Gsl 04

GSL

Global Securities Lending

MARKETS

Europe, US INDUSTRY INSIGHT

Auctions, migration, traders PROFILES

Northern Trust, eSecLending GSL ISSUE 04

Lending’s opportunity in parched markets

GBP 50 USD 85 EUR 60

GSL04 Cover_apr15_Pg1.indd 1

Plus: Exchange traded funds Collateral management: technology Auctions in 2009 15/04/2009 10:02

Raising the Bar

eSecLending is raising the bar in securities lending by providing lenders with • • • •

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 exclusive arrangements for specific portfolio segments or on a discretionary 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 2008 Awarded Top Rated and Best in Class 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.

Lend an Ear

GSL News 6

Auctions 26 David Rule, ISLA 11

Paul Lee, at Hermes Equities Ownership Services 24

Andy Clayton, Northern Trust 12

Liquidity 15

Lend an ear The gradual return of revenues and investor money into hedge funds bodes well for the lending and borrowing industry. At the time of the last issue, regulatory clampdowns on short selling threatened demand, and the supply side looked again at the implications of fuelling the financial world’s most infamous trading strategy. The wider financial markets may be near the end of the brief bond bubble, though the tendency for agent lenders to receive fixed income collateral has continued to grow, in Europe in particular.

At the same time, the European repo market has declined as lending money remains a scarcity. On the rise instead is the lending of units of exchange-traded funds, and many reasons can be attributed to this: their competitive price for pension funds in which to to invest; their passivity in a bear market; the number of indexes they can cover as a whole and their liquidity. The popularity of ETFs has led to a rush of potential buyers of Barclays Global Investors’ iShares arm, though what remains more surprising is BGIs decision to put it up for sale at all.

For liquidity will dominate the agenda as pension plans reassess their portfolios. At the GSL Summit in January the liquidity of a central counterparty was mentioned as an issue within the wider debate on the prospective exchange. GSL has frequently underlined the reflexive liquidity benefits of securities lending to their own book and the wider market. If lending and borrowing once again flows freely, the revenues could be invaluable for trustees, and may even help sustain their investment in alternative assets that in some plans have been reassessed on liquidity ground. Collateral and its use have become central to many

debates. Reports from the US showed that cash collateral pools, frequently held as index or mutual funds, could not be tapped by the pension plans that had helped generate them by their lending programs. This has frequently been on top of losses incurred from receiving cash. Instead, redemptions – the word that has been the scourge of innumerable hedge fund investors in the last year – have been put in place. For the management of collateral that can be freely managed, Anthony Harrington explores the tools available on page 23.

2 | Global Securities Lending Magazine | 2009

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43_A

clearstream

Here

Flexible solutions, tailored to your needs. Relationship management, built on deeper understanding. Service excellence - that you can take for granted. Clearstream. Right here, where you need us. Settlement and Custody - Global Securities Financing - Investment Fund Services GSL04 1-15 APR7.indd 3 43_Ad_GlSecurities.indd 1

get more 09/04/2009 17:38 18/07/08 11:53:55

Contents

Contents News

6 | News Top industry stories 8 | News analysis Barclays to retain iShares stake 10 | Across the Atlantic Two trade association figure heads give their view from either side of the pond Editorial: Ben Roberts, Brian Bollen, Anthony Harrington, Cherry Reynard

12 | CEO profile GSL talks to Andy Clayton of Northern Trust about his outlook for 2009 Industry Insight

Photographer: Lucy Johnston Front Cover Illustrator: Morgan Miller Operations Manager: Sue Whittle ([email protected]) Commercial Director: Jon Hewson ([email protected]) CEO: Mark Latham ([email protected])

14 | In a dry spell There are liquidity implications to the decline on the lending side. 16 | Regulation today Coverage of the changes in regulation and how the industry is adapting 18 | The grim repo Brian Bollen finds a decline in European repo transactions and gets market insight Technology

GSL|

Global Securities Lending

2i Media plc UK 16-17 Little Portland Street, London W1W 8BP, UK T: +44 (0) 20 7299 7700 F: +44 (0) 20 7636 6044 USA 410 Park Avenue, 15th Floor New York, NY 10022 T: +1 212 231 8421 F: +1 212 231 8121 © 2009 2i Media plc All rights reserved. No part of this publication may be reproduced, in whole or in part, without prior written permission from the publishers.

20 | Operational View: Pirum Rupert Perry gives invaluable insight into the technology aspect of the industry 23 | Fighting collateral damage Some call collateral management an investment discipline in itself. Anthony Harrington tracks down the leading systems to help prevent loss and further risk.

lending portfolios People

28 | Panel Few areas of securities lending have divided opinion as much as a central counter party. GSL brings together leading industry minds to discuss. 34 | Will Gow - eSec Lending From a financial credit freeze to an environmental freeze - Will Gow at eSec Lending shares his adventure in Antarctica 35 | Trader view Pierre Kherndoudi and Simon Waddington speak to GSL 37 | Migration Adrian Morris of MX Consulting Services explains the challenge of changing legacy systems 39 | Meat of the Meetings Our round-up of the first quarter's events - GSL Summit, Spitalfields Advisors' Forum and the IMN Arizona beneficial owners conference

Companies 4 Sight Software

24

Aleri

7

Allustra

23

Barclays Global Investors 8 BNP Paribas Callan Associates

35 15, 26

Data Explorers 6, 13, 28, 39 Deutsche Bank

39

eSecLending

14, 26 34

ETF Securities

6

EuroCCP

28

Euroclear

6, 24

FSA

6

ICMA

18

ISLA

11,39

JP Morgan Lehman Brothers

39 11, 13

MX Consulting Services NAPF

8

Northern Trust

7,12 23

Omgeo Pirum Systems RBC Dexia RBS

20 15, 36 8

Rule Financial

28, 39 39

SecFinex Spitalfields Advisors SunGard

37



39 17, 28

Zimmerhansl Cons. Serv. 28,39

43 | ETFs explained Ben Roberts gives an explanation as to the structure, use and changes in the market for exchange traded funds 46 | Directory Consulting, data, lending and technology service providers 48 | Statistics SunGard provides a pertinent overview of the market

26 | Auctions Update Will 2009 see an increase in the use of auctions for

ISSN 1759-0728 Printed in the UK

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GSL

GSL Summit|

Lending for Liquidity

Global Securities Lending

neW DaTe

Thursday, 14th May 2009

In parched markets, liquidity must be widely sought, and securities lending can be a vital source. Beneficial owners (pension and insurance funds in particular) can only understand the wider benefits of this liquidity if they are fully engaged with the lending process and understand the potential, the risks, and have opportunity to voice their concerns and views. GSL invites readers to an informative afternoon to discuss this topic along with wider issues of transparency, risk and returns at this crucial time.

GSL Summit

DaTe Thursday, 14th May 2009 LocaTion Four Seasons Hotel, canary Wharf, London 1:30 PM Registration/coffee 5:00 PM Drinks Reception

The event is free of charge to attend but by invitation only. Please contact [email protected] or visit www. GSL.tv for invitation request. Sponsors

28

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News

GSL News Top industry stories at deadline. For more recent updates go to www.isj.tv/securities-lending morning trading, according to Data Explorers. Shares of William Hill, Wolseley, Travis Perkins, Catlin, Beazley and 3i lent to the markert was also found to have increased, according to Euroclear figures. Meanwhile, Data Explorers appointed Lee Olesky as chairman of its board.

Securities Lending Global - Short investors increased their positions in Tiffany significantly as the bite of recession closed any further revenue from US holiday spending. The luxury jeweller’s shares on loan increased from 9% to 14% between November and today, according to Data Explorers, the stock lending data researcher and analyst.

Olesky succeeds Bill Cuthbert, who remains a board member. Market Infrastructure The Australian Securities and Investments Commission (ASIC) extended its ban on the short selling of financial stocks until 31st May, the only developed economy to do so.

Market volatility and potentially damaging investment strategies were given as reasons for the Fourth quarter results fell decision. It first imposed 76%, according to Bloomberg, a ban for 30 days last with its net income declining September. from USD127.4 million to USD31.1 million in one Banks and listed property year. It share price closed trusts had been lobbying at USD23.37 yesterday, up ASIC in the fear that they 15.52%. Net sales in the would be they would be the quarter declined USD841.2 target of short-sellers if the million, a 20% fall. ban were lifted. ……….. In the last month there has ETF Securities, the been a small amount of exchange traded fund short covering, from 15% issuer, is to launch a 'ETF to current 14%, which may Exchange' funded by a indicate the market had consortium of banks, the correctly anticipated that the first of its kind. stock would be up in Monday

The company reports an “overwhelming response” from more than 15 global banks and financial institutions from across the key financial centres of Europe, the United States and Asia to sign up, according to a press release. All ETF issuers have previously been owned and run by single financial institutions. Interested banks have been particularly attracted by the opportunity to provide their clients with access to a platform of the most liquid ETFs across different indices and asset classes. .............. London - The review of financial services and regulation by Lord Turner, the chairman of the UK’s Financial Services Authority, received endorsement from the Alternative Investment Management Association (AIMA). The industry body praised the “impressive and comprehensive piece of work” that it says rightly focuses on banks and not hedge funds, an investment community represented by AIMA. “We are grateful to Lord Turner for his even-handed and measured approach and for not making hedge funds the scapegoat for this crisis.”

The review states that regulators and central banks need to gather better macroprudential information on hedge fund activities. AIMA supports this pledge, it said in a statement, and reiterated that its policy platform on 24th February called for the disclosure of systemically significant information by hedge fund managers to their national regulators - not all assets are managed in a collective fund structure. ……… Madrid - The International Organisation of Securities Commission (IOSCO) published a consultation report entitled "Regulation of Short Selling" prepared by its Task Force on Short Selling (Task Force), which contains proposed principles designed to help develop a more consistent international approach to the regulation of short selling. The report recommends that effective regulation of short selling should be based on the following four principles. Firstly, short selling activities should be subject to appropriate controls to reduce or minimise the potential risks that could affect the orderly and efficient functioning and stability of financial markets Secondly, short selling should be subject to a reporting regime that provides timely information to the market or to market authorities.

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NEWS

Thirdly, short selling should be subject to an effective compliance and enforcement system; and short selling regulation should allow appropriate exceptions for certain types of transactions for efficient market functioning and development.”

Management, it was confirmed by the bank. Benoit Ruaudel, will replace Assayag in the interim until the completion of a merger between the SAI and Lyxor operations within the bank. ……

IOSCO´s recent work to close the regulatory gaps in financial securities markets was endorsed by the G-20 leaders, who met in London on 2nd April. The group’s Technical Committee also published a consultation paper – "Hedge Funds Oversight: Consultation Report" – containing preliminary findings and recommended regulatory approaches to mitigate risks associated with the trading and traditional lack of transparency of hedge funds. The Eurekahedge Hedge Fund Index – a leading benchmark for the sector - rose 1.3%1 in March, on the back of sharp reversals in the underlying markets, leaving 61% of the funds finished the month positive. Redemptions eased further in March, amounting to USD7 billion (net) or 0.5% of the universe, based on the data of 30% of the reporting funds. The index also showed that 96% of all reporting funds have outperformed the MSCI World Index (-12.5%) over the first quarter of 2009. ……. Paris - Arie Assayag is leaving Societe General Asset Management Alternative Investments to set up his own fund called Premium Asset

Washington - Federal Reserve’s Flow of Funds report found that US retirement plans – defined benefit and defined contribution - were down by 28% last year. The Los Angeles County Employees Retirement Association issued four request for proposals (RFP) for a securities lending programme for its USD1.19 billion equities and USD3.78 billion corporate bonds. The RFP deadline was 3rd April. …… US - A survey by Pensions&Investments and Capital Market Risk Advisors found that assessing counterparty risk is still down the priority list for pension funds. Around half the respondents said they did not measure the liquidity and leverage of the funds in which the pension plan was invested. Seventy per cent of the pension executives and trustees admitted they did not measure the counterparty risk for the whole fund. Technology Singapore City - Singapore Exchange Limited (SGX) is increasing the capacity of its SGXNET infrastructure.

This upgrade is scheduled to be completed in the third quarter of 2009. The number of SGXNET announcements filed has grown by nearly half over the last three years. Since last month, SGX has already increased the capacity of SGXNET to cater to an anticipated increase in corporate announcements at the end of this month – when many companies are expected to announce the results of their annual general meeting (AGM) resolutions. SGX anticipates a marked increase in the number of SGXNET submissions between 5 pm and 8 pm from 28 April to 30 April 2009. Companies may release nonmaterial announcements at any time. However, where a company’s Board of Directors has decided that a material announcement has to be broadcast during trading hours, the company should do so only after it has obtained a temporary halt in the trading of its securities.

solution leverages the Aleri complex-event processing platform for immediate and continuous monitoring and analysis, eliminating the need to wait for overnight consolidation and batch computations. Legal New York/Chicago - JP Morgan Chase and Northern Trust have been sued, separately, for losses incurred from their cash collateral reinvestment programs. On 30th March the USD19.8 billion Exxon Mobil filed against Northern Trust citing investment in illiquid as reasons for losses. The Imperial County Employees’ Retirement System filed against JP Morgan Chase following losses in connection with the investment of bonds issued by Sigma Finance. Both funds are seeking class actions stutus. Z

…... Chicago - Aleri, the technology provider, launched a risk monitoring framework for real-time assessments of market and liquidity risk. Real Time Risk Monitoring can also be used to measure counterparty and settlement risk ad can be customised The Aleri RT Risk Monitoring 2009 | Global Securities Lending Magazine | 7

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neWs anaLYsIs News Analysis

News Analysis

iShares deal at endgame Since 16th March, when Barclays Global Investors confirmed it was to sell its exchange-traded fund management arm (sending the bank’s shares up more than 22%), the sale has gripped onto the financial headlines. On 1st April, CVC Partners was confirmed as BGI’s destination of choice for iShares, and at the time of press they were going over the fine details. Barclays will retain the securities lending aspect of the business. The current state of play is a coup for the private equity sector - which had other suitors including Apex Partners against banking rivals such as Goldman Sachs. The bank dropped out of the race on the weekend of the 21st-22nd March, despite at one time considering a rumoured GBP6.5 billion bid, around GBP3.5 billion higher than the number on the table between CVC and BGI. The potentially lower price has perhaps less of a concern for Barclays since 27th March, when it was confirmed that the bank had passed a Government ‘stress-test’ that showed it would not need government aid. The iShares product is arguably one of the most innovative creations in the ETF space and wider asset management in recent years, built basically from the ground up by BGI. The often highly liquid funds suit many portfolio managers looking to move with the index in more volatile times and move as the space unfolds. They have been a revelation in securities lending, which can be used in lending deals in two ways. Firstly, the constituent assets of the ETF – by which it is able to follow a stock market or asset index – can be lent to the market. According to BGI, this accrues benefits to all fund shareholders as the securities lending value is reflected in the net asset value. Secondly, whole ‘units’ of ETFs can be lent by shareholders, which can lead to a direct profit to that shareholder.

