.6. Hybrid SLF System.............................................................................................. 8 3.7. Summary Survey of SLF Procedures Implemented in Select Mature and Developing........................................................................................................... 8 4. Accounting Principles..........................................................................................11 5. Putting a Securities Lending Facility in Place......................................................13 5.1. Background........................................................................................................ 13 5.2. Prerequisites for an SLF To Be Put in Place......................................................... 13 5.3. Decisions to Be Made by the DMO................................................................... 14 5.4. Possible Simplifications of the Standard Procedure at the Start............................ 14 5.5. Draft SLF Procedure Manual.............................................................................. 14 6. Conclusion..........................................................................................................15 ii Securities Lending and Related Standing Facilities Appendix 1. Clearing House Automatic Securites Lending Facility. Illustration: Belgium..................................... 17 Appendix 2. SLF: Determining the Appropriate Amount and Rate........................................................................ 19 Appendix 3. SLF Accounting. Illustration: Belgium............................................................................................... 21 Appendix 4. Draft SLF Procedure Manual............................................................................................................. 23 Appendix 5. Overview of International Emerging Markets SLF Experiences......................................................... 25 Appendix 6. Country Questionnaire on Securities Lending Facility (SLF), April 2015.......................................... 31 References............................................................................................................................................................... 37 Abbreviations and Acronyms iii Abbreviations and Acronyms BDA Belgian Debt Agency ASLF Automatic Securities Lending Facility BT Brazilian Treasury CH Clearing House DMO Debt Management Office GC General Collateral GMRA Global Master Repurchase Agreement ILB Inflation-Linked Bond MM Market Maker MoF Ministry of Finance MRA Master Repurchase Agreement PD Primary Dealer PM Procedure Manual Repo Repurchase Agreement SARB South African Reserve Bank SL Securities Lending SLF Securities Lending Facility SPF Social Pension Fund SSLF Special Securities Lending Facility TCS Temporarily Created Security 1. Introduction 1 1. Introduction Thesis aim of this draft background note is to provide public debt managers with an overview of the matters that need to be considered by debt management offices (DMOs) planning to provide a securities lending facility (SLF) to their primary dealers (PDs). “SLF” as it is used in this note means “a procedure put in place with a view to facilitating the borrowing of some specific securities in some specific instances, whether by way of a straight borrowing or a repo or a sell and buy back transaction.” The main providers of SLFs are clearing systems and DMOs. Clearing systems provide an SLF to their members to avoid delivery fails. DMOs provide an SLF to their PDs to enhance the liquidity of the secondary market in government securities by helping PDs to comply with their commitment to quote firm two-way prices. The provision by a DMO of an SLF to its PDs is not a requirement for a well-functioning secondary market. As an illustration, the US Treasury conducted in 2006 a market survey to establish whether it should establish a securities lender of last resort facility.4 The Bond Market Association responded by arguing that ensuring the ability of PDs to borrow securities in case of need is a responsibility of the market that the Treasury should not undermine. Yet a well-structured SLF provided by DMOs to their PDs is a powerful instrument to enhance the liquidity of the secondary market. Almost all mature markets with a PD system have an SLF in place. An increasing number of emerging markets are putting or planning to put an SLF in place. An apparent paradox is that an SLF is best little used. The explanation is that an SLF has to be a last resort mechanism. PDs should first try to cover their short positions by borrowing securities from the market. An SLF should be provided only as a safety net. If not, it would impair the development of the repo market. 4 Report on results of the OECD SLF questionnaire, U.S. Treasury Office of Debt Management, 2006. 2 Securities Lending and Related Standing Facilities Putting an SLF in place for PDs is only a technical to their PDs, and a hybrid system combining some features undertaking that raises minimal risks for DMOs. The of the previous two. It analyzes the ways that DMOs are terms of the SLF are set at the DMO’s discretion; the using an SLF to ensure the availability of the securities that maturity of the transactions is very short; their amount PDs are seeking to borrow: using a securities portfolio or is limited. The counterparts are well known to the DMO by temporarily creating and subsequently cancelling the because they are PDs. securities in question. A summary review of the applicable accounting principles follows. This background note is organized as follows. The usefulness of securities lending for market makers and for investors The background note concludes by summarizing the is reviewed first. The background note then describes the practical issues to be addressed when putting an SLF in different financial instruments that can be used to that effect: place, both the prerequisites to be met at the outset and the a loan, a repo, and a simultaneous conclusion of a repo and decisions to be made in the process. a reverse repo. It surveys the advantages and shortcomings of the different types of securities-lending facilities that can The appendices include a draft procedure manual to be put in place: an automatic SLF provided by clearing provide an illustration of the way that an SLF can be houses to their members, a special SLF provided by DMOs operated and a review of some international emerging markets’ SLF experiences. 2. Securities Lending 3 2. Securities Lending 2.1. Definition and Objectives Securities lending is a transaction whereby a market participant borrows a security for a certain period.5 The objective of the securities borrower is to avoid a delivery failure6 or to cover (or create) a short position in the security in question. The objective of the securities lender is to earn a commission, thereby increasing the return on its securities portfolio. 2.2. Link between Securities Lending and PDs’ Quoting Obligation PDs are committed to make markets for government securities. A trader who quotes two- way prices may be selling a security that it does not hold in inventory. It may not always be able to buy that security immediately in the market to cover its short position. It then needs to borrow the relevant security to deliver it to the buyer. Thus, a PD can make markets only if it is confident that it will be able to borrow the securities that it might need in the process. The primary objective of an SLF is thus to lower the risks incurred by PDs in complying with their market-marking commitment.7 In mature markets, this includes protecting PDs against the risks generated by a “market squeeze.” A market squeeze occurs when a trader holding a large portfolio of a certain series of securities takes advantage of its dominant position by selling or lending the relevant security at an artificially high cost to the other market participants. An SLF allows a DMO to mitigate a market squeeze by offering PDs the possibility to borrow the securities in question at a normal cost. Countering a market squeeze is the only instance in which the cost of borrowing securities under an SLF should be below the cost of borrowing the securities in the repo market (see section 3.3). 5 “Securities borrowing” is used in this note in its generic sense of temporary transfer of the legal ownership of a security, whether by way of a straight borrowing, a repo, or a sell and buy back transaction (see section 1). 6 This is a settlement failure in the clearing house resulting from the inability to deliver the securities to be transferred. 7 As a result, it is beneficial to have a SLF put in place by a DMO when the market is mature enough to allow imposing a quoting obligation to PDs but not so liquid that compliance with this quoting obligation raises no issue for PDs. A way to assess the status is to ask PDs “Do you feel comfortable quoting to investors firm selling prices for securities that you do not hold in portfolio?” 4 Securities Lending and Related Standing Facilities Technically, an SLF can also be used by PDs to intentionally Figure 2.1. Types of Repo Borrowing create short positions. Short positions are a legitimate part of market making.8 However, most DMOs limit S curiti s S curiti s the amount of securities that PDs can borrow under the L nd r Borrow r SLF so the SLF will not be used to allow excessive market speculation (see section 3.3). S curiti s Spot An SLF enhances the value of the status of primary dealer. C sh An SLF is fundamentally a compensation for assuming an obligation. Yet it is indirectly a privilege as the strengthened C sh Forw rd ability to quote firm prices (including the reduced S curiti s requirement of holding large inventories of securities) gives PDs a competitive edge over other banks. This can support 3. Figure 2.1 shows that a repo can be construed as a the development of the PDs’ customer base. borrowing of either a security or cash depending on which party takes the initiative in the transaction. 