Prime Services and Securities Lending

Course Objectives

Understand what Prime Services is Describe the range of Prime Services Recognize how and why market
and how it fits within a bank activities participants may ‘short’ stocks

Comprehend how securities lending Calculate the cash flows involved in

works and who are the market Securities Lending
participants

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Prime Services
(‘Prime Brokerage’)
What Is Prime Services / Prime Brokerage

Investment Banks
Provides specialized services to
hedge funds

• Outsource traditional middle

and back-office functions
• Helps keep their overheads
down

Prime Brokers

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What Is Prime Services / Prime Brokerage

1 Trade Execution, Clearing, and Settlement Prime Brokers Servicing

Single-Manager Hedge Funds (1)

2
1. Goldman Sachs
Financing of Trading Activities
2. Morgan Stanley Prime Brokerage

3 Custodian Services
3. J.P. Morgan

4. Credit Suisse Prime Fund

4 Securities Lending 5. UBS Prime Services

6. Bank of America Merrill Lynch

5 Reporting of Profit & Loss 7. Deutsche Bank Global Prime Finance

8. Citi Prime Finance

6 Risk Management Reporting 9. Barclays

10. Interactive Brokers

7
(1) Source: Preqin as of May 2018
Introductions to Potential Hedge Fund Investors

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Capital Introduction

Investment Banks

Hedge funds struggle to attract investors

Cap Intros
Prime Brokers
• Do not make recommendations
Introduce Investors to Hedge Funds
• Do not charge a service fee
Pension Funds Sovereign Foundations
• Hedge fund is expected to use Wealth Funds
prime brokerage or prime
services offered by that bank Endowments Private Banks Family Offices

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Capital Introduction

Consultation Introductions Ongoing

Relationship
1 2 3

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Trade Execution, Clearing, and Settlement Services

Prime Services
Most hedge funds maintain one or a few prime brokers
as the hedge funds prefer to consolidate their positions,
cash, and risk.

Trade Execution Clearing Margin Loans Commissions & Securities

Fees Lending

Settlement IPO Allocations Preferential

Cap Intro

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Trade Execution, Clearing, and Settlement Services – Executing Broker

Why separate executing

and prime brokers?

• Sometimes for large buy or sell orders,

it is useful to break a trade into
smaller pieces to minimize market
movements

• Helps portfolio managers maintain

their relationship with multiple
executing brokers

• Allows access to information and

allocation to new issues
Executing Broker

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Interaction Between Portfolio Manager, Executing Broker, and Prime Broker

Initiate trade Clearing

Double-checking the details of trade

Portfolio Manager Executing Broker System of both parties and ensuring both
parties have sufficient funds

Work on behalf of
portfolio manager

Executing Broker Buy / Sell Settlement

The actual exchange of the cash for

the securities

Prime Broker Clear / Settle

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Margin Maintenance – Prime Broker Give Up

Derivatives Trading

Once consolidated, the prime broker can

manage both the initial and variation margin
on behalf of the portfolio manager.

Portfolio Manager Executing Broker

Give Up
Consolidation

Executing Broker 1
Clearing House 1
Executing Broker 2
Clearing House 2
Executing Broker 3
Prime Broker

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Margin Maintenance – Prime Broker Give Up – An Example
MTM
Citi - $100 mm

JP Morgan - $50 mm

Deutsche + $250 mm

Hedge Fund A Prime Broker – UBS

CME - $25 mm

LCH - $25 mm

Combined MTM + $50 mm

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Financing – The Hedge Fund Balance Sheet
Liabilities Assets
Cap Intro
Cash
Private Banking
Bonds
Asset Management Equity
Financing Equities
Investment Banking
Loans
Insurance Business
Derivatives
Very few hedge funds can issue Fund of Funds
long-term debt directly
Investment
Most hedge funds use leverage Assets
to achieve their outsized returns
(up to 30 or 40x) financed largely
Debt
by prime brokers Financing

Prime Broker

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Financing – Debt Financing in the Form of Margin Loans

Debt Financing (Prime Brokerage)

Achieved by margin lending

What secures the loan?
Margin loans are adjusted to reflect risk of the
underlying positions
Debt
Financing • Hedge fund must allow their Loan rate varies on:
prime broker to use the • Size
securities the hedge fund • Volatility
holds as collateral • Currency
• Market Sensitivity
• Prime broker uses the • Perceived Credit-worthiness of the Hedge
collateral to raise cash by Fund
selling securities and make
margin payments as required

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Custodian – Asset Safekeeping (Long Assets)

1970s Exchanged via centralized

clearing entities:
Created logistical
nightmares and severe
• DTC
bottlenecks
• Euroclear
• Clearstream

Investors require a custodian:

CUSTODIAN
• Deliver payments

• Safekeep their long assets

• Administer any distributions, corporate actions, and

Prime Broker delivering securities once sold

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Custodian – Source Short Assets
How can hedge funds take a short position in the market?

