Gsl 006

GSL

Global Securities Lending

Markets

Germany, Mexico Industry InsIght

Traders, RMA, Pirum ProfIle

KAS BANK gsl Issue 06 Q4 2009

Share & Share Alike Is equity collateral a viable option?

Plus:

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etfs - collateral innovation hedge funds - rising amid changes gsl on the road - amsterdam summit 2009

gBP 50 usd 85 eur 60

29/10/2009 10:46

eSecLending Delivers

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eSecLending delivers to institutional investors • • • •

High-touch client service Comprehensive risk management Customized programs Optimal risk-adjusted returns

As a leading securities lending agent, we take a consultative, highly customized approach when it comes to structuring lending programs for our clients. Unlike traditional models, where many lenders’ portfolios are grouped together and their securities wait to be borrowed on a best efforts basis, we utilize a competitive auction to determine the optimal route to market for their assets. Based upon results from the auction, we manage clients’ portfolios either through agency exclusive lending for specific portfolio segments or on a traditional agency basis, where securities are lent individually. We focus on maximizing intrinsic returns in accordance with each client’s specific risk tolerances. Having built the program to incorporate investment practices such as the use of specialists, multiple-managers, unbundling, price transparency and competition, our approach ensures best execution and also provides clients with greater control over their programs, allowing them to more effectively monitor and mitigate risks and counterparty relationships.

United States +1.617.204.4500 Europe +44 (0) 207.469.6000 [email protected] www.eseclending.com

BENEFICIAL OWNERS SURVEY 2009

Overall Winner

Securities Lending Manager of the Year Global Custodian Securities Lending Survey Awarded Top Rated & Best in Class 2009 in $10B+ I 2008 in North America

European Securities Lender of the Year eSecLending provides services only to institutional investors and other persons who have professional investment experience. Neither the services offered by eSecLending nor this advertisement are directed at persons not possessing such experience. Securities Finance Trust Company, an eSecLending company, and/or eSecLending (Europe Ltd.), authorised and regulated by the Financial Services Authority, performs all regulated business activities. Past performance is no guarantee of future results. Our services may not be suitable for all lenders. eSecLending (Asia Pacific) - Registered office of Securities Finance Trust Company (incorporated in Maryland, U.S.A.), the liability of the members is limited.

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QUICK QUARTERLY VIEW

German market analysis

GSL News

Robbert Wijgerse, Robeco Auctions 26 Exchange traded funds

Patrick Avitabile Citi

Hedge funds

Lend an ear Improved conditions in global finance have brought more lenders back, but with a caveat in line with the findings of RBC Dexia Investor Services: there will be programme changes ahead. It seems a fair trade off, and with so much discussion cross-continents about the education and engagement of beneficial owners, their return should be unanimously welcomed. Agent lenders with non-cash collateral programmes can understandably feel satisfied. Cash had in some quarters become a by-word for risk, illiquidity and loss through its reinvestment. A non-cash philosophy has helped companies – particularly the big European players – to convey their strong risk management in this space to new clients. But let’s not swing from one extreme to another. Cash is still good in itself, still dominant in the world’s biggest securities lending market, and reinvested in the right conditions can

produce the kind of returns that can make the difference between portfolios when the relative performances are racked up. Our panel on reinvestment weighs up these considerations, and our Q+A on European securities lending also gives insight into how far the industry has developed. On the subject of Europe, GSL also made its first excursion to mainland Europe with its one-day event in Amsterdam on 8th October. It was a successful and informative start to the magazine's international tours - with such a sophisticated market for pension funds and stock lending it seemed like a good place to start. The last quarter has vigorously reinforced a simmering trend from this year. Prime brokerage market share seems entirely up for grabs. Since 2008, which brought the removal of one of America’s biggest brokers – the milestone collapse of Lehman Brothers – and the effective extinction of Merrill Lynch and Bear Stearns as independent

Geert-Jan Kremer KAS BANK

entities, competition has intensified further. How the innovations in prime brokerage will affect the remaining 'ruling class' of providers is yet to be seen, as will the range of services that brokers will cease to do for free. At the same time the successful hedge funds will perhaps be more discerning with the services provided by their prime broker, or brokers. Many of you might have read about the SEC's two-day summit on short selling, which featured many representatives of the industry in securities lending, which showed its sustained importance as an issue. Mary Schapiro, SEC chairman, explained that the regulator was open for what seems a rather ominous new debate concerning short selling and any future restrictions. Now is the ideal time for regulators to continue the recent positive views they have expressed for securites lending, and the distinction between it and short selling. Z

2 | Global Securities Lending Magazine | 2009

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Predictability in an unpredictable world.

Depend on us for market insight, flexibility and unwavering commitment to service.

Expertise in securities lending. You face unpredictable markets and must respond to the evolving strategies of your clients and competitors. CIBC Mellon offers you flexibility through innovative thinking, market knowledge and open dialogue. You can depend on us for solid execution, professionalism, and a stable growing supply of lendable assets. For more information on Securities Lending, please contact: James Slater Senior vice president & head of capital markets +1 416 643 5130 Robert Chiuch Executive director, global securities lending +1 416 643 5400 cibcmellon.com ©2009. A BNY Mellon and CIBC joint venture company. CIBC Mellon is a licensed user of the CIBC trade-mark and certain BNY Mellon trade-marks.

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CONTENTS

Contents News Editor-in-chief Roy Zimmerhansl [email protected]

6 | News Top industry stories. 8 | News analysis Research and results that have held a mirror up to the lending and borrowing world.

Features editor Ben Roberts [email protected] Reporters Craig McGlashan [email protected] Kimberley Ferguson [email protected] Contributing editor Anthony Harrington

People

Account managers Patricia De La Grange [email protected]

12 | Executive profile GSL talks to Geert-Jan Kremer of KAS BANK.

Cicely Lewis [email protected] Front Cover Morgan Miller Digital media producer Peter Ainsworth [email protected] Operations manager Nicolette Whittaker [email protected] Managing director: Jon Hewson [email protected] CEO: Mark Latham [email protected]

GSL

10 | Across the Atlantic Quarterly updates from trade associations, including new ISLA CEO Kevin McNulty.

Global Securities Lending

Collateral

14 | Shares for shares The use of equities as collateral for stock loans has divided opinion in the industry. Anthony Harrington weighs the views.

26 | Panel: Reinvestment Risk, mark-to-market and liquidation are just three of the issues considered by our panel regarding cash reinvestment. 32 | From the Trading Floor RBC Dexia and Robeco provide analysis from the desks. Conferences

34 | GSL Lending For Liquidity Summit GSL hosted an event in Amsterdam, a key country in Europe for pension funds and stock lending. 36 | London event GSL dropped in on a London conference to pick up the key points 40 | Panel: European securities lending Four participants answer GSL's questions.

16 | Market Profile: Germany Europe's biggest economy has struggled with liquidity issues in its securities lending

44 | ETFs The use of exchange traded funds as collateral has been increasing in the market, finds Craig McGlashan.

18 | Market Profile: Mexico A profile of the country.

46 | Directory The service provider listing.

Companies featured in GSL 4Sight Financial Software 34,44 Aviva Investors

38, 48

Barclays Capital

7, 38

BBH

6,40

BBVA Bancomer Mexico Bear Stearns

2i USA, 410 Park Avenue, 15th Floor, New York, NY 10022 T: +1 212 231 8421 F: +1 212 231 8121 © 2009 2i Media All rights reserved. No part of this publication may be reproduced, in whole or in part, without prior written permission from the publishers. ISSN 1759-0728 Printed in the UK

21 | Hedge funds: Rising amid changes The sector's resurgence comes amid huge changes in its brokerage relationships, finds Ben Roberts. Industry Insight

24 | Operational comment - Pirum Rupert Perry outlines the benefits of real-time processing.

48 | Lender Profile Sarah Nicholson of Aviva Investors talks to GSL.

8

BGI

38, 44, 45

Cantor Fitzgerald

7

Callan Associates

26

CIBC Mellon Citi

6 19, 21, 28, 38

Credit Suisse

36

Data Explorers 17,18,19,20,34 Deutsche Bank

44

ED-HEC Risk

34

Equilend

6

eSecLending

35

Fortis Nederlands

36

ING

35

ISLA

4, 37, 41

JP Morgan

7, 35, 37

KAS BANK

12

Laven Partners

36

Lehman Brothers 9, 27, 33, 40 Noster Capital

22

Omgeo

6

Options IT

6

peterevans Pirum

7 24

Prudential Capital RBC Dexia

38 26, 44

Rabobank

34

Robeco

33, 36, 38

RMA

10

Rule Financial

37

Sophis

7

SPF Beheer 2i UK, 16-17 Little Portland Street, London W1W 8BP, UK T: +44 (0) 20 7299 7700 F: +44 (0) 20 7636 6044

20

SunGard

34, 36

5, 12, 13, 15, 34, 35

TABB Group

7, 8, 21, 22

“Liquidity risk would best be mitigated if appropriate short-term investments are given proper considerations regardless of market environment" Who said this? Find out, page 28

4 | Global Securities Lending Magazine | 2009

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!"#$%&%

The financial information you need when you need it. Because there’s no pause button in business.

Considering the current economic environment, staying on top of your securities lending program and managing risk has never been more important. So Northern Trust has launched a specialized securities lending technology and reporting platform designed to provide you with transparent, targeted and timely information. Just one of the reasons we’ve been named the top Connectivity and Automation provider.* For more information, visit northerntrust.com/securitieslending or call Chris Doell at +1 312 444 7177 or Sunil Daswani at +44 (0)20 7982 3850. *International Securities Finance borrower survey 2009

Asset Servicing | Asset Management | Wealth Management © 2009 Northern Trust Corporation, 50 South La Salle Street, Chicago, Illinois 60603 U.S.A. Incorporated with limited liability in the United States. Northern Trust operates in Canada as The Northern Trust Canada, Branch which is an authorized foreign bank branch under the Bank Act (Canada) and as The Northern Trust Company, Canada which is an authorized trust company under the Trust & Loans Companies Act (Canada). Deposits with Northern Trust and its affiliates are not insured by the Canada Deposit Insurance Corporation. Northern Trust, London Branch (reg. no. BR001960) registered in England & Wales each with their registered office at 50 Bank Street, Canary Wharf, London, E14 5NT. Where Northern Trust’s UK entities undertake regulated business, they are authorised and regulated in the United Kingdom by the Financial Services Authority. Northern Trust (Guernsey) Limited, Northern Trust Fiduciary Services (Guernsey) Limited, Northern Trust Fiduciary Company (Guernsey) Limited and Northern Trust International Fund Administration Services (Guernsey) Limited are licensed by the Guernsey Financial Services Commission. Northern Trust International Fund Administrators (Jersey) Limited and Northern Trust Fiduciary Services (Jersey) Limited are regulated by the Jersey Financial Services Commission. Northern Trust International Fund Administration Services (Ireland) Limited and Northern Trust Fiduciary Services (Ireland) Limited are each authorised by the Irish Financial Services Regulatory Authority pursuant to section 10 of the Investment Intermediaries Act, 1995 (as amended). Northern Trust Global Services is authorised and regulated in the Netherlands by De Nederlandsche Bank. Northern Trust Global Services Limited Luxembourg Branch and Northern Trust Luxembourg Management Company S.A. are authorised and regulated in Luxembourg by the Commission de Surveillance du Secteur Financier. Northern Trust Global Services Ltd (UK) Sweden Filial is a BCD Passported branch of Northern Trust Global Services Ltd a firm authorised and regulated in the UK by the Financial Services Authority (‘FSA’).

GSL06 1-17 final.indd 5 !"#$%&%'()*+()*,-./01234!55666,

26/10/2009 11:59 ,%7,17%&666-8926$:

NEWS

News Round-up cover the securities lending market, in an effort to boost transparency and provide a benchmark for the sector. The S&P Securities Lending Index Series has been designed to measure the average cost of borrowing US equities, reflecting the average lending rate for the members of the S&P 500, S&P MidCap 400 and the S&P SmallCap 600.

Securities Lending

CIBC Mellon Global Securities Services implemented EquiLend's AutoBorrow and Trade20 software, in its aim to boost efficiency and client returns in its securities lending. The deal followed EquiLend’s earlier success when it gained regulatory approval in the country as an alternative trading system (ATS). Securities lending participants are holding firm or adjusting their risk parameters rather than suspending their programmes, according to the latest survey of beneficial owners and market intermediaries. Despite purported large-scale programme suspensions amid market volatility, only 17% of 86 respondents to the survey by RBC Dexia stopped lending. The majority, 60%, made no changes to their programmes at all. Standard & Poor’s (S&P) launched an index series to

The US financial regulator, the Securities and Exchange Commission (SEC) hosted a roundtable discussion focused on the opacity of securities lending as well as the practice of short selling. SEC chair Mary Schapiro said that the financial crisis has changed attitudes towards securities lending and short selling "has undoubtedly produced more letters from investors and brokerage firms, more enquiries from congress and more questions from reporters than any other topic."

People Moves Keith Haberlin moved across the pond from Brown Brothers Harriman’s Boston office to run the Europe and Middle East securities lending division from London. Mr Haberlin, who joined the company in 2004, has been part of the securities lending team since March 2008. Lombard Risk announced a series of new appointments to bolster its global collateral management team. Solution technologist Narasimha Kodihalli has joined the firm’s

Top industry stories at deadline. For daily updates go to www.gsl.tv

operations in the Americas, while collateral management expert Joanne Meaney joined in the UK. John Shield has rejoined Lombard to take on a leading role in ongoing senior level account management of the firm’s collateral and regulatory clients. Keith Butcher and Joanne McGarry have also joined the company as finance director and group financial controller respectively. Cantor Fitzgerald hired Bob Sherry and David Kim as COO for prime services and director of prime services technology, respectively. Sherry has worked in the financial sphere for more than a quarter of a century, filling roles at ING, ABN Amro and Furman Selz among others. Kim joins Cantor Fitzgerald from Citigroup, where he was senior vice president of prime finance technology, in charge of management and oversight of Citi’s hedge fund technology services. Before Citi, Kim worked at Lehman Brothers, where he was involved with a number of products, including the now-defunct firm’s client web portal, LehmanLive. Sandra A Urie of Cambridge Associates is set to take a place on the board of 100 Women in Hedge Funds, the non-profit organisation for investment management professionals. Urie has worked at Cambridge Associates since 1985 and is currently president and CEO of the firm, which provides investment research

and advice for investors and private clients.

Market Infrastructure Twenty-six leading financial institutions have been approved as members of Quadriserv’s AQS securities lending platform. New members include Bank of America-Merrill Lynch, Citigroup Global Markets, Mitsubishi UFJ Securities, Calyon Securities (USA), Interactive Brokers LLC, ITG, Jefferies & Company, Newedge USA, LLC, Pershing LLC, Susquehanna Financial Group, LLP, Virtu Financial BD, LLC and Wedbush Securities. Important initiatives and market exercises surrounding liquidity and bank stability from the UK's Financial Services Authority are in the pipeline for the final quarter of this year. In the midst of a wider global reform, that was discussed by the G20 finance ministers in London last month, the FSA will implement its Liquidity Reporting Regime and a market-wide analysis of Resilience Benchmarking. More shares issuances by banks are expected if plans among the G20 finance ministers to enforce higher capital reserves come into effect. Discussions in London led to an overall consensus that tougher regulatory sanctions on bank capital reserves, funded by a sale of new shares, needed to be enforced.

6 | Global Securities Lending Magazine | 2009

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NEWS

The International Organisation of Securities Commissions (IOSCO) published a series of regulatory standards for the funds of hedge funds market. According to IOSCO, the regulations are aimed at protecting the increasing number of retail investors who partake in hedge funds through funds of funds. The paper follows a document released in June 2008 which identified two main areas of concern; namely how managers of the funds deal with liquidity risk and the structure of the due diligence process used by managers.

Technology Omgeo, the post-trade automation specialists, hired three new associates for its collateral management product Omgeo ProtoColl. Steve Anglin joined from JP Morgan Chase to provide pre-sales market analysis. Greg Ballesty joins from Thomson Reuters and is to expand the offering in the Asia Pacific region. Antony Cure joins from Credit Suisse and will fulfil a sales support role for the EMEA region. Options IT, a provider of IT infrastructure to hedge funds and prime brokers, bought the hosted colocation business of BNP Paribas’ prime brokerage division. As a result of the deal, some of BNP Paribas’ hedge fund clients will use IT infrastructure provided by Options IT’s Core solution, although all of these customers will continue to receive prime brokerage services from BNP Paribas and will stay on the BNP Paribas platform. Sophis and JP Morgan’s prime

brokerage arm unveiled a product which aims to help hedge funds manage their portfolios and risk across a range of prime brokers. iSophis allows funds to see a consolidated view of their positions, providing reports, performance attribution and risk exposure, all from any standard internet connection. Funds will also be able to use the software for stress testing if they decide to boost trading volumes or expand their portfolios to include other asset classes. peterevans, the financial technology provider, launched a new product for managing and calculating daily margins. xanite Margin Engine (xanite ME) aims to provide greater transparency for the trading risk profile of non-clearing members and reduced margin risk exposure. A leading global investment bank – still unnamed by the firm – is already a customer. SunGard launched ‘SunGardas-a-Service’, its fully managed ‘private cloud’ service in the UK.