2.3. Securities Lending Instruments In general, repos are used as an instrument to borrow Three different financial instruments can be used to lend cash. They protect the lender against credit risk on the securities: a straight loan, a repo, and a simultaneous borrower. In this case the type of security provided as repo and reverse repo. In the last two cases, the same collateral by the cash borrower is indifferent provided financial result can be achieved by concluding buy and sell the securities in question meet some general eligibility transactions instead of repos. criteria. Thus, these repo transactions are referred to as 1. Straight loan: The lender transfers the securities to the general collateral (GC). By contrast, the repo transactions account of the buyer, who commits to transfer them initiated by a securities trader who wants to borrow a back on a certain date. The loan is usually secured by a specific security are referred to as special collateral. pledge of cash or securities. The lender is remunerated 4. Simultaneous repo and reverse repo: A repo “special by a commission. The commission is expressed as a collateral” done by a securities lender can be matched certain amount of cash. by a reverse repo GC done by the party borrowing the 2. Repo: The lender sells the security spot, and he or she securities. If the two parties charge one another the simultaneously commits to buy the security back at some same amount for the spot purchase of the securities, future date. The mirror image of the securities loan by the the corresponding two securities transactions are “cash seller to the buyer is a cash deposit by the buyer to the seller. neutral.” In this case, the end result for the “special collateral” securities lender is effectively the same as a The securities lender is effectively protected against the repo except that the collateral is securities instead of cash. risk of default by the borrower by cash collateral.9 As The remuneration of the “special collateral” securities compensation for lending the securities, the securities lender will be the margin between the interest paid on lender remunerates the deposited funds at an interest the cash it has borrowed and the interest earned on the rate below market, the difference representing the fee. cash it has lent. The commission of the securities lender is thus expressed as an interest rate margin. The width of the margin is a function of the availability of the relevant security. The less available the security is in the market, the lower will be the remuneration of the funds. 8 A market maker that systematically matches its short or long securities positions in the market is actually a market taker. It provides no liquidity. 9 Although the lender is protected by cash collateral, it is worth noting that as market valuation change, the initial haircut may not be sufficient and collateral must be monitored by the securities lender. 3. Securities Lending Facility 5 3. Securities Lending Facility 3.1. Securities Lending Procedures There are three different kinds of securities lending (SL) procedures. SL is generally done in the framework of a bilateral agreement between a lender and a borrower that are trading with one another in the market. This is the “normal” way of borrowing securities. By contrast, an SLF is a procedure put in place with the intention of facilitating the borrowing of securities by a number of counterparties but in some specific cases. There are two kinds of SLFs: the “automatic securities lending facility” (ASLF) provided by a clearing house to its members and the “special securities lending facility” (SSLF) provided by a DMO to its PDs. 3.2. Automatic Securities Lending Facility Provided by a Clearing House to Its Members An automatic securities lending facility (ASLF) is an agreement between a clearing house (CH) and its members, the objective of which is to avoid delivery failures. It is sometimes referred to as “optional lending, compulsory borrowing.” On the one hand, the CH members authorize the CH to lend certain securities booked in their account on their behalf. This is the optional lending. On the other hand, at the closing of the clearing session, the CH automatically—this is part of the design of the system—lends securities to any clearing member that needs them to avoid a delivery failure. This is the compulsory borrowing. The securities are generally lent on an overnight basis against the pledge of securities collateral. The borrower of the securities pays a commission that is split between the CH and the securities lender. The availability of the needed securities cannot be guaranteed. First, the lending is optional. Second, the parties, having opted to participate in the ASLF scheme, might not have the needed securities in portfolio. 6 Securities Lending and Related Standing Facilities 3.3. Special Securities Lending Facility An SLF offers two ancillary advantages to DMOs. First, Provided by a DMO to its PDs an SLF can be used as a tool to motivate PDs to perform. The objective of a special securities lending facility This is achieved by offering the SLF on more attractive (SSLF) is to help PDs comply with their market-making terms13 to the PDs contributing best to price transparency obligation.10 DMOs have a vested interested in ensuring (= quotation obligation) or to market liquidity (= largest that PDs support the liquidity of the secondary market. turnover on the secondary market). Second, the SLF provides DMOs with an additional (although typically An SSLF has four specific features: small) source of funding at an attractive rate. 1. PDs’ privilege: The facility is offered to PDs only. 3.4. Ways for a DMO to Ensure the 2. Guaranteed availability at all times of the needed Availability of Securities for Lending securities:11 This applies as a DMO can temporarily A DMO can ensure the availability of the needed securities create securities when necessary (see section 3.4.2). either by auctioning a supply of securities in excess of its 3. Flexible terms: A DMO can reserve the right to adjust funding needs, by temporarily creating the securities that a amount, tenor, and commission as a function of market PD wants to borrow, or by using the securities portfolio of conditions. a third party, usually the central bank. 4. One constraint: PDs should use the SSLF only as a last 3.4.1. In the framework of its regular auctions, a resort.12 PDs should first try to borrow the securities in DMO can routinely issue an amount of securities the market and the market mechanism given a chance to that is somewhat larger than the amount needed work. If not, the SSLF would impair the development of to meet its financing requirements. The surplus of the repo market. An SSLF should therefore be extended securities is credited to its securities account with at a penalty rate versus the OTC market. The SSLF the Central Securities Depositary. rate is not meant to become the prevailing repo rate As an illustration, the practice of auctioning securities for in the market. In addition, the SSLF is not meant to an amount larger than that of the DMO’s actual funding fuel disorderly market speculation by allowing funding needs is followed by the German DMO. The Finanzagentur of excessively large short positions. The demand for generally issues securities for an amount equal to about 120 borrowings can be reduced by making the facility more percent of its funding needs. The objective, however, is expensive. However, a widespread practice is to also set only to have a means to regulate the yields in the secondary limits on the amount of the securities that can be lent. market by selling the securities on tap in between two These two points are analyzed in more detail in section auctions.14 5.3. The advantage of this option is that it is administratively simple for the DMO. Its drawback is to overstate the DMO’s funding needs. This can weigh on the market. 10 Another incentive that can support market making is for the DMO to offer PDs the right to submit at the auction some noncompetitive bids at the weighted average auction price. This guarantees that market makers will have in their portfolios at least some supply of the securities for which they are committed to quote. This incentive is costless to the DMO. 1 As a result, a SSLF can be particularly beneficial in countries (e.g., Costa Rica) where repo collateral cannot be “rehypothecated,” i.e., disposed of by the securities buyer, thereby preventing repos from enhancing the liquidity of the secondary market. The rationale for the prohibition of “rehypothecation” is the risk of the buyer being unable to return the borrowed securities because of the illiquidity of the market. This risk disappears with a SSLF. 12 n most countries, the SLF is used very little in normal market conditions. In Turkey, the SLF has not been used since 2002. Portugal mentions a very small number of securities borrowing transactions in its 2009 debt management report (only 21 transactions in 2009 and 39 transactions in 2008, mostly T-bills). 13 For example, larger amounts or higher interest rates on the funds placed with the DMO. Mexico extends the SLF on more attractive terms to its best performing PDs. When putting an SLF in place, it may be efficient, however, to keep the SLF simple at the start and to use the SLF as a motivation tool for PDs only later. 