Securities lending in most mature markets is now a mainstream activity for many institutional investment funds. Beneficial owners consider the activity as a means to enhance the yield on their investments, or as a means to off-set costs associated with the management or safekeeping of their securities. The most common lending objective is the maximisation of revenue within a well-defined, low risk management framework.
Trustees and sponsors of funds now have choices as to how to engage in securities lending.Traditionally, custodians, and in some cases larger asset management firms, have been appointed for this purpose. Larger funds, however, might consider using third party lending agents or even establishing their own lending programs. This article considers at a high level, the requirements for establishing a successful program.
Some requirements are obvious – systems, people, office space, telephones, etc. Additionally, there are a number of other needs that must also be considered. We’ll start by considering three essential ingredients, the lending desk, systems, and operational support, and then discuss some of the other issues.
Lending programs have a number of important people requirements. Firstly, lending itself can be considered as a trading function. The personnel transacting securities loans are committing to delivery of a security, having negotiated a fee or interest rate, and usually a duration. As with all such trading activities, it is desirable, and many would consider essential, that the trading and related operational support are performed by different teams. Institutions operating smaller programs may have scale problems due to the need for both segregation of duties, and also for effective cover for holidays and sickness.
A second major hurdle when considering the staffing requirements of a lending program is the global nature of the market. Large lenders operate trading desks in all major financial centres of the world. This allows them to mirror the global reach of their borrowers and respond to developments in the time zone in which they happen. The resource requirement for this type of market presence will disadvantage smaller lenders.
Finally, given the return/risk objective stated, it is also important to
consider the type of personnel that are needed. Lenders that can identify and understand borrowers’ trading strategies, such as convertible bond and index futures arbitrage, risk arbitrage and divided or tax driven structures, are better placed to obtain fair values for loans. Employing the right people for this function can add significantly to the returns that can be generated from the program.
When looking at lending systems, it is necessary to consider what functions the system is expected to perform. In the first instance, the system must do a number of basic things – displaying securities available for lending, maintaining records of loans agreed, providing the engine for both fee accruals and the collateral process. But systems also play an important role in risk management. The lending system needs to reinforce the risk guidelines established for the lending program, ensuring amongst other things, that credit limits to borrowers are not breached, collateral parameters are adhered to, and entitlements are protected.
What is required here, once again, depends upon the size and sophistication of the program. Large agent lenders use sophisticated bespoke systems that have cost millions of pounds to develop. In addition, there is a range of specialist off-the-shelf packages that provide broad based lending functionality. Firms operating very small scale lending programs may attempt to operate using standard desktop spreadsheet and database applications. Considering the central role the system should play in both processing and controlling the lending program, it is hard to imagine using anything other than an off the shelf package – which may carry a price tag of several hundred thousand pounds – or a relatively sophisticated bespoke development to do the job.
Lending programs introduce a need for additional operational support. Certain processes such as daily
marking to market of loans and collateral, collateral management, and fee and rebate reconciliation, are very specific to lending. Lending however, also generates additional work for functions that exist independently of the lending business. Departments involved in corporate actions and dividend claiming will find their work increased as claims will need to be generated in respect of loans that straddle record dates. Groups with responsibility for reconciling custody and accounting records may also be affected, as typically loans are not recorded as disposals in the latter. Shortfalls in the settlement, accounting, entitlement tracking, and reconciliation functions are likely to lead to painful operating losses. Applying the right degree of operational support is therefore important and will involve establishing specialist teams or outsourcing work to other departments or groups – or more likely a combination of both. Systems functionality may offset to some degree the amount of personnel required, but any solution clearly involves cost.
There is obviously a lot more involved in the successful operation of a securities lending program than is covered by the three core elements discussed above. For example, a framework for establishing appropriate risk management rules is essential. This requires input from specialist credit, market and operational risk managers and is something that can never be a one-off consultancy exercise, due to the ever-changing markets in which securities lending plays a role.
The need for sound legal advice is also necessary. Despite the fact that the securities lending industry has gone to great efforts to establish market standard documentation, expert interpretation on their use in certain jurisdictions is prudent, as is advice as to the appropriateness of collateral types.
As pressure grows evermore for
settlement timescales to reduce, more and more attention is required on the effects of lending on the investment management process (as where securities on loan are sold, these must be recalled in advance of settlement to ensure that they are available for settlement). This pressure creates the need for an effective communication mechanism between the investment manager and the lending agent.
Finally, where cash collateral is taken, there is the need to consider how this is to be managed to provide the lender with an appropriate level of return and risk. Any decision to outsource this function, or indeed even to segregate it substantially away from those involved in the lending process, needs to be considered in light of the additional risks and lost opportunities this will incur.
I began by suggesting that trustees and sponsors of funds have choices as to how to engage in securities lending. Clearly choice is a good thing, enabling buyers of the service to obtain the right combinations of return, risk management and service. In practice, the vast majority of lending continues to be transacted by custodians and asset managers on behalf of existing clients, implying that buyers in fact have little choice. Futhermore, given the costs of operating a lending program, the barriers for new entrants looking to establish self managed programs are extremely high. Real choice however, is in fact emerging, as the more sophisticated agent lenders, that have invested large sums of money in infrastructures to support their businesses, start looking to provide this service to clients beyond their existing management and custody networks. Continued developments in technology and automation will also serve to support this evolution, allowing a seamless communication between all parties.
Kevin McNulty is head of securities lending, Barclays Global Investors, Europe, in London.