US court, UK players The class action undertaken by two UK pension funds against RBS in the US on the grounds of withheld information as to the health of the bank is “not surprising”, according to David Paterson, head of corporate governance at the National Association of Pension Funds (NAPF). The case – constructed by the Merseyside Pension Fund and the North Yorkshire Pension Fund and represented by Cherie Booth, QC, wife of former UK prime minister Tony Blair - has been launched in the US to take advantage of the ‘no win, no fee’ class action principle, which does not exist in the UK and can be costly for the loser. The two funds are suing the beleaguered bank on the back of misleading information concerning its finances in the period before and during its part nationalisation. The bank raised GBP12 billion from a rights issue in June 2008 to shore up its balance sheet - the first of the UK banks to do so - before accepting a GBP20 billion government rescue package the following November. Peter Wallach, the head of the Merseyside Pension Fund, told the BBC that the purpose of its joint action was to hold the bank to account. RBS's decline has made it a ripe target for shareholder action. “We have seen in the US a number of lawsuits launched against financial services companies and banks since the advent of the crisis,” Paterson told ISJ. “Given that RBS has been one of the major ‘fallers’ it would be logical to expect investors to look at the situation in some depth and see if there was some

case for litigation in the US – that would be the more likely ground.” Paterson added that pension funds were likely to demand an increase in disclosure requirements amid the wider investment drive for transparency. “We would expect to see – I hope – a significant improvement in the quality of disclosure in risk management in the accounts that have been published this year.” Issues of accountability are nevertheless fraught with grey areas. Investment by the fund, said Paterson, carries a risk element anyway, and it is the proof of fraud that is the challenge. “There’s fraud, there’s bad management and there’s bad luck: trying to distinguish between the three of them is the challenge for the lawyers and investors for that matter,” he said. The unorthodoxy of two UK pension funds represented by a UK human rights lawyer against a UK bank on American soil is not always successful, he notes. He reports examples where claims in a US courts against other non-US firms have been thrown out on the grounds that a US court would not be the most appropriate vehicle to administer justice. UK shareholders typically have more rights than their US counterparts, even though the class actions culture allows a quicker route to courts. Paterson added that he hoped the UK legal system, that is centred around more ‘comply and explain’ principlebased legislation, would not be overtaken by the US model that more frequently takes companies to court. Communication, he says, is the key to making the UK regime work. “I think whet we’ve been hearing from the regulators and from Lord Myners has been that this regime is workeable if there is an effective dialogue between companies and investors, and investors holding them to account for their strategies. “It’s difficult for the dialogue to take place because of the litigation that hangs over US shareholder relations – for better or worse.” Z

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ISLA & RMA Present

18th

2009

Annual

23 26 june

Conference on

international securities lending Hotel Arts • Barcelona, Spain

RMA conference

The joint U.S./European Securities Lending Conference sponsored by the two recognized industry associations. Issues that influence lending markets in Europe and around the world: • Change in Regulatory Requirements Affecting Securities Lending. • Beneficial Owners: Are You Lending Securities Now? • Industry Leaders: Surviving the Crisis and What’s Next for the Market? • Central Counterparty and Recommendations of ISLA Working Group.

Keynote Address: Risk Management Lessons from the Financial Crisis Juan Andres Yanes, Chief Risk Officer, Grupo Santander, Madrid

This is the conference that identifies best market practices and sets global standards in international securities lending.

Come and join your colleagues for these important updates and discussions! For more information and to register visit RMA’s Web site: www.rmahq.org/RMA/SecuritiesLending/ or contact Kim Gordon (215) 446-4021, E-mail: [email protected] Conference Chair: David Hopton, Managing Director, Santander Global Banking & Markets, London GSL04 1-15 APR7.indd 9

09/04/2009 17:38

aCross the atLantIC

Across the Atlantic

Trade association news from either side of the Atlantic over the last few months.

US: SEC round-up February 2nd Feb - SEC announces the temporary suspension of trading in the securities of Global 1 Investment Holdings Corporation (GOIH) (Global), terminating on 13th Feb. 13. 5th Feb - Robert B. Malhotra is appointed to serve in the SEC’s Office of the Chief Accountant as a senior adviser. 6th Feb: SEC suspends trading in the securities of BIH Corporation 11th Feb - SEC suspends trading in the securities of five Issuers for Failure to Make Required Periodic Filings: The Jockey Club, Inc., Juina Mining Corp., Inc., JumboSports, Inc. (JSIBQ), Just Like Home, Inc. Just Toys, Inc. 17th Feb - SEC charges Robert Allen Stanford and three of his companies, alleging a fraudulent, multi-billion dollar investment scheme. Meanwhile, Kayla J. Gillan was named senior adviser to the chairman Mary L. Schapiro. 20th Feb - The SEC made the following statement regarding its enforcement action against Robert Allen Stanford: "At the request of the SEC, Special Agents of the Federal Bureau of Investigation's Richmond Division today located and identified Stanford Financial Group chairman Allen Stanford in the Fredericksburg, Va., area. The agents served Mr. Stanford with court orders and documents related to the SEC's civil filing against

him and three of his companies. The SEC very much appreciates the outstanding assistance of the FBI in this matter."

4th March - James Brigagliano is appointed deputy director in the agency's Division of Trading and Markets.

On the same day the Commission adopted a final rule adjusting the maximum amounts of the civil monetary penalties for the Securities Act of 1933, the Securities Exchange Act of 1934, the Investment Company Act of 1940, the Investment Advisers Act of 1940, and certain penalties under the Sarbanes-Oxley Act of 2002.

He replaces Robert Colby, who left the agency at the end of February.

24th Feb - Michael A. Conley was named deputy solicitor in the Appellate Group of the SEC's Office of the General Counsel. March 2nd March – SEC charges Oregonbased Sunwest Management Inc., with securities fraud. The commision alleges that Sunwest, which operates hundreds of retirement homes across the United States, lied to investors about its operations and concealed the risks of the investments, exposing investors to massive losses when the economic downturn triggered Sunwest's collapse. Sunwest raised at least USD300 million from more than 1,300 investors nationwide by promising a steady income stream and touting its success in running the properties, according to the SEC's complaint.

April 1st April - SEC charges Edward T. Stein with securities fraud and froze his assets to halt an ongoing alleged Ponzi scheme. The Court also froze the assets of seven entities, which Stein controlled, and the Commission charged as relief defendants, including investment funds Gemini Fund I, L.P. (Gemini) and DISP LLC (DISP), as well as, Prima Capital Management Corp. (Prima), Edward T. Stein Associates, Ltd., Vibrant Capital Corp. , Vibrant Capital Funding I LLC, and G&C Partnership Joint Venture. 8th April - SEC votes unanimously to seek public comment on whether short sale price restrictions or circuit breaker restrictions should be imposed and whether such measures would help promote market stability and restore investor confidence. In June 2007, the SEC voted to eliminate price restrictions. The Commission decided to reevaluate the issue due to extreme market conditions and the resulting deterioration in investor confidence.

Z

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across the atlantic

UK: ISLA view

The International Securities Lending Associations’s (ISLA) CEO, David Rule, writes of short selling regulations, ISLA's GMSLA review and the Lehman default.

The Lehman default understandably led many beneficial owners to reconsider risks in securities lending. Some suspended lending programmes and securities available for lending globally are estimated to have decreased by 10-15%. While it is right that beneficial owners review their risk management, ISLA believes that most can find a way to continue lending within their risk appetite. Indeed, our feedback is that lending supply has now stabilised and some of those that stopped lending in Q4 2008 have returned to the market. Risk concerns centre around counterparty default, but also reinvestment risk on cash collateral and reputational worries following the regulatory actions on short selling. A lot of effort has been made to address these risks by lending agents. For example, an ISLA survey in December 2008 showed that they had tightened counterparty credit limits, raised collateral standards, increased collateral haircuts and restricted further any exposure to settlement risk. Most had restricted collateral to cash or liquid securities such as G10 government bonds and, in some cases, main index equities. Collateral haircuts had been raised and were more tailored to the nature of the collateral and lent securities. For example, the most common haircut for taking equity collateral against equity

loans was 110%. Following the failure of Lehman Brothers, ISLA believes that the great majority of lenders were able to close out any securities lending exposures by realising collateral and repurchasing the lent securities leaving little or no residual exposure.

“Lending supply has now stabilised and some of those who have stopped lending in the fourth quarter of 2008 have returned to the market" So the features of securities lending designed to ensure that it is a low risk activity for a lender – overcollateralisation, daily margining, standardised legal agreement, ability to recall lent securities on demand, indemnification (if desired) by agent lenders – worked as intended. On the issue of short selling, ISLA supports the initiatives by IOSCO internationally and CESR in Europe to develop more consistency in regulation, focusing on disclosure requirements and prevention of market abuse. It also welcomes the statements of support by regulators for securities lending, emphasising its importance in maintaining market liquidity and efficiency. For example, the mandate to IOSCO’s taskforce

on short selling noted, ‘legitimate securities lending… [is] critical to capital formation and to reducing market volatility’. ISLA has engaged a professional writer to produce a booklet targeted at beneficial owners, providing facts about the market and addressing concerns about, for example, risk and short selling. Supported by local members, we plan a number of seminars across Europe for beneficial owners to promote the booklet in 2009. We believe that the potential returns from securities lending cannot be ignored by beneficial owners and that there are ways of managing the risks – through collateral selection, haircuts, indemnification etc – in line with almost all risk appetites, however low. Moreover, an active securities lending market is in the interests of all beneficial owners because of its importance for cash and derivatives market liquidity leading to lower trading costs and more efficient pricing.Z

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ceo Profile

Andy Clayton Andy Clayton was named head of securities lending at Northern Trust seven months ago, is into his thirteenth year in the securities lending division of Northern Trust, and despite a the wider financial turmoil it has hardly seems to be been an unlucky number move for him. The industry continues to provide him with "an opportunity to learn something new every day". Clayton began at Northern Trust in 1986 and started in securities lending as an equity trader in 1993. He eventually moved to head of international trading, including fixed income and short duration. With the content of these two roles it seems inevitable now he would oversee a securities lending division, and in 2003 was made head of international lending and, in 2008, was named global head of lending. New things to learn can be significantly attributed to the changing market: fluctuating demand for both lenders and borrowers; short selling restrictions; wider volatility and credit market issues all combine as significant elements to the lending market. Agent lenders will be a key component in helping fix the securities lending market, he believes. "Transparency and education of regulators and beneficial owners is important." Part of this educationAlso key to operating in the current environment is surrounds understanding the intrinsic value of loans. This is against occasions among other lenders that receive cash collateral to boost overnight liquidity in the case that prime brokers seek to reclaim collateral on the back of declining value of the shares on loan. "At Northern Trust, we strive to extract the highest amount of intrinsic value on each loan... to make trades financially viable, lenders must understand intrinsic value."

of Northern Trust Global Investments talks to GSL about change, risk, regulation and communication

and whether they have the potential to dry up liquidity, making the market less efficient." As global head of lending, Clayton is responsible for the risk and return profile of all market-related activity. "We work with our clients to explain the risks associated with lending and how we mitigate those risk. We have processes in place, and senior committees that oversee, all aspects of our lending program including borrower selection and collateral investment." He is careful to weigh the strengths and weaknesses of installing a central counterparty into securities lending - reflecting the divisions in industry opinonopinion that has become a mainstay of conference discussion. " The real benefits toof CCPs is the ability to help reduce counterparty “We strive to extract risk... and it will significantly reduce the capital required to support the highest amount of lending transactions." intrinsic value... to make securities "However, I do have an ongoing trades financially viable, concern around the operational risk lenders must understand associated with CCPs, which will need to be reduced before this is a widely intrinsic value " viable option." He adds that there could be Northern Trust also has a hand in significant evolution for the concept. In looking towards the future, the regulatory environment. Partners at Northern Trust are on the boards of Clayton says that there is potential for the major industry associations - ISLA, further consolidation in the industry PASLA, and the RMA - he adds, "which - both on the lender side and the gives us the opportunity to help shape borrower side. "Agent lenders will be focused on new risk modeling and the industry and keep our clients informed". transparency. In this light, Northern Financial institutions working Trust has developed a new reporting with regulators will be a significant portal to provide clients with quick feature this year, he says, and cites the access to customised securities lending discussion around the ban on short reports and tools." selling ban as an example. "Northern Trust is actively involved in industry Andy Clayton is the senior vice president associations and working with and head of global securities lending at regulators because securities lending Northern Trust Global Investments is a vital part of efficient markets, providing liquidity and efficiency. However, there is concern around some potential regulatory measures

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cover feature

In a dry spell? A decline in the number of lenders had liquidity implications for both pension funds' portfolios and the markets in which the transactions are made. But greater communication between pension funds and agent lenders is needed and there are encouraging signs. The credit crisis disrupted what had been a 15-year growth in lending, borrowing and participants. The growth had partly been driven by the economies of scale offered by custodial lending agents, mobilising large assets pools drawn from many smaller underlying funds. In so doing they protect borrowers of securities from the administrative burden of dealing with many different funds and became part of the bundled custody service that included collateral management. The demand from hedge funds also spurred growth, and ran parallel to an increased investment into hedge funds made by retirement plans. CalPERS, for example, had increased its allocation to hedge funds from zero to 3.5% in the last seven years. But events leading up to, and including, the collapse of Lehman Brothers, dramatically decreased the volume of available shares. According to Data Explorers Securities Lending Index (DESLI) around 13% of stocks globally were withdrawn from the securities lending market after 1st September 2008 and according to SunGard Astec Analytics around 12% of borrowers left the market. This has had massive implications in terms of liquidity and stability in the capital markets. Securities lending is an oft-cited liquidity mechanism, by dint of the volumes of trades, to the fixed income, equity and the money markets. But the

“Agents have had to accept the fact that the general collateral (GC) lending strategy is flawed in this market environment" Chris Poikonen, eSecLending communication between custodians and beneficial owners in explaining this mechanism has been a continuing subject of debate in industry conferences. With only a partial view of the market, beneficial owners have been inclined to stop lending. Further, reports surfaced at the beginning of February as to the valuation and access problems of cash collateral pools – frequently commingled or mutual funds. As liquidity continues to dry in the wider market, the restrictions that were placed on the availability of this cash

for a pension fund to use for other investments. Custodian banks’ role as agent intermediaries has been essential to the year-on-year growth in volumes that we have seen over the years. Banks can also provide indemnities against counterpart default for securities lending transactions and can manage cash collateral. These have been two crucial factors for many beneficial owners. The Lehman Brothers collapse and recent short selling regulations had a huge impact on beneficial owners view of the business - around 13% left programmes. In many cases, beneficial owners incurred losses in relation to cash reinvestment programmes and the majority reconsidered the risks in their programmes and altered counterparty selection, collateral eligibility, collateral valuation and haircuts, cash reinvestment mandates and indemnities from agent lenders. For the most part, the process

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of unwinding exposure to Lehman Brothers for lenders who accepted non-cash collateral was relatively calm. In most cases agents were able to sell the collateral and buy back the lent securities and there seem to have been very few losses reported from these basic securities lending transactions. For those who accepted cash collateral, however, there were losses. Cash collateral reinvestment is frequently cited as distinct securities lending – it is an investment discipline. There is a much higher risk reward ratio for those who reinvest their cash because the lender has to make a judgement about which securities to invest in. Higher risk securities bring higher returns, but in a default situation this can be problematic. When Lehman Brothers collapsed it created a situation of distressed debt, and impaired and strained the securities that the cash collateral was invested in. Most funds were invested in Lehman Brothers paper, for example, which became virtually worthless. As asset values dropped clients considered exiting lending programmes because they were worried about losses or liquidity risk, but found it difficult to withdraw without incurring losses. Commingled cash collateral reinvestment pools also created problems. The benefits of economies of scale and improved liquidity in pooling the cash collateral, proved problematic as liquidity dried up. Clients wanting to exit at the time of the Lehman Brothers collapse, created disadvantages for the remaining investors. They took a portion of the cash pool with them and caused issues surrounding the attribution of proceeds or losses when a security is sold. Predominantly the US model has always been driven by cash collateral and the European model by non-cash. However, European investors were also affected by the US market. “A lot of our clients took losses on their cash reinvestment programmes -

we are talking hundreds of millions of dollars," says Tim Reucroft, director of research at Thomas Murray. "One of the things that concerned us deeply was the fact that European investors who were involved in cash reinvestment programmes were going through non-regulated conduits and weren’t protected, whereas US investors were going through regulated programmes and they were protected. A lot of our European investors lost a lot of money and so a lot of them withdrew from their custodial lending programmes. There’s a lot of broken relationships out there.” Some commentators have said that the lending agent’s ability to manage the cash collateral pools has now been permanently put into question.