14 The banks active in the German government securities market—Germany has no PDs—are not supportive of this procedure. The corresponding unscheduled supplies of securities to the market create an additional element of uncertainty when trying to forecast the level of yields in the secondary market. 3. Securities Lending Facility 7 3.4.2. The prevailing practice in mature markets 3.4.3. In some emerging markets, the DMO borrows is for DMOs to temporarily create the securities securities belonging to a third party, usually the that are needed by the SSLF. The procedure is Central Bank, to supply the SLF. This applies in identical to that followed in the framework of any Brazil and Mexico (see section 3.7). other securities issuance by the DMO (auction, tap, Alternatively, a DMO can arrange that an SLF be provided syndication, etc.), although it often proceeds much to PDs by another entity. In Denmark, two lending more rapidly. It is implemented in two steps. facilities are offered to PDs. The facility used depends on 1. Creation of securities: The DMO instructs the Central the security that the PD wants to borrow. For a bond series Securities Depositary, usually via the Central Bank or of which the Social Pension Fund (SPF)15 owns a sufficient settlement agent, to post the securities to the credit of its amount, the SPF’s lending facility is used. For bond securities account. securities outside the SPF’s facility, the central government 2. Cancellation of the securities lent when the securities has its own SLF. loan is repaid: The applicable procedure is identical to that implemented when a government security is being 3.5. Comparison between CH and DMO- repaid at maturity. Provided Lending Facilities An ASLF is complex to implement. It requires putting in Therefore, from an operational standpoint, a securities place an agreement between the CH, lenders, and borrowers. lending facility granted by a DMO to its PDs is actually a It also requires software to select lenders and borrowers when combination of two existing standard procedures. Securities the supply and demand of securities do not match. are created after every auction, and they are cancelled when they mature. The only specific condition of an SLF is that An ASLF also has two limitations: The needed securities (a) the creation of securities is not linked to an auction, may not be available, and borrowings can only be made (b) the cancellation of securities is not linked to their final overnight.16 maturity, and (c) the created securities are credited to a specific securities account of the government (different from An SSLF is simpler to put in place than an ASLF. It the standard issuer’s account; see section 4). Nonetheless, in involves fewer parties, and there is no need to create a pool some countries, creating and cancelling securities without of lendable securities. a link to an auction date and a final maturity, respectively, An SSLF is more labor intensive to operate than an ASLF. requires a modification to the relevant software. It is not automatic, and its terms may be negotiable. In The advantages and drawbacks of a temporary creation of general, however, the manpower needed by the Ministry securities are the mirror image of section 3.4.1. The net of Finance (MoF) to operate a SSLF is quite limited. In debt of the government does not increase as a result of the the Front Office, only one person (with a backup) should temporary creation of new securities. The latter are a new be available during about two hours every day to receive liability of the government. However, they are also an asset and process the PDs’ securities borrowing requests. The that can be sold or loaned. The government thus effectively number of securities lending transactions is generally quite holds a claim against itself. On a net basis, the two items then small,17 because the SLF is meant to be used by PDs as a cancel out one another. As for the cash leg of the repo, it is a last resort instrument. The assignment of one person to borrowing made by the DMO, and it should be accounted manage the SLF would provide an opportunity to initiate as such. However, the corresponding cash inflow decreases him or her into dealing in the market. This would be a the funding requirements of the government. Thus, it useful training, because the DMO is likely to be actively normally replaces a borrowing that would have been done if involved in the domestic money market to manage the the securities lending had not taken place (unless there is an government’s daily liquidity position. offsetting reverse repo as in some countries). The operation is then net neutral on the balance sheet of the government. 15 The SPF is a government fund, and the day-to-day management of the assets in the fund is undertaken by the government’s debt management unit. 16 The lender of the securities might need them on the next day. 17 The experience across many countries is five or six trades at most on a busy day. However, the number of trades can be higher (e.g., Hungary reports a daily average of 10 to 15 trades in 2014–2015). 8 Securities Lending and Related Standing Facilities From a legal standpoint, both the auctioning of an borrowers (PDs and non-PDs) who may have different additional amount of securities and the temporary creation objectives (to create or to cover a short position and to of an SLF by the DMO should be authorized by following avoid a delivery failure) and to whom different conditions the same procedure as for any other form of securities could apply. The DMO may itself wish for different issuance by the government, that is, generally by a law or conditions to apply within the PDs’ group depending by decree. on the quality of each PD’s performance. In addition, an automatic SLF normally steps in only at the end of the day 3.6. Hybrid SLF System to cover delivery failures. A market maker PD may wish to Conceptually,18 a DMO could support an ASLF provided finalize a borrowing of securities during the day. by a CH instead of itself providing an SSLF to its PDs. Second, the DMO has less flexibility in tailor-making the The DMO could supply the securities unavailable in the terms and conditions of the securities lending as a function lending pool19 to the ASLF, with the understanding that of the PD borrowing them (i.e., in using the SLF as a tool the DMO would step in only to meet borrowing requests for rewarding a PD for the quality of its performance). The submitted by PDs20 as opposed to requests submitted by DMO is not in direct contact with the relevant PD. other CH members. Third, CHs tend to prefer lending securities with straight The eligible borrowers would be determined by the CH. loans collateralized by securities rather than on a repo basis. However, the ASLF system should offer the possibility of They do not need the cash generated by a repo, and CH the PDs benefiting from special terms and conditions set members can easily offer securities as collateral. By contrast, by the DMO at its discretion. DMOs prefer using repos because they wish to support the This option has two advantages: It is administratively repo market and they have the use of the generated cash. simpler for the DMO because it steps in only when the CH needs support. It also reinforces the automatic SLF 3.7. Summary Survey of SLF Procedures system of the CH. Implemented in Select and Developing However, this option has three drawbacks. First, the ASLF Mature Markets Tables 3.1 and Appendix 6 outline the SLF regime in becomes administratively more complex for the CH to selected mature and developing markets. manage. The CH is dealing with two kinds of securities Table 3.1. Select Countries with DMO-Provided SLFs: Mature Markets Australia Belgium Denmark Iceland The United Netherlands Kingdom Agent RBA — — — — PDs only? No Yes Yes Yes Yes Yes Instrument CMRR Cash-matched CMRR Collateralized Repo or CMRR repo securities loan CMRR at PD’s option Securities Any GS Any GS On the run Any T-bill and T-bond only Any non-rump subject to benchmark T-bond GS some RTLM securities requirement 18 To the best of the authors’ knowledge, such a hybrid system has been put in place only in Hungary (see appendix 5). The possibility is being analyzed in Brazil. The objective is to encourage the members of the securities settlement system to contribute to the pool of securities available for lending by giving them the assurance that the loan will be repaid at maturity, without a delivery failure. 19 The DMO would then need to open a securities account in the CH to that effect. 20 The eligibility for using a securities lending facility extended by a DMO is typically considered to be a PD’s privilege.. 3. Securities Lending Facility 9 Security RBA portfolio TC Portfolio CB TC TC TC + CB source + TC and State pension fund + TC Maximum $5 billion €500 mm Bonds: DKr 4 global amount per PD and billion per maturity for all PDs combined Bills: DKr 10 At DMO’s €10 billion No maximum billion discretion, per maturity but can be but typically limited at ISK1-2 billion DMO’s for each discretion benchmark bond per PD Maximum Overnight Overnight maturity with RO RO max 20 1 to 5 28 days Up to next Overnight, working days auction; maximum two maximum one weeks rollover month Collateral DMO margin Maximum DMO margin Lending rate is Maximum 300 bp below remuneration 300 bp GCRR: 25 bp 20 bp bonds; Central Bank GCRR: 25 bp Bank of 15 bp bills policy rate + England’s bank 20 bp rate on the reverse repo subject to a floor of 10 bp per annum Haircut 2% × 2 0 2.5% × 2 Between 2% 0 5% and 7% as a function of residual maturity of securities Note: CB = Central Bank; CMRR = cash-matched repo and reverse repo; GCRR = general collateral repo rate for same maturity; GS = government security; RLTM = remaining life to maturity; RO = rollover; TC = temporary creation of security. 