International ~ecurities len~ in~

Finance and Capital Markets series

Erik Banks Asia Pacific Derivative Markets Erik Banks The Credit Risk of Complex Derivatives (2nd edn) Erik Banks The Credit Risk of Financial Instruments Erik Banks Emerging Asian Fixed Income Markets Nick Caval/a OTC Markets in Derivative Instruments: strategic issues in

asset/liability management Kevin Connolly and George Phillips Japanese Warrant Markets Daniel Corrigan and Mark Pohlman Bonds and Bond Futures Charles Errington Financial Engineering: a handbook for managing the risk-reward relationship Andrew Inglis-Taylor The Dictionary of Derivatives Sandy McKenzie (ed.) Risk Management with Derivatives Judith Mabty (ed.) International Securities Lending Ron Paterson Off Balance Sheet Finance 1i·evor Pijper Creative Accounting: the effectiveness of financial reporting in the UK Zoe Shaw (ed.) International Securitisation: the scope, development and future outlook

for asset-backed finance Robert Tompkins Bond Options Robert Tompkins Options Explained (2nd edn) Jackie Whitley ( ed.) TheALCO Jackie Whitley Foreign Exchange: function, limits and risk

Richard D. Willsher Export Finance Nicholas Wilson ( ed.) ESOPs: their role in corporate finance and performance

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Editor: Judith Mabry

~ MACMILLAN Business

© Macmillan Press Ltd 1992

All rights reserved. No reproduction, copy or transmission of this publication may be made without written permission.

No paragraph of this publication may be reproduced, copied or transmitted save with written permission or in accordance with the provisions of the Copyright, Designs and Patents Act 1988, or under the terms of any licence permitting limited copying issued by the Copyright Licensing Agency, 90 Tottenham Court Road, London W1P 9HE.

Any person who does any unauthorised act in relation to this publication may be liable to criminal prosecution and civil claims for damages.

First published 1992 by MACMILLAN PRESS LTD Houndmills, Basingstoke, Hampshire RG21 6XS and London Companies and representatives throughout the world

ISBN 978-0-333-55922-2 ISBN 978-1-349-12588-3 (eBook) DOl 10.1007/978-1-349-12588-3

A catalogue record for this book is available from the British Library.

This book is printed on paper suitable for recycling and made from fully managed and sustained forest sources.

10 9 8 7 6 5 4 05 04 03 02 01

Contents

Contributors

Preface Judith G. Mabry

Introduction: Securities Lending Simon Luhr

PART I

viii

xi

1

1 The UK Gilts and Equities Markets 9 Patrick Mitford-Slade History 9 The Gilt-edged market 10 The equity and fixed interest market 16

2 Securities Lending in the German Market 20 Douglas G. Ziurys and Gunter H. Femers The long and hard road to securities lending 1986--1990: major

market factors affecting rapid development 21 Major market developments in 1990: securities lending finally

established as a viable product 26 Current status of securities lending in Germany: the Deutscher

Kassenverein system 27 The current status of securities lending in Germany: alternatives

to the KV lending programme 37 Legal and accounting aspects 41 Required changes and future prospects for securities lending in ~m~ G

3 The French Market 47 Michel Sidier Structure of the securities industry The settlement system Who can lend and who can borrow: the Law of 1987 The existing lending techniques on the French market

47 51 57 59

v

The securities lending market Conclusion

62 64

4 Lending Securities in Japan 66 Jiro Takahashi and Makoto Yokota History of the Japan Securities Finance Co Ltd 66 Domestic lending 67 International lending 73 The present situation for international lending 78 The outlook for domestic and international lending of Japanese Moe~ 79

5 Financing transactions as short-term Investments 80 Steven R. Meier Introduction to the United States market for repurchase

agreements 81 The mechanics of repos 82 Repo collateral 83 Types of repos 84 Delivery of repo collateral 84 Determination of repo and reverse repo rates 86 The matched book 87 Dealer's availability of rcpo collateral 88 Parties involved in the repo market 90 Repurchase agreements: a hybrid transaction 90 The evolution of the repo market 91 Financing transactions and the 'Big Picture' 96 International financing transactions 97 XYZ Bank - February 1990 99 Suggested guidelines for investing in 'repurchase agreements' 102 Summary 102

PART II

1 Risks in International Securities Lending - Identification and Minimisation 107

vi

Habib Motani Essential elements of a securities loan Main areas of risk Credit risk Default Operational risks Conclusion

