From the desk of Roy Zimmerhansl
Practice Lead, Pierpoint Financial Consulting
Today is a day of inspiration. We are always interested in hearing ideas from our readers on topics for our blog posts. Today’s post has been suggested/is inspired by an insightful beneficial owner with whom I have had many meaningful conversations over the years. More on that topic in a moment.
The image below is inspired by International Women's Day and the launch of the London chapter of Women in Securities Finance. I find it strange that there have been so few women attaining senior positions in securities finance over the years. Although I was involved in securities lending as a sideline at three previous firms, I moved into securities finance full-time in 1992 while at Chase Manhattan Bank, thanks to a decision by Beth Siano and Kevin Burke, who were jointly heading up of securities lending. Beth left Chase shortly thereafter for a similar senior role in Bank of New York's securities lending programme, with Joanne Ciaciarelli becoming co-head with Kevin at Chase. Security Pacific Bank's securities lending programme was led by a woman at that time as well and there have been a few notable others, but the reality is nowhere near any sensible balance based on skills and knowledge. That was 28 years ago, so it is hard to believe this is still an issue, but Women in Securities Finance is a fantastic initiative the industry should get behind. Hurdles no more!
Back to today's primary topic. The suggestion from our reader was that we examine the decision-making process for a borrower when sourcing supply from lenders. At first glance, it seems obvious – the borrower will go to the cheapest lender. I suppose there is still a place for that approach and at one time it was that simple for everyone under all circumstances. Regulation, technology, cost and other factors have conspired to force more selective channel optimisation today and I fully expect this to become more refined and widespread over time.
Internalisation is the process whereby a prime broker receiving a short sale notification from a client is able to source the securities either internally from the firm’s long position or another client’s long position. Prime brokers (PB) typically have access to client positions when providing financing or have an arrangement with clients enabling the PB to use assets either free of charge or in return for a fee. As one might imagine, this is a powerful action – the PB does not have collateral costs, has no capital reserve charges for the ‘lender’, the short sale proceeds provide positive funding to the firm and the fees are at worst the same price as external lenders and usually free of charge.
There is no question that internalisation has had a material impact on external borrowing activity over the past decade. The public data on lending volumes does not take internalisation into account so when we see equity loans hovering consistently around the €800-€1,000 billion range year after year, the full figure covering shorts is much higher.
However, internalisation has its limitations. Banks don’t carry as much inventory as they did prior to the restrictions on proprietary trading that were implemented after the Global Financial Crisis. With respect to other clients’ long positions, funds following similar strategies are likely to be positioned on the same side of the trade for the same securities – either long or short. PBs with clients deploying a wide range of trading strategies are better situated for crossing client longs and shorts.
Where internalisation isn’t sufficient to cover the short, the PB must go to its external network to find securities – its exclusives, its agent lenders and even other banks and securities firms. This is where PBs become more selective. All things being equal, borrowers should select the lender based on the optimal combination of direct and indirect costs.
Profit motivation drives the need for selectivity, regulation and costs direct the decision, and technology enables it.
The tangible issues that are part of the decision-making process include fee/rebate, lender dividend requirement (manufactured dividend replacement cost), a lender’s range of approved collateral, collateral structure (transfer of title or pledge), effective netting opinion for the lender’s jurisdiction, and counterparty (lender) risk-weighting cost.
In addition to the tangibles to which one can ascribe a cost, there are always intangibles for a borrower to consider. Historically, the borrower/agent relationship was at the top of the list of intangibles and while I accept this is still important, stability remains as important as ever.
Borrowers want supply stability for several reasons, three of the most important being:
Client Service – Of paramount importance is continuity of supply for the end-borrower. No PB wants to be in the position of having to recall a client, forcing them to close out a position early.
Transaction Cost – Wherever possible, unnecessary settlement charges should be avoided. Stable supply minimises market-side settlements.
Operational Effort – Another less obvious reason that stability is important is the operational cost of replacement – aside from settlement charges, the rebooking from ‘Lender A’ to ‘Lender B’ generally represents human time and effort and the potential mis-bookings resulting may lead to further operational costs down the road.
Degree of ‘Specialness’
I was advising a Fintech firm ten or so years ago when I suggested the word ‘specialness’ to differentiate between GC, warm, special or super-special securities. My colleagues cringed just as I am sure you have now also done. It is clear that the supply source will be impacted by the supply/demand balance for each security and that in an efficient world every borrow decision-making process would be determined by the specialness of the security.
I have provided a table below which shows a series of cost factors that go into choosing where to source an individual security. For each factor, there is an assessment of how important that item is in making the decision. For example, for a lender to optimally position its GC stock to a borrower, the preponderance of GC means that in addition to having the stock, the lender must have a clean netting opinion, accept the collateral the borrower wishes to provide, have the lowest available substitute dividend cost (equivalent to highest withholding tax rate), be perceived as a stable lender and of course be available at a competitive fee/rebate. Additionally, it would be ideal for the borrower if the lender had the lowest available cost of capital and could also take pledge collateral. However, not all borrowers or lenders prefer/permit pledge and it isn’t always possible to drill down through an agency programme to the underlying client level to determine capital cost.
At the other end of the spectrum – the super-specials – the hurdle rate is much lower. It’s all about getting the stock, with other factors influencing but not driving the decision. Stability may be very important here as a prime broker will not wish to provide stock to a client only to turn around shortly afterwards and ask for it to be returned. There are exceptions for unstable stock situations, but usually, the PB will advise its client beforehand in instances where is stock available, but it is from an unstable source.
Barriers to Execution
Hopefully, the table is conceptually straightforward, although no doubt some people will argue for the use of other words to describe the relative importance of an individual factor. However, the bigger issue is the degree to which this can be applied in practice at trade execution.
One of the biggest barriers is the existence of lending pools at most agent lenders. This generally constrains the ability for a borrower to drill down to the most granular level at the time of trade execution. ‘Smart bucketing’ by agents may address some of the issues, but it is usually not possible to see through pools to specific clients and it is only in the post-execution phase where fine-tuning of lender exposure can be influenced by borrowers. Pooled agent lenders already group similar clients into clusters, often organised by collateral type or withholding tax levels. Smart bucketing takes that approach to a more granular level moving from lowest common denominator to having several buckets requiring multiple characteristics in common, adding other qualifiers such as domicile and legal structure. This makes borrower selection more effective, but still not ideal as it cannot, for instance, validate that the borrower has credit line capacity for an underlying beneficial owner.
Agents that operate segregated accounts have a clear advantage for GC in that so long as their clients can satisfy the criteria, a borrower can select the lender that best fits its needs.
The scale of the business and the inherent costs of maintaining it require an efficient execution infrastructure across pre-trade, trade execution and post-trade maintenance. Technology and service providers offer some solutions today and are working on others for the future, but that is a blog for another day.
The Securities Finance Transactions Regulation (SFTR) is forcing a greater degree of micro-management and granularity on the industry. Hopefully I have given some lenders food for thought as to how the decision-making process happens today and could do tomorrow, leaving them to consider how to position their programme for the future. Of course, that’s where Pierpoint’s knowledge and experience can be invaluable to assist lenders when making critical business strategy and risk decisions and then implementing them.
I see a market with ever-higher percentages of trades that are straight-through-processed from pre-trade through post-trade maintenance. Without a reimagining and further investment, I fear a continued cap of business volumes at today’s levels.