STATE STREET CORPORATION
Abstract: As the advantages that deep, liquid capital markets offer to national economies—most notably, enhanced capacity for economic growth—become more evident, policy makers in nations around the world are seeking ways to foster capital market growth. As capital markets evolve, they divide risk even more finely—by evolving new financial instruments such as options and futures (derivatives) and new investment vehicles and strategies such as mutual funds and hedged investments. The single most important quality that securities markets need to function successfully and to grow is liquidity—the ability to buy or sell substantial investment positions quickly, smoothly and with minimal market impact. One of the most important factors in fostering liquidity is the evolution of a broad array of securities lending functions. The ability to borrow securities is, in fact, a key element in the development of advanced capital markets. Wherever securities lending has not yet become accepted practice, the evolution of national or regional capital markets is stunted—limiting their ability to allocate capital more efficiently to economic development.
Keywords: bank, borrowing, borrowing of securities, capital market, counterparty risk, financial services, lending, lending of securities, lending securities, securities borrowing transactions, securities finance, securities lending, securities lending transactions
Capital markets play an indispensable role in economic development and securities lending enables these markets to work much better and to evolve. Many nations have been moving to remove legal and regulatory obstacles to securities lending and to encourage more participation in the practice as a way to spur the growth of their domestic capital markets.
The world's leading central banks themselves engage in the closely related practice of using repurchase transactions (repos) in government securities markets as an element in managing their monetary policies. These institutions have also been encouraging a wider array of private securities firms to participate in this market alongside them. The growing official consensus in favor of capital markets and the increased recognition by policymakers of securities lending's function as an important market lubricant will ensure that securities lending remains a central element in twenty-first century capital markets.
This chapter discusses the central role that securities lending, liquidity, and a strong capital-based market system play in creating a robust economy. Securities lending and capital markets evolve in tandem. The evolution of the securities lending market has been a significant component to increasing market liquidity, globally, and the ability to lend and borrow securities is an essential element in the development of advanced capital markets. Securities lending has the effect of increasing the total supply of assets, and nations are acknowledging its significance and encouraging the injection of new liquidity into their capital market systems through this practice.
The financial history of the world s most developed economies through the twentieth century centers on a single theme—the securitization of finance—as capital markets grow to supplement even to displace traditional banks as the prime intermediaries between borrowers and lenders of capita (see Chernow 1997).
The last decades of the twentieth century saw capital markets in the most developed nations come to eclipse traditional bank-dominated financial systems. Fueled by a multitrillion dollar-wave of pension and retirement savings capital markets in the United States the United Kingdom and other leading economies have grown well past the scale of the total holdings of their national banking systems.
Capital markets in these nations have in fact replaced banks as the dominant source of corporate finance. In the United States for example this process of disintermediation is so far advanced that less than 30% of corporate finance now comes from traditional commercial banks. Some of the most dynamic growth areas in these nations' banking industries now center on the transformation of traditional bank products such as mortgages or credit card debt into securitized products that can be traded on the capital markets.
The forces driving the rise of capital markets remain strong. These range from the aging of the global population the attendant multitrillion-dollar rise in retirement savings the continuing triumph of capitalism itself progress in the application of both raw computing power and quantitative strategies to investing the explosive growth of derivatives and hedge funds and the ubiquitous availability of information to guide and execute investment and trading strategies on a global basis.
A capital markets-based financial system can systematically provide seed capital to entirely new high-tech industries. It is almost inconceivable for example that the Internet biotechnology and other new economy industries now rising in the United States and elsewhere could have been financed so rapidly or on today's scale through traditional lending by an old economy banking-dominated financial system.
A growing number of economists and policy makers backed up by day-to-day experience now share a new consensus view robust capital markets which offer a full array of modern financial products and practices contribute to long-term national economic growth by encouraging entrepreneurship and innovation even given periodic market corrections (see Levine and Zervos 1999).
Capital markets can finance economic growth more efficiently than traditional bank lending systems that depend on making a spread of interest rate revenue over the banks' costs of funds. Capital markets can more easily diversify and distribute risk by dividing shares in the equity ownership or portions of the debt involved in financing enterprises into stocks and bonds which in turn can be much more widely dispersed among investors than traditional bank loans.
