The following presentation was made in a slightly different form to the October, 2006 Marcus Evans Conference on Risk Management in Securities Financing.

Creating a network for Securities Financing

For more years than I care to remember, I worked for a large corporation, mostly in securities lending/equity finance, though I began as an auditor, and I was a stockbroker for a while, too.

However, since the 1st Quarter of 2001, I’ve been a consultant, providing marketing services for both US and European clients who want introductions to contacts within the international securities lending industry in order to do various kinds of business.

Against the background of my earlier experience within the self-contained citadel of a large corporation, my more recent experience in the broader industry has given me two separate “takes” on the issue of networking in the securities lending business.

Like most long-term corporate employees, I learned early how the network within the corporation works. But often in an activity like securities lending, which might be located in an operations context, it’s difficult to get out into the larger industry and see where and how all the pieces out there fit together.

However, I’ve now been outside a single corporation for a while, so I can see the larger picture, too. Networking in securities lending happens both inside a single company, and around the larger business itself. Sometimes things work in conflict, but sometimes there are synergies.

The point, I think, is to see how network members see their own risks and opportunities. I think that those two ideas are the key to good networking – you need to remember how the players see themselves, and work from that knowledge. Then you can move right along.

Just for the avoidance of doubt, I’m using the term networking here to mean finding out how the system you’re part of works, and then using that knowledge to make the system better and make yourself a more effective player in that system. It’s about meeting people, finding out what they do and finding out how you can work together for mutual benefit, working out how you can all be on the same side.

Marketing seems to me to be a pretty good perspective on the securities lending network. As a marketing consultant, I know the point of view of the service provider (they’re the people who hire me, after all) much more clearly now than I did before. I can see from their perspective where and how business relationships fall apart; how things don’t quite mesh, or else once they’ve meshed, how they begin to, and do, unravel. That failure usually provides an opening for a competitor – hopefully the one represented by me – and the competitor who can step in fast with a better solution can seize the day.

And now I really listen to things about service providers that I’d heard before, but which didn’t register in quite the way they do now.

Here are a few things I’ve heard recently from unhappy users:

“Now we’re finding out what they CAN’T do.”

“I hate those guys; I never see them! When I call them, I get their damned voice mails!”

“We’re leaving them, because they can’t deal with our data and they absolutely refuse to help us with the problem.”

“We had a deal with them, but it was so hard to implement that we finally chucked them out.” AND FINALLY “I just added it all up, and you know what those guys are CHARGING us?”

At a recent industry conference, I heard a really pathetic whine from a service provider:

“Well, we’re going to drop by next week and then maybe we can just sit down and talk about it.”

This begs not one but two Questions. “Where have they been all this time?” & “How did the situation ever get that bad?”

But remembering the point of view of the consumer of services, I know what’s happening.

You’re loaded with work, lumbered with huge profit targets, short-staffed and harassed because your IT system is being replaced while your head of IT is off on Paternity Leave! Projects are running two months behind schedule. And you’ve got a problem, niggling at first, and then it gets bigger.

But wait a minute, here comes somebody with a solution. And maybe somebody else, too, and before you know it, you have a whole series of time-consuming, but promising, presentations; and finally, you make a decision, choose a service provider and hope for the best.

And then it doesn’t come off. So you are not a happy camper, and maybe you’re in trouble by this time with your management for having made the wrong decision about service providers.

What good networking is about, it seems to me, is avoiding such nasty situations, both internally, and externally. It’s about understanding how the system works, what everybody needs in order to move forward, and finding LOTS of alternatives and options. And it’s about watching what’s coming down the road, too.

Players in the System

The securities finance business operates like any other system, with work flows, feedbacks & tensions, and all the rest of it. Everybody has their own interests at heart, and we’d be foolish to ignore that fact, just as we need to remember that it’s in everybody’s interest that the machine continues to work.

Let’s look at the major players in the system. I want to chat briefly about who wants what and who works with what risk. I also want to show where in the network motives become a bit different, and to make a point about possible future business in that area.

1) Relations between lender/beneficial owner and borrower are especially fraught because sometimes board members of beneficial owners are not investment professionals, and who sometimes don’t take the advice of their professional managers. In a way, the internet has made this worse.

It’s useful to remember the ideas and misimpressions beneficial owners may have picked up from the press or from surfing the internet, especially now that the pressure for good corporate governance is on board members as well as everybody else.

They may have the impression that short selling is vaguely dishonest, that it has something – no telling what – to do with naked short scams, and that back in ’06, the legislature in the US State of Utah stood alone in dealing with the problem until the US Fed stepped in and stopped them. No telling how paranoid these impressions can get.

