AN INCREASINGLY COMPLEX MARKET: SECURITIES LENDING IN CONTEXT

CHARLES RIZZO, SENIOR VICE PRESIDENT, CHIEF FINANCIAL OFFICER FOR THE JOHN HANCOCK FAMILY OF FUNDS AND CHAIRMAN JOHN HANCOCK FUNDS RISK COMMITTEE. We have over 200 funds and half of those are authorised to lend. Frankly, our focus over the past year has been on the threat of rising interest rates and its impact on our collateral pool and lending funds collateral investment. We have an in-house managed cash collateral investment vehicle that has always been managed conservatively, similar to a money market fund. With the prospect of higher rates, our focus centred on the general collateral (GC) balance our funds had outstanding, particularly given that reinvest earnings relative to the federal funds rate continued to decrease, and the risk return trade-off did not justify the GC balances. Consequently, a series of decisions were made to de-risk the lending program. At this point, we are not lending general collateral unless a minimum basis point spread is achieved. We are however lending specials because the spreads in our view are appropriate relative to the risks that our funds are taking on the lending side as a beneficial owner.

CRAIG STARBLE, CHIEF EXECUTIVE OFFICER, ESECLENDING: Our goal is to grow our business and we do that in two ways: one is acquiring new clients as third party lenders; the second is expanding business with our current clients into new products, new markets and new opportunities. Some of those are on the collateral side; some of those are on the lending side. Of all the trends impacting securities lending, perhaps regulatory changes are the most significant. Some of those changes impact our clients, especially in Europe; some of those changes impact our competitors through higher capital charges as an example. We have always handled indemnification in a different way than our competitors, using a sophisticated insurance policy that has an explicit cost, which is beneficial to our business as it allows us to control costs, especially in this particular environment. Clearly, the market has changed. The demand for borrowing is very different today than it was four years ago. Nonetheless, I see a good outlook for the marketplace. In particular, as Charles mentioned, we have noted a heightened focus on the intrinsic side of the business. These days, there is a lot of money to be made on specials. Moreover, in some cases there has been a move away from cash reinvestment. Elsewhere, clients are taking advantage of opportunities on the cash collateral side. One area of interest, which is of particular interest to eSecLending, is servicing the CCP marketplace. It has potential to be an important pillar in securities lending and we are now working on products and services to provide to CCPs as clients.

DAVID GURTZ, DEPUTY CHIEF INVESTMENT OFFICER, DIRECTOR of RISK MANAGEMENT, MASSACHUSETTS PENSION RESERVES INVESTMENT MANAGEMENT (PRIM) Board: Our current assets are approximately $60bn. We feel our primary focus should be on asset allocation while picking top tier external managers, monitoring them and trying to maximise returns while minimizing the risks. Maybe a little history on why we have recently gotten back into securities lending might be useful. PRIM has been around since the mid-80s and we have gone in and out of securities lending participation throughout that time period. Most recently we were in securities lending in the mid-2000s but our investment committee in the fall of 2007 (just before the financial crisis really started) questioned whether we should be in securities lending. We think it is good practice to issue requests for proposals (RFPs) to procure competitively most of our services. In 2007 we had an exclusive securities lending arrangement with Goldman Sachs and its contract was expiring at the end of 2007. The then CIO brought the RFP for procuring a securities lending agent to the investment committee for consideration and the committee decided that the revenues we were earning from this programme were not sufficient to justify the potential risks we were holding. As we all know, a few months later the financial crisis kicked off, and the Committee and Board were happy to not have incurred reinvestment losses related to securities lending which many other funds did. Looking back, the programme we had in place was very conservative and would have performed well throughout the crisis as our collateral investment was in US Treasuries. Fast forward to 2014 and a couple of new Investment Committee members suggested we get back into securities lending; or at the very least research it, and understand where others may have went wrong. We undertook a detailed review, under the umbrella of an important internal initiative called Project SAVE. The SAVE element stands for Strategic Analysis for Value Enhancement, which caused an examination of all of our asset classes, processes, and infrastructure to ensure that we operate cost effectively and that whatever we do, or at least as much as possible of what we do, adds the greatest possible value at the lowest possible cost. We had a target goal for Project SAVE of $100m. One of the initiatives we undertook under Project SAVE, which helped us surpass our $100m goal was securities lending. Securities lending is a perfect example of adding value to an institutional investor like PRIM.

