Section 2 - FTSE

THE SECURITIES LENDING ROUNDTABLE
64
DAVID RULE, chief executive officer, International Securities Lending
Association (ISLA)
COPING WITH MARKET VOLATILITY
FC: How does current market volatility play out? Does it
favour custodians or third party lenders?
RS: One of the things that helps players better differentiate
themselves is: did their performance track the rising market
or did they actually outperform it? This is where more
transparency of data can help. When it comes to the more
volatile markets we are seeing at the moment, it’s really time
to revisit your lending programme parameters such as cash
investment guidelines to determine that they are appropriate
given the concerns we are seeing. In this sense you have to
step back and say that although people may be looking for
alpha, they are not willing to risk their portfolio in a market
like this and are looking now to manage risks accordingly.
CJ: Many beneficial owners have under taken reviews of
their programs in response to recent market events and are
evaluating their approach and reviewing the risks and
returns within their program. Some beneficial owners have
made changes to certain parameters or guidelines where
appropriate, while others have reaffirmed their existing
structures. This is not unique to custodians, third parties or
direct exclusives. It’s a client issue related to their specific
goals, return expectations and risk profile.
MC: As the old saying goes, return of your capital is more
important than return on your capital. I suspect that what
is happening in the market at the moment will probably be,
in the medium to long term, healthy for the industry. The
closest thing most people can remember that compares to
this in recent times is probably Long Term Capital
Management, back in 1998. That whole episode spurred the
development and improvement of collateral management
in terms of its robustness, pricing methodology etc. It is only
in times of crisis that any flaws or weaknesses in the system
become apparent. It is too soon to say whether we will see
any in our little subset of the overall market universe. The
area of the securities finance industry that is probably most
exposed to a potential credit loss is the cash reinvestment
business, run predominantly by the US global custodian
agency lending programmes. Over the course of the history
of this industry, any credit losses have been on the cash
reinvestment side rather than on the actual lending side of
the business. We do have some cash reinvestment business
but ours is all fully collateralised and pretty low risk.
MF: The key questions that Mick partially addressed there
was, “How much of my lending revenue actually comes
from lending? How much of my lending revenue comes
from cash reinvestment? And these are going to be the
questions that people are going to be focusing on, if they
aren’t already doing so, now and in the coming weeks.
There are lots of different ways to make money from cash
reinvestment, as we know. Invariably, the strategies
employed by certain re-investors of cash will come under
scrutiny and the clients will ask themselves and their
providers,“was that a good strategy or a bad one for me the
client who is at risk?” I don’t think for one minute that
anybody engaged in securities lending has deliberately
breached client guidelines. Everybody in securities lending
knows that they cannot do that. Nonetheless, there are
providers who, if you ask them, will say: “We always
operate well within or right in the centre of our clients’
guidelines. We actually do take less risk than our clients
would allow us to take on their behalf because we have got
tremendous understanding of the money markets and
strong internal controls. ”I believe many of them when they
say that. However, they also privately allude to there being
providers that are out there trading on the edge of client
guidelines a little bit and we may find that those might have
some issues. This could be sour grapes at losing business to
high income projections from competitors—but if it isn’t the
clients, the market will find out very soon. In the Financial
Times recently, Deutsche Bank said something of vital
relevance. It had to do with confidence and banking and
noted that crucial questions in the next days and weeks
include “How do you mark your positions to market? What
price are you putting on the securities that you have
invested in?”It is a question that investors want answered
by their cash reinvestment providers and I would really
encourage anyone who is a lender who takes cash as
collateral, to consider asking them now. Some will take
great comfort from the responses – others may not.
FC: What role can ISLA play in encouraging that dialogue?
DR: One of the things that ISLA has been doing is
developing operational best practice guidelines, including
NOVEMBER/DECEMBER 2007 • FTSE GLOBAL MARKETS