The availability of active markets for shares in new enterprises then enables venture capitalists to make a range of investments in a variety of high-risk ventures—in the hope that one or more spectacularly successful initial public offerings (IPOs) will more than make up for other ventures' failures and losses. Traditional commercial banks by contrast cannot risk lending to an array of unproven start-ups—however promising—because banks can not earn enough additional interest on those new firms that succeed to make up for capital they are likely to lose when other unproved borrowers fail.
In addition as capital markets evolve further they can split the atom of risk even more finely—by creating new financial instruments such as options and futures and new investment vehicles and strategies such as mutual funds exchange-traded funds and hedged investments. These provide investors with new ways to increase returns and manage risks and to do so more cost effectively.
Given these dynamic growth-fostering advantages it is no surprise that both developed and emerging nations are actively seeking to follow the same process of financial evolution so evident in the United States the United Kingdom and other capital market leaders. The movement away from communist economic regimes in the 1980s and 1990s has spawned a huge expansion in the number of global stock markets that money managers and institutional investors have to consider—from fewer than 80 in the early 1980s to more than 160 by the turn of the twenty-first century.
Much of that growth has been concentrated among the world's most advanced securities markets—notably New York and London—where market capitalization on the leading exchanges multiplied 10-fold in the 1990s. As the strategic growth advantage that developed capital markets offer to national economies become more evident policy makers in many nations are coming to view capital market development as imperative to their nations' futures to their ability to finance new high-tech industries and to their competitiveness in a globalizing economy.
Over and above their growth advantage the development of deep liquid capital markets also offers nations the benefit of greater financial system stability. As former Federal Reserve Board chairman Alan Greenspan noted the existence of strong capital markets alongside well-regulated banking systems may help insulate a nation's whole financial system from systemic risk by providing alternate sources of liquidity and financing that can be tapped when either banking systems or securities markets are in short-term crisis (Greenspan 1999).
This is not to suggest that capital markets represent some magic elixir for economic growth or that traditional banks are moribund. Even when accompanied by well-developed rule of law advanced accounting standards and free flow of information capital markets can at times overinflate or depress underlying economic value creating bubbles and panics. As the Fed chairman noted the central banks' ability to inject liquidity into the financial system through banks was essential in containing the financial contagion that had frozen many securities markets in the wake of the 1997-1998 Asian financial crisis.
The key point is that having both advanced capital markets and strong banking systems gives nations both greater competition in the provision of capital (and the possibility of turning to complementary financing systems) and eliminates the need to simply rely on one or the other. The securitization of the U.S.-based mortgage industry for example helped keep housing finance flowing which limited the depth of the 1990-1991 U.S. recession precisely because banks could repackage and sell their mortgage loans into capital markets.
Besides their sheer scale the world's most developed capital markets have become vastly more complex and transnational in scope. Companies doing business in and serving these capital markets—both buy-side institutional investors and sell-side brokerage firms—have expanded their horizons from national to global markets as they seek to manage the largest pools of long-term investment capital in history.
Investors have also changed their own investment and trading habits in a process that some analysts have dubbed financial intensification. This refers to both the vast proliferation of new financial instruments—mainly options futures and other derivatives that investors use to manage and mitigate risk—and to the dramatic rises in trading volumes as investors engage these new instruments to conduct trading and investment strategies that often produce vastly higher turnover.
Taken together the rise of cross-border investing and the proliferation of financial instruments that serve to arbitrage differences between national capital markets points to the emergence of a single truly global capital market which is subject to the law of one price as domestic price and regulatory differences erode (see Bryan and Farrell 1996). Individual nations' markets then become nodes in this emerging global network and their success depends on the extent that national policymakers make their markets attractive to domestic and foreign investors.
Clearly what capital markets need above all to grow to become liquid and to sustain increasing volumes of transactions is capital—preferably sustainable flows of long-term patient investment. The prime source for funding the rise of late-twentieth-century capital markets has been domestic pension savings and the evolution of collective investment vehicles. It is no coincidence that the nations with the highest ratios of equity market capitalization to gross domestic product (GDP)—for example the United States the United Kingdom and the Netherlands—also have the most well-developed systems of pension collective fund and personal retirement savings. While domestic pension savings have been a prime fuel for their growth the most advanced capital markets also benefit from their openness to cross-border investing which grew explosively in the 1990s.