Borrowers TABB Group, the New York research firm, estimated that prime brokerage would hit a USD10 billion profit next year, with hedge funds achieving an estimated USD1.5 trillion in assets under management. The company's latest research comprised of interviews with 62 US-based hedge funds, concluded from current performance that next year would see a return to profits similar to levels in 2007.

The research concluded that changes in the relationship between hedge funds and their prime brokers would continue as funds explore more options, including the development of using multiple prime brokers and non-prime broker affiliated custodian banks. The UK and US financial regulators announced plans to work together on joint regulatory requirements for hedge fund reporting. In particular, the Financial Services Authority (FSA) and Securities and Exchange Commission (SEC) hope to agree a “common, coherent set of data” to collect from hedge funds, in order to help the watchdogs identify potential risks to their own particular goals. FSA chief executive Hector Sants and SEC chair Mary Schapiro revealed the decision, following the fourth meeting of the SEC-FSA Strategic Dialogue. JP Morgan created a PrimeCustody Solutions Group, to focus on delivering the company’s integrated custody and prime brokerage platform. The team will work with asset managers and hedge funds which are looking for a combined prime brokerage and securities services offering. JP Morgan opted for the move because of current prevailing trends, under which hedge funds are opting for long-only funds and are seeking custodians for their assets, while traditional asset managers are looking for prime brokers to finance long/short strategies. Ashley Wilson from Barclays

Capital predicted that the traditional “duopoly” of prime brokers is to be broken, with five or six major players to populate the landscape in the future. He was speaking at a London conference on securities lending last month. Wilson was a recent recruit from Bank of America Merrill Lynch to serve as head of prime brokerage services for Europe, Middle East and Africa. He now oversees the investment banking divisions Prime Services franchise, which includes equities and fixed income financing, futures and its cross-asset prime brokerage platform. At BofA Merrill Lynch he served as a managing director. New York University's Stern School of Business found that a fifth of hedge funds misrepresented elements of their funds during investor due diligence. The amount of money they had entrusted to their funds, their performance and their regulatory and legal histories, were three key areas in which inaccurate accounts were given.

Repo Transaction volumes in the European repo market have increased since the start of the year in a sign the sector is stabilising. The latest survey from the International Capital Markets Association (ICMA) shows that outstanding repo trades increased from EUR4,633 million to EUR4,868 million from December 2008 to the end of June, a rise of 5.1%. Turn to page 9 for an analysis of the ICMA report.Z

2009 | Global Securities Lending Magazine | 7

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NEWS ANALYSIS

News Analysis As markets 'come back' and GSL makes its Summit debut in continental Europe, there have been many notable reports and studies that provide useful insight into today's securities lending industry. Ch-ch-ch-Changes RBC Dexia’s recent survey on securities lending participants shows that beneficial owners and market intermediateries are more likely to adjust risk parameters than suspend their programmes amid the current market volatility. Whilst 60% made no changes at all to their programmes, only 17% of the 86 respondents to the survey actually stopped lending. An overwhelming theme of the outcome of the survey was the increase of focus on risk mitigation and capital preservation, with 80% of respondents rating these areas as ‘highly important’. Blair McPherson, head of technical sales, global market products and services at RBC Dexia, told GSL: “Where as it used to be returns, risk is now the number one priority. It’s not that people didn’t consider risk (prior to the financial crisis), it’s just that the understanding from an education stand point wasn’t as prevalent as it is now.” For those whom had undergone alteration to their programmes, the most common adjustment was in relation to borrowing counterparties, cited by 38%, closely followed by 35% who had made adjustments to the type of collateral accepted. “For example, we are seeing a lot less cash being accepted as collateral. Whist it has traditionally been widely used, due to its ease of management, when it comes to reinvestment, it can be quite risky,” Mr McPherson said. The main drivers precipitating alterations included: less confidence in counterparty stability (65%), lower risk tolerance (59%), desire for greater levels of indemnification and provider strength/stability (44%), short selling

restrictions (32%), and fear of cash reinvestment losses (9%). “Whilst these results show that in the short term, market practitioners are reviewing their structures and their routes to market, in the long term, I think the focus on risk will remain. The great thing about securities lending is that it is always changing. As emerging markets become mature markets, and as globalisation continues, it will continue to grow.” RBC Dexia’s survey also sought to explore the perceived link between short selling and the movement of share prices. 92% said it had some influence, but it was not regarded as a deterrent to securities lending.Z

Lending by numbers Source: RBC Dexia Investor Services

Key figures:

60% made no

programme changes

17% stopped lending 38% of those who

made changes altered their list of borrowers

10% ranked

securities lending as 'highly important'.

Prime time to reassess Prime brokerage revenue will hit USD10 billion in 2010, with their hedge fund clients expected to return to form with an estimated USD1.5 trillion in assets under management, according to New York based research firm TABB Group. Following extensive interviews with 62 US-based hedge funds, next year would see a return to profits similar to levels in 2007. Until then, the research concluded that the relationship between hedge funds and their prime brokers would continue current changes, including the development of using multiple prime brokers and non-prime broker affiliated custodian banks. The report highlighted September 2008 as a turning point for hedge funds. The collapse of Lehman Brothers, just a few months after the rescue of Bear Stearns – two companies that claimed around 30% of the brokerage market – was the catalyst for many funds to reassess the counterparty risk inherent in their relationships. "Typically we were talking to the head trade, CIO, portfolio manager, so the funds range from those who were less than USD500 million, which we consider small, from USD500 million to USD3 billion," Matt Simon, a TABB analyst, told GSL. "We found a few major things this year which fall into the whole landscape and industry change in prime brokerage in the US particularly, post Lehman [Brothers] and Bear [Stearns] and the bankruptcy of Merrill [it] had all been changed due to counterparty risk and counterparty diversification. In particular, 66% of the singleprimed hedge funds interviewed were

8 | Global Securities Lending Magazine | 2009

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NEWS ANALYSIS Source: TABB Group

considering a move to a multi-prime strategy, allowing fast movement of assets between service providers. The sector remains at a crossroads, the report concludes. Nearly 80% of hedge funds have the same or fewer assets under management (AuM), leverage remains low, and scrutiny from investors and legislators has intensified. This has had a knock on effect on prime brokerage. But while AuM is still down from all-time highs, significant net inflows and performance-related asset increases are expected. The prime brokerage landscape

Repo returns The September survey from the International Capital Markets Association (ICMA)reported good news for the repo market as a chief sign that the sector is stabilising. Outstanding repo trades increased from EUR4,633 million to EUR4,868 million from December 2008 to the end of June, a rise of 5.1%. Although this figure is down 20% against the June 2008 figure, the results of the influential survey show that the wider money lending freeze and deleveraging activity – quickened by the default of Lehman Brothers almost a year ago – is starting to lessen. Government bond collateral fell from 83.6% to 81.2%, close to the record 81% rate reached in June. The share of government bonds in a tri-party setup increased, however, to 53%, with the triparty market generally increasing to 11.1% of the market, up from 9.4%. The increase of corporate bond locates has been visible as government bond use declines. A trader at RBC Dexia said: "Corporate bond locates have definitely increased. We've noticed in the last few months it has picked

GSL06 1-17 final.indd 9

Key figures:

may appear very different by the time it hits the USD10 billion mark. Adam Sussman, TABB Group head of research, posited that if new asset increases come from new fund launches it could lead to opportunities for small prime brokers. “If a new crop of hedge fund managers is going to be responsible for a renewal of industry assets, it could very well be the smaller prime brokers that gain in market share,” he said. “Then, the challenge will be to hold onto those relationships as today’s Davids become tomorrow’s Goliaths.” Z

66% of funds

considered multi-prime

45% added at least

one extra prime broker

USD127 billion -

AuM of hedge funds interviewed

up quite a lot. At the same time you see the two desks merging together." Responses from the survey were the fees coming down for European collected from 61 offices of 54 financial G10 debt." institutions, mostly banks, including Godfried De Vidts, chairman of a number of tri-party agents and the ICMA’s European Repo Council automatic repo trading systems and credited the “inherent stability” of the London-based Wholesale Market the European repo market despite Brokers’ Association. The survey asked fragmented settlement infrastructure, comparing favourably with the uneven for the value of the cash and reverse repo contracts outstanding as at 10th infrastructure in the US market. He June 2009. added that as the European Central Undocumented buy/sell backs Bank gradually reduces its involvement decreased in volume, indicating in repo to recapitalise markets, there would be an increase in wholesale repo. the greater importance of legal ICMA EUROPEAN MARKET SURVEY JUNE documentation in the wake2009 of the I 11 The amount of securities lending on REPO Lehman Brothers default, increased repo desks also increased, up to 19.1% from a record low of 12.5%. The trader concern around counterparty risk added that this was part of an increased and the implementation of the Counterparty analysis Global Master Repurchase Agreement merging of equity and fixed(Q1.1) income desks. "There has been a lot of uptick in (GMRA). Table 2.2 – Counterparty analysis June 2009 users

Dcember 2008

share

users

share

June 2008 users

share

direct

61

52.1%

61

51.6%

61

51.7%

of which tri-party

31

11.1%

31

9.4%

30

10.1%

voice-brokers

50

19.3%

48

20.2%

46

23.1%

ATS

46

28.5%

48

28.2%

47

25.2%

sharp recovery seen in the to execute December was consolidated. The The graph shows how the methods repo2008 trades have changed share of electronic repo trading in

Triparty activity recovered. little in 12 months. The proportion of automated trading systems

remained at the level of the increase at the end of last year. other

Table 2.3 – Numbers of participants reporting particular types of business

statistics in the survey found that direct bi-lateral trading stood at Dec-06

Jun-07

Dec-07

Jun-08

Dec-08

Jun-09

51

56

48

47

48

46

35

33

Source: ICMA 38 33

41.1%; domestic trading rose to 34% from 32% and anonymous trading ATS

gained fromATS 12.7%33 to 14.5%.39 anonymous voice-brokers

54

54

51

46

48

50

tri-party repos

37

45

36

30

31

31

total

73

2009 77

The principal automatic trading systems (ATS) operating in

| Global 68 Securities 61 Lending 61 Magazine 61 | 9 Figure 2.1 – Counterparty analysis

26/10/2009 11:59

NEWS ANALYSIS

Model citizens Research by Bank of New York Mellon and Casey Quirk found a rise in revenues generated from the intrinsic value of loans, rather than from cash reinvestment. Revenue from intrinsic loan value usually means a rise in cost for the borrowers, particularly when the beneficial owners' portfolio contain numerous 'hard-to-borrow' securities. These extra costs may combine, the report notes, with additonal outlays based on a change of a prime brokerage model and balance sheet constraints "that make pre-borrowing for anticipated loans more difficult". The report also highlights the increase in hard-to-borrow rates paid by hedge funds since last year. At March 2009, 26 stocks on the S&P 500 were borrowed at hard-to-borrow rates, compared with five stocks a year before. This produced the usual effect of making S&P 500 stocks almost as expensive as the small-cap S&P 600. A closer relationship between agents and beneficial owners could also cause a rise in quality, rather than quantity. "Brokers can no longer commit large portions of their balance sheet to general collateral borrowing and must instead focus on the immediate needs of the underlying client. This dynamic means less lending overall but also a heightened focus on the value of specific securities in the market on any given day." The study considered lending in the context of MiFID. 'Intrinsic value' is in some ways a combination of market norms and values, rather than a strict definition, and "in many ways is similar to seeking best execution in an equity trading market but without consolidated rates or prices flashing on a screen". As MiFID demands traders take into account the client's best interest regarding price, cost, and the likelihood of trading settlement, "this may well point to the future of securities lending". Z

Across the Atlantic Trade association news and comment from either side of the pond.

RMA: Michael McAuley

In my previous columns, I have focused on the financial crisis and the ensuing changes to the securities lending industry. Now, however, as we continue to see positive signs that the industry is moving toward recovery, I would like to turn to the topic of regulation. Regulation is one of the major risks facing our industry. There are several proposals coming from the regulators designed to address specific issues and reform in the financial markets. Many of these regulations could have a significant impact on the future of the securities lending business. We strongly support the regulators in their efforts to eliminate naked short selling and reduce systemic risk. Naked short selling has been a thorn in the side of our industry for years, as it has been incorrectly associated with securities lending. However, it is our hope that regulation focuses on those areas that need improvement and does not attempt to reengineer the aspects of the securities lending business that worked extremely well and efficiently both before, during and after the financial crisis. One of the most significant proposals is the US Treasury Department’s policy statement, “Principles for Reforming the US and

International Capital Framework for Banking Firms,” or “the Principles.” In the statement, the Treasury “sets forth the core principles that should shape a new international capital accord to better protect the safety and soundness of individual banking firms and the stability of the global financial system and economy,” according to its website. There are eight core principles focusing on capital sufficiency. Treasury considers these core principles “essential to enhance the resiliency of the global financial system". Core principal 4 focuses on capital charges for securities finance transactions. The implication is that more capital will need to be allocated to securities lending transactions and current methodologies in the Basel II framework will be revised. The increased capital requirements and the expense of revising internal risk models could lead to more industry concentration and a change in pricing models. Recently, the Securities and Exchange Commission (SEC), in finalising amendments to Regulation SHO, took another step toward its goal of reducing fails to deliver and permanently adopted Rule 204T. According to the SEC, the amendments are intended to help address abusive “naked” short selling in all equity securities. The SEC is also proposing approaches to restrictions on short selling: a price test that would apply on a market wide and permanent basis (“short sale price test” or “short sale price test restriction”) and one

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INDUSTRY BODY COMMENT

that would apply only to a particular security during severe market declines in that security (“circuit breaker”). At our annual Conference on Securities Lending on October 12-16 in Miami, Florida, RMA will most likely discuss the Treasury and SEC proposals. There is also a proposal from a group of US senators that the SEC and The Depository Trust & Clearing Corporation develop a central database of stock loan information and require identification of actual shares to be borrowed to cover a short sale — a “hard locate” requirement that will be discussed. I believe there may be even more developments by the time of the conference.

“Many clients that have either stopped or restricted their lending programs are lending again, but they are doing so with more specific lending and cash collateral reinvestment guidelines" Michael McAuley, RMA RMA is hopeful that regulatory agencies will work together so that the changes made by one regulator do not shift liability from one set of regulated entities to another. As an industry, we understand the need to reduce systemic risk in the market, but we want to maintain a vibrant securities lending industry that can continue to provide liquidity to the marketplace. Z Mike McAuley is writing as the Chairman of the Risk Management Association's securities lending committee. He is also senior managing director and chief product officer in State Street Corporation’s securities finance division.Z

"I am hugely excited to see the tremendous amount of engagement with firms, who seem really enthusiastic with what ISLA is doing"

ISLA: Kevin McNulty As with any new role, the first couple of months have been incredibly busy as I try to get on top of everything that’s going on. So far, I am hugely excited to see the tremendous amount of engagement with our member firms, who seem really enthusiastic with what ISLA is doing. And in securities lending, there is a lot going on. We have recently published the Global Master Securities Lending Agreement 2009, which is designed to replace the previous version, produced in 2000. Although the agreement was due to be updated, we have ensured that the new version incorporates some important changes that derive directly from lessons learned by our members over the past 18 months. We have included what we think is an improved default valuation methodology for loans and collateral which is designed to better protect the non-defaulting party. We have also been busy on the regulatory front and have been involved in several consultation exercises including the CESR short selling disclosure paper issued in the summer.