107 108 109 112 113 115

2 Global Custody Daniel R. Roccato Functions of a global custodian Evolution of global custody Image

116

117 120 122

3 The Function of the Clearing House 124 Securities Lending in an International Clearing System: Cedel's

Securities Lending Programme Susan Alexander

4 The Euroclear System 132 Mal'tine Dinne

S The Taxation of International Lending Transactions 140 Jurgen lung Introduction 140 Tax treatment of securities lending transactions in Germany 141 Tax treatment of securities lending transactions in France 144 Tax treatment of securities lending transactions in Japan 149 Accounting and tax treatment of securities lending transactions

in the UK 150 Tax treatment of securities lending transactions in the United

States 152

Index 155

vii

Contributors

Susan Alexander joined Cede), Luxembourg, in 1989. Since then she has had a range of responsibilities which have included being project manager for securities lending, overseeing customer documentation, and developing com­puter based training. Before Cede), Susan was a vice-president at Oppen­heimer & Co., New York, working first as director of commodities research and later in fixed income product development and international securities trading. Previously, she worked at Kidder, Peabody in their futures depart­ment.

Martine Dinnc, Managing Director, heads the Euroclear Strategic Research and Product Management Group. The group conducts research on markets and Participant service requirements which defines service upgrades and new market and instrument priorities. She joined the Euroclear Operations Centre in 1969 and became Area Manager in 1984, after serving as Account Manager for Belgian, French and UK accounts. In 1985 she was promoted to assume responsibility of the newly-created Strategic Research Group.

Gunter H. Fcmers is a Vice-President and Manager of the Securities Liquidity Management group at J. P. Morgan GmbH in Frankfurt. His previous assign­ment was marketing various operational services to international brokers/ dealers and banks. Prior to joining J. P. Morgan in 1985, he worked on project and export fi!lance with Commerzbank.

Jiirgen Jung is a tax partner in the Frankfurt office of Arthur Andersen & Co., and specialises in the areas of capital markets and the financial services industry. From the outset of the firm's activities to establish the German Exchange for Options and Financial Futures, he was responsible for the non­systems area during a three-year assignment. He has published several articles on the tax and accounting treatment of financial instruments and speaks at seminars on this topic.

Simon Luhr is a Senior Vice-President at Nomura Securities International, New York. A widely known expert in the domestic and international securi­ties lending business, he was previously at Morgan Stanley in London where he had worked since 1986, most recently as worldwide head of the firm's

viii

international securities lending. Prior to that, he worked for James Capel and Citicorp Scrimgeour Vickers in London.

Judith G. Mabry is a Vice-President with Morgan Stanley & Co., New York. She has been with Morgan Stanley since 1981 in a variety of roles involving securities lending and repo. These include US Marketing Manager for domestic/international securities lending with MS Securities Services Inc, product development for international securities lending with Morgan Stanley Global Securities Services and Product Manager for International Securities lending with Morgan Stanley Fixed Income Division. She has spent time working in both the Tokyo and London offices of Morgan Stanley, and is now based in New York. Prior to joining Morgan Stanley she spent four years at Salomon Brothers.

Steven R. Meier is currently a Vice-President and Trading Manager with Merrill Lynch, New York, and is responsible for their worldwide non-dollar financing activities. In addition, he is the Product Manager for all automated repo programs, bond borrowing and securities lending activities. Upon gradu­ation he joined Merrill Lynch's Capital Markets Training Program and is a member of the Finance Trading department. He possesses an extensive background in financing and matched book trading activities involving US treasuries and agencies, money market instruments, various mortgage­backed securities and a full range of international debt obligations.

Patrick Milford-Slade is a partner in Cazenove & Co. and Managing Director of Cazenove Money Brokers. He was a member of the Stock Exchange Council between 1976 and 1991, Deputy Chairman of the Exchange from 1982 to 1985, and is still a member of the Gilt Edged Market Committee. He has been closely involved with the Exchange's market and technical developments, including the Central Gilts Office project, for several years. He was Chairman of the Securities Industry Steering Committee on TAURUS (SISCOT) and is now Chairman of the TAURUS Rules Commit­tee. He has been in charge of Cazenove's stock lending activities since 1972 and is Chairman of the Money Brokers Association.

