Chair: Annabelle Palmer, Global Investor/ISF
Charles Murray, vice president, State Street
Oberon Knapp, senior vice president, business development, eSecLending
Nathalie Bockler, managing director and head of equity finance sales North America, Societe Generale CIB
Mark Fieldhouse, principal, Mercer
Reeve Serman, director of trading and market excecution, global securities lending, RBC Dexia
Phil Zywot, head of trading, global securities lending, CIBC Mellon
Chair: To what extent has the financial crisis and the Eurozone led beneficial owners and lenders to increase their focus on risk management?
Reeve Serman, RBC Dexia: Risk management is a very large focus within securities lending programmes. It’s almost a given that any credible securities lending agent has sophisticated and dynamic risk management processes and policies in place. Clients are asking a lot of questions around risk specific to the Eurozone.
Any risk management process has to be keyed in to what is happening there and it’s critical to make clear to clients that you, as their lending agent, understand it, are on top of it and are dynamically managing it. Exiting your position expeditiously in the event of a default is another key question both internally and among our clients. You want to ensure that the liquidity of your collateral is sufficient, that you can liquidate the position quickly and can purchase back the security you lent out.
Phil Zywot, CIBC Mellon: Canadian beneficial owners have always had a fairly conservative collateral policy. That conservatism is one of the reasons we were able to emerge from the financial crisis relatively unscathed. But there have been some changes over the last few years in terms of collateral acceptability and the ability to obtain credit has become more difficult. Ten years ago, when you required more credit, it was relatively easy to obtain whereas today you have to put a formal business proposal together and justify the use of credit and satisfy much more rigorous risk mitigation guidelines.
Mark Fieldhouse, Mercer: There is also a greater need for oversight and scrutiny on the lending programmes. The days of a passively run lending programme are gone for the majority of beneficial owners. Active involvement and ongoing communication is the real evolution we’ve seen.
Charles Murray, State Street: Clients are looking to tailor their programmes a lot more than they were. They’re much more specific on the collateral that they want to take, who the borrowers are and the quality of offering. They are taking a much greater interest in who is on our approved borrower list and how we vet them – and some clients vet borrowers themselves.
Nathalie Bockler, Societe Generale CIB: Given the fact that the Canadian marketplace is conservative, we’ve seen fewer kneejerk reactions in the Canadian market than other places in the world. The question of reducing overall exposure has been brought up but also most counterparts don’t want to get into a situation where risk is concentrated.
For example, a client recently mentioned, ‘with the European downgrades and the US downgrades, soon we’ll only be dealing with Canadian banks and Australian banks’. Which leads to other concentration and pricing issues. Trades are being viewed on a risk reward basis like other investment decisions to ensure restrictions do not eliminate a whole level of expertise.
Chair: Could equity collateral grow in importance in Canada?
Murray: Equity collateral’s been in existence for our clients globally during the crisis and post-crisis. One of the things we garnered from that was the transparency and liquidity of equities as well as the correlation. More clients now understand this.
Serman: The industry has had a mindset change. Two years ago I was at a conference in New York, I was on a panel and I mentioned that we were seriously looking at equities as collateral and I was challenged by the audience. Now it’s gained a lot of traction and clients are starting to understand it much better. Their initial reaction is, ‘Equities are more risky,’ but then you take them through the process and you explain the reduced correlation risk dynamic, and the ability to exit your position with a lesser impact on the collateral versus a government debt portfolio that you’d want to liquidate.
Fieldhouse: Pre-Lehman beneficial owners thought, ‘there’s never been a default and we have absolute 100% guaranteed government debt available in the event there is.’ People have realised sovereign debt isn’t necessarily the best position to be in if a default occurs. Speed to execution turned out to be the most critical thing and that’s fed into the realisation that equities actually provide excellent diversification and from a liquidity standpoint probably greater security than sovereign debt.
Oberon Knapp, eSecLending: The US view on equities as collateral is a little more progressed than Canada, having started earlier. Equity collateral was accepted before Lehman, but after Lehman everybody started looking at it from an execution standpoint rather than from a credit matrix standpoint.
