CDSC Board Members present
Chief Executive Officer, Management and Staff of CDSC
Chief Executive Officer, Nairobi Securities Exchange
Chairpersons, CEOs of intermediaries and Industry Associations, FMA, KASIB, KBA
All Protocols Observed
I am delighted to be here today at in this Webinar and would like to thank each one of you for your presence.
Having a functional securities lending market is a key component of efficient and liquid securities markets. The ability to borrow a stock enables market participants to sell short, and smoothens the settlement process in the cash market. It also enhances arbitrage activity between the derivatives and cash markets, aiding the liquidity of both.
For us at the Authority, this event marks a serious milestone in a journey we have walked for many years now, because the transactions involve two parties on agreed terms. The beneficial owner (lender) temporarily transfers title of the security and associated rights and privileges to a borrower who is required to return the security either on demand (commonly referred to as an open loan) or at an agreed date in the future (commonly referred to as a term loan.
The borrower, being the new legal owner of the security receives dividends, interest, corporate action rights etc., but is required to “manufacture” all economic benefits back to the original lender. The “manufactured” payment from the borrower to the lender is a substitute payment that replaces the dividend or interest the lender would have received had the security still been in custody. The lender maintains an economic interest in the security on loan and therefore is still exposed to the price fluctuations of the security as if it was still physically held in his custodial account. During the term of the loan, proxy voting rights transfer from the lender to the borrower of the security, as the borrower has legal title over the security. However, under the legal contract between the lender and the borrower, the lender has the right to recall the security for any reason, including voting at an annual general meeting (AGM) or extraordinary general meeting (EGM).
Ladies and Gentlemen, the question is what then motivates securities lending and borrowing?
- Market-Making and Sell Fail Protection - When market-makers that are required to make two–way prices in a security. The market-makers do not hold every security for which they make a market, and the only reason they are able to perform their function is because they can borrow a security to settle a purchase request from their clients.
- Collateralization- A significant contribution to the demand for high quality sovereign debt in a securities lending program is the requirement to borrow the security in order to collateralize other transactions, including securities lending.
- Arbitrage -Arbitrage strategies exist to take advantage of discrepancies between prices or markets, for example:
- Dividend Yield Enhancement: Discrepancies between the net dividend received by beneficial owners in different markets.
The structure of securities lending varies significantly around the world. The most common structure globally is through over-the-counter (OTC) transactions: an intermediary takes on counterparty risk in exchange for collateral from the borrower. However, in a screen-based, exchange-traded system, there is a counterparty that collects collateral. In addition, market events during the financial crisis reminded securities lending participants that securities lending has a risk/return profile and should be evaluated based on the risks inherent to each lending program’s specific structural characteristics, just like any other investment decision.
It is for the above reasons that CDSC has chosen to take a cautious path by conducting a pilot test to ensure that the final product is homegrown and appropriate to our Kenyan market. It is important to note that out of the six firms that are currently in the Capital Markets Regulatory Sandbox, CDSC was the fourth firm to be admitted. The application by CDSC for a screen-based Securities Lending and Borrowing is welcome and timely. While the existing Regulations envisage a bilateral model of SLB, the screen-based model is expected to allow any investor perform an SLB transaction through approved Central Depository Agents. If the test is successful, the current Securities Lending and Borrowing Regulations will be amended to include the screen-based model and address other issues which have hampered the uptake of the bilateral SLB product.
In line with the expectations of the Capital Markets Master Plan, the Authority lauds the significant work has been expended by the CDSC to ensure that the necessary technical arrangements and infrastructure to facilitate allow for SLB in Kenya’s capital markets. With the introduction of securities lending, investors will be able to allocate all or part of their holdings at CDSC to a lending pool. Market participants (not restricted to market makers) will be able to borrow securities from this pool for a fee paid to the holders, which can then be applied towards meeting delivery obligations resulting from short selling. This will significantly boost market liquidity which currently is quite low with an annual turnover ratio of 7-8% by increasing the volume of securities potentially available for trading and further increases depth and efficiency in the capital markets through price discovery.
It is also a a significant step towards achievement of the MSCI Emerging Market status for Kenya and for Nairobi to enter the Global Financial Centre Index (GFCI) as outlined the Capital Markets Master Plan, which further advocates for innovations to broaden product and service offerings, deepen market participation and drive transformative economic development.
Ladies and Gentlemen, as I conclude, I wish to thank you the market for your support in the development of the short term capital markets strategy in June 2020 and wish to confirm that the strategy has been progressed to high level policy makers. In summary the strategy which seeks to centrally position the Kenyan capital market to support rapid post Covid-19 economic recovery is anchored on 5 key pillars, namely:
- Sustaining market vibrancy by enhancing liquidity of existing products (which is clearly aligned to the CDSC initiative);
- Supporting market-based long-term funding for all sizes of business to jump-start economic recovery and growth through flexible and smart regulatory frameworks;
- To support alternative approaches to increase retail and institutional investor and participation in the primary and secondary capital markets leveraging ICT and specifically M-commerce;
- To support business continuity by embracing digital technology and application of ICT in all aspects of capital markets business (except where impractical); and
- To support capital markets stakeholders to weather the Covid-19 impact and sustain businesses
I urge us all to play your respective roll in implementing this strategy which will see the capital markets take its rightful position in catalysing Kenya’s economic recovery. Once again, congratulations CSDC for this bold initiative to make our markets more vibrant and liquid and thus making it more attractive to both local and foreign investors.