ROUNDTABLE: Skin in the game

Indemnification in securities lending means providers have ‘skin in the game’, keeping them honest. But there are signs that indemnities are weakening. Plus, directors of Ucits funds should scrutinse lending agents’ fees more. These are two of the issues our lending panel discusses. Chaired by Nick Fitzpatrick.

Xavier Bouthors, senior investment manager, treasury (ING Investment Mangement)
Stuart Catt, senior associate (Mercer Sentinel)
Mick Chadwick, head of securities finance (Aviva Investors)
Will Duff Gordon, research director, (Markit/Data Explorers)
Maurice Leo, senior managing director (State Street Global Markets)
Kevin McNulty, chief executive (International Securities Lending Association)

Funds Europe: What have been the main drivers of securities lending over the past two years? And how has the character of demand changed, if at all?

Will Duff Gordon, Markit: Not only is there less M&A and less leverage, but people are also grappling with new regulations, a very different hedge fund industry, and a restructured investment banking industry. Data have shown a fairly flat demand picture – though the supply of securities has increased recently as markets have risen.

Mick Chadwick, Aviva Investors: Most major wholesale banks and investment banks have downsized or exited from proprietary trading, which historically was a significant source of demand for securities lending. Much of that demand has effectively been outsourced to the hedge fund industry. 

Statistics show more money being allocated to hedge funds but not a huge amount of this is currently being allocated to the types of trading strategies that generate borrowing demand. 

Flow remains relatively subdued. There are pockets of demand that have remained reasonably robust. The death of the arbitrage strategy around European dividend withholding tax has been predicted for a long time, but it’s still with us. 

Other market-neutral trading strategies on the equity side, such as scrip dividend arbitrage, remain attractive. 

But probably the biggest change in the last couple of years has been on the fixed income side – particularly with the increasing focus on high quality government bonds for collateral and liquidity purposes.

Maurice Leo, State Street: On the supply side, we’ve certainly seen a recovery in the level of lendable assets within our securities lending programme and this is probably true of the broader agency community. From a demand perspective, the character of the fixed income lending market is markedly different from 2007. 

We see increased engagement with borrowers over formalised term-trade arrangements, as borrowers are seeking high-quality sovereign debt collateral against alternative collateral types, such as equities and corporate bonds.

Kevin McNulty, ISLA: The views expressed so far are completely consistent with what we hear from ISLA members. Demand has been flat for a year or more. But there is an evolution in demand drivers which now also includes collateral transformation. I think this is encouraging for the securities lending industry, which certainly has a role to play in this.

On another note, in terms of regular flow business, there is some optimism signalled by the IPO market now, which appears to be in a growth phase. IPOs generally drive demand for certain types of arbitrage transactions.

Xavier Bouthors, ING IM: A year ago, on the fixed income side, we saw quite an increase in activity against cash, but with low interest rates we stopped that. However, we then moved more into high yield and credits.

Stuart Catt, Mercer: Returns from lending suffer when equity markets are high, because the benefits are counter-cyclical. Beneficial owners benefit from high asset values and will not look to make a few extra basis points from securities lending when markets are high. 

The counter-cyclical benefits come from increased short selling and arbitrage when markets are volatile and falling – which is not the case recently. 

Securities lending is, therefore, looking to plug into some of the areas of regulation around collateral needs, though that’s an evolving picture, which is only starting now. 

Chadwick: Yes, but as mentioned, with more confidence in markets and valuations rising, a busier IPO line or increased M&A activity means there’s probably better prospects for that sector of the market. 

Duff Gordon: But there are not many CEOs out there now looking to do transformational takeovers. Instead, they are doing share buybacks and increasing dividends. They are showing restraint, not taking risks involved in a huge transaction. I’m a little bit less optimistic about the benefits of major M&A activity in the next half-year.

Leo: It’s important not to completely overshadow the core value proposition of the product even in a bull market. This is evidenced by the positive disposition of physical ETFs towards lending and the growth of that market in Europe in the last three years. Regardless of a bull market, the performance differentiators that securities lending can deliver for some strategies are quite pronounced.

Chadwick: In the fixed income market, where yields look set to be low for some time, the additional incremental yields that can be generated from a securities lending programme can actually make proportionately more difference to an asset manager, particularly if you’re operating in a culture of relative value and relative performance, where a few extra basis points can nudge you up from second quartile to first quartile and potentially get you on recommended lists.

Duff Gordon: On that point, people might have high capital values, but what they need every year is income. Insurers need to pay out liabilities, for example. Securities financing has a huge role to play there, taking assets that are just sitting there and seeking extra yield from them in a very controlled, risk adjusted way. That’s what we will see as the collateral transformation business opens up. 

Funds Europe: How advanced is the Ucits funds industry in the use of securities lending? Are opportunities being missed? And what are the risks for these funds? 

Leo: The Ucits sector is a pretty broad adopter of the product, across domiciles, with ETFs almost at the vanguard in more recent times. The ETF sector has probably grabbed the most headlines, and as a consequence, this has led to certain regulatory reforms that the industry is realigning itself towards in terms of transparency, operating models and underlying guidelines that govern lending programmes. 

There has been something of a bifurcation within Ucits participants over the past five years. There is a group that has gravitated towards what we widely refer to as intrinsic value lending, which are high-value specials, equity-orientated programmes, lower volume, and which tend to be shorter tenure loans with higher spreads. 

At the other end of the spectrum is fixed income-type activity, the returns from which are more dependent upon the underlying collateral guidelines.

Chadwick: Two of the key themes from the Ucits regulation are disclosure and transparency, which by definition implies a broader set of stakeholders as far as beneficial owners are concerned. It’s important that any institutional investor involved in this product is aware of what’s being done in their name. 

Catt: I agree. Disclosure is what the securities lending industry is lacking at the moment within the Ucits framework. 

I think it’s fair to say, when we compare a client’s segregated lending activity to what goes on in, say, the funds that they buy for passive exposure, there’s a very distinct mismatch of risk profile. 

Investment funds generally take on a riskier profile [when they engage in securities lending] than the securities lending programmes of the underlying asset owners. Which seems to go against the philosophy of what they’re looking to achieve. They allow people they delegate to, to take bigger risks on their behalf, certainly for portfolio management reasons, which doesn’t make sense at the moment. 

And there’s a broader problem within Ucits, certainly where you have affiliated managers and securities lending agents. We typically see those funds not getting the revenue splits they should be getting. There’s not enough competition there. 

It’s not generally the fault of the agent, because they’re operating at arm’s length and have to make the best commercial decision for themselves. But the Ucits board of directors should be doing more to push for better splits and really holding the affiliated lending agent’s fees up to scrutiny to get the best outcome for the investors. The board of directors of each fund needs to be doing more to oversee what’s going on.

McNulty: When you look at lending from pooled, commingled fund structures, I would say that historically there was less disclosure than we see today. ISLA does not have a view on what the right level of fee splits are for any provider, but we certainly do support the notion that there should be full disclosure surrounding activity so stakeholders – be they the fund’s board of governors, trustees or investors – have the opportunity and the information to be able to challenge a service provider, and that’s how we see this issue being resolved.  

Leo: A lot of this goes back to the quite public debate between the physical ETF community and the synthetic community. Before regulators intervened, those two communities were actually driving transparency forward far faster than the rest of the Ucits sector. They were fully publicising the underlying collateral constituents underpinning synthetic products on a one-day lag basis. These groups established heightened transparency in this area prior to it being mandated by current regulation.

Chadwick: A component of our programme comprises Ucits funds. In the broad Ucits arena, I think that there is increased awareness of, and engagement with, both the risks and the impact on the bottom line.

McNulty: Ucits funds are clearly a very important participant in this market. There are numbers that suggest mutual funds at the global level are the largest players in securities lending by category and Ucits funds are a growing component of this. We’ve certainly seen a big uptick in the engagement that we have with, not just fund management companies who come to us to talk about securities lending arrangements, but the associations that represent them both here in the UK and across Europe.

Funds Europe: To what extent is the evolution of the securities lending market causing its main providers to consolidate and innovate? What are some of the most notable corporate or product-development events of recent years?

Catt: There have been two events over the past 18 months, both good and bad. Asset earners are becoming much more sophisticated in how they evaluate collateral, even if they are well behind the sell side. They are looking at doing some interesting things around equities, for example, working around specific tri-party co-actions, to choose the risk, the kind that they want to take on in their programme. They are looking at term loans as well.

On the negative side is the Basel III capital impact. One securities lending provider has looked to significantly reduce the value of their indemnity, which obviously we don’t like. 

We like more protection for our clients, not less. We’ve seen one case where the indemnity was weakened to the point where we felt it was not an indemnity at all.

Chadwick: The indemnification question is an interesting one. In some ways it’s perhaps unfortunate that the market seems to have evolved with indemnification as part of the furniture. On the one hand, it keeps the provider honest, because it makes sure that they’ve got skin in the game, meaning they do their counterparty due diligence properly and their risk mitigation procedures are all in good order. 

But if you actually look at the quantum of risk involved in this activity, it’s relatively low, so the problem is really one of perception. 