For nations whose capital markets are less developed one clear lesson is the removal of obstacles to foreign investment is itself a prerequisite for the development of effective capital markets (World Trade Organization 1997). Improving regulatory transparency is also necessary to boost foreign investment. Transparency leads to business predictability for foreign entities that are expanding to new markets and taking the risk of dealing with many uncertainties. In turn the ability of a given national or regional securities market to attract capital—whether from domestic savings and pension funds or from offshore investors—depends critically on the creation of efficient well-regulated mechanisms for handling rising transaction flows settling trades and mitigating risk.
The single most important quality that successful securities markets must foster is liquidity—the ability to buy or sell substantial investment positions quickly, smoothly and with minimal market impact. An analysis from the Counterparty Risk Management Policy Group (1999) states market liquidity is a precondition for the smooth pursuit of all financial activities, including the pricing of financial products, the risk management of financial institutions, and the conduct of monetary policy.
There is, of course, a notorious circularity in analyzing the root sources of liquidity, because it is, to a large degree, a self-fulfilling phenomenon. Investor confidence spurs a general willingness to trade, the participation of many transactors deepens markets and smooths trading and these qualities of a market further raise investors' confidence. Liquidity is, or can be, the function of such a virtuous circle.
Definitions of liquidity range beyond the ability to deploy capital into and out of a market in an efficient way— that is, without excessive transaction costs or impacts on securities prices. Microanalysis of a given market measures its liquidity in at least three dimensions (Bank for International Settlements, Committee on the Global Financial System, 1999):
Tightness—how far transaction prices diverge from mid-market prices—a metric generally visible in the size of bid-asked spreads.
Depth—how large a volume of trades can be processed without significantly affecting prevailing market prices or the amount of orders on market makers' books in a given time frame.
Resiliency—how quickly price fluctuations resulting from trade are dissipated and/or how quickly order flow imbalances are adjusted and price recovery occurs.
In a somewhat broader sense, liquidity includes the ability of market participants to make money by trading when a market is moving downward as well when that market is trending upwards. Liquidity also relies on efficient price information and settlement systems, low transactions pricing and spreads and low infrastructure and tax costs.
These overall features of a market's efficiency, all of which contribute liquidity to traders and investors in a market, are continually evolving. National laws and regulations, systems for trade settlements and record keeping, provisions for the security of investors' own data and that for greater transparency of financial information provided to the market can all enhance liquidity if they are well designed and implemented. Alternatively, regulatory restrictions on short selling or hedge funds and other, even more inhibiting measures—such as capital controls or transaction taxes—can discourage investors and erode liquidity.
Ultimately, liquidity is a function of investors' confidence that they have the ability to buy and sell their investments when they want in markets that may fluctuate but will not stall or fail. Clearly investor confidence—or its withdrawal—has a self-reinforcing impact on any market's liquidity. Fostering such confidence, then, has to be a central aim for national authorities intent on developing their capital markets. One way that governments and central banks foster liquidity directly is through implicit assurances that they will provide market participants with funds to keep orderly trading under way and mitigate trading freeze-ups or panicky sell-offs if market crises do occur.
Offering a specific asset class—such as long-term government bonds—with specific policy assurances that the government will keep the market liquid, can also be a useful way to ensure that even amid the evaporation of liquidity from some markets, at least some benchmark asset that the rest of the market relies on to price other risks and values will continue trading freely until confidence generally can be restored (Bank for International Settlements, Committee on the Global Financial System, 1999).
Another way to encourage liquidity is for national regulatory authorities to allow and encourage more market participants to engage in lending and borrowing securities already outstanding in the nations' equity and bond markets. (Such permission, even encouragement, is already common in most markets for government bonds, because most central banks are themselves major players in these markets.) Regulators can further assist by understanding and encouraging the use of swaps, options, and other derivatives, which encourage liquidity by enabling traders and investors to mitigate their risks.
The development of a broad array of securities lending activities can provide a very significant source of liquidity to any well-developed capital market. A brief review of how securities lending has evolved in U.S. markets—the world's deepest and most liquid securities investment and trading arena—can help illustrate the critical role that securities lending practices play in providing liquidity to increasingly vast capital markets which are executing increasingly complex trading strategies.