The GMSLA 2009 is up and accessible on our website, and we are currently producing a set of guidance notes for users. This and an ongoing workload supporting our member firms, dealing with a host of other initiatives related to tax, operations and things like agent lender disclosure have been keeping me busy. My assumption is that ISLA will carry on functioning similarly to the way it has in the past, but something we are taking a closer look at is the association’s role regarding education. We want more people understanding what securities lending is all about- from beneficial owners, to the regulators, to the media. Whilst its early days, and this is still very much at a conceptual stage in terms of how we go about this, I think it is a very important thing for a trade association to foster such education and awareness. I also plan to spend time working more closely with beneficial owners. From recent meetings with a number of them, some have expressed concerns about their awareness of risk, and others believe there should be more transparency. We have started the process of maintaining a regular dialogue with these institutions to try and ensure they stay up to date with developments in securities lending. Z

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EXECUTIVE PROFILE

Geert-Jan Kremer, KAS BANK The head of treasury at the 'pure play' custodian KAS BANK talks to Ben Roberts about the vindicated success of a non-cash, principal programme and the pros and cons of a central counterparty Geert-Jan Kremer covers a number of different areas at KAS BANK as the head of treasury, though he is at the same time typical of the pride the company has in offering a specific range of securities services. He oversees the clients’ business with the bank in the foreign exchange and money markets, and securities lending – primarily as a non-cash

bank’s clients have lost money in their securities lending programmes with the bank during the financial crisis. Another quarter of his time is spent on the operational aspects, including exploring new products for clients. But it does not compromise his description of the firm as a “pure play custody bank”. “Everything we do is custody related. For instance, we don’t have our own money market funds. Some prospective clients in the past were unhappy that we did not have our own money market funds nor reinvest cash. Now that discussion has changed.” He is adamant about the cash-free profile of KAS BANK’s lending, and that this view has been vindicated throughout the struggles of the

financial markets. “We feel that accepting cash as collateral is mostly a sub-optimal solution. It is not that we’re against cash as collateral as such, but there were no economically efficient proposals in that case. We did not believe that the economics of the trade could simply be found in the reinvestment of the cash collateral. “If a customer asks for a cash reinvestment possibility, then they can find a provider for that and we will help them implement that solution, but we won’t offer that actively,” he adds. Mr Kremer’s career in Treasury began with PVF, the Dutch asset manager that later merged with Achmea Global Investors, which subsequently merged into F&C. In 2000 he moved to Achmea, running

“If you are a small fund it will not be worth your costs setting up a lending programme yourself. You need a specialist volume handling front office desk to execute lending successfully - that's what we offer" principal lender – is integral. “Acting as principal entails managing the risk positions for our customers in conformity with our arrangement with them and our position in the market,” he says. He adds that around a quarter of his time is focused on risk management, and says none of the

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EXECUTIVE PROFILE

the Treasury in its main insurance arm in the areas of retail, mortgages and private banking. In 2008 he moved to the swiftlydeveloping KAS BANK. He points to the selling of its private banking arm as an example of how it has retained its focus on custody, along with some administration – the latter demonstrated by its purchase of the administration business of Deutsche Postbank in July. But it is decidedly not an asset manager: “It is not in our genes to be all things to all people.” Mr Kremer has seen the kind of stock value decreases in the Dutch market that have been common

“We did not believe that the economics of the trade could simply be found in the reinvestment of the cash collateral" to other countries. He says that discussions with beneficial owners wishing to restrict or stop their lending activity run along three lines. Firstly, he says the bank is still fielding questions about short selling. Secondly, beneficial owners are still concerned about the perceived risk of lending in comparison to the relatively low returns. Both of these perceptions are not correct, Mr Kremer believes. “Securities lending is a low-risk business as people can see from their own portfolios, during the credit crisis and the returns from all over the portfolio quite interesting.” Thirdly, he says some beneficial owners often have had other, more immediate concerns than their securities lending activities, which has led to the indefinite suspension of some programmes. As with a number of beneficial owners and agent lenders at the last GSL Summit in May, Mr Kremer believes securities lending is a front-

office activity, and that is how it is marketed by KAS Bank. “We take the execution of lending very seriously. It needs very special attention and you need qualified people to execute it, so you need considerable size to do it effectively. “You can compare it to currency hedging activities or treasury activities in general. If you are a small fund it will not be worth your costs setting it up yourselves. You need a specialised volume-handing front office desk to execute lending successfully – and that’s what we offer.” He is also in support of a central counterparty. The Netherlands was one of the four ‘Euronext’ markets to be included in SecFinex’s groundbreaking central counterparty, launched in June this year. “We are open to a central counterparty because we feel that if it works along very clear guidelines it makes the market operate better, it will solve a number of counterparty analysis headaches for us, it can uniform collateral schedules. "It also gives a lot of additional tools to work with to optimise a risk management of our clients and opens up a number of other areas to explore.” He adds, however, that a central counterparty will only be as strong as its members. “Operationally, a central counterparty must be very strong, it must be a centre of excellence – otherwise it will not work.” However, he also understands the critics of a CCP model who would rather retain the bi-lateral element of transactions. “If I have as one counterparty a highly-rated bank that is solid. That would be fine with me, and if it defaulted I would still have the collateral. I understand the discussion about the CCP but I would rather have one bilateral triple-A rated counterparty than a CCP that is built on number of weak market participants." Do you think lending and borrowing volumes will increase next year? “Yes I do. A lot of customers

"If you are a small fund it will not be worth your costs setting it up yourself. You need a specialised volumehandling front office desk to execute lending successfully" will see that when executed properly, and executed for its own economic reasons – and not for other reasons such as cash reinvestment returns – securities lending will be an interesting proposition.” He adds that the level of demand will be critical to the growth of the industry, though he is also positive about this volume. Whether securities lending returns will be as high as precrisis levels is still to be decided, he adds. Z

KAS BANK - an overview Specialism: wholesale securities services Main target clients: Institutional investors - pension funds, insurance companies, investment funds and asset managers - and financial institutions (banks and brokers) Key offerings: Brokers - clearing, settlement, sub-custody Value-added services: for treasury, risk management and investment management Global custody: 90 markets Offices: Amsterdam, London, Wiesbaden

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COVER FEATURE

Shares for shares In a future dominated by risk-adjusted programmes, there is a detailed and healthy debate around equities as collateral for stock loans, finds Anthony Harrington One of the more esoteric market changes that the default of Lehman Brothers might yet bring about is a shift in the securities lending industry’s fixation on cash collateral. This hasn’t happened yet, though a shift to equities as collateral is now visible in Europe with additonal signs in the US. Slow changes might be understandable given that the first impulse for many involved particularly beneficial owners of the shares - was to step back from securities lending. As Cédric Gillerot, director in Euroclear’s Collateral Services Product Management Division, observes, the risk-versusreturn equation seemed to have caused many to focus intently on the former. “There is little doubt about this. The data clearly shows that from September 2008, volumes in all the securities lending markets plummeted,” he says. While market participants had some months to ponder the problem,

“As a beneficial owner of a security, our experience suggests that if you were pushing for a bit more than 5% as a haircut you might well get it. In fact, up to 7% might be achievable" Ed Oliver, Data Explorers the conclusions drawn across the repo market, the tri-party OTC market with collateral management, and the securities lending market were similar.

Gillerot points out that in essence people came to three conclusions. The first was a renewed urgency about making sure that all exposures were fully collateralised, particularly in securities lending. The second point was a much more careful analysis of the liquidity of the collateral being taken. People only felt comfortable taking collateral that was highly liquid - that could be sold in the case of default of the counterparty - and judgements about the liquidity of the collateral became critical. As Gillerot puts it, “Liquidity of assets became a parameter of the utmost importance”. The third conclusion was that securities lending had to be achieved

The obvious advantage that equities bring to the table is the ready availability of pricing information in a cost effective and efficient way for both sides of the transaction, encompassing the collateral used in the management of the loan. Ultimately, this mandates the need for highly efficient back-office procedures and systems. Though the securities lending market was already fully collateralised, as was the repo market, the focus fell on the quality and type of collateral

T t

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COVER FEATURE

being taken. “Major lenders started to think about the respective merits of fixed income, cash and even equities as collateral. The US is historically cash collateral orientated, but lenders studied collateral management in the repo market where fixed income and equities are deemed to be valid types of collateral, and are starting to think about their use in securities lending,” Gillerot says. With liquidity as a fundamental driving criterion, the obvious advantage that equities bring to the table is the ready availability of pricing information, and the fact that good quality corporate equities can be turned into cash very easily, in a very transparent way. Much the same argument can be made for some fixed income, particularly highly liquid government bonds. In fact, as Gillerot notes, once lenders start exploring this avenue it quickly becomes obvious to them that, in a sense, the only really important feature about the collateral they are taking is whether or not it is available for efficient, seamless realisation. “The most appropriate questions to ask of a piece of equity collateral are: Is this the right quality equity? Is it easy to sell and do I have enough of it?” Of course, the volatility of equities can vary from moment to moment, depending on what is happening in the market and what is happening at the level of the particular issuer. However, if the collateral is being marked- to-market and the margin on the collateral is managed in near real time, there should always be sufficient collateral for the lender’s purposes. Again, as Gillerot notes, where this takes us is that it is not the quality of the collateral per se, but rather the quality of the processing of the collateral that matters. “This is where we definitely see ourselves making an impact. Euroclear Bank has a fully automated tri-party collateral management service which caters for a variety of fixed income or

equities collateral. In fact, we have the capacity to process transactions in over 400,000 different securities,” he says. Gillerot points out that there are a number of proxy measures which give a very good guide as to how liquid a particular security is at any given moment. “All these parameters can be monitored and manipulated and the impact on the sufficiency of the collateral assessed. "Clients entering into a collateralised deal using Euroclear Bank’s triparty collateral management service have complete control over the assets accepted or pledged, via the use of sophisticated eligibility screening.

“Major lenders started to think about the respective merits of fixed income, cash and equities as collateral" Cedric Guillerot, Euroclear For example, a taker of collateral can restrict or expand the total percentage of equities received by sector or market,” he says. If the rise of equities as collateral is being driven by liquidity issues, it is also being driven by the fact that, from a borrower’s perspective, major dealers are in the throes of consolidating their fixed income and equities desks. Once this is done, it becomes essential for the dealer to be able to manage equity and fixed income pools from the same desk. “Such dealers are sitting on large pools of collateral that they have to finance and exploit. "We have a very compelling offering here. Although traditionally known as a fixed income house, we have an equities service, EquityReach, that provides wide access to many domestic markets,” he says.

Euroclear provides equities services to 27 markets, 18 of which are in Europe, and the service range is being extended. It is a 'chicken-and-egg' situation of sorts: dealers will be more relaxed about offering equities - and lenders in taking equities - if there are services to make the mark-to-market side work in a fluid and seamless way. “What we are seeing a good deal of right now in Europe is borrowers consolidating systems to manage their cash securities business, with fixed income and equities being managed in combination, and both being used to collateralise the dealer’s exposure in the securities lending market or to borrow cash in the repo market,” Gillerot says. He points out that the risk monitoring associated with adding equities to the mix is predicated on the idea that both parties will have transparent and granular reporting which will demonstrate to each of them that there is the right amount of collateral in place at any point in time. The collateral management service provider will not make judgements about the liquidity position. That is for the lender, and also, by implication, the borrower, to agree. They will do so using efficient proxies for the liquidity of the collateral and because these proxies will be agreed in advance, and that agreement will be part of the securities lending contract, there will be no room for disagreement between the parties. What the collateral manager will do is simply provide the data stream that enables each party to see where they are with respect to the sufficiency of the collateral at any point. Gillerot points out that in an important way, this post-Lehman focus on liquidity has added new criteria to the collateral management process. “It is our role, as a service provider supporting all the collateral management tasks, to provide the parties with tools that will enable them to implement pre-agreed parameters

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COVER FEATURE

between the trading parties,” he says. Clearly all of the usual equity services, such as corporate events management, will also be part of the mix. The collateral management service agreement will define, in advance, how corporate events will be processed. While mandatory events are subject to automatic collateral substitutions, in the case of option events, the borrower will decide whether it will take that particular security back into its own account and replace it with a similar eligible stock, so that it can exercise its option as the beneficial owner in the most advantageous manner. In any case, both the borrowers and the lenders will have previously received relevant corporate events reporting on the securities used as collateral. Ed Oliver, global head of consulting at market data providers Data Explorers, and Leslie Gaynor, head of consulting for North America each have considerable experience in the securities lending market globally. Oliver says that given that liquidity is now a major issue for both sides in a securities lending transaction, equities now make a great deal of sense as part of the collateral mix. This is especially true, Oliver argues, where they are being correlated with a lent security that is in the same currency. “If you are lending the CAX versus the DAX for example, with both sets of securities denominated in euros, then provided you are talking about mainstream equities within the right parameters, and with appropriate diversification, then the case for exploring the use of equities as collateral is compelling.” Borrowers and lenders, he says, will have to work out between themselves what constitutes an appropriate level of diversification. For lenders, a diverse basket of ten different company stocks would probably make sense in an index like the FTSE 100. Another issue that they will have to grapple with is the acceptable level

of “haircut” to be applied to equities being offered as collateral. Lenders will be pushing for quite severe haircuts and borrowers for the lightest possible discounting. However, Oliver argues that given that borrowers in Europe would generally like to be able to include equities in the mix of securities they offer as collateral, they will generally demonstrate at least a degree of flexibility. “As the beneficial owner of a security, our experience suggests that if you were pushing for, say, a bit more than 5% as a “haircut” you might well get it. In fact up to 7% might be achievable. If, however, you wanted to be ultra conservative and were to

“Right now, equities as collateral is definitely a step too far for US beneficial owners" Leslie Gaynor, Data Explorers

demand 20%, then the probability is that you would not shift any of your securities at all. The borrowers just would not stand for it.” Oliver says that in his view, we can expect to see haircuts being much more proactively used as a tool, as the use of equities as collateral moves forward. “It follows from this that as more and more beneficial owners come to the market and show a willingness to take equities as collateral, there will be more competition and borrowers will be able to drive down the level of the haircut viewed as acceptable by the market,” he says. However, the additional security offered by a haircut goes back to how closely the two sides are prepared to monitor their securities lending programme. If you are a pension fund using an agent to mark-to-market you will

go into a pooled programme and will have to live with the standard parameters of that programme. If, however, as an owner you strike an exclusive arrangement where a single particular borrower gets the exclusive use of the portfolio for a period of time, that will generate a premium return of at least 25 basis points to the lender, Oliver says. It all comes down to how closely the pension fund as the beneficial owner wants to be involved in the process. “Do you just want to get a cheque for the use of your assets, or are you actively looking for trading opportunities to maximise returns? "Asset managers tend to be much more proactive because they treat securities lending as a portfolio management style of investment and will always look to squeeze a bit more out of a trade. They will apply this to equities as much as to anything else,” he says. Leslie Gaynor says that the discussion, under the surface, to change the US cash collateral model has really heated up since the default of Lehman Brothers. “People are now much more aware of the counterparty risks associated with cash management and with the investment risk issues, since the borrower wants a return on the cash he/she is putting up,” she says. The initial steps in this market might be a move to take more US treasuries instead of cash. If the US does finally start to take equities as collateral, she says, it is a racing certainty that beneficial owners will apply the biggest haircuts they can get. “Right now, equities as collateral is definitely a step too far for US beneficial owners to get their heads around. "However, if you are lending equities versus equities on the same index, with no currency risk involved, then you have the same volatility on both sides of the balance sheet and that might be a more attractive place for US lenders to begin to add to the collateral mix,” she concludes. Z

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MARKET PROFILE

Germany Lending is down despite big investment into the economy, writes Kimberley Ferguson. As an open economy with

significantly over the last two years. As of September 2009 the total value of German equities on loan is down roughly 44% since the same time a year ago. There was a seasonal peak in value on loan in May, but this was significantly below the levels seen in previous years. A German borrower, who chose not to be named, explained that “the cost of finance, balance sheet restrictions, counterparty risk, reduced supply and restrictive lending are all factors that affect liquidity and have reduced demand”. Torten Biesel, global head of securities financing at Landesbank Baden-Württemberg (LBBW) confirms that volume has indeed decreased. “During the banking and liquidity crisis the overall lending volume was significantly affected because some of the direct and agent lenders decreased their lending volume. And whilst it is difficult to calculate the exact extent of this decrease, it is safe to say that the German banks with greater economic troubles were more affected by the changed landscape.” Mr Biesel adds that this decrease has affected the types of collateral now being accepted in German securities Top five companies - percentage of stock outstanding on loan

% shares outstanding on loan 5.00 4.00

Q-Cells Ag 21%

3.00

Aug 09

July 09

June 09

May 09

Apr 09

Source: Data Explorers

Mar 09

Tui Ag 8.68%

Feb 09

0 Jan 09

Thyssenkrupp Ag 8.68%

Dec 08

1.00

Nov 09

2.00

Bilfinger Berger Ag 18.51%

Oct 08

Solarworld Ag 18.88

Sept 08

strong foreign trade links, Germany’s market is swiftly returning after one of the most difficult economic times experienced in many decades. To manage the crisis, the Financial Market Stabilisation fund was set up to offer a range of financial support to safeguard the stability of banks, insurance companies, pension funds and other financial institutions domiciled in Germany. After the EUR480 billion invested in the stabilisation fund, the federal government contributed a further EUR 90 billion as an attempt to strengthen internal growth and domestic demand. Germany has also tried to enhance the resilience of the financial system by initiating structural changes regarding regulation, transparency and accountability. An example of this is the 2009 Financial Standard Reform Act (Bilanzrechtsmodernisierungsgesetz) which aims to reduce bureaucracy in pension accounting and bring local GAAP (General Accepted Accounting Principles) standards closer to International Financial Reporting Standards. In securities lending, Germany experienced the biggest short squeeze of 2008 with Volkswagen and Porsche shares. In October of that year, Volkswagen’s shares more than doubled in value after Porsche unexpectedly disclosed that by using derivatives it had increased its stake in VW from 35 to 74.1%, forcing hedge funds and proprietary traders to cover short positions by buying stock from a shrinking pool of shares in free float. In addition, Germany is one of the next venues for SecFinex, the securities lending platform, to establish a central counterparty in November 2009. The volume of securities lending transactions, this has changed

lending. “The quality of collateral has become far more important than it used to be. In the past, unsecured bank bonds were viewed as the standard collateral in trades with agent lenders. "Now, covered bonds as well as government or agency bonds are the norm. Even if unsecured bank bonds are accepted as collateral, they are subject to an in-depth analysis with regards to their liquidity, ratings and pricing in the secondary market -if one exists.” One source adds: “Borrowers are more likely to collateralise trades with their cheapest form of collateral, normally assets- non-cash or cashthey are long of. It pays to be flexible, as a lender who is more open in their collateral profile can receive a broader audience”. Cash collateral remains a viable option for some lenders. “At LBBW, we are definitely still accepting cash,” says Mr Biesel. “LBBW is not a classic agent or direct lender. We have a combined repo and securities financing desk, so all of the collateral coming in through securities lending is reinvested in our other trading activities. On the other hand, if we are long of cash, we invest it in the tri-party market and feel comfortable doing so.” BaFin, Germany’s market regulator, extended a ban on the short-selling of shares in 11 financial sector companies until 31st January, 2010. The ban applies to shares in Aareal Bank AG, insurer Allianz SE, AMG

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Generali Holding AG, Commerzbank AG, Deutsche Bank AG, Frankfurt stock exchange operator Deutsche Boerse AG, Deutsche Postbank AG, reinsurers Hannover Re AG and Munich Re AG, Hypo Real Estate Holding AG and MLP AG. However, as Mr Biesel explains: “The short selling ban applies to uncovered short positions. This means that one can short a position as long as the stock is borrowed for settlement purposes. We believe that the ban will be lifted towards the end of the year when the crisis calms down a little further. "In Germany, the crisis is no longer a liquidity crisis but rather a moneylending crisis. As a result, the need to protect banks from short selling is no longer there. Furthermore, since a lot of European banks are now partly government-owned or are receiving help from the governments, the bans are no longer as relevant.” Just over a year ago there was no securities lending market for corporate bonds and unsecured bank bonds. Prime brokers had to trade on a commitment basis with their clients; however, refinancing those assets in the inter-bank market was nearly impossible. “Even the spot market was not functioning properly,” Mr Biesel reflects. “As of today, the spot market is once again extremely liquid and even the repo market has seen big improvement. For about four to five months we have been seeing decreasing haircuts as well as a much broader range of accepted collateral. Although there has been no full recovery, the German market is definitely picking up again.” The graph is based on the average of shares out on loan in relation to shares outstanding, for 182 German companies. To meet the criteria to be included in this graph, the company had to have market capitalisation of over USD100 million. The spike in between April- May reflects dividend season, suggests Len Welter, chief technology officer of Data Explorers. Z

Mexico Market pressures have not prevented a gradual growth in Mexican securities lending, finds Kimberley Ferguson.

