Transcript Margin Trading and Short Selling Summary

Introduction to Short Selling
Charlie Rubin
Egypt Financial Services Project
March 2007
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Short Selling
 A New Leveraged Vehicle for Securities Trading being
Introduced in Egypt
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Why Introduce Short Selling?
 Good for Customers
 Opportunity to profit when prices decline
 Increased trading activity
 Leverage
 Flexibility
 Interest income for Lenders
 Creates a “better” marketplace
 More liquidity and smaller spreads
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Why Introduce Short Selling (cont)?
 Good for Custodians and Brokers
 More activity = more commissions and fees
 Traditionally, interest income –
 Customer cash deposits (for brokers)
 Customer lending – (for custodians)
 Must be regulated, appropriate surveillance, and oversight
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 Margin Trading and loans, in general
 Cash is loaned (to finance purchase)
 Securities are collateral (for loan)
 Short Selling
 Securities are loaned (to borrowers / short sellers)
 Cash is collateral (for loan)

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Customer Lenders and Custodian earn interest
 Definition:
Selling something (a security) that is NOT owned:

Long sale versus Short sale
 Objective:
BUY Low, SELL High – it shouldn’t matter which comes
first.
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 Long Sale – Sell stock that you Own
 Short Sale – Sell stock that you do not Own, but still Owe
 Borrow from Lender, Deliver to Buyer
 For short seller –
 Lender needs collateral for price increase protection
 Broker also needs price increase protection
 For Lender – MCDR provides (loans and) protection
 For Broker – Customer Margin system provides protection
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Customers may have 3 Related
Accounts
 1 = Cash Account
 2 = Margin Account (Purchases)
 3 = Short Sales Account
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Selected Securities
 Same securities for margin trading and short selling
 Liquid securities
 Securities selected by CASE
 Approved by CMA
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Agreement between Customer, Broker
and Custodian
Can be same Agreement for both Margin Trading and
Short Selling
 Margin Accounts and Short Accounts handled and financed
by CMA Approved Institutions
 Custodian handles securities. Broker handles money – same
as Cash Accounts
 Margin accounts - Financing terms ( interest rates charged on
Debit balances )
 Fees, collateral requirements, responsibilities and liabilities
defined
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Agreement between Client, Broker and
Custodian
 Margin accounts may have credit balances from which
Customer’s may earn additional interest income.
 Explanation of the risks involved.
 For short selling – allocation of interest income between
Custodian and Lending Customer.
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Short Selling -
Major concept
 Lenders (of securities) retain ownership rights of the security
(e.g., dividends)
 Borrowers (short sellers) create additional ownership
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Short Selling – Major Concept
 Borrowers (Short Sellers) will be charged for all corporate
actions (e.g., dividends)
 Lenders will be credited for all corporate actions (e.g.,
dividends)
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Short Selling
 Borrowers may be required to pay more (cash) collateral
(receive a margin call). This will occur if price of borrowed
security rises. If payment is not made, position may be
liquidated.
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Margin Requirements for Margin
accounts
Initial Margin – 50% equity
(client pays 50% of transaction value)
Current CMA Maintenance Margin – 60% Indebtedness or 40%
Equity – (traditionally, Equity amount is less)
CMA may revise Margin rates
 Broker may require a minimum Account Equity
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Margin Accounting for Short accounts
Margin deposit requirement for customer – 50% of initial transaction (proceeds)
(Initial Margin deposit + proceeds = Initial Margin requirement = 150%)
Cash collateral percentage:
 If 140% of the short market value exceeds the Initial Margin requirement, a
Maintenance Margin call will be issued.
 International rates are more like 135%, 130% or 125%
 CMA collateral percentage are subject to change
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Other Regulation Provisions:



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CMA approval required to be engaged in (handling Margin
and) Short Selling Account activities – capital (to be
defined) and operations adequacy requirements
Broker must have adequate margin system and personnel
Broker may use a service bureau
“Undue Concentration”
 Limits for Short Positions:
 Single related clients business versus total shares available for lending
(e.g., 2%)
 Single security amount versus total shares of that security available for
trading (e.g., 25%)
 Single broker versus all brokers (e.g., 20%)
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MCDR / CASE System
 Would not permit trades unless securities are available in Lending Pool

