Stock Lending Today - An Industry Under Siege!

News from the Beach

Taking a break this week, but the news goes on … please find a selection below.  The picture is me sitting at the "Irish Bar" last night for a pre-dinner drink of cherry juice.  No Guinness, Jamesons or Irish staff, but yet somehow it's an Irish Bar.  Explain that to me ...

This is the second story of this type that has come out of the US in the past month.  Both have focussed on relatively small samples and look only at lenders that take cash collateral, but is a concern.  Much ado about nothing, or a worrying trend?
48% of investors unwinding sec lending program - Global Pensions

While the lenders noted above are trying to get out of the business, others are trying to expand.
HSBC to launch prime brokerage unit - FT.com
Cantor Fitzgerald creates prime brokerage business - Yahoo Finance

I really liked this article as it gives readers a better understanding of the drivers of success year-to-date and indications going forward.
Hedging back in vogue among lucrative convertibles - Reuters

Have we finally hit the bottom, or is this a blip?
Hedge-Fund Assets Rise for First Time in Year to $1.43 Trillion - Bloomberg

I don’t really cover people stories, but couldn’t resist this one.
Morgan Stanley, UBS Swap Executives -WSJ

Gordon Gekko updated for the “Naughties”?  Can this be true?  Hat tip to Mike for pointing this one out to me.
Short-selling villain casting call - FT Alphaville

Continuing to work on my tan while hoping to keep you up to date!

On the road to Barcelona

I am writing this as I sit on the plane, on my way to the 18th Annual ISLA/RMA conference on securities lending. I think that I have been to 15 of the 18 events, and I can't recall a more important nexus for the industry.

Hedge funds remain the single most important driver for the growth of the business.  Hedge fund data from May have finally shown a turnaround in fortunes for the alternatives industry. Performance is up virtually across the entire spectrum of funds, new investments have exceed redemptions for the first time this year and some sizable new fund launches are in the works. Yet one month's figures do not constitute a trend.  In addition to the natural challenge for performance, regulations loom large and ominous for hedge funds around the world. Regulators and politicians in practically every region want more controls, restrictions and reporting.  The impact of these forces is hard to predict at this time, but they will have an effect on the business.

On the morning of last year's ISF awards announcements in September, I suggested in my blog that the winners on the borrower side of the survey enjoy the celebrations but the lenders shouldn't take any notice of the rankings. My feeling at the time was that the past winners would perhaps for the first time not be a useful guide to future winners and that there would be a new order arising. I feel pretty good about that prediction.  I don't think there is a prime brokerage firm out there that isn't grappling with the after shocks of the Lehman default last year. Numerous hedgies have changed and/or added PBs, and many of the switches involved moving their relationships into the US offices of their PB. The original move to providers based outside the US was to take advantage of more commercially oriented leverage arrangements from non-US offices of the prime brokers. However, given the very low degree of leverage this is no longer an issue, and many funds feel more comfortable dealing with future potential insolvencies in the US as opposed to other jurisdictions. PBs are having to re-examine their service and funding models, coming up with different and innovative solutions for their clients. Any provider that hasn't added any new services, arrangements or features over the past 9 months or isn't working on them now is likely to be left behind by the end of the year.

Agent lenders have been on the firing line for much of the past two years as a result of the credit and liquidity crisis that has hit the cash reinvestment side of the business. The core challenge for these agents has been less about the selection of investments and more about their ability to keep the pools funded in a shrinking market. Forced sales generally have unfortunate outcomes. Agents who predominantly lend against non-cash collateral have had a growth spurt in business as their clients haven't had cash reinvestment losses and the collateral profile is attractive to the majority of borrowers. The debate about the purpose of collateral - safety net or alpha generator - is surprisingly still in its infancy. Borrowing demand is down from peak levels a couple of years ago so lenders have to work harder just to stand still.

Beneficial Owners that participated in cash programmes ... Hmmm.  Are they the victims in the cash reinvestment story or willing participants until the tide turned against them? Have they been ill-educated and uninformed by their service providers or were they only interested in the bottom line?  "Securities lending in five minutes a month!" Which Ben Owner wants to admit to this approach these days? For those funds that took non-cash collateral, they missed the best of the returns generated by their cash-oriented brethren, and with market volumes down are no doubt well off their best revenue years. I suspect however that this is the group that feels least stressed (depending on how much business they did with Lehman and the type of business).