Wider economic pressures in Mexico have stunted the growth of the securities lending industry. Between April to June, 2009, Mexico’s economy shrank by 10.3%. The outbreak of swine flu driving tourist numbers down was a contributing factor to this extreme decrease, as was the global downturn affecting demand for exports. With approximately 80% of the country’s exports sent to the US, it has been hugely affected by the fall in US consumer spending- particularly in the industrial and services sectors. The US recession is also thought to be a huge factor in the sharp drop in the amount of money sent home by migrant workers. Mexico, which is Latin America’s second largest economy, went into recession in the first quarter of 2009, when it saw GDP drop by 8.2% compared with the same period in 2008. On the securities lending side, albeit being slow to get underway, Mexico now has an active market. Up until 1994, the only foreign bank in operation in Mexico was Citibank, before the North American Free Trade Agreement (NAFTA) opened the securities markets to the US and

“We have seen the volume of securities lending incrasing about 25% in the last two years” Patrick Avitabile, Citigroup Canadian firms. Large international banks, such as BBVA (Spain), Banco Santander (Spain), HSBC (UK) and Scotiabank (Canada) along with Citibank (US) acquired most of the largest Mexican banks and began lending. In 1995, more foreign banks entered the market, including ABN Amro, Fuji and Societe Generale. Tokyo Commercial Bank began participating in 1997 and Deutsche Bank in 2000. Despite the industry being over a decade old, many lenders are only now establishing a presence in the country. A move in 2005 by Banco De Mexico to open up the local markets to foreign entities and to encourage mortgage companies to start lending gave the market a boost; however this was stilted when ambiguities around tax regulations caused many of these new lenders to pull out of Mexico. Len Welter, chief technology officer of Data Explorers provided the graph on the next page, which represents the average of shares out on loan in

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MARKET PROFILE

“Whilst in Mexico there is a bit of flow, in comparison with some of the Western markets, it’s not big at all” Len Welter, Data Explorers rules and regulations don’t include accepting cash as collateral” explains Mr Barajas. In addition, people are becoming far more cautious in terms of the types of collateral they accept. “Locally, clients lending securities are being more careful about the collateral they will accept, they usually ask for government bonds or liquid shares. For example, in the past they were more open to receive mutual fund shares,” said Mr Avitabile. Z

Mexican wave The Mexican market has seen a steadier rate in the availability of stock for borrowing. July saw the highest rise in 12 months with a sharp dip to August. Separately, at the beginning of that month, the Maxico Bolsa index reached 27692, up from 23359 after the first week in July. Since May the index has seen one of the most impressive rises in world markets, from 23014 on 4th May to 30881 on 14th October.

% shares outstanding on loan

Source: Data Explorers

5.00 4.00 3.00 2.00 1.00

Aug 09

July 09

June 09

May 09

Apr 09

Mar 09

Feb 09

Jan 09

Dec 08

Nov 09

0 Oct 08

relation to shares outstanding from September 2008 to August 2009. To fit the criteria for this graph, market capitalisation of the country had to be over USD100 million. In Mexico, this equated to 54 companies, including Telefonos de Mexico and Wal-mart de Mexico. Mr Welter, who traded securities at Morgan Stanley for ten years before joining Data Explorers last year, said: “Whilst in Mexico there is a bit of flow, in comparison with some of the western markets, it’s not big at all. This is reflected in the graph, which bounces between 40.4 and 40.5%. This is pretty indicative of not a lot of liquidity in the market”. Manuel Torres Barajas, the executive director of treasury and short term interest rates for BBVA Bancomer, Mexico, notes that the volume of securities lending transactions has decreased over the last two years. “At the end of last year, securities lending was affected by the global crisis, which led to a loss of participation of many market makers. Before this, the daily average was MXN50 billion, compared to MXN35 billion at which it currently stands.” Patrick Avitabile, managing director and global securities finance head of equity trading at Citi’s Global Transaction Services in New York, disagrees. “Within Mexico, we have seen the volumes of securities lending increasing about 25% in the last two years,” he says. “The short sells are increasing, and therefore, the

market need for securities lending has grown. Offshore, we have witnessed an increase of roughly the same magnitude. “The increase is mainly an offshoot of additional borrowers participating in the Mexican market. We now trade with in excess of a dozen counterparties, where that number was two-to-three two years prior.” And what about collateral? “In Mexico, eligible collateral is set out by the Mexican authorities,” says Mr Barajas. “Whilst corporate bonds are still being accepted, the global crisis has highlighted that these bonds have lower liquidity than federal bonds. Therefore, the acceptance of corporate bonds depends on their own liquidity ratios and credit worthiness. Typically, federal bonds have far higher levels of acceptance in regards to collateral. And in spite of the advantages of cash, for example, no haircuts or interest accrual, the current

Sept 08

“At the end of last year, securities lending was affected by the global financial crisis, which led to a loss of participation of many market makers” Manuel Torres Barajas, BBVA Bancomer Mexico

20 | Global Securities Lending Magazine | 2009

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HEdGE FundS

Hedge funds - rising amid change Past models and assumptions as to the workings of funds and brokers have changed, finds Ben Roberts. Hedge funds have been dealt a mixture of tough luck and tough love in the last two years. Declines in hedge fund asset values have run parallel with much of the hard times felt by asset managers worldwide, currently around USD1.34 trillion in total assets under management, down from USD1.95 trillion, according to Eureka Hedge. But their mainstream brethren have not experienced such acute scrutiny from regulators, investors and politicians to add to these losses. Deleveraging, both in anticipation and realisation of market declines, further reversed the enormous growth that hedge funds achieved for much of this decade. Those who still sought leverage experienced a shrinking pool of resources as fears of counterparty risk prevented such funding. Short selling restrictions prevented the possible gains from a declining market, though this could be argued as a temporary blip in an otherwise open season for short sellers – particularly regarding financial stocks. As pressures on leverage and stock borrowing - the classic offering by prime brokers to funds – grew, changes and a re-evaluation in the relationship between fund and brokers became inevitable. The tough love appears in what has been termed the ‘institutionalisation’ of its sector. Greater transparency, more third party administration and a greater emphasis on asset segregation – often safely separated in a custody account – have been three examples of the enforced drive away from its supposed secretive world. The decline in its wealthy private clientele also spurred the need to widen its marketing net to retain investment. Such changes, some would conclude, are timely. The European Commission’s

businesses. I think [the draft proposals are] just creating a layer of bureaucracy that’s unnecessary. “Wouldn’t it be much simpler to regulate the prime brokers - the top 10 prime brokers probably account for the vast majority of hedge fund assets - rather than regulating 9,000 different hedge funds?” Extra bureaucracy will hit small funds particularly hard. But at the same time hedge funds might accept the extra administration that comes from diversifying their spread of assets – both between different brokers and in setting up custody accounts. The key is to reduce exposure to any one prime broker. Gavan McGuire, director of Alternative Investment Services Sales for draft proposal for stricter legislation EMEA, Citi, said: “Some of the bigger on alternative funds, released earlier players are looking towards multiplethis year, has hung around the neck prime broker relationships to help of the industry. Despite the underspread counterparty risks and give instood calls for improved parameters vestors more comfort. People are lookconcerning leverage and liquidity, ing deeper and evaluating the benefits industry practitioners, the industry of the traditional long-only custody body – AIMA - and even a handful of model for their unencumbered assets.” politicians have voiced their concerns This can add operational cost to the as to the weight of regulation on a fund. Hedge fund managers will have sector largely blameless sector. to bear in mind, if they have additional Pedro Noronha, managing partcustodian relationships, be it prime ner at Noster Capital, is particularly brokerage or traditional custody it will incensed by the proposals, especially add to the underlying costs - but this as hedge funds largely outperformed may simply be the cost of doing busiglobal indices. Partly, he says, it is ness in the changing regulatory. down to erroneous perceptions of the The trend for multi-primes and sepasector. “People were looking at hedge rate accounts was played out in recent funds like they were absolute return. comprehensive research by New YorkThey have to realise there will be based research firm TABB Group. In every now and then a one-year event its study of 62 US-based hedge funds, where the industry takes a hit. Unfair “Prime Brokerage 2009: The Hedge attention is give hedge funds rather Fund Perspective”, 66% of respondents than banks. that used a single prime broker said “I would say the majority of the in- they were considering a multi-prime dustry operates well within the lever- strategy. age restrictions and operates honest At the same time, the study ex2009 | Global Securities Lending Magazine | 21

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PIRUM

HEdGE FundS

pected more ‘mini primes’ to grow and increase their market share, breaking the strangle hold on the market by US brokers such as Goldman Sachs and the ‘bulge bracket’ European players such as UBS, Credit Suisse and Deutsche Bank. Matt Simon, an analyst at TABB Group, told GSL: “There have been a number of new offerings, particularly from the introducing prime brokers and the mini-primes, as well as the reshuffle of client assets.” But he added that the idea of ‘multiprime’ needed clarity when assessing this trend in the industry. “Multiple prime meant ‘if you’re a hedge funds and you have many brokers, you’re multi-prime’. That’s not necessarily true for everyone. Depending on where the fund is located, many hedge funds may have multiple funds and each fund may be located at one prime versus another. So the number of hedge funds who have true ‘multi prime’ relationships was not that many. The idea of splitting assets within a fund between primes was not as common as a lot of people in the industry thought it was.” Just as hedge funds are re-evaluating their services, prime brokerage is also reassessing the counterparty risk – as well as the returns – in the relationships. Smaller, or less successful hedge funds that have brought in less money for the broker are now more likely to be shown the door by providers that must adhere to the bottom line. This played out in TABB Group’s research. Prime brokers, says Simon, claim that a lot of hedge funds “‘are becoming too expensive to have on our technology platforms and we’d rather stay focused on the largest clients.” Medium sized funds pose more risk and might not be profitable. This compares starkly with the boom years earlier this decade, when prime brokers would have the resources to nurture small and start-up hedge funds on the back of future growth, McGuire at Citi notes this is still happening to an extent.

“From our perspective we are willing to work with managers who have potential, of which there are many,” he says. “Talented managers need to be nurtured and given time to build out their track record and develop their business.” Perhaps ironically, a hedge fund that seeks to lessen its risk and shore up its future by separating some assets into a custody account could lose their lustre to prime brokers. Fewer assets on the broker’s books means fewer assets for the prime broker to rehypothecate. Noronha believes this is too much to ask. “If a hedge fund says: ‘I’ll use you as prime broker, but I’ll use a separate

“People were looking at hedge funds like they were absolute returns” Pedro Noronha, Noster Capital custodian’, you’re basically saying you’re not allowing the prime broker to run their business as they used to,” he says. “The reason why someone like Goldman Sachs is a great provider to borrow stock is because they’re the leader for prime brokerage. They have a lot of clients with a lot of securities with them, so when you have to borrow certain securities, it’s easy. “If you start segregating accounts for fund A, B or C, the broker as a whole loses part of the attraction of its business model. Either they would have to charge higher fees or charge for something else. That “something else” could be many of the additional services provided by brokers that came for free when money from rehypothecation rolled in. These include trade settlement, the management of margin, and payments, as well as the swift execution of corporate actions where necessary. McGuire at Citi points out that the custody product is very different from the traditional prime brokerage operational model that hedge fund managers

have become used too. “The traditional custody model requires different infrastructure requirements for hedge funds,” he says. “Hedge funds will need people with experience of working in a the traditional custody process, for a small hedge fund with five or six people, it’s another resource.” In such changing market dynamics, the measure of a successful brokerage could be minimising the perception of change. Noronha says stock borrowing costs and availability has barely altered in the downturn due to the strength of the broker. But the ban on short selling did alter the perception of both the strategy itself and its practitioners. It also meant ‘covered’ short selling was conflated with ‘naked’ shorting – selling into a market without the prior stock borrow. “In the US, naked short selling was a big thing. I think naked shorting should be a criminal offence. If you don’t have the borrow, you shouldn’t be able to short.” He denies the occasional charge that naked shorting is necessary for market makers, such as in the options market. “There’s only options in securities you can short. You cannot buy a put on a security where there are short sell restrictions, as the person who writes the put off to you, they need to hedge everyday and short or maybe buy depending on the delta of his option,” he says. “If there are no shorts allowed for the security, there won’t be a put option. It’s that way, not the other way around. If the cost-of-borrow is very high, it’s implied in the price of the option.” Also changed is the ease of identifying stocks to borrow and short. “After 2007 there were many easy shorts where you could make a substantial amount of money with a pretty high probability of being right. Now it’s different. Through my career most of the time the short book was an insurance policy and it was a drag on performance that enabled us to smooth the performance and to try and deliver absolute returns, month in, month out.” Z

22 | Global Securities Lending Magazine | 2009

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Operations comment: Pirum Rupert Perry of Pirum Systems outlines the next generation of post-trade automation - real-time

as part of an overnight batch, this straight forward approach is not viable for the International market, as the required data is simply not available overnight. Marking international securities in Europe (as per ISLA’s best practice guidance) requires market participants to use same day closing prices for Asian markets and previous processing. day closing prices for European and North American markets. In Europe, Not many years ago, post trade processes in the international securities this generally dictates that marks must be processed early in the afternoon, lending market were mostly manual and often very time consuming. Today, once the closing prices for Asia for the same day are available. many of the more straightforward Unfortunately, the requirement to operational processes, such as contract process marks in the middle of the comparison and billing comparison, benefit from extensive automation. This business day creates a new issue relating to timing differences. It is very difficult allows higher volumes to be processed to find a consistent time during the with much tighter risk control. business day when the timings of each But the job of automating all post party’s internal updates to settlements trade activity is not yet complete, as of new loans and returns, market prices many other processes are still very and foreign exchange rates are in synch manually intensive and require careful with each other. If marks are generated coordination and communication between borrower and lender. A couple and processed when the data is not of good examples are the daily mark to in synch, this tends to cause a large market and returns processes, but there number of mismatching marks which require further manual investigation/ are many others too. So, why have these processes generally processing. Using real time feeds to update a set not benefited from automation of proposed marks for both parties already? Whereas contract and billing comparison are based on daily/monthly is a much better approach, as it is data feeds generated by overnight batch more tolerant of the daily variances in the timings of settlement updates processing, the nature of processes or problems that can occur with like marks and returns is that they market data feeds. With real time require much more up-to-date data reconciliation, market participants to work effectively and this ultimately can immediately identify differences requires real time feeds and real requiring investigation or more simply, time reconciliations, which are more if more time is needed for the updates complex and have not been available to flow through from the underlying until more recently. systems. When the marks are ready and Furthermore, to successfully in synch, they are automatically posted automate marks and returns, you by both parties in their own books and first need to have clean and matching records. positions within contract compare, Today’s returns process is another as there will otherwise be too good example of a post trade process many exceptions requiring manual processing. It is only within the last few which currently requires considerable manual effort from both the borrower years that most market participants and lender to be processed. While have got on board with this first borrowers will usually have internal essential step. automation to identify when a loan is While automated marks in the US Domestic market are usually processed ready to be returned, they usually need

to call in the returns to the lender by e-mail, fax or telephone call. When the lender receives this request, it has to identify the correct trade(s) and book the required returns in their system. Using real time data feeds, the complete process of calling in returns can be fully automated, happening within minutes of the borrower booking the return in their own system. Validation logic is applied centrally, before returns even reach the lender, so that any which fail to meet the lender’s pre-defined validation criteria can either be rejected immediately or else held in a queue for manual review. A real time version of contract compare is an essential part of this process, as it automatically determines the correct translation between specific borrower and lender trades in each security, so that when a return is booked by the borrower it is always booked against the correct transaction on the lender’s side. This avoids the common contract compare breaks that often result from returns being booked against a different trade in the same security than was intended by the borrower. As the industry moves forward, it is increasingly apparent that further automation of post trade processes will increasingly rely on real time feeds. It provides both parties with a continuously updating view of the matching state of the transactions in their respective books and records throughout the business day. Real time processing also enables any corrections identified on the reconciliations to be entered in source systems and then fed through to update and correct the reconciliation, ensuring that exceptions are minimised and STP is maximised. Z About the author: Rupert Perry is a founding director of Pirum, the leading provider of post-trade automation services to the international securities lending and repo markets. Services provide include real time processing for contract comparison, marks, returns, prepay and exposure reconciliation.