Habib Motani is a solicitor and a partner of Clifford Chance. He is a member of Clifford Chance's International Financial Markets Practice and Head of its Derivative Products Group. He has been with Clifford Chance for some 14 years and during that period has undertaken considerable work in relation to derivative products (including risk assessment) and other money market and capital markets instruments, netting and payment and settlement systems as well as a wide range of financing transactions.

ix

Daniel R. Roccato began his career in the financial services industry with Morgan Stanley International, London, in 1986. Prior to joining Morgan Stanley he taught economics for two years in the USA. In 1987 he was assigned to Morgan Stanley & Co., New York, where he was a start-up member of a project team which managed the firm's entry into the global custody business. He has also worked with the network management team with regional responsibility for Europe and subsequently the Far East. In 1990 he returned to London and is currently Vice-President with overall responsibility for Morgan Stanley Global Securities Services (MSGS) in the UK.

Michel Sidler was born in Paris and educated at H.E.C. in Paris followed by an MBA at Columbia University, New York. In 1972 he joined Banque lndosuez, Paris, where he occupied various positions before moving to Aus­tralia and South Africa on behalf of the bank. In 1987 he was transferred to London to head the new International Securities Lending desk. He returned to Paris in 1992 to take up a new position with J. P. Morgan.

Jiro Takahashi is an Associate Director, Head of Systems and Head of Treasury of Mitsubishi Bank, London. He has been with Mitsubishi Bank since 1975 after graduating from Keio University. Since then he has worked in Tokyo and Osaka before joining the London office in January 1990.

Makoto Yokota joined the Sumitimo Trust and Banking Co Ltd in 1984 where his responsibilities have included being Officer for Private Banking, Assistant Manager for Custody Services and, more recently, Manager for Securities Lending and Custody Services.

Douglas G. Ziurys is a Vice-President and Manager of the Securities Trust & Information Services group at J. P. Morgan GmbH, Frankfurt. His responsibilities include the marketing of OEM securities lending, clearing, custody, and execution services. Prior to joining J. P. Morgan in 1986, he managed a representative office in Hamburg for CoreStates Financial Corp. Before entering banking, he worked in the electronics industry as a product line marketing manager.

X

Preface

International securities lending has become an increasingly important market over the last six or seven years. This product is growing and expanding into new countries as tax, legal and regulatory barriers are being toppled. More and more countries are accepting the importance and necessity of securities lending. Opportunities continue to grow for participants in the securities lending market. With the endorsement of the Group of Thirty, added credi­bility and support has been given to this product.

This book is intended to serve as a comprehensive guide to the origins, development, current status, and future direction of the international securi­ties lending market. In a series of chapters written by industry professionals - bankers, brokers, lawyers and tax experts - both broad overviews and specific issues are presented. The contributions of each author reflect their personal experiences and opinions, making this a timely and inside view of a rapidly-evolving product.

Chapters cover the five major marketplaces in which securities lending has taken hold: Germany is profiled by Douglas Ziurys and Gunter Femers; France by Michel Sidier; the USA by Steven R. Meier; Japan by Jiro Taka­hashi and Makoto Yokota; and the UK by Patrick Mitford-Slade. Countries not covered were not omitted due to lack of interest or importance, but due to time, energy and space constraints.

An assessment of the risks involved in securities lending is skilfully addressed by Habib Molani of Clifford Chance. His chapter outlines the major issues on which every participant in this market should focus. Jtirgen Jung of Arthur Andersen ably tackles the somewhat daunting task of present­ing the major tax issues for each of the five countries covered.

The major role which the Global Custodian plays in this market, as well as the importance of the two major clearing houses, Euroclear and Cede!, is also discussed. Understanding how these institutions operate is key to appreciating the basic building blocks of securities lending.

Several of our contributors, particularly Michel Sidier and Patrick Milford­Slade, have given a very thorough overview of the structure and operation of their local markets. This was intended to help the reader appreciate where and how securities lending fits into the day-to-day trading and settlement of securities. In many cases it is critical to understand the cash and derivative

xi

markets in order to appreciate the significant role of securities lending. Our contributors have attempted to provide this insight.

With constantly changing markets, timeliness is key to understanding securities lending. We have attempted to compile material in this book that is both broad and detailed, while remaining up to date. Every effort has been made by the contributors to keep the information as current as possible up to the time the manuscript goes to press. Many revisions and rewrites have made this possible. My thanks go to the contributors for their patience and perseverance in this effort.

Please use this book as a guide to the basics of international securities lending. As always, consult with your own tax and legal advisers before entering into any new product.

Thanks also to the financial editors at Macmillan Press for giving us the opportunity to put together this volume on International Securities Lending. A tremendous amount of information and knowledge has been compressed into a relatively small volume by the hard work of the contributors, with the guidance of Macmillan Press. They have made my task as Editor much simpler than originally imagined!

xii

Judith G. Mabry New York May, 1992