Historically, the earliest evidence of securities lending in the United States can be traced back to the market for U.S. government war debt following the Declaration of Independence in 1776. But a considerably more robust market for private securities lending in both the American and British stock and bond markets developed throughout the 1800s.
From those centuries-old origins well into the mid-twentieth century, the lending and borrowing of securities evolved as a private, ad hoc practice usually transacted directly between investors or broker-dealers. It was not until the 1960s, in the United States, that securities lending began to develop as a substantial day-to-day market of its own served by specialized institutions and practitioners.
The most important factor driving the emergence of the modern securities lending industry was the revival of interest in stock market investing brought about in the 1960s by the U.S. economy's booming growth. Many of the leading firms on Wall Street not only notched record profits, but also drew a level of individual and institutional investment not seen since before the crash of 1929 and the subsequent Great Depression.
As rapid economic growth fueled a booming equity market on Wall Street, first individuals and, increasingly, pension funds, rushed to invest. Many corporations also took advantage of rising share prices to issue equity-related hybrid securities convertible into common stock. Other companies used their rising stock as currency to take part in a wave of corporate takeovers and restructurings.
Both of these developments opened new opportunities for professional traders to arbitrage between common stock and hybrids—or between the stocks of acquiring or target firms engaged in takeover battles. The bull market also revived interest in American Depositary Receipts (ADRs), an instrument developed in the late 1920s to represent foreign shares traded in markets in other countries. Not least, as stock prices soared, more bearish speculators sold shares short in hopes that prices would later decline.
By the early 1970s, both stock exchanges and securities firms were struggling to cope with the huge upsurge of trading brought on by these overlapping waves of change. The result was a series of major back-office snarls, some severe enough to lead to the collapse of major Wall Street trading firms and an explosion in settlement failures. These symptoms of operational dysfunction—and classic market illiquidity—were eased in the course of the 1970s by two developments. First, the trade settlement process was increasingly automated and the back-office paper jams eased. Second, a true securities lending industry began to emerge, which was able to reduce trade fails substantially by providing borrowed assets to arbitrageurs, short sellers, and other traders who needed securities that they did not own to conduct their investment strategies.
The growth of institutionalized securities lending was a timely development for U.S. markets since it paralleled a further surge in the demand side of the securities lending equation. This was brought about by the boom in option trading and other derivatives in the mid-1970s set off by the application to capital markets of the Black-Scholes option-pricing model. This analytical tool provided traders with a more reliable formula for gauging the value of put and call options on stocks. With a reliable metric for measuring values in the options markets, volume exploded. Trading strategies based on options required the borrowing and lending of shares for hedging as well as for arbitrage. As the so-called derivatives revolution rolled on, the investment strategies born of the Black-Scholes model laid the groundwork for a fresh wave of financial innovation centered on new derivatives, index arbitrage and other complex investment and trading strategies throughout the 1980s and 1990s—all of which drove demand from dealers and investors for borrowed securities to execute their trades and hedge their market risks.
On the supply side, U.S. custodian banks moved to meet demand for borrowed securities in the 1970s by devising lending services for such institutional clients as insurance companies, corporate investment portfolios and, later, college endowment funds. Legislation soon permitted pension funds to join the quest for enhanced returns by engaging in securities lending. By the mid-1980s, the majority of institutional investors in the United States were using securities lending routinely as a way to earn extra income to offset custodial fees—and securities lending in the United States had itself become a thoroughly institutionalized industry.
The key lesson of this U.S. experience is simple: Securities lending and capital markets evolve in tandem.
In mobilizing the securities already outstanding in a market, securities lending has the effect of increasing the total supply of assets available to support trading and settlement. This enables the outstanding stock of assets, in effect, to do double duty in the service of market liquidity by converting otherwise sterile holdings into a dynamic, internally generated source of finance that can support higher trading volumes and more sophisticated trading strategies.
By turning existing stocks and bonds into financing sources for further transactions, a well-developed securities lending business can minimize trading friction, improve efficiency, reduce settlement failures, and lower transaction costs across an entire capital market. The benefits are multiple. Risk mitigation is made easier by the options that securities lending provides to investors wanting to balance long positions with offsetting short positions. Indeed, all market participants benefit—not just those who engage in securities lending or borrowing.