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24 | Global Securities Lending Magazine | 2009

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Global Securities Lending 2009

PAnEL: REInVESTMEnT

Panel: Reinvestment Taking cash as collateral has divided market opinion and is for some the epiome of the risk-return evaluation. GSL quizzes the experts. Virgilio “Bo” Abesamis, III, senior vice president and manager of the Master Trust, Global Custody, and Securities Lending Group. Bo joined Callan Associates in 1987, initially working in the Capital Markets Research Group with responsibilities involving asset/liability modeling, manager structure, benchmark and database reviews, style analysis, and research.

Sonja Spinner is senior associate at Mercer Investment Consulting. She has previously acted as European investment reporting manager at Canada Life, as well as senior internal auditor at the firm.

Brian Staunton is managing director, Securities Finance, EMEA, at Citi. He is responsible for the securities finance business within the EMEA region. Before re-joining Citigroup in October 2004, Brian worked for Deutsche Börse Group in London, formerly Clearstream Banking, for seven years as Regional Manager for the UK, Ireland and Scandinavia. Prior to that, Brian was at Citigroup in London where he was securities lending sales head in Europe. NB. Additional comment from Steve Beill, director, securities finance at Citi.

1. For some agent lenders, there has been an increased focus on the profits that can be derived from the intrinsic value of the loan itself – rather than returns from cash collateral reinvestment. How significant do you think this shift will be to overall cash taking and reinvestment levels? ABESAMIS: The focus on intrinsic

value vs. reinvestment of cash collateral would definitely have an impact. We believe that this shift away from cash collateral reinvestment could mean a 40% to 60% reduction in revenues. However, we also believe that those clients with real inventory of intrinsic value securities would be paid commensurately and should achieve better demand spreads of at least 10% to

20% than usual. SPINNER: I consider that the Tony Baldwin short term intrinsic valueisofhead loansofshould be the interest andactivity fundingasatopposed Daiwa driver ofrates lending Securities SMBC Europe. The firm is to cash yields. Many of the issues based out of London and its opwhich have owners erations areimpacted currently beneficial split into four in agent lending programmes arose different areas: equity, fixed income, because the focus was onderivatives. an aggressive investment banking and cash reinvestment programme as

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PAnEL: REInVESTMEnT

opposed to prudently managing securities lending programme risks. Whilst money market yields remain low it is difficult to make a case for accepting cash collateral as the incremental spreads over a non-cash programme are not outweighed by the additional reinvestment risks. Recent market events have also highlighted the issues associated when collateral pools are shared by multiple lenders. I always steer clients with the risk appetite to accept cash collateral to a segregated cash fund. STAUNTON: I think it’s important to reiterate why we take cash. Some brokers prefer to give cash as they’re long cash, and it must be then reinvested to earn a yield. In addition to the yield the broker will want compensation in the form of a rebate The interest rate earned from the re-investment should always be higher than the rebate level, and that yield is very much a function of what re-investments are permitted. The more conservative the reinvestment profile, the lower the revenue will be. Our view is that we generally lend assets out which do have some form of intrinsic value – whether equity or fixed income. We’re not ‘pumping out’ securities to generate cash. There’s generally a level of intrinsic value in the loan itself.

ABESAMIS: Before any talk of liquidation or exit strategy, we believe that the prudent approach is to have those reinvestments be marked to market to determine “real” valuation levels and the potential market impact of a forced sale, especially in this environment SPINNER: The use of a constant dollar net asset valuation (NAV) is common industry practice for cash collateral reinvestment pools. I don’t think that there is a requirement to amend this when computing revenues and fee splits. Beneficial owners would, however, gain additional transparency

“Now the vogue is triparty, and it’s fantastic - you can work with the tri-party agents and set your risk parameters around a very finite set of categories” Brian Staunton, Citi

if mark to market valuations were also published. Many beneficial owners had no transparency regarding the performance of commingled cash reinvestment pools until agent lenders informed them that the fund could no longer support a constant dollar BEILL: After the default of Lehman NAV and that funds were trading at a Brothers there was a pull back from considerable discount. cash as a form of collateral. There may This is clearly inappropriate as be lenders that hadn’t really understood mark to market valuations gradually all the potential risks and downsides decreased over the later part of of having cash. That said, we’ve been 2007 and 2008 and then decreased through a re-education process with substantially following the collapse of lenders and now I think lenders are Lehman Brothers. returning back into cash as a form of Sharing mark to market valuations collateral. with beneficial owners would have alerted them to the issues facing some 2. At the height of the financial cash reinvestment funds and enabled crisis, many beneficial owners did them to make the decision whether to not seek to liquidate their cash fund losses and suspend lending earlier reinvestments due to the loss they would incur. Should the status of these and at less cost. reinvestments be marked-to-market? STAUNTON: Some lenders in the

industry faced a situation where they wanted to suspend lending because of the market volatility, but to do so would have incurred a loss on the cash collateral re-investments. So the question they ask is: ‘do I liquidate and take a loss or maintain the positions until final maturity in the hope they’d maintain their value?’ I don’t know if the investments should be marked to market. If they were – perhaps if there was a shortfall in collateral value – who’s going to post the additional margin? In a classic mark to market process you’re marking the loan and collateral whereby you’re taking more collateral if need be. But marking the cash re-investment isn’t a classic mark to market, as you’re marking an investment that’s possibly lower than the value you bought it for. So whose responsibility is it to top up the value? Under the current legal arrangements it is the lenders’ responsibility. 3. Will the last quarter’s improved market conditions have encouraged beneficial owners to stick with the reinvestment plan – or would this be the time to get out on the back of potentially smaller losses? ABESAMIS: Depending on client considerations (i.e. liquidity needs, rebalancing, asset allocation, etc.) and risk assessment, this is the time to assess the investment policies and guidelines governing the reinvestment of cash collateral. Within that construct, it would also give a client a way to evaluate the profile of their program and if needed “clean-up” or employ a “controlled un-wind or work-out solution” that would bring the program into compliance. SPINNER: Beneficial owners in lending programmes with losses in their cash reinvestment pools are not yet out of the woods. Where losses have resulted from mark to market losses on asset backed securities the lack of money market liquidity, and

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PAnEL: REInVESTMEnT

investor appetite, means that the losses can still be substantial. Some owners have decided to fund losses or to take vertical slices of cash reinvestment pools in order to facilitate an exit from lending. However, I think that it’s fair to say the majority, albeit reluctantly, are remaining in their lending programme. STAUNTON: A lot of these assets are very illiquid and difficult to price. If there was a mark-to-market process, would you have sufficient security that the mark-to-market is pricing that investment adequately. In reality, if you have an illiquid asset, you don’t know the real value until you sell it; it’s not like index equities. BEILL: the sort of products we’re talking about that incurred the big mark to market losses are in the ABS space. Citi EMEA stopped buying short-based asset-backed commercial paper a long time before the default of Lehman Brothers. I’ve seen a few reports suggesting that liquidity is returning to the ABS sector, and it’s difficult to say if it will encourage lenders to pull out or stay. 4. Some call the reinvestment a front office activity and an ‘investment management overlay’. Will this evolution of cash reinvestment into the asset allocation space help the understanding of risk, liquidity and returns? ABESAMIS: This is a very good question. We believe that a client should assess securities lending from both direct lending (i.e. custody, a third party agent or principal) and indirect lending (i.e. mutual funds, commingled funds, index funds, etc.) viewpoint. Those that participate via indirect lending should take into consideration that seclending is already embedded in the asset allocation, especially those using index funds as the core exposure to asset classes. In the area of direct lending, the issue is not that simple. Two factors have to be given proper consideration- wherein (a) securities lending is utilised as a fee/

cost offset or (b) securities lending is employed as an alpha generator. As a fee/cost offset, the client has to weigh the merit of securities lending as a front-office or investment management overlay activity. This could be problematic for those clients because a fee/cost offset approach does not align well with risk taking. On the other hand, if a client believes that this is an alpha generator, then this needs to be factored in the risk budgeting exercise and in what context of the asset allocation should it be carved out. SPINNER: Cash reinvestment absolutely is a front office activity. Beneficial owners choosing securities

“Lenders are effectively stuck in their lending programme as a result of inappropriately constructed portfolios which have failed to consider an investment basic: to match assets with liabilities” Sonja Spinner, Mercer Consulting

lending programmes with cash reinvestment need to apply the same due diligence process and monitoring of managers to cash reinvestment funds that they apply to other manager mandates. I would encourage all owners lending securities against cash to view their lending programme as a cash fund investment, with all the same risk and return considerations as any other money market fund investment. I would also encourage all beneficial owners lending against cash to reflect whether they really consider that the additional revenues they may receive if they lend against cash really are sufficient to compensate for the additional risks.

STAUNTON: That’s a good question, and it is one of education. If you’ve appointed an agent lender for a specific role, that lender should have the capability to manage, calculate and record risk and provide a very good and professional level of cash reinvestment as good as any money manager. I think there are players who can do that very well. As a firm we have that capability so we agree with the statement – it is a front office function. I would go a step further too: because it’s defined as front office it needn’t go to a traditional fund management firm – if you have the capability in-house it’s a good situation. 5. Where might cash be most commonly reinvested next year – will there be a weight towards short-term investments? ABESAMIS: Callan does not have a crystal ball on the future. Market participants in securities lending should understand the risk/reward and asset/liability issues inherent in the transaction. Liquidity risk would best be mitigated if appropriate short term investments are given proper consideration regardless of market environment. SPINNER: There are considerable risks associated with running cash reinvestment plans with duration mis-matches between loans and cash reinvestment. Long term investments are not suitable for cash collateral reinvestment pools, even if they benefit from interest rate resets, as they lock owners into lending programmes in the event of a liquidity shortfall. In response to increased investor risk awareness, increasing numbers of agent lenders are investing maturing assets in instruments eligible under Rule 2a-7 of the United States Securities and Exchange Commission. The combination of these factors will results in weightings towards shorter term investments.

28 | Global Securities Lending Magazine | 2009

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5/8/08 12:15:12 26/10/2009 12:12

PAnEL: REInVESTMEnT

STAUNTON: The bigger shift is going to be towards secured investments – tri party repo, for example. That gives you the double protection of counterparty risk and that’s backed by the securities you’ve taken as collateral with any margin. In the unsecured space, banks have been getting their funding from the central banks that have pumped so much money into economies that they often do not want to issue in to the market, and except for the three-to-six month space you won’t see decent returns. Now the vogue is tri-party, and it’s fantastic - you can work with the tri-party agents and set your risk parameters around a very finite set of categories. 6. What regulatory changes or developments might be influential on the cash reinvestment space? ABESAMIS: The most significant regulatory driver to the speed limit of cash reinvestment would be the fine tuning of SEC Rule 2a-7. This is currently being evaluated by the government and the industry in terms of acceptability of certain types of securities, maturity considerations, credit, issuer limits and liquidity. Once the dust settles on this important guideline, the industry would have a better sense of the speed limit and have a sense of the potential risk (up or down) if they decide to push the reinvestment guideline. SPINNER: I would welcome increased scrutiny of commingled cash reinvestment pools. Some agent lenders ran very aggressive cash reinvestment programmes with substantial allocations to asset backed securities. Additionally, some “cash funds” with apparently low weighted average maturities were running bar bell strategies with a proportion of short dated assets and a rump of assets with years to final maturity. Lenders are effectively stuck in their lending programme as a result of these inappropriately constructed portfolios

Statistically speaking Cash reinvestment losses have by now been well-documented. But the recent study by RBC Dexia Investor Services found that the issue is still far down the list as a specific topic when beneficial owners across four continents were asked for reasons for changing their lending programmes, despite a decline in risk appetite overall. Source: RBC Dexia Investor Services

“Liquidity risk would be best mitigated if appropriate short-term investments are given proper consideration, regardless of the market environment” Bo Abesamis, Callan Associates which have failed to consider an investment basic: the matching of assets to liabilities. Moves to force greater transparency can only be welcomed. Additional regulation or guidance on the differential between a fund market to market NAV and constant dollar NAV that can be permitted before investors must be informed that cash reinvestment funds have broken constant dollar NAV would also be welcome. Many investors had mark to

G w m a

Reasons given for changing programme:

65% reported

less confidence in counterparty stability

59% cited lower risk

tolerance

44% sought

greater levels of indemnification

9% looked to avoid cash reinvestment losses.

market losses between 3-5% of their portfolios before they were alerted to issues with their programme. STAUNTON: I think there’s a need for greater transparency of cash reinvestment, reporting to all parties all the investments. What will be interesting is what comes out of the SEC meeting that took place last month. I think it’s important to remember that this industry was around USD14 trillion in available securities in 2008 with USD4 trillion on loan - a huge amount of liquidity. For the most part securities lending worked extremely well. In that sense we have to put the problems that have arisen around cash in perspective. Z

T a y i i a w T c i

Next issue panel topic: ‘Regulation’. If you would like to be part of the next Q+A, contact Ben Roberts (ben. [email protected]) or James Olweny (james. [email protected]).

30 | Global Securities Lending Magazine | 2009

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08/10/2009 12:12 18:11 26/10/2009

TRAdInG

From the trading floor Jeroen Bakker gives an insight into the trading operations of RBC Dexia, including its plans to develop its agency lending platform. The global coverage of RBC Dexia’s securities lending business means that we’re working with our colleagues around the world, particularly with the other trading desks in Sydney and Toronto –there is information flow across regions and coordination globally. Trading is around 50-60% of my day-to-day job, I am involved with other projects, qualifying various trade structures and deal opportunities and product development initiatives Next to this there is a lot of interaction with other departments such as operations and risk. Collateral Our collateral schedule is non-cash, and primarily G10 paper. Given events such as the default of Lehman Brothers and the credit crisis, I would say our non-cash programme has benefited well compared to a noncash programme. Borrowers ask for collateral flexibility and the ability to change the collateral based on their access being either G10, equities, corporate bonds or cash. This would allocate additional baskets, additional balance or higher fees to those agents or principal lenders. However, I would say that changing the collateral framework is not a process you want to do overnight. RBC Dexia has a prudent risk management framework and so doing the due diligence and making clients comfortable with additional paper or collateral must be ensured prior to launching a new collateral instrument.

“With a CCP, there are potentially two hundred borrowers behind it - but who are they?”

However, we’ve expanded our collateral schedule to accept additional OECD government bonds, German and French agencies to meet borrower demand. Our clients come in many different kinds. Some just are interested in just a monthly cash flow. Some would like to see the breakdown of the revenue that is being generated. In these cases, every month the trading desk will inform those clients via our technical sales department what might be happening in the US, the Far East and other regions, which securities are specials, and so on. CCP When it comes to trading using a central counterparty, I think a key question still needs to be answered: where is my risk? Is it with SecFinex, or Eurex? It is difficult to see ‘behind’ the platform. With my current bi-lateral

transactions, our risk department will fully assess the counterparty risk. They will check what are the outstanding loans versus the collateral received and calculate the value at risk (VaR). With a CCP, there are potentially two hundred borrowers behind it – but the question is: who are they? What would happen if one of them got into trouble – would it trigger a domino effect whereby the entire CCP goes bust? So if I used a CCP, then as a lender with a duty towards my clients I would have to say: I would have to better understand how to measure my risk. From now on At this stage in the year, we have seen less market activity regarding M&A and rights issues compared to the first half of the year which saw a decent number of rights issues and takeovers. This being said, we are seeing increased amounts of GC month after month and the trading desks have been setting up these trades. Our balances are growing, and not only due to the rise in the stock markets. So we’re keeping ourselves busy despite that it has been more quiet than others’ summers. Z

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TRAdInG

“It is important to be aware of the correlation between the loans ad the collateral; especially the liquidity of all these securities.”

