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 significant paradigm shifts 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’s increasingly about delivering performance, using a broad suite of products to create innovative structured solutions that deliver absolute returns.
The growth of exchange traded funds and progressive regulations such as UCITS III and the forthcoming UCITS IV Directive have 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.
Change of perception among beneficial owners
With the extraordinary market conditions that have prevailed since the summer of 2007, it was inevitable that securities lending would be damaged to a degree. But the value of secured transactions such as securities lendingwere thought to be widely recognised, understood and even encouraged. So why then did some beneficial owners suspend their lending activity, or consider suspending?
It appears that the impact of the credit crisis resulted in a change of perception of securities lending by beneficial owners. 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.
This latter point may have come as an unwelcome surprise to some. The credit crisis gave rise to a host of questions from beneficial owners that the industry, collectively, could not answer, or answer quickly enough.
Exceptional volatility and illiquidity in cash, bond and equities markets
As some borrowers scaled back activity and underlying clients sold holdings, especially equities, lenders during the credit crisis faced the dual challenge of increased loan returns and recalls. Returns and recalls though, have not been asset class generic. While equity demand fell, lenders of government bonds have seen both demand and fees increase significantly as borrowers sought quality assets with which they could raise liquidity.
For all lenders, counterparty risk, the quality of collateral accepted in their programs 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.
Whereas at the start of the credit crisis a flight to quality was witnessed, as the months passed a growing recognition of the importance of liquidity developed. While the markets themselves were volatile, the liquidity of the cash equity markets, as well as their correlation to equity loan positions, meant accepting equities as collateral became an ever increasing consideration among lenders.
For beneficial owners in cash collateral programs the credit crisis also highlighted the inherent risks within commingled cash collateral pools. Superior performance to segregated cash programmes 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 to securities lending with its own specific risk-return considerations.
Since early 2008 the borrower landscape has dramatically changed, most notably in the cases of Bear Stearns, Merrill Lynch and Lehman Brothers. The net result, unavoidably, has been an impact on demand (see Fig.2).
The consolidation and surrounding events refocused attention on risk management issues relating to the forms of collateral accepted by lenders. In securities lending, the primary risk that needs to be managed is counterparty risk, the second is collateral. Selecting appropriate collateral to secure a securities lending program is essential. Quality collateral never turns a bad borrower into a good one but in the event of default, as the Lehman events demonstrated, the collateral being held is the lender’s next, and best, level of protection.
What the Lehman events also highlighted was that previously untested market-standard documentation, when called into action for the first time, was shown to be robust. The fact that it has now been tested and proven should give securities lending participants greater comfort.
Asasset managers restructure their businesses along these lines, they are challenging their service providers to evolve with them. And if companies do not offer clients the right products, risk management framework, operational infrastructure or service model, they will lose business. However, these features alone won’t guarantee success. Competition on price will also be tough and service providers will have to be able to compete at every measurable level.
This institutionalisation of alternative strategies has market participants on all sides reviewing and adapting their business models. The linear relationship that has historically existed in the securities lending world – with beneficial owners at one end, proprietary desks or hedge funds at the other and intermediaries such as custodians and prime brokers in the middle – is being increasingly challenged. The introduction of central counterparties has the potential to change the model still further.
For beneficial owners, advancements in technology, settlement systems and connectivity has 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 – namely, it is a product that 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.
Technology has had the biggest impact in the post-trade environment for the simple reason that securities lending is difficult, though not impossible, to commoditise from a trading perspective. Securities lending is a multi-trillion dollar business and small improvements in operational efficiencies can create millions of dollars of cost savings to market participants on all sides.
Today, however, we are seeing increased focus on electronic trading, which is a positive development. Any offering that may provide added value to clients should be welcomed. That said, each initiative should be evaluated carefully on its own merits as, even if the model is sound, they won’t all achieve the critical mass needed to succeed.
Interest in the concept of best execution in relation to securities lending will continue to grow. Clients will simply demand this because it is ultimately about them being in possession of ever-stronger information to measure, assess, and benchmark their programs from a risk, revenue and operational efficiency standpoint. Consequently, demand for technology developments that improve the quality and depth of information in all these areas will be strong, with initiatives in the areas of pricing, short interest activity, performance attribution and risk-adjusted return measurement likely to prove popular.
Looking to the future
Possibly the most lasting and major impact of the credit crisis on the securities lending industry, has been the short selling restrictions that many of the world’s regulators temporarily introduced and which, in some cases, still remain in force.
The speed with which they were introduced inevitably resulted in their application being slightly different from country to country. They also revealed different perspectives between regulators, which may be one of the reasons behind the establishment of the International Organization of Securities Commissions (IOSCO) Technical Committee Task Force on Short Selling (which published its final report in June 2009) – to provide a more consistent global regulatory position.
For borrowers, such as proprietary traders, securities dealers and banks seeking to underwrite corporate issues, the restrictions were a source of frustration, inconvenience and, more importantly, not without financial and risk management implications.For beneficial owners, what perhaps has been missing is a greater explanation of how short selling is used in practice and the distinction between short selling and securities lending.
If the securities lending industry has a challenge, it is to help regulators and trade associations better communicate that securities lending adds value to all market participants.
Whilst such efforts are vital, securities lending is at the end of the day a predominantly demand-driven product. Volumes, and with them revenues, will only recover as hedge fund and proprietary desk activity rebound. 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. Tighter oversight and controls regarding rehypothecation and developments such as central counterparties may also be expected to change the way borrowers access the market.
As regulatory, asset management and market consolidation developments gather pace, efficient collateral management will continue to grow in importance. Regulators are increasingly expecting and demanding that beneficial owners both understand and appreciate the risk dynamics of programs that their agents/third party lenders are running for them. Basel II will also progressively change the competitive landscape. Variable capital charges on haircuts and margins means 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, asset managers and financial media. At the end of the day, securities lending should not impact or inhibit the investment management process.
Oliver Madden is responsible for technical sales and relationship management for RBC Dexia’s securities lending business, having joined RBC Dexia in December 2007 role, he provides specialised product support for RBC Dexia’s Sales and Relationship Management team. He has a BSc (Hons) in Accounting and Financial Management from Loughborough University.