1 Borrow the asset

We will sell it
‘short’s
2 Sell it short

3 Buy to cover the short

4 Return the asset

Prime brokers help hedge funds by:

Sourcing Deploying Lending

assets to excess cash out
short balances securities

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Custodian – Managing Margins

IM Initial Margin Percentage of cash that is required for a margined or

derivative trade.

VM Variation Margin Increase or decrease in margins due to the price

fluctuations of the trade after it is executed.

Party A Party B

Makes a payment
(Calculated and paid daily)
Lose money Gain money

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Custodian – Managing Margins – Bilateral vs. Cleared Derivatives

Bilateral derivatives are traded over-the-counter (OTC) between

BILATERAL

two counterparties.

OTC • Prime broker helps the hedge fund post margin to their
counterparty on each trade

Cleared derivatives are where the counterparties face an

CLEARED

exchange to trade their securities.

• Prime broker posts margin to the clearinghouse

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Reporting

Hedge fund clients may need real-time updates on their:

1 Cash 2 Position Size

3 Profit & Loss 4 Risk Metrics

• Realized vs. Unrealized • Aggregate VaR reports

• Intraday • Scenario analysis

• Hedge fund • Shock testing

performance – MTD,
QTD, and YTD • Greeks

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How Do Prime Brokers Make Money

Commissions on Charging a spread

trade execution on financing
1 2

Prime Broker

Performing Securities Lending

custodial duties
3 4

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Securities Lending
What Is Securities Lending

Lending and borrowing facilitate investors and traders with shorting Short a stock
stocks.
• Investors sell a stock that
they may not own

COMPANY ABX • Express a view that the stock

1,000 Shares is overvalued

Long a stock

• Investors own that stock

• Express a view that the stock

is not overvalued

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What Is Securities Lending – Short Seller vs. Stock Lender

Deliver stock
(T+2)

Seller Buyer

Short Seller Stock Lender

• Borrow stock from existing • Commands a fee to lend their

holders for a predetermined stocks
term or open basis
• Receives their stock from
• “Cover their short” from the the short seller
market and return

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What Is Securities Lending – Short Seller vs. Long Seller

Short Sellers Long Sellers

• Face an unlimited loss • Cannot lose more than what

they paid for the stock
• Profits only when price falls
• Profits only when price
increases

Profit Profit
Stock Stock
or or
Price Price
Loss Loss

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Short Interest – Refinitiv Workspace Screen

Short Interest

A gross measure of the total Share Price

number of shares of a stock that
investors have sold short, which
have not been repurchased to
close out the short position.

Short Interest Shares

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Short Interest – Refinitiv Workspace Screen

Short Interest

A gross measure of the total

number of shares of a stock that
investors have sold short, which
have not been repurchased to
close out the short position.

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Short Equity Metrics

1. Not all short-sales are related

to investor pessimism

2. Short interest is a gross

number 1

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Short Equity Metrics

1. Short Interest = Total number of

shares of a stock that investors have
sold short

2. Short Interest % of Float 1

3
= Short Interest / Amount of stock
outstanding available to be traded 2
by the public 4

3. Short Interest Ratio

= Short Interest / Average Trading
Volume (30 or 90 days)

4. Short Interest Days to Cover

= Number of Shares Shorted /
Average Trading Volume

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Short Selling Example

Borrow a stock from

1 stock lender
$

2 Sell stock for $100

100
80
Repurchase stock for
3 $80

Return stock to stock

4 Time
lender Sell Buy

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Short Selling Risks

Market The shorted stock rises rather than falls.

Borrowed securities can be recalled at any time by the

Recall lender. If the short seller is unable to find an alternate
lender, they will be forced to close their position.

With less liquid securities, the short seller may be unable

Liquidity to find securities to buy, making it difficult to close
positions.

If the borrowed securities declare dividends, the

Dividends borrower will be required to pay the lender the dividend
(if shorting the stock before the ex-dividend date).