Further, the issue of electronic trading and central counterparty is finally real rather than an abstract idea for the future. The question here seems to be more an issue of those fighting for the status quo rather than considering whether CCP is a valuable part of the future of the business. Indeed, individual firms have their own best interests in mind in their actions. However, a number of the arguments made against CCPs don't bear up under scrutiny.  Typically it is regulators that are tasked with determining what is best for the wider markets. I'm not sure this an issue the stock loan industry wants to leave solely in the control of the regulators.

Finally, the subject of short selling has never had so much focus as it has over the past twelve months.  Securities regulators, politicians, church hierarchy, day traders, pensioners, corner shop owners and cab drivers have all been given time to air their views, happily accommodated by a media fueled by frenzy.  We have almost emerged from the fog of fear and a more considered and thought-out regime will likely result over the coming months - although it is likely to be different on a country-by-country basis.

All in all, we see a securities lending business that is still huge, and recognised as a cornerstone of the capital markets.  But we also see an industry that is dealing with important fundamental issues that will shape the market for years to come.  What that final shape will look like however, is yet to be determined.

Should be an interesting conference.

(A long post - hope you made it to the end.  See what happens when the flight is delayed and I have too much time on my hands.)

ISLA / RMA Conference - Which subject interests you most?

I am getting ready to go to the conference and was just reviewing the subject matter one more time.  I will be covering the event for Global Custodian Magazine and have been considering which session carries the best potential for stories.  I'm always interested in what you think, so I have listed below the the titles of the different panel sessions.  Which one interests you the most?

If you have any questions or comments you want raised at the event, let me know and I may get a chance to ask them on your behalf.  Drop me an email at roy@stocklendingtoday.com

Regulatory Corner
Last Friday was a busy day for regulatory reports.  IOSCO produced its Final Report on the Regulation of Short Selling.  I haven't had a chance to do anything other than skim it so far.  More in the coming days. 

Friday was also the deadline for public comments to the SEC for Short Sale price tests and circuit breakers.  Over 5,000 submissions were made by interested parties.  My feeling is that the most interesting comments weren't made public .... How You Doin? 

"Best Price" in Securities Lending

I got into a discussion with someone last week regarding the “best price” concept as it applies to securities lending.  It would seem to be an obvious and straightforward one, but never has been.  Unlike a straightforward trade execution where the measurement is an absolute price in the context of the day’s trading range, securities lending pricing has other factors that influence the assessment.

While there are overriding risk issues such as legal, tax and operation that apply to stock loans, these are germane to the business and don’t have an influence on individual trade prices for comparative purposes.  Counterparty risk and collateral management are two transaction-specific issues that have a direct impact on the assessment of whether “best price” has been achieved.

Counterparty Risk

Each market participant makes its own decision on the counterparties with which it will trade.  There is no centralised or commonly agreed rating or ranking on counterparties, so it is an individual selection based on the credit analysis and judgement of its trading partners. 

For example, Lender “A” may have a different view than Lender “B” as to the creditworthiness of Borrower “C”.  Except with hindsight, there is no way to determine whether either or both views are correct.

Collateral Management

What is the purpose of collateral in stock loan transactions?  It seems there are two broad approaches. 

One is that collateral is to be used as a safety net in the event of a borrower default.  The collateral is then liquidated and used to repurchase the stocks and bonds that were loaned out to the borrower.  This approach suggests that securities are taken as collateral against securities on loan.   Even here there are differing views.  Some look at “AAA” rated government bonds as the best type of collateral.  To the extent that they are unlikely to default, and are typically very liquid, there is merit to the argument.  The other view is that in line with normal investment criteria, the key is correlation.  That is to say that in order to replace a wide range of securities that are loaned to a given counterparty, the best collateral is to take a diversified portfolio that broadly resembles the securities on loan.  In other words, a portfolio of international equities and bonds is best collateralised by another basket of international equities and bonds.  The values of the portfolio on loan and the collateral portfolio should move in similar directions in terms of total value.

The second approach carries the same underlying purpose of asset replacement protection, but adds in the potential for enhanced returns.  This extra performance is achieved by taking cash collateral which is in turn used to buy money market instruments. In essence, the purchase of additional securities adds an element of leverage to the portfolio and adds incremental risk to the transaction.  Hopefully it also adds additional income.  Since this entails an actual investment transaction, the caveat that prices go up as well as down, and that historical performance is not necessarily a guide to the future is appropriate.  Making this decision requires investigation and analysis to ensure that one understands the pitfalls. 

Summary

Best price is not something that can practically be achieved in the context of a mulit-layer risk transaction like securities lending.  The best anyone can hope for is a meaningful discussion and analysis of revenue attribution and the risks pertain while achieving the income.

Sorry, I wish there was a more straightforward answer.  Do you agree/disagree?  Let me have your comments on this issue.

