Steady. Securities lending has come through a rough. Securities lending post-lehman. Investments

Transcription

1 Investments Steady state Securities lending post-lehman. BY Scot Blythe Securities lending has come through a rough two years globally. Surprisingly or perhaps unsurprisingly, given the country s seemingly inherent financial conservatism Canada hasn t been affected all that much. In fact, one observer thinks custodians serving Canadian clients ought to be congratulated for not getting carried away. Nevertheless, custodians have stepped up client reporting, as well as due diligence on counterparties, after the startling collapse of Lehman Brothers in September The ensuing bankruptcy left a number of hedge funds in the U.S. and Canada unable to trade the securities they had borrowed until British administrators settled creditor claims as they wound up Lehman s London prime brokerage unit. But those were the borrowers. On the other side, Canadian lenders were unaffected: custodians moved quickly to liquidate collateral to replace the shares on loan. In the interim, lenders have learned a lot about how the theoretical risks of securities lending can play out in practice. You don t get paid more money without taking more risk, says London-based Mark Faulkner, founder of and head of innovation at Data Explorers, which tracks the global securities lending industry. If they are in a situation where they are getting, for want of a better word, somewhat extraordinary profits from lending securities, you can bet your bottom dollar it s because they ve more risk in the program. Canadians lenders were spared that risk. Cash and Non-cash Collateral Securities loans can take two forms. The first is cash, which is reinvested in programs run by custodians. The second is non-cash reinvestment. Securities borrowed are exchanged for other high- benefitscanada.com june

2 Securities lending involves three main parties Those that own the shares: pension plans, mutual funds and insurance companies. Those that want to borrow the shares: prime brokers at investment banks on behalf of hedge funds and the investment dealers themselves on behalf of their proprietary trading desks. Custodians, which, as agent lenders, manage loans on behalf of beneficial owners while monitoring the credit quality and operational strength of the borrowers. quality securities. Positions are marked-to-market daily, and if there s a shortfall, borrowers are required to post higher collateral. In non-cash reinvestment programs, lenders earn a fee for their securities loans. In a cash reinvestment program, beneficial owners pay the borrower a rebate rate that is less than the market rate that they receive on their reinvestment of that cash collateral. Reinvestment assets could include repos collateralized repurchase agreements commercial paper, floating rate notes and even asset-backed securities, Faulkner explains. It was cash reinvestment programs that were most affected during the financial crisis. In the event of something like a Lehman default, the critical question is, Can I liquidate what I own at close enough to par to have enough money to buy back what I have lent? Faulkner says. The problem for many lenders and I m not suggesting Canadian lenders around the world was, when that moment came, the answer was no. Some didn t have sufficient funds, or the prices at which the assets they bought were trading were so unpalatable that they couldn t bring themselves to sell. So they couldn t buy back the stock that was on loan. Lehman wasn t necessarily unpredictable. Nor were Canadian beneficial owners necessarily exposed. Faulkner notes that most Canadian lenders (80%) opt for non-cash reinvestment, unlike U.S. lenders (4%). We were building liquidity ahead of that time, says Don D Eramo, senior managing director, securities finance, with State Street Corp. in Toronto. So if there were any fluctuations in balances, you are positioned to meet those requirements. Northern Trust adopted a similar stance, says George Trapp, senior vice-president, securities lending, with Northern Trust in Chicago. Our focus was on making sure we were prepared for any borrower filing for bankruptcy whether it was Lehman or any other counterparty. And it was making sure that we understood what our collateral positions were and that they were marked-to-market on a daily basis. Then it was quickly executing on the liquidation of the collateral and the purchasing of the securities back to get them back into the client accounts. In all, it s been a salutary process, to the benefit of plan sponsors. Certainly, the whole credit crisis created a level of angst, says James Slater, senior vice-president, capital markets, with CIBC Mellon in Toronto. That said, it did provide an opportunity from a provider perspective to validate a lot of what we do. The Lehman situation, he adds, is not something that you would wish on yourself or that you d ever want to go through again, but I think there were some positives that came out of it. The contracts we had stood up extremely well; the processes, the risk modelling that we did, the theory that we d built around that which drove a lot of the components in terms of how we managed the business held up as we expected. In the aftermath, plan sponsors took it upon themselves to learn 40 june 2010 benefitscanada.com

3 more about the lending program in terms of understanding what the risks were and made decisions as to whether to stay in or whether they needed to make adjustments. Few left; however, many recalibrated their risk appetites. Not because they saw losses, but because they understood the potential for losses under exceptional market conditions. Changes Post-Lehman So what s changed? Well, there have been several regulatory misfires. A temporary ban on short selling at the height of the crisis did little to help provide what investors needed most: liquidity. Citing an Oliver Wyman study, Faulkner notes that bid-ask spreads widened, liquidity left the market and price discovery was impaired. The relationship between securities lending and short selling was also poorly understood. A small portion of our business is probably uncovered directional short selling, explains Yvonne Wylie, head of securities lending at RBC Dexia Investor Services in Toronto. There are a number of other trading strategies that exist in the market today that are driving the need to borrow securities. It s not just specifically tied to short selling, she adds. There are other trading strategies among them, convertible bond arbitrage, index arbitrage, mergers and acquisitions activity where borrowers use short selling to hedge their exposure to adverse stock market movements. Still, the Lehman default did cause the spotlight to shine on securities lending a bit, and although for some that may have been uncomfortable, says Slater, we saw it as an opportunity to engage our clients and provide them with information in terms of how the program worked, how we worked to manage the risks and how we could increase the level of information reporting in order to build their comfort. Of course, there was heightened due diligence on counterparties. There was more attention focused on the quality of collateral. There have been, in some instances, higher margin requirements. Typically, in Canada, bonds are collateralized at 102% and equities at 105% of the amount borrowed. And there was a re-evaluation of cash reinvestment programs. In the end, custodians have refined their reinvestment program guidelines, not so much in what they take as collateral but rather in making more explicit to beneficial owners how their programs work and tweaking them where necessary. We pride ourselves on ensuring that we optimize within a client s risk profile, whether that is in a non-cash world or a cash structure, says D Eramo, adding, [It s important] to ensure that you have ongoing conversations with your clients to understand what goals and risk parameters they want to insert in that program. benefitscanada.com june

