Securities lending programmes are becoming a common practice for institutional investors. John Piccitto presents a range of agency lending options for shareholdersAgency lending bridges the gap between the beneficial owner who holds shares and the broker/dealers and (via Prime Brokerage Units) the hedge funds whose voracious appetite for securities has nearly doubled in the last two years, and is likely to continue to increase as long as investors can make more money from investing directly in hedge funds than they can by investing in the stock markets of the world. Since hedge funds by their very nature take on greater risk, they generate high returns for themselves and for their investors.
And since it feeds this hungry money-spinner, and for several other reasons as well, agency lending is necessarily a growing industry, morphing and diversifying by the day.
For the beneficial owner, especially the smaller beneficial owner pension funds, mutual funds, county councils and other professional organizations it is folly not to lend out at least a portion of a portfolio because of the income that would be foregone by not doing so. Pressures on these funds have increased sharply in the past several years because of declining markets, because of the increase in the number of pensioners and their increased average life span, among other factors. Greater investor knowledge and activism have also made fund managers nervous, as have increased regulatory and legal scrutiny. Sitting tight and collecting dividends is no longer an option, if indeed it ever was. No more taking time off to watch the world cup. Ironically, securities lending, once seen as dodgy in some quarters has rapidly become an imperative for fund managers; the problem is no longer whether to do it, but how.
Beneficial owners who choose agency lenders to enhance the income of their programs tend not to have in-house facilities to conduct lending by themselves. By working with an agent lender, the beneficial owner saves the costs of setting up and maintaining a trading desk, outsourcing the work of lending in anticipation of income at month-end.
For these most risk-averse of groups, the issue of safety is paramount. So if the beneficial owner decides not to build an in-house lending desk, then the next stop must be a custodian who will add the beneficial owners shares to his existing pool (sometimes a very large existing pool) of shares from other beneficial owners, and lend them out to broker/dealers or (occasionally) to hedge funds.
Such loans are made on the basis of an algorithm; everybody in the pool gets an opportunity to earn income, depending on the demands of the market for the shares in the pool. If your portfolio has the only issues in your custodians pool of the hottest stock in South Korea (unlikely as it is that a small pension fund would have bought these), then youve escaped the algorithm, and youre now very much in the profits column. But if you have a largish portion of blue chips (as might be expected of a prudent beneficial owner), then you may not see too much action from your custodians pool arrangement, since your portfolio will be used to meet borrower demand along with the portfolios of all of the other wisely purchased portfolios of the wise and conscientious portfolio managers gathered under the wing of your custodian.
The algorithm determines whose portfolio gets tapped for what loans. But two million shares of Blue Chip Issue A is still only two hundred thousand shares per client among a pool of, say, ten clients who own Blue Chip Issue A. So this loan would only yield 200 per year in income at a lending fee of 10 basis points when calculated on a total loan value of 200,000 not exactly worth an Extraordinary Notice to your Board. This level of lending however is an essential feature of a custodians agency securities lending pool programme; its convenient, its safe, but its got a problem.
The problem is that the beneficial owner would like to find a way to barge the queue implicit in the algorithm, if at all possible, in the nicest possible way, of course. Plans and programs for getting the most and more out of a third party lender, as well as war stories of failures to do so, decorate the conversations of beneficial owners when they talk together frankly.
And it is evident, listening in on the conversations of concerned agency lenders, that they are more than happy to provide whatever comfort they can to their clients, specialized technology (ABNAMRO Mellons iBID auction service, for instance), prompt payment of cash dividends on payment date (whether or not the money comes into the bank from the paying agent), marshalling of sufficient resources to avoid most potential fail-to-deliver transactions (the custodian will simply borrow the necessary issues from other clients who hold the same issue), client-customized reports and other techniques for producing the appearance of seamlessness.
Agency lenders act on behalf of their clients, offering back office services, including collateral reinvestment, corporate actions and comprehensive reporting. The beneficial owner foregoes a degree of control (having done a meticulous risk/reward calculation, of course) and collects the income. The majority of US custodian banks act in an agency capacity when lending securities owned by the clients in their custody programme. Some custodians, notably Swiss banks, act in a principal capacity; that is, the borrower deals directly under contract with the bank and not the beneficial owner of the security, so in case of beneficial owner bankruptcy, the borrower has recourse against the custodian bank. European custodians, once overwhelmingly operated as principals, but now they often operate in either capacity, as required by circumstances. Anomalous in the agency lending business are those private Swiss Banks, who in compliance with Swiss Bank Secrecy Laws will act in an agent capacity for an undisclosed principal. Some of these banks have in the past amended their contractual wording to accept principal risk with the borrowers collateral.