SUSAN PETERS, MANAGING DIRECTOR, SCORPEO US: Scorpeo enables portfolio managers to maximize the return that they gain from corporate actions associated with securities held in their portfolios. This strategy includes helping them manage corporate events such as optional cash stock dividends, tender offers, Dutch auctions and mix and match. Particularly in the European markets, dividend strategies are becoming more and more complex. Value added revenue can certainly be captured through securities lending. However, it can also be captured through a strategy that does not require moving the underlying securities into somebody else’s hands or the risks associated with managing collateral. Our research indicates that with respect to optional cash/stock dividends, for example, investment managers leave quite a bit of money behind due to sub optimal elections. This may simply be due to an index manager defaulting to cash simply because they do not want to incur tracking error. Scorpeo’s method for optimising such revenue can complement an existing securities lending program or operate as a standalone strategy.

ROBERT ZEKRAUS, DIRECTOR, PRIME SERVICES, SCOTIABANK GLOBAL BANKING AND MARKETS: As a growing business in the prime services market space, one of our goals is to stand out, beyond our traditional Canadian footprint. This is a demanding and fascinating goal, the opportunity which in some respects is driven by regulatory changes impacting an already established order of banks in prime brokerage. The changes around incremental funding, the provision of stable liquidity and other scarce financial resources and heightened activity in the securities lending space are being re-evaluated. Some of these elements are, naturally, a work in progress. Around that we are mindful of the usual array of influencers on the business set, some of which have been outlined here (regulation, for instance and the challenges and changes around that from both a markets and jurisdictional perspective). Clearly we are looking at how it impacts clients; around securities lending and the growth of that business, primarily on the supply generation side and the impact that will have on collateral demands of the marketplace; and then, finally, on the growth of capacity on financing and funding away from wholesale funding and using collateralised transactions as a way to grow our footprint in that space. Scotiabank has been in the prime brokerage business ten-plus years but it is only in the last four or five years that the bank has increased its market share. Therefore my current capacity here, four months in, is not dissimilar to what I experienced in previous roles helping develop a securities financing platform. The one major change being the marketplace and the environment has changed tremendously post-crisis.

CHRIS VALENTINO, DIRECTOR, SALES, EQUILEND: EquiLend has been a leading provider of trading and post-trade services for the securities finance industry since it went live in 2002. Two years ago we started a market data business called DataLend. I’ve been with the organisation for a little over two years. Covering our global client base is what I do on a daily basis. Our clients, who include many of the players in the securities finance business, are very serious about growing their business and utilizing technology, automation and market data to assist them throughout this process. As a provider of all of these things, we find ourselves in a very unique position within the market. We are constantly looking for ways to help clients gain efficiencies in both cost and time. Some popular trends we see in the market are with regards to more automation around trading and post-trade activities. Transparency provided through tools like DataLend is also a very popular trend. The market is thirsty for clean, concise and flexible market data.

HAS REGULATION AFFECTED MARKET PRACTICE AND BUSINESS VOLUME?