“A lot of our clients took losses on their cash reinvestment" Tim Reucroft, Thomas Murray Bo Abesemis senior vice president and manager at Callan Associates, says: “If they cannot model credit and liquidity risk, and they are ill equipped to deal with distressed debt situations, then beneficial owners will be unwilling to come back to the market. What is needed is a distressed debt manager with proven ability to model liquidity and credit risk.” Jerry May, Securities Lending and Cash manager at Ohio Public Employees Retirement System agrees. “When you look under the surface securities lending is still a sound business, however, there needs to be some more communication from lending agents to the beneficial owners and specifically regarding the risks on the cash collateral side," he says. “I think it was somewhat assumed that boards understood the risks. Boards in particular need to have a level of understanding, which right now is not there. It’s difficult with a public board. Not all trustees are investment experts and you have to

make it very clear and talk in layman’s terms. Agents haven’t, in the past, done a good job of this, although I see more and more now that they are trying to communicate in layman’s terms, and making sure everybody understands by bringing in chief investment operators or chief finance officers to discussions. These are positive changes.” At the IMN Beneficial Owners’ conference in Arizona this year there was a panel discussion entitled “Securities Lending Monitoring in 10 Minutes a Day.” It has been a subject of debate with various commentators. Chris Poikonen at eSecLending for example was surprised by the context of the discussion. “These are not risk-less transactions. It is important for beneficial owners to actively manage their lending program. By working closely with their agent and by implementing prudent guidelines, beneficial owners can mitigate the associated risks that exist. ” May agrees: “I think if you don’t have the resources to devote to the investment decisions and the associated risks, it’s not an investment that should be made. It’s a matter of what resources are available, however, and in the current economic environment I don’t know if any additional resources are going to be forthcoming.” Clients are now demanding much more information and transparency from their lending agents and are spending more time monitoring their programmes. Paul Wilson, managing director of financing and market products, explains that he has seen a shift both within his business but also in the market as a whole. “It would be fair to say that the most sophisticated beneficial owners that I deal with have always had a high degree of oversight and a thirst for knowledge and transparency,” he says. “On the whole all beneficial owner organisations are now moving in the same direction in terms of more information, transparency and customisation and they are paying a great deal more attention to and

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interest in securities lending activities.” There is a drive towards customisation of programmes to allow more control. Wilson explains that J.P. Morgan is customising all components of the lending programmes to a client’s specific needs, whether that is regarding the markets they lend in, the borrowers they lend to, the ability to manage levels of loan activity and discover the reason for loan activity. Also in terms of cash collateral reinvestment strategies being able to determine credit risk, interest rate risk, and liquidity risk. Brooke Gillman, managing director of client relationship management at eSecLendings, says that customisation is something which they have always focused on as the basis of their business model. “We do not pool out clients' assets together,” she says, “we treat each as a separate client and a separate customised programme, according to their indivual and risk/return profile. Our clients are involved in the process and view it as an investment overlay product which the market is likely to replicate. Beneficial owners who have historically viewed it as an ancilliary product to custody services will demand more customisation and transparency in their lending programmes, and most lending agents will need to adopt their model. “The one size fits all model where many clients are placed in the same structures and types of programs and are provided the same services and reporting revenue stream will likely need to change over time as a result of the need to become more focused on individual client objectives and risk profiles." Custodial lending agents are also now moving into a very intrinsic value driven and risk averse type platform. They are moving away from emphasising the cash reinvestment value and focusing on the highest intrinsic value of each loan. According to Abesemis the implications of the departure of lenders and less cash reinvestment are

far reaching. “The lending agents have been forced by the marketplace and current economic conditions to morph into a intrinsic value driven business. This means that the supply, the lendable base of what’s out on loan will adjust as the supply and inventory shrink as the cash collateral will be bound by risk averse type reinvestment policies and guidelines.” This also has implications for the custodial lending model. It puts the onus on the intrinsic demand spread of lending securities as the profitability of cash collateral reinvestment diminishes. “Funding costs have increased significantly during the credit crisis. This increase has heavily influenced the type of collateral broker/dealers

lending – the very complicated nature of securities lending transactions – should participate,” he says. “They are the ones with the large blocks of securities, the inventory to provide the liquidity to the market place. The large institutional investors are the foundations of the mechanics, they are providing the liquidity.” It may be the case that smaller lenders will find it harder to participate as they look at the risk adjusted returns of participation and realise that the risks are not worth it. It may also be that they will look at the ratio of returns versus time spent on monitoring risks in the programme and calculate that it isn’t worth it economically. Gillman says: “Historically securities lending has been viewed as an operational function, which offset “The large institutional the cost of custody services. Today, more beneficial owners view securities investors are the lending as an investment function and foundations of the bring the decision making process for mechanics, they are securities lending into the front office. Whether it’s their portfolio managers, providing the liquidity" chief investment officers or heads Bo Abesamis of fixed income or equities – it will Callan Associates be these people paying attention to securities lending programmes. are willing and able to pledge and Wilson says: “If securities lending is the levels at which they are willing to an investment overlay strategy, which trade, says Poikonen. “The general involves a certain amount of risk, as collateral (GC) lending strategy, where it has always done, how does a client institutions would typically ask dealers or pension fund fulfil it’s fiduciary to carry large easy to borrow balances responsibility if it doesn’t have the in exchange for an allocation of time or resources to provide the specials, has fundamentally changed. oversight. It’s a question that more and Agents have had to accept the fact that more beneficial owners are going to this strategy is flawed in this market have to ask themselves and it may lead environment. They will now gravitate to certain funds decide that they don’t more towards pure intrinsic value want to participate in lending.” lending which is a back to the basics Over the next year custodial and approach, focusing on extracting the securities lending mandates will most out of every security. It will be probably move around as beneficial less about pumping out huge volumes owners look for agents who match in exchange for specials." their risk appetite. The practice of According to Abesemis, the small to predominantly offering commingled mid sized institutional investors should fund solutions for cash reinvestment probably not participate in securities rather than creating segregated lending. “Only the large institutional accounts will be a differentiating factor investors with the staff and resources as with ability to evaluate liquidity and to address the many facets of securities credit risk. Z 2009 | Global Securities Lending Magazine | 15

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REGULATION TODAY

The furore over short-selling has put securities lending in the spotlight. While it is acknowledged that securities lending creates liquidity and hedging opportunities to investors, the industry has suffered some less welcome associations of late. Lenders fretted that their own stocks had been unscrupulously used to drive down share prices by abusive hedge funds. Many lenders consequently suspended their lending programmes pending a thorough investigation of their lending arrangements and a return of some certainty to the value of stocks. An element of certainty has returned and a number of lenders have restarted their programmes, much to the relief of lending agents and borrowers. All participants, however, are awaiting the full extent of new regulatory requirements and the level of disclosure that will be expected of them. And while no-one will openly oppose a principle of greater transparency or insist that there is more than enough of it already, there is a clear concern that new measures may not be fully thought through, and the benefits to lenders and borrowers may not outweigh the cost of meeting the requirements. Securities lending, as an over the counter market with no central exchange or counterparty, is one of the least transparent sectors in the financial markets. Deals are done through private negotiations and disclosure is minimal. The UK’s securities lending industry is pursuing the call of greater

transparency in two main areas. The first of these is agent lender disclosure (ALD), where the agent lenders must disclose to borrowers exactly who the underlying lenders are in each transaction. Such arrangements have been in place in the US since December 2005. A number of highprofile defaults in the early part of the decade had alerted the Securities and Exchange Commission to the inadequacies of agent lenders’ levels of disclosure and the effects on borrowers’ credit exposure analysis. Agent lenders were then mandated to provide full details to borrowers of the underlying lenders or beneficial owners involved in transactions. A similar initiative has taken place in Europe although it has been more inspired by the capital adequacy demands of the Bank of International Settlements’ Basel II guidelines on risk management. In order to meet their Basel II obligations and lower their capital charge, borrowers need a complete picture of the underlying lenders in their securities lending arrangements. These initiatives have the support of the industry’s most prominent association the International Securities Lending Association (ISLA). “We certainly welcome standardisation of reporting to help agent lenders be transparent and allow lenders and borrowers lenders and borrowers make more informed credit decisions and monitor their business,” says David Rule, chief executive of ISLA. The association has established the ISLA EU ALD Working Group, which contains a number of agent lenders and borrowers. The working group issued a model for agent lender disclosure in Europe back in June 2008 which stated the intention to follow the US model where possible in terms of standardised file formats and replicating the use of a single data

Rule changes to improve transparency has led some to questions the regulator’s own clarity exchange hub such as the one provided by the US-based Depository Trust and Clearing Corporation (DTCC). But transposing the reasonable successful US model to Europe’s fragmented and complex market is not so straight-forward. And while the general principle is supported, there is some concern about the practicalities involved. “Agent lenders will have thousands of lenders in their securities finance programmes and to provide all of this information is a complex undertaking, so it is important that the industry finds a way to introduce a consistent framework,” says Oliver Madden, technical sales, Securities Lending, at RBC Dexia. Madden adds that while the bulk of the ALD obligations fall on the agent lenders, borrowers have an obligation to use the information provided. “It is up to the agent lender to provide full details on a daily basis of all outstanding loans and collateral and to get all that data together in a standard format. It is then up to borrowers to be able to accept that data in a standard format and actually do something with it in terms of calculating their credit risk exposure and then use it within their capital models.” With so much emphasis on standardised file formats and exposure modelling, systems vendors providing platforms and frameworks are integral to reaching this end. And while they are no doubt pleased to have this role, many would prefer a great deal more certainty over what the requirements will be before they can commit to any serious development work. “From a vendor’s perspective, the first requirement is to have a clear interpretation of how the regulatory framework applies to the securities finance market,” says Jane Milner, solutions specialist for Securities Financing at systems vendor SunGard. “For example, the capital adequacy

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requirements for Basel II were meant to have taken effect in 2008 but here in the UK there is an FSA approved interim solution until January 2010, and people are still talking about how the requirements should be interpreted and whether they are applicable to them.” Milner refers to the experience of ALD initiative in the US as an example of regulators, industry participants and system vendors all working together to achieve the same end. “Everyone was involved from the beginning and able to contribute to the practicalities of the systems needed. It was a successful project and demonstrated the importance of having all parties, including technology solution providers, involved.” SunGard is working with the ISLA on the extensions that will be needed to current systems in order to meet the likely changes to ALD requirements, the first of which is expected to be the move from monthly or quarterly reporting to daily reporting. The more complex extensions are likely to centre on the international securities lending market and where there will be some additional functionality required, particularly relating to triparty collateral management, repo and reverse repo processing. “For the vendors it is a challenge,” says Milner. “We have clients asking whether our updated solution will be available by January 2010, and yet details of the business requirements are still being debated. Nevertheless, it is an interesting space to be in.” Short-selling disclosure There is a general acceptance of the ALD requirements’ priciples, despite some future updating. The same cannot really be said of the vague proposals surrounding the disclosure of short-selling positions within securities financing arrangements. When the FSA introduced a ban on short-selling in September 2008, it also mandated that market participants disclosed any short positions in excess of 0.25% of any of a selected number (34) of firms’ share capital. The ban

expired in January but the following month the FSA suggested that it was considering extending the disclosure rules and applying them across the board, adding that it also believed that these proposals should be aligned with those being developed on an international basis. This has concerned those in the securities lending market who have sought to disprove both the link between securities lending and shortselling and short-selling and falling share prices. “Our view is that if you are worried about short-selling then you should be looking at short-selling positions, not securities lending positions,” says ISLA’s Rule. For example, research commissioned by ISLA along with the Alternative Investment Managers’ Association and the London Investment Banking Association and carried out by Norman Niemer of London-based Cass Business School, showed that the emergency shortselling restrictions introduced in various markets had no impact on the behaviour of stock returns. Back in September 2008, when the fears over short-selling emerged and the links with securities lending were insinuated, the industry was unable to produce any market-wide data that could disprove the allegations. “There is a lack of quantifiable information regarding short-selling,” says RBC Dexia’s Madden. “When there was concern from the public and the regulators that short-selling was driving down share prices, the securities lending industry was unable to quickly produce data showing daily or weekly volumes of short-selling transactions. This left the industry vulnerable to these accusations from people outside the market because it was unable to produce any figures to disprove them. “The FSA admitted that in normal market conditions short-selling was a legitimate practice; however, they now consider we are in abnormal market conditions. But where do you draw the line between normal and abnormal?

We really need to put quantifiable measures on all of these adjectives and accusations that are being used. Until we can find an easily understood way to quantify these issues and put them in context, beneficial owners can’t tell if this is a storm in a teacup or not.” There is feeling within the National Association of Pension Funds that, while disclosure is obviously welcomed, there must be some consideration made of the practicalities and cost involved. “To press for more disclosure in stock lending is not helpful unless you can make explicit what information you want and why,” says Julian Le Fanu, Policy Adviser: Investment Regulation and Funding at the NAPF. “I don’t think that investors want to see every detail of every transaction and there are circumstances where the disclosure can become so voluminous that people lose sight of the wood for the trees.” He cites the example of companies’ annual reports, which are often so vast that any potentially interesting information contained within is lost and clearly there is a desire that the same thing should not happen with stock lending disclosure. There also needs to be clarity and consistency, says Le Fanu. “You cannot have vague requirements. If you allow each agent lender to make their own judgments on what should be disclosed then the figures will become meaningless for investors. We see a need for greater disclosure but you have to be very careful that it is justified in terms of benefit and cost.” The challenge is in being able to mandate disclosure in the areas that are of most concern to lenders and investors without having to have every single transaction disclosed, therefore avoiding the prospect of an information overload. The FSA has issued a deadline of next month for the industry’s responses to its short-selling disclosure proposals. The clock is set, let the lobbying, the negotiation and, above all, the co-operation begin. Z

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EUROPEAN REPO

The grim repo Brian Bollen tracks the decline in repo transactions in Europe. a huge shock to the system and we are witnessing a sea change. Things are worse than people thought.” The contraction reflects other realities, however. Bank consolidation has caused other contributors to the repo market to follow Lehman Brothers off the survey. Domestic repo business also continued to decline, Comotto adds. “This is a structural trend over several years, as operations become concentrated in one geography, leading to growth in cross-border business. This bears out the ECB’s observation that people are not repatriating repo.”

The results of the latest survey International Capital Market Association (ICMA) survey of the European repo market makes for interesting reading. The headline figure shows that the total value of repo contracts outstanding on the books of the 61 institutions surveyed was EUR4,633 billion, down more than 28% from EUR 6,504 billion in June 2008 and the peak of EUR6,775 billion reached in June 2007. This is the most severe reduction in the headline number since the survey began in 2001. The survey goes beyond the headline figure, however, as this reflects the activity of what Richard Comotto, the survey’s author, says is a changing sample. Using a constant sample comparing the aggregate returns from a sample of institutions that have participated in all of the last three surveys - the European repo market contracted by almost 26% in the six months since the June 2008 survey, after a modest contraction in the previous six months. The average size of repo books has shrunk since June 2008 from EUR107 billion to EUR76

The nature of collateral is changing significantly as market participants review their use of repo and scrutinise their operating parameters. The billion. share of the market underpinned by An increase in deleveraging – an government bond collateral increased, institution reducing its borrowed money – due to a declining appetite to rising to 84.7% from 81%, reflecting fund riskier investments, is the primary the desire of market participants to reduce risk and undertake a flight to reason for the decline in ‘repo’ deals, Comotto finds. The collapse of Lehman quality. The percentage of German Brothers, a pivotal event throughout the collateral has jumped, to 29.8% from 25.5%, an increase of nearly 17%. Relative spreads between bonds “There is a concentration issued by different governments in Europe are widening as participants problem if all if a CCP differentiate more clearly between their blows up, with all your respective credit risks. Debt issued by the government of Greece, for instance, eggs in one basket” has fallen off a cliff in the recent past Richard Comotto ICMA with the spread for overnight financing of Greece versus Germany widening Centre to 30 bps and on the 10-year issue to 300 bp - observes Godfried de Vidts, chairman of ICMA’s European Repo financial markets, was a catalyst. Council. “The earlier survey did not show a serious effect; although some market Securities lending off repo desks, participants were cutting back, others which had climbed to 21.7% of total were stepping in to compensate,” he says. outstandings, fell back to 12.5%, hit “But [Lehman] has raised everyone’s fear badly by the low number of special of counterparty risk to a new high. The stocks, and the huge appetite for survey really did confirm that people bonds. have had difficulty funding profitable With falling equity values in a risk-taking opportunities. This has been

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number of markets, most notably banking, some might find it odd that the equity repo market has held up relatively well. “In fact, it enjoyed a boost,” says Richard Comotto. “You can always price equity, and people are taking a new look at it as collateral.” It is probably safe to say, though, that demand for bank equity collateral will remain subdued for the time being. Another key influence on repo transactions has been the shortening of maturities, despite the distorting effect in December as banks seek to lock in funding at year-end – another hint as to the concern at reducing risk. ICMA argues that the European repo market has continued to function as an essential source of liquidity for financial institutions throughout the worst of the market difficulties. It is also clear that the long-running trend towards secured forms of financing and away from unsecured forms of financing is even more well established than ever. “The unsecured market is dead, and won’t come back,” says de Vidts, who is also head of European affairs at Icap. If anything clear-cut has emerged from the fog of recent events, it is arguably the reinforced desirability of dealing with a central counterparty (CCP). Those arguing in favour of a CCP say that it is an attractive way of doing business for a number of reasons. One, it shifts risks to a common pool. Two, initial margins provide a degree of protection. Three, it allows offsetting and netting, improving collateral management. “We see from the survey that while the political and regulatory debate regarding the use of CCPs continues in other markets, the repo market has been ready to embrace the benefits of netting and avoidance of counterparty risk,” says de Vidts. He warns against complacency, however, and reminds market participants and infrastructure providers that much remains to be done to reach the goal of a single competitive European capital market. “Barriers that still exist for some

Euro government bonds in the use of CCP services need to be resolved immediately,” he says, and notes that it is not possible to use third-party repo in Greece and Spain, or that Eurex Clearing remains inaccessible to other trading systems. His message to infrastructure providers for fixed income securities and equities is a simple one: allow full access and interoperability. “Only an open, competitive landscape can provide stimulus for growth in the secured markets and the benefits that this brings. It is not a panacea, but a well capitalised CCP can help increase market efficiencies and reduce costs,” he continues. While Richard Comotto agrees that a CCP is helpful for providing a means of net risk reduction, he feels it would be a mistake to force all kinds of financial business through a CCP.

