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 2)
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: The strong recovery expected at 2009 has not yet come to fruition. In view of this, how have expectations been revised and how do you see the market developing going forward?
Fishwick: I don’t think the deleveraging story is over yet. If you look at Basel III you realise that the banks were leveraging themselves up significantly, it wasn’t just the hedge funds. Everybody focuses on hedge funds and their amounts of leverage, but actually the banks and investment banks were very heavily leveraged as well. So the story that deleveraging process through Basel III will keep driving the market trends adversely for securities lending. The demand won’t come back.
Wilson: 2010 has been a year where most of the factors that could collude against you did so: oversupply in the bond markets, quantitative easing, lower dividend yields, lower hedge fund activity and minimal M&A and IPO activty. Many of the headwinds came together and impacted at the same time. I don’t think 2011 is going to provide a vast amount of relief. There may be more positivity on the equity side but I wouldn’t suggest it’s going to be substantial.
But it’s interesting how the market adapts to these situations. Right now, for lenders willing to lend bonds for more than a year, there is the potential to substantially improve the return. This is because the banks are very keen to borrow securities for longer than a year given new capital requirements coming out of Basel III and other regulatory requirements. Different enhanced revenue trades do exist in the marketplace today for those that are willing to take them up.
But overall from a lending perspective, the recovery has not happened. As noted we may see a modest recovery in 2011, there is going to be continued pressure on the P&Ls of many market participants. As a result, you may see a classic two-tier market, with three, maybe four, very large, dominant providers and a number of niche organisations. Everyone will have their place, but it will be a different, more bifurcated model than it is today. The profitability of the industry will drive that.
Funds Europe: Would you say that the market would be more efficient then when it comes back? Will we see better regulation, better risk management and more efficient processing?
Nicholson: From a regulatory perspective, no one knows yet. There are many items of legislation in discussion, all of which could impact the business in some way and all of which may be preventing people from trading at the moment, in one way or another. So there are opportunities that hedge funds are simply not taking because they don’t know what the short-selling regulations are going to be, they don’t know what the capital requirements are going to be and they don’t know how individual country regulators are going to continue to view the activity. The regulation is getting to the stage where it’s a case of, ‘just give us some certainty, we’ll work in a framework but we need to know the framework’.
Right now we’re all somewhat trying to second guess what’s coming, and that is definitely impacting the business. Paul’s description of the different tiers of activity is absolutely right. Asset managers like ourselves are looking much more at the strategic transactions rather than the flow business. We’ve never been able to compete with the likes of J P Morgan or Citibank when it comes to high-volume, low-margin flow business, so for us, its much more about working with the fund managers to deliver the investment objectives.
Working with the clients and identifying strategically aligned transactions is what is going to bring in higher returns. Our volumes are down and I don’t see them increasing particularly. What I do see is an increasing level of sophistication around the transactions.
Allen: Trading is now more about quality over quantity, to some extent. There will always be trading opportunities and demands for collateral that emerge from different scenarios – whether it’s the greater demand for bond collateral because of central clearing houses and counterparties or short selling hedge funds or banks looking to make sure they have sufficient collateral to meet all their margin calls. There is always going to be something driving the next demand for securities.
Wilson: You’ve currently got record issuance by the US Treasury, coupled with a wide variety of government liquidity programmes so that the market is awash with public money. We need to start to see a reversal of that, and I’m sure the Fed [US Federal Reserve] and the ECB [European Central Bank] would like to replace public money with private money. However, in an environment where there’s minimal spread and a flat yield curve that might not happen as some lenders will not want to lend those securities.
We need economies to be stimulated, which would mean that the government programmes can start to be wound down and interest rates start to rise. This will lead to some spread coming back into the market, which will make it more attractive for the lenders to put more of their fixed income securities into the marketplace. If this doesn’t happen, it is just cheaper for the dealers to go directly to the Fed or the ECB right now.
Nicholson: But securities lending can also play a role within insurance companies and pension funds around efficient capital and cash-flow management. There are long-term transactions and structures that can help insurance companies and pension funds in managing this
Gillson: The changes in margin requirements and insolvency rules for insurance companies and pension funds across Europe will continue to drive business growth.
Nicholson: And that is going to be where the priorities are. The opportunistic flow business is going to be more of a secondary focus.
