The time has come, the walrus said, to talk of many things. Of shoes. And ships. Of sealing wax. Of securities lendings.
That's not true, of course, it was 'cabbages and kings', not securities lendings, but author Lewis Carroll would surely have had some fun writing about the arcane and often misunderstood world of securities lending, especially when the time comes to take a look back at the past 12 months and ahead to the next 12.
Opinions on how and where the market has developed, and on what lies ahead, are as many and varied as the underlying markets, even the underlying stocks. "It's been a very good year for both beneficial owners and providers," says Chris Jaynes, President of the auction specialist eSecLending. "People have seen solid growth in returns and in underlying demand. We are also seeing more borrowers participating on an exclusive basis and seeing increased demand for exclusives across a wide range of asset classes including fixed income."
"The main areas of focus over the past 12 months have been around regulatory and tax impact on lending," says Paul Wilson, Senior Vice President, head of securities lending in Europe, Middle East and Africa for JPMorgan Worldwide Securities Services. "Agent lender disclosure, MIFID and Basle II have had everybody's focus and the discussion and the debate over corporate governance has continued. In Europe, the tax environment has remained challenging as more cases come before the European Court of Justice. Overall, the industry has seen a higher level of lending activity in all segments as well as new sources of supply coming to the market. We have also seen a greater level of business conducted in an automated fashion than ever before. These issues have a fundamental impact on all market participants, including beneficial owners, agents or borrowers, and require focus and resources to understand and manage through these changes in a considered and controlled manner."
Growing pressure on fees by beneficial owners is also provoking some concern, notes Andy Clayton, head of international securities lending at Northern Trust Global Investments. "We're making money in a relatively benign environment, but a fall in market values could hit revenues hard. On the other hand, enough new assets are coming into our programmes to offset that." Nick Thomas, Head of Specialised Sales, HSBC Institutional Fund Services, concurs. "People are starting to ask about the cost of borrowing from prime brokers," he says. "I recently heard about a fund manager buying a synthetic short on the FTSE250 and paying 140 basis points for it. As the price on UK stock is typically 10-25 bps, that's a big margin for the prime broker for what is only a modest piece of packaging."
On the demand side, there has been continued growth from hedge funds, leading to a record high in Europe, says Simon Bennett, managing principal of operations change specialist Capco. "Every time a hedge fund short sells, it needs to borrow stock. We're also seeing big increases in proprietary trading by big European and US banks as risk appetite grows. This raises the question, though, of whether the industry has the capacity to cope with the growth. Do the banks have the plumbing?"
Many of the issues and points have been on the horizon for a while, but during the past 12 months they have started to become more of a reality, he continues. "Additionally, a new Royal Decree relating to stock lending by certain collective investment undertakings has been adopted by the Belgian government and gave the possibility to Belgian SICAVs to enter into certain types of stock lending transactions which were previously prohibited."
This new Royal Decree, which became effective on 10 March 2006, creates new business opportunities and may have some consequences for Luxembourg, says Guy d'Albrand, Global Head of Liquidity Management, Société Générale Securities Services. "Securities lending transactions are still on a good trend with increasing demand from hedge funds," he goes on to observe. "European markets are very active. There is no dramatic change in the basics of securities lending, even though actors become more sophisticated and new players are still entering the market. We are in a stable environment and stock lending is seen has a low risk transaction. Trends are well established, and year after year, securities lending is more and more recognised as useful and as transactions which increase liquidity and market efficiency."
"The fundamentals don't change very much from year to year, but the biggest issue is arguably the Agent Lender Disclosure Initiative (ALDI)," comments John Arnesen, managing director, The Bank of New York in London. While to some, ALDI might conjure up images of European low-cost retailing, it is in fact the initiative briefly referred to by Paul Wilson above. "Under this initiative, which comes into force on October 1 and is in fact a restatement and reinforcement of an existing SEC regulation, borrowers will know who the end lenders are," says John Arnesen. "This will have an effect as lenders and borrowers scramble to meet its requirements."