“While the political and regulatory debate regarding the use of CCPs continues in other markets, the repo market has been ready to embrace the benefits of netting and avoidance of counterparty risk” Godtfried de Vidts, Chairman, ICMA European Repo Council “That’s scary,” he says. “You can’t have a one size fits all solution. There is a concentration problem if a CCP blows up, with all your eggs in one basket, and it’s not suited to all types of business. You have to plug into a CCP, and trade electronically, or at least have a means of entering your deals very very quickly. It’s not suitable for low volume participants or retail participants, and it’s not suitable for structured deals.

Inevitably, the question is: what happens now? It will be interesting to see how we move forward,” Richard Comotto told GSL. “Back in June last year we saw signs that the instability was moderating, but of course Lehman set the whole market back on its heels again. Repo is obviously still fundamental to the whole financing process. Unsecured financing has its place, people will always do it but only with the very best counterparties. For anyone else, in the current environment it is extremely difficult to do and you wouldn’t want to be over reliant upon it ever again; people want collateral. Repo continues to function, although on restricted terms. It is the main financing tool so as financing needs are cut back, repo takes the hit. It’s a flexible tool. It’s easy to do and it’s easy not to do.” But is the investment banking model really broken, as some market commentators have claimed? That is possibly a more difficult question to answer, and could depend upon the area of activity. But even as the financial services world goes to hell in a hand cart, investment bankers are finding ways to make money. It is almost reassuring for those desperate to convince themselves they can see green shoots of recovery, however tender those green shoots might be. Richard Comotto suggests that investment banking will in essence continue, though for “public consumption”, participants “might prefer not to call themselves investment banks” Forms of funding may change also, he adds. “It was the excess to which the originate and distribute technique was pushed, rather than its creation, which created problems... It’s a question of degree. Highly structured obscure securities are not welcome. People will not stop securitising. People will not stop leveraging.” Z

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PIRUM

technology

Operational view

Rupert Perry, co-founder of Pirum Systems, explains the workings and necessity of contract compare and brings together common industry feedback

What’s the point of Automated Contract Compare? Running automated Contract Compare for all open positions and actively reviewing the resulting breaks every day is recommended as a “Best Practice” by both The International Securities Lending Association (ISLA) and The Risk Management Association (RMA). The key benefit it provides is a daily verification that the core books and records for open stock lending / repo transactions are accurate and complete. This mitigates the plethora of risks associated with incorrect positions and significantly reduces the time spent investigating break issues in downstream processes.

We’re too busy to look at contract compare...

When operations teams get busy or staff turnover is high, contract compare is often one of the first operational processes to suffer. Whilst in the short term, a reconciliation not done today can always be picked up tomorrow, if work pressures remain over an extended period, tomorrow soon becomes next week, then next month and before long, breaks may not have been reviewed or investigated for several months. Accurate data is the foundation for the smooth running of almost all other post-trade operational processes, so when data integrity cannot be assured, exceptions in the exposure, marks, returns, monthly billing, and dividend/ coupon claims processes will often cause much more time to be spent in these areas than normal. There is no doubt that dedicating time to clearing contract compare breaks actually saves significant time and effort overall given a holistic view of all post trade processes.

For example, the correct calculation of dividend/ coupon claims requires accurate positions and matching dividend rates. When positions and dividend rates have not been agreed with the counterparty, any undetected differences will delay the payment of claims and has the potential to cause significant funding costs to Lenders who have a contractual requirement to pay dividend claims to beneficial owners on the dividend pay date. Often these breaks are much harder to resolve once a claim has been issued, as the underlying error may have occurred some months earlier. When fee and rebate rates or positions are mismatched, the resulting billing difference at monthend will often cause payment of the bill to be delayed (sometime by many months), whilst the source of each discrepancy is investigated. Furthermore, internal P&L reporting will probably then be inaccurate and may require significant adjustments to

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PIRUM AD CONCEPTS FINAL:Layout 1

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technology

“A depot reconciliation with the custodian is a useful control, but it does not provide much assurance about the accuracy of stock loan transactions in your books and records system”

be posted after month-end. Automated contract compare is also a very useful way of ensuring that your counterparty has accurate books and records too. Even when it turns out that your own records are accurate, you may need to expend significant operational effort proving the accuracy of your data if your counterparty thinks otherwise.

But we reconcile our positions manually... Whilst it is possible to reconcile stock lending transactions by hand, it’s a very time consuming process (unless there are only a handful of trades open) and it’s uneconomic to do this on a daily basis. As a consequence of infrequent reconciliation, breaks tend to be numerous and differences will often remain undetected for significant periods of time causing increased operational friction. Manual reconciliation also lacks the common workflow for communicating, clearing and assigning breaks that an automated comparison tool provides.

because collateral pledges (other than pool cash) do not appear on the billing statement and contractual elements of the trades which do not affect billing are not shown and cannot therefore be verified (e.g. dividend rates and term dates). Another key issue with relying on billing reconciliations alone is that discrepancies will rarely be identified on a timely basis, as billing by its nature is always looking a month behind. The timeliness issue also has a tendency to make the breaks harder to fix, as traders can more readily recall what was agreed when a break is identified promptly than they do if it isn’t brought to their attention for some weeks or months. Z

“If work pressures remain over an extended period, tomorrow soon becomes next week, then But we reconcile our depot next month” positions with our custodian...

A depot reconciliation with the custodian is a useful control, but it does not provide much assurance about the accuracy of stock loan transactions in your books and records system. For example, trades may be booked with the wrong counterparty or with incorrect fee, rebate or dividend rates without causing a depot break.

But we compare our billing statements each month... Unfortunately a billing reconciliation on its own cannot verify the accuracy and completeness of all positions, 22 | Global Securities Lending Magazine | 2009

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Fighting collateral damage Events in the financial markets since the collapse of Lehman Brothers have been unprecedented and extremely stressful for many participants. They have also brought about some fundamental rethinking of the role of collateral management in de-risking trade between counterparties and in helping to drive greater transparency and increased efficiencies through the system. Tim Lind, managing director, Strategic Planning, at Omgeo, which specialises in operational risk management and in collateral management, says that buy side players are now very focused on the technology that they need to manage credit risk with the broker dealer community in OTC trades. Despite the calls on every hand, from governments and regulators for virtually all trades to go through a central clearing process, the demand in the market for bespoke derivatives contracts is bound to resurface in strength, and these deals, by their nature, will be bi-lateral. Whether the details of the transaction will loop through a clearing or registration process once the contracts are formulated is another question, but the nature of the deal will be one on one into the distant future, he argues. Hence the issue of counterparty risk and the need to mitigate that risk will remain. The two key elements of the transaction infrastructure which were thrust into the spotlight by the failure of Lehmans, he suggests were the need for certainty as to what the universe of contracts is with counterparties, and the ability to achieve a reconciliation of the value of those positions. “Without certainty as to what the universe of contracts is, how could you possibly manage your risk exposure?” he notes. When you know the exposure, the parallel question is:

career,” Lind says. Paul Wilson, 4sight Manager of Roadmap Project & Conceptual Design, Customer Collaboration and Business Analysis says that while it is undeniable that volumes in the market have plummeted since the current crisis began, the pause has given companies time to rethink risk mitigation through collateral management. “We now have the one commodity that has been in limited supply – time! Wise institutions looking to the future and “Without certainty as a return to greater volumes have had some breathing space to plan, develop to what the universal and test new collateral management contracts is, how could software,” he says. The rush is on to get ready for the 2009 dividend season. you possibly manage According to Wilson the company your risk exposure” has seen a marked increase in interest for its Xpose Collateral Management Tim Lind, Omgeo module. “We’ve been installing one a have I mitigated that risk properly with month since November and we have had serious requests for enhancements,” sufficient high quality collateral? he says. These have been particularly in In fact Omgeo was drawn into the the area of collateral eligibility, haircut collateral management arena because rules and liquidity/concentration it felt that the infrastructure available to clients to manage credit risk did not scenario analysis – all areas which, in match their appetite for the derivatives the past, have not been huge priorities for clients, but which have now moved space. “There was an imbalance, long right up the agenda. before Lehmans, between the risk “Clients willing to participate in infrastructure and the types of trades securities lending programs and being engaged in. It follows after Lehmans that buy side firms will be even associated cash collateral reinvestment more willing to invest in infrastructure programs are going to want to perform very strong due diligence on the to manage this,” he says. reinvestment managers risk policies Omgeo bought Allustra in 2008 and and systems for liquidity risk, liquidity acquired a standardised product to pooling and duration risk,” he says. His manage collateral and the exchange of company will be releasing a module for collateral with broker counterparties. Q3 2009, the Cash Mismatch Monitor, “The experiences of recent months designed specifically around duration have only heightened the relevance of risk analysis. this kind of system,” Lind says. What With the focus swinging increasingly the crash showed was that exposures to liquidity risk management, that companies did not think were particularly on the part of regulators, particularly large or dangerous turned out to be massive. “There is now a new collateral management systems have a level of introspection in the sector that role to play and suppliers must expect their products to be affected, Wilson I have not encountered before in my 2009 | Global Securities Lending Magazine | 23

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says. “Any regulation dictating requirements- especially if combined stochastic and deterministic quantitative methodologies for institutional short and long term liquidity analysis are part of the equation- leads to potential complex development work and performance handling. Someone has to pay for all of this, so it’s important for collateral management technology providers to be an integral part of the conversation,” he argues. As a result of the crash there has been a real flight to quality in the collateral space and unratable structured products have disappeared off the map. This in turn has shrunk the available pool of acceptable collateral fairly dramatically and has led to some real trading difficulties, particularly, for example, US Treasuries. “What we have seen, beyond doubt, is that the quality of collateral risk management, the efficiency of liquidity controls and the need for fine grained daily control of the allocation across pools, or client’s accounts, have been getting sustained attention over the last six months to a year. The front runners here have been innovative and technology-savvy institutions who wish to seize opportunities for business by being more flexible and diligent in their collateral management offerings and control systems,” he comments. In his view, 2009 will see more of the same, with a continued focus on risk and control, on workflow automation, collateral adequacy and liquidity controls, all going with an increased use in triparty agents. Cedric Gillerot, Euroclear Director, Product Management Collateral Services, points out that in the secured money markets, the reduction of repo transaction volumes reflects a massive deleveraging by banks. The securities lending market has woken up to the complexity of some risks inherent in securities lending as a consequence of the failure of Lehmans, and it too has contracted. The focus, going forward, will be on risk mitigation

and while Gillerot argues that it is still too early to specify the technological components that will be involved, it is clear that automation and control of the post trade settlement process will be key requirements, along with timeliness and granularity in reporting. In the US where cash has always been by far the most used form of collateral, providing an important and fungible source of reinvestment, collateral risk has a very specific meaning. Cash reinvestment is a business in itself with its own risk and returns. In Europe, Euroclear bank and other triparty agents have developed securities lending infrastructures and services to facilitate the use of securities as collateral. This makes it easier for lenders and borrowers to strike agreements by providing lenders with the ability to specify a pre-defined range of acceptable securities collateral, in a risk controlled environment. “With Euroclear’s service, the integration with securities settlement and custody, and a solid IT risk framework, translates into strong benefits in terms of collateral servicing,” he says. Counterparties benefit from a very high degree of automation, scalability and optimisation in the processing of their collateral resources. This reduces back office costs and risks, but it is also vital in enabling firms to understand the procedures and challenges inherent in liquidating collateral, should that be necessary. “In Euroclear Bank’s triparty environment, the collateral positions are transferred into the collateral taker’s segregated collateral account. This enables not only a constant monitoring of a firm’s collateral holdings, but also the immediate realisation of collateral in the event of a counterparty defaulting,” he says. Jean Robert, Head of product management for global securities financing at Clearstream says that their experience of the market in recent months has been anything but quiet. “The monthly outstandings for our GSF products, which cover triparty

repo, securities lending and generic collateral management, has reached new highs,” he says. The last month in particular has been well above 460 billion, compared to a 2008 peak of 398 billion. However, Robert points out that large amounts of collateral have moved from the interbank repo and triparty repo market to Central Bank funding facilities and the GC basket repo product provided by CCP, such as Eurex Repo/Eurex Clearing (EuroGC Pooling). “What we are finding is that collateral optimisation is more important than ever, and this is exactly where technology can make a difference. Settlement interoperability, real-time processing and on-line access have become absolute “must haves” for any collateral manager,” he says. At the same time there is a heightened awareness in the market of collateral reinvestment risk and the need to mitigate this. Cash collateral reinvestment is now a major theme. “For a long while it was the major contributor to the profitability of lending programmes and some beneficial owners have recently understood to their cost (not to say, losses) why it was so profitable! We are now seeing a real interest from lenders for our most conservative securities lending programme, versus non-cash fixed-income collateral. It is quite clear that risk management is now much higher up the agenda than absolute return when looking for a new securities lending service provider,” Robert says. As we move forward balance sheet deleveraging and careful management will continue to mandate, and even accelerate the optimal use of non-cash collateral, Robert argues. All assets on the balance sheet will need to be converted into collateral one way or the other and technology will be needed to leverage other asset classes than just cash and fixed-income securities. Equities, investment funds, bank loans (credit claims) and commodities will all be part of the mix. Z

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AUCTIONS

Auctions make a bid for growth

Some thought auctions would be a credit crisis casualty. Cost issues for beneficial owners who sought to auction assets themselves, and the demand for the more esoteric portfolios suited to the auction market, were set to dry it up. However, as yet, this does not appear to have happened. Of the USD16 trillion securities lending market, only around USD2 trillion is put to auction, according to eSecLending. This has come down as assets have depreciated. Greg Korte, principal of Korte & Associates Consulting, says those who are invested in it have to convince their managers that it is a profitable idea. “They have to assess how much it will cost, both financially and in terms of time and oversight. “There is real oversight involved and you have to ensure it is worth it for the investment scheme,” he says. But the issue of oversight is a problem most pertinent if a beneficial owner is organising the execution and management of the auction in-house. “Most beneficial owners often do not have the resources available in-house to manage effectively all aspects of risk in their lending program,” says Christopher Poikonen, head of global trading and product development at eSecLending,. We offer the tools and reporting that they do not have in house to assist them in effective monitoring.”

