Securities Lending and Borrowing & Short-Selling Regulations expected to enhance liquidity in the capital markets
Nairobi 16 January 2018….The Capital Markets Authority (CMA) has lauded the Cabinet Secretary to the National Treasury for the gazettment of the Capital Markets (Securities Lending, Borrowing and Short-Selling) Regulations 2017, which are expected to facilitate enhanced liquidity in the capital markets.
Speaking while confirming the new development, the CMA Chief Executive, Mr Paul Muthaura said, ‘’Making the Kenyan capital markets highly vibrant and liquid is a key priority for the capital markets industry and the Securities Lending, Borrowing and Short-Selling Regulations are expected to facilitate this’’.
Mr Muthaura further observed that this new development is one of the recommendations of a 2015 World Bank-supported study on the state of liquidity in Kenya which recommended several measures to improve liquidity. Some of the proposals included: introduction of market makers, removal of pre-funding and pre-validation checks, introduction of circuit breakers instead of price bands, Securities Lending and Borrowing (SLB) and Short Selling. Among the key initiatives which the World Bank Report recommended for immediate implementation was the introduction of Securities Lending and Borrowing (SLB) as well as Short Selling.
Mr Muthaura added that the initiative is aligned to the Authority’s mandate of promoting the development of Kenya’s capital market to be an investment destination of choice through facilitative regulation and innovation as anchored in the Strategic Plan (2013-2017) and Capital Market Master Plan (2014-2023). He explained that in the pursuit of this mandate, CMA has been implementing regulatory reforms as well as introducing new products and services aimed at deepening, diversifying and strengthening the securities industry.
Recent developments include the publication of Policy Guidance Notes for Exchange Traded Funds & Policy Guidance Notes for Asset-Backed Securitization; the implementation of a cross-sectoral program on Islamic Finance development and the implementation of a new Code of Corporate Governance Practices among others.
Securities Lending and Borrowing (SLB)
This is the temporary transfer of securities from one party to another, with a simultaneous formal agreement to return the securities at a pre-agreed price either on demand or at an agreed date in the future. Full legal title to the securities is transferred from the lender to the borrower so that the securities can be used entirely as the borrower desires, including selling them onward to others. SLB transactions are governed by the terms of securities lending agreements aligned to terms and conditions as agreed by the parties and in line with international best practice. Lenders and borrowers will always have unique characteristics that cause them to either remain on the borrowing side or lending side. Borrowers are market participants who identify trading opportunities that will more than make up for the lending fee costs. Most borrowers are therefore active market participants who take advantage of price movements. They include market makers, arbitragers, directional short sellers or players in the derivatives and Exchange Traded Funds markets.
Unlike borrowers, lenders are usually institutional investors, particularly pension funds and insurance companies, that are long or medium term investors in the securities. We also have high net worth individual investors whose interest is to grow the value of their portfolios over the medium to long term. They therefore lend securities in order to earn a lending fee and increase the return on their portfolio.
The loaning of securities may be for a fixed term, or at times may be left open so that securities can be recalled by the lender or returned by the borrower as and when necessary. The structure of SLB involves three parties i.e. the lender, lending agent and the borrowers. The impetus to lend securities stems from a desire to increase the financial performance of the funds while creating minimal risk to the funds. Lending agents provide support services to lenders. They maintain a pool of assets available for lending and cut on administrative costs for the lenders. The above set up improves liquidity by unlocking securities to facilitate trades and subsequently increasing the number of transactions.
Under normal circumstances, the securities to be returned by the borrower are not required to be the same, i.e. same registration number, and rather will be what is referred to as wholly equivalent. Wholly equivalent means the returned securities are of equivalent value/maturity or the same number and counter. One critical thing that an effective SLB program needs to address is potential lender’s risk in the event that the borrower fails to return the borrowed securities. Normal practice is therefore that securities lending is always accompanied by collateral from the borrower. The collateral is thus used to mitigate the credit risk between the counterparties. The collateral may be delivered to the lender, or to a person acting as an agent for the borrower, or be maintained within separate accounts by the borrower on behalf of the lender. The collateral is usually in the form of cash or liquid securities.
With regards to the economic interests of the lender, it is important to note that lenders have a medium to long term horizon which is tied to the return on his/her holdings. It is therefore in their interest to ensure that as much as the securities are loaned to the borrower and the legal title transferred to the borrower, they seek to retain the economic interests in the same such as those related to voting rights for equities. Securities loans are therefore constructed in a way to enable the lender continue enjoying all the economic benefits of ownership of the securities, during the period of the loan. That means that even though the dividends and interest are paid to the borrower, the borrower is under obligation to pass them to the lender at an appointed time.
As a consequence of the arrangement, the lenders are equally exposed to investment risks such as rise and fall in the value of those securities as well as default risk by the issuer.
Short selling is a transaction involving selling a financial instrument that the seller does not own at the time of the sale. Normally, the short-seller will “borrow” or “rent” the securities to be sold, and later repurchases identical securities for return to the lender. SLB and short selling are a complementary pair. While short selling facilitates trade, securities lending and borrowing ensures settlement. Without short selling, an investor’s activities are pegged and limited to the size of their asset holding. This implies that even when demand prevails, the degree to which they take advantage of that demand is limited.
Short-sellers profit from a decline in the price of the financial instrument. Short selling or “going short” is contrasted with the more conventional practice of “going long”, which occurs when a financial instrument is purchased with the expectation that its price will rise. This is the current option in the Kenyan capital markets for both equity and debt markets which ultimately restricts the benefit of market activity to when the market is only moving in one direction. Typically, being “long” is a way of saying that you own a positive number of the securities while being “short” is where you own a negative number of the securities. If the security price rises, the short seller loses by having sold them for less than the price at which he later has to buy for return to the lender. The practice is risky because prices may rise without bound, even beyond the net worth of the short seller. The act of repurchasing a shorted security is known as “closing” a position or “covering”. There are some costs involved in short selling, notably that the lender charges a fee for loaning out its securities, but in an ideal world the shorter may still stand to make substantial profits where he has planned appropriately. The process generally relies on the fact that securities are fungible, so that the securities returned do not need to be the same securities (i.e., the same registration numbers) as were originally borrowed.
Capital Markets Authority
The Capital Markets Authority (CMA) was set up in 1989 as a statutory agency under the Capital Markets Act Cap 485A. It is charged with the prime responsibility of both regulating and developing an orderly, fair and efficient capital markets in Kenya with the view to promoting market integrity and investor confidence. The regulatory functions of the Authority as provided by the Act and the regulations include; Licensing and supervising all the capital market intermediaries; Ensuring compliance with the legal and regulatory framework by all market participants; Regulating public offers of securities, such as equities and bonds & the issuance of other capital market products such as collective investment schemes; Promoting market development through research on new products and services; Reviewing the legal framework to respond to market dynamics; Promoting investor education and public awareness; and Protecting investors’ interest. For more information, please contact Capital Markets Authority Head of Corporate Communications, Antony Mwangi on email@example.com.