Securities lending in the UK was seriously affected by the crisis. But despite low volumes, industry experts are glad to see the activity is now being considered an investment decision. (part 1)
Sara Nicholson (Aviva Investors), David Carruthers (Data Explorers), Roy Gillson (Aerion Fund Management), Paul Wilson (JP Morgan WSS), David Allen (Citi GTS), Robert Fishwick (Thomas Murray), Kevin McNulty (Isla)
Funds Europe: Some have spoken about the danger of securities lending being overused, mostly by fund managers, in that they have been criticised for potentially getting too much return for their securities lending programmes. Is there truth in this, and if so, what can be done about it?
Sarah Nicholson, Aviva Investors: Fund managers are required to ensure they’re charging market levels, so I don’t think that fund managers are taking more out of the trade than any other securities lending service provider. Whether that’s an appropriate level is a different question. There is definitely a range of fees charged and service levels received. It’s a dynamic market and agents need to be able to continue to invest in the product and people.
David Carruthers, Data Explorers: We consider a very broad range of funds and it can be a bit tricky to generalise. But what is certain is that the amount of securities lending being done has clearly dropped over the past few years, partly because there is less demand from hedge funds and the industry in general, partly because the values have dropped, although that is beginning to recover. If fund managers were to be accused of getting too much of their return from securities lending, that might reflect the fact that they’re making less return elsewhere, in terms of excess return. The other point is that if you look at the return profile of securities lending, you can view it as being a diverse asset. It’s kind of an asset class in its own right, and the returns generated are very different from any other investment returns you might get from other asset classes. This is because the returns from securities lending are made up of two things: one is the fee you’re getting, and those have generally been higher, and the volume you’re doing, which is generally lower. Therefore there’s a lot of benefit to a fund manager from securities lending. The key issue is that the volume of assets they may be exposing to default risk may be quite high, but there are many ways in which that can be mitigated.
Paul Wilson, JP Morgan: From my experience, the motivation for a fund manager to participate in securities lending is not to take a couple of percentage points out of the revenues; in fact, this is one of the last things they generally think about. They’re primarily focused on how much value the securities lending programme can add to the overall return of their funds. Many fund management agreements were established at a time when fund managers didn’t contemplate that they would need to provide oversight of a securities lending programme. The big sea change that we have witnessed in the post-crisis market environment is that oversight, transparency and risk control have become paramount. There is a very good and realistic justification for asset managers to provide oversight of their lending activities, whether they lend themselves or use an agent. In most instances the fund manager is usually a separate legal entity from the underlying mutual fund, insurance fund or pension fund. Therefore, the fund manager will always need to justify to the independent fund board that any amount that they themselves were taking for providing oversight was an appropriate amount for services that they were providing.
Roy Gillson, National Grid UK Pension Scheme: This argument falls squarely in the agent issue, and how you reward agents and what jobs agents are given. Stock lending is a return to the asset owner, not to the fund manager per se. But when the fund manager is acting in an umbrella capacity on behalf of a large number of clients, and it’s got a pool of assets, then that delegated authority would be given to the fund manager and they would act as an agent in those circumstances and pass on the appropriate return to the owner of the assets. The issue is when the return generated by securities lending gets confused with an investment return on investment performance, which it clearly is not. There should be a clearly identifiable separate line between these two types of return when fund managers report back to the owner of the assets.
Roger Fishwick, Thomas Murray: Yes. You wouldn’t want to boost the returns that you are showing as investment returns by adding in the stock lending.
Gillson: I assume we are all sat around this table because we believe securities lending provides a sensible return to the owner of the assets and that fund managers are acting as sensible agents in those cases.
Fishwick: As a consultant we’ve seen that the trend of fund managers lending their own client assets has fallen away in the last couple of years. A number of people that used to lend the assets that they manage, so used to also act as securities lending providers, have pulled out of the market and have appointed a third-party lending agent.
Nicholson: You can definitely see a trend in that respect. Provided the firm has invested in the business over the years, then it continues to make sense to retain it as an in-house service sitting alongside the fund manager. This allows you to be much more reactive to any kind of change in investment strategy. But there is a significant outlay in setting up a securities lending facility so you would need to be of a certain size to justify the set-up and have an ongoing commitment to retain the ability.
