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Quadriserv, Inc. Futures and Options Expo November 2003. What is Stock Loan?. Pension fund/Plan sponsor is the “beneficial owner” of the securities. The securities have additional value as collateral to borrow cash at low rates. Beneficial owner lends assets through custodial bank.

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quadriserv inc

Quadriserv, Inc.

Futures and Options Expo

November 2003


What is Stock Loan?

  • Pension fund/Plan sponsor is the “beneficial owner” of the securities.
  • The securities have additional value as collateral to borrow cash at low rates.
  • Beneficial owner lends assets through custodial bank.
  • The cash collateral is invested at a rate above the borrow cost.
  • Revenue is shared between the owner and the lender

The Current Process

  • Agent lender sends portfolio availability to prime brokers.
  • Hedge fund determines his PB can provide the security he wants to sell short.
  • After canvassing lenders by telephone, the PB borrows security then re-lends it to the hedge fund.
  • The PB re-lend “mark up” can be substantial depending on how “hot” the stock is.

Synthetic Lending through Futures

  • Stock loan can be effected synthetically using an EFP
  • The basis between stock and futures is comprised of dividends, transaction fees and carry costs
  • The IR component reflects the implied financing rate for a long position or rebate rate for a short position
  • Long stock holders can use futures to lend their position
  • Borrowers can achieve short exposure through the future

Synthetic Lending (long stock)

  • A customer who is long stock could synthetically lend their stock using an EFP transaction
  • The customer would sell their stock and buy the equivalent number of futures at a basis which implies incremental net lending income
  • The customer now has long exposure to the stock through the futures market

Synthetic Lending (GC short stock)

  • “GC” financing for shorts is generally Fed Funds less 20-30 bps (the interest received on cash from short sales)
  • Industry participants are able to finance long stock at Fed Funds plus 10-15 bps
  • The result is a spread differential of 30-45 bps
  • Thus, in absolute terms, the customer should be able to get short exposure through the futures market at better short rates

Synthetic Lending (special short stock)

  • Customers are charged a rebate rate to borrow “special” stock (they pay interest in order to borrow the shares)
  • The cost to borrow special stocks can be as high as a few hundred bps, depending on the issue, the broker,etc.
  • Given a broader base of potential “synthetic” lenders, the costs of borrowing special stocks could be reduced
  • The potential new revenue to customers long special stock can be realized

Synthetic Lending (cost structure)

  • The financing spread differential between cash securities lending and synthetic lending (using futures) is reduced by the transaction fees associated with futures clearing
  • For example, if short stock can be financed 35 bps cheaper using futures, then total transaction costs need to be less than $.35 per contract (per 100 shares)

Synthetic Lending (problems)

  • Problems with synthetic lending:
    • Active traders (stat arb hedge funds) may not want long exposure to the market in the form of futures.
    • Prime brokers may simply reduce short rates below competitive market rates, and kill the trade.
    • Long exposure through futures is a term loan.
    • Additional costs are incurred to either take delivery of the stock at expiry or cover the long prior to expiry.