For Securities Lending and Custody, Is Decoupling Gaining Momentum?

(March 16, 2011) – For what seems like a decade, industry analysts have been predicting that commonly custodial-based services, such as securities lending and foreign exchange, would eventually be decoupled from the core custody business. In practice, however, such change has been tempered: the issue of fees makes decoupling just too cost-prohibitive, it seems.

If recent activity at Deutsche Bank is any indication, however, this may be changing. The Frankfurt-based global bank recently secured a five-year mandate from the $25 billion Employees Retirement System of Texas (ERS) to execute its securities lending program. JP Morgan was ERS’ custodian as of February 22, 2011. This deal adds to recent success by the bank: in 2008, the Colorado Public Employees Retirement Association gave a similar mandate to Dresdner Bank, whose securities lending team was sold to Deutsche Bank in May 2009. In January of this year, the bank won a similar mandate from the Missouri State Employees’ Retirement System (MOSERS). The Florida Board of Administration (FBA), which manages well north of $100 billion in pension capital, is reportedly looking to follow suit.

According to a report and audio of ERS’ February board meeting posted on the fund’s website, the bank won the mandate out of a total of 10 bidders, which was eventually reduced to three finalists – Deutsche, Bank of New York Mellon, and State Street. State Street was subsequently eliminated due to manager turnover, according to the report, and the board ultimately selected Deutsche Bank based largely on its status as a non-custodial, “intrinsic value” lender. In contrast, the staff noted, “a custodian based lender has a tendency to focus more on general collateral lending than intrinsic value lending as the size of the lendable base and number of clients push the economies of scale in that direction.” In assessing the firms, ERS did not emphasize forecasted revenues. The report noted that reference checks on Deutsche Bank “confirmed staff’s perspective that Deutsche is a strong intrinsic value lender with excellent customer service.” Intrinsic value lending entails a distinct focus on lending securities that are in highest demand by borrowers, i.e. “specials,” which ERS contrasted with “general collateral” lending, where the focus is on lending securities with little or no demand characteristics for the purpose of generating returns chiefly associated with the reinvestment of cash collateral.

Following the 2008 crisis – and the numerous lawsuits facing custodians over securities lending and foreign exchange – decoupling of services has been viewed as increasingly likely. In April 2010, Global Custodian, a sister publication to aiCIO, wrote that “the agent lenders which succeed in 2010-11 will be those that adapt successfully to the changed balance of power between themselves and their institutional clients.” At the time, the magazine wrote, there were “already… signs of the ‘unbundling’ of custody, cash management, collateral management, and securities lending, and the spread of lending business across multiple providers to mitigate risk.” The recent ERS report seemingly shows agreement: in it, the fund wrote that it wants to “see the risk and returns in the program” – likely a response to cash-collateral pools that increased risk for securities lending participants unknowingly during the global financial crisis. Under the deal with ERS, Deutsche Bank will accommodate new risk controls identified by the ERS staff, as well as provide enhanced indemnification against risk, the report stated. The pension fund will also receive a greater portion of securities lending revenue sharing. Of course, talk of securities lending and custody decoupling has been occurring since earlier in the last decade: In a report from 2002, New York-based ASTEC Consulting “…analyzed the securities lending programs of 10 large US public pension funds between 2000 and 2002—and found that, in 2002, public funds with at least one non-custodial provider earned 40% more, on average, than funds that used only their custodian for securities lending,” according to sister publication PLANSPONSOR. Whether the status quo remains or whether recent moves by ERS, MOSERS, and FBA indicate newfound momentum toward third-party securities lending mandates has yet to be seen.