David Allen, Citi: It may be worth maintaining the investment, but starting up new investment would probably be counterintuitive at this stage.
Nicholson: As an asset manager you would have to have a significant supply source to justify the type of investment needed to do it properly. It’s a complex, operationally intensive business and needs proper systems, risk monitoring and market expertise.
Wilson: The cost of being in this business is only going to go up. Client demands are increasing and complying with regulation will also be expensive. It’s becoming a scale game in a challenging economic environment. To be frank, 2010 has not been the best year for earnings from securities lending.
Allen: Though it might be better than 2009.
Gillson: I find that many of these services are just a scale business, and some fund managers would be big enough to operate in that, but many would not.
Allen: Relative to the utilisation of the balances, the volume of securities lending is clearly down. So it is not overused relative to where it was. If anything, the opposite is true, you would say it is underused relative to the historical levels.
Fishwick: Yes, certainly a lot more people would like to get a lot more assets lent out there in the market, if there was the demand there for them.
Kevin McNulty, International Securities Lending Association: It’s not generally possible to manufacture more lending in this market because the volumes of securities lending are a function of some other trading activity, like short selling, for example. Therefore, it is difficult to imagine a situation where someone can get into this market and say, ‘I’m going to do five times more lending than I did last week’, because they just can’t do that.
Wilson: About three years ago, lenders would constantly look at utilisation levels, but the issue rarely comes up these days. Lenders are more focused on what the return is versus the lendable base. In fact, utilisation was always a misnomer because every beneficial owner or pension fund wants the lowest level of utilisation and the highest level of return. In its simplest form, this is the best risk-adjusted position.
Carruthers: One point worth touching on is this debate about whether short selling drives down share prices. As a result, there are lenders now who are making a decision to pull out of securities lending because they don’t want to support short selling in individual names. Another reason why high utilisation might be something of the past, is that the individual names that people might want to short are not the ones that are in the lending pools anyway, so there’s a structural gap between supply and demand. The other point to make is that short positions in general are not quite the lowest they’ve ever been, but they are pretty close to it. The world in general is a very long place.
Funds Europe: How has the way agreements are drawn up changed over the last two years? Have borrowers and lenders been asking for new, or more stringent terms because risk is now high on the agenda?
Fishwick: People who take cash collateral are being much stricter in terms of what will they allow it to be reinvested in – they want a segregated account and they don’t want to be in any kind of pooled vehicle. So yes, on the cash collateral side, for those that are still taking it, the cash reinvestment mandate terms have tightened up considerably and become much more cautious than they were three years ago.
Wilson: There is a lot more discussion around what will actually happen in a default scenario. Although the industry has lived through this situation, most of the large agents are offering indemnifications. So the question is to what extent are the beneficial owners ensuring that their agent can stand behind these commitments? We have definitely seen a number of lenders focusing on and tightening up around these issues. In reality lenders are being more realistic and understand that it’s impossible to have a guarantee that they will always buy the lent security back. As the industry has seen in recent years, there will always be securities that have stopped trading or are completely illiquid. I’ve seen contracts from some agents where they have stated they would guarantee to buy or get the client’s securities back.
Nicholson: But that doesn’t happen anymore.
Wilson: Beneficial owners are a little bit wiser to the realities of the world.
Gillson: It’s very clear that in the crisis, the risks involved in the detail of stock lending agreements became very much more visible to the owners of the assets. People responded to this at different speeds, but everybody has responded in one way or another. On the whole, this has been beneficial because people now understand the risks involved far better than they did before. They are reacting rationally and understand that securities lending is a business with a risk and that it’s an income source. Ultimately, it’s a trade-off between those two things. I would hope that the owners of assets have upped their game when it comes to understanding the parameters that need to be put into agreements, and working with their agents to achieve successful outcomes.
Fishwick: One of the things we noticed, particularly with older agreements, is how opaque the so-called indemnities are. We push very hard to try to make the indemnities absolutely clear in all agreements, to know what is indemnified – in which circumstances – and what is not. Sometimes the language is just so opaque.
Wilson: There’s always been a debate on whether indemnification is a good or bad thing. Prior to the market crisis, the agent’s indemnification was the first line of protection for most beneficial owners, while now it’s the last form of protection. Beneficial owners are doing all of the other things that are sensible and prudent to manage the parameters of their lending activities and then, if all else fails, they have the agent’s indemnity.
