EFP vs. Securities Lending
http://theocc.com/clearing/clearing-infomemos/infomemos1.jspong>Single Stock Futures: An Alternative to Securities Lending
Securities Lending is primarily a back-office function that effectively is an over-thecounter derivative transaction. Mutual funds and Pension plans (Funds) lend (actually sell) assets today with an agreement that they will get the asset back at some point in the future. During the interim they will not lose economic exposure to the position and will receive additional compensation for participation. This transaction is substantially similar to an EFP (Exchange Future for Physical) transaction using Single Stock Futures (SSF) but with some very important differences:
- • The SSF EFP is a trade on a regulated exchange.
- • SSF trade in a competitive environment where finance rates are established by multiple market participants.
- • Transparency in pricing.
- • No counterparty risk as all trades are cleared through the AA+ rated Options Clearing Corporation (OCC).
Securities lending is currently an operations function. However it should be viewed as a trading strategy and therefore be included in the investment manager’s responsibility. There are substantial profits being ceded to intermediaries that could accrue to the funds and their clients instead.
http://theocc.com/clearing/clearing-infomemos/infomemos1.jspong>Securities Lending Overview
Securities lending markets has two sides. First is cash driven whereby institutions finance their operations by borrowing cash in return for collateral. The second part is the securities driven whereby hedge funds firms employing short delta strategies such as the 130/30 are required to borrow securities prior to shorting. This activity is increasing the demand for the available supply of stock to borrow. The hedge funds look to the brokerage firm to service the request. The brokerages can meet some of the demand from their own inventory but must look to the beneficial owners (the pension and mutual funds) to satisfy the total demand.
The beneficial owners make their supply of securities available by contracting with either a custodian or the brokerage firms for the wholesale distribution of all or a portion of their portfolio.For this they receive a guaranteed fee and/or a split of the reinvestment of the cash collateral the contracted party receives.
The disadvantages to this arrangement are the concentration of credit risk with a sole counterparty and the ceding of potential profits to these agents.The funds can achieve the same end of providing the market with the assets they need but not have to split the profits with a third party.
Funds will argue that the securities lending involves a variety of complex administrative, operational and accounting activities including credit evaluation and cash management which may be better handled by specialists in that field. Fair enough. However with SSFs they can participate in this process and earn higher returns on the assets under their management.
There are financial products that have the same economic effect as securities lending that do not involve any securities being exchanged. These are off-balance sheet transactions such as equity swaps, total return swaps and Contracts for Difference. However, unlike SSF these products still entail some counterparty risk.
While SSF are a derivative product, they are the simplest derivative of them all. The value can be derived by using grade school mathematics. An SSF’s price is the forward value of today’s stock price which is derived by multiplying today’s price by the risk free rate of interest out till expiration of the future and subtracting any dividend that is paid (if any) during that time period. The formulae are as follows:
For stocks that do not pay a dividend:
Equation 1. SSF = Stock * er*((tx-t0)/360), where r is the effective federal funds rate, tx is the expiration date of the future and tt0 is the date of evaluation.
For stocks that do pay a dividend:
Equation 2. SSF = Stock * er*((tx-t0)/360) – Div*er*((tx-td)/360), where r is the interest rate prevailing starting at the ex-dividend date, tx is the futures expiration date and td is the exdividend date.
So for a $100 stock that pays no dividend in a 2% interest rate environment the six month SSF will have a fair value of $101. If the stock paid a 20 cent dividend then the the six month future would have a fair value of approximately $100.80. (Approximate only because a higher resolution fair value could be obtained by taking the present value of the future dividend stream into consideration but for simplicity deducting the full value works.)
Now a trader should be ambivalent about buying the stock at $100 today or receiving the same stock at $101 (in the no dividend example) in six months in a 2% rate environment. The physical settlement of the SSF means that upon expiration the fund holding the long SSF will receive the CUSIP as the future expires and the party holding the short SSF will be required to deliver. One of the most fascinating aspects of the SSF is that unlike all other futures products where the positions are offset prior to expiration more than 95% of the SSF positions traded on OneChicago actually make or take delivery upon expiration. So for funds who invest by buying and holding there is no difference in the two transactions of either buying today at one price or buying a SSF for delivery of the underlying at expiration except for the fact that they may be able to purchase the SSF at a lower net cost and therefore reduce the price they actually pay for the resulting position.
To understand how to price an EFP please see our page on How to Price an EFP using Single Stock Futures.
Securities Lending is where buyers and sellers meet to exchange an asset for a short term in return for basis points of compensation. Lenders can deliver the asset to the borrowers through an SSF transaction by either purchasing outrights for future delivery or pricing the EFPs in such a way to increase the basis points received for the ‘loan’. Funds have a fiduciary responsibility to their participants to maximize the returns without exposing the assets to unnecessary risk. SSFs competitive trading in a transparent process without counterparty risk exposure is a viable alternative.