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Short Selling Risks – Short-Squeeze – GameStop Example

Short-Squeeze

• Good news can trigger high buying

pressure on heavily shorted stocks
forcing short-sellers to buy back
shorted stocks
Stock Price
• Contrarian investors seek short-
squeeze situations to make a profit
Percentage of shorts
over the free float

In 2020, short sellers lost over

$245 billion in mark-to-market
value on their short positions.
(2) Source: S3 Research Shortsight Data

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Who Shorts Stocks – Asset Manager vs. Hedge Fund Manager

Asset Manager Hedge Fund Manager

Investment Vehicle Traditional “Long-only” Mutual Fund “Long/Short” Equity Hedge Fund

Benchmark Index (Dow Jones Industrial Average) Absolute Return

“Bearish” Trading Underweight versus benchmark, overweight Short IBM (most likely leveraged) and buy
Strategy on IBM AAPL instead AAPL (or some other name altogether)

Return Outperforms if IBM falls and AAPL gains Gain if IBM falls and loses if IBM gains

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Why Do Short Sellers Need to Borrow Stocks – DTCC’s Role

Clearing and settlement services for all

stock traded on US stock markets

Provides a central record of stock

ownership

DTCC Requires and maintains a sizeable

amount of collateral from all
participants to ensure settlements and
loss coverage
Depository Trust and Clearing Corporation (DTCC)

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Why Do Short Sellers Need to Borrow Stocks – Covered vs. Naked Short

Short sellers have borrowed or are in the process of

Covered Short
borrowing a stock BEFORE selling short.

Short sellers do not borrow nor intend to borrow a stock

Naked Short
BEFORE selling short.

Why take part in a “Naked Short”?

Difficult or impossible to borrow Security and Exchange Commission (SEC) in

US prohibited naked short selling following
To maliciously manipulate market the 2008 Global Financial Crisis.
– “bear raid”
SEC

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Why Short Sellers Need to Borrow Stocks – Other Reasons

Good
Good Fails
Fails

Human error

Administrative delays

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Why Short Sellers Need to Borrow Stocks – Other Reasons

Bad
Bad Fails
Fails

Failing party is forced to buy-in by Clearinghouse prioritizes buy-ins, and it will

the buyer via the clearing house be covered at the highest prices

Seller failing to deliver to buyer Results in sanctions, fines, and expulsion

for several days

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Other Reasons to Borrow Stocks

1. Option Hedging 2. Index / Delta One Hedging 3. Convertible Bond

Arbitrage

Delta hedging trading strategy Delta One desks need to borrow Convertible bond traders buy a
stocks to replicate a short CB and sell the related stock short

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Other Reasons to Borrow Stocks

4. Share Class Arbitrage 5. Exchange Borrowing

Profit by identifying company Stock exchanges borrow to

price discrepancies facilitate clearing processes

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What Is a Securities Lender – Example of Securities Lending (Part 1)
BORROWER LENDER
Hey BONY, we Hey Fidelity, can
Trading Strategy: Trading Strategy:
need 100,000 IBM you lend 100,000
Bearish on IBM Long-only IBM
shares. IBM shares?

I’ll check. Yes, I can deliver.

Hedge Fund – Citadel Securities Lender – BONY Asset Manager – Fidelity

Please post cash 100,000 IBM

as collateral. shares @
$133/share

$13.566 mm
cash @ 2%
collateral

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What Is a Securities Lender – Borrow Fee to Security Lender

Borrower needs to pay a

borrow fee to the securities
lender 1

The borrow fee is determined

by supply and demand of the
individual stock

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What Is a Securities Lender – Borrow Fee to Security Lender

Stocks with high liquidity

risk will have higher
1
borrowing fees

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What Is a Securities Lender – Example of Securities Lending (Part 2)
BORROWER IBM share price after 30 days LENDER
Trading Strategy: $133 $103 Trading Strategy:
Bearish on IBM Long-only IBM

Hedge Fund – Citadel Stock Exchange Securities Lender – BONY Asset Manager – Fidelity

$10.3 mm cash

100,000 IBM
shares @
$103/share $13.566 mm
cash collateral

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What Is a Securities Lender – Example of Securities Lending (Part 2)

Security Lender adjusts the amount of

collateral required daily

Interest earned and stock borrow

fee is also calculated daily
Securities Lender – BONY

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What Is a Securities Lender – Distribution of Borrowing Fees

