Financial Services : Securities Lending in Ireland
Author: Rachel Kelly
The Irish equity securities lending market has grown from €200 million in 2000 to over €1 billion in aggregate securities loans per day in 2004. So, what is securities lending?
Securities Lending is an activity whereby a security is transferred from a Lender to a Borrower on a temporary basis and eventually returned or recalled. Lenders generally are Banks, Insurance Companies, Pension Funds, Mutual Funds and similar financial institutions. Borrowers tend to be Investment Banks, Investment Managers and Prime Brokers who need securities for settlement and trading purposes. A lender retains all rights to a security except voting rights. In other words, a Borrower is liable to the Lender for all benefits of ownership, except voting. These benefits include dividends, interest payments and other corporate activities. A Lender who wishes to retain voting rights can arrange for the return of a security prior to a shareholders meeting record date. A Lender usually receives collateral from a Borrower usually at a level above the market value of the securities on loan to cover market fluctuations (105% for equities and 102% for bonds). The securities are marked-to-market every day so the collateral levels can be adjusted accordingly. The form of collateral offered can range from cash, government bonds and letters of credit to other types of instruments such as certificates of deposits and major index equities.
Securities Lending transactions are typically done on an open basis, which means a borrower and lender have he right to terminate a securities loan at any time. A Borrower is required to give at least one business day's notice to a lender. If a Lender wishes to recall a loan, the Borrower must be given sufficient and timely notice to allow for the return of the securities. This call-back feature is an important aspect of Securities Lending, since it allows the Portfolio Manager to sell securities in line with normal market practice even though a security may be on loan.
Regulation
The introduction of a regulatory framework by the Irish Financial Services Regulatory Authority (IFSRA), the Irish Revenue and the Irish Stock Exchange in 1999 led to the growth in recent years in Securities Lending in Ireland, which, in turn has created market efficiency and liquidity.
More and more Irish Insurance Companies, the National Treasury, Superannuation Schemes, and a growing number of Collective Investment Schemes, UCITS Variable Capital Companies and Unit Trusts based in Dublin's Irish Financial Services Centre have joined the market. UCITS have their basis in EU legislation and, once authorised, may be marketed throughout the EU.
It is estimated that the Irish Funds industry today has grown to a staggering €600 bn.
The provisions governing Securities Lending are captured by a number of regulations.
The Irish Revenue Statement of Practice Note from April, 1999 for Irish Lenders recognises the substance of the transactions involved i.e. a loan of Securities notwithstanding that legally a transfer of title to the loaned securities and collateral takes place.
Manufactured payments are exempt from tax in the hands of the Lender where the receipt of dividends by the Lender would not have been taxable. The transfers of securities under a securities loan are exempt from stamp duties and the loan will not be regarded as a disposal or acquisition for tax purposes. Any profit earned as a result of the loan and return taking place at different prices will be treated as a fee and taxable as income or exempt from taxation if the recipient is not a taxable entity. The practice note applies to institutions within the scope of Irish tax which are companies, building societies, pension funds, charities or collective investment undertakings and the maximum term of a lending transaction is six months before Stamp Duty is applicable.
The Investment Intermediaries Act, 1995 exempts collective investment schemes and the depositories and managers of such schemes insofar as the activities of the collective investment undertaking are subject to regulation by IFSRA. Thus a proposal by a collective investment scheme to engage in Securities Lending activities, on the assumption that its constitutional documents permit Securities Lending, does not require separate authorisation.
The Netting of Financial Contracts Act, 1995 provides protection on insolvency for bilateral netting, set-off, guarantee and collateral arrangements and subject to certain exceptions provides that netting agreements in relation to financial contracts are enforceable against a party to the netting agreement.
The EU Finality of Settlement in Payment & Securities Settlement Systems Regulations 2000 extend the ambit of the Act to sale and repurchase transactions, and lending and borrowing transactions to encompass such transactions relating to equities. Buy and sell back transactions in securities and equities are now also addressed.
Challenges
The main barrier to entering into securities lending still appears to be a lack of understanding of the industry. This is why the entities that can benefit the most from it (pension firms, insurance companies, mutual funds etc.) need to be educated about the process.
In terms of legal documentation, of all the Lending agreements, the General Master Securities Lending Agreement (GMSLA) is now becoming widely used as the market standard legal document to include netting, force majeure and other precautionary clauses.
The accountancy profession has gone some way to acknowledge the increase in securities lending activity.
The Accountancy Standards Board (ASB) approved a revised Statement of Recommended Practice Financial Reports of Pension Schemes, in 1997. This includes a section on Stock Lending, whereby Pension Schemes should disclose where the scheme's investment custodian is authorised to release stock to a third party under a stock lending agreement (even if no stock lending activity has taken place in the year) and where stock lending fees are material, disclosure should be made of the major characteristics of the lending arrangements in place.
Any securities out on loan at the scheme year end should be included in the net assets statement and the total value of securities out on loan at the year end should be disclosed in a note to the financial statements together with an analysis by asset class of the securities out on loan a description of the related types of collateral in place.
Another of the major challenges for the industry will be to continue widening the forms of collateral used to include Exchange Traded Funds, introduce alternative forms of Equity Financing such as Equity Swaps and Fixed Term Collateral Financing Trades which will make securities lending more attractive to borrowers.
The Future
The highly regulated Securities Lending product is an integral part of the Irish Capital Markets and Ireland has joined the ranks of the growing Securities Lending markets around the globe. The dramatic growth in onshore and offshore lending and borrowing of Irish and foreign Securities will create an even more diversified and efficient capital market. Securities Lending within the funds industry is still in its infancy with most fund administration companies not even realising the potential fee income that can be derived from a lending program. The Pension Funds in Ireland are slowly beginning to embrace Securities Lending and the incremental fee revenues that can be earned with such a conservative, low risk product. Another trend in Securities Lending in Ireland is a shift from a growing number of Institutional Lenders, UCITS and Life Companies to secure exclusive contracts with Borrowers to removing their Securities Lending programs from their Custodians by either lending directly through in-house programs, via other Custodians Agents or specialist Third-Party Securities Lending Agents to capture the maximum in fee earnings. Securities Lending can be a major fee revenue and cost recovery contributor for Lenders with virtually no risk.