Custodians’ Role

"Lessons learnt from the Maxwell saga"
By David Cowan
London "Financial Times" July 10, 1998

Custodians have drawn back fund managers by playing an intermediary role.

Custodians have played a pivotal role since the Maxwell saga in boosting securities lending volumes by offering programmes putting the custodian between the lender
and the borrower.

Securities lending is a low margin business and there is a risk/reward equation to consider, which combined with the Mirror Group pension fund's "creative" use of securities lending has made fund managers and trustees more cautious.

John Piccitto, director of group administration at Merrill Lynch says: "What's happened is that fund managers, rather than doing it themselves, tend to give a lot of their securities lending business to their custodians, leaving custodians to vet and arrange acceptance of borrowers. All this came out of the Maxwell affair."

When the role of securities lending in the Maxwell situation was publicised many fund managers withdrew their collateral from the business, but by playing an intermediary role based on existing relationships, custodians have successfully drawn them back along with new entrants.

Mr. Piccitto explains: "What this meant for custodians is that they could say to fund managers 'We'll do this for you, you can trust us, we've been working together for a long time.' What followed was that custodians saw they could control the process and persuade fund managers in because of the growth in the pool of available securities."

The Maxwell saga meant heightened attention was paid to the risks inherent in securities lending, namely default by the borrower and the use to which the collateral is put. These are now addressed by regular credit reviews of borrowers and tracking to ensure that all loans are fully collateralised. Fund managers have become more cautious in their lending programmes and are playing an active role in defining the dos and don'ts of lending.

This growing sophistication by both custodians and fund managers has demonstrated to potential new entrants the value of joining securities lending programmes. One such new entrant has been the Universities Superannuation Scheme (USS), which joined Chase Manhattan's discretionary global securities lending programme in May this year (1998). The USS fund has in excess of £17 billion covering a membership of 138,000 and is the principal superannuation scheme for academic and senior administrators in British universities and educational institutions.

Colin Hunter, chief accountant at USS, explains the rationale for using securities lending: "We shied away from securities lending a while back, but decided to revisit the idea.
USS is keen to ensure that revenue opportunities are exploited within the constraints
of risk mitigation, and we saw that while risk exists in securities lending there are considerable revenues."

The focus of the programme is risk mitigation, whereby all loans are precollateralised so that no stock is released to a borrower until the custodian receives collateral in excess of the value of the loaned stock. If the stock loaned increases to a value greater than the collateral held for the USS account then further collateral must be provided. The custodian indemnifies USS if insufficient collateral is held in the event of default. The custodian assesses the credit worthiness of all borrowers and only lends to those on its approved borrowers lists. The banks used to hold collateral by way of cash deposits and letters of credit must have an acceptable credit rating and approval by USS.

Mr. Hunter explains: "The main constraints we placed on our custodian were that they
only used non-UK collateral, because the income is not significant, and that we wanted
the programme to be transparent to the investment manager, so that if the investment manager wants to sell a security or vote then it's up to Chase to get it back. The investment manager shouldn't be constrained."

The industry standard for collateralisation of international deals is now a minimum of 105 per cent, compared with an average range of 100 per cent to 103 per cent a few years back. The steps taken by custodians to provide full service programmes combined with attractive standardised collateralisation minimum makes for an attractive business case. To further secure the business, The London Investment Bankers Association (LIBA) has been working with the International Securities Lending Association (ISLA) to consolidate the agreements covering securities lending transactions.

Mr. Piccitto says: "We are working for a standard agreement to enable broker-dealers, banks, institutions and fund managers to sign one contract with one counterparty, rather than having all these different agreements for different types of business. I think this will
be achieved sometime next year."

Robert Ash, vice president of State Street, says: "The trend we're now seeing is that
there is a more sophisticated view of the role of securities lending programmes, using
more sophisticated tools in mitigating and quantifying risks. This is a happier situation
than a few years ago when these issues were not addressed."

Mr. Ash adds: "The last four years in particular has seen a very strong growth in securities lending, both in terms of clients joining programmes and the scale of assets on loan in the market. The reasons for this have been a wider recognition of the role of securities lending programmes and the continuing growth in borrower demand, in terms of new markets coming on stream and new products such as derivatives."

To show off their new found maturity, securities lending providers are now offering benchmarks for customers to measure performance, with State Street and Securities Finance International (SFI) coming to the fore. The idea being that in order to manage risk you have to be able to measure it, but that may be easier said than done.

Jamie Ball, head of international securities lending at Mellon Trust, says: "Benchmarks can be very problematic. Owners of securities set different reinvestment guidelines, and it is difficult to make comparisons. Some may have a riskier profile while others may have a simple overnight low-risk profile. How do you compare across this range of profiles? It's a great idea in theory, but in practice it has yet to be standardised."