CHARLES RIZZO: We have pondered this question a lot lately. Clearly the impact of Basel III is something we have begun to actually witness now. Banks and dealers are much less willing to hold securities on their balance sheets given the capital implications and this, clearly, has had an impact on our cash collateral pool in terms of the availability of repurchase agreements. It is pretty evident today that you need to get into a market a lot sooner with regard to your repo investments than you had to in the past given reduced market availability. The implications of liquidity ratios on short-term funding arrangements can have not only an impact on lending capacity, but also on the costs of providing such funding. Knowing this, we have begun to evaluate our cash reporting process to determine if changes in the work flow can save time in reporting to the cash desk so that our investment managers can make cash investments even sooner. Additionally, given the risk element of rising rates we also shortened the duration and weighted average maturity of our collateral pool. Moreover, we continue to track market developments closely and keep our eye on emerging regulations because of the potential impact on our lending program. Additionally, through last year we continued to monitor the progress of the financial transaction tax (FTT) in Europe. It hasn’t taken hold yet, but if it does, we will evaluate the profitability of making loans during the foreign dividend season and determine whether engaging in lending on these transactions makes sense. We are also keeping track of Dodd-Frank’s Section 165 implications with regard to the amount of exposures our lending agent banks can have to a counterparty. That might limit the amount of borrowing our agent lenders can do on our behalf if they are too weighted towards one particular borrower, given the other financial activities they may have within the bank with that entity. Clearly, there are many dynamics in play. Let me tell you, it is a challenge to keep up with it, but we have a very strong team and internal committee structure to oversee all aspects of the security lending program and are very much involved in industry committees to further our learning. We bring our agent lenders in for educational sessions during the year to try to keep abreast of impending regulation and regulation that is already in play and ways in which it could affect us over the near and longer terms as well as learn about developing industry practices. Once we have all that in our pocket, our working group starts to make decisions about how we want to manage our lending programme. As I explained earlier, because of the interplay of all these elements, it makes sense to shorten the duration and weighted average maturity of our collateral pool. Let me explain some of the mechanics and changes we are making. The way we manage our collateral pool assets is pretty unique. Currently, we have a 40-act vehicle that manages assets based on the old 2a-7 money market rules, not the money market reform rule amendments from 2010, which tighten liquidity requirements such as shorter maturity limits. Therefore we are able to apply the old rules in our cash re-investment strategy which gave us a lot more flexibility in a more favourable market and interest rate environment. We recently made a decision to formalise our current strategy by changing our investment policies which will require the lending funds collateral assets to be managed like current money market funds. Therefore today we are well below 60 days weighted average maturity, and because of that we have less sensitivity to interest rate risk as we are managing on the short end of the yield curve. It is clearly a dramatic shift and we are comfortable that our current strategy aligns well with our view of the market.

FRANCESCA CARNEVALE: Charles has articulated substantive changes both in the management of assets that are allocated to securities lending and in the entire investment spectrum. How have service providers responded to that and helped client firms manage their risk exposure more effectively because of regulation?

CRAIG STARBLE: What Charles experienced is representative of what we have seen across the broader market. eSecLending has always been very focused on the intrinsic side of the business. We continue to do that. The way our auction process assesses the market for some assets is, in my mind, regulatory-friendly because it allows borrowers to bid on only the assets that they want to bid on, and does not require that they borrow a combination of specials and GC in order to accommodate those assets that are typically lent on a discretionary basis. Even so, we have clients who are using minimum spreads. That is a business model that is very reasonable and is used throughout the industry. We are working very closely with the borrowers because they are impacted on what they can or cannot borrow; and what they want or do not want to borrow. That involves working very closely with them on the reinvestment side of the business. Is there a way to give them appropriate funding which satisfies some of their liquidity ratios (or capital ratios) in a more reasonable way? I think so. One of the benefits we enjoy is that we are not subject to Dodd-Frank 165. That is only impacting systemically-important financial institutions (SIFIs), and coincidentally, many of the major players in the securities lending space are designated as such. On the borrower side we are beginning to see business move away from the top tier borrower base. Clearly other prime brokers are going to benefit over time as hedge fund activity migrates away from the bulge bracket firms and migrates towards other smaller, nimbler firms. Finally, I see the same thing happening in securities lending; a portion of business (not all of it of course) is migrating away from the major players toward providers that are able to offer diversification. There is a good reason for this dynamic; it works to the client’s advantage. Moreover, as we begin to feel the effects of regulatory change, there will also be more discussions about the cost of indemnification and the long term impact of all these changes in the market.

FRANCESCA CARNEVALE: Craig has outlined a number of structural changes that are occurring in the market because of regulation: a flight to diversification, a flight to quality perhaps and liquidity, where it can be found. Is that your view as well Robert?

ROBERT ZEKRAUS: In the marketplace where regulatory changes are forcing people to re-evaluate their overall portfolio and book of business, in this case from a securities financing aspect we are seeing traditionally smaller market participants standing potentially to benefit from some of that change not only in the Americas—Canada and the US—but also globally as well. Businesses are positioning themselves to capture market share. Even so, the overall universal model for this particular business may only be secured by a few of the larger industry players; yet even at those firms client re-pricing may take place and meeting internal return hurdles (i.e. returns on assets) are being more scrutinised. Therefore some of the mid-tier and smaller players will have an opportunity to alter the landscape. From a Scotiabank perspective notwithstanding, other banks of similar size, with a strong balance sheet, credit and compelling offering, stand to benefit in the prime services/prime broker arena as well as in the agent lender and other market participant space.