4 The Lehman default did cause the spotlight to shine on securities lending a bit, and although for some that may have been uncomfortable, we saw it as an opportunity to engage our clients and provide them with information. James Slater, senior vice-president, capital markets, CIBC Mellon Clients Response Post-Lehman, obviously, the risk profile that certain beneficial owners had in their cash collateral programs trended to a more conservative type of reinvestment guideline, notes D Eramo. We ve seen trends where clients would move from commingled structures to segregated account structures so that they can fine-tune their reinvestment guidelines. So we ve seen a trend toward more segregated, more conservative guidelines. Fine-tuning client guidelines also means more granularity, so plan sponsors can get a better picture of their exposure. Part of it, from an underlying lender s standpoint, is understanding the parameters of their program, explains Wylie. It s really getting into a higher level of detail in terms of understanding what securities are going out on loan, whom you are actually lending to and the type of collateral you are holding at any one time. Granularity, in turn, feeds transparency, giving plan sponsors an overview of not just their risks but their risk-adjusted returns and an ability to compare those returns against a benchmark group of similar participants in a securities lending program. We report back to clients daily, whether it s securities on loan or collateral at the asset level, or assets in their reinvestment portfolios. So we ve always been transparent, D Eramo adds. We would like to see the industry move to a much more risk-adjusted, transparent type of reporting, which we ve obviously seen a demand for. Transparency is a universal theme among clients, acknowledges Trapp. Our commitment to clients is that we re transparent. We ve always made it a priority to provide clients with reports that help them understand their risk and return in securities lending. Now, in response to client demand for more frequent and easily accessible information, we have launched an automated reporting platform, the Securities Lending Dashboard on Passport. Creating CASLA Transparency goes further. Last year, as securities lending began to recover, Canadian custodians and other market participants created an official association to be an advocate for the industry before governments and regulators the Canadian Securities Lending Association (CASLA). Originally, there had not been a formal Cont d on page june 2010 benefitscanada.com

5 Cont d from page 42 lending association in Canada, explains Rob Chiuch, CASLA president and vice-president, head of trading, global securities lending, with CIBC Mellon. But the various market participants had had success on an ad hoc basis, working on various initiatives that were of interest to the industry. There s no mystery behind it. We decided at a critical point that it made sense to organize officially. CASLA s officers are drawn from the four custodial banks, which are, in total, responsible for 90% of the securities lending in Canada as well as a large Canadian pension plan, the prime brokerage units at Canada s big banks and the law and accounting firms that service the industry. One of the successes of CASLA has been that we quite deliberately differentiated ourselves from other similar groups by inviting participation from non-lenderborrower participants, says Chiuch We re trying to attract a greater breadth of experience to the association so we can more broadly address industry issues. That s not a model that s typical of the other associations around the world, and I think that it s getting some attention. closure of hedge funds. I think even from the borrower side, they re more selective on the type of trades they re willing to do today. In the end, Canadian lenders and custodians have fared pretty well after Lehman. So have Canadian hedge funds, which are reporting reduced borrowing costs. But the future is probably going to be similar to the pre-lehman past. Securities lending should be two or three things, says Faulkner. It should be unexciting [and] simply low return which is not very positive. It should be low risk which is good. Therefore, it should offer a high-risk-adjusted return. People should be looking for a steady, stable, high-risk-adjusted return contribution to their portfolio. BC Scot Blythe is a freelance writer in Toronto. rsblythe@hotmail.com Recovery Mode Despite the angst over securities lending at the height of the financial crisis, the industry has come back in Canada though, with a twist: the securities are available, but the demand from borrowers has decreased. Canadian lenders on-loan positions are down 30% to 35% from the peak in 2008, says Slater. The global numbers are actually off substantially more, in the neighbourhood of 60%. Definitely, the borrowing volumes are off, but what we have seen in the last six months is that they are stabilizing. Borrowing may be down thanks to a variety of factors, he adds. There are some cyclical aspects to what s going on. I don t think they re secular. I think they re cyclical in that the equity market s been on quite a run, so there absolutely is a long bias to the market. With a long bias, borrowers are not necessarily hedging their positions or taking directional bets. But beneficial owners are more confident. Those that did exit the program have predominantly all come back into it, notes Wylie. I think there is lower demand than what we ve seen in the past, and that might be related to a number of borrower consolidations over periods and deleveraging or benefitscanada.com june