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Securities Lending in the


Emerging Markets
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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 worlds
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

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 dont 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?

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Regulations 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.

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