The development of a sophisticated securities lending industry has, in fact, played a central role in enhancing the liquidity of those markets that have managed to leap to maturity. Indeed, market maturity may best be defined as the level of liquidity that can attract significant investment from large global investors.
In country after country through the 1980s and 1990s, new or revitalized capital markets began their economic take-offs by first attracting increased attention from domestic investors and from the most venturesome of foreign investors. Almost by definition, it is this first wave of inward investment that makes an emerging market actually emerge. To continue growing, a capital market needs to draw investment that is more stable and longer term—from larger investors who are typically much more risk averse than the pioneers.
This has required capital marketplaces around the world to improve and automate their settlement processes, to establish central securities depositories (where they did not yet exist) and to decertify securities ownership and unclog paper flows.
As these changes take hold and investment in a given market rises, further pressures build—for better data, for greater transparency and for the creation of derivatives or short-selling practices that, increasingly, larger investors need to hedge their investment risks. The demand for means to hedge exposures is particularly acute among global pension funds.
Bound by fiduciary standards of prudence, many institutional investors are virtually obliged to use derivatives, repos, and other instruments to manage their investment exposures. The rise of markets in derivatives instruments, in turn, depends on the ability of players in the real or underlying securities markets to engage in substantial short selling and securities lending, and so to sustain liquidity amid rising transaction volumes.
In markets where securities lending is underdeveloped—or explicitly discouraged by regulatory or cultural barriers—evolution to a world-class level is simply stunted, at least until these barriers are removed.
As this market development pattern has replayed time after time, more and more governments, multilateral agencies like the World Bank, and economists have come to acknowledge the catalytic role of capital markets in economic development. Institutions like the Bank for International Settlements are also now acknowledging the role of securities lending in helping securities markets to function well.
A new consensus is emerging according to the Technical Committee of the International Organization of Securities Commissions (1999): the ability to borrow securities is an indispensable element in the development of advanced, effective capital markets. Indeed, the greater the turnover in a market, the more important securities lending becomes. Securities lending, in short, is no longer an ad hoc, back-office operation that enables borrowers to trade on securities they currently do not own. Nor is securities lending merely a low-risk way for institutional investor lenders to earn a few more basis points or cut their custody fees on their holdings. Securities lending as an industry has matured to become a major source of internal financing that any capital market needs to achieve a world-class, twenty-first-century practice.
It is little wonder that a report by the International Organization of Securities Commissions and the Bank for International Settlements (1999, p. 2) concluded:
Securities lending markets are a vital component of domestic and international finance markets, providing liquidity and greater flexibility to securities, cash and derivatives markets.... Securities lending activity will continue to increase and become an even more integral component of financial markets in the future.
Sophisticated regulators and policy makers in many nations now recognize securities lending provides the liquidity that lubricates their capital market engines. As a 1998 report by the Bank for International Settlements, Committee on the Global Financial System (1998) notes, investors are more willing to transact and take positions in markets where they expect liquidity to continue at a high level for the foreseeable future... and market liquidity tends to be enhanced when instruments can be substituted for one another, since the market for each of them will be less fragmented.
This growing recognition by governments and regulators of the value of securities lending should not be surprising. It stems, in large part, from central banks' and monetary authorities' own reliance on the closely related practice of using repurchase agreements (repos) in their government debt markets as a key element in monetary policy—a development we will turn to shortly. However, we will first explain how securities lending finances liquidity.
To understand how securities lending concretely contributes to market liquidity, consider the structure of a specific equity lending transaction in its simplest form. In basic equity lending, a counterparty borrows stocks against a collateral obligation. The borrowed shares are cycled back into the trading market and the collateral (if cash) is used to purchase additional instruments, generally short-term money market or other fixed income instruments. Both components of the transaction—the lent securities and the reinvested collateral—inject additional securities or cash into capital markets, enhancing liquidity both directly and indirectly.
The increased supply of assets that lending makes available to support transactions in a given market facilitates that market's efficiency in the pricing and settlement of transactions, which helps the market's trading flow move more smoothly and with less market impact. This is virtually a dictionary definition of what liquidity means.
