Stock Borrowing & Lending Seminar Securities Institute Wednesday 15 th April 2009

1. Stock Borrowing & Lending SeminarSecurities InstituteWednesday 15th April 2009

2. Contents Part 1 Equity Finance – Stock Borrowing & Lending - Myths & Reality : Joseph Hine Part 2 Changing the Industry – The introduction of an Exchange Platform for Stock Borrowing & Lending : Peter Fenichel • Topics: • Stock borrowing & lending (SBL) has received a lot of attention recently, both as the mechanism that underpins stock shorting, and as a key enabler of the financial markets, but remains poorly understood. This seminar will seek to describe the workings of the SBL market, debunk a number of the myths which surround it, identify its problems, and discuss approaches to addressing them.  • •             What is SBL; where did start; why does it exist today? • •             Who are the participants? • What are the motivations of participants? • •             Does SBL create downward price movements or volatility in the markets? • •             What are the risks of SBL? • •             Why change the SBL model? • •             The Central Counterparty proposal (Is it a solution?) • •             The future for SBL markets/The future of short sales • “Stock Prices may go down as well as up” • [Why should Investors only make money when a stock goes up?]

3. Part 1 Equity Finance – Stock Borrowing & Lending -Myths and Reality • Reality • Globally SBL is comparable in size to the worlds equity markets. The value of outstanding loans is around $6trillion at any time. • SBL is only one tool for bear investment: CFDs and derivatives (OTC and on-exchange) are more significant worldwide. • ‘Dividend plays’ are increasingly difficult as authorities tighten their net. Tax evasion through SBL has largely disappeared • SBL has traditionally been a facilitation business often only marginally profitable at the desk level– but it supports profit elsewhere. • There is no evidence that SBL positions were the major driver in reducing the value of banks stock • Without SBL the UK equity market (and many others) would become less liquid or cease to function altogether Myth • SBL is a small backwater of the Securities Industry • SBL is the prime tool for downside investment • Most SBL is undertaken for tax avoidance • SBL is a highly profitable business for banks • SBL brought down the UK banking sector • SBL should be made illegal as it de-stabilises markets

4. Why SBL • Administrative Shorts The complexity of markets and the lingering inefficiency of internal systems means that many firms find themselves short in settlement. SBL with its T0 or T+1 settlement provides a safety valve • Dividend Plays Transferring title from firms with a higher tax liability to ones with a lower tax liability at the payment point of divided. – Not relevant in the UK and increasingly rare in other jurisdictions. • Market Short Direct use of SBL to produce bear positions is, we believe, less than 10% of the business (by number of trades) in the UK • Special Situations Gaining control of stock through borrowing for elective events and in take over- situations is more difficult now • Funding Use of SBL structures by lenders to generate funds (used as an alternative to Repo) a major driver in the USA. • Hedging derivative positions Increasing driver for derivative market MMs and OTC trading firms • Hedging CFDs Major driver of the market in UK and Europe.

5. Models for Shorting (SBL and CFD) SHORTING VIA SBL SHORTING VIA CFD Collateral Collateral Prime Broker Hedge fund shorting market Lender Lender Borrowed Stock Borrowed Stock Market Sell Stock Cash margin Cash CFD Hedge fund shorting market Market In the UK and Europe the CFD route is much more popular as it allows gearing and avoids SDRT – The SBL trade is used as a hedge as it is usually more cost effective and flexible than using derivatives

6. Participants and Motivations • The effect on the term curve of different participants using SBL in different ways The SBL market is used by many different participants for many different reasons. This results in a multi-modal term distribution. The curve differs markedly between different countries where motivations can be different. Special Situations Strategic Positions Fail Management Tactical shorts & CFD hedges

7. Effect on the Equity Markets • Equity market Liquidity • Availability of shares • Increasing trading • Confidence to trade • Use of SBL for fails management • Administrative fails • ‘Held Away’ fails • Fail chains • Use of SBL for profit enhancement by lenders • Size of revenue opportunity • Specials • Trends in profitability • Ensuring Exchange traded derivative liquidity • Specialists’ position management • Keeping markets ‘honest’ • CFD and other OTC derivative market hedging • CFDs as a proxy for equity • Equity liquidity issues

8. Inherent Risks • Counterparty risk • Credit issues • Market risk • Margining • Squeezes • Default resolution • Unwinding fails • Structures to reduce risk • Collateral and Margin • Triparty Structures • Systemic risk – the length of the lending chain • Speed of unwinding • Operation risk – what is being guaranteed. • Agent Guarantees • Capital application • Who should apply capital

9. Summary • SBL is here to stay • SBL is integral to the current market but inefficient – especially as regards risk and capital • SBL needs to restructure • SBL needs to re-think its facilitation model and perhaps re-price itself. SBL is an little understood minority area of the securities industry and like any minority it has been a convenient scapegoat - blamed for recent market dislocation. In fact SBL is no more to blame than any other part of the industry. However this does not mean that SBL should continue unchanged.