"It will be mandatory for agent lenders to disclose the identity of Beneficial Owners to The Securities Borrowers and this will have a massive impact on infrastructure and IT development," says Fred Francis, Toronto-based Head, Global Market Products at RBC Dexia Investor Services. "Every broker-dealer has to have it, and every borrower regulated by US law has to have it; thousands of pre-approved lines of credit and exposure approvals will be required, and it could potentially make some market participants rethink whether they want to do securities lending in the first place. It will affect virtually everyone in the industry and have a substantial investment cost for both borrowers and agents."
"It is a very complex operation and there has been a mammoth investment of time and energy and internal resources to enable this increase in transparency," adds Rob Coxon, head of international securities lending at ABN AMRO Mellon. "The issue of transparency has come more to the fore over the past few years, as industry consultants Data Explorers and Aztec Consulting gain access to more data on rates and volumes," says Chris Taylor, who heads up State Street's securities lending business in Europe, the Middle East and Africa. "Disintermediation is also growing, while the industry faces a greater number of possible tax issues arising from attempts to harmonise arrangements in the European Union, and amendments to double taxation agreements between Europe and the US."
"We understand that a lot of market participants are struggling with supplying information to broker-dealers on the thousands of lenders in their programme, and struggling is a polite word," says Tim Smollen, global head of agency lending at Dresdner Kleinwort. "As we've been supplying that information since we started in this business four years ago, we're ahead of the curve."
" In the United States, the biggest issue would have to
be Agent Lender Disclosure," chips in Brian Lamb, CEO of
auction platform EquiLend. "The work involved to enable
agent lenders to communicate the principals in the lending transaction
and the work for broker-dealers to take that information in has
been quite considerable. In Europe, the regulatory landscape has
also been active with Basle 2 on the horizon, MiFID and its related
implications for securities lending
participants [see separate story]. The regulatory landscape continues
to evolve as the marketplace
responds to the needs for greater transparency and continued increases
in efficiency and automation."
For Jerry May, the securities lending office at the Ohio Public Employees Retirement System (OPERS), one issue that remains is the question of proxy voting, and how the practice can be reconciled with lending stock. "I don't think there has been any resolution from our point of view," he says. "We've reached a balance which we feel is legitimate, balancing short-term revenue against the very long-term impact of good, responsible corporate governance, but I don't think the market as a whole has defined a framework for this balance yet." OPERS has drawn up a list of stock that it will never lend, but to put it into perspective, that list accounts for less than 5% of its total $70bn portfolio, he confides.
Ciaran McNamee, head of European strategy and sales at Brown Brothers Harriman, says the market has continued to see substantial volume growth in securities lending. "The market has become more mainstream, and those beneficial owners who are not participating in a lending programme are disadvantaged," he says.
Against a relatively turbulence-free background, the short selling debate also appears to have quietened down in recent months. But opinion is divided on whether the beast has been truly slain, or whether it is merely dozing in its cave. Some market participants believe the argument has been won for good that short selling aids liquidity and is not responsible for the evils often attributed to it by people who don't understand the complexities of a modern sophisticated capital market. Others believe that short selling will provide a first-rate scapegoat when a major, unpredictable market event erupts.
"The noise around short selling is always there in the background, but these days it is just not as loud as it was a few years ago," says Paul Wilson. "In part, this is due to a) there being a lot more information readily available about lending activity and market size, and b) more beneficial owners making their assets available for lending and thus recognising the benefits to them and the market."
Adds Guy d'Albrand: "The short selling debate shows the increasing role of the clients of the prime brokers, hedge funds. Hedge funds are competing as well and are putting increased pressure on prime broker services. Being more mature, hedge funds tend to challenge spreads and now seem to expect more information about market levels."
With more sources of supply coming to market there is greater demand from borrowers for more flexibility, whether it be in collateral or in fewer restrictions or limits, says Paul Wilson. "There is more interest in looking at new opportunities either in terms of new markets or in terms of alternative or non-traditional areas. And in the last twelve months the US Fed has consistently raised interest rates.