10 Securities Lending and Related Standing Facilities Table 3.2. Select Countries with DMO-Provided SLFs: Developing Markets Brazil Hungary Malaysia Mexico South Africa Turkey Agent CB — — CB CB CB PDs only? No No No Yes Yes Yes Instrument Cash-matched Cash-matched Cash-matched Collateralized Cash-matched Collateralized repo repo repo loan repo loan Securities Government Benchmark All GS subject Government Government Benchmark GS bonds GS subject to to minimum bonds bonds RLTM request amount outstanding requests Security CB portfolio DMO CB portfolio DMO TC Bank lenders source portfolio portfolio + TC Maximum Amount Ft 79 billion As per CB 4% per issue No limit Per PD: global amount offered by CB for 2011 holdings and 2% of sum 5% of total in 6 month (adjusted of all issues; benchmark repo annually) limit applies issuance * PD’s both per PD market share and for all PDs in primary combined market Maximum 6 months Maturity is 1 month Overnight; RO Overnight 1 week, 2 maturity always one allowed up to 2 weeks, 1 week days before the month, 3 bond maturity months Collateral 6 month HUFONIA Determined Premium = 0% Fee determined remuneration repo rate as minus 25 bp by DMO WGRF × by CB determined factor by the weekly auction Haircut Determined Function Negotiated by 102% of 120% of the 300 bp below by CB of security the two parties loaned security net amount of Bank of RLTM + premium to transaction England’s bank CH rate on the reverse repo subject to a floor of 10 bp per annum Note: CB = Central Bank; CH = Clearing House; CMRR = cash-matched repo and reverse repo; GCRR = general collateral repo rate for same maturity; GS = government security; RLTM = remaining life to maturity; RO = roll over; TC = temporary creation of security; WRGF = weighted rate on government funding In mature markets, the prevailing procedure seems to be so much below market that PDs would be deterred from to ensure the availability of the securities by temporarily quoting prices with tight spreads because of the increased creating them and to lend the securities by doing cash- cost of trading if they have to use the SLF. matched and reverse repos. The objective is to avoid any impact of the SLF on the management of the DMO’s daily In developing markets, most DMOs seem to supply the liquidity position. The prevailing interest rate at which the SLF with already existing securities. The range of prevailing collateral provided by PDs is remunerated is below market practices is wider with regard to the remuneration of the to ensure that the SLF is used only as a last resort but not collateral. See Appendix 6 for detailed country practices and SLF 4. Accounting Principles 11 4. Accounting Principles The following principles are generally applied: 1. The securities that have been temporarily created for on-lending are booked in a special account, distinct from the issuance account that is used when securities are created in the framework of an auction. 2. The securities booked in this special account are merged with the issuance account to report the amount of the debt in official documents. Temporarily created securities (TCSs) increase the gross amount of the public debt, the same as any other government security.21 However, the net debt is not affected as long as the TCSs are held in portfolio by the DMO. In this case, the government debt owes (and services, as the case may be) the debt to itself. 3. When the DMO sells TCS on a repo basis against a cash collateral, the repo creates a new debt: the DMO has borrowed cash. The amount of net debt increases by the amount equal to the proceeds from the sale of the securities. The impact on the amount of debt of the sale of TCS is neutralized when the proceeds from the sale are used to repay another debt of the DMO. The increase in the debt is then offset by a matching decrease in the liability side of the balance sheet. In mature markets, the decreased liability is typically reduced overnight borrowing, or when there is an offsetting reverse repo, increased overnight lending. In an emerging market, it could be a lower overdraft (if allowed) in the DMO’s account with the Central Bank. The impact of the repo on the amount of gross debt is not neutralized if the DMO reinvests the proceeds of the sale in a reverse repo or an interest-earning deposit. The impact on net debt depends on the definition of net, which can be country specific. 4 This is the reason why the U.K. DMO has provided in the terms and conditions of its overnight standing repo facility that no gilt created under this facility shall be eligible for inclusion in the calculation of FTSE or iBoxx gilt indices. 12 Securities Lending and Related Standing Facilities An illustration of the corresponding accounting entries Table 4.1. Advantages and Drawbacks of done by the Belgian DMO is included in appendix 4. The Cash and Securities Collateral status is different when the DMO sells TCSs on a repo basis against securities collateral. In this case, the repo trade Cash Securities done by the DMO (= sale and buy back: step 1) is matched Advantages Simple Cash neutral by a reverse repo (= buy and sell back) done by the DMO • Fewer risks of with the PD for the same amount of cash (step 2). In other mistakes words, DMO reinvests with the PD the cash borrowed by • Faster (later the DMO from the PD in step 1. deadline for PDs to Figure 4.1 assumes that the PD borrows a certain security submit borrowing (“S1”) from the DMO and offers the DMO another requests) security (“S2”) as collateral. In both cases, the transacted Supports the repo amount of cash is 100. market • A PD may have to Figure 4.1. Example of PD Borrowing and do a repo in the market to secure Use of Collateral the cash owed to the DMO DMO PD Drawbacks Affects the cash More complex position of the to processa DMO (it creates a S1 S1 Spot: S curit 1 reinvestment need) C sh 100 100 Note: DMO = debt management office; PD = primary dealer. S curit 2 S2 S2 a. Repos with securities collateral have the advantage of being cash C sh neutral. PDs do not have to borrow cash in the market, and PDs do 100 100 not have to reinvest the cash if they cannot use it. However, (1) a securities collateral doubles the number of transactions (including Note: In a forward, the above two transactions are reversed the collateral revaluations), (2) in practice, PDs can generally use the cash since they are structural borrowers, and (3) even when a PD has to reinvest the cash, it can do so with one (or a few) global If S2 is another security issued by DMO, then a case could trades instead having to doubling the number of transaction(s), each repo requiring a reverse repo. be made for arguing that the net debt of the DMO is not increased in this case: (1) the collateral held by the DMO is a claim against itself; (2) on a net basis, the DMO has not borrowed any cash. In fact, the cash transfers are only a way to link the collateral (S2) to the trade being collateralized (S1). Again, however, the impact on net debt depends on the definition of net, which can be country specific. Conclusion: The above analysis suggests that cash and securities collateral each have their respective advantages and drawbacks (see table 4.1). 5. Putting a Securities Lending Facility in Place 13 5. Putting a Securities Lending Facility in Place 5.1. Background Putting a securities lending facility (SLF) in place is a technical initiative that raises only minimal risks for the government. Securities are lent for small amounts22 and with a short maturity. The procedure and the terms of the transactions (amount, maturities, cost, etc.) can be adapted by the DMO, at any time and at its full discretion, to adapt them to the experience gained from practice. The fact that the counterparts of the DMO are PDs only further limits the risks. PDs are well known to the DMO. If the relationship has been well managed by the DMO, PDs should be eager to please to retain their status. Risks exist nonetheless, for example, credit risk (collateral depreciation), legal risk (recharacterization of the transaction), execution risk (misunderstanding about some provision of the repo agreement), or operational risk (nondelivery of the collateral because of the absence of, or a failure in, the DVP system). A robust contractual arrangement (global master repurchase agreement [GMRA]) and a careful collateral management policy are required to minimize these risks. The MoF might wish to keep the procedure as simple and straightforward as possible at the beginning. This makes it easier to get started. The procedure can be refined later on with the experience gained from practice. Possible simplifications in the standard procedure are listed in section 5.4. 5.2. Prerequisites for an SLF to Be Put in Place Three prerequisites should be checked at the outset before an SLF can be put in place. 1. Is the DMO legally empowered to issue securities for on-lending to its PDs? Public debt laws often empower the MoF to issue securities only to meet the financing needs of the government. 2. Can securities be temporarily created? This is not the only way to supply an SLF with the needed securities (see section 3.4). Yet it is worth checking because it seems to be the most efficient way. This is a technical issue, but a procedure for it needs be put in place. 22 The SLF is linked to the PDs’ quoting obligation. PDs need to be protected only against the risk of being unable to cover the short positions incurred in the framework of their market-making activity. The amount of securities that PDs need to be given the ability to borrow should therefore be a small multiple of the minimum amount that they are committed to quote. A maximum multiple of six for each PD would protect PDs against up to two uncovered quotations for three different maturities each. In normal circumstances, PDs’ short positions seem unlikely to exceed these amounts. 