It may also be the case that board members feel that speculation is an immoral act – Sharia law, for instance frowns on it – and in that case, I don’t know what you can do to reassure them, because I know from experience that the assertion that short-selling is just a way to make money in a falling market isn’t going to cut it.

One of my clients was almost at final contract, until one of the pension fund trustees decided that he needed to Google the terms “short-selling” and “securities lending”, and the whole project was stalled off for a couple of months until the Board Members were satisfied that their shares would be safe in the hands of a US broker/dealer that was rated AA.

Here is the risk in this situation; namely that the board member, especially the non-professional board member, has a legitimate concern. He or she must perform due diligence on all categories of clients. Because lenders are becoming more and more concerned with controlling the risks associated with lack of liquidity, poor credit, and counterparty default among other risks.

The lender wants 1) safe, maximum returns on capital: “We didn’t want to leave shares idle” said one lender recently. But 2) increasingly, the lender wants to be seen to be a good corporate citizen by voting early and voting often on anything and everything.

Beneficial owners will now tell you that they are very concerned about the long-term welfare of the businesses whose shares they hold, and that’s why they must vote.

The trouble is these motives can be contradictory. They aren’t necessarily, but they can be, because the more use the borrower has of the shares, the more money he can make for the lender (and for himself).

The guy at the other end of this arrow, the borrower, wants 1) to use the maximum number of shares as flexibly as possible, and 2) to pay as low fees as possible while using the shares. So the point for the networker is to reassure both sides, in terms of what they see as their risks. Beneficial owners fear safety (or lack of it) and low returns.

2) Now let’s look for a moment at the role of the custodian, who also loans shares, but on behalf of owners whose shares he holds in custody. While recent developments among custodians include lowering of rates, owing to fierce competition, and the development of added value services such as 3rd party agency lending, both beneficial owners whose shares are being held in custody, and borrowers who look to custodians for supply need to balance risk against cost. This can be a very tight complex equation owing to the complexity of the custodian’s activity.

Suffice it to say that, like everybody else, the custodian is in business for profits, looking for the greatest point spread and the lowest risk. So users need to examine the custodial program in terms of exactly what you need to have done, and what are the competitive costs, including lost opportunity costs.

What’s the risk of working with a custodian? It’s minimal, since most custodians will be rated AA or AAA. But trades still fail, so there may be an operational risk to consider.

3) Next, let’s take a look at borrowers - prime brokers and broker/dealers - and talk for a minute about things from their point of view. Then we’ll look at their customers, namely the hedge funds.

In a way, the broker/dealer is the workhorse of the system, but maybe I think that because I worked for one for so long! There are plenty of risks here, failed trades, daylight exposure, no signed documents, which is a legal risk…these are some of the biggies. But the main concerns are still balancing profits and risks, meeting demand and keeping everybody happy.

The prime broker is concerned to borrow low and lend high. Point spread is the basis of a prime broker’s profit. But a couple of other factors enter into the system here.

When you deal with prime brokers, it is useful to remember that the way they recommend themselves to THEIR clients – the hedge funds - is by the variety and depth of the securities they have to loan. It’s called “bragging rights.” A prime broker who has access to supplies of hot stocks – whatever those are at the moment – is going to attract business from hedge funds who will pay (nearly) anything to borrow them.

Everyone should, by now, know what the risks are for a prime broker. The prime broker must consider WHO actually runs its counterparty, what strategies they are using, and what sort of risk controls are in place? There should be some internal transparency with the Hedge Fund’s business model. This is “Know Your Customer” and it is very important.

But besides these, the prime broker has a supply issue. A prime broker won’t stay in business unless he has a well-deserved, frequently demonstrated capacity to produce lendable shares to support the trading strategies of his hedge fund clients. A reasonable, reputable, well-managed hedge fund will pay nearly anything for badly needed shares to support its trades. The risk to the prime broker of not having adequate supply is a major worry for them.

So NOTE THAT THE BALANCE of emphasis BETWEEN RISK and INTERESTS CHANGES at this point in the system, because there is such GREATER concern with volume and variety of stocks available to show to customers, and correspondingly less concern with point spread.

During the early, wretchedly miscalculated days of Eurodisney, the stock was shorted constantly, and supplies of lendable shares got tight as the shares got hotter and hotter.

Finally, one broker/dealer even tried calling Michael Eisner’s Office (Chairman of Disney at that time) in Los Angeles in order to borrow some Eurodisney shares from the source, probably figuring that if Eisner couldn’t make any money selling Mickey Mouse and Donald Duck to European customers, he could at least make some money lending his Disney stock.

