Quadriserv, Inc. Futures and Options Expo November 2003

2 Pension fund/Plan sponsor is the “beneficial owner” of the securities. The securities have additional value as collateral to borrow cash at low rates. Beneficial owner lends assets through custodial bank. The cash collateral is invested at a rate above the borrow cost. Revenue is shared between the owner and the lender What is Stock Loan?

3 Agent lender sends portfolio availability to prime brokers. Hedge fund determines his PB can provide the security he wants to sell short. After canvassing lenders by telephone, the PB borrows security then re-lends it to the hedge fund. The PB re-lend “mark up” can be substantial depending on how “hot” the stock is. The Current Process

4 Stock loan can be effected synthetically using an EFP The basis between stock and futures is comprised of dividends, transaction fees and carry costs The IR component reflects the implied financing rate for a long position or rebate rate for a short position Long stock holders can use futures to lend their position Borrowers can achieve short exposure through the future Synthetic Lending through Futures

5 A customer who is long stock could synthetically lend their stock using an EFP transaction The customer would sell their stock and buy the equivalent number of futures at a basis which implies incremental net lending income The customer now has long exposure to the stock through the futures market Synthetic Lending (long stock)

6 “GC” financing for shorts is generally Fed Funds less bps (the interest received on cash from short sales) Industry participants are able to finance long stock at Fed Funds plus bps The result is a spread differential of bps Thus, in absolute terms, the customer should be able to get short exposure through the futures market at better short rates Synthetic Lending (GC short stock)

7 Customers are charged a rebate rate to borrow “special” stock (they pay interest in order to borrow the shares) The cost to borrow special stocks can be as high as a few hundred bps, depending on the issue, the broker,etc. Given a broader base of potential “synthetic” lenders, the costs of borrowing special stocks could be reduced The potential new revenue to customers long special stock can be realized Synthetic Lending (special short stock)

8 The financing spread differential between cash securities lending and synthetic lending (using futures) is reduced by the transaction fees associated with futures clearing For example, if short stock can be financed 35 bps cheaper using futures, then total transaction costs need to be less than $.35 per contract (per 100 shares) Synthetic Lending (cost structure)

9 Problems with synthetic lending: Active traders (stat arb hedge funds) may not want long exposure to the market in the form of futures. Prime brokers may simply reduce short rates below competitive market rates, and kill the trade. Long exposure through futures is a term loan. Additional costs are incurred to either take delivery of the stock at expiry or cover the long prior to expiry. Synthetic Lending (problems)