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THE SECURITIES LENDING ROUNDTABLE 62 DEFINING BEST EXECUTION DR: In general terms, my understanding is that for agent lenders, best execution mean looking to get the best deal for customers, having policies setting out how you do that and being transparent with customers. Most people have behaved that way and we have a well regulated and fair industry in that respect in any case. MF: And shame on the industry for lobbying as they did and getting off the hook on this one. DR: I do not think that they did get off the hook, because I don’t think there was a hook in the first place MF: But there is no obligation to provide best execution. There was discussion as to whether it would be relevant and extended into the world of securities lending and the industry got together and wrote a letter, which quite frankly shocked me in terms of its contents and got off the hook. So, typical clients who spend very little time thinking about securities lending, would reasonably expect to be protected by MiFiD and best execution and they aren’t. DR: They will be actually, because many agent lenders are concluding that they actually do have to offer best execution to their clients, because they are going to be treated as professionals and depending on your interpretation of the runes from the European Commission, securities lending may or may not be—and some people are concluding that it is—an execution of client orders MF: That would be very welcome. I am heartened to here that, the clients will be too and that will be a winning strategic decision. DR: The question is what does best execution amount to? What it doesn’t amount to is that you have to execute at this market price, which is on a ticker tape, because that does not exist in securities lending and securities lending transactions are not as simple as equities sales. There are different dimensions to the transaction, and therefore acting in the client’s interest does not necessarily mean dealing at one particular price—it also depends on the client’s collateral needs and tax status, etc. So what the best execution will amount to is in effect having a policy that says to the customer that we will act in your best interests. RS: The debate has actually moved on. Looking at the latest guidance provided by the FSA and the response of the European Commission to CESR, a client will always need to be properly protected whether retail, professional or eligible counterparty. Every lending provider has to look at this in the context of the firm’s overall approach to best execution and JPMorgan has written a best execution policy which outlines very clearly how we would operate on behalf of our clients to obtain the best possible outcome. The challenge is that securities lending is not a business that fits very neatly into a trade by trade disclosure regime and people arguing for that are potentially going to do the industry a disservice by leveraging a huge cost base on it, which frankly it is not in a position to support at the moment. CJ: I would come back to the issue raised earlier about pricing and so called cherry-picking. It is a strange concept in this industry where some view that there is something bad about a beneficial owner choosing to take their assets and lend through a different route or a different provider. They feel that it is somehow unfair to a custody provider who now only has to charge transaction fees for supporting the custody function of lending. Securities lending is not an entitlement of custody providers so their pricing should just be set according to what service they provide. The industry should stop utilizing opaque pricing structures where the clients do not know how much they are actually paying for the different services being provided. These bundled arrangements prevent beneficial owners from evaluating all options and making proper informed decisions. JP: Until recently, I had never seen an RFP response from a custodian that did not include the condition that this pricing structure is conditional on them getting more securities lending. MC: When I asked this question of a custodian in a similar forum earlier this year, they told me that increasingly they were being asked to strip that out and quote separately for securities lending and ‘core’ custody. Because of the rise of third party lending agents, auction platforms, alternative routes to market, there is a desire on behalf of the ultimate customer to see that transparency and the custodians simply do not have a choice here. JP: That is very true but they used to just ignore it. In RFP exercises before I joined Mercer, we were absolutely explicit. The actual phrase used was: “You should assume that you will get none of our lending business”. We still got fee quotes that assumed a level of lending income. Then, there was then surprise when we lent the most lucrative asset classes through a third party. MF: I am asking for some adoption of standards that apply across the industry, not more information that is part of this kind of gentle obfuscation of pricing and information and bundling together of everything. Those days should be and are slowly going away, but this is just is just another subtle example of just more obfuscation. RS: Many of us use independent data providers to report to our clients on their programme performance. However most clients do not want to be called every day, preferring to look at it over a period of time and my second point is: what would the benchmark be, and could it have been implemented effectively in time? NOVEMBER/DECEMBER 2007 • <strong>FTSE</strong> GLOBAL MARKETS
MF: No idea. It would not have been beyond the wit of this industry to meet this challenge head on rather than duck it. That is a hypothetical question really and one for about 18 months ago and not for today. What I am responding to is a call for clarity from a client of the global custody industry; a client of the securities lending industry. When they asked for clarity of pricing they were ignored—so they took their valuable assets away and their provider got upset. That seems like a logical response by the client to an illogical act by the provider to me. It seems almost deliberate the way that some providers ignore the clients’requests for information. This is not a recipe for long term success. BUNDLING & UNBUNDLING CJ: I’d like to dispute the notion that something was taken away. The provider should not feel entitled to a client’s business, so nothing was taken away from them. Rather, the beneficial owner just chose a different provider to perform a specific service. No one has the entitlement to be a client’s sole provider so it should not be seen or accepted as a takeaway if a Beneficial Owner decides to transfer a portion of their business to another firm who they feel can add value JP: One of the problems with custodians, is that they have not got their heads around the fact that lenders became better educated and more knowledgeable. If you go back 15 years, the choice of a custodian was an obvious solution because nobody on the lending side, or few people on the lending side really understood the risks and the rewards and the nature of securities lending. As you become more knowledgeable, you become more sophisticated and better able to choose the best provider, which goes back to what Chris was saying earlier, different asset classes, different structures lend themselves to different ways of accessing the best risk/reward trade off. It is not always the custodian, and the problem today is that the custodian sometimes seems to think that it is almost theirs by right and it isn’t. MC: In defence of the custodian, there will always be a role for the custodian. The overwhelming volume of assets that are made available to the Street are in fairly fiddly, administratively and operationally intensive clumps,and the custodians should be given credit for mobilising those assets. They are and will remain a permanent feature in the landscape; no-one is trying to disintermediate them out of existence. From our perspective, there are certain markets and asset classes where we don’t think we add any value for the client, so we let the custodian do the lending. On the other hand, there are markets where we do have the scale and the expertise, the revenue potential is there, so we handle the lending ourselves.Then there are other portfolios that maybe lend themselves to auctions or exclusives. There is enough money on the table in this product for various different types of provider to make a living. <strong>FTSE</strong> GLOBAL MARKETS • NOVEMBER/DECEMBER 2007 RICHARD STEELE, head of product development for securities lending, JPMorgan Worldwide Securities Services JP: A handful of basis points can make a huge difference to how performance is perceived and therefore it is almost an obligation on us, to certainly give the service that we sell and claim to be providing to our clients. We don’t just claim to find the best managers to deliver alpha. We also claim that, we are offering more challenging of service providers generally. This includes indentifying better ways of delivering peripheral returns on things like securities lending CJ: Another important development that has helped facilitate more choice in providers is technology and the improvements in communications and settlement platforms. It was more difficult to operate in a third party environment ten years ago than it is today. Some of the inherent advantages that custodians had when it was more difficult to transact outside of a custody framework have now disappeared due to these technological advancements. It is now an efficient process for everyone, regardless of where they are located. MC: Custodians have historically relied on client inertia, because it was always incredibly difficult and complicated to switch providers. That said, just as in UK retail financial services, people can now switch providers in a way that they never used to be able to. To be fair, that has forced the custodians to raise their game. I can remember years ago, a custodian pooh-poohing the concept of third party lending, saying it was never going to fly. Nowadays custodians not only accept the existence of third party lenders, but they are also establishing third party lending programmes themselves. 63
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