If this business is as innately low-risk as participants claim it to be, some people don’t understand why they need an indemnity at all.

Catt: Well, you can take that argument two ways: if it’s innately low-risk, why does it need an indemnity? Or, if it’s innately low-risk, surely the indemnity can’t cost much for the agent lender
to provide.

Chadwick: The cost of providing indemnity is one of the issues on the table at the moment because of the implications of Basel III. The requirements around the regulatory capital of providers are likely to lead to some difficult conversations about the provision of indemnities, costs and the extent of indemnification.

Catt: It’s going to polarise the market – but it will also weed out players who are only in it because they are covered by an indemnity.

If you are covered by an indemnity, the attitude might be that you don’t need to look so closely at a trade – you’re indemnified, so what else is there to know? 

The sophisticated players will remain, and those that were only in the market for easy revenue covered by a nice protection, may not be so keen to stay in the business.

Leo: The discussion should commence on the higher cost of indemnification and how this might call for a new commercial equilibrium, fee splits or minimum spreads on transactions and so on.

Any conversation with clients about the dilution of indemnification terms along the lines mentioned is an inappropriate approach. 

To the points about oversight and governance, and the commitment that a fund promoter has to make to a product, there is a question about whether an investment manager should absorb these fees within the IMA [investment management agreement]. Historically, they do not; typically, fees are related to the core pure portfolio management of a product. Esma, in its December 2012 guidelines, takes into consideration the coverage of appropriate oversight and governance costs 

Bouthors: Indemnification is like the cherry on the cake for the lender who doesn’t want to bother much about assessing the risk in the portfolio, because they believe their counterparty risk is covered by indemnification. 

But if you look at the environment that regulators are creating, then in future lenders will have to understand more about risks. They will have to be able to assess counterparties themselves, and to identify appropriate collateral that falls within a fund’s investment guidelines, ensuring that if a counterparty defaults then the lender knows how long it will take to liquidate a position.

Chadwick: Much depends on the sophistication of the underlying client. For relatively large, sophisticated, engaged clients, nobody I talk to relies on indemnification as the primary layer of risk protection. Having said that, there is a very large universe of relatively small, arguably less sophisticated clients for whom securities lending isn’t a major part of their day job, and for whom, were one to withdraw the indemnification, participation in these programmes becomes uncertain.

One can envisage some bifurcation, where you have large sophisticated clients potentially lending on an unidemnified basis, and other clients lending on an indemnified basis with either a much more conservative set of collateral criteria or different fee splits.

McNulty: From ISLA’s perspective, we certainly see lenders that are comfortable lending without indemnification, and those that will only lend if they have it. 

I agree that this is all about economics. The reason this discussion is starting to be had is because regulation is increasing the cost – not just of securities lending and indemnification – but pretty much everything that banks do. The question that isn’t yet known is how much more expensive it will become. We think it’s premature for anyone to be concerned at this stage and we remain optimistic that the effects won’t be that great. However, the question for banks may be about how they deal with customers in a more expensive world. It might be that the banks decide to absorb those charges themselves or share them with clients.  

As the rules are not fully developed, banks do not yet fully understand the cost implications of Basel III on this part of their business, but over the next two years I expect we will see more and more of those conversations.

Funds Europe: The FSB is concerned that repo and securities lending have a role in creating instability from their position within the wider shadow banking system. How does the panel react to the FSB’s recommendations to strengthen the securities lending environment?

McNulty: It is important to be clear about where securities lending fits into shadow banking, because a lot of securities lending activity is not shadow banking.

Speaking to the FSB, the piece of the business that they consider to be proper shadow banking is where cash collateral is taken by a lender and reinvested as this can create some maturity mismatching. But beyond that, largely they don’t consider securities lending as shadow banking.

We do know, however, that regulators, more broadly, are interested in understanding the securities financing market in terms of possible systemic risk.

At one level we have welcomed the FSB’s interest in this market, because what we hope to achieve is a harmonised global framework for regulating securities lending and repo. 

One key objective of the FSB is to increase transparency and we have offered to make information available to them about the market. While there is talk of trade repositories, we are not convinced these are necessarily the best way of achieving transparency and we expect to continue to work with the FSB and others to help identify the right solutions.

Beyond transparency, there are some proposals around cash collateral that we think are broadly sensible; there are other proposals around the management of collateral more generally, and they also make sense. And we were pleased to see that the FSB saw no reason to push further for the use of central counterparties in this market. They believe that there’s enough regulatory incentive for market participants to use them if they wish. 

