From the desk of Roy Zimmerhansl
Practice Lead, Pierpoint Financial
We return with our weekly blogs today, having taken August off, and for those of you in the northern hemisphere, I hope you had a great summer. We are in the home stretch for budget targets, and while this year is better than last, it hasn’t been anything to write home about. (Do people even know what that means anymore?)
Last year I wrote a blog titled “8 Issues Emerging Markets Must Address for Success” in order to become fully functioning securities finance markets. The benefits of doing so? Increased liquidity, better price discovery, lower funding costs on debt for governments and corporate borrowers. There you go, job done, markets will open, and revenues from new activity would flow to investors through their agents and service providers. Not exactly.
I have been involved with emerging lending markets since the beginning of my full-time career in securities finance in the early 1990s. While at Nomura, we carved out an emerging market niche with innovations such as guides to lending in new markets such as Thailand. This invaluable information, unavailable elsewhere, gave us an edge and led to several exclusives in hard to borrow markets. In the mid-1990s, I wrote an article for Global Custodian predicting that Brazil, India and China would be the future of securities lending revenues. Perhaps I was a bit early with that, and it was done before my first of several visits to meet with Indian regulators (1997) and long before I met with Chinese equivalents. Each of these visits put a damper on my enthusiasm.
I’ve heard both sides of the long and short equation lament the lack of opportunity in emerging markets. Long investors, particularly emerging markets specialists and funds, are all about performance, and high lending fees can make meaningful contributions to returns. Similarly, hedge funds are there to provide uncorrelated performance, with emerging markets being an obvious target, especially if they can get short exposure directly or through synthetics offered by their prime brokers and others. Typically, these synthetics are hedged with cash positions from those synthetic providers – if possible.
Unfortunately for both ends of the ecosystem – lending investors and would-be short-sellers, this is another example of the “chicken and egg” conundrum: Long-side investors are often happy to make their positions available for loan if they can be convinced there is demand to borrow. Why do they need convincing? There is due diligence, risk assessment, potentially new workflows that may be required, and there are almost certainly approvals that need to be sought prior to commencing lending. Given the pressures that financial institutions face, the reluctance to proceed without some certainty of outcome is hardly surprising.
Would-be shorts that identify new market opportunities are happy to borrow but can’t commit unless they know stock is available. Generally speaking, managers want to apply proven investment techniques and strategies to new markets, seeking an edge, but unless they have some visibility and certainty as to the availability of specific securities, there is little value in committing time and brainpower.
The result is somewhat of a standoff – “I’ll make my securities available when you commit to borrow them” versus “I’ll finalise my strategies and borrow securities once you tell me your securities are available”.
Let me give you a real-life example of how this was ‘resolved’ in the real world. At the start of this century, South Korea was the up-and-coming lending market. Borrowers wanted stock – many Korean companies were large, world-class entities but under-researched providing fundamental managers with opportunities for information-edge and stock turnover that meant potentially meaningful trades and performance. Additionally, the lack of active short selling meant lo-risk arbitrage opportunities were available in abundance.
Institutional investors had oodles of South Korean stocks - Korea was often the second-largest Asian portfolio allocation after Japan. Significant portfolios in a new, relatively liquid market that apparently was in demand from borrowers – a fantastic opportunity for lenders.
So how was the Chicken/Egg issue overcome?
The intermediaries stepped in to bridge the gap – Prime Brokers and Agent Lenders. Agents wanted to make stock available, and PBs wanted to borrow them …, but there remained the perennial questions: How much borrowing interest was there and how much would be paid to get access? The answer “TBD” is not a great one, but maybe naively, some people believed in:
“Build it, and they will come”
Maybe they can be forgiven. After all, it had only been about a dozen years or so since the movie Field of Dreams used that phrase to justify the creation of a baseball field amid corn crops, risking financial ruin, but [spoiler alert] ultimately viewers infer that people do indeed come and the dream is realised.
The intermediary impasse was resolved when PBs jumped in and provided guaranteed bids to agents for exclusive access to individual client portfolios - with committed fees in the 200-400 bp per annum range. Let that sink in. I recall a $250 million portfolio we bid on, and ‘won’ at 300 basis points for the year - $7.5 million guaranteed to go out the door with zero commitments from our borrowing clients. We had of course, canvassed them, getting into deep discussions about their needs and objectives with some warm and fuzzy noises from clients giving us enough confidence to proceed but no firm commitments.