Bo Abesamis, senior vice president and manager, Callan Associates, says that there will often be insufficient people in the back office for clients to go about their own auction process. The revenues from securities lending are often not substantial enough to warrant a dedicated person or investment in auction software. Abesamis adds: “If the intention is just to maximise revenue everyone would just go to an auction platform, but you have to look at the risk/reward of the process. Once risk management is in the picture, a straight auction may not resolve the issues.” Korte maintains it’s a question of portfolio type: “The make-up of the investment pool is the most important consideration. Traditional, large cap portfolios are not that attractive, particularly not at the moment. A medium pool of small cap or international securities is much more suitable. Because the assets are harder to source, there are likely to be more bidders.” Auction platforms accommodate both portfolios and individual securities. It is usually up to the agent to package securities in the way that will be most attractive to the highest number of potential bidders. Mark Tidy, head of international business development, securities lending, at Bank of New York Mellon, says: “With any auction, we could technically ask every single borrower to participate. In

The auctioning of securities lending portfolios has been a sustained line of business in the downturn despite drops in lendable assets, in line with the market trends to diversify and improve risk management. practice, that never happens. We know that only certain counterparties will be interested in a basket of French shares, for example.” What makes a good auction platform? Korte believes a good auction leader is like a good diamond polisher: always making little cuts and facets and polishing it to make it better. “It is the same thing with cutting up a lending portfolio. The auction leader will be in touch with what the market wants and always look for a more advantageous position in terms of risk and market price.” Abesamis identifies three aspects to a successful auction process: price discovery, “so it needs an intelligent way of assessing what the market is willing to pay”; the risk assessment of counterparties, and the ease of use. After the auction process, lenders can decide whether they will then go down the route of a traditional lending programme or form an exclusive agreement. That exclusive agreement can be with one or several counterparties. Jerry May, cash and securities lending officer at OPERS, says: “We use eSecLending to auction our US equity and US corporate bond portfolios. eSecLending manages the entire auction process and subsequent program administration. However, OPERS has the ability to control the asset award decisions with borrowers. We choose our agents both for the price we believe they will be able to achieve on our portfolio and for their global reach.” OPERS uses agent-managed exclusive arrangements with multiple borrowing counterparts typically for a term of one year, according to May. Borrowers and their agents will not

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necessarily take the highest bidder. Tidy says: “An exclusive auction is very much a client consultative process. Price is the main driver, but the customer may decide to distribute the assets to get diversification. For example, if one borrower has won everything, they would mix it up to ensure they didn’t have too much exposure to a single counterparty.” The creditworthiness of counterparties will be monitored by the auction platform credit and risk team. For example, eSecLending’s credit team are independent from the trading and operations functions and they extensively monitor all the broker dealers. They monitor on a deal to deal basis and watch the CDS market and credit agencies. The most important impact of the economic downturn has been the increase in the cost of funding, which hits collateral. Cash collateral has become very expensive and securities lending has had to adjust. Poikonen says: “The market value of lendable assets has decreased as market values have depreciated. Hedge funds are deleveraging, which has had a significant impact on utilisation rates and the cost of funding for broker dealers has increased substantially.” He adds that the short-selling bans have caused some lenders to become nervous, leading some to temporarily suspend their lending programme or restrict certain stocks or certain asset classes from loan. Despite greater nerves, most groups have not fundamentally changed their counterparty risk assessment processes. Poikonen believes that eSecLending’s risk management approach was shown to be robust in the downturn. May says that OPERS looked carefully at all its processes to ensure that they were sufficiently strong following Lehmans collapse, but has not changed its approach. However, he says he has found increasing cautious on the borrowing side. Tidy has seen increased focus on diversification: “The Lehman default has caused beneficial owners and

borrowers to review the risk dynamics of exclusives. Both now fully realise the downside risk of the concentration of lending activity through a limited number of distribution channels. These factors, coupled with borrower balance sheet constraints, have caused a fundamental re-evaluation of how the business is conducted.” Despite a shrinkage of the pool of available assets from some lenders, Poikonen maintains that global lending volumes have not been impacted as much as expected. Certain areas have been hit worse than others. Corporate bonds, for example, have been affected and there has been little demand. Government bond lending, in contrast, has been relatively unaffected. Some asset prices have changed significantly, with some receiving lower bids as hedge funds deleverage. Taxable non-US markets are as strong as a year ago and are receiving a lot of interest from broker dealers. Cash markets are normalising, but people increasingly want cash in their home currency. Tidy says the desire to bid en masse for an inventory is fading: bidders are more targeted in their approach and auctions have benefited from their transparency. Poikonen says that clients have been receptive to the disciplined approach behind auctions, adding: “Exclusive auctions are a fantastic way of handling the process for clients – it takes the emotion out of it and allows lenders to make unbiased and informed decisions.” Korte says that traditional lending programmes can be about who you know and as such can be less transparent. However, he admits that brokers are less keen on using the auction process because the purpose is to extract maximum value for the lender. As Tidy says, “We’re not there to be the borrower’s friend.” Some businesses impacted more than others in the current market, adds Poikonen. He adds: “Proprietary trading has certainly decreased as there is less appetite for taking risk on banks’ own books. Ultimately, there will continue to be demand

from borrowers, particularly for those lenders with a flexible collateral profile.” Abesamis says that the credit crunch is forcing everyone to look at the intrinsic value of lending. “The auction will be a key platform going forward, but it is only half of the equation. The other half remains risk management and collateral management. The price discovery aspect has to be reigned in and risk management emphasised. This is a watershed event.” However, there are signs that the worst may be over in terms of declining volumes. Icap, the interdealer broker, says that confidence has risen considerably since a low in the last quarter of 2008. Its trading platform iSec has seen an increase in daily transactions in January and February - up strongly from November and December. There are also more participants trading on a daily basis. The European and US auction markets remain very different. The European market is more driven by auctions - with the bid often going straight to one or several counterparties - whereas the agency approach has reduced the number of auctions in the US. Counterparty risk management is generally considered to be stronger in the US. Revenue generation from the auction process has typically been higher in Europe, but this is likely to change as both lenders and borrowers put greater emphasis on risk management. May believes the length of exclusives may reduce as lenders are unwilling to tie up their assets for a long time. Equally, borrowers may be encouraged. eSecLending has always counselled its clients to offer their portfolio periodically for re-auction to ensures optimisation for the market. Overall, the market sentiment is rising. eSecLending says that through early March 2009 it has conducted five auctions this year totalling over USD50 billion in assets with close to 20 global counterparties competitively placing impressive bids. Z

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Panel: Central counterparties



Diana Chan has been CEO of EuroCCP since November 2007, and has 20 years experience in securities services. EuroCCP was selected to provide central counterparty service for SecFinex’s security lending and borrowing service for the U.K.

Mark Faulkner is managing director of Data Explorers. He has worked at L.M. (Moneybrokers) Ltd., Goldman Sachs and Lehman Brothers. In 1995 he co-founded Securities Finance International and Spitalfields Advisors in 2004.

1. Would a CCP sufficiently reduce counterparty risk to make it a worthwhile project? CHAN: Over the last several months securities lending volumes have been constrained by counterparty risk concerns and an acknowledgement of the relatively blunt tools used to assess and control risk. For example, with respect to European equities, haircuts of 5% of the loan value are common, and in the midst of the recent crisis, this was often raised to 10%. Borrowers may feel more comfortable with posting these haircuts when such loans are sourced directly from institutional lenders, but where the loan is from a market professional, this haircut itself creates risk. Market participants must assign scarce capital to securities lending/borrowing activity that reflects their assessment of counterparty risk. CCPs involved in securities lending/ borrowing adapt their existing risk models to margin participants based on the proven risk models rather than arbitrary haircuts. These risk models consider many risk factors to

Roy Zimmerhansl is founder of Zimmerhansl Consulting. He has extensive experience in the securities lending industry at leading institutions, including Icap, the inter-dealer broker.

Peter Fenichel is chief executive Officer of SecFinex Limited the leading European electronic marketplace for stock borrowing and lending. SecFinex is a subsidiary of NYSE Euronext. He is a senior adviser to Cairneagle Associates, a strategic consultant.

include the price volatility of the entire participant’s portfolio of loans, borrows and collateral. The CCP may also consider the impact of any number of historic stress events on the portfolios of its participants and require collateral be posted which would increase the safety of its guarantee. Usage of proven risk models by CCPs brings extra safety to the market; this is reflected by the reduced capital requirements. Under Basel 2, the capital requirement is zero when a participant faces a CCP. The CCP model also reduces the administrative burdens and capital cost that arises from borrows sourced via agent lenders and reduces the expenditure of risk resources in assessing numerous counterparties ZIMMERHANSL: A CCP changes the risk scenario from multiple bilateral risk relationships to a single centrally managed risk counterparty. The value in the CCP risk reduction process will be determined in due course by the number of market participants

John Grimaldi is executive vice president & general manager, Loanet, capital markets and investment banking at SunGard

David Little is head of securities finance at Rule Financial, a leading Londonbased consultant and solution provider for the financial services industry.

that use the CCPs. The value it brings to the business is dependant on the how much business is put through it rather than a question of whether it is beneficial. That it could bring clear benefits for many users is a given and the acceptance of CCPs in many other parts of the financial markets is evidence of that value. FENICHEL: The central counterparty is principal in each transaction. The central counterparty interposes itself legally between counterparties, becoming the borrower to each lender and the lender to each borrower. As principal counterparty on each side of a matched transaction the central counterparty guarantees re-delivery of stock or collateral. CCPs do not extend ‘credit lines’ to general clearing members and individual clearing members. Instead CCPs apply financial and regulatory eligibility criteria to membership. Upon acceptance, members are subject to a) margining (initial margin is calculated on the trade date; mark-to-

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market margin is calculated daily) and b) contribution to a default fund. Globally regulators treat exposure to CCPs at zero weighting for regulatory capital calculation purposes. And, for those market participants who are not self clearing members of CCP’s they can easily gain access to the SecFinEx CCP marketplace via General Clearing Member arrangements, just like organizations who are not Exchange members trade through arrangements with Exchange brokers. GRIMALDI: Beauty is always in the eye of the beholder or in this case, your relative position in the marketplace. CCPs in other securities markets have helped to reduce counterparty risk and in time increased volumes due to increased liquidity. CCPs level the playing field and can allow smaller less capitalised firms to play on equal footing with their larger counterparts. In this scenario, lower capitalized participants realize the benefit of the CCP through increased credit that would not have been available in a bi-lateral relationship. One could also argue that increased or unlimited credit to smaller firms could lead to greater market exposure. The larger well capitalized firms do not necessarily like this position and view their size and credit worthiness as a competitive advantage. By levelling the playing field through the CCP’s credit intermediation, their advantage is diminished. The key question is how the CCP is structured or funded to function in the role of guarantor. Another key question is how the CCP will margin the positions to reduce market exposure. Clearing Corp or Exchanged based CCP’s typically utilize their participant/ member fund to provide the guarantee. However in the event of a failure, the entire membership is subject to the market risk (albeit lessened), since the participant fund is guaranteeing the trades. CCP’s certainly go a long way in reducing counterparty risk but do not eliminate it completely.

LITTLE: A trusted central counterparty name, with the appropriate structures to ensure robust credit risk management, is an effective mechanism for mitigating counterparty credit risk, through the novation of trades to the central counterparty. 2. Would a CCP have lessened the impact on the operation of the securities lending industry after the Lehman Brothers default? CHAN: As a whole, CCPs performed extremely well in the Lehman default situation. At DTCC we assumed over USD500 billion in positions in both the US and Europe and liquidated these exposures without any loss to participants. Other CCPs likewise did a very effective job. DTCC has over 30 years of experience managing through default and wind-down situations without any loss to participants. EuroCCP had to manage its first (Lehman) within a month of launch and liquidated risk exposures without any loss to participants. Around the time of the Lehman default we noted that many Lehman counterparties with trades not guaranteed by a CCP were scrambling to discover their exposures to include settlement status and market risk. This situation affected institutional investors as well as the sell side and the value of CCPs was clearly demonstrated. FAULKNER: It’s difficult to know how in the sense of detail or construction what the detail might be. Without the buy-in and tacit and legal confirmation and approval and validation of participants joining they would be looking for benefits, be they risk mitigation, operational straight through processing, in it’s construction I would hope that it might make things easier but again the devil’s in the detail. ZIMMERHANSL: The securities lending industry should be proud that it has emerged from the Lehman crisis with its default processes and procedures challenged and proven successful. The question is whether the

process would have been less fraught had CCPs been an important part of the business for market participants including Lehman. The answer is uncategorically “yes”. FENICHEL: During recent turbulence in financial markets, central counterparty clearing houses have proven reliable, resilient and robust for all asset classes they serve. CCP’s coped successfully with the recent default of Lehman Brothers by closing out or transferring the positions of the defaulter, without impacting other participants, and within the margin accounting available to them. To my knowledge there was no need to resort to default funds. Problems arose in OTC markets where CCP’s were not involved. If we experienced a default in the securities finance market post the introduction of a CCP via the SecFinEx marketplace I would anticipate a similar positive and effective unwind. GRIMALDI: If the entire marketplace did business through a CCP facility then a bankruptcy by one of the market participants would have potentially spread the market risk/exposure across the entire industry. Certainly it would have allowed for the unwinding of the positions in an orderly fashion. That in and of itself, could have helped to reduce or lessen the resulting losses. For trades done outside the CCP on a bilateral basis, the presence of a CCP would have done nothing to lessen the impact of a failing participant. LITTLE: Anecdotally, market counterparties to Lehman’s SBL trades were reasonably well collateralised, bilaterally. The LCH experience of Lehman’s demise (in markets other than SBL) was that it provided good evidence of the Central Counterparty model working correctly i.e. to protect member’s interests in the event of a default. Had Lehman been trading under a CCP they might have been able to keep the collateral which they lost and were

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unable to recover. Whether that would have been sufficient to avoid their collapse is, of course, unknown 3. In what ways would CCPs increase or decrease transparency? CHAN: Currently, the parties to a securities lending/borrowing transaction are known to each other. When using a CCP for securities lending/borrowing, the parties may continue this arrangement and give up their trades to a CCP for risk management purposes or they may elect to borrow/loan on an anonymous basis; both options are available via a trading platform. Where the anonymous route is chosen, the CCP is the counterparty, so there is a loss of transparency with respect to the source of the securities. However, it is likely that price transparency will increase under an anonymous trading/CCP model. All trading firms posting prices to the trading platform are potential counterparties to each other, regardless of “relationships” or legal agreements, and borrowers and lenders will see prices from many different sources, not just from the limited number of bi-lateral relationships they maintain today. In today’s market, borrowers often use their general collateral borrowing as a quid pro quo to obtain “specials” and lenders may reward borrowers on large volumes of general collateral by making “specials” available. With an anonymous trading/ CCP model, we anticipate that the rate on specials could be bid up with a corresponding fall in the value of general collateral loans. FAULKNER: In terms of increasing transparency, depending on the scale, success, volume going through the exchange there’s an opportunity for data to be derived that could help transparency in the market place, but that’s dependent on volumes licensing being agreed, etc. In terms of decreasing transparency, I think that’s the primary concern that some of the panellists were raising in the

Arizona event, which is kind of like – yes I know the exchange but I wouldn’t know that my trade has necessarily been settled with Lehman Brothers. There’s an element of potential increase in transparency, if the central counterparty is a focal point for volume in the business and therefore there can be some increase in transparency. Not necessarily knowing who you have dealt with, knowing that you have an exposure to the exchange is something that would reduce transparency. ZIMMERHANSL: It depends on which element of transparency you

“The CCP model is ideally suited to those transactions with a longer timeframe to closure” David Little, Rule Financial are trying to address. From a traded price point of view, I don’t believe that CCPs in and of themselves change the dynamics. However, trades are typically executed electronically prior to being “given up” to the CCP and as a result, price visibility may occur through the trading venue. On a per transaction basis, a user has no transparency in terms of which counterparty is lending or borrowing the stock, but such information isn’t really meaningful anyway. FENICHEL: The CCP model applicable to SecFinEx involves the use of the SecFinEx Order Market. The Order Market is an anonymous application where the lender and the borrower view all contributed orders in the market, including price and size, which are on a firm-to-trade basis, providing instantaneous price-driven trading. Participants view best bids and best offers in selected markets and can drill down to see the depth of book for an individual security.

The SecFinEx CCP market is fully transparent yet remains completely anonymous post trade. Market participants will benefit from increased market data and broader markets generally without compromising individual transaction confidentiality. GRIMALDI: CCP’s in and of themselves do not necessary aid or hinder transparency. CCP’s that function with an electronic marketplace will bring transparency to the market. The existence of an electronic marketplace where participants can enter bids (offers to borrow) and asks (offers to lend) anonymously by definition will enable the marketplace to achieve transparency and price discovery. CCP’s who operate with bi-lateral negotiation trading will not necessarily bring transparency to the marketplace. In this scenario the CCP’s role is primarily settlement and credit intermediation. LITTLE: Three ways: firstly, price transparency, increased by use of exchange (not strictly CCP). Secondly, counterparty transparency is reduced – i.e. anonymity of your trading counterparty Thirdly, Lenders get improved access to market through the trading exchange (not strictly CCP) 4. Would a functional CCP rely on the elimination of the current custodial lending model? CHAN: Not at all. Any clients of custodians wishing to access the CCP will come in under the risk guarantee of a General Clearing Participant, which could be the custodian bank or another agent. The Custodian or Agent lender can continue to act for the underlying beneficial owner as long as a clearing arrangement is in place. FAULKNER: Not necessarily, although it’s actually quite a challenge to understand exactly how one could be constructed given the agency lending participation in the market place. The typical central counterparty

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structure involves principals choosing to do business with one another, or principals acting as sponsor members or gate keepers for non participants. It seems strange that some of the largest participants in the market place, ie. the agents might need sponsoring to be part of this structure but that might be the only way forward. So it isn’t necessarily the case that it requires a re-writing of the entire industry handbook, but it might require some creativity and malleability on behalf of the participants to kind of reverse into a CCP structure that fits into the market. ZIMMERHANSL: A CCP could be used in conjunction with a custodial lending model. The two businesses are not mutually exclusive. In the same way that global custodians use subcustodians or tri-party collateral agents, a custodial lender having a CCP as a counterparty would just be another way of conducting business.

