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Transcript
Citi OpenInvestor SM Securities Lending in the Emerging Markets Transaction Services 2 Citi Transaction Services Securities Lending in the Emerging Markets The strong growth rates in emerging market economies over the past few years have resulted in an increase in portfolio allocations among investors across the globe. As emerging market countries open up their financial markets and align their regulatory regimes to international practices, holders of emerging market securities can benefit from the economic opportunities that securities lending can present. Experienced agent lenders, with knowledge of multiple markets, varying operational requirements and emerging regulatory trends, can demystify securities lending in the world’s fastest-growing markets for the benefit of borrowers and lenders alike. Securities lending and short selling are a twopart market reform aimed at enhancing market depth, liquidity and efficiency. A majority of securities lending transactions take place in developed markets; however, as investor portfolios become more heavily weighted toward emerging markets, they are increasingly looking at lending these securities to earn additional income for their funds. However, investors seeking to engage in securities lending in the emerging markets cannot assume that the working methodologies that they have applied in the developed markets are identical. The emerging markets are diverse and idiosyncratic in their financial regulations and practices. For example, Turkey adopted securities lending standards closer to those prevailing in neighboring Western Europe. Other emerging market countries, for example, India, Brazil and Taiwan, have implemented lending, but with their own specific market requirements. In many of these markets, the development of the securities lending industry must defer to regulatory concern over short selling, specifically relating to issues of market and settlement efficiency. Many frontier and emerging markets are contemplating the allowance of short selling. However, most markets will require that the institution undertaking short selling have securities lending agreements in place to ensure that they can cover their short positions. In this regard, securities lending and short selling are a twopart market reform aimed at enhancing market depth, liquidity and efficiency. Liquidity, Regulation and Market Structure In many emerging markets, securities lending volumes are initially accounted for by domestic lenders providing liquidity for local markets. For these local lenders, the principal risks generally emanate more from operations and settlement than from counterparties. Another consideration is that in many emerging markets, a handful of large-cap securities dominate equity market capitalization. Both of these risk concerns ultimately focus on liquidity. If the calculation is that the market is illiquid, investors may refrain from lending those securities. The structure of the securities lending market in a country is important for institutional investors who are looking to lend their local securities. In some emerging markets, notably Brazil and India, securities lending activity can only take place onshore through a central counterparty model. Central Counterparties (CCPs) act as legal counterparties between lenders and borrowers and take responsibility for all the obligations related to securities lending transactions. Due to the specific requirements and regulations associated with CCPs, investors might be discouraged from participating in these markets. In addition, regulations could prevent certain institutions from participating as well. Securities Lending in the Emerging Markets 3 From Frontier to Emerging In frontier markets, investors often find regulatory impediments to short selling and securities lending. “Frontier markets” are those emerging markets that are considered investable, but don’t normally receive institutional investment allocations because their market capitalization and liquidity are lower than that of conventional emerging markets. Many observers include in this classification markets such as Dubai, Qatar, Saudi Arabia, Romania, Nigeria and Pakistan. In an effort to attract global investment, many frontier markets seek to be included in a major emerging markets index, such as the MSCI Emerging Markets Index, which is a free-floatadjusted market capitalization index designed to measure the equity market performance in global emerging markets. However, to achieve classification in this index, frontier markets must meet several standards centered on the sustainability of economic growth and the depth and liquidity of local capital markets. The allowance of short selling and securities lending are essential to creating these market conditions and, therefore, classification in a major index. Regulators seeking to transition their market from a frontier market to an emerging market will typically initiate the development of local securities lending by focusing on domestic lending programs with local borrowers and the use of local collateral for loans. Once these markets become accustomed to short selling and securities lending, they often undertake a staged transition by relaxing rules to allow the participation of foreign investors in these local markets. In many frontier markets, governments are instituting legal and regulatory reforms that allow for short selling and the use of offshore broker-dealers and collateral for securities lending in an effort to enhance market depth and liquidity and to attract flows from global institutional investors. Experienced Agent Lenders Experienced agent lenders with broad geographic exposure and expertise can serve as a guide, helping lenders to understand the operations of securities lending in any new market. In order for a lending agent to launch services in a new market, a number of points must be evaluated such as: •Collateralization/Margin •Accounting •Taxation •Legal and Regulatory Considerations •Market Settlement Process •Loan and Return Process •Documentation for Lenders, Borrowers and Agents •Recall Process/Buy-ins •Local Costs and Penalties •Which Entity Serves as the Counterparty •Corporate Actions and Dividends •Proxy Voting •Local Reporting As with any financial transaction, practitioners undertaking securities lending in the emerging markets should take into account a variety of legal and tax considerations. For example, when a stock is lent in the market, is it considered a disposal for tax purposes? And when manufactured dividends — as opposed to regular dividends — are received by the lender, is there any difference in the tax treatment? 4 Citi Transaction Services Regulation’s Impact on the Market The impact of short selling in providing for market transparency and price discovery has been well documented. A landmark study by the Cass Business School (City University of London) of 30 countries using data from nearly 17,000 stocks between 2008 and 2009 concluded that bans on short selling are “bad for liquidity and do not help to support prices.” Moreover, the Group of 30 and the International Securities Services Association (ISSA) in their 2003 recommendation document, Global Clearing and Settlement: A Plan of Action, specifically called on emerging markets to permit securities lending and borrowing as a means of expediting settlement and improving overall market efficiency. In emerging markets with high levels of foreign investment, and in which regulations do not allow lending, liquidity “logjams” can impede basic market functions. Because liquidity is critical, regulations by themselves are not sufficient. To be successful, emerging market securities lending programs need both policy support and market participation by lenders, borrowers and agent lenders. Even where regulations allow for short selling and arbitrage strategies, if supplies of securities and counterparties are limited, investors face a “chicken and egg” dilemma between market rules and market activity. Both elements are clearly needed. The Future Financial globalization will continue its steady march toward greater trading volumes and deeper integration. As history has shown, frontier and emerging market practice and standards will, over time, come to more closely resemble those of developed markets. As the worldwide securities lending industry expands in depth and geographic coverage, lenders and borrowers should look to market-leading agent lenders to monitor this complex global environment and guide activities through new channels as they open up. As with other areas of financial markets, the expanded adoption of best practices and increased regulatory harmonization can be expected to result in deeper, more liquid and more efficient capital markets for the benefit of all market participants. As history has shown, frontier and emerging market practice and standards will, over time, come to more closely resemble those of developed markets. Citi OpenInvestorSM is the investment services solution for today’s diversified investor, combining specialized expertise, comprehensive capabilities and the power of Citi’s global network to help its clients meet their performance objectives across asset classes, strategies and geographies. Citi OpenInvestor provides complete investment services for institutional, alternative and wealth managers, delivering middle-office, fund services, custody, and investing and financing solutions that are focused on its clients’ specific challenges and customized to their individual needs. Citi Transaction Services transactionservices.citi.com © 2012 Citibank, N.A. All rights reserved. Citi and Arc Design is a registered service mark of Citigroup Inc. OpenInvestor is a service mark of Citigroup Inc. 999358 GTS26001 09/12