10. Part 2Changing the Industry – The introduction of an Exchange Platform for Stock Borrowing & Lending • SBL is now too important to be done on a ‘Best Endeavours’ basis • Certainty of price • Certainty of terms • Certainty of returns • Certainty of credit • Exchange Platform without CCP • is half of the solution • Current Exchange Platform model • CCP without Exchange Platform is too clumsy Risk Management Margin and Collateral Failure Management CCP Trading service Trade validation Member Validation Billing Communications MTF

11. Why Change? • Counterparty Risk • The industry is becoming paralysed due to counterparty risk issues outside SBL • Administrative Overheads • Disproportionate to the business profitability. • Act as a brake on new business • Agent Lender Disclosure • Not acceptable to some • Expense for all • Collateral Issues • Collateral excess rising 110%+ • Excess collateral used to cover concern over counterparty risk • Acceptability rules are various and complex • Collateral security issues • Capital • Frequent confusion and contradiction regarding capital allocations • Bi-lateral model gives limited scope for netting • Counterparty risk requires capital allocation under Basel II

12. The Critical Importance of Capital and Credit • Collateral only reduces risk – it does not eliminate it. • Counterparty risk must be assessed for Basel II • Agent guarantees (lending agent or Tri-party agent) help but risk of agent failure must be accounted for. • Capital allocated to SBL desks has been reduced • Credit lines which stretch over many businesses are being withdrawn or reduced in investment banks • Small trading firms and hedge funds can not get credit lines without depositing cash or near-cash instruments with bank. • For many firms the only way to continue in the SBL business is by using a CCP to eliminate counterparty risk and credit issues.

13. Alternative Structures Tripartite (Use of central agent to reduce risk) Patron Bank (Netting on the balance sheet of large bank/ prime broker) Liquidity location & Post-trade admin (Centralised checking, settlement routing, registration, etc) OTC Bilateral (Traditional phone market or using bilateral communications e.g. via Bloomberg) Value added Benefits Drawbacks • Risk elimination • Capital relief under Basel II • Large pool of counterparties • Increased cost CCP • Collateral management • Access to counterparties • Operational guarantee • Credit risk still exists • Still uses capital • Pool is limited JP Morgan Euroclear Morgan Stanley Goldman Sachs • Potential for netting • Operational guarantee • Limited pool • Capital impact on bank • Risk • Reduced administrative Overheads • Reduced operational Risk • Credit problems • Counterparty risk E Seclending Bloomberg • Flexibility • Choice of Counterparties • Confidentiality • Costs • Credit problems • Risk

14. Features of CCP • Capital Reductions For firms facing CCPs • Credit EnhancementOvercomes counterparty credit issues • AnonymityThrough SecFinex matching system • Name Give-up Anonymous trading not compulsory • ALD Reduces administrative load • Returns No singling out of counterparty for early returns • Strategic Prime Broker need not see positions of Hedge fund clients • Operational BenefitsReduced Contracts, credit agreements, position monitoring etc • Collateral & Margin Central point for collateral and margin • Reduced Collateral In some cases may be as low as 100% • Margin Netting Net position with CCP can be margined • Two sides margined Margin from Lender and borrower • Regulation Improves regulator’s vision of the market Reduces systemic risk

15. The SecFinex Solution - 1 OUTLINE SCHEMATIC OF GENERIC STRUCTURE POST CCP CCP becomes Counterparty Bi-lateral trade given up to CCP via SecFinex CCP Lender Margin Novation Risk Management Exchange Trade Post trade management Exchange Trade Trading System Borrower Borrower Collateral Accounts Exchange Platform Settlement System

16. The SecFinex Solution - 2 • CCPs appropriate to individual markets. • Slightly different models of clearing dependant on different market traditions, regulations and abilities • Issues of tax resolved • Issues of Basel II counterparty relief when trading member is using Clearing Member are resolved

17. Incremental Change • The move to CCP will be gradual and will never be 100% • On-market anonymous trading will grow but will not eliminate bi-materal trading novated to the CCP • As CCPs become more comfortable with the market changes in collateral rules will make the proposition even more compelling • Most firms will retain bi-lateral ability in their back offices but some will move to a ‘CCP only’ model • MTF/CCP model is likely to increase SBL activity due to reduced overheads and capital requirements • Extension of MTF/CCP model outside Europe is being considered