Serman: Equities also have significant value from an economic perspective. It’s much cheaper for the borrowers to pledge equities as collateral compared to government debt which has become very expensive. That’s now the difference between borrowers actually putting on trades or not.
Bockler: Coming from the borrower side, every trade will be looked at with regards to the different collateral that we can put against it, and we will decide to enter into a trade or not simply based on the collateral structure. Having that flexibility and the option to use the equity as collateral is very important.
Murray: If you engage in an equity for equity trade, not only are you receiving a higher margin on the equity collateral, you are also receiving a higher spread, so you have more highly correlated collateral, higher margin and a higher spread. This is a positive on both sides of the trade.
Fieldhouse: Did you find a change in dynamic with the volatility that was experienced in 2011 around the equity markets?
Bockler: Large cap pretty much remained the same. When you went smaller cap, where the volatility was actually much higher, then you would see a change in the haircuts. Murray: We have actually increased our margins.
Serman: There are a reasonable amount of borrowers that are prepared to increase their haircuts for equities. Between 5% and 10% is not too much to ask, and we are finding a receptive response to that request. So that gives the underlying lenders an additional layer of comfort. For the volatility that you’re talking about the market has to move 5%-10% in one day for them to experience real exposure.
Knapp: Despite the increased volatility, beneficial owners are more educated and engaged and risk management is not a binary decision in that as volatility is increased they want a bigger haircut. The risk managers of some of the larger plans have incorporated lending into the broader enterprise level risk management and collateral management, and it has become more of a decision around ‘what are my exposures to everybody?
What are my overall capital markets lines? How do I feel about them? How are the CDS of these different borrowers moving? Do I want to think about more dynamic margining and maybe not worry about the haircut on the equity?’ It is a positive shift that we’re now much closer to the overall trading and risk budget of clients. The downside is that lending is the easiest place to express changes to risk policies and credit positions as it’s a lot easier to unwind loans or eliminate certain collateral rather than reducing your exposures through swaps, for instance. It’s a bit of a blessing and a curse.
Chair: How important is collateral flexibility for borrowers?
Bockler: The liquidity ratios that the banking community has to deal with has placed collateral management at the forefront of how we do business. Once you start attaching the real cost to collateral people have to take notice. It is a scare resource so, a counterparty that has the flexibility in terms of different sorts of collateral, different sorts of maturities, will be our favoured or preferred counterparty to deal with and they will get the bigger trade allocations.
Knapp: Clients are listening to what the borrower community needs and the types of trade structures in which they will engage. It’s much more opportunistic now. If you want to exceed your baseline level of returns, you have to want to hear what Nathalie is selling and what you can do within your guidelines as opposed to just allowing the programme to push balances and expect the returns to come to you.
Murray: Both borrowers and lenders seem more willing to listen, to look at, and vet opportunities with alternative types of collateral than previously.
Serman: That trend will continue to pick up momentum as we see more pressure on GC activity, fewer specials in general and the revenues going down.
Bockler: The new GC trade will be a collateral upgrade transaction. Lenders or beneficial owners that have the ability and that flexibility will be able to increase their utilisation much more.
Chair: Fees are currently low for beneficial owners. Is the type of collateral accepted a major factor? How else could revenues be increased?
Zywot: For GC loans you’ve seen spread compression happen in the US given that the market is dominated by cash collateral and you’ve got cash trading at historic lows. In Canada we haven’t necessarily experienced the same compression, as Canada has been and still is dominated by non-cash collateral. There has been some spread compression in terms of the fees that broker dealers are willing to pay to borrow securities and also in terms of what beneficial owners are expecting in the way of revenue splits with custodial lenders.
Serman: Underlying lenders are putting a lot more pressure on the split, shifting more to their favour which clearly impacts lender profitability. What lending clients don’t realise is that custodians have increased risk management, reporting, benchmarking obligations and additional costs in general. But we have nowhere to pass that onto, so the lending clients are squeezing their agent lenders as they assume more cost to do business.
