US Beneficial owners roundtable

US Beneficial owners roundtable

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  • Chairman: Hugo Cox, Global Investor/ISF 
  • Chris Valentino, vice-president, business development DataLend 
  • Michael McAuley, managing director, global head of product and strategy, securities finance BNY Mellon Markets Group 
  • Jim McDonald, global head of trading, securities finance, State Street 
  • Tred McIntire, managing director, Goldman Sachs Agency Lending 
  • Eric Pollackov, managing director ETFs, client portfolio strategist Charles Schwab & Co 
  • Charles Rizzo, CFO John Hancock Group of Funds, John Hancock Investments 
  • Jim Vance, vice-president and treasurer, Western & Southern Financial Group 


What trends are you seeing in the securities lending data you collect?

Chris Valentino: From an asset class perspective, the largest revenue generators globally are equity common shares. Equity common shares account for 73% of total revenues in the US, 70% in Emea and 96% in Asia . Of the remainder, in the US, 8% comes from ETFs, 7% from sovereign bonds and the remaining 12% from depository receipts, corporate debt and other instruments. 

valentino equilend

US equity loan balances have been on a slow and yet steady climb over the past eight quarters, up 26% from $340bn in Q1 2013 to $430bn as of November 30 2014. Inventories are around $4trn, up from just over $2.5trn at the beginning of 2013. Most of the rise in inventory can be attributed to an appreciation of the US equity markets – with the S&P up 29% in 2013 and up 13% in the year to the end of November – rather than new players coming into the lending pools. Utilisation is slightly down from 14% in 2013 to 12% in 2014. 

In Europe, equity utilisation levels came in at 9.25%, with the exception of Q2 where we saw the usual pickup in seasonal activity. Equity loan balances and inventories across Asia have been on a steady rise since early 2013. As of November 30, Asian equity markets saw loan balances of $103bn and inventories of $1.1trn, so utilisation levels of 9.7%. 

Charlie Rizzo: Following the Basel III requirements to strengthen their balance sheets banks have moved away from certain types of loans, decreasing inventories. Does that show in this data? 

Valentino: We track lendable inventory, so if there was a pullback in what beneficial owners are injecting into the supply pool, we would see that. As of now, we have seen no certifiable evidence of a retrenchment in lendable inventory. 

Regarding spreads, it has been a relatively good story in the US. Average spreads for the year have been climbing steadily from 60 to 80 basis points (bps). In Asia, spreads have been relatively range bound between 100 and 120bps. And in Europe, outside of the busy summer season where spreads spiked to 120bps, they have traded in that 40 to 60bps range. 

The US equity market continues to be an opportunistic and specials-driven market. Of the current loan balance, 88% is trading under 50bps. Only 6% of the average daily balance is trading over 150bps. It is a similar story in Europe, where 80% of the market is trading at general collateral (GC) levels, and the remaining 20% is left to drive revenue. Asia has a bit more of a balanced market with 73% of the market trading below 50bps and 26% of the market trading between 50 and 500bps. 

Rizzo: If a substantial portion of the revenue is coming from specials, are you still seeing your clients loan GC? And, are there specific types of products, such as an index? 

Jim McDonald: Yes, we do still have clients lending GC, but client interest varies. Certain client types, including public pension and sovereign wealth funds with stable, multi-asset class portfolios, tend to be more comfortable with managing cash or collateral that generates sufficient yield to make the GC product interesting. In the last few years, however, many other clients have adopted minimum spread requirements for all transactions that effectively limit lending to higher spread specials.

BO roundtable 

Rizzo: Would that be mostly your investment company clients? McDonald: Yes. Would you say that since 2007 clients such as pension funds have become more comfortable with securities lending? 

McDonald: Yes. I think that a lot of clients have become more comfortable in recent years through a better understanding of lending. Generally, beneficial owners are more engaged in understanding what securities lending is and have become more comfortable with the risk-return dynamic that their programme generates. So, whatever their programme is, their comfort level is higher than it was. Whether they choose to participate is a separate question. 

Michael McAuley: I agree, some of the changes made in securities lending programmes since 2008 have improved the risk-return dynamic. The move away from commingled vehicles to separate accounts and revisions to investment guidelines are two examples of changes that have further reduced the risk associated with a lending programme. 

Within certain clients there has also been a change in the management of the programme, with the responsibility moving from the back office into the front office of the investment management function. Much of this has helped generate an increase in client participation. 

Valentino: Also, as part of our analysis we ranked each of the global equity markets by its top-earning sectors and securities . In the US, the top-earning sectors were healthcare, consumer discretionary, IT and energy. 3D Systems was the number one short on the street in 2014, generating approximately $90m in revenue with an average utilisation of 93% and an average daily spread of more than 1,000bps. Other top earners included GoPro, Myriad Genetics, Sears Holdings and MannKind.

Beneficial owners, have you been pleased with your lending programmes during 2014 and what impact has the low rate environment had? 

Jim Vance: In terms of our underlying insurance business, the prolonged low interest rate environment has been particularly challenging. In terms of securities lending, we went into the year a little more watchful about what we thought our utilisation rate was going to be. We were not sure whether the hedge funds and short desks were interested in doing their trades more via the cash markets or via derivatives. That has a big effect on our portfolio’s utilisation. 

BO roundtable 1

In general, we were pessimistic about 2014 but we exceeded our expectations. Our utilisation was substantially up – it picked up right after March-April and then we continued to have a steady increase in the amount on loan throughout the year. Underlying that, with the drop off in QE, there seemed to be a little bit more appetite for fixed income securities, which dominate insurance company investment portfolios. There has also been a lot of appetite for Reits and ETFs. 

Rizzo: In the second quarter, we pivoted to take a more conservative view of our lending programme because of the riskreturn trade off. As a beneficial owner, we have historically liked the GC trade but as reinvestment yields decreased we utilised caps to our total lending programme to squeeze out GC loans. More recently we increased our minimum spreads and then worked with our agent lenders to make sure they understood what our new standards were. As GC loans were returned from borrowers they were not reissued – by not recalling the GC loans the reinvestment vehicle was not disrupted – so the effect is that we are basically out of GC today. 

Why the shift? As Chris’s data showed, a significant portion of the funds’ revenues were coming from specials and, with the threat of rising interest rates, the risk of unrealised losses in our collateral pool caused us to pivot. We felt that it did not make much sense to have a lot of GC that would be earning little income and exposing our lending funds to unrealised losses. 

Today, we have done a lot of work with our boards to help them understand why we lend and the dynamics of lending, and communicated the senior management group standpoint that we are comfortable with the risk-return trade off with a specials-only strategy. 

Now, this does not mean we eliminate all GC – we would consider the issue of GC loans if we felt that it would be advantageous to the fund, such as with a market correction and resulting margin calls because our borrowers were over-collateralised. 

We let the fund managers decide whether they want to lend and if they want to put other restrictions on the programme, such as only lending certain asset classes or holding a certain percentage back from lending. We have about 220 funds and about 133 are lenders. We reach out to all the lending managers on an annual basis and make sure that they are still comfortable with their decision to lend. For those that do not lend, we have information to explain the opportunity costs of not doing so. 

Eric Pollackov: In the ETFs that we manage, it has all been about scale. We have taken in about $7.2bn this year into ETFs and that allows us to now start lending many of the securities that make up those portfolios. 

In terms of the revenues from securities lending by Charles Schwab Investment Management, all of it goes back directly to the shareholder – lending is not revenue generating for our firm. Within that, roughly, 85% goes back to the shareholders and 15% goes to the lending agent. There are ETF manufacturers that use securities lending as a revenue-generating enterprise, but we are not one of them. 

With regards to Charles Schwab clients, we have seen for the most part this demand for greater yield where this wanting of greater yield: they are getting a basis point on the money market funds but nothing else anywhere else. So we have seen an uptick in people wanting to start lending via margin accounts. 

Our fully-paid-for lending programme allows clients to lend their fully-paid stock, receive cash collateral from Schwab and get paid while the stock is on loan. They have the right to sell the stock at any time while on loan or to ask for it back but it is a yield enhancing product for our client base and as rates have remained low for so long we have seen a steady up-tick in client demand for this product. 

Is it because you have relatively smaller customer accounts that you impose the 100bps minimum? 

Pollackov: We impose a minimum floor of 100bps on stock loans to ensure that we do not have GC loans on our books. Ours is a different client base, it is important to realise, from the institutional clients traditionally involved in this market. So many our clients do not fully understand exactly what securities lending entails and what the risks are. We do spend a lot of time explaining the risk-reward balance and the trade-offs of becoming involved. Those who are interested are the more sophisticated ones that are reaching for that higher yield generation and understand the risks and rewards. 

Agent lenders, how typical is the type of retrenchment that Charlie described? 

Tred McIntire: It depends on the segment of the lender supply chain. The ’40 Act fund community has been relatively conservative – many of them have implemented minimum spread criteria over the last three or four years. Separately, the index funds and quant managers have a different view of GC lending. A very important part of managing an index is being able to keep your cost base really small, and any contribution from lending is important. 

