Participants:

Alastair O’Dell, Global Investor/ISF, chair
Craig Starble, chief executive, eSecLending
John Griffin, senior risk manager and head of derivatives & trading counterparties, Himco
Tred McIntire, managing director, Goldman Sachs Agency Lending
Doug Brown, managing director, Americas sales and relationship management, State Street
Mike McAuley , managing director and global head of product and strategy, BNY Mellon

Chair: As a beneficial owner, how do you view indemnification?

Griffin: It is very important in the current world. But if the world starts to change and it becomes more expensive, then it becomes a risk management question – choosing who you do business with – that may potentially further separate the tier-1 from the tier-2 service providers. Buy-side firms may not see the value add in paying for it if the cost gets passed on.

We would just review which counterparties and administrators we are doing business with. For mutual funds that are required to be indemnified the question is whether it is economical to maintain their programmes. The buy side are ultimately paying for it now, one way or another. If it becomes more expensive for agent lenders, they will pass it on to us. The question is whether it will still be worth us being in the business. Is it nice to have or essential to our business model?

Starble: Traditionally, when new regulations come in a cost analysis is done and products are developed – there is innovation – so clients can still lend with the appropriate fees and are not asked to bear the cost. Some clients are going to end up being provided with full indemnification at relatively little cost. However, once the analysis is done, others may find they are not offered indemnification at a low rate and they can either take the charge or they will not. Clients will not appreciate it and will look for the industry to innovate in order to continue offering products.

Doug Brown: If the banks have capital issues and firms with insurance do not, the industry will move into action. There are other structures – there will be no real damage if there are options to utilise.

McAuley: The interesting thing is some of these regulations if not modified may have the effect of pushing more activity into the unregulated space and that is probably not the best outcome.

Starble: The regulators are trying to diversify risk. They are concerned about systemically important institutions, ones too big to fail. The consequence may be that some business is pushed to smaller entities. On the broker-dealer side, it is going to be the same. The biggest houses will do business with fewer hedge funds – so the other hedge funds will find smaller broker-dealers to do business with. It is an efficient market.

Griffin: It cannot be that they have such a short-term memory that they want to drive business to smaller, less well-capitalised players that are under a lighter regulatory framework. That would just create the potential for the next savings and- loan-type crisis with perhaps not the right market participants providing services in the space.

McAuley: It is going to cost more to provide indemnification but I do not think indemnification will disappear. There will be innovation. Certain lower yielding trades might eventually be transacted through a central counterparty (CCP). There are also ways to reduce the capital impact. For example, expanding collateral flexibility to allow for the option of matching currencies between loans and collateral.

Moving to a matched currency transaction could reduce the risk weighting for a transaction by approximately 5.7%. Most programmes – with good intrinsic value business – will meet their required return on capital hurdles and since the indemnification does not consume leverage, it will remain a profitable business.

The bigger issue with indemnification is the large exposure proposals from Basel and under Dodd-Frank 165(e) because they impose a hard limit for each counterparty. It will require more diversification of counterparties and balances.

Starble: Partnerships should be created – that is the real innovation. The industry will figure out how to make them work within the regulations – how to use both excess capital and companies that have insurance or another way to indemnify. The business will not go away – the industry is very smart.

Everyone’s capital treatment will be different so the industry will figure out a way to do trades appropriately for clients. I am confident there is enough ingenuity in the market. Importantly, we are only talking about at-the-margin transactions – all trades with intrinsic value will continue to make sense.

Griffin: Yes, marginal trades may just not be good trades any more. Maybe they never really were, just artificially subsidised.

Brown: 80% of revenue comes from 20% of trades. So, for the other 80%, is there truly a need for investors to buy those assets? If they do not really see value in those low-profit assets then we will see some shrinkage.

McAuley: In the existing business model, there are owners and end users on either side with two credit intermediaries in the middle. Under the new rules there may not be enough capital, leverage or counterparty credit for that business model to continue to meet market demand. There is going to be change. Agent lenders will need to find new ways to distribute client assets. This will create opportunities for traditional custody banks to absorb some of this demand.