Exclusive vs. Agency

"Learning how to lend"
By John J. Piccitto
ISF Magazine
4th Quarter 2001

"Once you have taken the decision to lend your assets, the real work begins. How can you ensure that you submit to the programme that is right for you? John Piccitto examines the options open to the fledgling lender."

If you are a portfolio manager who’s just decided to do stock lending, congratulations are in order. You have embarked on a low-risk strategy that will add a considerable amount to your bottom line without a great deal of extra effort on your part. But having taken the decision to lend, you are now faced with some important questions. You must decide which of the options open to you is the best, most cost-effective way to lend out your portfolio. Agency? Exclusive? Or a combination of the two?

This decision will be the result of your own assessments and aspirations. How much money do you think you can safely make on your portfolio? And when do you want to make it? Up front on a monthly basis, or as and when it is earned?

In an exclusive lending arrangement, a portfolio of selected issues is auctioned off among potential borrowers who bid for the sole right to borrow from it. The auction to establish an exclusive borrower will produce immediate, pre-agreed income.

In an agency lending relationship with a custodian bank, the bank acts as the agent for the portfolio manager. The agent will deduct fees from any gross income it earns on your shares, and pay you a net return. And this income will come in sporadically, rising – and unfortunately, falling – with the market. An agency arrangement is market-sensitive, whereas, from the lender’s point of view, at least, an exclusive arrangement is not.

To a large extent, the makeup of your entire portfolio, and subsets of it, will determine what kind of lending arrangement you select. Does the portfolio contain a few issues, or does it have a wide range of issues? Is it made up of issues from one or two different countries or a range of countries across the globe? And what is your best guess (or research) about what the markets will be doing in the next twelve months?

It should be pointed out here that the size of the portfolio is not an issue. Some custodian banks look at the overall banking relationship when deciding who to accept into its lending pool. And therefore will accommodate very small and / or highly specialised portfolios.

If a portfolio manager decides to give a portion of his fund, or all of it, to an agent bank, the bank would then add those securities to its pool of available lendable positions and on-lend as and when requests are received. For these shares, the agent bank might pay the portfolio manager somewhere in the region of 40% to 60% of the income generated by its on-loans (after internal bank charges are deducted, of course). This arrangement allows the portfolio manager to take advantage of an unforeseen rising market.

In an agency arrangement, the portfolio manager is not locked into a set price, and if the market for his shares gets hot, he collects his percentage. On the other hand, if the shares are not so hot – if nobody wants to borrow them -the custodian is obviously not obliged to pay for anything, as nothing has been loaned.

But if the portfolio manager auctions a portion of the fund, or all of it, for the exclusive use of a bidder, there will be an immediate payment. After that, it’s up to the successful bidder to decide how to use the shares.

But in either arrangement there is always the matter of risk, and in particular, credit risk.

The Achilles Fund

To illustrate all this, we will consider an imaginary example: the Achilles Fund - a portfolio of securities which contains issues from the following countries: Australia, France, Germany, Hong Kong, Italy, Japan, The Netherlands, Sweden, Switzerland, and the United Kingdom. This fund will be referred back to as an example throughout the remainder of this article. The total asset value of the portfolio is approximately UK £4.4 billion.

Exclusives

The portfolio manager who decides to set up an exclusive lending arrangement for the Achilles Fund must first determine which portion(s) to put out to bid, and that does not necessarily have to be the whole portfolio. In our working example, all the Japanese shares (20% of the portfolio, with a value of £880 million), or all the Swiss shares (£440 million), or a combination of two or more segments might be gathered together to be auctioned, for instance. It depends on the market, and on your opinion of which securities would be most lucrative to control for a whole year, perhaps even to the point that they would “carry” other, less desirable securities.

An auction is then organized: potential bidders notified and provided with lists of shares. The winning bid is selected and the cheque is banked.

In an exclusive arrangement, you will retain physical control of the portfolio. Your successful bidder will notify you every time he wishes to borrow your shares. For the duration of the exclusive contract, even though you have auctioned off the exclusive right to borrow shares from the portfolio, you can still buy and sell shares from it. All corporate actions still revert back to you - in other words, you still retain the right to receive all cash and/or securities that your holdings generate in the form of dividends and share offerings. You are still the beneficial owner of the securities, even though you have given up registered ownership of those securities out on loan.

However, you do not retain the right to vote your loaned securities at any Annual General Meeting (AGM). You give up this right when you loan the securities to a borrower because the ownership has changed. The only way to retain voting rights is to recall the securities prior to the AGM, thus ensuring that your name is back on the certificates, and that you are the holder of record prior to the AGM date.

Notification of AGMs only goes out to those clients of the issuer who are noted on the books and records as of a particular date in time, otherwise known as the record date. Some borrowers may say that they will protect you and vote your securities according to your wishes, but this implies a great amount of trust on the lender’s part that the borrower will in fact carry out the instructions exactly as you would have done. Be warned, however, that sometimes slip-ups do occur.

The portfolio manager can expect to earn a good rate of return on the portfolio from an exclusive borrower. If you award the bid at, say, 25 Basis Points (bps), you will get that amount, regardless of the going rate of some of the issues. However, a “hot stock” can generate income far in excess of the 25 bps you received on the bid price. But, you have traded that opportunity to make more money for the assurance that your entire portfolio has generated income for the year (the usual duration of a bid), no matter what the market does to the issues in it.