The pros and cons of auction platforms continue to be the subject of debate. According to Paul Wilson, the main development in this space over the past 12 months has been the development and use of Equilend's AuctionPort platform. "From our perspective we have seen just about the same level or maybe slightly less auction activity in 2006 that we saw in 2005. It has not had the impact in 2006 that they may have had in previous years," he says.
But the sale of eSecLending to a private equity firm also caught
the eye. While it looks like an odd move even by the standards
we have come to expect from the private equity industry which
moves in increasingly mysterious ways, the official line is upbeat
and positive. "eSecLending is extremely pleased to be partnering
with TA Associates for strategic, long-term growth," said
a company official, asked to elaborate upon the sale. "We
are confident this will benefit the firm, our employees, and the
services we provide. The firm will continue to be managed by the
existing executive team and management committee. Employees will
retain an ownership stake in the company to ensure continued commitment
to providing the highest level of service to our clients."
The outlook is positive for EquiLend, says Brian Staunton, Director,
Citigroup Global Transaction Services EMEA. "The ownership
structure gave EquiLend a captive market and critical mass straightaway.
In 12 months time you'll find that most of the large players
will be actively using EquiLend for something, either for the
use of the autoborrow functionality or as a means to broadcast
and auction portfolios."
Gazing into a crystal ball is an uncertain exercise, but few can resist the invitation to give their view of the shape of things to come. "Going forward will probably be similar to what we've seen recently," predicts Paul Wilson. "There will definitely be a push into emerging markets and alternative structures and there will be a greater push for more flexibility from beneficial owners especially as pricing pressure starts to impact vanilla business. The tax and regulatory environment will continue to be complex and challenging and probably more than ever, technology and the ability to absorb greater volumes and achieve higher levels of STP will be critical. There has been some development on the emerging markets side of things, most notably in Taiwan, Hungary and to a lesser degree Turkey and Philippines. Markets such as India, China, Russia, Poland and Brazil remain on the watch list as their offshore SBL framework evolves."
"Emerging markets become mature markets when new entrants make stock lending a common trade with a spread decrease and when regulation evolves," says Guy d'Albrand. "The pace depends on overall market conditions but also on local market attractiveness which in turn influence conservative counterparties and local regulators. A stable and growing business environment makes those markets appealing to conservative counterparties. Emerging markets are determined of course by local regulations (exchanges etc.) which tend to converge to world standards when the political and economical trends are favourable."
"Equity and fixed income trading were not so long ago two very different cultures," adds Guy d'Albrand. "Many desks have merged the two products and service providers are merging their offers. Trading through a broker or an electronic platform is a common route for stock lending and we might see more fixed-income related activities in the future if participants think it is appropriate. Securities lending markets should continue to grow over the next 12 months in many instances. Should economic trends stay good, volumes will keep on rising and routes to securities lending will continue to specialise based on size and spreads. In case of growth disruption, even with disinvestment, losses and falls in the value of the assets, there should though still be demand for stock lending due to the acceleration of the investment allocation in alternative strategies."
The demand for securities lending is heading only one way, according to Fred Francis, and that is upwards. "As traditional asset managers begin to follow the example of hedge funds and adopt shorting strategies, they'll be looking for sources of stock to borrow," he argues. "The convergence between hedge fund strategies and traditional asset management strategies is a major element of change in securities lending that will drive growth for several years, probably at an accelerated rate, just as hedge funds have done for the past five to 10 years."
For all the talk, though, of emerging markets embracing securities lending, John Arnesen has a clear desire to see securities lending being made more welcome closer to home. "We have clients in Belgium actively pursuing securities lending as a direct result of the new regulations there, but we believe it's important for a number of other mature European markets such as Spain and Finland to allow securities lending to take place," he says. "Regulation will be the dominant theme of the next 12 months."
"From a performance perspective it is hard to predict what will happen over the next 12 months," concludes Ciaran McNamee. "global monetary policy, political instability in the Middle East, volatile equity markets and uncertain corporate performance, all will have an impact on what happens, but who knows in what ways? It could even present unexpected and unsuspected new opportunities."