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THE SECURITIES LENDING ROUNDTABLE 60 MF: A number of issues come into play. What will be the investment path taken? Established markets first and then more emerging markets? It is likely to be the established markets first. Will 130/30 follow the ETF model? Only now, for instance, are you seeing really esoteric emerging market ETFs. It must be remembered that shorting is not that easy. It is not as easy as just selling securities that you do not like. Take the S&P 500, the ‘bottom” or most shorted 10 securities are already over 60% utilised, trading at a massive premium in the securities lending market, difficult to borrow and keep short. Moreover, the role of your prime broker(s)—and/or your custodian(s) who are increasingly becoming competitors in this space—will be critical in getting sustainable access to securities, for the newer borrowers to base their strategies around. If, say, I ring up a major prime broker or custodian and I am a relatively new fund and I say that I would like some hard to borrow stock, they will more than likely say,“You know, you aren’t borrowing billions of dollars of general collateral (GC) securities from me. I cannot give it to you. I am going to give it to the guys that I have an historic, balance-driven relationship with.” It is going to be very difficult to break into those more obvious trades and those hard to borrow stocks if you are a relative newcomer. PRIME BROKERS & CUSTODIANS: A MERGING OF INTERESTS? FC: David how do you see this dynamic evolving? MARK FAULKNER, chief executive officer, Spitalfields Advisors DR: One of the differences between prime brokers and custodians is the leverage that they provide and that prime brokers lend against the assets. One reason why prime brokers have never been disintermediated by the custodians with hedge funds is because they would not take the credit risk. Actually, to be precise, they could not manage the credit risk in the way that the prime brokers can and whether they will be able to provide that kind of leverage to asset managers, I don’t know. That said some big hedge fund managers now are beginning to look more like traditional asset managers. MC: Prime brokerage has long been to the hedge fund industry what global custody has been to the long only side. With the blurring of the boundaries between the long only and long/short, inevitably there are going to be attempts by both the investment banks and the custodians to drive their tanks onto the other’s lawn and try to erode the other guy’s franchise. The market is sufficiently diversified that one cannot easily pick a winner.There are going to be funds and strategies for which the custodian is the natural provider. Conversely, the prime broker will be best placed to provide the relevant service for other funds, other strategies. The beauty from a beneficial owner’s perspective is that there’ll be choice. Greater transparency will facilitate the unbundling of these various products and services, and you don’t have to put all your eggs in one basket.You can do certain activities with one provider and others with another. FC: Chris is there is room for everybody? CJ: There will always be room for providers who can add value. It is a huge market that is controlled by a small number of significant players so there is absolutely room for providers offering a differentiated product or a new approach. Increasingly though, with the shift that Mark talked about earlier regarding the move from a back office to a front office function, there will be different expectations placed upon providers and there will be an increased demand for performance measurement and other data that did not exist a few years ago. As Beneficial Owners continue to un-bundle securities lending they are demanding a higher service level and specialized capabilities, based on each provider’s specific competencies and expertise. It does not need to be a one-stop shop or one size fits all approach like it was year’s ago. RS: We have very good relationships with the prime brokers. However, I can’t see them ever wanting to get into the core custody space, because it is not going to be remunerative enough. You have to be able to offer both scale and customisation at the same time, and on a very cost effective basis. However, they are going to try to cherry-pick the best relationships if they can. Fundamentally, custodians and prime brokers have radically different business models and so as you have seen convergence, arguably between hedge funds and long only managers, it is interesting to understand where the interface is going to be between the different providers. NOVEMBER/DECEMBER 2007 • <strong>FTSE</strong> GLOBAL MARKETS
MF: That’s a good point. I predict, though, that within a year we will see a major acquisition or transaction in the financial markets along the lines of custodian and broker dealer getting together. Moreover, one of the primary reasons cited behind the transaction will be to do with financing and servicing the growing section of the investment management community that go long and short. There will be headline announcements and some of the words in those headlines will be will be ‘long/short’, ‘prime brokerage’ and ‘global custody’. Like Richard says, prime brokers are reluctant custodians and very few dominant custodians if any of them, have a prime brokerage capability or prime broking operations worth talking about. The capabilities shouldn’t be mutually exclusive but in practice they seem to be. However, some of the custodians do have the