BO roundtable 2

McDonald: I think the key point here is that clients have generally become more engaged with their lending providers to both design and, as needed, dynamically manage their lending programmes to align them with their individual risk profiles. Some have adopted more conservative cash collateral investment guidelines and adopted minimum spread requirements. 

Some have expanded their approved non-cash collateral options. Virtually all have increased their understanding of the product and their ongoing due diligence efforts to better ensure that they are comfortable with the risks and rewards available to them. 

Vance: One thing that our risk management framework uncovered, which ties in to cash reinvestment and counterparty exposure, was the fact that, if you invest in commingled funds, the lion’s share of your investments are with financial service companies. The question of whether you want to have that much exposure to financial services has been an ongoing theme as we waited for the stress tests to come out. 

So we looked at cash investment levels, or we switched to US government only fund investments, because we wanted to prune our ratios in that regard. And we have specifically earmarked certain banks in the programme that we will allow to trade through as well as be allowed in a cash reinvestment via repo. Now, this creates a self-fulfilling prophecy – if you limit your cash reinvestment then by definition you are going to be shrinking the size of your programme. 

What effect will the net stable funding ratio (NSFR) rules have on the industry? 

McAuley: What the NSFR will look like here in the US is currently unknown as regulations have yet to be proposed. Looking at the final Basel rules, the NSFR could increase the borrower’s cost of providing cash collateral to a beneficial owner. The cash that a borrower provides as collateral is an asset on the borrower’s balance sheet that under the NSFR requires a certain amount of required stable funding. 

BO Roundtable 3

Under the Basel rules, this is generally 15% for loans with a term of less than six months. On the liability side, the borrower gets no credit for cash raised in the overnight market or for cash provided by its client from short sale proceeds. As a result, the borrower would need to raise additional funds in the term market, significantly increasing its cost. 

McIntire: Yes, it is important to recognise how the NSFR will impact the current short sale model. Currently, the prime broker borrows stock from one of the beneficial owners on a principal basis and lends it to a hedge fund or other party that then sells the stock short. The short sale proceeds pass through the prime broker, along with a little bit of extra margin, to the lender, without creating extra liquidity for the broker. 

However, the latest NSFR pronouncement introduced the concept of a “linked transaction”, and it defers to national regulators for interpretation in their respective jurisdictions. At this point, it is not clear how much of the short balance will be subject to the 15% funding requirement. 

What prospect is there of having equities approved for use as collateral in the US? 

McIntire: There are two parts to that question. One is whether the SEC will allow brokers to give equities as collateral to customers. The second part is whether it will give brokers relief in how the 15c3 formula is calculated. 

McAuley: I think the prospects are good. The agent lending community has been engaged on this issue for many years. The Securities Lending Committee of the Risk Management Association produced a white paper on equities as collateral several years ago. Also, the last time rule 15c3 was amended, the SEC specifically asked for comment on whether certain large institutional investors should be excluded from the definition of ‘customer’. 

While the SEC understands the benefits to all parties, however, it was really never pushed by the entities that it regulates . Now equities as collateral is a solution to a number of regulatory challenges the broker-dealers are becoming engaged on the issue. If they can find a good solution to the formula issue, I think we will see equity collateral here in the US. 

What progress has there been on central clearing and what are the main obstacles? 

McAuley: Again, it is the leverage ratio and the pressure on dealers’ balance sheets that is driving the increase in discussion around finding a buy-side friendly model to centrally clear securities finance transactions. Because the dealer’s counterparty is always the CCP it provides the dealer with some ability to net transactions. 

This could allow them to do more transactions without increasing balance sheet usage. We view central clearing as a distribution method that may help to preserve demand for our clients’ securities. It should develop in a way such that central clearing becomes a negotiated term at the point of trade with a different pricing structure from non-centrally cleared transactions. 

How is indemnification being viewed by beneficial owners? 

Rizzo: In general, most consider it as an insurance policy against losses and that is reassuring. But when you step back from it, for it to kick in you need to have a market rally, where the value of your loan is higher than the collateral you are holding, and the borrower to go out of business. That is probably a remote circumstance. 

Vance: This discussion goes directly to our board and our finance and risk committees. They are very aware that there is a cost of capital for our banks as well as for us. I think the members have accepted a certain level of risk that comes with indemnification being provided so that if it were taken away, albeit one can describe the risk as remote, they would still miss the indemnification. 