14 Securities Lending and Related Standing Facilities 3. Is a repo agreement available to operate the SLF? The • For what maturity? The procedure that seems to be agreement can be a master agreement or an agreement applied most often is to allow only overnight borrowings signed bilaterally. that can be renewed only a certain number of time (e.g., seven working days). 5.3. Decisions to Be Made by the DMO The following decisions need to be made by the DMO: 5.4. Possible Simplifications of the Standard Procedure 1. Kind of SLF: SSLF or hybrid system23 Possible simplifications in the procedure when it is first 2. SLF manager: DMO or agent 24 established are the following: (1) lendable securities: benchmark bonds only (this increases the attractiveness of 3. SLF instrument: Securities lending, repo, repo, and benchmark securities); (2) loan maturity: overnight only reverse repo (or alternatively, sell buy back, sell buy back, (with a maximum of four rollovers to make it a one-week and buy sell back)25 financing); (3) value date: T+1; (4) initial margin: 2%; (5) 4. Collateral: Type? Cash (= repo) or security (= repo collateral: cash only. and reverse repo)? Remuneration? If the collateral is remunerated, what are the reference interest rate and the 5.5. Draft SLF Procedure Manual size of the DMO margin?26 It is recommended that the DMO consults with its PDs about the SLF procedures that it plans to implement by 5. Valuation: Size of the initial margin or haircut. submitting a draft procedure manual for their review and Remargining during the life of the repo is seldom applied comments. The DMO might wish to inform the PDs that (1) in view of the short maturity of the transaction. the draft is submitted to them with a view to obtaining their 6. Securities: input before putting in place a SLF, (2) in submitting their comments and suggestions, PDs should keep in mind that the • Which securities can be borrowed? Government bonds, MoF wishes to keep the SLF procedure as simple as possible, also government bills, all aforementioned securities and (3) the objective pursued at this stage is only to design the or benchmarks only, also Central Bank bills? Possible provisions needed to put an SLF in place. The procedure can exclusions: securities with a short remaining life to be perfected later with the benefit of experience. maturity27 and securities paying a coupon over the life of the transaction.28 A draft SLF procedure manual is appended as an illustration of the way that an SLF can be operated (appendix 5). • What amount of securities can be lent? Different ceilings This draft incorporates the simplifications suggested in can apply. For example, a limit per PD, per security section 5.4. PDs should confirm the agreement with the series and globally, and/or a limit for all PDs together provisions of the manual. Alternatively, the document can per security series and globally.30 be structured as a bilateral agreement. 23 See section 3.6. 24 If an agent is used, a memorandum of understanding should be in place. 25 A straight loan collateralized by a pledge of securities has not been included in the list. This procedure is frequently used for an ASLF (see section 3.2). A CH is unlikely to have the use of the cash generated by a repo. However, a straight loan might not be the best procedure for an SSLF. DMOs want to encourage the use of repos, and they can use the generated cash. 26 DMOs always remunerate the collateral funds received from the borrowing PD at a spread below market. The objective is to ensure that the SLF is used by PDs only as a last-resort measure. The spread also remunerates the DMO for the administrative work performed. In the euro zone, the spread below the market rate for overnight borrowings (EONIA) ranges from 0.25 percent up to EONIA itself (this applies in exceptional cases only, because the funds are then effectively placed by the relevant PD at 0 percent). 27 Securities tend to be increasingly less liquid as their maturity is getting nearer. In any case, the security cannot have a maturity shorter than that of the repo. 28 The payment of the coupon decreases the value of the collateral. 29 Market practices vary considerably. They are country specific, and there is no standard solution. The policies followed by DMOs seem to be a function of their degree of concern regarding short positions and the risk of market speculation. Some DMOs consider that their ability to increase the cost of borrowing the securities in case of need is enough of a deterrent, a formal limit on the authorized amount of the loan being therefore not required (e.g., Iceland, South Africa, and the United Kingdom). A majority of DMOs find it safer to limit the amounts that can be borrowed. Some DMOs have very large limits (e.g., the Netherlands, or to a lesser extent Belgium). Other DMOs prefer to begin with a simple SLF system imposing small limits (e.g., Morocco), with a view to refining it thereafter with the benefit of experience. 30 An SLF offered by a DMO is meant to avoid a situation where a market maker is put under pressure to cover a short position at any cost when under a timing constraint. The SLF is not meant to enable a PD to carry a short position indefinitely. The horizon is thus definitely short term. 6. Conclusion 15 6. Conclusion It should be possible for an SLF to be put in place within a short time frame (tentatively estimated to be between three and six months) provided the required prerequisites are met (section 5.2), and that the SLF of the MoF is developed independently from the development of an ASLF in the CH. The time frame could be shorter depending on legislation and on the time required for the recommended market consultation before putting the SLF in place. The launch of the SLF is an initiative of a technical nature, which raises only minimal risks for the government. Appendix 1. Clearing House Automatic Securities Lending Facility Illustration: Belgium 17 Appendix 1. Clearing House Automatic Securities Lending Facility Illustration: Belgium31 The objective of this appendix is to illustrate of how an automatic SLF can work in practice. The following summarizes the main provisions of the agreements signed between the Belgian Clearing House (CH) and the clearing members interested in either borrowing or lending fixed income securities settled in the CH. 1. Automatic lending 1.1. The lender commits to the CH to lend certain securities it holds in portfolio. It indicates which securities it is willing to lend. It guarantees it is the owner of the relevant securities or to have been duly authorized by their owner to lend them. It can limit to a certain percentage of its holding (minimum l0%) the amount of securities that can be lent. 1.2. The CH commits to the lender to lend the securities in the CH’s name but on account of the lender. At the end of each day, the CH determines the global amount that needs to be borrowed for every security to avoid delivery failures (“A”) and the global amount that is available for lending (“B”). If A < B, the CH uses a formula to determine which account(s) will be selected as lenders. For every lending account, the CH does the following calculation. The global amount that has been lent by the relevant account since the beginning of the year is calculated first. The global amount that has been available for lending in the relevant account every day that a borrowing need has arisen since the beginning of the year is calculated next. Both aforementioned amounts are expressed as a logarithm to the base 10. The ratio amount lent/amount available for lending is then calculated. The selected lending accounts are those of which the coefficient is lowest. If A > B, the CH allocates the securities between the borrowers. The borrowers who need the securities to pay back an outstanding loan of securities are served first. The remaining borrowers are served in the chronological order of the matching of the notifications that have created the borrowing need. 31 Source: Belgium National Bank Securities Department, sample lending agreement (Dec. 2008).. 18 Securities Lending and Related Standing Facilities 1.3. The securities lent must be repaid the next working 2.3. Securities borrowings can be renewed only for a day. The CH charges a commission of 2 percent p.a. maximum period of 10 consecutive business days. The commission is split 0.50 percent for the CH and At that point in time, the relevant securities can be 1.5 percent for the lender. The commission is paid on borrowed again only at the expiration of a period of a monthly basis by the borrower to the CH and by the five business days. CH to the lender. 2.4. If the borrowed securities are not repaid on the 1.4. If the securities are not repaid by the borrower, the due date, the borrower is charged a penalty of 1.50 loss (if any) is shared between all lending accounts. The percent p.a. over the marginal lending rate of the loss is allocated on the basis of the formula used for European Central Bank, calculated on the market value selecting the lending accounts when the global amount of the borrowed securities. The CH is authorized to that needs to be borrowed to avoid delivery failures immediately buy in the market the amount of securities is smaller than the global amount that is available needed to repay the outstanding securities borrowing. for lending (see section 1.2 of this appendix). The coefficient applicable to any given lending account is 3. Collateral divided by the sum of the coefficients applicable to all The borrower must pledge securities of an amount equal lending accounts. The corresponding ratio determines to 110 percent of the value of the borrowed securities the share of the loss that will be allocated to the account as collateral. The borrower can provide this collateral in concerned. advance. Alternatively, the CH can secure this collateral by 2. Automatic borrowing selecting at its discretion securities in the account of the 2.1. The borrower commits to borrow automatically borrower. The CH can then also allocate this collateral at from the CH the securities needed to avoid a delivery its discretion to any specific securities borrowing done by failure. He also commits to be a lender of securities as the relevant participant in the clearing. described in section 1 of this appendix. 