"The life of a loan"
By John J. Piccitto
ISF Magazine
2nd Quarter 2002
"I think we want to do it, but we're deciding
how to decide..." A South African friend of mine
- and I hope a potential client - spoke for a lot of
folks I've talked to recently.
All over the world, insurance companies, pension funds
and other institutions have heard about the profits
you can add to your company's bottom line by lending
out stock that otherwise would remain unproductive.
But exactly how do you go about it? What are the basic
considerations in making such a decision?
These notes should provide a starting point.
The first question you need to ask is whether or not
stock lending is LEGAL in your country. There are some
areas of the world where stock lending is regarded as
a sale and not a loan versus collateral. If this is
the case in your country, all you can do is organise
an effort to change the minds of your financial regulators,
perhaps by pointing out that stock lending adds liquidity
to the market and reduces fails to deliver. Generally,
if you can sell short, and if fails are covered, then
the rudiments of stock lending are already part of the
culture of your local financial marketplace.
Assuming the legality of the programme, you can ask
a CUSTODIAN BANK to lend out your securities for you,
OR you can set up an IN-HOUSE stock lending operation.
My very rough guide to how to make that decision is
two-fold: to set up an in-house stock lending programme,
you need
a) Approximately $500 million to $1 billion in a
b) Varied Portfolio
But these are very elastic ideas. So if you only have
20 different issues worth $2 billion you might still
want to go to a custodian bank. But if you have 100
different issues worth $750 million, you might profit
most if you set up an in-house operation. It takes a
practiced eye to make the call, one used to looking
at the market to see what kinds of securities are being
borrowed. And of course, if you've got both high value
and diversity in your programme, an in-house stock lending
operation is obviously a great idea.
If you decide to give your portfolio to a custodian
bank, you can set up a variety of arrangements, depending
on how much control you wish to retain. Or, you may
wish to outsource the work completely, and the outsource
agent will return profits to you regularly, less its
costs, and fees, of course.
A custodian bank adds your securities to its own pool
of stock and the resulting diversity attracts borrowers.
For some portfolio owners, this is the only way to get
their portfolio noticed by borrowers. But for other
lenders, there's a serious drawback to using custodian
banks. A custodian bank will loan out your securities
for about 50 basis points or less. Then it will subtract
its costs, and only then will it return to you anything
from 40% to 60% of the net profit. That could be a very
good reason to build an in-house programme. It all depends
on the quality of your portfolio.
But if you don't go to a custodian bank with the contacts
to use your portfolio, how do you let potential borrowers
know what you have to offer? In other words, what about
MARKETING? There are two ways to do this and I suggest
you plan to use both. First, you can contact the major
Prime Brokers who will be able to use your portfolio
best if you provide an online listing of what you have
available for loan. But a Prime Broker will want a cut
for their services. If they borrow a security from you
at 50 basis points, for example, they will onlend it
for 100 to 125 basis points, or even more if the security
is greatly sought after.
The second way to market your portfolio is directly.
Find out who is borrowing securities like the ones you
hold - hedge funds, broker/dealers, trading companies,
for example. Phone them up. It's as simple as that.
This way you eliminate the middleman.
But what are the RISKS associated with a stock lending
programme? There is always a risk in any securities
trading environment, of course. But compared to businesses
like derivatives, commodities, foreign exchange and
futures trading, stock lending is a business with minimum
risk. All loans are collateralised at a minimum of 102-105%
of the loan's market value, and every loan must be marked
to market daily. Various forms of collateral exist,
and may be varied to suit both parties to the deal.
And standard documentation protects you and your potential
borrower from any misunderstandings.
What about PROFITS? How much you make in stock lending
depends on how good you are at trading with your clients,
how much inventory you have at your disposal, and whether
or not your collateral manager is doing a good job.
And who trains up your desk staff in the first place,
and how the market is moving at any given time. In short,
this one is pretty much incalculable. But in the final
analysis profits only come from good trading. A net
profit of between $500,000 and$1,000,000 after an initial
start up period is about average. And you can achieve
profits in the eight-figure range by just sticking with
a stock lending programme over the long haul.
So how much is all this going to COST? The answer is
that while set-up costs vary, they aren't incalculable.
You will need systems, staff, facilities and the cooperation
of several other areas of your company. The most popular
stock lending systems around today all cost about the
same, depending on what you add or subtract from the
basic package on offer. You could try to write something
in-house, but you'd be sorry, I think. Staff must include
at least three people - two traders and a collateral
manager. One of the traders can be called the desk manager
so that you will have someone who can resolve disputes
between client and desk trader. The collateral manager
can help out with the trading when not managing the
collateral. In addition you will have to have back office
and IT support. You'll need access to legal help, to
negotiate agreements with borrowers who aren't content
with the standard documentation, and help from credit,
tax, and regulatory people. Obviously, facilities include
telephones and fax lines, PCs, Bloomberg Terminals,
etc.
How about the TIME frames? Somebody who knows what's
going on would be able to set up a straightforward stock
lending programme pretty fast, say in about two to four
months, depending on the size of the portfolio and other
internal factors.
"Depending on...hummmmmm." OK, let's deal
with the problem directly. Internal company politics
can sabotage any programme, and stock lending operations
are no exception, believe me! You should initiate a
stock lending programme with a strong MANAGEMENT COMMITMENT
at the highest level. Because stock lending requires
the cooperation of a wide range of talents within an
organisation, foot-dragging by anybody can be especially
problematic.
What about MORE INFORMATION? Stock lending as a profession
is well furnished with sources of information, although
as far as I know, there is no chat room yet! Each quarter,
there is a securities lending conference someplace in
the world, some more informative than others. But all
of them provide excellent occasions to meet like-minded
people and trade ideas. Professional organisations,
including ISLA (London), PASLA (Far East), ASLA (Australia)
and RMA (USA), are helpful. And finally, there are a
number of publications, including, ISF, The Financial
News, Global Custodian, Global Investor, and Euromoney,
among others.
For additional information or for help in making decisions
on stock lending matters, please contact me on any of
the following:
