Looking to the future
The credit crisis - and particularly problems around cash re-investment - focused the attention of beneficial owners on their securities lending programmes. Blair McPherson argues that this is an opportunity for the industry to step out of the shadows
Securities lending has come a long way from where it began - as an arrangement principally designed to facilitate greater settlement efficiency. Since then, the product has evolved to fulfil other purposes and the industry has expanded exponentially as a consequence of similar growth in the asset management and wholesale financial markets.
The inter-relationship between securities lending and both capital markets and the asset management world are strong and symbiotic. Consequently, any developments in these industries have a direct influence on the securities lending industry itself.
There are major changes occurring within the global investment management world. Less than 10 years ago the focus of long-only investment was on asset gathering and benchmark-driven relative returns. Today, it is increasingly about using a broad suite of products to create innovative structured solutions that deliver absolute returns. The growth of exchange traded funds (ETFs) and progressive regulations such as UCITS III has opened up new opportunities through greater product availability and strategic options. As a result, the landscape is becoming more integrated and complex. We are now in a world of multiple products, asset classes and investment strategies.
For beneficial owners, advancements in technology, settlement systems and connectivity have meant the variance in costs of each route to market has diminished significantly. As a result, securities lending for beneficial owners has largely reached the same point as other value-added products, in that it can be provided as part of a consolidated offering from their custodian, or it can be unbundled and the lending decision taken independently of other investor services.
Evolution and challenges
While the securities lending industry was already going through a period of change prior to the credit crunch, the exceptional market conditions experienced since the summer of 2007 have also had a major impact.
Despite some criticism for its association with short selling and certain cash reinvestment pool losses, securities lending also remains universally acknowledged by regulators, central bankers and exchanges worldwide as being a vitally important product for the efficient functioning of global capital markets.
Proponents assert that, when conducted within well managed, transparent and properly controlled programmes, securities lending is a highly efficient and low-risk method of generating incremental returns from otherwise idle assets. Despite the events of recent months, securities lending continues to generate billions of dollars and euros of revenues annually for beneficial owners and asset managers across the globe. So why then did some beneficial owners suspend their lending activity, or consider suspending?
Market conditions created an environment for securities lending returns to both under-perform and over-perform significantly - and securities lending is not normally associated with return volatility, or worse still, losses. The credit crisis also gave rise to a host of questions from beneficial owners that the industry, collectively, could not answer, or answer quickly enough.
Against this backdrop it is entirely understandable that beneficial owners and asset managers should ask themselves if securities lending is an activity they want to, or should, continue to participate in.
For all lenders, counterparty risk, the quality of collateral accepted in their programmes and the concentration, liquidity and correlation of both loan and collateral portfolios came under unprecedented scrutiny. In recent years many lenders adopted comprehensive and efficient risk, capital and collateral management models, notably to be compliant with the advanced risk requirements as detailed by Basel II. The focus on ensuring that concentration, correlation, liquidity and counterparty risks remained within stringently set and continuously reviewed parameters was unparalleled.
Whereas there was a flight to quality at the start of the credit crisis, as the months passed a growing recognition of the importance of liquidity occurred. While the markets themselves were volatile, the liquidity of the cash equity markets, as well as their correlation to equity loan positions, meant that more lenders considered accepting equities as collateral.
For lenders running non-cash collateral programmes the credit crisis presented exceptional circumstances. For lenders with large cash reinvestment programmes, the situation was further exacerbated by an increasingly illiquid cash market. Those lenders were faced with the significant challenge of trying to avoid unwinding positions in their reinvestment book and realising losses.
A common practice among cash collateral-based lending agents is to reinvest the cash in a variety of investment vehicles and asset classes and across a range of durations in an effort to maximise yield. The success of such a strategy is predicated on the ongoing ability to maintain a stable level of both supply and demand for the securities involved. However, recent market conditions resulted in market volatility that necessitated those lending agents to unwind locked-in cash investments in order to free up collateral as corresponding loans were terminated.
Unwinding such investments can, and has, resulted in significant losses to lenders - both revenue and capital - for the simple reason that there was, and to an extent remains, the absence of liquid secondary markets for many of those assets. That resulted in a natural desire for some beneficial owners to exit lending immediately. However, this may not have been possible without facing the prospect of additional losses. It is fair to say that such a scenario was neither anticipated nor expected by most participants when they commenced securities lending.
For beneficial owners the credit crisis also highlighted the inherent risks within commingled cash collateral pools. Superior performance can be achieved through aggregation and size in strong markets but what happens when everyone wants to take their money out? How is that achieved in an equitable manner?
The overall impact of these developments is that perhaps more so now than at any other time it is evident that cash reinvestment is a distinct but related activity with its own, potentially very different, risk-return profile.
Looking to the future, with regulatory, asset management and market consolidation developments gathering pace, efficient collateral management will only grow in importance. Regulators are increasingly expecting and demanding that beneficial owners both understand and appreciate the risk dynamics of programmes that their agents / third party lenders are running for them.
Borrowers will continue to seek greater certainty and consistency on short selling rules so they can appropriately trade and hedge their books. Time will tell the extent to which IOSCO’s guiding principles for short selling regulations are adopted worldwide.
Basel II will also progressively change the competitive landscape. Variable capital charges on haircuts and margins mean participants will be able to factor in the cost of capital and differentiate by collateral and trade type. As the true cost of capital to firms becomes clear, the days where variable haircuts are applied to securities loans may well be close, or at least closer. In today’s sophisticated world the market practice of applying a standard flat margin does appear anachronistic.
Securities lending and borrowing, repos, derivatives and clearing house margining all involve the management of cash and non-cash collateral. As asset managers follow banks and broker dealers and increase their use of these products, there will be a natural progression towards more efficient management and utilisation of available assets for cross-product collateralisation.
These may be challenging times for securities lending but they also present an opportunity for the industry to finally step out of the shadows - to demystify itself in the eyes of beneficial owners and asset managers.
Beneficial owners want information, transparency and assurances. They want to know why their securities are being borrowed, that they are achieving a fair risk-adjusted return and that their securities lending provider is managing their programme in accordance with their instructions. At the end of the day, securities lending should not impact the investment management process.
It is essential that every beneficial owner and asset manager that participates in securities lending has a clear understanding of what it wants and expects from its securities lending programme. The key for any lender is to actively manage, monitor and review its policies and procedures and, where applicable, clearly communicate them to its securities lending providers.
Equally, securities lending providers must work closely with their clients to provide them with the information and assurances they demand. In this current economic climate, perhaps more so than ever before, beneficial owners and asset managers need strong, proven securities lending providers that recognise their changing needs, are able to demonstrate a shared vision, and which proactively build strategic relationships with them.
Blair McPherson is global head, technical sales global market products & services, at RBC Dexia Investor Services