Carruthers: The regulators were surprised how dependent the world had become on short-term repo finance two or three years ago. What we need is a structural private sector solution, which provides longer-term funding for those very activities. There are, however, a few little potential bright spots on the horizon. One of them is actually to do with regulation. We have seen the move against use of CDSs [credit default swaps] impacting on corporate bond loan balances. As a result of both Obama’s war of words against CDSs and the moves in Germany, people at the margins are moving back to shorting actual corporates rather than doing so through pure naked CDSs. That’s a positive development.
The other bright spot is Ucits and the expansion of long/short funds within that framework. At the moment they are a miniscule part of the overall activity, but it wouldn’t take much for the traditional long-only managers to do more in that space and therefore boost the demand for short selling and hence for lending. We must not forget that hedge funds represent about 2% of global assets under management, so if the long-only managers move, even a small way, in that general direction, that’s got to be a positive. So individually these developments may not be that big, but the trends are positive.
McNulty: I’m certainly not going to try and predict what will happen in terms of the global economic outlook, but that’s clearly a big part of the future of securities lending. The issue around regulation is the great uncertainty that needs to get settled and we can hope that the situation does get clarified. So one component piece that may be holding back some of the ability for this market to grow should hopefully get settled in the next 12 to 18 months.
Fishwick: Paul, do you think clients of the mid-tier players are going to move away from them, and that you’ll see an increase in third-party business of the big four and a decrease in the business of the mid-tier players?
Wilson: Not necessarily. It’s about service, capability and investment in the business; these are going to be the key drivers of the industry. We’ve been a net hirer of people this year, particularly on the client side, which has become more demanding. Right now, having the optimal levels of client service, in its broadest sense, is a really important factor. When a client comes with a question or wants to understand how market dynamics impacts lending you need to have experienced and skilled people who can answer it immediately and can give the level of transparency clients are now expecting.
We’ve certainly seen substantial growth in our third-party business. A few years ago we all predicted that there would be more unbundling of custody and securities lending, particularly outside of the US. This year, we have won two to three times more third-party mandates than in prior years.
Allen: We can definitely back that up. When it comes to the choice of custodian and the choice of lending agent, clients are going for who they consider to be the best provider of the different services. If they’re not the same then so be it.
Nicholson: A couple of years ago it was all about the fact that custodians were telling all the clients how very difficult it would be to unbundle custody to third parties. Has that improved since you’re both taking more third-party lending mandates than custody?
Allen: It’s a change of attitude together with technology enhancements that has made a difference. Also, the client is the central pivot. If they want to do that then they will demand their custodian work with their lending agent.
Gillson: But it comes down to that circular argument about which comes first, the chicken or the egg? Is there willingness from the custodians to separate their services or do they have to be pushed to do so by their clients?
Allen: They [clients] realise they now have more leverage with their providers.
Nicholson: Compared to a few years ago, it is now a much easier process to select a lending agent who isn’t your custodian.
Wilson: To be fair, it’s not for everybody. There has to be an element of economics for both the agent and the lender, otherwise it just makes no sense to unbundle because of the size of the assets or the nature of the assets. We have also seen a large difference in the way that custodians approach the support of third-party lenders. Also, there are a number of agents that don’t have the full array of securities lending capabilities.
Gillson: That is a clear economic process within the generalised securities lending industry. But there are places for niche players and there will be specialist niches within it.
Allen: From a niche point of view, we’re seeing the development and growth of individual markets. Potentially, using a bank like Citi for certain markets and keeping the broad lending mandate for developed markets with an existing provider can make sense. Choice is there and people are selecting particular solutions for their specific needs. By and large, it is probably easier to change your lending agent than it is to change your custodian, and that plays a factor as well.
Fishwick: Looking at the third-party mandates coming in, are the other big custodians or the smaller custodians losing the lending?
Allen: It’s both. Some of the big custodians that had pooled investment vehicles obviously suffered in terms of publicity and that engendered certain discussions around finding a replacement lending agent. When it actually came down to it, I’m not sure how many actually moved. But if nothing else, what it has done is driven the discussion around the choice of lending agent and who is the best lending agent. Now, the fact that your lending agent was your custodian doesn’t mean it will continue to be going forward.
Wilson: It’s also worth noting that quite a few of the deals coming to the market right now are from lenders that exited during the market crisis. They may have gone through a bad experience, but are now getting to the point where they want to re-engage. But it’s just not an automatic process where they appoint their prior provider, it’s more about going to market to see what else is available. For the lenders there is so much more choice out there right now. Those that take the time to get under the bonnet and have a look at the engine are in a great place. The differences between all the lending agents are vast in terms of their attributes and what they’re good at and what they’re not so good at. So taking a long hard look at the different players allows for the right decision to be made.