Now, we do not see collateral levels changing as a result of this. I think as things become more transparent you will be able to compare and contrast your risk and economics with and without indemnification. 

McDonald: Much of the recent discussion about indemnification has framed the question of whether it makes sense for an agent lender to offer it as one with a yes or no answer. But the answer is probably more complicated and nuanced. The question for an agent offering an indemnity is whether the use of regulatory capital is justified. For any financial institution that is managing and allocating limited resources, there are usually broader considerations beyond any individual transaction. 

Also, there are ways to reduce the impact of indemnification on regulatory capital – through the efficient use of counterparties and collateral or, in certain cases, by providing an indemnity on a partial basis to cover the tails of an unwind event. Many transactions should not really require a full notional guarantee from the agent. 

McAuley: Most large agent lenders are likely to be constrained by the leverage ratio. Since indemnification has little or no impact on the leverage ratio it is likely to continue to be a standard offering. It will cost the agent more to provide it but as long as the agent is earning a good return across the client relationship, then it is unlikely to be limited. 

Has there been a material effect on supply? 

Vance: Something that follows from the low interest rate environment is where investors are looking to get yield. You are definitely seeing portfolio managers and investment mandates expanding out or changing asset allocations – maybe increasing allocations to emerging market debt or Asian securities, maybe looking at dividend strategies where you can get better yields on owning AT&T stock than you could on the AT&T bonds, albeit there is still a credit analysis. So, as asset allocations change, it will change what is available in your portfolio to lend. Some of those asset allocations are more attractive to lend than domestic fixed income.

McIntire: I do not think that supply is the interesting story. As evidenced by the decline in utilisation, there is plenty of supply in the market. Another indicator is the lack of aggressive bidding for exclusives – there is so much supply that borrowers can buy what they need in the spot market without paying for an exclusive to lock it in. 

Having said that, there are still some institutions that withdrew from lending after the financial crisis that remain on the side-lines, and we are seeing some of those accounts gradually come back to the lending market. 

There are also other beneficial owners that have never lent before – particularly in Asia where we have seen interest from certain insurance companies and investment managers. Even in Europe, believe it or not, there are some pension funds that have never lent so there is new supply coming to market there too. 

McDonald: I agree with Tred , and that is especially true in the equity space. The other place we have seen some new activity is in collateral transformation. There have been significant opportunities for lenders that are holders of high grade government debt that are willing to lend those assets against something of a lesser credit quality. That market has become much more robust and should remain so going forward. 

McIntire: I would just like to add a comment about the US equity specials market. We usually compare sector results to the same period in the prior year to account for seasonality. The first half of 2013 was really strong in the US specials market but then many of the ultimate borrowers suffered on positions in alternative energy and web services stocks. 

The first half of 2014, compared to 2013, was pretty soft, but from June onwards the US specials market picked up tremendously – the month-to-month comparisons were significantly stronger in 2014. And it is not driven by one or two home runs – there are a lot of singles and doubles, and a few triples. It has been a broad-based, diverse range of warm to hot names that have driven US lending revenue. 

McDonald: We have seen the same. The second half of 2014 was significantly better in terms of overall demand for specials, at more enhanced spreads, particularly in the US equity market. 

Valentino: The data most definitely supports the comments made by Tred and Jim . 2014 definitely saw a larger number of high- margin opportunities. It is not just a handful of names driving revenue. 

McDonald: Measuring the demand for large cap equities can be an interesting exercise in this market. If you look at the utilisation rates for this universe, the demand seems low. However, at least one reason for that has to do with the changing source of, and borrower access to, large cap supply. Borrowers are looking to become more efficient in managing their balance sheets and therefore are trying to use more internal supply or to trade synthetically to cover shorts when they can. When they do source assets from a lender, borrowers are trying to optimise loan terms, including collateral posted. What are the prospects for fixed income assets? 

McIntire: Recently, there has been concern around fixed income ETFs and how liquidity is maintained in a period of stress. Is that something that the ETF community talks about? 

Pollackov: Yes, all the time. With ETFs you are potentially taking an illiquid instrument and making it somewhat liquid on an exchange. We have an aggregate bond, a short-term treasury, an intermediate treasury and a TIPs fund – so a broad range of very liquid products. But if you look at something like senior bank loans, or high-end corporate bonds, then potentially the tail could wag the dog – these are difficult to price as it is and if there is a knee-jerk reaction to a Fed rate rise from the fast money then it could be hard. There have been instances in the past in the ETF market where this has happened and we talk to investors all the time about how and why but explaining the risks is never easy. 

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