The landscape for arbitrage

European policymakers, and some other regulators, have for decades set out lofty ambitions to harmonise and unify capital markets, but the reality is that securities financing markets, including equity-based repoes, continue to exhibit a rich tapestry of intricate quirks and anomalies, even within a single country. Implied financing rates can diverge from implied repo rates and various other financing curves for derivatives. Sometimes the costs might be explicit and separately identifiable line items, and at other times they could be embedded in the pricing of instruments. Term structures for cash and fixed income can also be asymmetric, with different rates for spot and term financing based on the gradient of various curves.

Why anomalies exist 

A myriad of reasons can lie behind these differences. Beyond interest rates and exchange rates, the level of short interest, various corporate actions, dividends, credit, regulation, accounting and prudential rules, withholding taxes and financial transaction taxes, and other taxes, can all count towards explaining some anomalies. “There are usually a mix of these reasons, and we do not always know the exact number and type of reasons for the anomaly. There are so many parameters to explain why one entity finds it more difficult to finance than another, and ultimately the subjective funding decision is the most important,” says Hamar, who teaches a course on Delta One Arbitrage at ESLSCA Business School in Paris.

Various other market inefficiencies lead the divergences to persist. They can include incomplete information; the fact that some participants, such as long only asset managers, face limits on hedging, and legal considerations. There can even be different opinions about how to value a corporate action.

No prime brokers

Hamar previously pursued the strategy in a proprietary trading environment at CDC-Ixis/Natixis, where he was Head of Equity Finance Delta One, and Head of Equity Finance. “For almost 10 years we were the most profitable desk in equity derivatives in Natixis,” he recalls. Nowadays, the banks have become less active in the space due to risks and scalability, leaving prime brokers and other funds as the main competitors. 

The Cellyant strategy does not use prime brokers, precisely because it is in some cases seeking to arbitrage discrepancies between the financing rates offered by prime brokers and other participants in the market. “Using prime brokers would create a conflict of interest,” Hamar bluntly states. The fund itself can act as a market maker, and sometimes an intermediary in securities financing, bridging gaps between lenders and borrowers for mutual benefit.

Skillsets and relationships

The strategy demands a versatile skillset and range of relationships. The requisite skills include mathematics, IT, and a precise understanding of legal documents and regulations. The operational and counterparty framework requires the ability to execute and settle on many markets, and source stock borrow through counterparty relationships and solutions in this fragmented market. 

For instance, sourcing of what are usually hard to borrow shares, is based on direct custodian relationships. “The intuitu personae parameter prevails in the stock lending and borrowing world: for hard to borrow it is a people business,” explains Hamar.

“Another counterparty is also used, which acts as a matched book principal intermediary,” reveals Hamar. Cellyant have an open and transparent dialogue with financing counterparties about the target financing rates needed to make arbitrages work. “In some special situations, the extra cost of borrowing special collateral is very marginal compared with the potential profit on the trade. ADRs can sometimes plug a gap. In other cases, we simply judge that the difficulty of sourcing borrow is too great, and do not bother,” says Thomas Neveux, Cellyant’s Investment Risk Officer.

Drivers: volumes and volatility

The opportunity set is linked partly to volatility and volumes of corporate actions and can be marginally affected by interest rates and regulations. “Higher interest rates can improve theoretical basis returns, but overall volumes and volatility tend to be more important,” says Hamar. Credit spreads do not have much influence on repo margins, which are somewhat divorced from other risk premiums.

Categories of arbitrage

The textbook arbitrage equation states that futures prices should equal spot plus carry minus corporate actions, such as dividends, but this does not always hold. In practice, the implied financing cost can deviate from the repo or borrowing rate, and a large enough gap between the two opens up a potentially low risk arbitrage opportunity. Cellyant can arbitrage between equities and single stock futures, in either direction: cash and carry, or reverse cash and carry.

Other strategies could trade a rights issue entitlement, or another subscription right related to a capital increase, against the underlying equity. They might also trade new against old shares, possibly based on different dividend entitlements.