Gillson: That process depends on the level of sophistication both of the client and the agent. But we’re saying that there’s a real market in separate lending services as opposed to custody. Clearly having a separate agent may be a good risk management tool.
Nicholson: That’s the kind of service we offer. Although we have our own lending desk, we understand that we’re not necessarily the experts in every market. So there are certain markets in which we will outsource to a third party purely because they have the scale and the knowledge in that market. But it comes back to that oversight process, having somebody who is looking over the whole programme and at the best way to manage positions across the board. With longer-term, more strategic transactions increasing for insurance companies and pension funds, it makes sense to have somebody who can look at all of those things in the round, instead of having your asset manager doing one thing, your custodian doing another thing and a third party doing something else. Having one entity acting as a central hub says ‘this is the way the portfolio needs to be used in order to maximise the returns and the benefits’.
McNulty: Third-party lending is one of the things that, over the past few years, has really been of a huge benefit to this marketplace. It stands alongside some of the developments in transparency we talked about earlier and some of the other developments in market-based technologies which have helped the industry become more efficient. What third-party lending has clearly done, in my opinion, has upped the game of every player in this particular market.
Nobody can sit on their laurels anymore and just assume they’re going to get business. There’s always a risk that they could lose business and they are very aware of that now. The reality is that not every investor is going to be able to have a third-party lending option. They may not be big enough, they may not have the clout or the expertise to really force through change, but because that choice exists for some, it’s actually been a benefit to everybody.
Allen: What it does is raise the quality of service because the custodians know they have to do more.
Fishwick: There used to be an implicit or explicit bundling of the custody fee and the stock-lending revenues, so there was a cross subsidisation between them which is now being pulled apart.
Allen: Partly, its because they originally sold to the administration side of the client, and it defrayed the cost of the custody fee.
Funds Europe: Revenues from securities lending in Asia rose by 25%. How are the providers around the table tapping into these markets? Are there any challenges specific to the Asian markets?
Carruthers: There are a few highlights I would mention about Asia. For the first time ever, the value of the quantity on loan in Hong Kong exceeds that of Japan. This is happening at a time when you’re still relatively restricted in what you can do in Chinese shares. So there’s clearly a big pent-up demand that is coming from the sheer level of activity in mainland China. It’s clearly a China story and although mainland China is reasonably benign in terms of supporting short selling and securities lending, it will probably be a while before that comes to full maturity. There’s growth in India but it’s restricted to what are called P Notes [participatory notes to foreign investors issued by Indian-based brokerages buying India-based securities]. In Taiwan and Korea it’s mainly swap based, so the market is still synthetic. Broadly speaking, Asia is a growth story and securities lending is benefiting from that.
Allen: Citi has a large sub-custodian network and has a well-established local presence in these markets. Offshore investors often chose Citi when looking at those [Asian] countries, because of its size and scale. We’ve been one of the first to market in a number of these regions, such as Taiwan and Korea. We found that dealing with local regulators and officials to structure a programme benefits our clients and also benefits the broader market in terms of the way that that information is played through the trade associations.
New markets have huge potential if they deregulate enough to allow securities lending models to be applied. If there’s demand for borrowing securities in these markets and they are deregulated, the supply will be there. If Asia is the growth centre of the world, as it has been until now, then securities lending will follow.
Another benefit of being new to some of these markets is that it’s a good time, from an investor and a beneficial owner point of view. This is because the demand is
greater than the supply. So there’s a real opportunity for beneficial owners to be able to enter these new markets and take advantage of the situation.
Nicholson: The spreads are also high because the risks are higher. No beneficial owner should be going into this thinking that the spreads are high just because it’s the ‘new, new thing’.
Allen: Again it depends who your borrowers are, what collateral you take and so forth.
Nicholson: It also depends on the regulators because a lot of these markets are quite unstable – we’ve seen it in Malaysia, Thailand and in Hong Kong over the last 15 years, where the regulators have come in and just changed the rules overnight, and lenders are scuppered.
Gillson: And a lot of business opportunities arise because there are local rules that create inefficiencies. If that is true, then those rules can change very rapidly and unexpectedly and you have return sources which can disappear, or you have reasons for the practice not to look as attractive.
