Securities lending agreements in the US were found to be robust, despite the crisis. Expertsdiscuss market challenges and developments. (part 2)
(NY State Insurance Department), Josh Galper
(Finadium), Anne Sylvester
(JP Morgan WSS)Freeman Wood
(Mercer Sentinel), Laurie Zeppieri
Funds Europe: There does not seem to have been a huge amount of knee-jerk, punitive regulation in the US market, unlike than in the UK and Europe. Dennis, do you think that more punitive regulation is on the way?
Fernez: I guess some people would hold that our circular letter is punitive, but I don’t particularly think that it is. If there were more regulation it would probably come out of the federal government. They had many people talk to Congress, and with AIG being one of the bail-out companies, they’ve focused on two areas, which are credit default swaps and securities lending. In the federal government’s eyes both of these areas were equally concerning.
From my perspective, I regulate the insurance industry. Securities lending has traditionally been done by banks because of their relationship as custodian, holding the assets of the insurance companies.
However, there are larger companies that have gone out and no longer utilise a bank and instead do it themselves.
There is more transparency now. Some insurance companies never reported doing securities lending, it was just done. The industry had been doing it successfully for over 25 years. 2008 should not be a measure of its success just because, all of a sudden, lending was unsuccessful. But I don’t know if there’ll be punitive regulations. That’s still to be seen. We will have to see how Dodd-Frank comes out.
Wood: I think that regulators recognise the value of the function of securities finance and the liquidity it provides, so in my mind it would be very difficult for them to take actions that would dramatically reduce that function in the market.
The question is around transparency and the impact on leverage, and I think that it’s the impact of leverage and activities around it that the authorities will focus on.
Galper: IOSCO [the International Organisation of Securities Commissions] put out a report last March to that effect, that they were in support of short selling and securities lending. These are legitimate market processes.
Funds Europe: How transparent now are the lending agreements? Has that changed at all?
Zeppieri: Agreements were completely transparent before and have not changed. But I would say we’ve seen a lot in the press about enhancements to a lot of platforms that providers are offering with respect to reporting. Citi has always offered a very robust reporting platform; it’s certainly been enhanced, and I think there’s a renewed interest on the part of the lenders to be able to access accurate, complete, comprehensive information so that they are both informed and in a position to make strategic decisions on a dime if they need to.
Wood: I would completely agree with that. The demand from our clients comes around transparency. They want to understand the lending programme in more detail. That transparency isn’t necessarily a function of a change in the agreement, it’s just enhancements around the service that they’re getting from the service providers. I think there have been lending agreements in the past that were not well structured or well defined, but most people that had those have tightened them up.
Sylvester: While we also have robust reporting tools in place, clients are continuously seeking additional ways of looking at the underlying data. We expect this trend to continue and therefore, we will continue to invest in technology to accommodate our clients’ needs.
Funds Europe: What are the most popular types of lending transactions?
Zeppieri: We are finding in the US that it’s predominantly still a cash market, unlike in the UK, which is predominantly non-cash. However, we have seen demand and interest on the part of the lenders in accepting non-cash, certainly in the fixed income markets.
Galper: Data that we collected last year showed about 6% of US collateral was held in non-cash across around 90 large public funds.
Funds Europe: Are you tapping into the Asian markets, where securities lending has risen?
Zeppieri: Citi is an active lender in the Asian markets. Citi was the first agent lender in Taiwan and that market continues to be very active as are Singapore, Korea and Hong Kong where there are strong demand for specials.
These markets have mandatory buy ins, so as a consequence it is important to carefully manage the recall process to make sure sales notifications are managed effectively.
Sylvester: We share that experience. Given the economic challenges in Europe and America, we’ve seen a broad-based pick up in the investment appetite for Asian securities, translating into an increased interest in lending into these markets. While we continue to look at expanding into markets such as Malaysia, the Philippines and in India, there is significant work to be done on the local regulatory environment and the challenges.
Wood: I think the focus around some of those markets is on the regulatory and legal environment, what could happen in the event. That is a big fear, a big concern of the lenders.
Galper: As a consultant to beneficial owners, I would agree with that. When we’ve had RFPs that dealt with Asian securities it’s pretty much been part of the rest of the basket of securities and there hasn’t been anything overwhelmingly special, particularly when it’s a small portion of the securities basket. However, I would add that from the regulatory perspective, when you’re dealing with twelve or 15 different markets where you could be active in securities lending across Asia, each one having its own regulatory components, and some of whom have or are introducing central credit counterparties, there’s a lot more work for agent lenders.
Zeppieri: If structured correctly these markets present a nice opportunity for lenders. At Citi our lenders take advantage of the opportunity to lend in these markets and we help them to structure a programme that effectively addresses the mandatory buy in requirements.
Funds Europe: Do certain clients still have an appetite for more risk than the benchmark if there is more of a reward?
Galper: A few, yes.
Wood: There are clients who still are willing to take risk. The big change is in understanding all the aspects of that risk. That is more where the focus is now, because if clients are going to take exposure, on the cash collateral side presumably, they’re willing to do it if they’re being compensated for it, but understanding that risk is important.
Sylvester: Many of our lenders would consider investment management as one of their core competencies and are therefore more comfortable taking risk in their portfolios. For this profile of lender, there is naturally a level of comfort in taking additional risk.
Galper: And, in fact, we see some of those funds that are willing to take more risk managing the collateral in-house themselves.
Zeppieri: Lenders are interested in realising rewards and they are prepared to take risks. Notwithstanding, they want to do everything in their power to mitigate the risks and make sure they have proper controls in place for the operation of their programme.