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FENICHEL: The securities lending market is undergoing a shift at the counterparty level caused largely by the perilous state of the credit markets. Furthermore, the relationship between market segments (beneficial owners, agent lenders, prime brokers and alternative investment managers) is being redefined. Existing business models are being reassessed by all market participants. Going forward, we believe all market participants will see value and opportunity in participating in the evolution of the business. GRIMALDI: We do not believe this to be the case. Unless the beneficial owners are going to enter the marketplace directly, there will always be the need for a custodial or agent lender. We believe it would be highly unlikely for them to go direct. Certainly there are always exceptions

to the rule, but that would only be those beneficial owners that have size and the wherewithal to build the required infrastructure. It is not in their nature to participate directly in the markets whether they are buying or lending securities. They have portfolio managers to manage their investments and agent/custodians to manage their securities lending portfolio. custodial/agent lenders will continue to participate even in a CCP based securities lending world. LITTLE: It disintermediates custodians to some extent. 5. CCPs would enable beneficial owners, practitioners and other market participants to benchmark prices and streamline price discovery in a way only possible through comparison to peer groups before - in what ways would this transform the securities lending industry?

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panel: CENTRAL COUNTERPARTIES

CHAN: Greater price transparency will be introduced under an anonymous trading/CCP model. It is possible that the greater transparency, lower administrative and capital costs, and elimination of counterparty risk will in combination significantly increase the size of the securities lending and borrowing market. An anonymous trading venue linked to a CCP will allow a true market price to be established for both GC and specials. It may be possible to further transparency by reporting historic spreads on certain types of loans. Access to a transparent market coupled with live, executable prices introduces the concept of trading at best market price. FAULKNER: I’d have to declare an interest in that – that is now possible already and what is contingent on that statement is that should they get enough volume that this would give another opportunity to understand pricing in the securities lending market. We would observe that pricing is only part of the picture, that actually the utilisation of assets, comparing loan volumes with inventory available and portfolios made available for loan is as important a point as prices. If you lend something cheaply you can lend lot of it and make good money, if you lend something expensively you can make less of it and make exactly the same money so price discovery isn’t the only bases upon, which benchmarking might take place. I agree that if a central counterparty can draw liquidity and volume to it you get a sense of price, but in the supply side of the market that’s only part of the story. ZIMMERHANSL: The CCPs are not the price discovery points; the transaction venue is where prices are taken/given. CCPs only receive trades that have already been executed elsewhere. While they would hold the pricing data, not all trades would be part of CCP transactions. It is difficult to imagine a market where all trades were settled and managed through

a CCP. Even the most adamant and focussed CCP participant would still have bilateral trades. The only way to get a correct view of pricing would be to monitor both bilateral and CCP trades. This would most likely be conducted by the benchmarking vendors as it is done today FENICHEL: The SecFinEx Order Market connected to a CCP facilitates a transparent market for securities lending. Access to a transparent market coupled with live executable prices, introduces the concept of trading securities at the best market price and increases the number of potential counterparties without taking on increased counterparty risk

It is likely that price transparency will increase under an anonymous trading/CCP model” Diana Chan, Euro CCP GRIMALDI: As mentioned before, CCP’s that function with an electronic marketplace where orders are entered anonymously will bring additional transparency to the marketplace. If adopted and the industry utilizes such a vehicle to conduct a portion of their business, then one would expect spreads to narrow over time. Not so much in the GC market, but with the specials. Of course the economics of supply and demand will still continue to have some influence on spreads. Prime Brokers borrowing on behalf of their Hedge Fund clients will have additional benchmarks that will impact pricing. The true value of a security will be more available to all market participants. Primes may need to transform their business model as a result. LITTLE: It’s the exchanges which provide this transparency rather than the CCP. It’s likely that, as exchanges

and CCPs grow, contracts will become more standardised since the CCP model is not well suited to lifecycle events. 6. Some have said that CCPs only work for industries where the transaction ends at the time of execution - do you think this is true? CHAN: For CCPs, transactions only start at the point of execution—they never end there. For cash equities traded on exchanges or alternative trading venues, the transaction starts at the time of execution but continues to downstream events, including settlement. Rules and procedures must be in place to cover such items as fails, buy-ins and corporate actions on failing positions. For CCPs supporting fixed income trades, the settlement cycle often extends beyond three days, e.g. mortgage backed securities will settle 30 to 60 days forward while repos have terms lasting up to two years. The role of a CCP in securities lending transactions extends some aspects of asset servicing to include fee billing and collection, corporate action processing, collateralisation and margining. FAULKNER: No. ZIMMERHANSL: There are already CCPs for markets that carry on-going credit exposure. One needs look no further than the repo markets for an example. FENICHEL: The value proposition of the CCP model includes the automation of transaction processing, which increases the efficiency of market operations and reduces the likelihood of manual errors. Securities lending involves, over the life of a transaction, many “moving parts” such as the provision of cash/non cash collateral, rerates, partials, recalls and corporate action processing. It is partially because of these on-going administrative tasks that securities lending activities have remained a bi-lateral, relationship business during an era when other asset classes have

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adopted centrally cleared processes. The CCPs partners who are working with SecFinEx will be able to provide the required administration processes during the transaction life of each securities loan. GRIMALDI: One could argue that there are a lot more complexities in an environment where the transaction has a lifecycle, and this is what makes securities lending very different to other markets with CCP’s. These are the challenges for the CCP solution provider, in addition to, the additional integration required between the electronic marketplace/ CCP and their customers. The key to success is the ability of the CCP to integrate with participants systems to support the activity post execution. Seamless straight- through processing is an absolute must for success. This will certainly be one of the greatest challenges, but an area that could deliver great efficiency benefits if done correctly. LITTLE: Not true - the central counterparty model is ideally suited to those transactions with a longer timeframe to closure, i.e. those transactions where counterparty credit risk persists for a period of time e.g. futures, repos and potentially Stock Borrow/ Loan. Central Counterparties are, though, naturally reluctant to embrace long life-cycle transaction types where there is a need for extensive trade maintenance between underlying counterparties, other than margining. i.e. extensive re-rating, collateral substitution. 2. Lifecycle events are problematic – exchange trading and trade novation require product standardisation. 7. Do you see securities lending CCPs as an integral part of the market infrastructure in ten years time and why? CHAN: Over the next 10 years, we see that securities lending CCPs will attract a significant market share and that the existing bilateral market that

does not use a CCP, will co-exist with lending done through a CCP. The key role of CCPs in reducing risk will be increasingly valued by both market participants and regulators FAULKNER: I think if it doesn’t get traction now, it might not get traction for some time. Ten years is a very long time and most of the practitioners who are leading businesses at the moment will hopefully be on the beach by then. ZIMMERHANSL: CCPs have the potential to provide tremendous improvements to the securities lending business. Many firms would benefit from reduced capital allocations. Most

“One thing is for sure: everyone’s eyes are focused on reducing risk and enhancing efficiency, and a CCP can do both” John Grimaldi, SunGard people would recognise the improved risk exposure processes and the safety net provided by CCPs. Some organisations could improve their distribution and access to securities by engaging in trading processes that include an integral CCP. History has shown that the launch and active use of CCPs has assisted markets in developing standards and best practices that go beyond trades that only settle in CCPs. The more efficient use of capital and enhanced risk management that CCPs would bring should result in a more effective and profitable business in the future.

wider market, reduction of bilateral counterparty risk, elimination of need for multiple agreements and benefit from full STP. The SecFinEx central counterparty initiatives are creating market disciplines and standards that are widely understood to be beneficial for the evolution of the securities finance business. We feel the total value proposition is very compelling. GRIMALDI: Certainly if there was any time in which a CCP was going to succeed in the securities lending market, now is that time. The conditions are right and the market is willing to entertain change as the competitive landscape changes. The CCP/Electronic trading venue will have its place in the market. As with most markets that have CCP/Exchanges, an over-the-counter (bi-lateral) market will also exists. Securities Lending will be no different. Without a doubt there are benefits in having a central counterparty, but I anticipate that those benefits will be governed by the sophistication of the CCP implementation. One thing is for sure, everyone’s eyes are currently focused on reducing risk and enhancing efficiency, and a CCP has the capability to do both. So yes, I think there will be adoption, but I suspect that it will not be an overnight result. LITTLE: Yes, but for a fraction of the market only. There is plenty of resistance to CCP from the entrenched players, but I certainly think it looks attractive and distinctive enough to grab a worthwhile share of the market. Z

FENICHEL: CCPs have proved that they contribute to market integrity by being able to meet their obligations to all participants throughout an unprecedented set of market-wide events including participants’ defaults. The value proposition for CCP in securities lending includes capital allocation reduction, market transparency, anonymity, access to a 2009 | Global Securities Lending Magazine | 33

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PEOPLE

Pole position for Will Gow In October 2008, Will Gow, Senior Vice President of Business Development EMEA at eSecLending, embarked on a 900-mile unassisted trek across Antarctica reaching the South Pole on 18th January. The Shackleton Centenary Expedition consisted of a team of descendants of Sir Ernest Shackleton’s band of Antarctic explorers. They followed in their ancestor’s footsteps to recreate the 1909 Nimrod Expedition, originally intended to be the first mission to the South Pole. “With two hours of travelling left we had our last few moments to reflect on an amazing journey. “At that stage I thought that I would feel relief and excitement that it would soon be over; however, those feelings were overwhelmed by a sadness that our simple existence in this beautiful and hostile continent at the bottom of the world was coming to an end. We had become accustomed to the peace and solitude of our own company and now that would be shattered with our re-entry in the hustle and bustle of modern life. “The South Pole Station is home to 250 US scientists - who showed us great hospitality. Our expedition was unique: it was the first time that Shackleton’s compass had made it to the Pole, and I was the first of

the family to actually make it after 100 years! I felt a huge sense of achievement being able to finish the journey started 100 years ago by my great great uncle. “We had worked so hard to get to 88’23 South on January 9th where we met up with the other team. We were truly elated to make Shackleton’s furthest south to the day, especially as we had been delayed by two weeks at the beginning of the trip and thought

we had no chance. “The last three weeks of the journey really took their toll. I hadn’t given the polar plateau much thought prior to the expedition, as my main concern was safe passage up the Beardmore Glacier. However, as we climbed to 10,000 feet, the air became thinner (as the air on the plateau goes through strange geophysical effects, it feels as if you are at 15,000 feet), and I started to suffer from altitude sickness and lost my appetite for about four to five days, which is when I used up my reserves! “I hadn’t appreciated just how severe the winds were going to be. The katabolic winds blowing off the Pole whistled down the plateau and when we were travelling through the 87th degree the winds were relentlessly blowing 60 knots in our faces. The snow at that altitude becomes so sticky, it was like pulling our sledges through wet sand. The air temperature never got warmer than about -30°C (-20°F), without the wind chill, so all in all it was pretty miserable; yet there was a

strange beauty that is hard to describe. “For all three of us, the highlight of the expedition was making it to 88’23S on the same date, 100 years later. It was quite incredible to think that Shackleton, Wild, Adams and Marshall had then turned around and headed back the way they had come, back across the Plateau and down the Beardmore. The suffering they experienced is quite remarkable. Their expedition, in total, would have been 128 days, there and back. Our journal was 66 days and we were extremely exhausted by the time we reached the Pole. “During the expedition I thought about what I have learnt from the experience and realised that the success of the journey has taught me three things: preparation is the key to success; the importance of teamwork and working together to achieve one’s goal; and self belief – you can make your dreams become a reality. “Now, the Antarctic seems like another universe. “Finally, I would like to thank all our sponsors, family and friends for their support over the last few months - in particular, eSecLending as one of the main expedition sponsors and also for giving me the sabbatical to fulfill my dream. Hopefully our achievement will stand for a few years and I also hope that The Shackleton Foundation will continue to inspire future generations to become inspirational leaders. Z

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people

From the trading floor

Pierre Khemdoudi Senior Trader – Securities LendingBNP Paribas London (UK) In the wake of the sub-prime and liquidity crises and downturn of the equity markets in September, authorities across the world, decided to implement a short selling ban in an attempt to curb the slide in share prices. As a result, the securities lending market was placed under increased scrutiny by the regulators and the business model was placed under pressure. The direct consequence of increased regulation and market turmoil was that some beneficial owners stopped lending their assets as others decreased the size of their lendable asset pool. At the same time, hedge funds were deleveraging and the demand for stock was decreased, which limited the impact of the reduction of the liquidity

in the stock loan market. Volatile stocks and emerging markets supply were impacted the most by the lack of liquidity. Another consequence of the crisis, and maybe the most significant, has been the rise of collateral costs. As investment banks tightened their funding requirements (termed funding favoured to overnight funding), borrowing securities became more expensive due to these collateral costs. Furthermore, credit concerns pushed institutions to only accept cash and main index securities as collateral; collateral management became central for institutions. As short selling bans, who’s effectiveness is questionable, are being lifted demand is anticipated to increase within the next few months. Some institutional investors are reopening their lending program, prioritising creditworthy counterparts and asking for new requirements (e.g. haircuts, collateral). Combined, these

measures should increase liquidity, although the balance will remain tight. As a consequence of all these unprecedented times ,the stock lending market structure is set to change with counterparty risk being now one of the main concerns, and securities exchanges looking to address the issue and deliver solutions There have, over the past few years, been several securities lending exchanges that were created to bring visibility and liquidity to the stock lending world. However, many of them to date failed to attract significant volumes. They are now trying to introduce a central counterparty model (CCP) in order to address the counterparty risk and are being backed by major securities exchange (NYSE Euronext). These solutions are still being developed and therefore, at this stage, it is hard to estimate their impact. Z

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PEoPLE

From the trading floor

Simon Waddington Head, Trading - Europe Securities Lending Background I’ve been working in the securities lending industry for ten years now. After graduating from McGill University, Montreal, in 1999 with a first in Classics, I joined the newly formed London trading desk of Royal Trust under Nick Thomas. Four years later I took over running the trading desk in London, and then after the joint venture with Dexia in 2006 I was given responsibility for managing all European trading for RBC Dexia Investor Services.