However, securities lending also enhances liquidity indirectly. The smoother transaction flows that lending facilitates contribute to investors' confidence that they can trade with less risk of fails or market freeze-ups. This holds true not only for the simple example cited above, but for the whole array of complex trading strategies that have evolved over recent decades, all of which depend on a robust securities lending market for their execution.
As a market grows in value and trading volume, market participants create new instruments and trading strategies that increase demand for borrowed securities. Securities lending thus evolves from a settlement and back-office function to the supplying of securities to cover short positions to the supplying of lent securities to support global trading strategies.
By reintroducing shares, bonds, or other financial instruments into the market on a cost-efficient and timely basis, securities lending enables market participants to use these assets in ways that rebalance prices, diversify risk, minimize trade and settlement failures, and allow positions to be exchanged even when parties to a trade do not own the securities being traded.
Here is a further example from the world of arbitrage, one of the heavy generators of demand for securities lending in today's marketplace. Arbitrage trading, the object of which is to capture differences in prices for the same security or its equivalent in different markets, generates continual demand for securities borrowing as arbitrageurs seek to exploit often minimal and transitory price differences between securities they may not own. The arbitrageur's profit is often minuscule. But he repeats this strategy all day long, whenever the price spread gets out of line on either the high or low side. That makes him an omnipresent rebalancer of prices—and an incessant contributor to liquidity on both sides of the market. Although arbitrageurs seek profit from inefficient pricing, it is their trading, often supported by borrowed securities, that keeps bringing prices back in line and makes overall markets more efficient.
In ADR arbitrage, for instance, the arbitrageur trades back and forth between a depositary receipt traded in the United States and the actual shares traded in, say, Frankfurt, capturing price discrepancies as they arise. The arbitrageur borrows securities as needed to execute her trade—and in the process deepens trading volume and pushes the prices back in line. Similarly, index arbitrage keeps pricing in line between a basket of shares and an index futures contract.
The more complex strategy of risk arbitrage in corporate merger and acquisition deals also rebalances and adds liquidity to securities markets. When one company offers its shares to buy another company, the arbitrage strategy is often to purchase the target company's shares, borrow shares of the acquiring company, and sell them short to capture the premium (often 20% or more) the acquirer is offering as an incentive to the target company's shareholders. When, or if, the deal goes through, the arbitrageur can capture the premium by delivering her shares in the target company in exchange for the acquiring company's shares, which she then returns to the securities lender.
Target companies sometime object to risk arbitrage activity on grounds that a large proportion of its shares in arbitrageurs' hands will swing a shareholder vote in favor of the deal. Risk arbitrage, however—and the securities lending that makes it possible—benefits the market by absorbing a large portion of the acquisition risks, bringing pricing in line with those risks and adding trading liquidity that permits shareholders in the target company to sell their shares and capture a portion of the premium before the deal goes through.
The decade of the 1990s was bracketed by two major policy reports that resoundingly endorsed the role of securities lending in capital market development—and urged nations to do more to encourage it. The first was a 1989 report by the Group of 30 (G30) on clearing and settlement systems. One of the report's recommendations urged governments and regulators to facilitate securities lending in order to reduce the high rates of trading fails that were discouraging cross-border investors and rendering domestic capital markets illiquid and prone to paralysis.
The G30s call to take down regulatory and taxation barriers that inhibit securities lending has received increasingly positive response through the 1990s (International Organization of Securities Commissions, Bank for International Settlements, July, 1999). Japan, Australia, the United Kingdom, Switzerland, Italy, France, and other nations acted to remove legal and regulatory obstacles to securities lending and to encourage more participation in lending, swaps and securities sell-buy-back agreements by both domestic and foreign entities.
At the same time, in the form of repurchase agreements, securities lending has become a vital tool of modern monetary policy though the activity of central banks themselves in government securities markets. Leading central banks all now use an active repo trading strategy to add liquidity to their sovereign debt markets, to stabilize their currencies, and to attract foreign investment.
Amid the explosive growth of global capital markets— and the increasing use of securities lending and hedging techniques by central banks and governments—the decade of the 1990s closed with this conclusion from a joint study by the International Organization of Securities Commissions and Bank for International Settlements (July 1999, p. 5):
Securities lending has become a central part of securities market activity in recent years, to the point where the daily volume of securities transactions for financing purposes considerably exceeds that of outright purchase and sale transactions.