The agents were possibly the happiest group because they arranged the exclusives, thereby guaranteeing income to subsidise the substantial costs of opening a new market even then. I write ‘possibly’ advisedly as agents are conservative as disgruntled lending clients make for difficult corporate relationships. Risk-taking is understandably not in their nature.
Launching a new market today is much more expensive as due diligence, legal, tax and risk issues inevitably become better understood over time - more deeply researched, assessed and where possible mitigated.
The PBs excitedly showed stock in this burgeoning demand market to an eager audience of potential borrowers. Then the cold, hard, sharp slap came. What unfurled over the first two or three years of live lending activity in Korea was the stark realisation that almost all non-resident portfolios looked pretty much the same – concentrated into 8-15 stocks and by value almost half in Samsung, which could already be borrowed as an ADR. A LOT of money swirled down the drain as firms learned this expensive lesson. I don’t think there were many funds that felt satisfied despite the huge investment from PBs.
Eventually, domestic Korean investors joined in (both shorts and long), lending agent salespeople learned how to target portfolios more effectively and viewed in its entirety Korea has been a very active and profitable market, making a significant contribution to the business (aside from the period of the short-selling ban which expired a few months ago).
However, I submit to you that Korea is a rare exception. First, it was a different era, more focused on revenue generation to support an industry that had grown astronomically over the preceding decade. Also, near the start of this post, I used the words “emerging lending market” advisedly. Nigeria, Egypt, UAE, the Philippines, Indonesia, and others are emerging investing markets, whereas Korea had already been a developed market adding lending. Emerging markets are minnows relative to the whale that Korea was, so while in my opinion, unfortunately, today’s working world discourages a ‘Build it and they will come’ approach, it has never really been an appropriate strategy for small markets. Generally, hard-edged economic decisions have more sway than visionary aspirations. Few are willing to take long-term decisions in a business world laser-focused on short term performance and with personal career longevity challenged by decades of ‘juniorising’ the business.
Practically speaking, the lion’s share of new market due diligence falls on the agent lenders. They have their own issues to address, but beneficial owners rely on their agents to do the bulk of the work and look after their client’s interests. Custodian banks have learned the lesson that the deepest pockets are the primary target if something unexpected happens.
But to continue with my lines from old movies, in “The Wrath of Khan”, Mr Spock sacrifices himself, stating that “Logic clearly dictates that the needs of the many outweigh the needs of the few” (to which Captain Kirk adds “Or the one”).
Imagine you run an emerging market ETF, for example, which might have extensive holdings in a new market where lending revenues could move the needle for their performance, likely attracting inward investment. Similarly, consider the position of an Emerging Market hedge fund that believe they can demonstrate their stock-picking skill if only they could get their hands on some stocks to short as well as go long. In both situations, you are the “One” and want your needs to outweigh the product development prioritisation queue of your service providing with many other clients.
Those service provider intermediaries look on emerging markets as a bit of a punt as to whether supply might meet demand, the low market turnover of an emerging market means the likelihood of sizable shorts is de minimis.
The typical fee split for beneficial owners/agents is typically 80/20, sometimes 75/25 and often 85/15 or even higher for very large beneficial owners. In practice, a $1 million loan at a special rate of 200 bp pa at 80/20 generates just under $11 a day for the agent. Against that, they absorb all the transaction charges and manage the day-to-day administration of the loan. Transactions charges are inevitably higher in smaller markets than large markets. New markets result in very few, low notional value lending transactions as market liquidity can’t absorb large new shorts, and even if they could, exiting the positions for the short seller might be even more difficult (short squeezes anyone?). And oh yeah, the legal, tax and operational DD costs are borne by the agent on behalf of the Ben Owner who may do their own work, but even so, likely assessing their agent’s work rather than starting from scratch). It takes more than a few $11 days to cover those costs, so usually, the agent tells their client there is no tangible interest (which is true) – even where there may be theoretical short interest. Synthetics are a partial answer but bring their own hedging challenges, and I won’t veer off to discuss them in this post.
With demand uncertain (the chicken), supply unlikely to become available (the egg), and the intermediaries unwilling to fund the gap (the nest), is there any hope for small emerging markets?
Yes, but it requires innovation, focus and bespoke solutions crafted amongst interested parties. But the additional income at the individual investor level (long or short) can move the needle if successful.