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THE SECURITIES LENDING ROUNDTABLE 58 TRENDS TO WATCH CHRIS JAYNES, PRESIDENT, eSECLENDING: There is an increasing demand for lending in emerging market countries. It been a growing trend for a number of years and agent lenders are more actively looking at different ways to structure trades to gain access to these markets. As well, beneficial owners continue to unbundle securities lending from custody and utilise multiple providers and different routes to market to optimise their programmes. Institutions increasingly view lending as an investment decision and now use multiple providers across different parts of their lendable asset base. This allows the beneficial owner to choose the provider with the greatest expertise and ability to add value in each market, asset class or route to market and enables them to better benchmark performance against other providers. MARK FAULKNER, CHIEF EXECUTIVE OFFICER, SPITALFIELDS ADVISORS: The big trend? There are now fund managers who traditionally shunned securities lending and left it to be dealt with in a back office manner by back office people who are now borrowing securities for the first time. Not only 130/30 investment strategies, but also new regulations and deregulation have encouraged investment managers to recognise that borrowing securities and shorting them is actually good investment management practice and not just something that “evil people do”. A problem the industry faces is that it is still built upon the same operational foundations that it always has been. The good news is that some of these traditional fund managers will wake up to this fact and actually make things better and move securities lending closer to their front offices.That will happen when they realise how much money they have to pay to borrow securities, how much money they can make as lenders, how inefficient the market is, and how opaque the pricing is. This trend is welcome, forceful and positive. RICHARD STEELE, HEAD OF PRODUCT DEVELOPMENT FOR SECURITIES LENDING, JPMORGAN WORLDWIDE SECURITIES SERVICES: The market is definitely evolving. Until quite recently the industry was pretty segmented— some might say almost regimented. There were people who lent their own portfolios on a directed basis, and then there were agent lenders (typically custodians). We also see new third party providers coming in and offering more unbundled services. Traditional providers recognise this development and have responded accordingly by providing a much broader product range. At the same time, our more sophisticated clients now look to us to provide more flexible solutions than may have been the case before. In particular, traditional long only managers are looking to utilise their portfolios in different ways and asking service providers to accommodate that change. Faced with this unprecedented level of demand some providers find that their platforms may need to be overhauled, so they can provide the flexibility that clients require and it is interesting that prime brokers are looking at this space as well. DAVID RULE, CHIEF EXECUTIVE, ISLA: Big regulatory changes are underway. For example, the introduction of Basel II, with dealers in particular having to obtain more information from agent lenders about the underlying principals to their loans and the allocation of collateral among them. Mark has talked about securities lending moving towards being a front office activity and part of that is going to be more price transparency. We have already seen the growth of an interdealer market with the introduction of ICAP’s platform recently, which further encourages price transparency. JOHN POOLE CHIEF OPERATING OFFICER - EUROPE, MERCER INVESTMENT MANAGEMENT: UCITs III considerably increases the flexibility of what we can do in our core funds. We can now adopt shorting strategies, so the challenge for us is to find a cost effective way to implement 130/30 within a UCITs structure, which involve some additional regulatory restrictions. With our long only funds on the one side, and hedge type funds on the other, one of the things we want to do longer term is borrow securities from one of our long only funds and lend them to one of our long short funds. There are some huge compliance issues in that. Nonetheless, we want to cut out some of the people who would normally be in that kind of structure. Why should our long only funds lend to a third party only for our long short funds to borrow from them? The lending fund gets a lower return, and the borrowing fund pays a higher financing cost. We want to get rid of those costs to our funds. We need to find somebody to work with, to achieve this and ensure that we behave in a way that is fair to both funds. MICK CHADWICK, HEAD OF TRADING, SECURITIES FINANCE, MORLEY FUND MANAGEMENT: I echo John’s sentiment about the convergence between traditional long only fund management and the long/short space and that the compliance hurdles are significant. However, even if we cannot go so far as to disintermediate prime brokers altogether, the mere existence of both strategies under the same roof can at least keep the prime broker honest. I also strongly echo Mark’s sentiments. There has been a debate about where the product should actually sit. Is it an operations function? Alternatively, is it (to use fund management jargon) a potential source of alpha? We are now able to benchmark performance in a way that we were not able to five or ten years ago. Practitioners can now judge the performance of a programme in both absolute and relative terms. Moreover, as the industry becomes more competitive, securities lending becomes an increasingly important source of revenue. In the overall market, two trends dominate. In relatively mature, commoditised markets, where price discovery is less of an NOVEMBER/DECEMBER 2007 • <strong>FTSE</strong> GLOBAL MARKETS
