Securities Lending is the last bastion of manual intervention in an otherwise automated trading world. The process remains the same as it did years ago. You pick up the phone, call your borrow contact at a prime broker, and get quoted a rate. This process repeats itself once for every prime broker. Then, you arrange a borrow and hope that the shares are delivered to your account.
Everyone knows this price discovery and stock locate mechanism is time-intensive. The question is will it ever change. In a world, where you can use E-bay to buy a vintage Superman T-shirt from Bangkok, you would think a better way exists to manage the black-hole of securities lending. However, guaranteeing the delivery of a T-shirt and a hard-to-borrow stock are about as similar as ant and a whale.
With this in mind, I have been reviewing securities lending models from upstart securities lending portals. My goal in this review was to understand if these electronic marketplaces can succeed in changing the current lend-to-borrow process while creating a transparent price discovery mechanism.
Inventory, Culture, and Switching Costs
The $5 trillion securities market is an attractive unbundling play because of the opaque nature and the intrinsic value of bringing buyers and sellers together electronically (think Nasdaq in the late 1980’s). While, in theory, the automated matching of borrows and lenders is a given. In practice, it is not so easy. Inventory, Inventory, and more Inventory. Without it, these marketplaces are nothing but an E-bay without the cool stuff. Who controls most of the inventory…large Prime Brokerages who have an interest in not cannibalizing their existing revenue streams.
While some believe competition will lower the rate for securities lending even without an electronic marketplace, today’s model has benefits for borrowers that go beyond the lowest rate. Culturally, even the largest hedge funds need to maintain good relationships with Prime Brokers that in many cases provide a variety of services from research to trade data aggregation. In addition, switching from a Prime Broker to an electronic marketplace is operationally expensive. In today’s model, the Prime Broker maintains reporting mechanisms on lending and borrow. Unbundling this relationship and potentially moving more of these operational costs to a fund may be more hassle than having a marginally lower rate on a hard-to-borrow security.
Who’s out there?
A number of online marketplaces exist. Each site has a different model and potentially a different audience. The maturity of these sites vary. Some marketplaces are in early production or a beta stage. Others have been in production for a while. Most sites are still early in the adoption cycle. This review will include Lendex/LocateStock.com, Quadriserve’s Aquas, eSecLending, ICAP’s I-sec, One-Chicago’s single stock futures market, and other players in the market.
Note: This is the first of a multi-part series on Securities Lending Models. The next entry will focus on regulation, price-discovery evolution, and trading/settlement models.