Portfolio Exclusives

One of the most common points of discussion in all my meetings over the past few weeks has been the area of Exclusives.  Are exclusive arrangements doomed to extinction or do they still play an important role in the industry? 

First, to make certain we are all on the same page, let’s define “Exclusive”.  For the purposes of this article, Exclusives are an arrangement whereby a Beneficial Owner agrees to give exclusive access to a pre-defined group of assets to a borrowing entity for a fixed period of time.  In return for the exclusivity, the borrower pays a specified fee and in some cases makes additional commitments in terms of minimum cash collateral balances.  The assets may be an entire portfolio, or subsets thereof and is unique to each situation. 

"Exclusive arrangements are dead"

Hardly

There is no question that the securities lending business as a whole has contracted substantially from where it was earlier in the year.  There are several reasons for this reduction – limited trading opportunities for proprietary trading firms and hedge funds, hedge fund redemptions, and the increased financing costs and impact on firms’ balance sheets and capital.

However, trading hasn’t disappeared, and many are expecting increased demand once we get into the New Year.  Tax efficient trading will always be in demand, although the savings/earnings opportunities may fluctuate dramatically.  As some beneficial owners have stopped lending, there has been an overall reduction in supply across the board so exclusives remain a valid alternative.

A high quality portfolio will always have demand for exclusive arrangements

Borrowers don’t want to pay for exclusives

Kind of …

Exclusives are a bet on the future for dealers.  They want to identify portfolios that will generate better value than their cost outlay.  The Beneficial Owner gets certainty of income from the fixed fees.  They are protected from a fall in borrowing demand – that risk is bourne by the exclusive buyer.  They lose out if the demand for their stocks goes through the roof and this valid argument is often made by agents looking to dissuade Ben Owners from going exclusive.

Given the falling market over the past year, you know that the dealers have been sucking up these costs while the demand side of their business has also fallen off.  So there is no question that the desire to “pay up” has been impacted.  For the past year the Ben Owners' (and actively involved agents) income has been protected by the exclusive borrowers.

Further, the cash re-investment side of the business for agent lenders has had an indirect impact on exclusives.  In order to attract and keep cash in their pools, agent lenders have been offering stocks to borrowers at unprecedented levels.  Give stocks away and the dealers will be attracted. 

The bottom line is that many dealers are still willing to pay, but not necessarily at the same levels as before.

Beneficial Owners don’t want exposure to exclusive borrowers

Maybe …

There is no doubt that everyone is more concerned about counterparty exposure than ever before. That applies to all sides of the market – Beneficial Owners, Agent Lenders and Borrowers. 

One of the negatives levied against exclusives is that it concentrates counterparty exposure into a single entity.  Most exclusives don’t result in an entire portfolio being awarded to a single counterparty.  If that were the case, it should indeed bring up the question about counterparty concentration.  The overwhelming majority of exclusives are parceled out to multiple counterparties and they typically have maximum borrowing limits imposed on the dealers.

Whether a beneficial owner lends to 5 dealers in a conventional lending programme with maximum exposure limits, or whether they are lending exclusives to the same 5 firms, the counterparty risks remain the same.  (Of course, this doesn’t take into account the impact of indemnifications which I will look at in the future.)

If a beneficial owner doesn’t want counterparty exposure they shouldn’t be lending their portfolios.  And that’s one of the reasons why some have pulled out of the market.

Summary

Exclusives are an important part of the business and will remain so.  Quality portfolios will always be in demand.  I think there was a time not too long ago where just about any portfolio could get a bid on it.  That’s no longer the case.

You also need to remember that not all firms are experiencing the market in the same way.  The flight of business from some dealers and prime brokers to others has meant that while exclusive demand is shrinking at many firms, it is surely rising at others.