Keith Haberlin, with over 20 years of experience in capital markets, has worked with beneficial owners in all market conditions. He joined Brown Brothers Harriman in 2004 and has spent the past five years in leadership positions, most recently the global co-head of securities lending at the Boston- based firm. Haberlin will be speaking to delegates at the IMN Beneficial Owners’ International Securities Lending Conference, January 27-29, in Austin, Texas.
Haberlin says there are two critical issues dominating beneficial owners’ thoughts, which will be at the centre of proceedings – revenues and indemnification.
First, on the revenue side of the equation, beneficial owners are asking: Is the current, subdued revenue environment the new normal or is it a function of cyclicality?
Haberlin says it is not the new normal, just currently suppressed. “There are some structural as well as cyclical reasons, the latter due to current monetary policy.”
A low interest rate environment removes the ability to generate reinvestment income. “The consequent equity rally, caused by quantitative easing, is keeping short sellers on the sidelines for the time being and to some extent is hampering merger and acquisition activity as corporates are concerned about overpaying for companies.”
These factors are causing cyclical headwinds for revenues, but Haberlin expects revenues to pick up once monetary policy normalises.
“What we are saying to beneficial owners is hold serve for the time being and ride this cyclical trough out,” says Haberlin. “You will want to be in a lending programme when demand starts to rebound.”
The second key issue is whether indemnification will continue to be a standard offering. Historically, indemnification – an agreement to compensate the beneficial owner in the event of a loss – was effectively provided free by agent and custodial lenders because there was no charge to the bank’s balance sheet.
“I believe that the rubber is going to hit the road at this conference,” says Haberlin. “The discussion has been going for a couple of years, since the regulations were first proposed, and people have begun to realise that it is going to cost something when it is brought on to the balance sheet of banks.”
At the conference there will be a discussion about the future of indemnification – whether it is going to be scaled back, offered selectively, charged for or withdrawn completely. Both Basel III and Dodd-Frank will influence the fate of indemnification.
“If you think about it, the idea of providing a guarantee against losses, and providing that guarantee for free, does not really exist elsewhere in portfolio management, so it is not the worst thing if the regulations have prompted a re-evaluation of the whole concept”.
If indemnification is withdrawn, some risk will be pushed back on beneficial owners, so they will need to pay more attention to the parameters of their programme and the track record of their agent in managing risk. “This is going to be a good conference for beneficial owners, putting the issue into perspective.”
The conference will be bustling with agent lenders with varying approaches to the business, which they will put forward to beneficial owners at the many public panels (see box, overleaf). The closed-door sessions will give beneficial owners the opportunity to compare notes in private. “It will be a key conference for beneficial owners to determine their strategic participation in securities lending.”
It is perhaps too early to say whether beneficial owners will be happy to go without indemnification. It will, at least to some degree, depend on their level of sophistication. Anecdotally, some already consider indemnification to be of marginal benefit – as banks offering it may not be in a position to honour it should there be another crisis – whereas others see it as a necessity for continuing their programme.
“Sophisticated investors understand that it is a transaction that is fully collateralised, at a margin, and one where they control who they can lend to and what collateral they are prepared to take. Compared with other trades, it offers a really good risk-adjusted rate of return.”
None the less, more attention will be paid to the risk parameters of their programme, as well as the financial position of the agent or custodial lender they are partnering.
“If you put those two things together – subdued revenues and removal of indemnification – then the essential question for some beneficial owners becomes: Is it worth it?”
In an era of subdued returns, beneficial owners are looking for ways within their control to increase their revenues, such as entering new markets and changing their collateral profiles. “The conference is going to be good for addressing that question as well.”
In a low interest rate environment, beneficial owners are left wondering which levers can be pulled to generate more returns, including seeking out international opportunities. “They are very interested. As revenues in developed markets have become depressed – also due to tax harmonisation or a lack of market demand – they are looking to emerging markets to replace those revenues. They are very engaged.”
Markets such as Brazil and Taiwan, or further out on the horizon India and China, are under consideration and will be addressed at the conference. “Not only the returns,” says Haberlin, “but also the risk considerations, as they are not standardised markets.”
One of the other themes still circulating, at least among sell-side participants, is the potential for a shortfall of collateral . OTC derivative regulation and Basel III may increase demand for fixed income assets, potentially creating a shortfall that securities lending can fill with assets produced through collateral transformation, the practice of transforming assets that are not eligible at the central counterparty (CCP) to ones that are eligible.
“What is interesting is that, globally, some of the regulations are working against each other. Dodd-Frank and Emir [European Market Infrastructure Regulation] are forcing asset managers to put up high-quality collateral at the CCP while shadow banking and Esma [European Securities and Markets Authority] rules are going to make it very difficult to reuse collateral in transformation. It is a topic that is likely to be debated.”
Doubtless it will be so at the IMN conference. “While we are currently in a cyclical low point for demand, the long-term fundamentals for demand are strong. The principal reason for that is the growth of hedge funds.
They are the primary source of demand to borrow securities and we are seeing hedge fund assets really benefiting from a shift – you now have institutional investors and retail investors looking towards hedge funds as a way of getting less-volatile returns. They are really entering the mainstream and their assets are growing as a result.”
Haberlin estimates hedge fund assets under management total $2.4trn, above the $1.8trn peak before the crisis, and are set to grow further.
“That should mean more hedging, more shorting and good news for securities lending demand.”
We are now at the point of the cycle where hedge funds are putting their considerable assets to work in strategies that are not driving the demand to borrow, broadly speaking going long and riding the rally, but this may soon change as equity markets are hitting new highs.
“Even if indemnification is removed, and even in the current rate environment, we are still talking about collateralised transactions, with a margin, which delivers additional returns for fund managers on assets that would otherwise be sitting idle and incurring custody fees.”