Moving into Euroland
The global equity lending market exceeds $650bn, generating over $2bn of revenue for investors and professionals. The size of the bond lending and repo market is more difficult to gauge, but exceeds $5trn, generating at least as much revenue as equities.
Many investors embrace this 'peripheral' activity, taking various routes to the lending market: -
p Global/domestic custodian agents: - Using a global/domestic custodian is straightforward for a new lender. Given confidence in the custodian, this route poses few barriers to getting started.
p Third-party specialist agents: - Others appoint third-party specialists. Demand for this option often stems from frustration with custodial performance, sometimes it is in response to the increasingly competitive nature of the business and the propensity of investors, which could lend directly, to outsource to specialists.
p Intermediary (ies) principals: - Many intermediaries have global franchises and use their expertise and capital to generate spreads between two principals, unknown to one another. These principals deal with organisations typical investors may choose to avoid. The classic principal intermediary is the prime broker, borrowing from investors and banks to lend to 'hedge funds'.
p Proprietary principals: - As invest-ors develop further understanding of the market dynamic, they may wish to lend direct to the organisations that are 'final end-users'. Proprietary borrowers include broker-dealers, market makers and hedge funds.
p A combination of the above: - The options outlined above are not mutually exclusive. Choosing a custodian agent in the US does not preclude lending Asian assets through a third-party specialist and European assets directly to a panel of proprietary borrowers.
The securities lending market is driven by the demand for securities coming from proprietary traders selling the cash market short, frequently to hedge long derivatives. Demand for securities reflect constantly changing economic and market fundamentals. Some trades have fiscal components - many do not. Tax harmonisation is reducing demand in Germany, France and Italy. The euro will have a significant if unpredictable impact. Lending is also part of the broader securities finance market alongside the repo, swaps and prime brokerage products.
The adage that 'if you can't measure it, you can't manage it' is very apt regarding securities lending. Invest-ors should carefully investigate the revenue generating potential of portfolios before making a decision - ask your custodian for an estimate or use a specialist to solicit guarantees from a select group of principals on an anonymous basis.
Executives with a fiduciary responsibility to pensioners and investors, or an obligation to shareholders and sometimes both, should not ignore a potential multi-million dollar revenue stream. It is nonsensical that so much pressure is brought to bear on custody fees, foreign exchange and execution spreads etc, yet millions of dollars of low-risk lending revenue is foregone.
There are risks to be managed when lending. Investors should understand these risks, measure and manage them accordingly. To aid investors, the lending market has standard and well-tested documentation, independent collateral management services, agent indemnifications and specialised risk management software. Lenders choose their borrowing counterparts, risk tolerance, acceptable collateral and the portfolios they lend accordingly.
Lenders can select their own lending risk/reward profile. Some may restrict counterparts to AAA-rated entities, lending via an agent providing an indemnity, from a portfolio of government bonds and blue chip equities against letters of credit collateral and generate limited revenue. Whilst others may lend global equity portfolios directly to broker dealers rated A1 or better, accepting a diverse mix of bonds, equities and equity derivative collateral held, priced and reported by an independent triparty provider thereby generate significantly more revenue. Investors can calculate and compare risk-adjusted returns.
The revenue generating potential of portfolios varies significantly. Major variables impacting revenue generation fall into two main categories: -
p Management motivation: - Some investors view lending as a peripheral activity helping offset custody and administrative costs. Others see lending as a valuable contributor to revenues and a potential source of competitive advantage and act accordingly - sometimes a few basis points can make a real difference. The latter will generate more revenue given the same portfolios.
p Technology: - Vendor systems can alleviate much of the technological strain of securities lending. However, successful participants commit significant IT resources. More efficient lenders get the business.
p Credit and risk management: - A lender's collateral flexibility, be it in terms of cash reinvestment parameters or the ability to accept lower-grade securities, will be rewarded. An institution with a cautious approach to counterpart selection and a low tolerance for risk will earn less than one with a greater risk appetite. Risk is difficult to evaluate - specialist models are available.
p Total portfolio size: - Borrowers covet large portfolios more than small ones. However, a concentrated portfolio of even $50m of the 'right' securities is worth investigating.
p Size of individual holdings: - Average loan size nears $500,000, holdings of under $250,000 are of limited appeal to direct borrowers and best deployed through an efficient pooled lending programme. Agents charge a percentage of the revenue - although 'something is better than nothing'.
p Investment strategy: - active or passive: - Active trading increases the likelihood of recalls and reduces the attractiveness of inventory. It is better not to borrow a security than to borrow it and have it recalled. Passive portfolios are ideal for lending, although if you have the same inventory as everyone else, lending revenues are going to be low.
p Geographic and sectoral diversification: - A broad geographic and sectoral distribution is a positive factor. The markets are in constant flux, at any time a particular country or sector may be in or out of demand. Borrowers prefer lenders who offer a wide geographic range of liquidity. Acknowledging that the profitability of lending in certain markets may be marginal, they direct compensating business toward lenders providing service in the less profitable markets.
p Tax position or jurisdiction of the beneficial owner: - Manufacturing dividends is a major cost component when borrowing securities. An institution's tax position at a particular time is a given but understanding your status compared to that of your peers is valuable in researching the viability of lending.
p Attractiveness of the lendable inventory: - 'Hot' securities are those in high demand whilst general collateral or 'GC' securities are those that are commonly available. The 'hotter' your portfolio, the more revenue potential it has.
Investors often ask, 'how much money can we make?' This straightforward question requires a detailed answer. We are reluctant to answer without fully understanding the variables outlined above. However, as a rough guide, conservative investors should be capable of generating $1m per annum from a diverse $5bn portfolio of international bonds and equities - barely enough to move a fund up league tables - but a major sum when offset against custody fees and back office expense. Given the right organisational and portfolio characteristics much more money can be made. There are several investors generating over $20m per annum from securities lending.
Active lenders often comment on the difficulty they experience in assessing whether or not they are extracting fair value from their lending transactions. The symbiotic nature of the market, accompanied by its 'relationship' and OTC nature makes this difficult to ascertain.
Borrowers are the market professionals - either borrowing to fulfil their own trader's requirements or those of their external customers. Their business is intensely competitive and access to inventory is a key determinant of success. Some of the less experienced and more aggressive borrowers can become frustrated with the investors' conservative approach and damage relationships. Borrowers do well to remember that lending is a peripheral activity for investors.
As investors become more experienced there is a propensity for them to explore the commercial logic underlying loan transactions to help them understand the value in the trade. Some have become adept at extracting fair value - a few have gone too far - lenders do well to remember that whilst borrowers 'need' to borrow securities they assume most of the risk - in terms of collateral margin provided and market, fiscal and reputational exposure. If a lender ignores the downside risk in a transaction in pursuit of 'too much' of the upside they will inevitably become marginalised.
Price transparency is mixed in the lending business. There are a limited number of screens in the lending market and the majority of the transactions take place via the telephone OTC market. In the higher volume, fixed income repo markets some professionals distribute prices to investors and electronic trading is possible. This is far from the case in the equity lending market.
Fees and rebates are typically quoted on an annualised basis and range enormously - dependent on numerous factors such as the scarcity of a security, collateral required, tax status of the counterpart and term of the loan.
With so many variables to take into consideration and the absence of screens, it is not easy for an investor to ensure that they are extracting fair value. They should take the business seriously, understand the transaction motivation, and openly communicate with your counterpart or agent and to let them know that as the customer you reserve the right to shop elsewhere unless you get fair value. Alternatively they could take specialist independent advice - but we would say that wouldn't we?
Mark Faulkner is managing partner of London-based consultants Securities Finance International