But like a lot of misinformed beneficial owners, who think there is something vaguely immoral about lending stock, or else that shorting stock somehow drives the market for the stock down, the Disney Corporation representative refused. Basically he told the caller “Hey, I’m a mouse, not a rat!”

So that time, the prime broker didn’t get the stock, and the Hedge Fund had to look elsewhere to borrow the shares.

4) Now let’s have a quick look at Hedge funds. They care about point spread of course, but volume and variety of supply are paramount to support their various trading strategies.

One Additional Note: Future business. Look at where interests shift in our discussion above. Skipping the prime broker, leaving out the middle man, is tempting for the beneficial owner, because the hedge fund’s appetite for stock can be even greater than its caution on point spreads.

Right now, some lenders with appropriate risk parameters loan directly to hedge funds. However, these entities have different risk profiles to work from than some other beneficial owners.

I got a call from a reporter recently, asking among other things, whether or not I thought direct lending by beneficial owners to hedge funds was the future of the business. I told him that I think we may just see things move in this direction with two huge “IFs.

1) If hedge funds become more regulated than they are now – and the Amaranth debacle of 2006 is just one more step in that direction. And 2) if beneficial owners get more accustomed to securities lending as a business from which they can glean another source of income flow.

But then those regulated hedge funds won’t be hedge funds as we know them now, will they, and their legendary profits will be somewhat diminished from earlier levels. After all, they’re right to argue that if their investors and regulators know about their strategies, so does their competition!

Two Faces of the Network - Internal

Inside any corporation, the more people you can pick up the telephone and call, the better. I’ve used a broker/dealer model here, but I think the principles apply more widely than that.

A short and not very sweet example: I used to go off on joint marketing trips with the marketing Director of the fixed income group in my company. We both signed contracts with lenders, but sometimes only one of us signed, depending on what kind of business the client wanted to do. The fixed income desk featured a trader referred to (behind his back) as Captain Marvel, for reasons I leave to your imagination.

One day, I got a call from the Captain, who informed me that I had to transfer a million dollars (yes!) to the account of one of my clients, because the Captain had traded with one of his fixed-income clients, who was also one of my lender clients, relying on my OSLA document.

The problem was not the agreement between the two parties but the percentage of the coupon interest the Captain owed the Italian client on pay date. In the end, I phoned my marketing colleague, and said, “Hey, JD, I think you’ve got a problem” and saved my securities lending desk a million dollars, which it turned out we didn’t owe, in any case, but the Captain’s dealing book did!

In-house traders want to make the most money they can, because their employment and their bonuses depend on it. So you have to show them that you’re working in their short and long-term interest. And you have to be careful. For example, in-house traders often think they have a proprietary interest on the in-house box, and this is a matter to be resolved by a policy interface.

At some funds, in-house traders certainly do have first dibs, and I have been told that securities lending at one fund administrator would be stopped instantly if there were any conflict. But usually, at a broker/dealer with a prime broker and hedge fund clients, the matter is much different.

So if you talk to the in-house traders and find out what they’re trading and what their specific needs are in order to provide support, you have to remember that their needs may very well conflict with those of outside clients. The maintenance of Chinese Walls can be a very delicate matter!

I used to hear this question every day from my Convertible bond desk manager – “What’s Goldman borrowing this morning?” Early on in the development of the business, it nearly required armed guards on top of our Chinese wall before that particular convention became established!

Similarly, dealing with Credit and legal people – the credit analyst who gives credit approvals and trading limits can make or break an account relationship, so the credit person wants documentation, and continual updates, in order to maintain control. Information is their food and drink, and lack of it is their greatest nightmare.

Dealing with legal people is even more complicated as the current regulatory log-jamb piles up. I have found it useful recently to put the service provider’s lawyer in contact with the client’s lawyer and let them talk to each other in their own time and language, rather than to carry messages back and forth, which I once used to do on a constant basis.

If any single thing has changed in the last decade or so of the securities lending business, it’s the degree to which everybody in the business – including the lawyers - is wary of (and that’s putting it mildly) regulatory risk.

Two Faces of the Network - External

I tried to show earlier how networking in the larger business is affected by the perception of risk and opportunity on the part of each of the four players.

Beneficial owners – Hot stocks crop up at the strangest of places when you least expect them to. You may have a winner portfolio all of a sudden, so you need to think about that when you commit it to any relatively inflexible program, like an exclusive arrangement, for example.

Custodian Banks – The safest route; you increase risk when you move away from your custodian, and nobody knows that better than the custodian. Without the assistance of the custodian, transactions will fail. THIS IS A FACT OF LIFE. Just recall daylight exposure and what could happen if money or securities never reaches its destination.