When a short sale order is given, Lending Pool is checked,
and shares are “locked up” for the day
 Would not permit trades where limits on client, security pool and broker
maximums are reached
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Pre-Requisites or Conditions for
Executing a Short Sale:
 Guarantee that Securities must be available for Borrowing
(Link to MCDR Automated Securities Lending/Borrowing
System).
 Trade execution MUST be at a higher price than previous
price.
 Limits (client, broker and pool) can NOT be exceeded
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Current situation in Egypt
 There are currently no lending / borrowing systems in
Egypt.
 MCDR will provide an automated securities lending and
borrowing system to facilitate short selling
 A most admirable undertaking – an international standard
for countries without this current capability – can be an
international model
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MCDR Service
 Calculate and Collect cash collateral based upon short market
value from Brokers representing Borrowers
 Calculate and Collect additional cash collateral from these
Brokers if security price rises (as part of daily settlement)
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MCDR Service (cont.)
 Provide daily reporting to Brokers, indicating for each Customer’s short
account – short activity and positions, plus cash collateral requirements as
security prices fluctuate.
 MCDR will charge and collect from Brokers the market value of securities
borrowed, based upon closing price, + 25%
 As market price increases, MCDR will charge and collect from Brokers
accordingly
 As market price decreases, no collateral reductions at this time (international
standard)
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MCDR Service (cont.)
 Collect cash collateral for Custodians on behalf of their
Lenders
 Invest cash and share interest income with Custodians (on
behalf of Lenders)
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MCDR Service (cont.)
 Broker reports will also show:
 Customer short positions, by each security, plus totals
 Short security positions, by each customer, plus totals
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MCDR Service (cont.)
 All customers may lend their securities (to Borrowers or
Short sellers) via their Custodians
 Securities loaned to Borrowers from a Lending Pool – all
Lenders share pro-rata on all loans (and interest income).
 Lenders may add or remove their securities from Lending
Pool (e.g., remove security for voting)
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MCDR Service (cont.)
 Handle corporate actions – charge Brokers, representing
short customer accounts, for all cash dividends, stock
dividends, stock splits, etc.
 Credit above amounts to Lenders
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MCDR Broker Settlement
 Brokers charged on Daily settlement for Market Value of
Borrowed securities + 25% (representing a conservative
“cushion”)
 If closing price is higher than previous day – difference in
share value + 25% will be charged to daily settlement
 If closing price is lower than previous day – no credit at this
time
 Subject to change
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Short Accounts
 Brokers required to collect from customers Initial Margin
prior to trade execution.
 Brokers required to collect from customers Maintenance
Margin on (Margin) Call Date +2.
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Short Accounts (cont.)
 Margin valuation (and all margin systems) begin on Trade
date (T)
 Market risk or exposure starts after trade execution
 Valuation of positions are at “closing price”
 May be on line, real time
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Short Account Margin Major Points
 All Initial Margin (IM) and Maintenance Margin (MM) Calls
MUST be met – regardless of position being subsequently
closed or reduced, or a favorable price move (downward)
 Otherwise, Customer account should be “frozen” or
restricted from trading for a period of time.
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Short Account Margining
 Each security margined separately, but all short positions
margin due and margin excess, for each Customer, are
combined prior to a Margin Call being issued.
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MCDR Short Account Margin Interest
Allocation Quarterly Report
 To Custodians – on behalf of their Lenders
 For investing the cash held and for providing this lending /
borrowing service, MCDR will receive 30% of interest
income
 Balance of 70% will be distributed to the Custodians (on
behalf of their Lenders)
 Report will indicate allocation for each Customer, based
upon their pro-rata share of the Lending Pool
 Sharing with Customers – based upon agreement
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Monthly Short Interest Report
 For each security:
 Total number of shares short (in short accounts)
 Total number of shares available for trading
 Percentage (%) of short position
 Information from MCDR
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Short Selling Process
MCDR SLB
System
Lending Pool
Lending
Request
Lending
customer
Lending
Custodian
Interest
Income
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CASE
Trading
System
Sell
Order
Borrowing
Broker
Waiting Queue
Interest
Income Cash Collateral
Short Sell
Order
MCDR
Settlement
System
Cash
Initial
Margin
Margin
Calls
Short
Selling
Customer
Example: Short Sale Margin
 Replicating how Brokers perform the customer margin
accounting
 Short Sale of 1,000 shares of stock at 20 LE
 Sale proceeds = 1,000 X 20 = 20,000 LE
 Sale proceeds + 50% requirement = 20,000 + 10,000 =
30,000 LE (IM requirement)
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Example: Short Sale Margin (cont.)
 If stock price goes UP to 22:
 1,000 X 22 = 22,000 LE
 22,000 X 140% = 30,800 LE (exceeds IM requirement)
 Margin Call = 30,800 – 30,000 = 800 LE
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Example: Short Sale Margin (cont.)
 If stock price goes DOWN to 17:
 This represents a profit in the position, and any excess must still be
based upon meeting Initial Margin requirements
 1,000 X 17 = 17,000 LE
 17,000 X 150% = 25,500 LE
 30,000 – 25,500 = 4,500 LE excess
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Short Sale Example (cont.)
 If Margin Call is NOT met
OR
 If 130% of short market value exceeds IM requirement
 CMA requirement
Broker MUST liquidate sufficient securities to bring Short Account
into Initial Margin compliance
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Short Sale Example (cont.)
 Margin Call MUST be met within 2 days
 Direct deposit of additional Cash into Short Account
 Cash transfer from Cash Account or Margin Account
 Sell securities from Cash Account and/or Margin Account – 2
day settlement
 Cash transfer from Cash Account and/or Margin Account
 Can NOT have “long” securities in Short Account
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When short position is “covered”
(partially or totally)
 Short market value decreases, cash collateral collected for
those shares is returned to Broker (a credit on Broker’s daily
settlement statement)
 Cash in Lending Pool is reduced
 Securities returned to Lending Pool
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Surveillance
 MCDR – validate system
 Brokers:
 Margin calls made
 Collection follow-up
 Action taken, if appropriate
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Implementation
 Prepare Short Selling Margin and Lending / Borrowing
agreements (CMA approval)
 Brokers must have adequate margin system and personnel
with knowledge of this activity
 CMA approval of Brokers
 Review and Uses of specific CASE and MCDR procedures
and forms for Brokers and Custodians
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