Client participation in a lending programme also comes with more rules – clients don’t want to lend to everyone and they will only take certain forms of collateral, so it’s more difficult yet they still want more and more of the split. That is difficult for a lender, especially in a compressed spread environment. In this environment returns come from collateral flexibility, having discussions with underlying clients about alternative types of trades, like structured trades and term trades with rights of substitution. And like Nathalie said, collateral upgrade opportunities.
Bockler: Structured transactions are gaining more momentum. Demand from the hedge fund community has decreased impacting flow transaction. Where you can actually add value is in term/structured transactions. There is a benefit, the more highly structured transaction offers more transparency in terms and conditions. It’s a good development as it leads to very in-depth, transparent discussions.
As a result, it also improves the education of all the parties involved. Other fee generating opportunities exist with corporate actions and arbitrage transactions. This again requires discussions with the portfolio managers on the impact of a guarantee on the quantity and the election. Overall everybody is becoming a little bit smarter.
Zywot: There’s also an opportunity to look at those one-off special situations and capitalise on those by approaching beneficial owners that are not necessarily in a securities lending programme or are not interested being in the securities lending programme on a full-time basis. For beneficial owners that are uncertain that a full-scale lending programme is the right fit for them, supporting the client in capitalizing on a special opportunity gives a lending provider the opportunity to demonstrate strong execution, which can lead to further deals down the road. A positive experience can also help clients recognize the value of a lending programme in terms of enhancing returns and pave the way for an owner to choose to expand their participation towards a full-time lending programme.
Fieldhouse: If clients can capture 60-70% of the revenue and not take on the burden of the oversight requirements on their end on an ongoing basis, it absolutely makes sense and that’s going to be the right solution for a lot more people than it has been in the past. And it’s a lot less market exposure in the event that something goes wrong.
Murray: Yes, it gives them comfort because the loans are usually short duration with good yield. Fieldhouse: Canadian beneficial owners are also actively seeking greater exposure to the emerging markets from a direct investment standpoint. That’s a great trend for lending as far as helping drive those new opportunities forward.
Chair: Where does technology fit into revenue and cost management? Murray: From an operational risk and control perspective contract compare and web-based trading adds many controls and efficiencies to our processes and can mitigate some human error. On the borrower side, Canada has been a little slow off the mark to embrace those technologies. We have to engage borrowers, a lot more than we have historically. It doesn’t matter which service you pick as long as you have one.
Zywot: We’ve definitely seen technology increase revenues given that it has allowed us to capture efficiencies and free up capital and manpower to better utilise that capital on more revenue-added products or trading strategies. Why have a trader sit there and go through a 250 stock list on an Excel spreadsheet manually when you can utilise an auto-borrow feature and have it done in seconds?
Serman: Why do you think technology is not being embraced as fast here in the Canadian market as in the US?
Zywot: I think it’s due to the size of our market. We look at costs a little more carefully and given that our market is so much smaller than the US, it may not make sense for some of the broker dealers to utilise an auto borrow-type feature to implement their trades. It might be still cheaper to have a trader run through those lists.
Murray: I disagree. The cost was prohibitive a few years ago but is not prohibitive now. You’re creating operational controls and mitigating risk for a very small amount of investment, and I don’t think anybody these days is going to argue with that.
Chair: A few players dominate custodial lending in Canada, which is seen as a staid back office function. Should more be done to increase competition and could custodians do more to optimise performance?
Zywot: I don’t think you can look at custodial lending as a staid back office function. Thirty years ago it was considered a back office function but now it is seen as a front office investment function.
Murray: Being a custodial lender is not a cheap business to be in – there’s significant investment in infrastructure and reporting. As far as it being a back office function, we treat it as an investment function. In America there’s a lot more cash lending and sophistication in cash lending and that is a big part of State Street’s business, so it’s not back office, it’s an investment tool for State Street and as well for our clients, and they’re very involved in that and I think they view it as such.
Fieldhouse: There’s always going to be space in the market for custodial lending programmes. The benefits that come from having a critical mass of assets are key to lending clients. A large asset pool can be essential to maintaining operational transparency and settling trades, even more so with greater pressure on returning securities for proxies. Historically, the bigger the pool of assets you have, the more transparent the programme. There was a natural evolution to a small number of players for that very reason. The bigger you were the better programme you could run from an operational perspective but not necessarily a revenue perspective.