Securities lending and the market in repos have similar characteristics but with different legal structures. They both follow the same transaction structure whereby a security is transferred versus a collateral obligation. Repo transactions are outright sales of a security accompanied by an agreement to buy the security back at a specified price on a specified date—sometimes as soon as the next day. Thus, they can be used as either a securities borrowing or cash borrowing vehicle. In effect, the repo seller lends the security against cash collateral, while the repo buyer lends cash against the security as collateral.
Like a securities loan, repo may have the effect of bringing divergent prices back into line, of lowering the cost of financing and trading strategies and of splitting the atom of risk.
By the 1990s, the repo market was quite sophisticated (International Organization of Securities Commissions and Bank for International Settlements, July 1999, p. 10):
In the U.S. Treasury repo market, brokers began to run matched book portfolios to provide liquidity to their customers and to use the repo market to take positions on the short end of the yield curve. For example, a broker might lend securities on repo for one month and finance them for one week, in the expectation that repo financing rates would fall. Thus repo grew beyond a straightforward financing market to become a money market instrument in its own right, as an alternative to interbank deposit and treasury bill/certification of deposit markets.
Perhaps most significantly, repo has evolved to be an important tool in managing monetary policy for a number of central banks around the world. As noted by the Bank for International Settlements, Committee on the Global Financial System in its report on Implications of the Repo Market for Central Banks (March 1999, p. 11):
For the central banks that use them, repos have often become the most important monetary policy instrument. In a number of G-10 central banks, the proportion of repos used in the refinancing of domestic financial sector is over 70%.
Repo and securities lending are related transactions with related functions. They are linked by their similarity in providing a supply of securities, increasing trading volumes, diversifying risk and helping to keep financial markets running smoothly. These very similar practices are, in fact, linked across markets. As the Bank for International Settlements, Committee on the Global Financial System (March 1999, p. 8) notes:
In some instances, the supply of securities in repo markets can be increased by stock-lending agreements ... (such agreements) allow institutions that hold securities but do not want to (or are not allowed to) participate in the repo markets to earn a higher return. ... Since repo markets support securities markets, securities issuers sometimes take steps to promote them.
In addition to the increased liquidity that loans of securities inject into a capital market by directly facilitating various trading strategies, the collateral that is posted against borrowed securities also benefits the markets.
When cash is pledged as collateral, the general practice is to reinvest it in short-term, money-market instruments because securities lenders have to price, purchase, sell, and settle on a daily basis, and holding any illiquid instrument in a short-term fund would be excessively risky.
The need to invest such collateral, in turn, generates substantial, continuing demand from securities lenders for reliable money-market investments—adding breadth and depth to markets for supranational, corporate, and securitized short-term debt. Where noncash collateral is accepted, lenders will generally approve only issues that can readily be priced, traded, and liquidated for a cash position in order to protect securities loans.
As governments, multinational agencies and scholars recognize both the catalytic role of capital markets in economic development and the ways that securities lending keeps markets liquid, a growing number of nations are removing legal and regulatory obstacles to securities lending. Some are actively encouraging more participation in the practice by both domestic and foreign entities.
Nations are continuing to recognize the merits of securities lending and encourage the practice through reforms. Official support is particularly notable in the closely related arena of repo transactions in government securities markets—which have become central to the operations of the largest and most powerful monetary authorities in the world.
If the 1990s saw the rise of capital markets as the prime vehicles for financing the most dynamic economies in the world, the first decade of the twenty-first century will see these markets truly come of age. Growing awareness of the powerful competitive advantages that well-developed capital markets bring to national economies will spur their further development worldwide. The continued global movement towards pension and savings reforms will provide trillions of dollars in mass-based investment capital to help world securities markets grow.
Nations that want to harness these vast, stable flows of long-term funds to spur their capital markets will, in turn, need to open themselves to the full array of legal, regulatory and transaction mechanisms that make securities markets work. Derivatives, hedging, short selling, and securities lending are among the key elements that any market will need to make available to attract investors and grow.
The increased official recognition by policy makers and central banks that they need to stimulate securities lending in general and repo markets in particular promise to make securities lending a central element in the growth of twenty-first century capital markets. This implies that as astonishing as the rise of securities lending has been over the past 20 years, the industry's best days are yet to come.
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