issue, anything that moves is being automated. It’s all about scale; it’s all about operational efficiency. Then, at the other end of the spectrum you have some of the emerging markets where traditionally, standard securities lending has not been possible, and there you see the development of synthetic products that allow participants to generate returns in those markets. This is where it helps to work under the same roof as the fund manager who ultimately controls those assets, since such structures will typically involve the outright purchase and sale of the underlying securities. FC: I get a sense of a market in transition and becoming increasingly complex. How is that affecting the provision of your services Richard? RS: As the custodian and lending agent to a very broad and diverse client base we have had to develop flexibility as well as scale in our business for many years now. That is something that we have become very adept at and, at the same time, we are in a constant dialogue with our clients about their requirements and what they are trying to achieve. There are now many different routes to market and we all know that lending can be very portable nowadays. Above all, you must remember that it is not over when you have been awarded the portfolio mandate. In fact, that is where the relationship really begins. Clearly then in the final analysis if we are in the business, and also growing our book at a significant rate, we must be doing something right. 130/30 STRATEGIES & THEIR IMPACT MF: Recent headlines suggest that there is about $60bn in 130/30 dedicated investment right now, which manifests itself at ratios of $18bn worth of shorts, which is a drop in a bucket frankly. Looking forward, we are talking about something that could be much more important. If there is a take-off along the lines of that in exchange traded funds (ETFs), 130/30 could become very important, very quickly. It is interesting to see that many of the funds and firms that are focusing on this strategy are the same funds and firms that made a success out of ETFs. They were right last time and maybe they will be right again. We think that they are backing this horse. Therefore, it could be much more significant than it currently is, but it isn’t all that significant yet. RS: This sort of thing requires a long lead time and people need to decide where they are going to start investing in the cycle. With some of the deals that are going around at the moment, questions come up such as: “Can you support discretionary lending? Can you support directed lending? Can you support it in a pooling environment? Can you support a long short type structure?” I am not sure that everyone can tick all those boxes yet, and that is where it starts to get very, very interesting. <strong>FTSE</strong> GLOBAL MARKETS • NOVEMBER/DECEMBER 2007 CHRIS JAYNES, president, eSeclending FC: Chris, do you think that eSecLending can tick all those boxes? CJ: Absolutely. Each client will need to evaluate the various options presented to them. Mark’s point is pertinent in that long short 130/30 portfolios are not a significant part of the market yet, but it still is an important component for clients. No matter how small a component these new strategies may be to any client’s overall asset base, it is the first time many have been borrowers of securities and there is a need for education on the legal, regulatory and operational issues involved. There is a concern about how to manage this process most efficiently and to make sure that they are being charged fair and reasonable fees. Whether you are managing $100m in shorts or $5bn you still need to be able to answer all these questions. All of the agents are working on solutions in different ways to help clients determine how they migrate from a long only manager to a long short manager and the trend is clearly going in that direction. I do not think any of us can predict how big it will ultimately become but the trend is clearly happening and I do not see it stopping any time soon. JP: Do we see 130/30 being adopted across the board, across all equity asset classes? Or, will it be market specific? I can’t see us going down the 130/30 route in the short term in every asset class, but we are seeing a definite change in attitude to this strategy. The impression I have is that it has already been adopted quite strongly in US equities, and other asset classes are now catching up. I’m not sure of all the reasons for this, but certainly the relaxation provided by UCITs III, especially now we can physically short, makes the operational aspects of implementing 130/30 far less of a barrier. Clearly UK and European equities are more important asset classes here, and the UCITs III changes are now making the implementation of strategies like this easier for us. 59
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