From the desk of Jeroen Bakker
Benelux Consulting Lead, Pierpoint Financial Consulting
In a recent blog, my colleague Roy Zimmerhansl wrote about securities lending trade allocation by borrowers; what motivates borrowers to allocate trades to certain (agent) lenders. This week I would like to turn that around and talk about how lenders are choosing borrowers.
All lenders whether through direct, agency, exclusive or auction arrangements have to set up a suite of borrowers as inventory takers. This set-up includes agreements, credit facilities, client-specific account set-up and infrastructure prior to doing any business. Setting up and maintaining these relationships is costly and time-consuming, so both lenders and borrowers need to ensure the relationship is commercially sensible and viable on both sides.
Before I move to the selection process, we need to start with the types of borrowers that are in the market and the trades they engage in, as not all borrowers are created equal.
The majority of the borrowers are Prime Brokers (PBs); investment banks that offer a package of financial services to primarily hedge funds, money managers and other securities specialists. However, not all prime brokers service the same clients and as a result, each has a very different need for supply.
‘All asset’ prime brokers are PBs that offer the full range of services in all asset classes to a wide range of hedge funds; their demand will reflect this, however, most PBs will have a sweet spot and service a more specific type of hedge fund. This is typically related to a type of investment strategy, for example, it could be a statistical arbitrage fund, event-driven fund, long/short fund, macro and/or tactical fund in either fixed income, equities or both.
Investment banks have borrowing demand from internal departments that sit outside their prime brokerage business and I describe several below.
Delta 1 teams invest in products that closely track the price of the underlying asset and as a result generate a close to a risk-free return.
Index arbitrage – This is a strategy that attempts to profit from price differences between two indices or between the index and its composites. This could be long the future and short the underlying or the other way around. This type of arbitrage normally generates a vast amount of demand or inventory in main tier indices as the trades require high notional values to capture meaningful absolute profits from relatively small price dislocations. These tend to be traded at $100million or larger sizes.
Single Stock Futures – SSF is a type of futures contract between two counterparties to exchange a specific quantity of securities for a price agreed today with delivery at a specified future date. Demand is stock-specific and often a lender that has high withholding tax obligations is preferred.
Scrip dividend arbitrage – This arbitrage tries to benefit where an issuing company declares a divided where investors have a choice of stock or cash. Generally, there is a premium on stock dividend vs cash dividend, with the trade opportunity highly dependent on the election of the owner of the stock. When lenders can provide ’guaranteed cash elected stock‘ this stock would be very interesting to the borrower and would be reflected in the fee the borrower would be willing to pay. Unguaranteed or undecided stock is less valuable to the borrower as the lender retains the option to elect stock or cash and this creates an ‘uncertainty’ fee discount. Profit splits between borrower and lender are common in this type of transaction.
ETF/ETP – Exchange-Traded Funds or Products are investment funds traded on the stock exchange. Many investment banks issue their own ETFs for which they need to act as market maker. However, there are also other traders that try to benefit from the difference in price between the ETF and its underlying constituent elements (slippage or leakage). Demand could be generated from the underlying asset to ‘create to lend’ an ETF or from the actual ETF. In Europe, the supply in ETFs seems more difficult to borrow in comparison to the US.
Convertible bond arbitrage – This trading strategy aims to monetise the optionality premium in convertible bonds versus the equity from the same issuer. The trader will buy the bond and sell the underlying equity in a close to perfect hedge (Delta 1) and at maturity convert the bond to equity and redeem the borrow. Stable or even term inventory is valuable for these types of transactions. Again, profit split between borrower and lender is optional here.
Cash execution desk
Both the equity and the fixed income cash desks act as market makers for their clients. This business results in natural flow when the bank needs to be a seller to provide liquidity in the market but does not hold the positions in house and therefore needs to borrow the securities. This often generates a need for specials in small and midcap names.
Every (investment)bank will provide leverage to (internal) clients, however post-BASEL III, this comes with consequences on a multitude of ratios such as Leverage Ratio, Liquidity Coverage Ratio and Net Stable Funding Ratio. In order to comply with some or all of these ratios, the financing desk or collateral trading desk will have demand for High Quality Liquid Assets versus all sorts of non-HQLA collateral. Often they require the trades for fixed terms (e.g. 3m/6m/1y) or in extendible transactions such as ‘Evergreen’ structures. Term supply accompanied by term confirmations/letters will prevail over non-term inventory.
Custodial banks are normally classified as a lender as they lend their clients’ assets. However more and more of these banks are setting up ’investment bank‘ type teams to service hedge fund style clients or cover internal / client shorts often caused by operational errors.
Under the heading ‘brokers’ we can group the remaining borrowers which are securities finders or entities that trade back-to-back. These entities normally do not have internal demand but act as an intermediary between different companies rather than for clients. They are normally quite small in size with limited or no capital, however due to their contact networks can create or find transactions that other borrowers will not have on their radar.
For beneficial owners, selecting your borrowers and creating an approved borrower list is an important exercise and should not be taken lightly. Your agent will be able to assist you in this process.
However, it is important to keep your own objectives and priorities in mind. There should be a natural fit between the inventory you lend or make available for loan and the demand from the borrower side.
Keeping track of your revenue stream and especially the utilisation levels per asset class, split by market, should be done regularly as there are plenty of benchmark tools available that can assist you with this. Indeed, there are various utilisation strategies deployed by agents and it is critical that beneficial owners understand the implications of those strategies. Agents should deliver a strategy that fits with the beneficial owner’s objective rather than force-fitting the beneficial owner into the agent’s standard approach.
Re-evaluating your borrower list and the associated credit limits is an exercise that could fall by the wayside when everything is up and running. These should not be set in stone and always be seen as dynamic. When all is well, it is easy to ignore, however, vigilance will prove valuable in difficult times.
Coming back to the original question: ’Who to lend to?’ The answer is complex, with many moving parts but beneficial owners should ask themselves the following questions:
“How does my portfolio look like and what assets do I have or want to lend?” Match the inventory with the right type of borrowers; look at different markets, different asset classes and different trading strategies. Which borrowers have a natural axe? Which borrowers are market leaders (as distinct from just saying they are)? Which borrowers have an advantage in specific regions?
“What is my credit appetite?” There has been a lot of talk about disintermediation in the securities financing space, however, in those instances you do need to be comfortable in taking the credit risk of a hedge fund or lower-rated entity. Credit limits need to be regularly reviewed but lenders can generate a lot of revenue if credit lines are used wisely. As the reward goes up, the question is the degree to which risk also rises and how that fits into a beneficial owner’s credit appetite.
“What are my collateral parameters” Some beneficial owners have requirements set by regulatory frameworks and for some, these are set internally. Certain transactions are not in play if you only accept cash or G3 government bonds. Consider managing haircuts and concentration limits on an ongoing basis. Loosen requirements if you feel there is room to manoeuvre and additional revenue warrants it; tighten your schedules when you want to reduce risk for whatever reason.
“What are my term trading capabilities” Certain funds are prohibited from term transactions. However, these trades might be interesting for those beneficial owners that are not restricted. Investigate your opportunities; what terms, what maximum tenure are you comfortable with; what percentage of the portfolio should be eligible for term ensuring you maintain the necessary portfolio liquidity, what rights of substitution are provided, etc.
All in all, a lot to think about and keep track of. Do you feel your portfolio is underperforming in certain asset classes, are you uncertain about your approved borrowers, or do you just want to understand more about the options and opportunities by talking with an independent advisor? If so, speak to one of our Pierpoint consultants.