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IN OCTOBER 2010, at the aiCIO Chief Investment Officer Summit in London, Dominic Hobson, Editor-in-Chief of Global Custodian and grand man of all things custody, moderated a panel on the future of the securities-lending business. Speaking on the panel alongside Jack Cutler, Director of Pension and Thrift Management at Zurich-based ABB, and Roy Zimmerhansl, the well-known securities-lending expert, was a representative of one event sponsor. Hobson, known for his acerbic editorials and British wit, got right to the point with his first query, directed at the sponsor: “All your clients are suing you. Why?”
It was a fair question—but also one that now, nearly a year on, has been answered exhaustively. Some firms, such as State Street, have made clients whole; others are seeing litigation through the courts. Whatever avenue custodians and clients take, the dust essentially can be said to have settled. By the time the 2012 New York City Chief Investment Officer Summit came in May, the inevitable securities-lending panel—this time moderated by Teacher Retirement System of Texas Deputy CIO Jerry Albright—did not even touch on lawsuits. Instead, into this fleeting void of controversy stepped another battle—one that once again threatens to upend the age-old distribution chain of securities lending.
“For years before the financial crisis, the ends of the securities-lending distribution chain,”—which conventionally goes beneficial owner to agent bank/custodian to prime broker to hedge fund and back—”were under pressure from the middle to switch their business,” says Nicholas Bonn, Head of Securities Lending at State Street. Prime brokers wanted to go directly to beneficial owners to get securities, skipping the custodian; custodians, possibly to a lesser extent, wanted to lend securities directly to hedge funds, skipping the prime broker. “In the crisis, this disintermediary action was suspended as everyone tried to stay alive, but it has reemerged. Primes are trying to reinvigorate that process.” They’re not doing it quietly, either. Decoupling—or disintermediation, or, more colloquially, ‘taking-your-competitors’-clients’—has been a buzzword before, and promoted mandates may have been more anecdote than sea change. Whether this has changed post-crisis is unclear, but firms once again are claiming success, the most vocal being Deutsche Bank, eSecLending, and Credit Suisse. The Frankfurt-based Deutsche has been particularly active as of late: The firm recently secured a five-year mandate from the $25 billion Employees Retirement System of Texas to execute its securities-lending program, which builds on similar mandates from the Colorado Public Employees’ Retirement Association and the Missouri State Employees’ Retirement System.
Such wins, unsurprisingly, make sense to representatives of firms looking to break the custodial stranglehold on this business.
The Age Old Distribution Chain
“The securities-lending industry is evolving similar to how the investment management business evolved when it was no longer managed by the custodian,” says Peter Bassler, Head of North American Business Development and Product Management at Boston-based eSecLending. “You look at RFPs now and securities lending is unbundled from custody services given that it is a separate competency to a large degree. The custodians still compete, but they compete as a stand-alone-function.” It makes sense, Bassler claims, given that a custody bank’s core competencies are operations and processing, while securities lending is more of an investment/repo market function. Additionally, the structure of third-party securities lenders creates efficiencies unseen with custodians, according to some. “We’re a broker/dealer and a bank, and so combining both the agent and the principal programs creates numerous benefits,” says Dwight Skerritt, U.S. Head of Institutional Coverage for Securities Lending at Credit Suisse.
“Disintermediation is a natural pressure when you have a distribution chain like this. We’re fine with that.”
Custodians won’t go lightly, of course—and, with the robust infrastructure that many of them sit on, only a fool would predict the complete demise of these central players. While no custodians wish to be seen assailing third-party competitors—and, indeed, many custodians also have third-party lending units themselves— the sentiment that ‘we may have had some troubles, but how many custodians failed? And how many prime brokers failed?’ is prevalent on this side of the equation.
Regardless, custodians admit that 2008 and its aftermath produced some clear changes in the industry. “The one thing about the crisis is that it probably helped foster a better understanding of the true value of securities lending,” says Bill Kelly, Global Head of Securities Lending Client Management at BNY Mellon. “Clients came away with absolute clarity about where risks were—from both the borrower side and the cash-collateral side. This doesn’t mean they’re leaving in droves, though, for third-party lenders.” He adds: “I think there are aspects of third-party lenders thinking custodians are weak—which I disagree with—but I also think what has changed post-2008, in this regulatory landscape, is that you’ll see who is committed. A lot of prime brokers are now bank holding companies, and that puts a different view on the cost of capital, and the cost of doing these types of things. Where securities lending is a core business, you’ll see that commitment—but I think you’ll see a lot of people question whether they can be in this space.” Indeed, custodians might even be on the offensive. As eSecLending’s Bassler says, “Many custodians now are trying to ramp up their third-party offering in an effort to capture securities-lending market share. They’re going after other custodians’ clients just as aggressively as third-party agents.”
What does this mean for the asset owner, hesitant to re-enter or further increase their exposure to the market? For one, this competition is forcing vendors to refine their pitch. “When speaking to clients, yield used to be key,” says State Street’s Bonn. “Now, you leave via the window, not the door, if you walk into a fund and pitch yield. What we talk of now—and should be talking of—is prudent risk management. Funds have realized now that securities lending does contain risk, and it’s now an investment decision, as opposed to an operational decision.” The competition is also expected to provide, at a minimum, greater price transparency, if not lower pricing across the board.
Of course, talk is cheap—for both sides of the debate. In the final calculation, the true winners will be determined by one thing, and one thing only: the pitter-patter of institutional feet moving toward one model or the other—or, if history is any indication, remaining somewhere between the two. To see where these feet are heading, and to see other trends in the securities-lending universe, see this year’s Securities Lending Survey—a subset of Global Custodian’s annual report—below, and go online to ai-CIO.com for previous years’ results. —Kip McDaniel
Securities Lending Survey Methodology
The 2011 Securities Lending Survey comprised 157 survey responses from the clients of 11 separate service providers. Responses were collected between december 2010 and February 2011. In the questionnaire we ask respondents to rate the quality of service from their providers on a scale of 1 to 7, where 7 is excellent, 6 very good, 5 good, 4 satisfactory, 3 weak, 2 very weak, and 1 unacceptable. The questionnaire comprised 31 questions covering the following eight service areas: earnings Performance, risk Management, relationship Management, Client Service, Product development, reporting, operational Capabilities, and Compliance with Client guidelines. Additionally, we collected background and profile information about respondents and their relationships to their service providers through non-rating questions in the “about Your organization” and “about Your Securities Lending Provider” sections of the questionnaire. The weighting of responses was governed by two factors. First, credit was given for scoring well in areas named as important—respondents were invited to name the most important question in each category—by all respondents in the completed, qualifying questionnaires. Secondly, respondents were themselves weighted, according to the number of service providers used and the approximate value of total assets in custody with their provider. For more information please contact, Muzaffar Karabaev at mkarabaev@globalcustodian.com
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