Securities Services: Risk and return
The credit crisis has focused the minds of lenders on getting their risk-reward parameters right, as Susan Pike explains
The securities lending business is all too familiar with extremes. From available asset pools to revenues to the number of programme participants, the pendulum continues to swing. But securities lending has proven to be resilient in the face of market volatility, and opportunities for growth continue to develop.
We expect to see modest growth through the remainder of 2010 and beyond. General collateral activity is slowly returning and if market values rebound and corporate activity increases, again, so will overall revenue. The supply-side has also shown signs of improvement. Lenders who had temporarily suspended their lending programmes during the credit crisis returned after adjusting parameters to better suit their risk-reward profile, while there is growing interest in lending from new funds.
Securities lending is an important market facility and a valuable tool in generating significant returns from otherwise idle assets. It is widely recognised as an essential component of a well-developed capital market, despite some restrictions on some trading strategies, such as short selling, which represents only a small portion of the many legitimate securities strategies.
Securities are also borrowed to generate revenues from special situations arbitrage, covering failed trades, financing transactions and support hedging activities. If the industry has a challenge, it is to help regulators and trade associations understand that securities lending has something to offer to all market participants.
The relationship between securities lending, capital markets and asset managers is strong and comprehensible. It goes without saying that any developments in these industries will have a direct influence on the securities lending industry itself. And that is exactly what is happening today, especially in the area of investment management. There are significant paradigm shifts occurring with the investment management - there is a relentless march towards convergence. Managers are aiming to incorporate both alpha and beta strategies into their portfolios. As a result, absolute returns and not passive benchmark returns have become the order of the day.
Ten years ago, the focus on the long-only side was on asset gathering and benchmark driven, relative returns. Today, the focus is shifting from pure long-only strategies to long/short strategies, and securities lending is needed for that to work by opening up access to supply a broad range of general collateral to hard-to-borrow securities.
While the principles behind long/short investing are relatively simple, the operational and administrative challenges are significant. Equally as important, they require greater securities lending and borrowing facilities that are fully compliant with Basel II, so beneficial owners should look for appropriately skilled partners.
Whereas securities lending has been handled as a back-office function, many beneficial owners and investment managers now consider it to be more of an investment-related function. As a result, the discussions and decision-making process are now more front office than back.
Nonetheless, a lending programme should not be undertaken lightly - its goals and parameters should be clearly understood. The risks and rewards of lending vary significantly from client to client and require careful assessment. Some may prefer to adopt low-risk lending arrangements to generate returns purely to cover core custody costs, while others seek more aggressive lending strategies offering higher returns but with a potentially higher degree of risk.
A key lesson from the past is that an organisation choosing to lend its assets must know exactly what it wants and expects from its lending programme and its respective risk management requirements. To that end, the right choice of service provider is critical and an active and clear dialogue between client and provider is essential. In turn, the providers who work in genuine partnership with clients to maximise returns, minimise risk and adapt to their clients' changing business models will be in a better position to grow with the markets.
One of the most significant risks facing a lender is not understanding the full range of risks they need to manage. When undertaken within an appropriately managed programme with clearly defined policies and parameters, securities lending is relatively low-risk and can contribute significant risk-adjusted returns.
Within a comapany's risk management policies and procedures a key category for consideration is credit, or counterparty risk. Knowing your counterparty is the basic tenet of all risk management, and securities lending is no different.
Another area to focus on is market and liquidity risk. These are largely dependent on the collateral type. Collateral is essentially the second line of defence - there to protect the lender in the event of borrower default. Consequently, if the worst case scenario arises and there is a counterparty default, the lender must be confident that the collateral it holds is of sufficient high quality and liquidity. This is especially important with respect to cash collateral, where the lender has to have clear policies surrounding the type and duration of instruments it may be reinvested.
Since the beginning of the credit crisis, borrowers are pushing for more flexible collateral grids in order to optimise the balance sheet and reduce funding costs. As the collateral preference from borrowers can change from cash to non-cash, lenders have to be more flexible in accepting both types of collateral.
However, it is important that the risk-reward profile is understood and professionally managed. Collateral flexibility from lenders is highly valued and those who can accept a broad range of non-cash collateral have been rewarded with higher utilisations without necessarily incorporating higher risk. Loan and collateral correlation will become more important as a means to reduce risk (eg, equities vs. equities) and, if the market can establish a practical way to manage it, variable margins will become more common.
While credit and collateral risk may be the most notable categories, other considerations such as operational risk and legal/contractual risk are important. The key for any lender is to actively manage, monitor and review policies and procedures and, where applicable, clearly communicate them to securities lending providers.
The central counterparty (CCP) concept has been a common topic of discussion as a means managing credit risk within the industry for some time, but is now gaining traction. The concept of a securities lending CCP is fundamentally sound, and the overarching benefits are clear from their application in other financial markets. But the primary challenge here is in developing a thorough understanding as to how it will operate and in identifying the inherent risks within the context of a securities lending environment.
In the current environment where regulators are looking at securities lending more closely, the relative transparency of a CCP compared to OTC products makes a CCP much more attractive. However, until there is a broader acceptance from regulators or beneficial owners, the CCP model will not likely be adopted by the majority of industry participants soon. For a CCP to be successful, it also requires the co-operation and collaboration from prime brokers and agent lenders—and we have not progressed to that stage.
In order to support the demands in a market that is continuously evolving and complex, there is a heightened need for service providers to have a solid structured risk management and control process on a global scale. Having dynamic risk and collateral management capabilities is crucial and makes providers more responsive to a client's changing strategies and market conditions. The emphasis on a strong risk management infrastructure and Basel II framework makes them better able to identify and manage risk. It also offers the opportunity to help clients by accepting and managing a wider variety of collateral types, a definite advantage for lenders in mitigating risk.
The financial crisis underlined the critical need for beneficial owners and investment managers to analyse in full and understand the relative risk/reward ratios inherent in their lending programmes and the collateral management services supporting them.
Despite the challenges that the industry has faced, there are opportunities available to earn competitive returns while adhering to a prudent risk management framework. Both beneficial owners and their lending agents share responsibility to assess and manage programme risks, making certain that the programme is structured to meet the beneficial owner's expectations and risk tolerance.
Susan Pike is global head, market products & services at RBC Dexia