TECHNICAL COMMITTEE OF THE INTERNATIONAL ORGANIZATION OF SECURITIES COMMISSIONS (IOSCO) COMMITTEE ON PAYMENT AND SETTLEMENT SYSTEMS (CPSS) SECURITIES LENDING TRANSACTIONS: MARKET DEVELOPMENT AND IMPLICATIONS July 1999 Securities lending transactions: market development and implications, report prepared by the Technical Committee of the International Organization of Securities Commissions and the Committee on Payment and Settlement Systems of the central banks of Group of Ten countries. This publication is available on the IOSCO website (www.iosco.org) and the BIS website (www.bis.org). © International Organization of Securities Commissions and Bank for International Settlements 1999. All rights reserved. Brief excerpts may be reproduced or translated provided the source is stated. Bank for International Settlements International Organization of Securities Commissions Secretariat to the Committee on Payment and Secretariat Settlement Systems P.O. Box 171 CH-4002 Basel Stock Exchange Tower Switzerland 800, Square Victoria, 45th Floor Fax: (41-61) 280 9100 Montreal Quebec, H4Z 1C8 Canada Fax: (1-514) 875 2669 ISBN 92-9131-070-0 Foreword This report has been produced by the Technical Committee of the International Organization of Securities Commissions (IOSCO) and the Committee on Payment and Settlement Systems of the central banks of the Group of Ten countries (CPSS). It is the second report jointly produced by the two committees. The first, Disclosure framework for securities settlement systems, was published in 1997. The growth in securities lending transactions, such as securities loans and repurchase agreements, has been such in recent years that they now represent a substantial part of the daily settlement value in many settlement systems and play an important role in facilitating market liquidity. Past work by IOSCO and the CPSS has highlighted the expanding use of securities lending transactions and how these market transactions have increased the pressure on settlement agents to permit receipt and delivery of securities on the same day. However, none of these reports has provided a comprehensive survey and analysis of the use of securities lending transactions, the current dynamics of the market and the principal areas of risk. The two Committees therefore set up a Joint Working Group on Securities Lending to fill this gap. The Working Group was mandated to “develop a clearer understanding of the development of securities lending and its implications for securities regulators and central banks, in particular its implications for securities clearance and settlement systems”. As a key part of the project, central banks and securities regulators in each jurisdiction conducted a survey amongst market participants of the size and structure of their lending activities, and the factors that they felt were driving the market’s growth. These market participants included broker-dealers, custodian banks, institutional lenders, banks, securities settlement systems, clearing houses, providers of market services and industry consultants. In total, the members of the working group interviewed more than 60 institutions in over a dozen countries worldwide. The Technical Committee of IOSCO and the CPSS express their thanks to the many firms, institutions and individuals who assisted with the survey or who provided other assistance in the preparation of this report. It is expected that securities lending activity will continue to increase as an integral part of contemporary securities markets. The report provides an overview of the transaction structure, market development and risk issues of securities lending transactions, and discusses a number of implications for market participants, infrastructures providers and market authorities, in particular securities regulators and central banks. Mr Tamagawa and his colleagues are to be congratulated on having completed this important study. Michel Prada, Chairman Wendelin Hartmann, Chairman Technical Committee, IOSCO Committee on Payment and Settlement Systems Members of the Joint Working Group on Securities Lending Chairman Mr Masayuki Tamagawa Ministry of Finance Japan Australian Securities and Investments Commission Mr Nigel Morris National Bank of Belgium Mr Yves Pirlet Mr Willy Steppé Commission des valeurs mobilières du Québec, Canada Ms Renée Piette Bank of France Mr Frederic Hervo Commission des Opérations de Bourse, France Mme Bénédicte Doumayrou Deutsche Bundesbank Mr Johannes Esswein Securities and Futures Commission, Hong Kong Ms Stella Leung Bank of Italy Mr Giuseppe Maresca Commissione Nazionale per le Società e la Borsa, Italy Mr Giovanni Sabatini Bank of Japan Mr Tetsuya Sakamoto Malaysian Securities Commission Mr Ranjit Ajit Singh Bank of Mexico Mr José Quijano Comisión Nacional Bancaria y de Valores, Mexico Mr Rubén Shiffman Netherlands Bank Mr Hugo Spanjer Securities Board of the Netherlands Mr Hans Wolters Comisión Nacional del Mercado de Valores, Spain Mr Antonio Mas Mr Galo Sastre Mr David Vives Sveriges Riksbank Mr Martin Blavarg Swiss National Bank Mr Stéphane Fumeaux Bank of England Mr Ian Tower Mr David Rule Mr Bob Hills Financial Services Authority, United Kingdom Ms Ilene Hersher Mr John Whitmore Federal Reserve Bank of New York Mr Darryll Hendricks Mr David Mazza United States Securities and Exchange Commission Mr Larry Bergmann European Central Bank Ms Daniela Russo Bank for International Settlements Ms Cheryl Gleason Mr Masayuki Mizuno Mr Mark Attar (US Securities and Exchange Commission) also made significant contributions to the Joint Working Group’s work. Table of contents Executive summary ......................................................................................................................... 1 1. Market overview....................................................................................................................... 5 1.1 Introduction to securities lending markets....................................................................................... 5 1.1.1 Securities-driven and cash-driven markets ...................................................................... 5 1.2 Transaction structures...................................................................................................................... 6 1.3 Evolution of securities lending markets......................................................................................... 10 1.4 Market size..................................................................................................................................... 12 1.5 Recent market trends ..................................................................................................................... 13 2. Market structure .................................................................................................................... 17 2.1 Market participants ........................................................................................................................ 17 2.1.1 Intermediaries – service providers................................................................................. 20 2.1.2 Providers of clearing and settlement services................................................................ 24 2.2 Transaction structure: execution, processing and settlement......................................................... 28 3. Legal, regulatory and tax framework ............................................................................ 33 3.1 Overview........................................................................................................................................ 33 3.2 Legal issues.................................................................................................................................... 34 3.3 Regulatory issues ........................................................................................................................... 35 3.4 Tax issues and accounting treatment ............................................................................................. 37 4. Risks and risk management ............................................................................................... 39 4.1 Types and sources of risk............................................................................................................... 39 4.1.1 Credit risk....................................................................................................................... 39 4.1.2 Liquidity risk................................................................................................................... 41 4.1.3 Market risk ..................................................................................................................... 42 4.1.4 Legal risk........................................................................................................................ 43 4.1.5 Operational risk ............................................................................................................. 44 4.1.6 Settlement risk ................................................................................................................ 44 4.1.7 Custody risk.................................................................................................................... 45 4.2 Practices and procedures for managing risk .................................................................................. 46 4.2.1 Counterparty evaluation/credit limits ...........................................................................