Knapp: I beg to differ on the operational front. Technology has evolved where both standalone third party agents and third programmes run by custodians no longer face the operational hurdles they may have had 8-10 years ago.
Fieldhouse: At the same time with clients getting more actively involved in particular trades, does that need to be done through their custodian? I would say no. The more actively involved the beneficial owners are, the more it becomes an investment function and the more opportunities there will be to deal with more than one provider. Opportunities will be there for the lending agents that can deliver the revenue, the risk and the operational delivery regardless of whether or not they are the beneficial owner’s custodian.
Serman: When mutual funds started to lend in 2001 the regulator dictated that all mutual funds must lend their securities through their custodians, and there was some wisdom behind that. For any individual institution, no matter how large they are, to start up a securities lending programme from scratch is a massive undertaking. It requires a huge amount of knowledge, capital and funding. If you’re not good at it you are subjecting yourself to enormous risk.
Bockler: In the US some very large mutual funds have their own lending programme in-house, or they diversify and have part of it through their custodial, part of it triparty and part of it in-house. It’s a way of diversifying risk as they’re not depending on one provider. Every investor is a little bit different, so there is definitely a spot for custodial lending for the vast majority of clients, but you will have these very large institutions that have the capability and the knowledge to do it themselves and some of them do it very successfully.
Fieldhouse: Technology’s evolved to a point where it’s a lot easier than it used to be.
Knapp: In the US market the custodians still dominate despite widespread acceptance of third party lending. The view of securities lending bundled with custody is changing. Post-Lehman, an increasing number of RFPs have been unbundled from the securities lending decision. As it has become more of an investment function, larger beneficial owners have taken it out of that typical procurement process and said, ‘I’m going to look at you as an investment management hire, I’m going to run you through that due diligence process.’ It doesn’t seem that the market’s evolved quite that way in Canada yet, but maybe that’s just a matter of time.
Chair: What effect will the Volcker Rule have on securities lending in Canada?
Bockler: Volcker is/will have an impact on demand in Canada and worldwide. The demand for securities to cover shorts and the natural inventory that prime brokers had in-house is decreasing and eventually some will move outside. We could expect a transition period where some prop traders will move to the hedge fund space, and eventually some of the strategies will be picked up by hedge funds. At some point, they in turn will need financing and it will roll back to the prime broker. Pricing will probably change but all things being equal you should see the transaction flow in a circular pattern over time.
Chair: What impact will Basel III have on collateral requirements?
Serman: Basel III is creating an opportunity for securities lenders. We have clients with long quality assets, high quality government assets that other financial institutions need to borrow onto their balance sheets for term to demonstrate that they have liquidity. Utilisation levels will continue to climb and this will give some leverage to lenders and beneficial owners to charge higher rates for those assets.
There’s also going to be the need for high quality collateral in central counterparties in the OTC market. Where is everyone going to get that collateral from? It has to be from the lenders. A resulting liquidity squeeze for high quality fixed income is imminent and that is where the opportunity will present itself going forward. There’s still opportunity in the equity space but there is an opportunity in the fixed income space more so than ever before.
Knapp: With the collateral upgrade/ downgrade trade, some of it goes counter to what we talked about earlier with the awareness of equity and cash collateral. Now broker-dealers want to borrow high quality assets and they want to pledge lesser quality assets such as convertible bonds, municipals and non-investment grade corporate. So, on the one hand the industry says to clients, ‘the lesson from the credit crises is that you should be comfortable with equities and cash collateral’. On the other hand, the impact of regulations has created an opposing dynamic where the great opportunity is to accept the collateral that we’ve been saying is not as good from a liquidity standpoint.
Serman: You’re correct, but it depends how you look at it. No one’s very willing at a 105% margin to accept low grade corporate debt as collateral. It’s not easily priced, it’s not as liquid. If they’re that desperate to give me corporates and they really want me to take them seriously they have to give me a margin that makes sense so I can protect myself and my client in the event of a default. Bockler: Increased transparency is what everybody wants and reduced risk, but we do not yet know where the costs will be and if we can afford to incur them.