View from the trading desk The Lehman collapse began a period of turmoil in our industry that I suspect, and hope, we will never see again. Securities lending was hit from almost every angle - beneficial owners suspended or significantly limited lending activity, hedge funds collapsed or were paralysed by redemptions, banks and brokers were forced to reduce

their trading activity after writing off billions in toxic assets and struggling to maintain liquidity, short-selling restrictions brought lending in some markets almost to a standstill, and of course the Lehman bankruptcy itself was the largest default the industry has ever seen. Even for companies which ultimately did not lose any money because of it, the need to unwind billions of dollars in balances in a very short space of time caused business to grind to a halt. Across the entire spectrum of participants from beneficial owners to hedge funds, risk management took precedence over every other consideration. This chapter in our market’s history is not one that any of us will quickly forget. Many friends lost their jobs in the resulting fallout, and many long-standing relationships were abruptly altered by the spate of forced takeovers and bail-outs. It was perhaps an inevitable conclusion, however, to a very profitable number of years which too many had taken for granted. Regulators have been widely accused of being complacent and thus allowing first the sub-prime situation and then the financial implosion of the last six months, but complacency was not entirely absent from the financial industry either. Until 2008 lending was seen as a risk-free activity which provided a very healthy return on capital. Even the cash reinvestment side, perhaps the riskiest component, was not a major concern to most the enormous returns it generated were viewed as easily outweighing the potential risks. For many years beneficial owners received their rising income every month, the hedge fund industry was expanding exponentially, and lenders and borrowers alike profited from the growth on both sides. Every company had their own risk management and internal

controls, but naturally while times are good people tend not to question what can go wrong. Basel II/MiFID and ALD requirements began to change that mentality, just not enough to prepare the market for the scale and swiftness of the downturn. What should come out of this traumatic chain of events is a much more transparent, efficient, and educated market. Beneficial owners will gain a better understanding of the true risks involved in lending, lenders will become more sophisticated in their risk models and VaR analysis, and banks and brokers will grow increasingly selective about the type of business they are willing to take on. Securities lending is a very riskfree business if managed properly. Certainly there is room to reduce that small amount of risk even further with improved automation and such recent ideas as a central counterparty, but it’s far from essential for the market’s survival. And the market will survive. Already the balance between risk management and revenue generation is starting to shift very slightly back from being 100% risk focussed. People will always want to make money, and once confidence starts to return to the financial world our market, like many others, will slowly begin to recover from its current state. Those borrowers and lenders who survive will have a much greater comprehension of the previously untested risks, however small and unlikely they are, and ultimately they will be better placed to bring about the evolution that is needed. Z

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technology

Migration: the legacy system challenge

Adrian Morris of MX Consulting Services, explains the variables and considerations when switching between trading systems. It is often with great trepidation that managers begin the process of replacing a legacy system. One of the reasons that large trading system migration projects often run into trouble is they typically occur at 1015 year intervals. Because they are not common projects, many executives tend to underestimate the complexity of changing their securities lending platforms. This article focuses on the process and issues of selecting and implementing a new vendor system. The first rule of thumb is to not allow the selection process to become an emotional debate. Conducting an RFP (Request for Proposal) may be laborious but it is the key opportunity to make the right choice. It is important that this is a

joint business and IT led process and resources are not spared in analysing each vendor system. It is necessary to test the vendor’s answers in the RFP and have the business users review the system themselves. Do not allow presentations made by the vendor to suffice. When buying a new car people demand a test drive, it follows that buying a new system should be no different. Thorough analysis at this stage is often perceived to be wasting time and money but both can be recouped many times over compared with a bad decision. Once a lead vendor has been singled out, a functional GAP analysis of current system processes compared with the vendor system should be carried out. What enhancements might be required of the vendor system to meet the businesses requirement? Companies often have functionally rich satellite proprietary systems that surround the less versatile legacy system. Will the vendor agree to bespoke requirements? How long will it take? Complete reliance on the RFP should be avoided. The use of formal project

methodologies is often derided but projects must have a formal structure which provides a controlled and organised start, middle and end. The steering committee must have an executive decision maker with representation from senior users and IT managers. Inadequate definition and lack of acceptance of project management roles and responsibilities will more often than not lead to an absence of direction and poor decision making. Detailed up-front planning lowers risk in the execution phase of a project. It is a common experience that inadequate planning leads to a poor estimation of duration and costs. A fair expectation should be that 50% of the entire project lifecycle (including the RFP stage) is analysis followed by 50% execution. Projects that are light on the analysis phase tend to take a lot longer as unforeseen issues accumulate. Project managers must have properly conceived plans, risk and issues logs and these should be maintained throughout the life of the project. The project should be divided into manageable stages for more accurate

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technology

Art of the transfer: change from legacy to a target system has many elements

planning. Many projects only reveal their true status too late due to insufficient measurables and lack of control over progress. Once the vendor system has been set-up in a test environment the IT team will spend a large amount of its time focused on the data migration. A key risk in this phase is the data migration team becoming detached from the rest of the project and working in isolation. The migration of data is one of the most complex parts of any system transition and requires a great deal of expertise. Do not expect the vendor to manage this phase. Vendors will normally only take responsibility for their own systems functional ability to load the data as presented to them, not its outcome. It is very important that the business remain involved with this piece of work, after all it is their data that is being migrated. If done properly this can be a good opportunity to cleanse and transform stale security, SSI and other static data. The testing phase of any migration must be carefully organised. Project managers must ensure all test issues are recorded in an issues log (plenty of sophisticated software is available but a simple Access database with a report will suffice if nothing else is available).

The test team must understand what it is they are testing and what the desired outcome is. Thorough testing is critical to success.

Vendors will normally only take responsibility for their own systems’ functional ability to load data presented to them, not its outcome” One of the key pitfalls in most projects is the lack of involvement by the business in UAT (User Acceptance Testing). Many of the key users are either traders, collateral managers or those in operations who have very little spare time. The executive sponsors need to plan for this eventuality. During the life of a project key people emerge, sometimes a trader, other times an operations supervisor who have a depth of understanding and a natural inclination to be involved. Businesses should plan to support or backfill such people to enable them to engage properly with the project and UAT. Full dress rehearsals of a migration are a must. Often simple issues like the

accidental locking down of a server or a forgotten password can scupper an entire migration so it pays to be prepared. The actual migration itself will normally happen at a weekend, if things are going badly don’t be afraid to stop, step back, analyse the issues, regroup and re-plan for another weekend. Once the successful transition has taken place make sure a fall back plan is in place should things go unexpectedly awry. The securities lending industry has become far more complex in the last decade from both a business and technological point of view. It is no longer an area which is the domain of the generic project manager, analyst or developer. Successful projects usually have the same common denominators, a project team who have industry expertise and experience in delivering under pressure, a structured approach, good communication and a well engaged business. Migration projects are challenging, but can deliver great value to end users. Adrian Morris is the Head of MX Consulting Services a dedicated securities financing business & IT consultancy; recently responsible for the successful migration at Aviva Investors from Global One to 4Sight. Z

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Global Securities Lending 2009

The meaT of The meeTings

Winter fuel

On 15th January 2009, GSL hosted its first summit. Entitled, ‘The End of the Beginning?” it featured debates from industry figures on risk, central counterparties and lessons learned from the crisis. The first panel, chaired by David

Rule, chief executive of ISLA, analysed risk. Roy Zimmerhansl of Zimmerhansl Consulting gave a brief back ground as to the high profile fails of the past, including Drysdale Securities and Drexel. David Rule then announced the results, though not the final figures, of an ISLA survey of the lending market. He revealed that some lenders had reduced their activity by

Key points from the first quarter’s conferences

50%, though many had reduced by 10%, with a few actually increasing their activity. Most respondents had tightened up limits, he added, and tightened up their collateral, mostly by asset type than rating, with a general switch to government bond collateral. Haircuts had been “tightened” too, with 110% for equites the norm. Paul Lee at Hermes, said the stresses on the financial markets have had an effect on the views of beneficial owners, that they are “asking questions now they should have been asking for a long time – what risks, does lending damage our long-term interest and am I getting enough return?” Unless the industry can come up with answers, he added, beneficial owners will stay away. David Rule pointed out that the bond lending market had received less media attention. David Little of

Rule Financial said the repo and stock loan markets did relatively well in the turmoil. Further, the cash in the unsecured money markets has found its “next new home” in repo. “So we’re seeing a change in the market - the unsecured moving into the secured world.” A prospective central counterparty for the securities lending industry was another topic explored in detail. Peter Fenichel, CEO of Sex Finex, the lending platform that seeks to implement a CCP in different European markets using three different clearing houses, began by saying a CCP would be lead to a “truly anonymous trading market” similar to almost all other aspects of the capital markets. It would eliminate counterparty risk and reduce bilateral exposure in favour of direct CCP trades.

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The meat of the meetings

The bilateral element would not be removed entirely, however, by CCPs, as in the fixed income, futures and options markets. He then explained that a CCP would improve operational efficiency. With a single counterparty, he said, “the number of bilateral agreements you’d have to administer would reduce and so the administrative aspect of watching that exposure against each counterparty would be reduced.” Capital reduction was the third benefit. “Trades on exposure, either on borrow or lend, on a CCP would significantly reduce capital allocation to the traded counterparties in each case,” he said. Roy Zimmerhansl countered by pointing out that not every participant would benefit from a capital reduction as not everyone has capital charges. “If you look at it from an beneficial owners point of view it’s not the same relevancy as to a broker dealer.” However, Zimmerhansl did offer another benefit of the CCP model: that it would allow a broader exposure to counterparties that participants wouldn’t normally be able to deal with. But he warned that significant questions needed to be answered. “The fundamental challenge is weighing off those benefits and values against market practices and processes.” Paul Lee cited the benefits of transparency that a CCP would provide, adding that the lending industry spent too much time “in the shadows. In the second debate, chaired by Mark Faulkner of Data Explorers, Mark Coville at BlackRock cited a “tremendous lack of trust” among the beneficial owners. “I think we have to address that the cash reinvestment became the driver for securities lending and more than half the revenue derived from the lending transaction came out of the cash piece,” he added. “The prime broker model is broken, the broker dealer model is broken and the investment banking

model is broken”. Paul Wilson at JP Morgan said there had been a lot of fear among beneficial owners, but that the securities lending industry held up particularly well. He added that how the lending side handled events like the Lehman collapse would be important. Jane Karcewski at Deutsche Bank said people are now less concerned with ultimate revenue streams and about operational risk. She added that many would have been considered as the decision to engage in securities lending is a four or five year decision – “not overnight”. John McEllin at Bank of Ireland

added that deals with clients were very different to 20 years ago and an important lesson is for clients to go back and look at their contracts and see how up-to-date they are. Chris Taylor at State Street said the industry has done a good job, though added that asset consultants had been part of the problem. Mark Faulkner rounded up: assets have more of a risk orientation; there still needs to be more education for the owners of the assets; borrowers do default; check your contracts. Lastly, the collateral relationships need to be looked at: “It isn’t necessarily the most obvious forms of collateral that are the safest.” Z

Spitalfields Advisors forum The effect of the financial crisis on the securities lending and borrowing industry was discussed in some depth at the first talk, featuring Andre Stern, Doug Shaw, Jane Karzcewski, Brian Staunton, Sarah Nicholson and Rogier Buurman. Doug Shaw of BlackRock, who in January answered questions in the UK’s House of Commons as a representative of the hedge fund community, commented that he had some sympathy with the task of regulators in the last

year. “I can’t imagine what it would have been like to be a regulator and see Armageddon approaching.” He touched on the rise of redemptions seen by hedge fund investors but added: “clients coming back to hedge funds is a question of ‘when’ rather than ‘if ’”. One upshot of the crisis, he said, was that investors will value liquidity even more. On his turn in the House of Commons, he said: “I was invited to attend. There was a sense that we had to suck it up, ‘play for a nil-nil draw’ with a chance

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The meat of the meetings

for an ‘injury-time winner’.” “Were you giving 110%,” asked Mark Faulkner, to continue the volley of clichés common in football punditry. Regarding the short selling ban, Shaw said half of the company’s 6,500 positions were shorts. “The ban was a headache for us. We decided to hold our short positions as we believed them to have residual value. When I hear about the G20 talking about the shorting of stocks it seems extremely odd that people are singling out this activity. People don’t realise how much stock is available to lend compared to the entire float of the company.” Jane Karcewski at Deutsche Bank said life as a prime broker last year had been “horrible”. Apart from protecting business, day-to-day life presented multiple challenges. “We were dealing with the liquidity of collateral and dealing with lenders coming in and out. The infrastructure of prime broker was pushed to its limit.” The business still made good money in 2008, she added, leading to a change in higher management’s perception of this part of finance. “From the management viewpoint they viewed it less as simply part of operational infrastructure and more the driver of financial infrastructure.” The default of Lehman Brothers in September continued to hover over the panel’s recollections of 2008 and the implications for this year, and was mentioned by Brian Staunton at

Citigroup. “The Lehman default was blamed for a number of lenders pulling their programs,” he said, adding that he believed the short selling bans had a greater effect. “There are still a few lender still not lending, for some it may be down to the reputational damage of feeding short sellers.” Describing last year as “phenomenal” for most involved in securities finance, he stressed that it is important to separate last year to this. “2009 will be much tougher,” he said. “From my business it is about how to make the industry more efficient.” Karcewski agreed that a combination of the short selling bans and the Lehman default was detrimental to the number of lenders in the market. She added that many lenders had entered the industry having been “pumped up” on the returns that could be made, and may have followed the flow of others entering the market. Sarah Nicholson echoed the pivotal effect of Lehman Brothers. When asked to offer recommendations to educating others in the market, she said: “It’s all about engagement – this is always difficult as practitioners as everyone’s looking after their own business. She cited the paper by the International Securities Lending Association as offering clarity on the nature of the market, but emphasised that it was one sided – “the business protecting the business.” Andre Stern added here that the FSA says it is worried about market abuse but never

comes up with the evidence of this. From the floor, Roy Zimmerhansl, an industry veteran who now educates and advises potential entrants into securities lending through his company Zimmerhansl Consulting Services, questioned whether the industry has the press it deserves when organisations have such conflicts. He said he always challenges those who cite research that says short selling is non-abusive, despite the fact that it is often industrysponsored. “But not all research is sponsored by the industry. I’d like to see the research that says it is abusive.” Nicholson revealed that after Lehman Brothers, Aviva Investors doubled its margins for the collateral value it would accept for lending shares. “We needed to act very quickly, there was no science behind it, it was just a headline within the company that lasted two to three months,” she said. Z

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Global Securities Lending 2009

The meat of the meetings

IMN Beneficial Owners Conference: Scottsdale, AZ. The conference in Arizona last February came at a critical time, when some beneficial owners were considering stopping their lending programmes. Would the arguments to the contrary leave them Superboweled over?

The IMN’s Beneficial Owners Conference in Arizona February undertook some last-minute revision to its programme in light of the swift change in the financia,l market and its impact on sentiment in securities lending. Discussion included an analysis as to why some beneficial owners stopped their lending programme, the future of cash collateral investments, the use of treasuries and repo as collateral, and the ‘case for continuing participation in the industry John Tabacco, CEO of locatestock. com and LendEx the electronic marketplace that provides real time, single stock trading and market data for institutional securities lending participants, told GSL.tv that it was important to have a diversified set of ideas to look at the solutions to the current problems. “I think the

conference has enlightened some of the owners that there are other solutions out there,” he said. With transparency a ubiquitous topic, he said the drive for greater transparency was the central thrust behind the creation of LendEx. “We thought beneficial owners needed better opportunities to benchmark themselves and better ways to demonstrate their fiduciary responsibility, and put forward an open environment that demonstrates depth-of-book and dynamic rate transparency,” he said. “It seems the regulatory focus has shifted in the direction of more transparency in securities lending. The LendEx model is coming to the fore as one to be considered. Some of the larger firms are paying attention.” He added that transparency and innovation should go together “hand in hand” and that the past situation that securities lending was one of the “last frontiers of pacity” was changing in the minds of beneficial owners wanting a clearer insight. David Downey at OneChicago told GSL.tv that many beneficial owners at the conference wanted to reduce their exposure in this market and eliminate their participation. “I think it’s a tremendous mistake,” he said.

“There is a numerous amount of profits that can be made, they [the beneficial owners] now recognise the risks, they need to get this position out of the back office and into where it should be: this is a trade where there are risks in profits, and this is a front-office trading decision.” Greg Korte, founder of Korte Consulting, said: “The biggest issues today is cash collateral – what to do with your existing cash collateral pool. “There are here issues on the table. One is structured investment programs – SIVs – the other is exposure to defaulted items – most notably Lehman Brothers – and then there are ongoing valuation issues. Cash collateral is most often is managed in a fund which is valued at a dollar – the underlying value of those securities also has to be at a dollar. “For many of these funds regardless of provider, the funds are valued at 96-98 cents on the dollar. So these are unrealised losses that clients have in their collateral management pools. Some of the resolutions for SIF exposure aren’t pretty – there’s a lot of reading of contracts.” He added that valuation would be an ongoing challenge. Z

42 | Global Securities Lending Magazine | 2009

GSL04 39-48_apr8.indd 42

09/04/2009 20:18

Global Securities Lending 2009

Exchange traded funds

ETFs explained

Ben Roberts gives insight into the structures and benefits of ETFs .