P.S. 
The Dutch regulator AFM has announced that the short selling ban on financial stocks, including insurers will expire on 1 June.

Guest Blog - Cash Re-investment: What have we learned?

I am pleased to provide a vehicle for this Guest Blogger.  I have covered Cash Reinvestment issues several times, but this article is from an agent lender practitioner who is at the heart of the challenges on a daily basis.  The writer wishes to remain anonymous.  Please send your comments to me and I will pass them on.

What have we learned:  Well it’s certainly no free lunch!!!

It’s important to understand cash reinvestment is not securities lending – however as a product associated with securities lending it cannot be disassociated as some try to do especially when things go bad!

The plan as always is to have very liquid, highly rated securities. Generally the primary objective as stated at the top of investment guidelines is to protect principal value of cash collateral received and maintain adequate liquidity.

Outlining the benefits to a client is obviously important and is generally the easy part. Making sure all the risks are communicated and understood is the critical part.

Cash collateral reinvestment is an option and not obligatory when participating in securities lending. For those clients choosing cash reinvestment, they should agree and sign the investment guidelines. There should also be a clear section on the risks and health warnings! Cash reinvestment introduces leverage to securities lending that would not be the case if non-cash collateral were taken.

Ultimately cash reinvestment is about risk and reward. A lot of money can be made from this strategy but the risk will climb accordingly! It’s down to the appetite one has for the risks.

Choice of strategy is key.
•    Duration - Short term cash no more than 30days…. Or no longer than 180 days. Do you match duration of loans 100% or only match a small amount.
•    How much GAP is the client willing to take? Loans on open vs WAM on investments of 30 days?

One big issue is separating the interest rate WAM from the duration WAM.
•    Loans may be on open or have the rebate reset monthly, whereas the investment may reset month, quarterly or longer. This is a strategy in itself and must be understood and accepted by the client.
•    However for duration you could have loans on open against a basket of investments with a WAM duration of 2 years. This is a BIG risk should the client be downgraded or a systemic risk materialise as in the current environment. Should a borrower want to close all loans and investments have an average of two years to maturity, the only option is to sell. Selling bonds into an illiquid market will most likely result in losses! Client may not have expected any losses let alone big losses! Were they making enough revenue from the strategy to digest the losses, unlikely being that yields from securities lending vs cash collateral are generally in the range of 5-10bps.

So what has happened…

Clients invested in a variety of asset types, interest rate durations, maturities and credit qualities. Credit qualities were at the high end. As per RMA Q308 survey 91% of investments were AAA/AA/A1/P1. However with a mixed asset class of CP, ABS, Corporates, etc., how easy has it been to sell any of these securities with no loss?
As clients have considered exiting lending programs, whether being for economic reasons, not wishing to be associated with short selling, or concerns over the liquidity risk, they have come to realise it has been difficult to withdraw due to the illiquid nature of the investments.

This is no different to the crisis experienced in Money Market Funds in the US - as investors look to get there money back, some MMFs have to put a freeze on withdrawals from the funds. They have a certain amount of cash but are unable to sell investments without losses!

Another major problem has been comingled collateral pools. Are they beneficial? Can a client exit easily? In good times yes but should any investor want to get out now then there are concerns about disadvantaging the remaining investors. For example when a client leaves they take some of the cash portion of the pool! Should an asset go bad after a client withdraws, the remaining clients are left with the problem. When a security is sold either at a loss or profit who is attributed the proceeds/ losses and how? How do pools deal with these situations to ensure a fair treatment for all participants? The benefits are economies of scale and improved liquidity. Again pools have performed well until the crisis but now they are a source of concern to investors.

So what should be appropriate going forward…..?
The client needs to fully understand what they are getting themselves into. Not only at the beginning but there needs to be quarterly reviews with the client to go over the performance, including the cash reinvestment. A review of the guidelines should also be undertaken and any changes made. Getting written sign-off by the client on a regular basis goes someway to ensure all parties understand where they stand.

Be aware of the asset mix, reduce duration risk, and be comfortable with the credit quality. With downgrades happening in a regular basis it is important to have a plan for when this happens. Selling a downgraded security will likely result in a loss to the client!

Which brings us to the choice of investment manager! Make sure the client has done their due diligence of the IM. This should also be reviewed on a regular basis possibly annually. Is the client getting value for money?

At the end of the day when everything is taken into account is the client earning enough to warrant the risks? For years the cash reinvestment model has produced excellent returns for the client. But illiquidity, downgrades and reductions in lending balances have increased the pressure and risk associated with cash reinvestment.