Broker/dealers and prime brokers – You can never have too many contacts at broker/dealers and through them, with prime brokers. Broker/dealers and Prime Brokers know that customers on both ends (lenders and borrowers) shop around. Haggling can be a very useful talent in dealing with them.

Finally, these days, hedge funds are the drivers of the business. Without their exotic strategies lenders would only have fail coverage business to make a profit on. And believe me; you won’t generate as much income covering fails as you would lending stock to a hedge fund, I know from first hand experience.

Concerns for All Players:

Now let’s look at the issue of how to navigate around in this network. I want to start with some attitudinal and behavioural matters.

Of course, there are some extremes to which you are ill-advised to go, one of which is harassing informants and contacts to the point where they block your phone calls and emails! Another extreme was illustrated when a former colleague of mine tried to smooth the transition for the staff of a company that our company had bought by jokey put-downs that “Hey, Pal! Just remember: we’re Merrill and you’re not.” It didn’t work very well, especially when he tried to run the combined desk.

Another example is using the “good ole’ boy” approach, forgetting that many of the people you’re dealing with are not boys at all, and some of them are not particularly old, either.

Years ago a global equity finance managing director invited both male and female hookers to a major client event – he was being politically correct, I guess – but subsequent complaints from clients and their spouses who were present at the party produced a fairly unfortunate (for him) year-end performance appraisal.

There are some useful networking techniques:

1) Shut up and Listen - ears and attitude are your best assets. Let other people talk,
a lot

2) Answer all inquiries on demand: questions won’t go away, come up with at least some sort of response. That’s why God created email and telephones. Keep in touch until you give/get the specific information you want, and then keep the contact going as long as it’s producing. Knowing people – being able to pick up the phone and call them - is the most important networking tool you can have.

3) Everybody wants to know how much it’s going to cost, so when you can, try to give and get fairly specific price and cost estimates reports, on request, as you go along. You must have at least some ballpark idea.

4) Where appropriate and possible, maintain continuity of staff: as a service provider, try to keep the same people on the same accounts. “Face time” and personal contact count for an underestimated very great deal in securities lending.

5) Match presentation and actual delivery: the biggest single complaint I hear is that people who try to set up deals over-promise and “over-sell”. This causes protracted residual bad feelings of surprising intensity. And finally,

6) Direct access – The “press one now” approach is a real turn-off, no matter how efficient it may appear. Don’t play pass the parcel with clients. Client reps should not have to deal with more than, say, 30 clients, and marketing staff should be assigned specific clients who they communicate with regularly.

Creating Your Own Network

Listen to your present client base/contacts in the network carefully (Key points to listen for are: rueful humour, sarcasm and outright despair.) This may require fixing, finding out where a new/better connection is needed.

Get referrals. Where do you go to fix it, and where do you find the fixer? Seek out and meet these other people in the network: beneficial owners not yet involved in securities lending programs, prime brokers you don’t yet deal with, custodians who can offer you a better deal than your current custodian is offering you. You need LOTS of friends.

Attend conferences to find out what’s new and what’s threatening. The bars and coffee breaks are almost as useful as the meetings. Recently, a colleague of mine received a job offer at 3:00 am in the conference hotel bar. “I think I’ll wait till lunch today to ask him if he really meant it!” he said.

Know the current industry position on issues, short-selling (this affects dealings with beneficial owners especially), for instance, the current position (tricky!) on hedge funds (the move toward regulation increases attractiveness to beneficial owners).

Read industry publications for heads up and new possibilities – ISF, WSJ, FT, European press on-line, etc. It’s a close community and rumours travel fast, so a little research helps you to be able to ask useful questions.

Look into joining professional associations, industry bodies and stay in touch with government agencies; FSA, EU committees, etc., via the internet at the least.

The securities lending business has grown exponentially in the time I’ve been associated with it, perhaps not only through my efforts! Actually, it’s the hedge funds, and in the last 15 years, that have moved what was once a back office operation, first into a profit centre, and then into the securities finance group, which for most people involved, is a real money-spinner.

It offers to beneficial owners, including hard pressed pension funds, increased income at low risk. It provides market liquidity that supports trading strategies all around the globe.

Here are some pretty interesting numbers for you to think about. The current volume of securities on loan worldwide is approximately $7 Trillion, with 37% of that amount, or $2.6 Trillion, being transacted outside the US.

Networking in this industry is the same as anyplace else; but it works best if you know who the players are and what they’ve got on their minds.

I hope that today I’ve helped you see the business from several points of view, and that the experience will help your future networking efforts.