An outstanding piece of work by the FSB concerns the potential regulation of haircuts, and there’s a live consultation right now where the FSB asks a series of questions about a proposed set of rules. At the high level, we don’t have too many problems with the idea that every market participant has some sort of methodology to calculate haircuts, and also proposals for dealing with a series of numerical floors that should mean haircuts never fall below certain levels.

But there is a little bit of ambiguity about the scope of how these are applied and who they are applied to and we think there’s scope for them to interfere with the securities lending market in ways that we don’t think are intended. If everybody has to have a methodology to set haircuts, and that includes lenders and borrowers, then who is giving up the benefit of a haircut and to whom?

Chadwick: Establishing minimum hair cuts is tricky, with a potential element of moral hazard – if haircuts are too high you strangle the business, but if they’re too low the risk is that commercial pressure is applied to liquidity providers and regulatory minimum haircuts become the market standard.

The FSB, to its credit, is going about this in a suitably considered way. 

My concern is that there may be regional or national regulatory authorities that don’t think the FSB’s proposals go far enough and look to introduce more draconian measures that may be less well thought through.

Funds Europe: In broad terms, is the regulatory agenda supportive of the securities lending market? Are benefits weighted in anyway, such as towards beneficial owners at the expense of providers?

Duff Gordon: You have to be pragmatic and take every single piece that comes on its merits. Clearly, it’s all about protecting the ultimate investor, the guy with money in a pension scheme, or the guy with a Ucits fund or an ETF, and that drives up the cost and complexity for the people who sell the products. The people in the investment banks and the providers and agents, it becomes more difficult for them, and that’s the way it is. The champion is the voter.

Chadwick: It’s difficult to quibble with the motivations of regulators. After what happened in 2008, the system needs to be made safer to avoid a repetition. As a matter of principle, most of the benefits of this activity should flow to the underlying clients. It’s useful and necessary that regulators have a modicum of transparency, they can see what’s going on to ensure that all of this is happening. 

The main problem is simply the volume and timing of various regulatory initiatives. There’s so much regulation in so many different spheres, coming at a relatively quick pace, and a lot of it isn’t designed with our particular corner of the product universe in mind. 

If you apply a kind of high-level, principle-based regulation to the operational mechanics of our market, it can potentially throw up some nasty unintended consequences, which is why it’s important for the various trade associations to have the right level of engagement early enough in the process.

Leo: I don’t think regulation is designed to be supportive of any single sector or, indeed, providers. It is split along the fault lines that the FSB has identified and one of the agendas is certainly systemic risk. Perhaps by extension, regulation is trying to protect taxpayers against further intervention in the future.

The other agenda beyond systemic risk is more about investor protection. Whereas the FSB looks at the systemic agenda, Esma, the FCA, and so on, looks at the investor position.

Catt: Maybe not so much in the securities lending world, but more widely in post-crisis regulations, we’ve seen distinct contradictory viewpoints. I think it’s to ISLA’s credit that the securities lending market has been much less affected than other markets. 

In terms of how regulation is worded, I think it’s always good to have more protection for the beneficial owner, or certainly more transparency so they understand what’s going on.

Bouthors: A good aspect of regulation is that it is providing more transparency of, and understanding of, market activity for final investors. At the end of the day, as an asset manager, we manage their money, so they need to know what we do with it. But there are many different institutions providing recommendations or guidelines, and they don’t necessarily fit together.

Duff Gordon: Is all this at the expense of more innovation, though? Is regulation absorbing all the resources? Is it suppressing the launch of new products? That’s the great debate. Do people think that financial innovation is a good thing, or do you think financial innovation is a bad thing? We’re not going to see financial innovation whilst we have this much regulation.

McNulty: The securities lending market is subject to a wave of new regulation, as is every other sector of the financial markets, and on balance I don’t think we’re being singled out any more than most.

I’ve got nothing else to add in terms of the regulation, but I will pick up the point about innovation, because we’re starting to have discussions with our members about it and some of this is being driven by the effects of regulation. 

The innovation that I think is going to happen in securities lending is partly driven by banks who will be saying, ‘well, how do we continue to offer securities lending services to our clients in the most cost-effective way, so that our clients continue to get value, even if there will be increased regulatory compliance costs relating to providing the service?’ A good example is that we’re starting to have discussions with members, around the impact of Basel III, which affects the securities lending market in a number of ways. 

We’re starting to see firms focus on how they are going to respond and develop their products. To be clear, it’s definitely not about avoiding or arbitraging regulation; it’s about how we work within regulation – and be more efficient within the regulatory framework – to continue to provide what we hope is a valued service to our clients.

©2013 funds europe



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