PARTICIPANTS: 

• Alastair O’Dell, editor, Global Investor/ISF
  
• Naomi Heatley, DC product manager USS Investment Management
• Matthew Chessum, investment dealer, Aberdeen Asset Management
• Fuad Ahmed, investment management executive, Phoenix Group
• John Arnesen, global head of agency lending, BNP Paribas Securities Services
• Don D’Eramo, managing director, head securities finance, RBC I&TS 
• Stephen Kiely, head of new business development, securities finance, EMEA, BNY Mellon
• Nancy Allen, director, DataLend Product Owner

Regulation around indemnification will directly affect beneficial owners. Is 2016 the year it starts to bite?

Kiely: I saw in Global Investor/ISF recently that Xavier Bouthors of ING Asset Management is looking at having some of the programme indemnified and some of it not indemnified. He believes that it’s inevitable and he’s embracing it. It’s the first time I’ve seen a beneficial owner put that in print.

Arnesen: Splitting indemnification is a reality for US custodians. Not everybody will face increased costs – it will depend on whether you use the advanced or standard methodology. Foreign banks in the US are outside of this, for the time being. As an industry, we gave away indemnification during the pricing frenzy of the 2000s and it is very hard to ask for it back. The hardest thing about valuing indemnification is that it has almost never been used – even during the Lehman default.

Chessum: I love these conversations. For years, I’ve been told that not only will it save my skin but that it aligned my interests with that of the agent lenders. Now, I’m being told that I don’t need it and I shouldn’t have it. I’m slightly confused! Agents underestimate of how powerful it is for us to sell securities lending internally to sceptical fund managers and the risk department, which see lending as optional. It would take a long time to convince everybody that we don’t need it, since it was one of the programme’s biggest selling points in the first place.

Ahmed: I completely agree. The board would not be comfortable signing off without it. Kiely: It is very hard to reprice – but I’ll play devil’s advocate. I foresee the day when you ask your agent lender why you are getting lower levels of utilisation and they reply that it is because your whole programme is indemnified. Certain trades, for example GC, dependent on fee split, can theoretically no longer be as economically viable as in the pre- Basel III environment. If it’s on a fee split basis, interests are always aligned – the more the beneficial owner earns the more the agent lender earns. There has to be a realisation that if the cost of capital is too high, the agent lenders cannot provide the service.

Heatley: Matt’s point around the alignment of interest is the key one here. You don’t necessarily want your lending agent to be incentivised to earn more money if they’re not indemnifying.

They’re your assets. It’s exactly the wrong sort of behaviour to incentivise. Asset managers look at securities lending primarily from the risk perspective, then whether the revenue justifies that risk. Lending doesn’t make enough to justify itself if risk is increased. You’ve got to concentrate on your primary aim – revenue is secondary.

D’Eramo: The indemnity should not make an agent behave differently in running a prudent and appropriately risk-managed programme. From our perspective, there is no trade off between programmes’ offerings. Whether or not we indemnify, the rigour around our products doesn’t change. The programme would be monitored and reviewed equally and there is total transparency into which transactions are being indemnified.

Allen: Most lenders are going to evaluate the cost of capital at both the trade and client level. As indemnifications evolve – or perhaps no longer exist for certain trades, clients or portfolios – beneficial owners need to ensure they establish the correct level of governance over their lending agents. In my experience, beneficial owners take a long-term view of lending and look at it as an investment decision. 

To evaluate the pricing their agent offers, beneficial owners need to appreciate where returns can be generated in the market and how their agent is performing relative to those opportunities. These trends and opportunities can be identified within DataLend. 

Ahmed: It’s surely a good thing to monetise indemnification. In the past banks offered it regardless, without thinking about the risk or potential cost. If we move to it being properly priced, it would only be a good thing from an economic perspective. Indemnification should feed into the risk-reward analysis.

Chessum: The message is that everybody will be repriced. But if there’s enough competition and you’ve got the right assets, agent lenders will indemnify. We issued an RFP recently and every single agent came back and said it would. There might be an opportunity here for some mid-tier agent lenders to step up as, with fewer clients, the costs of indemnification will be lower.

Heatley: For most agent lenders, lending is not standalone. If there’s a wider relationship, especially for a custodian, the argument around the cost of capital is weaker. The capital structure and rating of the provider is of absolute importance.

Kiely: Not all indemnifications are created equal. I’ve seen RFPs that just ask ‘do you provide indemnification? Yes or no.’ That should just be the opening question, followed by what backs that indemnification, how much is indemnified, how you stress test and so on.

Arnesen: It is important to understand the details. Is replacement with cash, which you may not want, or absolute? Replacement now, or after a period? What if the asset is so illiquid you cannot get it back? We felt it was prudent to revisit our contracts – they are now incredibly clear. 

Heatley: It comes down to how savvy you are as a client and the expertise of your legal team. Last year we renegotiated and made some changes – it was hard getting our legal team up to speed as their focus is on negotiating private market deals. Once on board they were great – we got a good outcome – but many clients won’t have that experience.

D’Eramo: We need make sure that we do not lose sight of the fact that the goal of Basel III, and other capital rules, is to make the financial system more secure and clients take comfort from that. But some clients will definitely look at whether they need indemnification for all transactions. They may take a different view on certain types of transactions and collateral. Will CCPs be part of the solution with respect to GC? The industry is trying to answer these questions. The key point here is safety. The indemnification question should be considered in the context of the client’s risk appetite.

Phoenix Group just changed its agent lender. Was indemnification a major consideration?

Ahmed: It was. One agent lender in the process didn’t initially offer it, but then offered it with a reduced fee. It is an absolutely vital safeguard – but we don’t take it into account when managing risk. We have structured the programme so we would not expect to lose anything from a default.

Kiely: The biggest target is to remove GC indemnification. Would you consider a split? What if the agent lender says it would not indemnify GC trades – say with 10% utilisation in an extremely liquid name on an overnight rolling basis – but provide it for a deep special – a three month evergreen, high utilisation and duration, exactly to term. Would you consider that?

Ahmed: No, both historically and today. We’d want everything indemnified and would not distinguish between trades. But, if the market evolved to the point where we saw real price differentials, it would lead us to analyse whether the risk was worth taking. For our organisation, stock lending is a low priority. It’s the icing on the cake. If the risks and returns no longer make sense then we would close our programme. We have no appetite for losses from securities lending. 

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