The route to market
Finding the most suitable route to market is a key issue for any lender's securities lending business.
Navigating the labyrinth is not easy, it is no more a 'rocket science' than it is a 'free lunch'.
Lenders need first to consider the characteristics of their organisations and portfolios. As an institution is unlikely to reinvent itself, or adopt a new trading strategy, just to facilitate securities lending, this approach saves time and money.
Some organisational characteristics help lenders be more successful than others:
Management motivation Lenders whose motivation is solely to offset custody and administrative costs limit their potential. Lenders should regard the business as a contributor to revenues and a potential source of competitive advantage and act accordingly.
Technology The business needs technology. A propensity to invest in businesses, by purchasing vendor systems or targeted expenditure on interfaces, is helpful.
Credit The business contains organisations with a wide range of credit quality and collateral capabilities. A cautious approach to counterparty selection and restrictive collateral guidelines will restrict potential earnings.
Outsource or do it yourself Some organisations like to outsource services. Lenders should identify the route, via an agent or direct, that exhibits the most organisational 'fit'.
Early analysis of portfolio characteristics gauges lending viability:
Size Size helps. Borrowers prefer large portfolios.
Holdings size Loan transactions generally exceed $500,000. Lesser holdings are of limited appeal to direct borrowers. Holdings under $750,000 are probably best deployed through an agency programme.
Investment strategy Active strategies increase the likelihood of recalls, thereby reducing the inventory's attractiveness.
Diversification Borrowers want portfolios where they need liquidity. A global portfolio offers the greatest chance of generating a fit.
Tax jurisdiction and position Borrowers are responsible for 'making good' any benefits of share ownership (excluding voting rights) as if the securities had not been lent. They must 'manufacture' (ie, pay) the economic value of dividends to the lender. An institution's tax position is a given but understanding your status compared to others is important.
Inventory attractiveness 'Hot' securities are those in high demand whilst general collateral securities are those that are commonly available. Needless to say the 'hotter' your portfolios, the more lending merit they have.
The next step is to assess available options:
Don't go to the market While not going to the market will not endear a potential lender to the proponent of any particular route, this may indeed be the right decision. If, however, the characteristics are favourable, lenders should take the route offering the required return for a given level of risk and expense.
Use your global/domestic custodian as agent This is the least demanding route for a lender, especially a new one. Risk and expense are lower, as are revenues.
Appoint a third-party specialist as agent A lender, having decided to outsource, but not wishing to use its custodian(s) may appoint a third-party specialist. Demand for this option in the US stems from frustration with custodial performance. Elsewhere, it is typically a response to the high number of smaller lenders and a propensity of these and other institutions to outsource.
Select intermediary as principal Many wholesale intermediaries have developed global franchises using their expertise and capital to generate spreads between two principals that remain unknown to one another. These principal intermediaries are sometimes separate organisations but more often parts of larger bank, broker-dealer or investment banking groups. Acting as principal allows these intermediaries to deal with organisations that the typical institution may choose to avoid.
Lend directly to proprietary principal As institutions develop further understanding of the market, they may wish to consider lending direct to the end-users of their securities. Proprietary borrowers include broker-dealers, market makers and hedge funds. Some exhibit global demand while others are regionally focused.
Choose some combination of the above Just as there is no one right route to market, nor are the options outlined mutually exclusive. Deciding not to lend one portfolio does not preclude lending another, just as lending in one country does not mean lending in all. Choosing a wholesale intermediary that happens to be your custodian in the US and Canada does not mean that you cannot lend your Asian assets through a third-party specialist and your European assets directly to a panel of proprietary borrowers.
Adopting a logical approach to the lending decision will save time, money and frustration. Lending is not for everyone. Examine your organisational and portfolio characteristics before selecting a suitable route and approaching counterparts. When gathering information from the market, do so in a structured manner so that results do not add more confusion than they resolve.