I’d like to make a point about voting and ownership around securities lending in new markets. Whereas in the developed markets it’s relatively straightforward for the beneficial owner to get their stock back when they want to vote in critical issues, out in Asia that’s a very different and arduous process. This therefore interferes with the beneficial owner’s ability to stock lend.
Nicholson: All of these are just issues that beneficial owners need to be aware of and none should necessarily put them off from lending in these markets, but my concern is that the downstream impacts, that Roy has mentioned, are often not considered. The other thing is the reputational damage. It takes a long time to be allowed to invest in some markets and then if you decide to start lending and something goes wrong your licence can be revoked very suddenly. These things have to be considered before you go into it. There are great opportunities without doubt, but they don’t come without their risks
Wilson: In Australia, we have a sizeable portion of the pension market which has attractive, stable and growing assets and benefits from a currency with rising interest rates. Outside of Australia, while we have been winning new mandates and our business is much bigger, there hasn’t been a great deal of new supply coming into the market because most of it is dollar based and invested in Treasuries. Nevertheless, we now have people on the ground in all of the main markets – Taiwan, Korea, Japan, Singapore and Hong Kong. When it comes to securities in demand, there has been reasonable demand given a higher than average number of hot stocks. This is where the benefit of the large Asian programme really makes a difference.
In all regions, we manage our book prudently, maintaining good buffers across the entirety of our programme. As we manage a large amount of supply, we can mitigate much of the risk of failed trades and facilitate proxy voting, often without having to recall loans. We actively manage the buffers and we know our clients trading and voting behaviours across the programme. We can always retain enough securities so that when one client wants to recall, it’s actually just a swap across our books to another client. But as you enter new markets, places like Taiwan and Brazil, you need to do so prudently and possibly bring two or three clients in at the same time without pushing down the fees to the typically low levels in these markets. The way you do that is all about market access.
McNulty: One of the things that’s interesting about new markets, is that in places like Brazil and certain Asian markets, the local authorities have set up models which are different to how things are typically done elsewhere in the world. What’s interesting is how the market adapts and deals with that. I was involved in a debate about Brazil recently. It has a model that is based upon having a local central counterparty, which is quite different to how most beneficial owners, agents and borrowers would do business today. It’s probably unlikely that Brazil is going to change its model and make it easy for the conventional bilateral market model to operate there. So the challenge is, are the current providers in this place willing to look at the risks and adapt their models to work with some of these newer arrangements?
Wilson: We have spent a lot of time looking at Brazil where there are a lot of good opportunities. You’re not going to get physical sight of collateral in that market, but if you are already invested in Brazil, your securities are already held with the CBLC [Brazilian Clearing and Depository Corporation] and, fundamentally, your market risk is the CBLC for your investments. So, if you’re willing to have your assets in Brazil held by the CBLC, why would you be overly concerned that it’s also holding the collateral, from a securities lending transaction? If you were that concerned, you wouldn’t be investing in Brazil to start with.
McNulty: Just because it’s different doesn’t necessarily mean it’s wrong. It might be that lenders and borrowers need to think about the business in a different way.
Wilson: There are clear differences, but we take clients through those differences, and the risks, in great detail. Once we have this discussion, clients can see that they can get a relatively good level of return with perhaps moderately more risk than they might have elsewhere, but it’s actually quite complementary. They can then make a choice whether to lend there or not
Funds Europe: What impact will the Bank of England document Securities Lending: An Introductory Guide have on pension funds? Has it had any impact at all?
Gillson: It’s a good document and it sets out very clearly what is involved, but I have yet to hear a single trustee referring to this document. So I’d say it’s a successful document, but there have been issues in making sure it reaches the right audience.
McNulty: There are a couple of things to bear in mind when talking about this document. Most importantly, it is not primarily aimed at the beneficial owner who has spent time understanding this business, like Roy. It’s more aimed at the ones that have not been exposed to this industry and don’t really have the time and capacity to spend understanding it. It is therefore a deliberately concise document. The second, and perhaps most important thing, about the document is making sure it ends up in the right hands. There’s clearly a good bit of work to be done there and it won’t happen overnight. We, and other trade associations are working quite closely with organisations like the NAPF [National Association of Pension Funds]. I attended a trustee seminar where they gave us a platform to talk about the guide. We will look to do more things like that.
Gillson Once it’s part of the standardised trustee-training course organised by the NAPF, which I’m sure it will be, then it would have reached its required audience.
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