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In Part Two of this series, we documented how fees, dividends and defaults relate to securities lending by prime brokers. In this installment, we’ll discuss how counterparties transfer securities between borrower and lender.
Transfers are either physical, by way of a clearing organization, or by other means agreed upon between the counterparties. Physical transfers must be delivered along with duly executed stock or bond transfer powers with guaranteed signatures by a bank or member firm of the New York Stock Exchange.
Cash transfers must be made through a wire transfer, transfers through a clearing organization, or any other agreed upon method between the counterparties.
After the contracts are signed there are several issues which must be agreed prior to trading which are pertinent to the set up of the counterparty characteristics. These are:
- Rounding Factor (pricing of trades are rounded to nearest, lowest, or highest factor indicated). This is inherent to all trades for a given counterparty and not unique to a specific trade.
- Credit Limit: some form of credit committee will determine the value limit to place on the counterparty’s outstanding trades.
- Initial Margin: Trades are always margined at the outset, subject to SEC regulations. The securities borrower may give additional collateral to further reduce the lender’s credit exposure to the borrower. The price is agreed on trade date, but this can be changed prior to settlement if the market has moved significantly. Otherwise, after settlement, the position is subsequently marked to market and the amount of margin will be restored to its original percentage. Note that either party may experience credit exposure, depending on the performance of the borrowed securities.
- Acceptable Collateral: while regulations allow for various instruments, either counterparty may have restrictions that limit the type of collateral accepted. Additionally, the non-cash collateral may have a haircut (discount) applied, which decreases its value by the percentage stated.
- Trade structure: Determination needs to be made whether trades are cash, non-cash or cash pool trades. Furthermore, the trade type must be designated as a borrow, loan, repo, reverse repo, buy/sell back, etc. Any trade type can be used as long as it is an allowable trade type stated in the contract.
- Delivery and Payment Instructions: both counterparties will exchange instruction forms for each company’s system’s set up.
- Dividend Withholding: the counterparty will state the default withholding on dividend disbursements for each country they deal with.
- Contacts: the contacts for billing, confirmations, settlements, and pricing are exchanged between counterparties.
Copyright 2011 Eric Bank, Freelance Writer