4. Other Provisions 2.2. Securities are allocated between borrowers The CH publishes a list of the securities that can be following the provisions of section 1 of this appendix. borrowed. To be included in this list, securities must be Two ceilings apply. First, the global borrowing requests liquid and a trading price must be easily obtainable. for any given type of security cannot exceed 10 percent Securities are taken out of this list on five days before their of the amount outstanding of the relevant security. maturity date. Second, no individual borrowing request can exceed 5 percent of the amount outstanding of the relevant security. Appendix 2. SLF: Determining the Appropriate Amount and Rate 19 Appendix 2. SLF: Determining the Appropriate Amount and Rate The issue is to determine the amount and the rate that can be offered without (1) impairing the trading activity in the repo market by causing the rate of the repo facility to become the market rate and (2) encouraging market speculation by making it too easy to carry a short position. The answer is country specific. DMOs hold diverging views on this point. Some DMOs32 consider that a securities facility can be used for large amounts because it enhances market liquidity. Other DMOs33 consider that the amount of securities that can be borrowed should be limited—for two reasons. First, an SLF should be a last resort measure used only for small amounts. If not, it damages the interbank repo market, which should remain the main avenue for borrowing securities. Second, DMOs should beware of the risk of unwillingly supporting market speculation by providing PDs with an easy way to short the market. This risk can be addressed by lowering the repo rate. However, emergency measures are best avoided in the context of market speculation. Irrespective of country specifics, the conclusion should rest on a review of how the three main functions of the repo market could be affected by the implementation of the contemplated procedure. The three main functions of the repo market are the following: 1. To enable market makers (MMs) to carry their position (long or short) until they can match it. This is the primary function of the repo market. An efficient repo market is a prerequisite for a liquid securities market. A MM who systematically covers his or her position with a mirror trade provides no liquidity to the market. He or she is effectively a market taker. To fulfill this function, the repo market must not be subject to squeezes.34 The MMs then stop quoting unless they hold the squeezed securities in portfolio. 32 For example, Denmark, Sweden, and the Netherlands. As an illustration, the total amount of the securities that PDs can borrow from the Dutch DMO for any given maturity is “benchmark size” (currently €10 billion) minus the actual amount issued. In this way, benchmark securities have from their first issuance onward the same liquidity as they will have on the day that they are issued no longer. 33 For example, Belgium and France. 34 The impossibility to either borrow a security or do so against a reasonable price. 20 Securities Lending and Related Standing Facilities 2. To enable repo traders to make a profit by taking positions in the money market. To fulfill this function, the repo market has to show some level of volatility. No trading is done when nothing moves. A certain level of volatility in the repo market is also positive for the securities market: fluctuations in the repo rate have an impact on the securities price, triggering some additional trading as a result. This function of the repo market assumes the existence of a market for repo term maturities. For repo traders, the overnight repo market can be a trading market only to the extent that the overnight trade is one leg of a deal of which the other leg has a longer maturity. For securities dealers, the overnight repo market can likewise be a trading market only if their (undesirable) objective is to artificially engineer a squeeze (thereby causing the securities market to become illiquid). 3. To enable any market participant to avoid a delivery failure. Appendix 3. SLF: Accounting. Illustration: Belgium 21 Appendix 3. SLF Accounting. Illustration: Belgium35 Assumptions: Creation of bond • Nominal value: 100 • Market value: 99.5 • Bond loaned in the framework of a repo • Repo interest rate paid by DMO: 0.02 Accounting steps Assets Liabilities Gross Net Debt Debt 1. Creation of bond DR Securities created 100 CR debt +100 0 for on lending (1) >1 year: Note: If the created securities are 100 outstanding on a reporting date, the reported debt stock (gross debt) will increase by 100 2. Lending by DMO of created bond DR 99.5 CR repo +99.5 +99.5 cash debt: 99.5 Notes: 1. Created securities booked on the asset side in step 1 remain in the books in step 2. The “seller” of the bond remains its beneficial owner (2) 2. If the cash (99.5) is used to repay another outstanding debt, then the DR/CR of 99.5 net out; the accounting status remains the same as in step 1 3. If the cash (99.5) stays in the account of the DMO, then gross debt rises to 199.5 (the DMO now finances two assets: the bond and the cash) and net debt rises to 99.5 35 Source: Belgian Debt Agency accounting department 22 Securities Lending and Related Standing Facilities 3. Purchase back by DMO of loaned bond 99.52 DR repo (99.52) (99.52) CR cash debt: 99.5 DR interest paid: 0.02 4. Cancellation of bond CR securities 100 DR debt (100) 0 created for on lending > 1year: 100 Note: In this example, net, at the end, the only item that remains in the books is the interest paid by the DMO (0.02). Normally, however, the DMO books a profit. The repo has allowed it to either repay another debt (profit on the cost saving) or to invest the proceeds with a positive margin. 1. This is a different account from the “issuance account” debited in the case of an auction of securities. However, this is only to simplify internal accounting. In official reports, the debt has increased by 100. 2. It is meant thereby that it keeps entitled cashing in the interest earned on the bond as though it has not sold it. Note: CR = ??; DMO = debt management office; DR = ??. Appendix 4. Draft SLF Procedure Manual 23 Appendix 4. Draft SLF Procedure Manual36 Foreword 1. The purpose of the securities lending facility (SLF) is to support the market-making activity of the primary dealers (PDs) by enabling them to borrow government securities when they are not readily available from other sources in the market. The SLF is available only to the PDs. 2. The purpose of this procedure manual (PM) is to determine the terms and conditions subject to which the SLF is made available to the PDs. These terms and conditions are accepted by a PD by virtue of concluding a securities lending transaction with the Ministry of Finance (MoF). 3. The MoF reserves the right to amend the provisions of the PM in light of changes in regulations, market conditions, and/or market practices. Such amendments are published on the website of the MoF. The publication indicates the date from which an amendment is effective. Securities Lending Instrument 5. The SLF is operated through a Repurchase Agreement (“repo”) whereby the MoF sells the loaned securities to a PD and agrees to buy the loaned securities back at a certain future date. 6. The repurchase agreements concluded by the MoF with PDs are governed by the provisions of … (specify which repo agreement). Authorized Securities and Minimum and Maximum Nominal Values 7. The SLF applies to the government securities designated by the MoF after consulting with the PDs. 36 See section 5.5. 24 Securities Lending and Related Standing Facilities 8. The minimum amount of a securities lending transaction 15. The loaned securities are bought back by the MoF is a nominal value of _____. against payment to the PD of the cash amount initially received by the MoF plus accrued interest at the rate 9. The maximum amount of securities which a PD can agreed by the DMO with the PD when concluding the borrow from the MoF is a nominal value of _____ per transaction. bond series and _____ globally. 10. The maximum aggregate amount of the securities loans Timing of Borrowing Requests and Contact to PDs which the MoF is willing to have outstanding at any Persons point in time is a nominal value of _____ per security ISIN 16. PDs can submit borrowing requests to the MoF Code and a nominal value of _____ for all government between ____ PM and ____PM.38 Borrowing requests are securities together. communicated by telephone and immediately confirmed by e-mail. 11. When the total amount of the PDs’ borrowing requests exceeds the limits mentioned in article 10, securities are Sanctions allocated to PDs on a first come, first served basis.37 17. If a PD does not deliver the borrowed securities back 12. The MoF reserves the right to adjust the amount of the to the MoF on the maturity date of the transaction, the aforementioned limits without prior notice as a function MoF is entitled to charge a penalty interest on the value of market conditions and to reject an application by a PD of the loaned securities as determined in article 14 until to borrow or to roll over a borrowing when it deems the the securities are returned by the relevant PD. The penalty PD not to have taken adequate steps to cover its position interest rate is _____until further notice. in the market. If three days have passed and the PD has not yet delivered the loaned securities, the MoF may purchase the securities Value Date and Maturity in the market and charge the PD for all costs incurred. 