FRANCESCA CARNEVALE: Susan, as a provider of quite diversified value-add/risk management services, how is regulation impacting on you. Does it provide you with additional business opportunities and what are beneficial owners looking for right now in terms of requirements?

SUSAN PETERS: Scorpeo’s business model is not an outgrowth of the regulatory impact of Basel III, it comes from beneficial owners seeking to maximize intrinsic portfolio value while incurring minimal risk. I do think that a failure to understand the dynamics of the ebb and flow of liquidity is one of the root causes of the recent economic crisis and resulting regulatory change. The new regulatory environment has produced some odd results. I recently opened the Wall Street Journal and saw that banks were rejecting cash deposits. What are banks for? Certainly the founders of some of the old white shoe firms must be rolling in their graves to hear that significant cash deposits are being turned away by major banks. The regulatory impact of Basel III may indeed favour firms such as Scorpeo. One could argue that a favourable result of recent regulatory change is to place asset managers in the position of making active choices with respect to which route to market is best for them. In some cases, lending se curities may be the optimal choice, in others, the best route to market may be to optimize the revenue associated with corporate actions using Scorpeo’s methodology. It strikes me that the regulatory environment fosters a process where investment managers must actively manage which route to market works for them, given their risk appetite, the available revenue, their tax position and desire to manage operational risk in day-to-day activity.

CHRIS VALENTINO: Just building on what Susan said, from our perspective in the market we definitely see a desire from our client base for increased transparency within the market. Susan spoke about beneficial owners actively managing their securities lending programmes. We too now work with a number of beneficial owners who probably in the past would use a market data provider (like DataLend) primarily as a benchmarking tool to ensure that their agent lenders were acting in their best interests. There now appears to be a greater interest in utilising the data to identify and capitalise on intrinsic-value opportunities in the marketplace. EquiLend and DataLend are trying to seize this opportunity by providing a level of transparency that perhaps doesn’t exist elsewhere in the market, partnering with agent lenders and beneficial owners to help educate that community on potential opportunities. Clearly it is an opportunity for our business. Charles has spoken about a reduction in the general collateral balance; however, we haven’t seen evidence of that come across our pipes. We continue to add clients on both the trading and post-trade side of our business. Regulation has actually provided us with some new and rather interesting opportunities with which to add efficiencies and transparency for our clients.

ROBERT ZEKRAUS: Complementary to what Chris and his firm are doing within the market (and some of their competitors as well), there are a growing number of firms that are trying to replicate that level of transparency. I would call it almost a portfolio dashboard approach for the buy side, or the hedge fund manager, that might not have an in-house financing specialist within the fund but who nonetheless requires an overarching approach to manage financing across multiple prime brokers so they can make better and more informed decisions. Any number of considerations lie behind this trend: the changing regulatory environment; what impact regulation will have on their book of business with their prime brokers, particularly around funding and financing balances, not only on the securities lending side but on the margin lending side; and also they are aware there are risks in their concentration of positions across their multiple prime brokers. Clearly then as this market continues to evolve there is opportunity for technology-savvy and forward thinking lenders to offer similar products for beneficial owners, asset managers, etc. and their broker-dealer counterparts that will help them manage their decisions more effectively.

CHARLES RIZZO: From the beneficial owners’ side, I am starting to see advances in dashboard type reporting and some movement towards providing increased transparency with regard to lendable assets that are in a portfolio. Now, the reason that is important is that it can allow me and members of my team to engage in a discussion with the fund manager to make sure that they are aware of where the opportunity is with regard to performance enhancement. However, we do not interfere in buying or selling decisions. We do not think it is our role to tell a manager how to manage the fund, we view our role with them more as advisory/consultative, but if we have the information, and through some of these automation tools we can engage in that conversation much more effectively, we can come across more as a trusted advisor collectively pointing out opportunities that exist to enhance the overall performance of our portfolios. That is where automation and advances in technology can really benefit not only the providers, but also the beneficial owners as our interests are clearly aligned.