Robbert Wijgerse at Robeco highlights the prominent changes to lending programmes and the company’s collateral guidelines.

securities lending trade and not from the cash collateral reinvestment opportunity. Obviously non-cash collateral has risks too. It is important to be aware of the correlation between the loans and the collateral; especially the liquidity of all these securities. In the weeks following Lehman Brothers’ default we amended our It has almost been a year since non-cash collateral guidelines. Firstly, corporate bonds and the default of Lehman Brothers. Since September 2008 beneficial owners convertible bonds have been have reacted differently with regard to restricted because of a lack of market and credit risk. liquidity in these securities. Some beneficial owners have made Secondly, collateral margins have small adjustments to their securities been increased because of a high lending programme, while others have volatility in the market and increased stopped lending altogether. Another counterparty risk. Thirdly, settlement group wanted to pull out but could not risk has been decreased by receiving do so due to unrealised losses on the pre-paid collateral. And lastly, cash reinvestment in money market financials were removed. funds or directly in commercial paper. Currently we are seeing that As a non-cash collateral taker, borrowers are, once more, pushing we have had no issues with regard for more flexible collateral grids. to unrealised losses related to cash Some lenders are accepting financials reinvestments. It has been our policy and investment grade corporate not to create more leverage by bonds again as collateral. reinvesting. As exchange traded funds (ETF) The rationale is that the income become more and more traded, there is from securities lending must come an increased need to finance these from the intrinsic value of the as well.

Another trend is financing swaps where the stock is sold and hedged with a total return equity swap. Some beneficial owners, who only accepted cash collateral in the past, are starting to accept non-cash collateral. On the other hand, more borrowers are looking to pledge cash as collateral as some of them experienced a lack of non-cash collateral. As the collateral preference from borrowers can change from cash to non-cash, lenders have to become more flexible in accepting both types of collateral. Robeco, for instance, is starting to look at accepting cash collateral and reinvesting that cash through an overnight reverse repo. Whether it is cash or non-cash collateral that is being accepted, it is important that the risk-return profile is understood and professionally managed. It will be interesting to see how beneficial owners will act when they can pull out of the money market funds. Will they move to a trading model based on intrinsic value or will they stop as the risk/return was not what they expected it to be? Z

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GSL SuMMIT - REVIEw

GSL Summit - on the road Amsterdam Dutch Securities Lending Summit, October Venue: Krasnapolsky Hotel Sponsors: Fortis Bank Nederlands, Robeco, ING, J.P. Morgan, eSecLending.

Below: the second panel: (l-r) Sander Baauw, Fortis; Simon Lee, eSecLending Sonja Spinner, Mercer Consulting; Rogier Buurman, Robeco

Additional sponsors: 4Sight Financial Markets Solutions, Rabobank. The GSL “Lending for Liquidity” summit in Amsterdam on 8th October attracted some of the main players in the Dutch securities lending market and beyond. Discussion topics of the day involved whether securities lending was now a front office activity along with the risks involved in the market, but on a micro level one of the most popular issues was cash reinvestment. Mark Faulkner, founder of Data Explorers, opened with an overview of the current state of the industry. In contrast to some media reports, Faulkner stressed that securities lending is still a profitable enterprise, although the credit crunch has led to changes, particularly in the attitude towards risk management. He described risk as the new “key metric” in the industry, something which was also agreed upon at the recent roundtable discussions on securities lending and short selling at the US Securities and Exchange Commission, where Faulkner was in attendance as an advisor. “It’s not just about return anymore, it’s much more about risk, and I think this is long overdue. I just hope that collectively the industry and organisations can keep to that thought going forward over the next few years,”

he said. Jean René Giraud, from EDHEC Risk, provided an academic overview of the industry. Giraud criticised the media’s condemnation of short selling, which had been seen to be driving down the prices of firms. He said long investors – given their far greater number – were more responsible for the fall in stock prices, and also revealed some of the benefits of short selling. “Short selling is important for the portfolio management process on the one hand,” he said. “But it’s also important for the market itself, in terms of liquidity, because it allows for increased quality of price discovery.” The first panel comprised of Paul Wilson from J.P. Morgan, ING Asset Management’s Bert Mekes, Hans van Roekel of SPF Beheer BV and Paul Wilson from 4sight Financial Markets Solutions. The panellists discussed if securities lending is now a front-office investment.

Van Roekel revealed that SPF Beheer withdrew from its lending programmes after the financial crisis, but that it plans to begin the process again next year – although with more focus on the collateral side. He also agreed with chairman Roy Zimmerhansl’s suggestion that this pullout was not to do with securities lending itself, but more because it’s “a weird old market out there” and he’d rather be risking nothing. “The people on the floor are convinced about the product,” van Roekel said in reference to securities lending, but suggested that the board of directors were not as convinced – so SPF Beheer decided to “not take the chance” of giving securities lending a bad reputation just because of the current market. This volatile and changing market is also having an impact on the technology sector, 4sight’s Wilson revealed. “There is a great demand just now for change in the technology

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industry, and nowhere more so than in the Dutch market, where we support agency lenders who are probably amongst our most active clients,” he said. “There’s also been an obvious change in the way that technology has been used since the credit crunch and that’s all about collateral in large neon lights. As a vendor our focus became almost entirely collateral-based about 12 months ago.” Mekes, from ING, suggested that the use of cash collateral would allow his firm – which in the past only accepted non-cash collateral – to better its cash management processes. “Securities lending is a tool I can use in my cash management,” he explained. “It is not only about earning more money but also about managing cash better.” Mekes suggested that firms could benefit from the extra cash that would be available through securities lending programmes, which would allow them

to gain access to cash without being required to sell assets. Meanwhile, J.P. Morgan’s Paul Wilson suggested that the return of SPF Beheer to the securities lending market is indicative of a larger trend. Most of those who had suspended their programmes have now re-entered the market, while some bodies which have never lent before are now doing so. Wilson also mentioned a disparity between the European and US markets in terms of governance. He said: “For the most part we still see in Europe that the oversight, governance and responsibility for securities lending still very much resides in the operational division of beneficial owners, while substantially in the US, particularly on the asset management side, there has been an overnight shift of responsibility to the CIO.” Rogier Buurman from Robeco, Sander Bauuw of Fortis, eSecLending’s Simon Lee and Sonja Spinner from

Mercer Consulting were the members of the second panel. This group focused on a subject that had already been mentioned heavily – risk. Issues such as collateral choices and short selling limitations were on the agenda, but cash reinvestment seemed to be what everyone wanted to talk about. Cash collateral has received a bad press of late, but Lee, responding to a question from the audience, explained that it is important to distinguish the many possible reinvestment options, and the risks involved with each. For instance, he pointed to the difference between reinvesting cash collateral in asset-backed securities and overnight government repo – the latter of which may be much the same in risk terms as taking government debt as collateral in the first place. “It’s something that lenders have to be very, very aware of because it does make a fundamental difference

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cOnFEREncES

to the risk and revenue dynamics of their programme,” he said. “Lenders shouldn’t necessarily be dismissing cash collateral out of hand. Cash collateral managed in a risk-averse fashion can help significantly in terms of programme performance.” This move towards cash collateral was echoed by Buurman. His firm has traditionally taken non-cash collateral, but Buurman revealed that Robeco is beginning to accept cash collateral “more and more” – but in a risk-averse fashion. Robeco now accepts cash “not in a way that has caused other companies to have losses or any other type of problems, but in a way that cash collateral is used as a measure to mitigate credit risk and not as an investment opportunity”. Buurman added that the Lehman default required Robeco to undertake a number of changes, including to its collateral policy. However, Sander Baauw suggested that further changes are underway for the industry as a whole, particularly given the possible introduction of central counterparty (CCP) models into the sector. “I think that CCP is going to change this world,” he said. “Maybe next year and otherwise in two years, and then the risk profile of many counterparties will look totally different.” Sonja Spinner compared the Dutch securities lending industry and that of the UK. She described the Dutch market as “very well-educated” and revealed that many people in the Netherlands decided to suspend their programmes after the near-collapse of Bear Stearns in 2008. Her Dutch colleagues estimated that 40%-60% of Mercer’s pension fund clients in the Netherlands suspended their programmes after the events of Bear Stearns, while in the UK clients only began cancelling after the Lehman collapse. However, Spinner did add that people were coming back to the securities lending market. Z

London Securities lending forum, September

Discussions around brokerage opportunities, regulation and the newfound fame of the industry kept panellists busy in London last month. The securities lending summit in London on 21st September was a detailed and energetic overview, and given the improved market conditions seemed well-timed for a market cautiously expecting better times ahead. Summaries, statistics, anecdotes and conjecture from the ‘floor’ all played their part. Rob Mirsky, a partner at Laven Partners and leader for the first discussion, opened with a telling figure, that hedge fund assets have declined to USD1.3 trillion from around USD2.6 trillion at the start of the crash. Robert Maloney at Credit Suisse acknowledged the huge redemptions in the sector, and pointed to a brighter future for the rest of this year as DJ Euro Stoxx 50, Nikkei and other indices have risen by about 55%-60% from

market lows. Credit Suisse clients’ concern has been to protect capital, he said, though “one key element will be hedge funds meeting their ‘high water mark’,” which is linked to the fees they charge. 9%10% of funds are still 30% below their high water mark, he said. Confidence has also been growing in the sector recently, he said. Convertible arbitrage has been the most successful strategy and strategies with a short interest have performed very well, though investors are also looking at longer-term strategies, such as market neutral. He added that the UCITS fund structure – which has been growing in take up for hedge fund managers seeking a wider pool of investors – is very useful to many funds, as it gives their end clients fortnightly liquidity. “If you’re a hedge fund looking at UCITS and can reach out to investors, it’s a powerful product. You can reach out and there is regulatory support and approval.” Leverage has been low – since December the average fund has perhaps been two times leveraged, and this has increased to two-and-a-half. Separately others in the industry said a more telling statistic would be the median, rather than mean average. This makes sense: if the overall average is 2.5 yet there are a number of funds in London or Cayman around the six or seven mark, it might say more to look at those higher-leveraged funds. Charlotte Wall, managing director at Data Explorers, showed with slides how institutional investors are starting to buy again, and Ashley Wilson at Barclays Capital pointed out there had been a drop off in lending activity due to regulatory requirements, including

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From left: Robert Mirsky, Laven Partners; Charlotte Wall, Data Explorers; Ashley Wilson, Barclays Capital; Robert Maloney, Credit Suisse

disclosures. “The question is: has there been a transformation in prime brokerage? Yes. Investors are taking the lead and want more information as to how the prime brokers are working.” The two key areas for this disclosure are how to hold assets and how are they being hypothecated, and the prime brokers have had to respond. Further, prime brokers have put their highest rated entities to face the hedge funds; US investors have pushed prime brokers to move to a model more akin to broker dealers for better protection; and there has been a shift to using custodians to hold assets. He finished by saying that the “duopoly” of prime brokers would be broken, with five or six major players to populate the landscape in the future. Maloney agreed, and said there was a more “level playing field”, with some prices offered to end clients – such as pension funds – beginning to change. He said that pricing is a critical issue regarding the success of brokers up to this point and for the future. “We believe in holding the line – if we’ve missed the biggest problems it’s because often we believe that people should be paying market premium. We’d rather lose market share and

make a decent profit. Does a multi-prime broker strategy affect pricing, asked Mirsky. Maloney said that counterparty risk is key and not all market players are equal. He added that brokers would not be

“Regulators understand a lot but perhaps not all of the nuances of the benefit of securities lending” Kevin McNulty, ISLA earning their wage if they went to clients: trade with us, we give the best price. In the second talk, which focused on the regulatory and tax changes that affect securities lending, Richard Steele of JP Morgan acknowledged that regulators had to act fast in the midst of the global crisis, and some countries saw particularly stringent reactions from authorities, notably Spain and Italy. However, he added: “Regulators understand a lot but perhaps not all of the nuances of the benefit of securities lending.” Kevin McNulty, into his

second month as CEO of ISLA, joked that after taking the last 18 months off he returned recently to ask colleagues: “Has anything interesting happened?” He reiterated that anyone getting into securities lending must be able to understand it, including its regulations. There are regulatory risks, he added, and it is important to see where they are. Further, the reaction of regulators made it seem like they thought short selling was a “dodgy practice”, though there were also encouraging signs recently that regulation is now more coordinated. David Little of Rule Financial, the consultant, said that Corporate Social Responsibility, a self-regulating policy, was a “bit of a failure” as it only existed within Europe. “As politics enters the fray the thinking gets very much narrower.” He added that liquidity can mean different things. For FSA-regulated firms the UK watchdog frequently means payment liquidity as payments fall due. This is different from liquidity regarding assets. “The FSA is trying to bring the two together and manage across the bank – not just cash but how to bring it down for less liquid assets.” Changes ahead for banks, spearheaded by the FSA, will include

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daily reporting, stress tests, the active management of liquidity, with supervisors wanting to see good management. However, this could lead to a great decline in ‘sequential duty’: money used other night for other collateral. Further, liquidity buffers may lead to a shortage of collateral, and there might be a demand from banks to get beneficial owner assets for collateral purposes. Regulators want also for banks to charge for liquidity usage. However, he reiterated a point made in the RMA/ISLA conference in Barcelona, that the FSA is leading the way internationally, which could leave the UK out in the cold if they do not get sufficient support from other regulatory bodies. In the afternoon, Tim Smith, senior vice president at SunGard Securities Finance, gave a global market update for the industry. Using slides he showed that shares per value levels in fact remained fairly stable. He added that historically, securities lending has fiercely divided opinion. As a colourful illustration, he said that in his experience, almost all French asset managers were called Bruno. “Bruno A would be for securities lending; Bruno B would tolerate it; Bruno C would hate it”. He added that the availability of shares remained steady in recent years, though in the US there had been activity concerning a way out for many lenders for cash collateral programmes. This has pressurised fees, he said. Further, a lot of hedge funds are beginning to negotiate deals, becoming prime brokers in their own right. Sectors for the most expensive shorting interest included automotive, financial, health and telecom. He added – visible through another slide, that the shorting of Citigroup had a significant influence on the level of shorting activity in shorting generally. In the next panel – ‘Cash Collateral: What Does The Future Hold?’ – panel leader Olivier Grimonpont of

Euroclear said that a rule of thumb had been: “Don’t do anything you wouldn’t want to see on the front page of the Financial Times.” Referring to the unprecedented profile of securities lending, Andrew Dyson at Data Explorers pointed out that stock loans have even made it onto Radio 2, the BBC channel. He added that on a weighted basis lending remained a “vibrant industry”, particularly around dividend season, particularly the latest round of company pay-outs. Further, he said there had been a lot of talk about lenders moving into noncash collateral, such as equities, but this has not happened. “Equities had been traditionally a ‘no-no’,” he said, “but we feel with the right haircuts it can be a

“The question is: has there been a transformation in prime brokerage? Yes. Investors are taking the lead and they want more information as to how the prime brokers are working.” Ashley Wilson, Barclays Capital viable option.” Charles Lowe of Prudential Capital suggested there was a focus on how good risk models were in the crisis. “Lehman Brothers’ default was not predicted. The questions we have to ask ourselves is: ‘how good are these risk models?’ The jury is out and it’s something we’re working on.” Dyson said one of the challenges is how best to communicate the risks to agent lenders. He said one of the most effective methods was to demonstrate how many months’ revenue a company has at risk. A single view of risk management is no longer sufficient.

“It’s all about having information at people’s desks so they can take action.” BGI’s Stefan Kaiser added that it’s important to have one group in a firm to oversee all risks in a holistic way. The company’s model is based on statistical value-at-risk: the model hasn’t changed but the data has. “Liquidity was down and we had to react to that, and we stopped taking corporate bonds based on the liquidity.” He added that if trading volumes go down on a particular security then the firm doesn’t accept that security, and that equities vs equities in distressed situations has been “the way to go. It makes sense to go government bonds but also the equities route.” In the following discussion, on the suspension of lending programmes, Joyce Martindale of Railpen said that the fund didn’t accept cash as collateral. Specifically, she said there was always a danger that the manager of the cash for reinvestment could be appointed “by stealth” by the custodian, which didn’t sit well regarding the accountability to trustees. Hans Van Roekel at SPF Beheer BV in the Netherlands said that the fund only takes G7 or G10 government bonds. He added that there had been also time taken to look into the collateral schedule, including analysis on the high concentration of bonds of certain countries, including bonds of 30-year maturities or longer. John Poole, panel leader, asked if the fund had stopped taking equities, and Mr Van Roekel said yes. Rogier Buurman of Robeco said he took equities as collateral and that it had been “extremely liquid to sell when Lehman Brothers fell.” He added that margins for loans were raised to 115%. Sarah Nicholson of Aviva Investors said her scheme had also increased margins across the board to between 110-115%. “It became apparent that credit ratings were not the be-all and end-all and so we’ve taken to using the CDS market [in our analysis].” Z

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Global Securities Lending 2009

COnferenCes

Miami 26th Annual RMA conference The RMA conference in Miami was a timely event on the back of the two-day Summit on short selling and securities lending by the SEC the previous month. Central counterparty, cash collateral, capital requirements and counterparty risk all found there place in discussion amid an industry visibly increasing in confidence and open to discuss the answers to market challenges. Ed Blount, executive director at the Center for the Study of Financial Mark Evolution, told GSL of the upbeat mood from the delegates within a positive time for the market overall. “I think there was a fair amount of optimism among the attendees. The reports presented from the panels suggested that profitability on a broader base was improving, although the handful of extremely profitable trades that have driven lending profits over the last few years might have disappeared and the market is returning to a more conventional profit model.” Mr Blount moderated the panel on regulation (‘Financial market regulation - What does the future hold for us?’) which included representatives of the SEC, the New York Federal Reserve Bank and the Canadian Office of the Superintendent of Financial Institutions (OSFI). This talk included feedback as to the considerations that the international community had concerning how changes in capital requirements would affect the securities lending industry. The audience appeared to triple from the beginning to the end of the session, reveals Blount, as “attendees in the exhibit areas came to listen to a discussion with really significant implications for borrowers’ capital charges, as well as how the industry is being viewed by the regulators”.

