From the desk of John Arnesen, Consulting Lead
Pierpoint Financial Consulting
In my last blog, Getting the fee splits right, I referred to exclusive arrangements somewhat negatively. As I wrote last time, I didn't want to go down that particular rabbit hole so this week exclusives are my focus. The negative context is not because they are a terrible thing, it is because at the time I had to deal with them, it wasn't an agency lending decision, but one thrust upon us by a client entering into such an arrangement with a borrower.
At the time, the early 2000s, there was no other unit within my firm that could cope with the nuances of giving instructions, accepting collateral and maintaining the other post-trade services that the client still wanted my bank to support. I had argued that the whole arrangement should be moved to a custody support area to protect our resources. Eventually, I recognised that what was developing was a new product requirement and, at that point in time, agency lending was the only business unit that had the capabilities to 'process' the activity. Despite some heated exchanges with the exclusive borrower and more cordial exchanges with the client, an agreement was reached that we, agency lending would receive a percentage of the exclusive fees (similar to a fee-split) which we begrudgingly accepted given that the figure was higher than our current expected revenue estimate. All borrowing requests and post-trade services were to be conducted by us. What could go wrong?
Plenty as it turned out. Immediately the volume of borrowing requests began to explode and swamped the traders who struggled to cope while continuing to service all other clients. This had a knock-on effect on the entire business' revenue. If we didn't respond quickly to requests, the borrower complained to the client, the same happened if trades failed to settle. This managed to sour our relationships with both borrower and client. It took some time, but eventually, we managed to carve out support for this activity and shift it into a specifically governed group within agency lending that would book loans and returns and organise the receipt and maintenance of collateral. It still wasn't ideal as the resources used were not incremental, came from existing headcount and diluted the staff's efforts across a larger transaction base.
In today's market, exclusive arrangements are commonplace, more sophisticated and have moved on from my ad hoc arrangement described above. Let's break down the different types of exclusives and their pros and cons.
Investor driven exclusives
If an investor has entered into a commercial arrangement to lend securities to another party, this could be achieved by merely sending delivery instructions to the custodian to move assets in and out on a free delivery basis. In theory, a securities lending unit wouldn't know this exists. The custody staff may not be aware either if that is all they are required to do. However, this is rare; the investor would need to deal with all of the post-trade services themselves. Few have those facilities available in-house and would typically turn to the custodian to provide these functions. Many custodians now offer this type of support as a service, and deal with loans, returns, mark-to-market, collateral movements, and dividend and coupon substitute payments. Each of these functions carries a cost, and the investor should be charged accordingly. Documentation that governs the service is required, and most custodians have a standard agreement that needs signing.
The investor has to weigh up the premium it is receiving from the borrower against the concentration risk of giving exclusive access, the costs of the services provided and the elimination of indemnification. Of course, exclusivity in and of itself does not guarantee a premium these days. For some lenders, it is a trade-off for revenue certainty, avoiding the troughs of bad years in discretionary lending and missing out on the peaks in good years. Prior to making any commitment, it would be sensible for the investor to ask several agent lenders for revenue estimates to compare against one or more of the exclusive offers. As the investor is committing a portfolio, this will not work for many. The terms of the exclusive arrangement will be very prescriptive and may even require that individual stocks or bonds are always available to borrow throughout the duration. This locks in the investor, which will only work for those that know the portfolio is unlikely to change. The investor's loss of trading flexibility due to the requirement to have the securities available throughout the term of the agreement should be used by the investor to demand a higher fee premium offered by the bidding borrowers.
Agency lending driven exclusives
It is more likely that an investor considering an exclusive arrangement is already a client of agency lending. Whether through persuasive discussions with borrowers or prime brokers or out of frustration with revenue derived from discretionary lending programmes, clients are more likely to want the arrangements to be serviced by the agency lending unit of their custodian. After all, the pipework and processes are already there, and if the commercial agreement delivers more significant revenue than the agent believes they can generate themselves, it becomes more compelling. Of course, revenue is not the sole reason that an investor may choose an exclusive. For example, through exclusives, an investor may achieve positive discrimination towards borrowers it wants to have exposure to rather than having an array of borrowers that it may have exposure to at any given point in time.
The aspect that the agent must have some control over is volume. A borrower with a fixed borrowing cost will choose to utilise exclusives as much as possible, potentially creating huge volumes of short-term transactions. Better to have the borrower pay for all movements of securities, but if not, whether the client pays for transactions or they will be absorbed out the agent's revenue, it is sensible to limit daily volume. It can be a contentious point but a critical issue to avoid an overwhelming volume of trades or a negative impact on net profitability. These types of exclusives are often based on a specific market or index.
A better way
Once a client has determined that an exclusive revenue stream is more compelling to them than the estimated, but variable, revenue from a discretionary agency programme, they have to be supported in their effort to do so. My advice is to allow the agent lender to manage the entire bid-gathering process. A single quote from one borrower doesn't give the client a reference as to whether it represents value. An agent lender can use its extensive network to pick several borrowers whom they know through experience are likely to be amenable to exclusive offers and run an auction. The auction process has the advantage of extracting the highest premium for the portfolio, and the agent lender can use its experience in collating the various stipulations that each bidder attaches to their submissions. Regardless of how detailed the investor requirements are at the outset, the returning submissions will have optional figures depending on factors such as a change to collateral in portfolio composition or an insistence that a particular security holding is consistently held for the duration of the arrangement. The agent lender can collate the responses alongside bidder qualifications and provide interpretive commentary when presenting all options to the client. An agent could go one step further and continue to offer indemnification even though they no longer have discretion over the exposure to the auction winner.
There are drawbacks. Flooding the market with requesting bids can have the opposite effect and see some borrowers lose interest in a process they don't think they can win. Guaranteeing a revenue stream is not for the faint-hearted, and careers can be affected when things go wrong. The stipulations from borrowers can become so specific that the client can't make it work. Even so, auctions can be a useful process in extracting a guaranteed revenue stream at a premium and certainly offering an interesting adjunct to discretionary lending fee estimates.
eSecLending celebrates its twentieth anniversary this year and has built a business centred on the auction process and has attracted seasoned and talented staff over the years. I remember talking a few years ago at a conference to one of their clients who told me that this is the only way he will engage in the market.
The increased supply in the market has led borrowers to become selective in bidding for exclusives and very particular when agreeing the legal, operational and portfolio composition frameworks. The entire arrangement needs to be clearly beneficial to the borrower; otherwise, they will rely on the simpler alternatives of discretionary supply or the internal synthetic routes.
I have read with interest several articles this year that described how some agents are rethinking the way they support clients' changing needs by using their platforms and processing in innovative ways that deviate from traditional securities lending. State Street and JP Morgan, in particular, come to mind. Exclusive and auction arrangements are not new, but they can and should form part of service providers' offerings for the right portfolios and the right clients. Want to know more? Come and talk to us at Pierpoint Financial Consulting.