Introduction to Short Selling

1. Misr For Central ,Clearing, Depository and Registry Introduction to Short Selling Charlie Rubin Egypt Financial Services Project March 2007

2. Short Selling Misr For Central ,Clearing, Depository and Registry • A New Leveraged Vehicle for Securities Trading being Introduced in Egypt

3. Why Introduce Short Selling? Misr For Central ,Clearing, Depository and Registry • 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

4. Why Introduce Short Selling (cont)? Misr For Central ,Clearing, Depository and Registry • 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

5. Misr For Central ,Clearing, Depository and Registry • 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) • Customer Lenders and Custodian earn interest

6. Misr For Central ,Clearing, Depository and Registry • 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.

7. Misr For Central ,Clearing, Depository and Registry • 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

8. Customers may have 3 Related Accounts Misr For Central ,Clearing, Depository and Registry • 1 = Cash Account • 2 = Margin Account (Purchases) • 3 = Short Sales Account

9. Selected Securities Misr For Central ,Clearing, Depository and Registry • Same securities for margin trading and short selling • Liquid securities • Securities selected by CASE • Approved by CMA

10. Agreement between Customer, Broker and Custodian Misr For Central ,Clearing, Depository and Registry 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

11. Agreement between Client, Broker and Custodian Misr For Central ,Clearing, Depository and Registry • 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.

12. Short Selling - Major concept Misr For Central ,Clearing, Depository and Registry • Lenders (of securities) retain ownership rights of the security (e.g., dividends) • Borrowers (short sellers) create additional ownership

13. Short Selling – Major Concept Misr For Central ,Clearing, Depository and Registry • Borrowers (Short Sellers) will be charged for all corporate actions (e.g., dividends) • Lenders will be credited for all corporate actions (e.g., dividends)

14. Short Selling Misr For Central ,Clearing, Depository and Registry • 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.

15. Margin Requirements for Margin accounts Misr For Central ,Clearing, Depository and Registry 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

16. Margin Accounting for Short accounts Misr For Central ,Clearing, Depository and Registry 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

17. Other Regulation Provisions: Misr For Central ,Clearing, Depository and Registry • 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

18. “Undue Concentration” Misr For Central ,Clearing, Depository and Registry • 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%)

19. MCDR / CASE System Misr For Central ,Clearing, Depository and Registry • 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

20. Pre-Requisites or Conditions for Executing a Short Sale: Misr For Central ,Clearing, Depository and Registry • 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

21. Current situation in Egypt Misr For Central ,Clearing, Depository and Registry • 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

22. MCDR Service Misr For Central ,Clearing, Depository and Registry • 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)

23. MCDR Service (cont.) Misr For Central ,Clearing, Depository and Registry • 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)

24. MCDR Service (cont.) Misr For Central ,Clearing, Depository and Registry • Collect cash collateral for Custodians on behalf of their Lenders • Invest cash and share interest income with Custodians (on behalf of Lenders)

25. MCDR Service (cont.) Misr For Central ,Clearing, Depository and Registry • Broker reports will also show: • Customer short positions, by each security, plus totals • Short security positions, by each customer, plus totals

26. MCDR Service (cont.) Misr For Central ,Clearing, Depository and Registry • 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)

27. MCDR Service (cont.) Misr For Central ,Clearing, Depository and Registry • Handle corporate actions – charge Brokers, representing short customer accounts, for all cash dividends, stock dividends, stock splits, etc. • Credit above amounts to Lenders

28. MCDR Broker Settlement Misr For Central ,Clearing, Depository and Registry • 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

29. Short Accounts Misr For Central ,Clearing, Depository and Registry • 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.

30. Short Accounts (cont.) Misr For Central ,Clearing, Depository and Registry • 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

31. Short Account Margin Major Points Misr For Central ,Clearing, Depository and Registry • 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.

32. Short Account Margining Misr For Central ,Clearing, Depository and Registry • 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.

33. MCDR Short Account Margin Interest Allocation Quarterly Report Misr For Central ,Clearing, Depository and Registry • 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

34. Monthly Short Interest Report Misr For Central ,Clearing, Depository and Registry • 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

35. Short Selling Process Misr For Central ,Clearing, Depository and Registry Lending Pool MCDR SLB System Short Sell Order Borrowing Broker Short Selling Customer Lending customer Lending Custodian CASE Trading System Sell Order Lending Request Waiting Queue Initial Margin Cash Collateral Interest Income InterestIncome MCDR Settlement System Margin Calls Cash

36. Example: Short Sale Margin Misr For Central ,Clearing, Depository and Registry • 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)

37. Example: Short Sale Margin (cont.) Misr For Central ,Clearing, Depository and Registry • 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

38. Example: Short Sale Margin (cont.) Misr For Central ,Clearing, Depository and Registry • 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

39. Short Sale Example (cont.) Misr For Central ,Clearing, Depository and Registry • 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

40. Short Sale Example (cont.) Misr For Central ,Clearing, Depository and Registry • 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 ShortAccount

41. When short position is “covered” (partially or totally) Misr For Central ,Clearing, Depository and Registry • 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

42. Surveillance Misr For Central ,Clearing, Depository and Registry • MCDR – validate system • Brokers: • Margin calls made • Collection follow-up • Action taken, if appropriate

43. Implementation Misr For Central ,Clearing, Depository and Registry • 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