13. Securities are loaned by the MoF with value down to T+0 and for one business day. A PD can roll over a 18. PDs who are not complying with the provisions of securities borrowing transaction for a maximum of five this PM may be excluded by the MoF from its eligible consecutive business days. counterparts under the SLF, without prior notice, and their PD license could be suspended or revoked. Collateral and Forward Price 14. The cash amount paid to the MoF by a PD when purchasing the loaned security (“the collateral”) includes a premium of _____ % over the asked price of the relevant security at the time the securities loan is concluded. 37 Note: Another possibility is to allocate the available amount pro rata between PDs in case the global amount requested exceeds the limit. This is a less flexible procedure, however. The allocation can then be made only when all PDs have submitted their borrowing requests, i.e., at the cutoff time. 38 The period deadline is to be determined as a function of the deadline set by the CH to be forwarded the transaction details for a settlement in T+0. Some time must also be allocated for the MoF to process the securities borrowing transactions. Appendix 5. Overview of International Emerging Markets SLF Experiences 25 Appendix 5. Overview of International Emerging Markets SLF Experiences39 1. Brazil General remarks: The Central Bank of Brazil is the operator and lender of securities under the Brazilian SLF. Its main objectives are to help PDs comply with trading obligations by enabling them to temporarily cover the short positions incurred in the framework of their MM activity, especially of on-the-run securities, and to increase the general liquidity of the market by enabling market participants to take short positions. This is a non-PD exclusive system that can also be accessed by banks, mutual funds, and brokerage firms. The securities lending transactions are structured as cash-matched repos. Loaned securities: The securities lent are held in the bond portfolios of the Central Bank. The securities borrowed can be fixed rate bonds (LTN and NTN-F), floating rate bonds (LFT), and inflation-linked bonds (NTN-B). According to the Brazilian authorities, the securities lent increase the gross public debt (local convention). Lending limits: The total amount lent per security and for all securities and for all PDs has to be lower than the total amount offered in the six-month repo market. Drawdown procedure: Requests to borrow securities can be submitted on Fridays between 12 and 12.30 P.M. for a period of six months and value date T+1. Collateral and valuation: The cost of borrowing will be the six-month repo rate as determined by the weekly repo auction held every Friday. Sanctions: There have been no instances in which the securities have not been delivered at maturity. According to the Brazilian authorities, there was a work group, composed of the Brazilian Treasury (BT), the National Association of Financial Market Institutions (ANBIMA), and the BMF&BOVESPA (clearing house), to discuss the participation of the BT in the Security Lending Process of Public Bonds, to improve the number of the investors on this market. The idea was to guarantee that the borrowed bond would be returned to its owner at the end of the contract. 39 Based on the government authorities’ responses to a survey and on information provided by each government issuer in section. This section was drafted by Jose-Maria Fernandez, consultant. 26 Securities Lending and Related Standing Facilities It seems that certain participants, in particular pension Collateral and valuation: There is a haircut that depends funds, do not use the security lending process of public on the maturity of the securities. bonds because they are afraid that, if delivery fails, they may not have the exact same bond that they have lent. In Sanctions: They are regulated in the PD contract. the proposal under study, the BT would offer the bond, in Nonperforming PDs may be suspended from auctions and exchange for another public bond (more liquid), or would SLF for four weeks. Continued nonperformance results in issue it directly to the clearinghouse, which would deliver termination of the PD contract. the bond to the lender. Apparently this initiative was not successfully developed because of the lack of consensus 3. Malaysia among the parties involved regarding the diagnosis of the General remarks: The primary purpose of the SLF is to root of the problem. enhance the liquidity in the secondary bond market by providing a new mechanism to support trading strategies 2. Hungary for dealers and to enhance the return on bond portfolio General remarks: The primary purpose of the SLF is investment for investors. to decrease settlement risk in the government securities The SLF is linked to the Institutional Securities Custodian market and to support secondary market price quotation. Programme of the Central Bank, as part of which the Bank This SLF is non-PD exclusive. The securities lender and borrows securities from major institutional investors (who the operator is the public debt management office, but typically hold them to maturity) and uses them as collateral KELER (the Central Clearing House) lends the securities in its repo operations. to dealers, including the securities it borrows from the DMO. The SLF is open to PD and other market participants that are eligible to participate in Bank Negara Malaysia’s All transactions are structured as one-week repo transactions. repo transactions. The lender of securities is the Central One-day tenor is not supported by AKK out of concern Bank, which operates the system using repo transactions that it could result in a large number of transactions. The documented under a Global Master Repurchase Agreement current average daily number of transactions is 10 to 15. with a local annex. Despite the penalizing rate (HUFONIA, 25 bp), AKK’s stand-by repo facility is the major source of short covering Loaned securities: Participants can borrow scripless for local players. The collateral used is cash (Hungarian securities deposited under RENTAS (clearing and forints), and the legal documentation is the European settlement system) with a minimum outstanding amount Master Agreement of the European Banking Federation. of RM 1 billion, and the collateral accepted is scripless securities deposited also under RENTAS. The source of the Loaned securities: Discount T-bills with benchmark securities lent are holdings from Bank Negara Malaysia’s status and publicly issued government bonds with at least and institutional investors’ portfolios. 90 days’ remaining term to maturity. The source of the securities is a DMO account where extra securities eligible Lending limits: Under this SLF, the available securities for for repo are issued regularly. According to the Hungarian lending are restricted by the amount of securities available authorities, the loaned securities increase both the gross in the portfolios indicated above and there is no temporary and net amount of debt outstanding. creation of securities supplied by the DMO. Lending limits per PD: There is a daily transaction limit Drawdown procedure: The parties agree the value date of of Ft 3 billion for benchmark series, of Ft 1.5 billion for the repo, whose term has to be for less than one year. Every other series, and a total outstanding limit of Ft 10 billion day the borrowers of securities submit their requests before for all securities. 2:30 P.M. Drawdown procedure: The repo term is one week, and Collateral and valuation: Borrowers will have to pay the value date can be T, T+1, or T+2 by choice of the a margin to do the transaction that is determined at an counterparty. The borrowing requests can be submitted auction. A haircut is applied to the collateral provided; it daily between 9 A.M. to 12 P.M. and 1 to 3 P.M. (except depends on the remaining time to maturity of the security Fridays only until 2 P.M.). used. Any day before the end of the repo, if there are changes to the value of the collateral provided, lender or borrower, Appendix 5. Overview of International Emerging Markets SLF Experiences 27 depending on the direction of the change in price, has a authorities report that the loaned securities do not increase right to call for an adjustment to the collateral posted. the gross or net amount of public debt. Sanctions: None specified. Lending limits: There are some limits to the total amounts that can be borrowed: 4. Mexico • 4 percent of outstanding per issue per PD and globally General remarks: The primary goal of the SLF is to for all PDs encourage PDs’ involvement in the development of the domestic government debt market. These transactions • 2 percent of total Cetes, Bonos M, or Udibonos per PD facilitate the structuring of short positions, creating a and globally for all PDs greater dynamism in the domestic government debt market and thus improving the liquidity of government Drawdown procedure: Securities are lent overnight with bonds. This particular window is only for PDs and is one same day value date and can be rolled over daily until two of the benefits of being a market maker. In fact, since the days before the maturity of the bond. Securities can be introduction of the PD program in 2001, the SLF was borrowed every business day between 9 A.M. and 4 P.M. contemplated