However, Mellon Trust has found a way around the problem of hot stocks not producing their share of extra income for the portfolio manager. Mellon Trust has instituted auction bids on single hot stocks or a basket of hot stocks on-line, via its iBid system. Mellon Bank’s Jamie Ball, comments: “With iBid, our borrowers can bid on-line for particular securities or baskets of securities. During the auction, leader status is advised on-line to the borrower with the highest bid, although of course the position can change if another borrower outbids him. Borrowers only know if they are in the lead or not in the lead. No borrower, leader or otherwise, has access to any information about others bidding in the auction. The auctions are set for a specific time, usually 20 minutes to half an hour. When the auction ends, the winner has immediate access to the securities he has bid for. To date we have had great success with borrower participation.”

Operationally, the exclusive arrangement requires fewer man-hours than setting up an in-house desk, for example. Perhaps one or two operations staff might be required to deal with the borrower and with the custodian to arrange the movement of the securities from the portfolio manager’s depot to the custodian account of the borrower. This means that a staff member or two would have to be assigned to the borrower at all times to take calls and notify custodians of impending movement instructions, among other duties.

At the end of each month, the operations staff have to reconcile the custodian’s statement against that of the portfolio manager, and make sure the cash payment is received in due course from the borrower. This would need to continue for the life of the bid.

Approximately two to three months prior to the expiration of the bid, the portfolio manager must decide if the portfolio will be re-auctioned or cancelled. A pre-agreed exit strategy with the borrower is useful, even if you wish to cancel the arrangement, or put the portfolio out to bid again.

For a borrower, an exclusive portfolio is a very effective marketing tool. A prime broker, for example, sells itself to hedge clients partly on its ability to cover rapidly changing needs fast. And exclusively held portfolios increase its chances of doing that. For a lender, an exclusive portfolio is a way to guarantee income up front, in a less market-sensitive context.

Agency lending

If the portfolio manager decides to loan out the portfolio, or part of it, to an agent custodian bank, the first decision is to pick an agent to handle the business. This is usually done through his operations or bank relations management colleagues. Once a bank is selected as the agent, a strategy must be agreed upon with the prospective lender: how much of the portfolio should be given to the agent, what type(s) of collateral the agent bank should accept to secure loans of shares, and what types of reporting the portfolio manager wants to see and when.

Finally, the portfolio manager will want to know how corporate actions will be handled and what the income split will be after charges.

When all these matters have been agreed upon, the portfolio manager will also want to set up some arrangement to vet potential borrowers. Conflicts of interest do occur, and Chinese walls must be maintained by the agent. A portfolio manager would not like to learn that a recent trade made with Broker ABC had been settled with securities Broker ABC has borrowed from the portfolio manager’s own portfolio!

Operationally, the agency relationship is less labour-intensive than the exclusive relationship, because the portfolio is given over to the agent and not held in-house by the portfolio manager or his staff. But, statements must still be reconciled and income cheque's received and credited to bottom line P&L ledgers.

However, the daily communication between borrower and lender is maintained by the agent and his borrowers, not between the agent and the staff who work with the portfolio manager.

Again, there are pitfalls to be watched for. In an agency arrangement income may be much less that that of the exclusive arrangement, because the income earned will be shared by the agent and the portfolio manager after the agent has deducted its fees and charges for maintaining the portfolio and lending it out.

Also, widely varying amounts of the entire portfolio may be on loan at any given time. The agent has many clients; and he can lend securities belonging to any of them.

A bit of both

There is one other scenario that has not been touched on in this article: doing a combination of both techniques, placing a segment or two of your portfolio out to bid and giving the rest or a portion of the rest of your portfolio to an agent.

This creates the best of both worlds. The exclusive arrangement gives you up-front income for an established period of time, while the agency relationship brings in other income the rest of your portfolio, in response to market movements.

Fixing the balance here – lending the Japanese segment of the Achilles Fund on an exclusive basis, and the remaining 80% of the portfolio on an agency basis – is a delicate decision. And portfolio managers earn their salaries by maximising the return on their entire portfolio.

A few final points are worth mentioning. The differences between exclusive and agency lending arrangements depend on the quality of issues in the portfolio, the desired income flow, and the commitment of man-hours. An interesting portfolio is more important that a large one, although it is difficult to imagine an extensive portfolio that is absolutely devoid of hot stocks.

When the portfolio manager decides to auction a portion of the portfolio, the bidding analysis described earlier may assist. It is always useful to know how a client proposes to use what you’re selling him. But a note of caution is appropriate here. The highest bid is not necessarily the best bid to take, or the best bid to renew. A review of the past performance of the borrower is well worth making. If the borrower has a record of failing to accept loans via a custodian bank or does not pay loans back on time, this will certainly cost time and money to the portfolio manager, especially at dividend time or voting.

It pays to do your homework and analyse each potential long-term client because this is what is being contemplated – a long-term commitment of your portfolio(s) to one or more borrowers. If this falls apart, it can cost you in the short term as well as the long term.