Funds Europe: Dennis, we were talking earlier about the so-called 5% recommendation, where a dialogue needs to be opened if an insurance company wants to lend more than 5% of its assets. For those companies that were bypassing the bank as custodian, how many were exceeding that 5%?
Fernez: There really were not a lot of companies exceeding the 5%. Most of them stayed well below the 5%. There were two or three that exceeded the 5%.
I just want to clarify the 5% limit. It is not a consolidated number, this is for the New York-licensed insurance company. The New York company may have other insurance companies in the group throughout the United States and would not be subject to the circular letter limit outside of New York, but inside of New York they are subject to the 5% rule. Having said that there were not a lot of companies that really went over that number. From what we saw from the programmes that we called in before they downsized most of them were well below 5%.
Zeppieri: The SEC imposed quantitative limits by restricting funds to lend no more 33 1/3% of their assets, bearing in mind that collateral constitutes a fund asset enabling the limit to be 50%. As Dennis pointed out, the suggested best practice for US insurance companies is 40%. The 5% limit of admitted assets being suggested by the NYSID seems extremely restrictive in comparison to some of the regulatory standards already being adhered to in the industry.
Fernez: I hear what you’re saying. Outside New York, several states adopted the NAIC model law that has the 40% limit. I cannot talk about insurance companies licensed in other states, but if they were a licensed company in New York I can tell you they did not go out to 40%. We spoke to everybody that we saw lending securities with any value that we thought could affect their surplus in a negative way. We had conversations, and none of them were out to 40%.
That doesn’t mean they wouldn’t have an appetite to go higher. I know that the companies that were over 5% want to go back over 5%, and they probably will. I just don’t know when that is.
I don’t think it is our circular letter that is holding them back. I think it’s the current market conditions.
In New York you will probably never see a company go to 40%, 50% or anything like that. I just don’t think that’s plausible. If you do the math, the numbers are huge. The largest domestic company at 5% can do $16bn without a blink of the eye.
Zeppieri: If an insurance company did go to 50% but all they were taking in collateral was US treasuries, would that offend you?
Fernez: It probably would not offend me but they would not be getting the 50% for that reason.
Zeppieri: So if I understand correctly, what you’re trying to protect against is obviously the leverage and the risk exposure. To the extent that it’s a conservatively approached programme, 5% limitation is something to just think about. In structuring a programme they need to take into account risk aversion.
Fernez: Yes, and I look at our circular more as a dialogue. No company of any kind wants to have a dialogue with their regulator; the insurance companies don’t want to have a conversation with their insurance regulator neither, but that’s how we look at it. We think open dialogue is a good thing.We are going to expect companies to have risk mitigation processes. That’s what we’re looking for, and if they have these they’ll be fine and they’ll have a healthier programme than anybody else. It’s just a matter of having that conversation.
Wood: I think it’s incumbent upon the lenders to understand the programme they’re in, both structurally in terms of agreements, but also the risks that they’re facing. It’s not just about lending risk. There are significant cash reinvestment and implementation risks that should be considered. We experienced one form of market disruption, but it’s not the only form that exists and it’s not the only form that we’ll see in the future. You can envision events that could occur, that could negatively impact a programme fairly significantly, so understanding risk, understanding your programme, making it part of your ongoing decision and evaluation process is really critical, certainly from the beneficial owner’s side.
Fernez: In light of newspaper stories that really banged securities lending you could literally come to the conclusion that zero lending should take place. There were regulators outside of New York that were clamouring for zero.
Zeppieri: I hear you, but I also I think that was the aftermath of an unusual set of circumstances and a calamity in the marketplace. Just as lenders retrenched and paused for a moment, I think regulators paused too. I’d be surprised, though, if that were the prevailing thinking at this moment. It was probably a knee-jerk reaction to what was perceived to be a risky venture that ultimately isn’t if it’s structured correctly.
Galper: I would add that if regulators did go to no lending across different product types and market segments, the impact on a wide variety of markets, including equities, options and futures, would be so tremendous that I think the regulators themselves would be shocked.
Sylvester: And regulators are now better educated on the benefits and importance of the liquidity that these programmes provide.
Fernez: We’re certainly well aware of a trillion-dollar industry and what the effects would be if you shut them down in certain aspects of the market.
Funds Europe: If we use the $3.8trn out on loan three years ago as a benchmark of where the securities lending market could be – and today it is at roughly $2trn - how long before the market picks up again?
Galper: I think that 3.8 is many, many, years away. That’s not to say that there might not be a noticeable uptake in hedge fund activity as Anne noted, but I think even levels of three or 3.5 would still not be for ten to 15 years. That’s my guess.
Wood: I think it’s highly dependent on market conditions. You could envision a period of sustained low economic activity and low interest rates, like we’re in now, that could prolong the lower lending volume. You could also envision things changing fairly rapidly, such as much stronger demand from the hedge fund side. But I’m not sure that 3.8 is something you’re going to get to very quickly. I think that changing regulation and other market factors will impact demand one way or the other.
Sylvester: We are starting to see a pick-up in M&A and IPO activity and are optimistic that it’s not so far off, particularly if you look at all of the components affecting demand. We do expect some of the triggers to improve next year, but to get back to the highest peaks everything has to be back where it was, and that’s unlikely to happen for a number of years to come.
Galper: I think that a big part of the demand component will be the popularity of things like Ucits funds or retail investment and hedge fund strategies, through limited partnerships or through hedge fund mutual funds. I think that’s going to be a big portion of securities lending demand over the next five or seven years.
Zeppieri: We’re already seeing interest and growth in the ETF space, so case in point, and the entrants of ETFs into the lending arena as well. fe
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