managed’ equivalents. The types of Exchange traded funds are low cost, Within the securities lending world, ETFs, based on what they are tracking, tax efficient investment vehicles that BGI has ETFs in countries and sectors can range from commodities (ETCs), track indexes and can be traded like - across Europe and the MISC . The to hedge funds. Broadly, however, there basic premise is that you have to buy shares. The fund, which may contain are two main types: in specie ETFs and assets such as stocks or bonds, trade the underlying securities and lend them swap-backed ETFs at approximately the same price as the out. There is some difficulty in buying net asset value of its underlying assets. the underlying, because when you go in They are similar to traditional mutual the market and buy and sell underlying funds in giving investors an undivided In-specie securities, you’ve got tracking error, interest in a pool of securities and other execution risk - all sorts of problems assets. But unlike traditional mutual An in-specie ETF will buy up the that can happen with buying those funds, ETFs do not sell or redeem underlying securities in an index. Let’s underlying securities. individual shares at net asset value. say a company is writing an ETF on the 70 BPs 70Barclays BPs The below case studies demonstrate of the iShares ETF like constituents, combined with lending of the iShares units, can Instead, financial institutions purchasehow lending FTSE: an asset manager 60 BPs Swap-backed and redeem ETF shares directly from Global Investors (BGI) will go into deliver returns that entirely or in part offset the total expense ratio. 60 BPs the ETF in the form of units, which the market and buy all the underlying 50 BPs 50 BPs As from shown25,000 in the to table below,shares the combination of lending of within the iShares fund and lending of the iShares exceeded the These ETFs seekunits to replicate market vary 200,000 components the FTSE shares. These 40BPs BPs 70 40BPs BPs 70 The below case studies how lending ofare the iShares ETF constituents, combined with lending of iShares units, TER in selected cases, though it is noteworthy that the aggregate lending return was achieved in varying depending performance (ie,proportions it isthe still ‘tracking’ it)can depending on the fund.demonstrate shares ring-fenced into separate 45 30BPs BPs 60 45 40 30 BPs by holding a basket of securities along As they track indexes, rather accounts, meaning that there is no deliver thatexample, entirely an or in part offset the total expense ratio. on thereturns fund. For investor in iShares FTSE/EPRA European60Property, iShares40FTSE 250 and iShares MSCI Emerging BPs BPs BPs BPs 20BPs BPs BPs with while a swap agreement with third 50 than seek to beat themfunds withwould a better risk oftheir default a counterparty. 50 20 BPs Markets (US listing) have recouped TER from primarily by lending the ETF units, an iShares DJ Euro aSTOXX 50 BPs As shown in the table the combination of lending within iShares fund and lending of the iShares units exceeded the party – often a brokerage – which performance, they arebelow, ‘passive’ Further, there is fullthe disclosure of the 10 BPs 40 owner would have received over half of their total lending return from lending within the ETF. 10BPs BPs BPs 3 depending BPs TER in selected cases, though recently it is noteworthy thatholdings, the aggregate return was achieved in varying proportions investment vehicles – though will agree to pay the performance of fund’s whichlending suits400today’s 3 BPs BPs 45 300BPs BPs 45 40 30 BPs there have been some ‘activelythe index. It is the that ETF holds an administrative drive for transparency. onTable the fund. For example, an investor in iShares FTSE/EPRA iShares40FTSE 250 and iShares MSCI Emerging BPs 2 : Lending returns inside iShares ETFs and fromEuropean lending Property, the ETF units

Putting it all together: ETF Case Studies

Putting it all together: ETF Case Studies

BPs

BPs BPs

20 BPs

20 BPs Markets (US listing) funds would have recouped their TER primarily by lending the ETF units, while an iShares DJ Euro STOXX 50

ETFs

TER

Lending returns

Market data

10 BPs owner would have received over half of their total lending return from inside lending withinfrom the ETF. 10 BPs lending

Total revenue

Excess

return 3 BPs 3 BPs

Lending returns inside iShares ETFs andthefrom lending the ETF units the ETF units ETF 70 BPs1 0 BPs 70 BPs 0 BPs

2

Table 2 : Lending returns ETFs and40from lending the 60 iShares FTSE/EPRA Europeaninside PropertyiShares Index Fund 3 BPsETF units

45 48 8 60 BPs iShares FTSE 250 40 0returns 60data 60 20 BPs ETFs TER Lending 50 Market Total Excess 50 BPs iShares DJ Euro Stoxx 50 35 27 24 5160 16 inside from lending revenue return 40 BPs 1 60 40BPs BPs the ETF units2 the 70 ETF BPs iShares MSCI Emerging Markets (US) 75 6 BPs 288 294 219 70 BPs 30 BPs BPs 60 40 iShares FTSE/EPRA European Property Index Fund 40 330BPs 45 48 8 60 BPs 40 BPs BPs BPs These charts illustrate how much revenue an iShares40 investor would have generated from iShares FTSE 250 020 60the two sources 60of securities lending: 20 20BPs BPs 50 50 BPs

10 BPsis the cost of24 iShares DJ Euro 50 lending of iShares units. The ETF 35 total expense 27 5160 16 within the ETF Stoxx and the ratio an investor maintaining the iShares 10BPs BPs 40 60 40 BPs BPs iShares MSCI Emerging Markets (US) 75 6 288 294 219 0 BPs position over one year. BPs BPs 300BPs 30 BPs

70 BPs 7060 BPs BPs 6050 BPs BPs 5040 BPs BPs 4030 BPs BPs 70 BPs 3020 BPs BPs 7060 BPs BPs 2010 BPs BPs 6050 BPs BPs 10 BPs 0 BPs 5040 BPs BPs 0 BPs

4030 BPs BPs 3020 BPs BPs 70 BPs 2010 BPs BPs 7060 BPs BPs 10 BPs 0 BPs 6050 BPs BPs 0 BPs 5040 BPs BPs 4030 BPs BPs

40 Source: BGI 40 BPs 20 BPs BPsthe two sources of securities lending: These charts illustrate how much revenue an iShares investor would have generated from 20 BPs Chart 1 : Lending returns inside iShares ETFs and from lending the ETF iShares FTSE/EPRA European Property Index Fund iShares DJ units Euro Stoxx 50 10 BPsis the cost of an investor maintaining the iShares within the ETF and the lending of iShares units. The ETF total expense ratio 10 BPs

iShares FTSE/EPRA European Property Index Fund

position over one year.

60 BPs

70 BPs 70 BPs 60 BPs 60 BPs

45

40 iShares FTSE/EPRA European Property Index Fund BPs 50 BPs BPs 45 BPs

50 BPs 40

BPs

40 BPs 40 BPs 70 BPs 70 BPs 30 BPs 30 BPs 60 BPs 60 BPs 20 BPs 20 BPs40 50 BPs BPs 50 BPs 40 10 BPs 10 BPs BPs 40 BPs 40 BPs 0 BPs 0 BPs

3 BPs

40 40 BPs 45 BPs

3 BPs

60 BPs

30 BPs 30 BPs

20 BPs 20 iShares BPs

5040 BPs BPs 0 BPs

50 BPs iShares 50 BPs

40 40 BPs BPs

FTSE 250

10 BPs 0 BPs GSL04 39-48_apr8.indd 43

FTSE 250

3 BPs 60 BPs 60 BPs

30 BPs 70 BPs 20 BPs

40 BPs

3 3 BPs BPs

45 45 BPs BPs

20 BPs 70 BPs 10 BPs 60 BPs 0 BPs 50 BPs 40 BPs

3 3 BPs BPs

30 BPs

70 BPs 20 BPs

50 BPs 0 BPs

40 BPs 40 BPs

45 BPs

30BPs BPs 60 30BPs BPs 60

40 BPs

10BPs BPs 40 10BPs BPs 40

45 BPs

BPs 300BPs BPs 300BPs

20 BPs 20 BPs iShares 10 BPs 10 BPs

24 24 BPs BPs

3 BPs

35 35 BPs BPs

20BPs BPs 50 20BPs BPs 50

40 BPs

60 BPs 10 BPs

60 BPs

50 BPs iShares DJ Euro Stoxx 50

50 BPs 0 BPs

30 BPs

3 BPs

50 BPs

40 BPs

60 BPs 10 BPs

45 45 BPs BPs

BPs 45 BPs

6050 BPs BPs

7060 BPs BPs 2010 BPs BPs

0 BPs 0 BPs

60 BPs 50 BPs Chart 1 : Lending returns inside iShares ETFs and from lending the ETF units

10 BPs 40 10 BPs 70 BPs BPs 70 BPs 40 0 BPs BPs 0 BPs 60 BPs 60 BPs

70 BPs 3020 BPs BPs

iShares DJ Euro Stoxx 50

70 BPs

27 27 BPs BPs 24 24 BPs BPs

3 BPs

MSCI

35 35 BPs Emerging BPs

27 Markets (US) 27

BPs

60 BPs 2009 | Global Securities Lending Magazine | 43 BPs

40 300 BPs 0 BPs BPs 300 BPs 0 BPs

250 BPs 250 BPs

iShares MSCI Emerging Markets (US) 200 BPs

09/04/2009 18:51

Global Securities Lending 2009

Exchange traded funds

on the whole USD100 million short. has brought the underlying securities. exposure to the market: if the market Further, you can actually buy an ETF Further, you are putting in borrow fees goes up under the swap contract, the embedded into the stock, because that is that gives you the short exposure to an swap company pays the ETF company what is imbedded into the index when underlying index. So in the case of a the performance; if it goes down, the FTSE ETF short, if the FTSE goes down, you write a short index. ETF pays the swap company. They still have total market exposure, but one had the ETF increases in value. So to do that, the investment bank has to right the underlying securities as assets and Securities lending and one has the swap as the asset. Deutsche short performance swap to the ETF. ETFs Bank’s dbx trackers are all swaps of this It’s already got the stock, because it’s already written a long exposure because sort. There are two ways to lend with ETFs: it’s already holding the inventory. Given the chance of default of the the underlying shares themselves, or So, within the swap it can charge a third party, there is a greater concern the units. Owners of a units may lend stock loan fee, and charge 100% of the around counterparty risk for swapit themselves, giving direct potential dividend. backed ETFs, although UCITS ruling profit to the owner. See the top table on So it’s like shorting itself but is instead the previous page for an insight into the limits this loss to 10% of the value of the ‘netting off ’. If you are writing the ETF. different returns that have been made exposure of a USD150 million long The advantage of doing a swap back by the two methods. Z position and USD100 million short is you get the absolute performance of Asunderlying the investment manager for iShares ETFs, BGI is uniquely in the position, to hedgepositioned that position allsecurities lending marketplace to enhance client the market. The investment you have to do is buy USD50 million bank, which has provided a swap has returns. As described earlier, BGI’s lending expertise can deliver a risk/return optimised lending programme to clients. Borrowers worth of securities - that’stothe difference tonaturally hedge itself, written out theof significant look has to BGI as a holder iShares units available lend, and hence regularly come to BGI as first port of between the two. But in the swap, you performance of the FTSE, for example. call when trying to source a loan. This allows BGI to keep lending fees at or near the top of the market at any given point in time are charging one dividend rate on the To hedge itself, the bank would go and while alsounderlying maintainingcomponents high utilisation (percentage on-loan). USD150 millionProducing long, andthe onhighest the return to lendable - the measure of the buy all the of rates whole total returninfrom activitiesshort – involves thecharging combination of highrate lending rates plus high utilisation. The chart below you are a different that market the securities same waylending that BGI

BGI’s advantage as lending agent for iShares units

shows the return to lendable produced by BGI and the average return to lendable produced by the market.

Chart 2 : Return to Lendable: iShares iShares MSCIMSCI Emerging Markets US listing (EEM) US listing (EEM) Return to lendable: Emerging Markets Source: BGI 5.0%

BGI's return to lendable. 4.5%

Market's return to lendable.

4.0%

Return to Lendable

Return to lendable

3.5% 3.0% 2.5% 2.0% 1.5% 1.0% 0.5% 0.0% 06/06

07/06

08/06

09/06

10/06

11/06

12/06

01/07

02/07

03/07

04/07

05/07

Report Date Report date

Source: BGI, Data Explorers Limited – information available on www.performanceexplorer.com, as of end May 2007. returns are not reflective of future performance. 44Past| Global Securities Lending Magazine | 2009

As shown, BGI has delivered significantly better overall return to the client’s holding over this time period. In this example,

GSL04 39-48_apr8.indd 44 5.0% BGI outperformed

the market by over 1% during the period examined - an additional $1.1million of revenue on a $100 million

09/04/2009 18:51

Global Securities Lending 2009

exploring data

Barclays squeeze



- Data Explorers

600.00

1,400

550.00

1,380

500.00

1,360

450.00

1,340

400.00

1,320

350.00

1,300

300.00

1,280

250.00

-0

08

Quantity on Loan

-M 26

26

26

-Ja

ar

-F eb -

08 n-

ec -0 -D 26

8

1,420

8

Lendable Quantity(M)

“It was the top squeeze in our indicators yesterday and today; this means we caught the squeezes in Citigroup and Barclays before they happened. In Barclays, beneficial owners have been net purchasers of 100 million shares over the last week as lendable quantity has risen from 1.3 billion shares to 1.4 billion shares. With long buying and short covering, you have a perfect recipe for a rising share price. In this stock, hedge funds have been wrongfooted by the long side of the market, proving that getting caught in a short squeeze can be seriously bad for your wealth!”

Lendable Quantity vs Quantity On Loan

Quantity on Loan(M)

Barclays’ recent volatility leads to an example of a perfect calm. On 27 March 2009 shares up 17% after rising 13% the previous day.

Lendable Quantity

DPS

DNS

Xstrata Plc

69%

Liberty International PLc

56%

Standard Chartered Plc

69%

Thomas Cook Group Plc

49%

Alliance Trust Plc

67%

Next Plc

48%

Royal Dutch Shell Plc

66%

Tui Travel Plc

48%

Centrica Plc

66%

Hsbc Holdings Plc

47%

Wm Morrison Supermarkets Plc

66%

Foreign & Colonial Investments Trust

47%

Bae Systems Plc

66%

Vedanta Resources Plc

45%

Royal Bank of Scotand Group Plc

66%

Land Securities Group Plc

45%

Standard Life Plc

66%

Intercontinental Hotels Group Plc

44%

Tesco Plc

66%

Whitbread Plc

44%

DIV

DIPS

Liberty International PLc

46&

Barclays Plc

45%

Barclays Plc

43%

Xstrata Plc

41%

Land Securities Group Plc

39%

Legal and General Group Plc

40%

Next Plc

39%

Liberty International Plc

36%

Thomas Cook Group Plc

39%

Old Mutual Plc

36%

Legal and General Group Plc

38%

Prudential Plc

36%

Foreign & Colonial Investments Trust

38%

Hammerson Plc

34%

Old Mutual Plc

38%

Aviva Plc

34%

British Land Co Plc

37%

Standard Chartered Plc

34%

Hammerson Plc

37%

British Land Co Plc

34%

2009 | Global Securities Lending Magazine | 45

GSL04 39-48_apr8.indd 45

09/04/2009 18:51

direcTory

Directory

To be included email [email protected]

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.

W: www.mxcs.co.uk C: Adrian Morris Head of MX Consulting M:07879 475105 E: [email protected] C: Richard Colvill Senior Consultant M: 0777 1928113 E: [email protected]

C: David Little, Head of Securities Finance A: 101 Moorgate, London, EC2M 6SL, UK T: +44 (0)20 7826 4444 E: david.little@rulefinancial.com W: www.rulefinancial.com

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 short-side 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.

New York A:75 Rockefeller Plaza New York, NY 10019, USA T: +1 212 710 2210 London A: 2 Seething Lane London, EC3N 4AT, UK T: +44 (0)207 264 7600

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.

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

46 | Global Securities Lending Magazine | 2009

GSL04 39-48_apr8.indd 46

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Global Securities Lending 2009

direcTory

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

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.

Visit SunGard at www.sungard.com

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.

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

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.

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

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-the-art 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: [email protected] 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.

2009 | Global Securities Lending Magazine | 47

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09/04/2009 18:52

Statistics & Analysis

Statistically speaking Loans spreads are indicative of unique risks in cash-based lending programs, writes Andrew Shinn, CFA, at SunGard. Lenders in the U.S. have traditionally insisted on receiving cash collateral while European and Asian lenders have preferred to receive non-cash. The difference in lending styles was mainly a matter of academic debate before the credit crisis. New data from SunGard Astec Analytics demonstrate the real differences in the risk-return profiles of each lending method. As seen in Figure 1, before the credit crisis, cash-based loan spreads closely tracked fees from non-cash lending. Cash-based lenders have traditionally invested their collateral into short-term

assets with strong credit ratings so they could quickly adjust to changes in interest rates. Arbitrage between cash/ non-cash lending programs ensured that fees were similar.

Something changed several years ago, however, as cash-based lenders began to take on more risk in return for additional yield on the reinvestment side. In order to earn higher yields, lenders went further out on the yield curve and purchased lower-quality debt instruments, a move that some lenders now regret. As we now know all too well, the credit crisis drove down the prices of collateral reinvestments, boosting yields as seen in Figure 2. With higher yields, cash-based loan spreads increased. Fees, however, didn’t increase along

with spreads when the credit crisis accelerated in August ’07. The noncash fee displayed the “true” borrowing cost, while cash loan spreads were inflated due to markdowns in collateral

Figure 1: Cash-based loan spreads diverge from non-cash fees

reinvestments. Despite the newspaper headlines about the few securities lending programs that invested in mortgagebacked securities, most lenders did not invest in those now-depressed assets. Most reinvestment assets were marked down because of reduced liquidity. Since the assets in question continue to have relatively strong credit, if lenders are able to hold them to maturity, they should be made whole. We will undoubtedly see the average cash-based loan spread converge with non-cash fees again over the next couple of years. Once the liquidityconstrained reinvest assets are off the lenders’ books, it remains to be seen what changes will be made to the cashbased model. Z

Figure 2: Yield on cash reinvestment rises during credit crisis

48 | Global Securities Lending Magazine | 2009

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