capital to service this growing segment of the market, so there is an opportunity there for somebody to actually go out and do some financial re-engineering on a massive scale. The timing is now right. Prices are more realistic and the profile of the financing business has increased. Fortune favours the brave. MC: That will raise some interesting questions. I don’t dispute any of that logic; but at the risk of playing devil’s advocate, you already have institutions such as JPMorgan and Citibank who in theory could do precisely that already—offer both sides of the service under the same roof. However, whether the issues are cultural, operational or compliance, there hasn’t been much convergence to date. DR: They will also have an issue about how they offer best execution to both sets of customers. To a pension fund who wants to make sure that its securities are being lent to the best deal in the market and to the hedge fund who wants to make sure that it is getting its securities on the best terms. FAIR & TRANSPARENT PRICING JP: Basically we disintermediate relationships over which we have no control and limit ourselves to dealing with a party we have appointed allowing us better control over programme costs and greater transparency of information. I have an issue. I actually think that custodians are conflicted already and I don’t think they actually know who is really their client in their securities lending programmes. I suspect they make way, way more money from their big broker dealer relationships in terms of the cash balances that they maintain with them than they do from me, and so I have never felt comfortable with the idea that we get a disinterested service from the custodians. RS: I don’t think you will necessarily get a completely disinterested service from any service provider. However, custodians sign agreements with their clients who they represent as agents and they will get the best deal they possibly can on the terms that are agreed, which include your investment guidelines and any other risk/reward parameters that you choose to adopt. <strong>FTSE</strong> GLOBAL MARKETS • NOVEMBER/DECEMBER 2007 MF: The problem that custodians often face is that they have clients that want to lend that quite frankly should not be lending and all too often an overhang of easy to borrow securities in their lending pools. They don’t say “no” as easily as they should. The lending departments are very accommodating of their custody colleagues, because lending offsets the expense of custody for their clients. This has fuelled the third party lending business as they can afford to be more discerning in the selection of their clients and the securities that enter their lending pools. RS: Actually, we do manage the book much more rigorously than that and do turn away business that is not profitable. Sometimes it seems as if people are happy to take the aggregation benefits of using a custodian when it comes to all the products and services, but expect the custodian to invest the same amount in the supporting infrastructure when they want to cherry-pick the bits of business that make the most revenue. MC: To be honest you pass on those costs to your clients. The cost of settling a trade in CREST is what? 50 pence? The volume discounts available to custodians mean that it’s even lower than that. Meanwhile, many fund managers get charged between £10 and £15 a ticket. Now obviously there are fixed costs to cover, but custody is an inherently good business in which to be.The barriers to entry for any potential new entrant are huge, so effectively what you have is an established cartel, for want of a better word. If greater transparency facilitates unbundling and the potential for ‘cherry-picking’as you call it, perhaps the way forward is for custodians to charge a sensible price for each component of the service they provide, rather than one product effectively subsidising another within the current ‘bundled’service offering. MF:There has to be a catalyst for unbundling.You are absolutely right, something has to happen and what is happening is that fund managers are effectively popping up on both sides of the debate right now that they are both long and short—add in the hedge funds who are long and short as well and you have a heady mix. So the catalyst is people actually recognising the significance of this business, which is a good start. But then, what happens next to encourage change? Regulators, possibly, have a significant role to play because industries typically change slowly unless they are forced to. There may well be regulatory change forthcoming that will drive this business to take steps regarding transparency and best execution that this industry would not necessarily volunteer for. MC: Anyone who is making a living as an intermediary is hardly incentivised to promote greater transparency and greater efficiency. It has to come either from one end of the chain or the other, or it has to be imposed by regulation. The way to ameliorate any potential compliance issue is via the mechanism of price. There should be a transparent price for a product, or a transaction, or a service.This industry, despite the best efforts of guys such as Mark, is still bedevilled by its relative opaqueness. 61
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Page 29 and 30: THE FTSE IWANT THE WORLD INDEX FTSE
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Page 37 and 38: A SNAPSHOT VIEW OF THE SECURITIES L
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Section 2 - FTSE

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