Nicholson: Globally, we have two or three outsource arrangements where indemnities are in play, and historically, there has been an over reliance on the indemnity. Now it’s very much about getting to the detail first and considering the indemnity last.
Funds Europe: Would you say that lenders are becoming a lot more involved in the whole process?
McNulty: In the past couple of years there has been a tremendous drive towards greater understanding and attention to detail. There are two agreements to consider, the one that the beneficial owner signs with an agent and the one that the agent will typically sign with the borrower community. From an ISLA [International Securities Lending Association] perspective, we spend quite a bit of time on the second of those two, the market agreement. We published a new Global Master Securities Lending Agreement [GMSLA] at the beginning of this year, which was designed to give the non-defaulting party, in the event of something like Lehman happening again, a better and more realistic outcome. We are pushing quite actively to see that new agreement get adopted in the market.
Earlier this year we started a training course with ICMA [International Capital Markets Association], looking at the detail in the GMSLA and the master repo agreement. Our course was oversubscribed, which shows there is indeed a real interest in getting down to the detail of these things.
Wilson: ISLA has done some extraordinarily good work with the GMSLA, but one of the biggest challenges we have as an agent is that we have hundreds of clients that are using the old MSLA, OSLA or MIFISLA agreements. So to make the GMSLA effective with any borrower we would need all of these clients to actually review and agree to it. It therefore becomes really problematic to have some of our book under the old agreements and some under the new one. As we sign up new borrowers, using the new agreement is easier to do, but with your legacy borrowers, it becomes much more difficult because of the client impact.
Allen: We’re midway through a repapering exercise on all borrowers now, under the 2010 GMSLA. We’ve started to get responsive feedback from the borrowers using it only in the past month. There was really a slow take-up, although I’m not quite sure why. It may just be the daunting nature of having to redocument so much paperwork. The education of lenders around what this new document brings is really just a process you have to go through.
Funds Europe: The general consensus is that securities lending has moved from an operations function to an investment function.
Allen: Yes, it’s true. If you’re selling securities lending, you now deal with the investment side of the beneficial owner, not the administrative end. This is something that has completely changed. It probably moved a while ago, but it’s become transparently obvious now that that’s the case.
Carruthers: Compared with most other types of investment, securities lending has got lots of moving parts. If you run systematically through all of those, whether it’s the haircut, the margin you take, the range of counterparties you deal with, the diversity of the assets you are in, the type of assets you have acquired as collateral versus the loan – across all of those, the form of the indemnity has been tightened up. It is as if the various asset owners have looked at each of these components and have become stricter on each one. You’ve gone from a situation where two or three years ago, some of these programmes looked like accidents waiting to happen, to the point where some owners are handicapping themselves because they’ve gone to the opposite extreme. The data shows there’s an opportunity for people to move back towards a more moderate position and probably make more money.
Gillson: I would agree with that absolutely David. Moving to an extremely stringent position is just a normal reaction function to finding out you had a risk that was much bigger than you expected. You adjust all the terms and make sure you’re being cautious and then afterwards you can relax, although this hasn’t happened yet. I’m sure, however, that people will be looking to relax as time goes on.
Nicholson: We are definitely seeing an increased application of investment discipline around what historically may have been seen as either a no-risk or administration-type process. We’re seeing exactly what David has described, but all within the parameters of an overall investment risk appetite. Our returns and our risk processes are being compared to other investment strategies. Our clients are now definitely seeing it as an additional investment strategy that needs the same level of consideration.
Funds Europe: With transparency going up the agenda in every investment arena, how have securities lending programmes been affected? And also does this have any impact on smaller lenders who can’t offer that level of transparency?
Nicholson: We’ve always been very lucky in that we have a small number of clients, all of which we are very close to. Therefore we’ve always had very regular meetings and discussions. Over the last 18 months, though, we’ve been asked to provide more and more detailed analysis and transparency around why loans were made and why collateral was taken. Conversations are much more detailed and probing.
Funds Europe: Has that led to the need for more investment in that area to keep up with client demand?