This included equal, related interest from the SEC as to the rules which influence the attractiveness of cash collateral and its links to capital requirements. The structure of tri-party repo was also discussed – another area that the Federal Reserve, separate to the conference, is currently examining. “There’s a lot of intraday exposure in the tri-party repo market that the Federal Reserve wants to contain. That could have a bearing on collateral management for securities lending,” explains Blount. The future profit dynamic was also important to the participants, highlights Blount. “Participants of course want to know if they’re going to make most of their money on specials, or if they’re going to be able to live off the GC trade. “To a large extent, that’s going to be a function of the slope of the yield curve. There’s an expectation among cash managers that short term rates will remain low for a while longer, but there’s no telling when those rates will go up. When that happens, lenders will have to pay higher rebates to brokers, putting pressure on their cash managers, especially those with longer durations on the asset side of the cash pool. That could create negative cash

flow for the lenders.” Blount added that the debate concerning a central counterparty in the US was timely, particularly regarding the need to clarify certain areas. “Most borrowers want to know who their counterparties are. When you have a CCP, your counterparty is the CCP, so there’s no visibility on the back end of the trade. That’s a source of some concern, even though there would be capital efficiencies due to the netting of credit risks.” In the panel, the representative from the OSFI remarked that there’s a zero capital charge for a broker dealer involved in a CCP structure - an attractive proposition on the borrowing side but not for the lenders as the guarantees are those of the broker dealer. Agents operating with an indemnity plan would have to decide whether they or the CCP is to provide the indemnity. James Slater, senior vice president and head of capital markets at CIBC Mellon and a conference co-chair, said: “I was very impressed, not only with the number of people attending sessions, which were record numbers, but the also the number of senior level people taking in the sessions - both of which speak volumes. I thought the quality of the panels was very high, bringing great insight and clarity on some very complex issues. Our industry is at a critical point in its maturation; the timing for this conference was excellent as it came at a time when so many of us trying to get clarity on so many different issues.” Vic Chilelli, COO of LocateStock. com, which provides transparency and access to the hard-to-borrow market, agreed that there was a decent turnout and was a good opportunity both to bring people together and as an industry to be able to react to the SEC’s discussion. Z

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Panel: eurOPean seCurities lending

Panel: European Securities Lending Central counterparty and regulation are among the discussion topics for our panellists analysing the European market.

Jane Milner is a market specialist for securities finance at SunGard

Oliver Madden is in technical sales, securities lending at RBC Dexia.

1.The launch of a central counterparty by SecFinex was a watershed for European securities lending. But some claim that the additional, anonymous counterparties mean that it is difficult to know where a lender’s risk lies, that it could be with the CCP. What is your interpretation of the use of a central counterparty? MILNER: There are now multiple trading platforms on which there is an option for trades to be agreed with the central counterparty (CCP) rather than bi-laterally. Where the option to use the CCP is selected, the risk of the transaction is between the lender and the central counterparty, rather than with the ultimate borrower of securities. As the central counterparty is a different construct (shared ownership across multiple institutions), this results in reduced risk to the lender. Counterparty risk is never eliminated. The CCP has exposure to the borrower and in the event of a default the market exposure is ultimately shared by the larger group of participants utilising the CCP. MADDEN: The concept of a securities

Maria Carina is director, product management at Euroclear.

lending central counterparty, and tied closely to that is exchange-traded securities lending, is a sound one. The challenge for everyone is how it will work in practice. To some extent the industry is still at a formative stage in this regard. The high level benefits are clear and understood from their use in other financial markets; what isn’t clear yet is exactly how it can work in a securities lending environment, which markets or asset classes will lend themselves more easily to the model, and which providers will have the depth of participation to create the liquidity needed. We can though expect the debate to progress quite fast. In this current environment where regulators are looking at securities lending with great scrutiny the relative transparency and well-defined risk management procedures that exchange traded products and central counterparties offer versus OTC products are attractive attributes of the model. CARINA: We believe that the credit risk intermediation function of a CCP is useful in the lending world, especially in view of borrower balance sheet constraints and credit

Keith Haberlin is head of securities lending for Europe, Middle East and Africa at Brown Brothers Harriman.

risk concerns. We also appreciate that the multi-lateral netting role of a CCP is of less interest as securities lending is a one-way market - ie, between the lender and the borrower only. So, it will be necessary to adapt CCP business models to accommodate the specific needs of lenders and borrowers. For example, CCP admission criteria and collateral requirements might need to be reviewed in order to make CCPs accessible to beneficial owners. HABERLIN: The goals and drivers of the central counterparty are not currently clear to the industry. The benefit of central counterparty structures in other markets is chiefly to mitigate counterparty risk; however, this risk is already managed extremely well by the securities lending industry through collateralisation, borrower credit limits, contractual provisions and other risk management procedures. Further, beneficial owners receive additional protection against counterparty default risk through indemnification from their lending agent. The securities lending industry just faced the ultimate counterparty failure stress test when Lehman Brothers defaulted last year, and the procedures set by the industry to mitigate counterparty

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default were proven to work. At BBH, we feel our clients are very confident in our list of borrowers and how we manage the associated risk. They would need to be assured that a central counterparty would not undermine that confidence level while limiting the flexibility beneficial owners have come to expect. 2.Some lenders in the Euronext markets have remained resolute to a non-cash collateral programme, especially as reinvestment has been a key concern of the beneficial owners they service. Are there still any appropriate circumstances for taking cash and chances for this collateral to grow in the near future? MILNER: The key issues around the acceptance of cash collateral are to do with potential additional risks, and the need for relevant expertise, associated with the re-investment of the collateral. In some instances the beneficial owners/asset managers may outsource this responsibility to their agent lender, or alternatively, where the lender has the expertise in-house, they may choose to manage the cash re-investment themselves in compliance with their risk guidelines. This ‘unbundling’ of cash re-investment may, over time, lead to an increased acceptability of cash in the Euronext markets. MADDEN: Cash remains a legitimate option for lenders to consider as collateral – but it is just that, an option, with its own specific risk-return profile that must be clearly appreciated and understood. Cash is not intrinsically a safer or riskier choice as collateral as a security. The risk involved in cash collateral centres on how conservative or otherwise that cash is reinvested – for what tenures, in what instruments, on a segregated or pooled basis, etc. If a lender accepts cash as collateral their cash reinvestment parameters must be very well defined but ultimately cash reinvestment risk is a risk lenders do

not have to take if they don’t want to. CARINA: We are seeing continued use of non-cash collateral in securities lending transactions. The advantage of using this type of collateral is that there are no risks related to cash reinvestment. The management of securities used as collateral can be outsourced to a triparty agent to ease the securities selection and substitution process, among other administrative burdens. Euroclear provides different tri-party collateral management service levels to meet the varying needs of clients, specifically allowing lenders to focus on market opportunities instead of operational, back-office tasks.

“Moving forward, success will be judged more as a balanced blend of risk against reward than was considered previously ” Jane Milner, SunGard HABERLIN: It is important to separate the acceptance of cash as collateral with how that cash is reinvested. Accepting cash in itself may be seen by many as the best possible form of collateral as it provides the greatest flexibility for lending opportunities. However, as we’ve seen, that collateral can be compromised if it is reinvested in strategies and instruments that are not committed to principal preservation and attempt to generate more aggressive yields than may be appropriate for a securities lending programme. Providing prudent investment guidelines are created and then monitored to achieve the aims of capital preservation and liquidity, lenders should continue to consider cash as a collateral option. As the industry continues to evolve and lenders become increasingly sophisticated in their management of securities

lending programmes, the adoption of cash collateral will likely increase. 3.Some European lenders are also resolutely staying with lending on a principal basis. From an operations perspective, including risk management and client reporting, how different is this from acting as an agent? MILNER: The principal and agency lending models achieve the same result, that is generation of incremental revenues from lending ‘dormant’ securities, but the risk of the transaction lies in a completely different place, depending on whether the trade is carried out on an agency or principal risk basis. In an ‘agency’ risk trade the lending agreement, and associated risk, is between the borrower and the end lender, with the agent standing in the middle to facilitate the transaction. In this type of transaction it is common for the lending agent to indemnify the lender against borrower default. Under this arrangement the collateral that the borrower is prepared to give must comply with the collateral guidelines of the individual lender. Where the lending agent is acting as principal, there will be a borrow (or series of borrows) carried out to fulfil a corresponding loan. In each of these transactions the lending agent will be the principal counterparty, and therefore the risk on both sides is with the lending agent, and collateral requirements on the loan will be according to the agent lenders restrictions. Where ‘agency risk’ lending is performed, the Agency Lending Disclosure rules mean that the borrower now needs to know who the end/principal lender is, in order to measure the risk relating to the collateral given. Where principals are not disclosed in this way there is a greater capital implication of carrying out a stock loan transaction. MADDEN: A principal model arrangement is where the owner of the

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securities has direct relationships with borrowers. They may trade exclusively with a single borrower or they could have multiple direct relationships. Revenue generation, risk management and operational responsibilities remain with the owner of the securities. In an agency model, responsibility for revenue generation, risk management and operations is effectively “outsourced” to an intermediary typically in return for an agreed percentage of the gross revenues generated. The intermediary facilitates securities lending on behalf of the beneficial owner but is not the borrower of the securities themselves. Counterparty risk therefore remains between the beneficial owner and the borrower and the beneficial owner retains full responsibility for deciding which borrowers their securities may be lent to, against specific parameters. In turn, the agent has accountability to the beneficial owner to undertake securities lending in accordance with the beneficial owner’s risk policies and lending parameters. There is nothing in theory to prevent the owner of securities (eg, a UCITS fund, pension fund, or insurance company) lending directly to borrowers. In practice though, few do, and for legitimate reasons. Securities lending is a multi-trillion dollar market and few beneficial owners have the critical mass inventory size that borrowers prefer. Securities lending also involves significant operational and infrastructure costs – a key consideration in particular in the current environment where difficult markets and reduced returns have resulted in asset managers needing to manage their costs very tightly. Lastly, and possibly most significantly, securities lending is not the institutional investor’s or beneficial owner’s primary or core focus – managing assets is. For these reasons, intermediaries play a vital role. They have the size, resources and commitment to make securities lending worthwhile and they enable

beneficial owners with all portfolio sizes to participate in, and earn incremental returns from securities lending. Custodians, as intermediaries, typically best fulfill these criteria and have a large pool of lendable assets at the disposal – although they are not the only intermediaries. Specialist noncustodial agents also exist that offer a similar service. Whilst these types of intermediaries could run their securities lending programs using a “principal model” it is more common for them to operate agency lending programs. They do so primarily for capital and credit reasons and because their business models are such that they are not natural borrow-

“Few beneficial owners have the critical mass inventory size that borrowers prefer” Oliver Madden, RBC Dexia ers of securities other than on behalf of their clients. The agency model allows them to bring together their clients’ assets and lend them on a pooled basis – optimising and enhancing returns through scale and through the fact that no one borrower has the strongest demand for every asset class. HABERLIN: The biggest difference between the principal and agency models is that in a principal arrangement, beneficial owners forego additional lines of defense against counterparty risk. While principal lenders will ensure appropriate collateralisation levels, collateral is only one line of defense against a counterparty default. The role of an agent includes ensuring risk is diversified across a broader range of counterparties, and an agent can shift balances among borrowers should specific concerns arise with a particular borrower. This provides an

additional layer of oversight and support to a beneficial owner’s own procedures. Perhaps the best example of this was the expertise and resources agents were able to deploy in unwinding exposure to Lehman Brothers. Following the Lehman Brothers default, we have seen principal lenders recognise the value in working with a lending agent and many have shifted into agency programs. 4.The ‘perception’ of the industry has been cited as critical to its growth, and partly this comes down to how it is viewed and regulated by authorities. How do you assess the industry’s relationship with the European Commission and national regulators after the worst of the financial crisis? MILNER: Securities lending, and its relationship to short selling, is probably under more scrutiny now that it has ever been in its entire history. Part of the issue for regulators is how to be ‘experts’ in all aspects of the financial markets, and how to avoid unintended consequences from any regulations that they introduce. The danger of this was well illustrated by the negative impact that recent short selling bans demonstrated. Subsequent analysis on the impact of the bans, highlighted the fact that they had done more harm than good, particularly in further restricting market liquidity at a time when it was needed the most. It may be that events such as this will mean that regulators recognise the need for a greater understanding of securities lending and hopefully this will lead to a more collaborative approach between market participants and regulators. MADDEN: The industry’s relationship with regulators wouldn’t have necessarily been impacted because of the financial crisis but the fact that securities lending is being discussed by regulators globally perhaps more so

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than at any recent time has to be seen as a good thing. Regulators, by definition, have to take into account and consider the interests of many different financial market participants so opportunities to have direct dialogues with regulators, such as the recent SEC roundtable, are priceless. It allows the industry to improve its profile still further and present itself in a clear, objective and transparent manner. Ultimately the better informed regulators are about the industry the more appropriate their regulations will be. CARINA: During the crisis, when regulators examined the securities lending business, they focused on short selling, having issued short-selling bans in many markets. Market participants were then challenged to ascertain and obey the rules defined by the various national regulators, as nearly all of the countries issued different regulations. ISLA, the securities lending market association, took on the central role of distributing information on the different regulations, and lobbied different regulators to distinguish between ‘naked’ short sales and those covered by borrowing securities, for example. Regulators are still focusing on securities lending practices a year after the crisis. HABERLIN: The regulators now have a much better understanding of the securities lending business, the risks inherent in securities lending, and the role securities lending plays in the broader financial markets. In many ways, the initial short selling restrictions and their unintended consequences have helped to shine a light on the benefits of responsible short selling and securities lending. At BBH, we have made a concerted effort to engage with regulators to ensure they receive a balanced perspective on the business and to ensure any future regulations are based upon a full understanding of the risks involved

and how they can best be managed. The securities lending industry has been presented with the opportunity to develop a much closer, more transparent relationship with international regulators. Through ISLA, RMA and PASLA we need to maintain an effective and honest dialogue with global regulators, including the European Commission. 5.How will the success of securities lending by European players be assessed in a global perspective: will it be based on returns, the scarcity of losses, or some other means of comparison? MILNER: The way in which the success of European players is measured will vary depending on the reviewer’s standpoint. Moving forward, success will be judged as more of a balanced blend of reward against risk than was considered previously. Comparisons are always difficult to do, as it is not necessarily clear whether apples are being compared against apples or pears. Due to the complexities involved I do not see there being a simple form of measurement in the near future, however, another outcome from recent events, the recognition of the need for greater transparency, can do much to assist in facilitating performance measurement. MADDEN: Unquestionably risk is the pre-eminent measure by which securities lending providers are benchmarked today. Securities lending is a demanddriven product so by definition there is an element of return generation that is outside the control of lenders. That is not the case with risk management. Lenders have full control over how securities lending programmes are managed, controlled and how risk is appropriately mitigated in order to both ensure no impact to a manager’s investment management process or, worse still, realise any actual losses. The lenders that will come through the

crisis with their reputations enhanced will be those with strong balance sheets, who retained open, proactive dialogues with their clients and who are able to demonstrate track records of robust and prudent risk management and controls. CARINA: In Europe, success will be evaluated on the extent to which noncash collateral has been optimised, and when cash collateral has been used, how the risks relating to cash reinvestment have been managed. Hence, we believe risk aversion and asset optimisation will be the key factors determining success. HABERLIN: Generally speaking, prior to the credit crisis, securities lending providers were judged using measurements such as utilisation, overall returns, and fee splits. The detail of how risk was managed or how returns were being generated was overlooked in some cases. Now, the industry has turned 180 degrees, and while returns are still the primary reason lenders engage in securities lending, risk management has become the top concern for beneficial owners. The process by which agents are selected has changed with recent RFPs containing more detailed questions about exactly how each provider managed the Lehman Brothers default and how each provider’s cash collateral reinvestment vehicles performed. Beneficial owners are looking more closely into any pending litigation against their providers. Every provider is now talking about intrinsic value lending and focusing on risk-adjusted returns. As a result, lenders need to look at past evidence and how each provider performed during the credit crisis in order to fully understand their provider’s philosophy and risk management practices. Success will be judged on the ability to provide programmes which are transparent, put the clients’ interest first, and which get the balance right between risk and return. Z

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exChange traded funds

New moves into ETFs Craig McGlashan explains the popularity of exchange traded funds and their potential in securities lending in the search for flexible collateral. There is no doubting the increasing popularity of exchangetraded funds (ETFs). According to a report released in October by Barclays Global Investors (BGI), global ETF assets reached a record high of USD 891 billion at the end of August 2009 – 3.9% above the previous high set in July 2009, and 10.6% above the figure for April 2008, which was a record at the time. Companies like Deutsche Bank, meanwhile, now provide more than 100 ETFs which can track a large variety of asset classes, from equities to commodities, currencies to hedge funds. The bank announced in April that db x-trackers, its ETF platform, passed EUR 20 billion in assets under management. This growth in popularity has meant that more and more traders have ETFs on their books, which has led to growing numbers of securities borrowers offering the instruments as collateral. This is part of a wider trend, of course – many borrowers in the industry report that they are seeking to diversify the collateral they receive and move away from cash collateral, given its perceived poor performance during the credit crunch. For instance, at the latest meeting of the Bank of England’s Securities Lending and Repo Committee in September, Joyce Martindale from the National Association of Pension Funds commented that larger securities lenders were looking at segregated collateral pools and revising the collateral they would accept. Stefan Kaiser, a business strategist at BGI’s securities lending team, has also seen this trend develop. He explains that over the past two years his colleagues have increasingly looked at the

possibility of using ETFs as collateral, in addition to more traditional forms such as cash, equities and government

From the borrower perspective, any possible new form of collateral is likely to be seen as welcome, as it will provide extra flexibility debt. Kaiser works closely with iShares, Barclays’ ETF provider, and says that the use of ETFs as collateral has created even more opportunities to work closely together. However, this increase in use is not just down to BGI trying to encourage the use of ETFs in the industry as a whole, Kaiser explains. “It’s also because the brokers that are borrowing from us are increasingly active in iShares so they have a lot of ETFs that they want to finance, meaning they want to pledge them as collateral. A lot of the time they approach us and say they would like to pledge these securities as collateral.”