Pension funds, superannuation schemes and county councils among other beneficial owners who feel that they are too small to achieve much income from the ordinary operation of a custodians pool lending arrangements use 3rd Party Agent Lenders to improve their strategic position. Funds and security portfolios stay on deposit with the selected custodian bank, thus retaining the safety offered by the custodian bank in the form of counterparty indemnification, among other things. But the beneficial owner arranges with a third party/agent lender to manage his portfolio through the custodian. So the custodian loses the use of those shares in its lending programme, but still retains custody of the portfolios and gets movement fees when the shares are loaned out and taken back at the direction of the agency lender. The 3rd Party Agent Lender has access to a large and varied and sometimes specialised client base of borrowers (he may focus on certain classes of securities, or on several specific industries) and places the securities out on loan for the beneficial owner. The key to this new relationship has to do with the size of the agency lender: small is beautiful.
The 3rd Party Agent Lender has a small client base of beneficial owners; close client relationships are a most important aspect of his business. No more small fish in a large pond. Lending out as much of the portfolio as possible as often as possible is the chief objective because the 3rd Party Agent Lender has to do better than the custodian bank did with the portfolio, which is not only a function of scale.
So what are the future prospects for this business relationship? Where is new supply coming from in the next year? In the next five years? And where is the demand likely to come from in those same time frames?
Between 2001 and 2004, the number of active hedge funds has increased, from around 4,000 in 2001 to in excess of 6,000 the figures often mentioned in the London financial press. Professionals in the field anticipate the effects of this growth. I see new demand coming from the broker/dealers, especially from their Prime Broker units as new hedge funds come into existence and bring with them new trading strategies which will require a securities lending facility, says Ciarn McNamee, Senior Vice President, Brown Brothers Harriman. In addition, McNamee points out there is an increase in proprietary trading activity, which will also require additional supply.
Hans Beckmann, Managing Director of Guild Global Securities, Dublin, foresees for his third party lending agency intermediary service expansion throughout Europe this year, beginning in the UK and the US. But Beckmann has also targeted European countries Austria, Italy and Luxembourg, as well as other EU countries. In terms of demand, Beckmann adds, I can see a complete shift into more exotic, high fee earning countries and not the mainstream new markets everybody talks about like Taiwan, India, etc. He said, It would not surprise me to see markets like Greece, Israel, Eastern European Countries who have just joined the EU to start lending and borrowing activities along the same line Guild Global has kick-started in the Irish market.
But besides hedge funds and expanded or newly developed markets, there are internal prospects for increased action in the agency lending business. Growth in demand emanates from long holders of securities, according to Tim Smith, Head of Inventory Management at AXA Investment Managers GS Ltd. Investment managers are setting up their own hedge funds and long/short vehicles. Smith also pointed out that another source of different demand will come from the push for shorter settlement cycles, thus driving up the demand for more efficient coverage.
And supply? Supply is coming from the European institutions coming to market like pension funds, insurance companies, etc. McNamee says. It will continue to grow for the foreseeable future.
Smith agrees. Additional supply may come from the growing transparent nature of the securities lending business which leads to a greater acceptance by those portfolio managers that have previously looked slightly askance at the concept. Remembering a hard-won battle, he points out that, Securities lending is now ethical.
Interestingly, Smith added that the reviewing and tread towards relaxation of legal limits to lending by the regulators worldwide will increase the lending pool of assets. An example of this would be the recent change allowing more than 15% of OPCVM assets to be lent out in France.
Currently, a healthy competition exists among beneficial owners, custodians and their internal programs, and 3rd Party Agent Lenders. Choosing among the options for the beneficial owner can be a question of selecting the most pro-active programme within given risk parameters. Several varied scenarios exist for the beneficial owners to consider and take advantage of and profit from. And each scenario in turn provides a means to get securities to market, and to provide greater market liquidity.
D.I.Y.
What if you the beneficial owner decide to do it yourself? It can be a good idea, and incidentally, operating your own in-house desk does not preclude continuing to use third party lenders as well. An in-house desk allows the beneficial owner to keep close control over the trading of his portfolio. But an in-house desk can be very expensive and time consuming to establish, and the burden of risk assessment is one that a beneficial owner must be very careful about undertaking. And depending on the size of the portfolio under management, an in house desk can be costly and inefficient to operate.
Staff must be hired and trained (possibly a minimum of three full-time people). A comprehensive IT system must be installed, and one of the best of these on offer now goes for around 250,000 to 500,000. Other, less expensive systems can be purchased off the shelf from one of the industry specialists, or a system can be purpose built by an in-house systems architect who might or might not produce something as good as might have been purchased.
An in-house program must be marketed. Each new client must sign the standard format document (usually the UKs Global Master Securities Lending Agreement - GMSLA) prior to the beginning of trading. And most important, risk evaluations must be calculated on all new clients, which would cover credit, annual reports and trading histories, among other things. This last task is the sort of service an agency program does as a matter of routine. An agency lender has files from past business, access to data bases, and experience in both credit evaluation and in risk calculation.
In a recently released survey of their beneficial owner members, the International Corporate Governance Network (ICGN) found that a minority of respondents lend stock through in-house programmes. Twenty-one out of the thirty-one who lend stocks rely entirely on 3rd Party Agent Lenders. And four more of the remaining ten operate both in-house and 3rd party programmes. (www.icgn/documents/share_lending_report)