Nicholson: Absolutely. It comes back to our first point: securities lending is becoming a much more expensive business to be in. It’s not good enough to answer queries in a generalist way or take time to respond with more detail. All the information and analytics must be at your fingertips. You need to be able to respond to any query immediately.
Wilson: We allow all of our clients to fully customise every single component of their lending programme. Every one of our clients has their own separate cash collateral accounts and we provide around 150 daily reports and 50 monthly performance reports. On a quarterly basis, each of our clients has a fully detailed performance and relationship review. We view ourselves as a quasi asset manager and show clients how we’ve generated the return and the risk that’s been taken to get there together with an outlook for the following period. This performance package is highly detailed and some 50 pages long. To be able to produce that kind of report you need good technology and you need a high level of scale.
Clients are no longer just focusing on relative performance, although that remains part of their consideration. Only yesterday I was with the CIO of one of the largest asset managers in the UK and he was more interested in what alpha his fund managers added to his funds and what alpha was coming from securities lending. He wanted to analyse that by region and by segment. So although relative performance is a component of this, I would say that in the last two or three years, the number of clients using benchmarking tools has actually declined.
Allen: In some ways benchmarking was a start towards the transparency process, but it’s not the be all and end all. We’re seeing greater demand around the detail of the reporting, and I don’t think it will stop there. It’s going to go further and further, and it’s going to move more to the performance side of things. Also, by providing some of the raw data that goes into our client’s middle office systems and their accounting systems, we become part of the value chain rather than just a piece of the process.
McNulty: This market has come a long way in ten years and there is much more transparency. If you are an interested beneficial owner doing securities lending, you can find out an awful lot about how you are doing versus others if you are interested. This information is available from specialist data providers and often may be provided by a lending agent. While the information is there for lenders and borrowers that want it, if you are outside of the market circle it may be less transparent. I wouldn’t be surprised if we start to see more demands from regulators that want to know more about the size of the market, how it’s developing and how it’s growing.
Gillson: Over the last ten years, I’ve been surprised at how little interest there has been on behalf of regulators in the size of short positions. A long time ago, I suggested that the negative short positions in stocks should be as much public information as the long positions are, and until the crisis nobody seemed particularly interested in that; but it’s different today. The regulators, particularly the European regulator, are very interested in this information. I think the question of whether securities lending is a front office or back office process, is now at the front of people’s minds. It’s being integrated into the normal risk measurement return administration processes in a way that it wasn’t before the crisis. Before, it was an income source that got reported occasionally; now people want to know about the whole process and all the details that go into it.
Funds Europe: Roy, from your point of view as an institutional investor, has the transparency on behalf of your providers, increased? Have you started asking more questions? And are those questions adequately answered?
Gillson: Pension fund trustees ultimately just want to know that it’s operating smoothly and that they have appropriate agents in place who are controlling that process. They don’t want to see the detail unless something goes wrong, but they want to know that that detail is there and is being monitored and managed by their agents, whoever those agents are.
Carruthers: One of the issues with securities lending is that it crept up on asset managers as it emerged from the back office. It’s now being viewed more from a front office perspective. In the past few years, a lot of work has been done on performance measurement and standards for investment generally. Gips [Global Investment Performance Standards] is one example of the work done. It will be interesting to see securities lending handled in the same way, with drill-down attribution. I don’t think we’ve arrived yet, but we’re getting there.
Equally, there’s the focus on risk. We don’t yet have a proper global risk standard and until such a thing is introduced, there will always be an element missing and that’s preventing you from looking at the whole of the risk in securities lending. Having said that, we are moving in that general direction.
Wilson: We talked about securities lending becoming more of a front office activity, but notwithstanding this, most of our clients still want to know about operational aspects, such as how many trade failures occurred due to securities lending and how long they failed for. They are still very much focusing on the operational components of securities lending.
Nichsolson: There’s a difference between how much risk you are willing to take and how that risk is measured. If we have standard measurements, then people can actually take as much or as little risk as they choose. It’s about standardising the measurements, rather than prescribing how much risk investors can take.
Gillson: Pension funds don’t all have the same benchmark anymore, but we are all using the same UK equity performance measure across all the funds. Therefore, the more transparency there is and the more information is made available, the more we will understand what standards we should be using, even though they will differ [from one pension fund to another] because risk preferences are very different.
End of part 1
©2011 funds europe