Clearly, the securities lending industry is beginning to take notice of ETFs and their possibilities. In August this year, 4sight Financial Software announced that it was extending its 4sight Securities Finance (4SF) software solution to include support for the borrowing and lending of ETFs. Jason Hayes, the firm’s North American sales director, said at the time that the move had been taken to reflect the fact that ETFs are becoming “a more prominent feature of the securities lending landscape”. In addition, a number of conferences this year, including the International Securities Lending Association’s workshop at the end of September, have discussed the issues involved with using ETFs as collateral. These developments came after other events in 2008 that indicated a positive future for ETFs in securities lending, including ICAP, the interdealer broker, announcing that it was expanding its i-Sec electronic securities lending platform to include provisions for ETFs and exchangetraded commodities. So what are the advantages of using ETFs as collateral? From the borrower perspective, any possible new form of collateral is likely to be seen as welcome, as it will provide extra flexibility. Even those borrowers who are less active in the ETF field are often likely to be trading ETFs or will have exposure to them at some point. For lenders, however, the advantages are more precise. In standard equitiesas-collateral practice, lenders provide a security that is part of one index and take in a security that is part of another. “Liquidity, volatility and correlation” between these two indices is vital to this process, Kaiser explains, but the correlation between the two securities

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may not be as strong as the correlation between the indices. “But if you take ETFs as collateral the advantage that you have is that, at least on the collateral side, you get that index exposure that the ETF represents, so from a modelling and risk perspective they are actually superior,” he says. Additionally, ETFs offer an inherent diversification, providing reassurance for those investors who were stung by the credit crunch. “Just because you have a perfect slice of that index already, you’re better off than having just one security as collateral,” Kaiser adds. The liquidity argument also has a geographical element. Lenders holding collateral made up of – for instance – Chinese shares would be unable to liquidate them during late London trading, as the Chinese market would be closed for the night. However, collateral could be made up of ETFs tracking a Chinese index but listed on a UK-based index – allowing the shares to be liquidated during working hours. But the world of ETF collateral is not as simple as whether or not lenders accept them and borrowers can offer them. GSL’s Amsterdam Summit on 8th October saw a large period of discussion on the various types of cash collateral reinvestment and the pros and cons of each, and the ETF sphere is similarly complex. Broadly speaking, there are two main types of ETFs: the in-specie (or in-kind) model and the swap-based model. The in-specie structure sees investors hold a basket of securities from the index that they seek to track, resulting in returns similar to the index in general. The swap-based model on the other hand also requires a basket of securities, but these do not necessarily have anything to do with the index being tracked. Instead, the fund enters an index swap agreement with a counterparty which ensures the performance of the

underlying fund to the ETF. Currently, BGI only takes in-specie ETFs as collateral, Kaiser says. This again comes down to the issue of transparency. Various studies suggest that swap-based ETFs more accurately track indices, but Kaiser believes that their structure impacts their ability to be used as collateral. “With physically-replicating ETFs we know exactly what its structure is. Other kinds of ETFs are much harder to know what is really there once you want to liquidate it,” he says. Additionally, swap-based ETFs intro-

“Just because you have a perfect slice of that index already, you’re better off than having just one security as collateral” Stefan Kaiser, BGI duce counterparty risk, as holders have exposure to the bank which writes the swap, although UCITS rules limit this exposure to 10% of the fund’s net asset value. Despite these advantages, ETFs currently take up a very small percentage of total collateral in the securities lending market. While this may change as the popularity of ETFs in general increases, other changes may be needed to boost the market – including regulatory ones. “There are some regulatory hurdles to the growth of ETFs as collateral,” says Kaiser. “ETFs cannot be pledged as collateral in jurisdictions, for instance in Ireland.” This is because of the way the UCITS rules are interpreted in different countries – in the UK, regulators view ETFs as equities, allowing them to be used as collateral, while other countries consider ETFs to be funds. However, there are more practical

obstacles to the increased use of ETFs, according to Kaiser. In normal circumstances, borrowers are able to say they will take securities from an index, for example the FTSE 100. But in the case of ETFs, this is not possible – instead, each ETF offered as collateral must be observed on a “case by case basis”, which is obviously far more time consuming than accepting standard equities. There are also difficulties in understanding the trading volumes of ETFs, Kaiser adds, which can impact on their liquidity. “The trading volume that you see on exchange is not always a good measure for the true liquidity of trading that ETF,” he says. “For example, if you have a FTSE 100 ETF, and there’s only a few million pounds of trading during a particular day, that doesn’t mean that’s all trading that you could do. Looking at how much was traded of an ETF is not a good estimate of what you could trade.” The use of ETFs as collateral seems set to grow in popularity as the instruments themselves become increasingly accepted by the financial world – something that the Barclays report and similar studies over the past year have indicated is already happening. There are obstacles in the way, whether they are a reluctance among investors to alter strategies, regulatory constraints or a prevailing “wait and see” approach. However, the fact that borrowers are always looking for extra flexibility could be the clinching factor, at least when it comes to the first point – a reluctance to change – especially given the current move to new strategies and away from practices that stung lenders during the credit crunch. “A lot of the changes in the securities lending industry are borrower-driven,” says Kaiser. “If borrowers need to finance certain securities then they’ll ask the lender to take those as collateral. If the lender sees an opportunity for their clients to get additional lending balances, they will do that.” Z

SOURCE: Data Explorers

exChange traded funds

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direCtOrY

Consulting MX Consulting is a Securities Financing focused IT consultancy offering innovative business solutions. Experts in project management, Global One, 4Sight, Swift and STP solutions, software development, system migrations and back office outsourcing for the securities financing industry. In 2008 MX Consulting managed the trading system migration of Global One to 4Sight at a large asset manager, built a web-based proprietary payment, exposure and currency management system at a broker-dealer and also concluded a large Swift messaging project for a third-party agency business.

For over 10 years Rule Financial’s specialists have been working alongside their counterparts at the world’s top banks and hedge funds, helping to lower costs, improve productivity and extract the maximum value from IT investments. Our expertise in the management of change, project delivery and complex technology solutions has helped us build long-term relationships on a solid track record of success. Our prowess in system design, testing and rapid application development has earned us a powerful reputation. This means that at Rule Financial we have a thorough understanding of what the front, middle and back offices each require from their systems and processes, thanks to our practical experience and capability across the broadest spectrum of domains. Buy-side or sell-side, in both arenas we’ve attracted some of the best in the City to our doors.

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data services Data Explorers is the leading global provider of market information and consulting services to the securities financing industry and the largest provider of global shortside intelligence to investment managers. Our products provide market professionals with quantitative measures of securities lending, performance and risk. We are based in New York and London and collect data from over 100 of the top security lending firms representing over 75% of the global securities lending market. On a daily basis we process more than 3 million transactions from over 22,000 funds. On 1 December 2008, this included over 220,000 fixed income and equity assets worth more than USD11 trillion in lendable value of which over USD3 trillion was out on loan.

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securities lending eSecLending is a full service securities lending agent and administrator of customized securities lending programs.  Their program has been adopted by many of the world’s largest and most sophisticated asset gatherers including pension funds, mutual funds, investment managers and insurance companies. They are a third party industry specialist providing lenders with customized programs, high touch client service, comprehensive risk management, and superior risk adjusted returns. The firm takes a highly consultative approach with their clients by structuring separate, non-pooled programs and utilizing a competitive auction to determine the optimal route to market for their clients’ lendable assets. Having built their business to incorporate investment practices such as the use of specialists, multiple-managers, unbundling, price transparency, and competition, their approach ensures best execution and also provides clients with greater control over their programs, allowing them to more effectively monitor and mitigate risks and counterparty relationships. Additional information about eSecLending is available on the company’s website, www.eseclending.com.

Northern Trust Corporation (Nasdaq: NTRS) is a global leader in delivering innovative and customized Securities Lending programs to clients whose assets are custodied at Northern Trust and elsewhere. Northern Trust Global Securities Lending is a leader in the industry, operating trading centers throughout the United States, Europe, Canada and Asia to take advantage of markets throughout the world 24-hours a day. Northern Trust’s Securities Lending program is consistently recognized as a top lender; continuously outperforms the RMA’s Aggregate Composite; holds top positions at industry organizations; provides superior relationship management and technology; and maintains a strong 28-year track record.

T: US +1 617 204 4500 T: UK +44 (0) 20 7469 6000 C: Christopher Jaynes E: [email protected] W: www.eseclending.com A: 175 Federal Street, 11th Floor Boston, MA 02110, USA A: 1st Floor, 10 King William Street, London, EC4N 7TW, UK

Chris Doell Senior Vice President Head of North American Securities Lending Client Service +1 312 444 7177 Sunil Daswani Senior Vice President Head of International Securities Lending Client Service +44 (0)20 7982 3850

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technology C: Judith McKelvey T: +44 (0) 207 043 8319 E: [email protected] C: Jason Hayes T: +1 416 548 7922 E:[email protected] C: Peter Sanders T: +61 (0) 2 90378416 E: [email protected] W: www.4sight.com

A:EquiLend Europe Ltd. 14 Devonshire Square, London EC2M 4TE UK T: 44-207-426-4426 C: Michelle Lindenberger E: michelle.lindenberger@ equilend.com A: 17 State Street, 9th Floor New York, NY, 10004 T: US- +1 212 901 2224

W: www.eurexseclend.com T: +41 58 854 2066 F: +41 58 854 2455 E: [email protected] Eurex Zurich Ltd., Selnaustrasse 30, Zurich, CH-8021, Switzerland

4sight Financial Software is a leading supplier of innovative software solutions to the Securities Finance, Settlement & Connectivity markets with offices and clients worldwide. 4sight Securities Finance (4SF) is a flexible modular solution that empowers financial institutions of all sizes, from the smallest direct lender to the global custodian, broker or intermediary on an agency or principal basis. 4SF contains market leading functionality that provides greater automation, faster trading, improved risk management, and enhanced relationships with clients and counterparties. It supports borrowing, lending, repo, swaps and collateral management across the equity and fixed-income markets and provides 24 hour continuous operation, inter desk trading, a ‘global book’, real-time value dated position keeping and a powerful web reporting module, allowing full front to back office processing.

EquiLend is a leading provider of trading services for the securities finance industry. EquiLend facilitates straight-through processing by using a common standards-based protocol and infrastructure, which automates formerly manual trading processes. Used by borrowers and lenders throughout the world, the EquiLend platform allows for greater efficiency and enables firms to scale their business globally. Using EquiLend’s complete end-to-end services, including pre- and post-trade, reduces the risk of potential errors. The platform eliminates the need to maintain costly point-to-point connections while allowing firms to drive down unit costs, allowing firms to expand business, move into different markets, increase trading volumes, all without additional spend. This makes the EquiLend platform a cost-efficient choice for all institutions, regardless of size.

Eurex is one of the largest derivatives exchanges and the leading clearing house in Europe. Wherever you are located, we provide you with access to the benchmark futures and options market for European derivatives. Eurex also offers short term funding products, such as Eurex Repo. Eurex Repo is among the forerunners in providing integrated trading and clearing for repo transactions. Eurex’s latest innovative marketplace is called Eurex SecLend. Eurex SecLend. Europe’s leading investment banks participate as borrowers in the Eurex SecLend marketplace, acting as principal brokers, dealers and intermediaries. They all benefit from Eurex’s leading state-of-theart trading and processing services. For Eurex, service and technology innovation is not just a buzzword. New trends are being transformed into inventions through the adoption of advanced trading practices. Find out more on www.eurexseclend.com.

T: +44 20 7220 0961 F: +44 20 7220 0977 C: Rupert Perry E: rupert.perry@pirum. com A: Pirum Systems Limited 37-39 Lime Street London, EC3M 7AY W: www.pirum.com

Pirum provides a full suite of automated reconciliation and straight through processing (STP) services supporting Operations within the global securities finance industry. The company’s on-line SBLREX service encompasses daily contract compare, monthly billing comparison, mark-to-market & exposure processing, pending trade comparison, income claims processing and custody reconciliation. Subscribers to Pirum’s services significantly increase their operational efficiency and reduce their risk by using Pirum’s solutions, as staff are able to focus on fixing the exceptions instead of using their time to check and process routine business. These automated processes are more scalable and risk controlled too, allowing significantly higher volumes to be managed without corresponding increases in operations headcount.

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With annual revenue of USD5 billion, SunGard is a global leader in software and processing solutions for financial services, higher education and the public sector. SunGard also helps information-dependent enterprises of all types to ensure the continuity of their business. SunGard serves more than 25,000 customers in more than 50 countries, including the world’s 50 largest financial services companies.

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lender PrOfile

Lender Profile - Aviva Investors Sarah Nicholson, head of securities finance, talks to GSL.

the protection of our client so we need to be confident it will stand up to the rigours of a counterparty default.

1. What is your fund’s activity in securities lending? Aviva Investors lend on behalf of a number of underlying insurance and pension funds. The UK based activity is predominantly non-cash collateral, capturing the intrinsic value of long holdings, or versus cash collateral, which is re-lent on a collateralised basis, not re-invested directly in the market, to capture the liquidity premium.

4. How would you assess the overall contribution of securities lending to the fund?

“There are always lessons to be learned from experiencing events such as those over the last 12 months”

2. A recent survey by RBC Dexia suggests that beneficial owners are focusing more on risk rather than suspending programmes. Is this the case with Aviva, and if so, how are Now clients want to understand risk these changes affecting the models, see outputs and have an opsecurities lending programme portunity to question what they mean of the fund? Our underlying clients have always been very engaged in the business and fully ware of the potential risks. We have always had a robust risk mitigating framework, but clearly. over the last twelve months we have reviewed this with our clients, as I am sure everyone has. We have looked at how the framework has stood up to the challenge and whether we can strengthen it further. There are always lessons to be learned from experiencing events such as those over the last 12 months or so. The key change for us has been more in the reporting of the business from a risk perspective, more so than fundamental changes to the risk management of the activity. Historically reporting has been focused on counterparties, balances, revenues etc, and the risk analysis has been more an internal process to manage the programme within the client’s risk appetite.

more readily. This level of transparency and information is exactly what is needed across the industry: clients who are engaged in a business activity they fully understand and that is within their risk appetite and that they are comfortable with.

3. What is your collateral profile, and do you see this changing? The UK business is predominantly non-cash, although we do take cash if there is an opportunity to re-lend on a collateralised basis. The analysis we undertook post the Lehman default enabled us to model how assets classes behaved and their correlations in a real default situation, which led to some tweaks in the profile but nothing very significant. In respect to changing in the future, we are always open to new opportunities driven by collateral supply, but ultimately collateral is there for

Securities lending is an overlay investment strategy, allowing the fund to realise intrinsic value held within assets they have invested in. It does not drive the investment decision or process, but still provides a low risk performance enhancement that shouldn’t be ignored.

5. How do you perceive the challenges in the communication of securities lending’s risks and opportunities? There are a number of different aspects of communication that need to be addressed. To me communicating with the underlying fund owners is the most important. The liquidity they provide by participation in this activity is fundamental to the markets and yet many are not given full transparency to the information they need to make truly informed and robust decisions. It is a challenge for large agent lenders to engage with all their clients fully, and a challenge to many of the funds to give the activity sufficient time to really understand the detail. The industry also needs to engage with the national press, so that when short selling or stock lending are featured the views are at least informed and balanced, although this won’t make for such a good story though so it’s always going to be an up-hill battle. This role of educating in calmer times is very much a role that ISLA can help with, both with the national press, regulators and the industry more broadly. Z

48 | Global Securities Lending Magazine | 2009

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