Views from other side of the table
Pension funds are losing their traditional ambivalence about securities lending, according to ‘borrowing’ institutions.
Securities lending is becoming a mainstream activity,” says Roy Zimmerhansl, director of equity finance at Nomura in London. “There is a lot less fear and loathing than 10 years ago and more people are talking about it as a sort of investment activity.” Nomura is primarily a proprietary borrower, borrowing for its own positions, although it does supply some hedge funds as well. He continues: “Although it is a very low-risk activity there are risks inherent in it. There is also reward and ways to mitigate many of the risks and I think people have finally recognised that.”
John Piccitto, a director at prime broker Merrill Lynch in London, markets all securities lending outside the US for the bank. He says the market is obviously increasing. “Our balances have grown steadily in the last six to 12 months.” As a prime brokerage Merrill Lynch services proprietary trading and hedge funds.
Sarah Faulkner, who markets equity finance products at SBC Warburg in London, says that the most active markets are the UK, France and Germany and to a lesser extent Spain and Italy, although the greatest percentage growth is in Europe’s own emerging markets.
“More and more asset managers and pension funds are entering it to en-hance their portfolio returns. Supply is not outstripping demand by any stretch of the imagination, but it has equalised a lot over the past four or five years,” says Faulkner.
There is, however, a downside. The attractions to pension funds to enter such a market may decrease as a result of increased supply. Zimmerhansl says: “From a revenue point of view, the lenders are having to work hard to push the stuff out the door.”
Faulkner believes that, in Europe, yields from securities lending are probably getting lower, particularly on the more liquid securities and markets. This may not be good for funds that concentrate holdings on large caps. She adds, however, that smaller capitalised stocks from more diverse portfolios or stocks being used to finance convertible bonds will command higher yields.
She continues: “People who are lending to more than one firm get an idea of whether it is a hot stock or not. If everyone is clamouring for it, you know that it is worth more.”
Deals can also be differentiated by the type of collateral. Piccitto explains: “At one time it was strictly cash or other types of securities. Now people are willing to take equities, sovereign debt and convertibles.”
Different collateral changes the margins accruing to the lender. “Cash collateral brings a 102% return, equities 105% and bonds 110% and this can go as high as 125%,” says Piccitto. “They will agree on an acceptable collateral level or the business will not be done.” he says.
Zimmerhansl adds: “Historically the business was always done against cash collateral and the US custodians still concentrate on this. The upside is that they take that cash and then reinvest for even better returns but that cash gets invested into other securities, repo, commercial paper, so the fund ends up taking another level of risk.”
He continues: “In Europe, people haven’t really focused on the cash side. A US custodian for a European pension fund will push dollars as collateral and so by implication their clients have non-cash collateral. Government bonds and equities are be-coming very common. What they are doing is locking in the rate which doesn’t engender any additional reinvestment risk. They still have the risk they had originally, which is the counterparty risk.”
He also criticises the absence of any price differential recognising the creditworthiness of borrowers. “We would borrow the same stock from a lender and pay the same fee, with the same collateral with the same margin as a very poorly, thinly capitalised counterparty.”
Whatever the risks, this month the UK will catch up with Europe by lifting restrictions allowing most institutions to lend securities without using recognised intermediaries, many of which could be sidelined.
Merrill Lynch obtained intermediary status to enter the UK market initially, but stands in clear contrast to specialist companies such as London Global Securities. Specialists may not retain their niche as larger banks replicate their services and lenders worry about their capital backing.
This is not the only relationship that may change. “We certainly prefer to deal with the beneficial owner of the stock and the feedback we have is that they would prefer to deal with the end-user,” says Faulkner. “More and more funds and asset managers are doing it themselves and not going through their agent banks.”
Pension funds could therefore re-ceive more direct approaches from prospective borrowers. However, Faulkner accepts that many funds have neither the inclination nor the expertise or the size to lend, putting the custodians in a strong position. “Some people do this successfully with $1bn of stock and one really clued-up person, but generally the economies of scale in this situation would favour custodians.”
Zimmerhansl adds: “It is no secret anymore that people do securities lending. It is not a secret for a borrower to know who the lenders are so we can go directly to them or their agents.” He also suggests that the trend for risk reduction has helped larger borrowing institutions.
He maintains a strong relationship with lenders but adds that if he is looking for a stock and has drawn a blank withcustodians then he has nothing to lose by going to the beneficial owner. “Custodian banks are usually the last people into new markets.”
To strengthen its case, Nomura will also give a lender a guarantee of the yield, which gives funds a much stronger argument when talking to their trustees.
“We will see more and more non-traditional arrangements so I will go out and target niche portfolios or niche counterparties if I don’t think I am going to get access to them any other way,” he adds.
However, the custodian banks that offer securities lending do not expect to lose business. “We have seen an expansion in demand for our services,” says Bob Ash, head of business development for global securities lending at State Street Bank & Trust in London, which offers securities lending and custody bundled or un-bundled, depending on the market.
“It requires a lot of spend to set up an efficient and risk-effective programme in terms of the technology and expertise. If you have a portfolio of just a few billion you are glad of that expertise. It is a similar argument to the fund management business,” he adds.
At Chase Global Investor Services in London, where the service is completely incorporated into the custody, Ann Hunt, head of product development for securities lending, says that its activities are built on transparency. “One of the key points is that the fund manager can continue with his activity, ie, providing the lion’s share of added value to the fund, unimpeded.”
She continues: “As a custodian, we set out the parameters under which we operate the programme, which have been checked at every level.” The bank has 25 UK borrowers - on which it has carried out due diligence surveys - while trustees retain a right of veto. She adds: “Our system is set up to provide an indemnification for the pension plan. If the broker becomes insolvent the trustees have a backstop.”