as part of the MM program. The PD must pay a premium to Banxico for each lending In addition to this SLF, Indeval (the settlement and clearance transaction. This premium is calculated as follows: <> called “VALPRE-E” to its members to avoid delivery failure. • In the case of Cetes and Bonos M, the amount of the The ultimate securities lender is the federal government, premium is variable for each PD and each month and but the SLF operator is Banxico (Mexico’s Central Bank). is determined by multiplying the weighted rate on As the financial agent of the federal government, Banxico government funding published daily by Banxico by a is responsible for lending transactions carried out with factor. This factor is calculated by Banxico on a monthly market makers. basis and based on the repo and lending activity of each PD between the 16th day of each month and the 15th The PD has to ask Banxico for the securities, according day of the following one. Basically, the more active to the terms of the contract they each signed. Once a the PD, the lower the premium, and the more active participant is recognized as a market maker, it has to sign a its participation in longer-tenor repos, the lower the bilateral contract with Banxico, which stipulates the terms factor.40 This factor will be communicated to each PD and conditions for lending transactions, the rights and three working days before the end of each month and obligations of each party, and the procedure to create and will be applicable from the first day of the following cancel the corresponding collateral guarantees. This contract month.41 is valid for the period that the PD is a market maker. • For Udibonos, the premium is 7 percent of the weighted The securities lending transactions are structured as rate of government funding. <> collateralized straight loans. The collateral pool includes other securities that have the implicit guarantee of the Collateral and valuation: The PD must guarantee the federal government. loaned securities with Cetes, Bonos M, floating-rate bonds (Bondes D), Udibonos, Brems (bonds for monetary Loaned securities: They can be zero-coupon bonds (Cetes), regulation), or BPAs (bonds for saving protection). The nominal fixed-rate bonds (Bonos M), and inflation-linked value of the collateral must be equal to or or greater than bonds (Udibonos). The bonds on loan are securities held 102 percent of the loaned securities plus the premium by the federal government in a portfolio. These bonds have owed to Indeval. The securities lent will be valued daily already been issued but have not been placed through the according to the prices determined by Banxico. If the weekly auctions, green shoe, or other transactions. Mexican 40 See Annex 4 of the Mexican PD regulation for a detailed explanation of how this factor is calculated. 41 Newly appointed PDs will pay a 5 percent premium during their first two months of activity. 28 Securities Lending and Related Standing Facilities value of the collateral drops below the required margin, Collateral and valuation: Cash is remunerated at 0 Indeval will request the difference, thereby to maintain the percent, and there is no initial margin. 102 percent of the loaned securities (plus the premium to Indeval). If the securities are not transferred, Indeval may If the bonds requested are inflation-linked bonds (ILBs), not renew the loan. the ILBs held by the counterparty are marked-to-market daily using the Bond Exchange of South Africa closing Sanctions: Lending transactions are renewed every day, rates. The SARB will call for margin if the market value of which reduces the risk of nondelivery at maturity. In the ILBs exceeds the cash plus total interest for the period addition, each market maker has a guarantee fund in of the transaction (repurchase price) by an amount equal to Banxico that is affected if it does not fulfill the delivery or greater than R 1 million. terms. At maturity, Banxico is authorized to transfer from the guarantee fund to Indeval’s account the amount of If the repurchase price exceeds the total market value of the the loan. In addition to this, Banxico may suspend a PD’s ILBs purchased by participants by R 1 million, the SARB right to participate in the SLF if the PD holds a relative will, at the request of the counterparty, transfer the excess net long position in any Bono or Udibono greater or equal margin. to 40 percent over a period of one month. Banxico will Interest on cash margins will be calculated at the SAONIA inform a PD if it exceeds this limit, and its right to use rate on a daily basis and paid to the counterparty at the SLF will be suspended three days after it is notified. maturity of the reverse repurchase transaction. The same The suspension will be lifted the first business day of the principle will apply when the SARB is called for margin. following month after the PD has held a net long position less than 40 percent for two consecutive months in any 6. Turkey Bono or Udibono. General remarks: Turkey’s Central Bank has an SLF whose purpose is to help PDs comply with their quoting 5. South Africa obligation by enabling them to temporarily cover the short General remarks: The primary purpose is to manage or positions incurred in the framework of their MM activity. eliminate settlement risk. It is meant to be a tool of last Only PDs have the right to borrow and lend securities at resort for PDs. In principle, they are encouraged to go the Securities Lending Market. Non-PD banks can only to the market before approaching the National Treasury. lend securities, and other market participants can lend When all fails, then they may utilize the facility that applies securities via PD or non-PD banks. to all government bonds and is restricted to PDs that can use the SLF on behalf of other market participants. The lenders are PD and non-PD banks that satisfy the participation criteria, and the operator of the system is the The lender of securities is the National Treasury, and the Central Bank of Turkey. operator of the system is the Central Bank (South African Reserve Bank [SARB]). The transactions are structured as The transactions are structured as collateralized loans, repos where the National Treasury issues and lends a bond and the collateral comprises government securities. To and the PDs deposit cash as collateral. The transactions are participate in the system, the participants should sign a documented using the SARB repo Master Agreement and commitment letter. an Addendum. Loaned securities: The securities lent are benchmark Loaned securities: Fixed rate and inflation-linked bonds securities that PDs are obliged to quote in the secondary can be borrowed. These securities are temporarily created market in the context of their MM obligations. According when needed. According to the South African authorities, to the Turkish authorities the temporary creation of the gross amount of debt increases during the duration of securities is also allowed. the repo transaction (local convention). Lending limits: Each PD could borrow up to the amount Lending limits: There are no limits as to the amount of of 5 percent of the total issuance multiplied by the PD’s securities that can be created. share of primary market purchases. For each benchmark security and for each PD, the total limit is the amount of Drawdown procedure: The repos are overnight for the 5 percent of the total issuance multiplied by the PD’s limit same value date, and the bonds can be requested every day for all securities. For all the PDs, for each benchmark, the until 15.30 hours. Appendix 5. Overview of International Emerging Markets SLF Experiences 29 total limit is 5 percent of the total issuance, and for all securities together the limit is 5% of the total issuance of all benchmark securities. Drawdown procedure: The loans can have a tenor of 1 week, 2 weeks, 1 month, or 3 months, and the orders can be submitted between 11 A.M. and 12 P.M. and 1:00 and 3:00 P.M. Collateral and valuation: The Central Bank determines a fee to be paid for the transaction. The initial margin is 120 percent of the net amount of the transaction, and there is a 5 percent margin maintenance provision. Sanctions: The collateral provided is used to cover nondelivered securities. If the collateral does not cover the nondelivered securities, the Treasury issues the noncovered amount. In addition to this, the bank that does not deliver securities at maturity will be charged twice the fee for future lending. Moreover, the Central Bank has the right to take action on the accounts of the bank at the Central Bank that does not deliver the securities at maturity. Finally, the bank’s right to participate in the market or other markets under the Central Bank could be temporarily or permanently cancelled. Appendix 6. Country Questionnaire on Securities Lending Facility (SLF), April 2015 31 Appendix 6. Country Questionnaire on Securities Lending Facility (SLF), April 2015 32 Securities Lending and Related Standing Facilities Appendix 6. Country Questionnaire on Securities Lending Facility (SLF), April 2015 33 34 Securities Lending and Related Standing Facilities Note: CB = Central Bank; CH = clearing house; DMO = debt management office; GMRA = global master repurchase agreement; GS = government securities; MoF = Ministry of Appendix 6. Country Questionnaire on Securities Lending Facility (SLF), April 2015 Finance; MRA = master repurchase agreement; PD = primary dealer; SLF = securities lending facility. — = not available. 35 References 37 References Securities Lending Facilities for Primary Dealers, Gemloc Peer Group Discussion (April 2011), www. Gemloc.org Country Questionnaire on Securities Lending Facility (SLF), April 2015, WBG Government Bond Markets Advisory Services Program .