Annualized Rate of Interest Earned by Effective Borrowing

Borrow Fees Cash Pledged as Rate
Collateral

0.64% – 0.10% = 0.54%

Calculating Borrow Fees

𝐷𝑎𝑦𝑠 𝐵𝑜𝑟𝑟𝑜𝑤𝑒𝑑
Borrow Fees = Effective Borrowing Rate x Initial Share Price x Number of Shares x
365
= 0.54% x 133 x 100,000 x 30/365

= $5,903

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What Is a Securities Lender – Distribution of Borrowing Fees

Borrow Fee = $5,903

MSLA

Master Securities Loan Agreement

Securities Lender – BONY Asset Manager – Fidelity

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Securities Lending Models
1. Custodian – Prime Services,
BONY, State Street

• Lend securities and manage collateral on

behalf of the lender

• Are very large to achieve economies of scale

• Bundled securities lending arrangement is

known as a “Custodian” model

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Securities Lending Models
2. Direct – Fidelity

• Very large investors with scale to build in-

house securities lending operations

• Direct lender has own resources to manage

securities lending business

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Securities Lending Models
3. Agency / Third Party Lending

• Securities lender facilitates asset lending held by

a third-party custodian on behalf of the lender

• Benefits lender as multiple third-party lenders

compete for the highest borrow fee

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Securities Lending Models (Part 2)

IBM Example
Lenders can earn additional income
through borrow fees
Gross Revenue = $1 bn x 20% x 0.54%

= $1.08 mm
Borrow fees are split between the
asset owner and security lender

• Revenue from securities lending is returned

to the fund, providing additional yield

• In some cases, securities lending revenue is

Mutual Fund allowed to offset expenses

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Securities Lender Fee Models

1. Discretionary – Best Efforts Basis 2. Principal Exclusive – Flat Fee

• Securities lender lends on a “best • Securities lender pays the lender a

efforts” basis flat fee for “exclusive” portfolio access

• Lender can take advantage of spikes • Lender gives up upside from borrow
in borrow fees for scarce stocks fee spikes by committing to fixed fees

• Some lenders negotiate to share in the

upside beyond a certain threshold

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Securities Lending Market Overview
Global Lendable Supply Split by Fund Type
46%
Mutual / Retail Funds

20% According to IHS Markit, global

Pension Plans stock borrow revenues were
worth $7.4 bn, and the average
16%
borrow fee was 0.77% for the
Undisclosed / Others
first quarter of 2020.
8% (4) Source: IHS Markit Securities Finance 2020

Insurance Companies

6%
Govt. / Sovereign Entities /
Central Banks

2%
Banks / Brokers

1% (3) Source: IHS Markit/ISLA

Foundation Endowment

1%
Corporations, LLP & LLC

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Securities Lending Market Overview
Global Securities Finance Snapshot – Q1 2021
Q1 Revenue Rev YoY % Avg Balances Bal YoY Fee YoY Avg Util YoY
Asset Class Avg Fee
($ mm) Chg ($ bn) % Chg % Chg Utilization % Chg
All Securities 2,644 15% 2507 19% 0.40% -1% 6.70% -8%
All Equity 2,148 20% 1121 20% 0.80% 2% 3.70% -17%
Americas Equity 996 13% 560 19% 0.70% -4% 2.90% -22%
Asia Equity 404 -6% 216 13% 0.80% -16% 4.60% -16%
EMEA Equity 295 5% 206 12% 0.60% -7% 4.50% -12%
ADR 290 279% 50 118% 2.30% 75% 8.30% 20%
ETP 137 42% 83 41% 0.70% 6% 12.80% 13%
Government Bond 383 4% 1158 20% 0.10% -12% 26.70% 15%
Corporate Bond 102 -17% 210 8% 0.20% -22% 4.10% -3%
Note: Includes only fee revenue (5) Source : IHS Markit 2021

In 2021, GameStop stock was heavily shorted, and SPAC “blank-check” companies were
heavily borrowed.

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Securities Lending Market Overview – Govt. Bonds vs. Equities
Government Bonds Equities

Repurchase Agreements Stock borrow / lend

Product
(Repos/Reverse Repos ) (Securities Lending)

Average Balance (2020) $ 960 bn $ 956 bn

Average Fee (2020) 0.15% 0.77%

Revenues (2020) $ 1.5 bn $ 7.4 bn

Lender Purpose Financing Earn borrow fees

Borrower Purpose Invest cash / Borrow bond Borrow stock

Documentation GMRA (Global Master Repo Agreement) MSLA (Master Securities Lending Agreement)

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Conclusion