Scrip entitlements to dividends can also be hedged and traded, and in some countries such as France scrips offer a way to buy shares at a 10% discount.

Cellyant can also sometimes help with sourcing financing or facilitating and arranging financing for other parties, both as a standalone strategy, and to enable their own strategies. 

The strategies are usually distinct, and it is very rare for a trade to involve more than one of them. (One exception is that a capital increase could lead to an old versus new shares trade.)

The allocation to strategies is completely opportunistic and might be entirely in one of them over a quarter, so long as the liquidity and volatility make sense. The manager does not feel the need to diversify into 10 or 15 deals at any one time, though there might be 10-15 over a whole year.

“There might for instance be 30-40 share issues and scrip dividends each year in the French market, but we will only select those offering the best risk reward and satisfying multiple other criteria,” says Hamar.

WHT and FTT

Withholding taxes and financial transaction taxes can sometimes be one factor indirectly explaining divergences in financing rates offered by third parties, but the Cellyant fund usually does not pay these taxes, nor is it seeking to arbitrage or reclaim them. “Withholding taxes and double tax treaties are not really relevant sources of alpha as taxation becomes more harmonized at fund levels,” points out Hamar.

Risk factors

Though the setups can often sound like very logical textbook arbitrages when held to maturity, they are not entirely without risks. In contrast to some “equity capital markets” strategies, there is not any direct underwriting risk. 

Presuming that interest rate and currency risks are hedged, the risks mainly relate to operational matters. 

The most important factor is usually sourcing secure, stable and affordable borrow and financing, based on counterparty relationships. “There is sometimes a risk of security borrow being recalled or repriced, or both, since locking it up can be too costly and it may not be realistic to fix the cost. This could result in unbalanced hedging and/or eat up the arbitrage,” says Hamar. 

There are ways to mitigate this, however. “We try to diversify and sometimes mutualise this risk by alerting lenders to profitable strategies that make use of the borrow,” says Hamar. Cellyant works collaboratively with counterparties, in areas such as collateral upgrades, intermediation between counterparties, and optimization strategies, to take advantage of corporate actions.

There might be a dividend risk, though this can sometimes be hedged through dividend futures in very specific situations, such as for a new versus old shares trade. Dividend risks could include a surprise cut or more unusually, the “Black Swan” risk of cancellation of dividends, as a few companies did during Covid. For instance, in 2010 BP cancelled its dividend during the Deepwater Horizon disaster, and in 2020 it halved the dividend during the Covid crisis. 

All legs of a trade need to be executed simultaneously to lock in the arbitrage, and this becomes especially important in more volatile markets. This can be relatively easy to address: “Asynchronous execution risks can often be dealt with through a double fixing on Euronext,” says Hamar.

There can also be a limited degree of credit and counterparty risk, though regular sweeping back and forth of margin means that this is usually limited to daily mark to market movement since the last margin call. To be comprehensive and conservative, credit risk could also include clearing houses, which have sometimes failed or come very close to failing before being bailed out.

Beyond these risk factors, the manager admits that there could be some vulnerability to events such as major credit events, tax changes or major operational problems, which might lead to drawdowns of more than the base case 2% estimate.

Returns, leverage and the opportunity set

The return target is an average of 10% per year, though it could be higher in a year such as 2018 with more opportunities and might be lower in other years. Target returns for the individual strategies range from 2-3% up to 12%, and the maximum expected drawdowns for each run from 1% to 3%. Performance fees apply only above a floating interest rate (EONIA) hurdle.

The strategy has generally not used leverage but might be more inclined to as it grows. Capacity is probably at least $100 million to $300 million, and more assets would expand the opportunity set in part by allowing for more leverage, which has not historically exceeded 2x. 

In June 2023, Cellyant circulated a note alerting potential investors to exceptionally attractive arbitrage opportunities in the French market. Though financial markets and interest rates are to some degree normalizing, plenty of anomalies and arbitrage opportunities remain in securities financing arbitrage.