DAVID GURTZ: As the asset owner at this table, all of these things are exactly what we are looking for. In terms of regulation, regulation might not impact PRIM directly but it certainly impacts our investment managers, it impacts the plumbing, so to speak, of the entire marketplace. Therefore we are keenly aware of monitoring how our managers and how others are improving their compliance and improving their technology to deal with all the regulatory changes that have been taking place over the last five to seven years and are coming toward us in the near future. At the end of the day, one of the things that we are really looking for as an asset owner is full transparency. We want to know as much as we can to make informed decisions and these kind of products that you guys are speaking about that allow us a better understanding of the return potential, and the risks involved are exactly what we want to be looking at and utilising going forward.

THE MACRO ENVIRONMENT: WHEN PATHS DIVERGE, CAN WE TAKE BOTH?

FRANCESCA CARNEVALE: As Charles intimated very early on in this discussion, against a regulatory background the macro environment is ready for change. Certainly in the United States, interest rates will start to rise this year with an attendant effect on most financial activity. Chris, how are you preparing for this change? Do you think that the new macro environment will provide a fillip for securities lending this year and/or collateral reinvestment? Or, do you think that this year is just another continuation of 2014 where extraneous risk factors have essentially determined the investment outlook?

CHRIS VALENTINO: I have a very positive outlook on the marketplace. Higher rates helps in terms of demand from hedge funds; volatility also helps. What we have seen in the last three months has been healthy. We have had fairly significant moves in all the major market indices. That’s healthy. The real issue, I believe, from a lending perspective, is that the market has witnessed strong one-way directional sentiment. When you think the market is going to appreciate over time, it is hard to get a lot of interest to take positions outside the norm. The fact that we have seen some volatility and higher rates might cause a few headaches for investment managers, but I believe it is good for the lending business. It allows for more alternatives and will inherently create more demand from the borrower’s side of the business. A more robust marketplace makes banks healthier overall, which is good for our industry, and over time, you’ll have more intriguing products to engage in. I can’t predict what those are going to be, but when you have an interest rate curve in the marketplace, you at least have decisions to make. Frankly, over the last four years, the market has been rather mundane, but over the last quarter at least, a much more robust market looks to be underway. The US market from a lending perspective had a very good fourth quarter, and I see this trend being a good one for clients and for those people who are participating in lending in 2015. I believe that regulation actually creates opportunity; you have to work at it a little bit harder, but that is what agent lenders are here for, and that is what the borrowers are there for. They have created opportunity, whether it is for their hedge fund clients or for their agent lending clients. Don’t forget, securities lending is critical to the overall market, particularly from a liquidity perspective, and that won’t change, whatever macro trends are in play. It will improve in some quarters and deteriorate other quarters, but generally it appears we are on a good upward trend.

DAVID GURTZ: What’s good for the securities lending industry is not necessarily so great from an asset owner’s perspective. As you mentioned Chris, high volatility, potentially rising interest rates, are in play and frankly, it’s a challenging time to be an investor right now. It is particularly challenging from an asset allocation perspective. Even so, I have to stand with everyone around the table and acknowledge that these are good reasons to be back in securities lending. The rest of the portfolio might be challenged, but additional revenues from our securities lending programme will help, for sure.

CHARLES RIZZO: When you talk about decisions around changes in regulation firms may wish to contemplate how a floating NAV collateral pool fund may align with a particular lending philosophy. The most recent amendments to the money market rules issued last year require floating rate funds for institutional money market funds. During the last five to six years we have had a floating rate NAV fund structure in our cash collateral pool. We thought that was very innovative at the time. We felt that a floating NAV fund is a good structure for a cash collateral vehicle because portfolio managers are used to a floating NAV for their funds they manage and when they make investment decisions they always have to think about risk and return, just like buying a stock or a bond and a security loan is no different. We didn’t feel that in a stable rate cash collateral fund structure it made a lot of sense for us as the advisor, primarily because all the benefits of the lending programme were designed purposely to move to our funds. We wanted our shareholders to benefit. We weren’t in it to make an advisory fee on the assets. For these and a host of other reasons, we went to a floating rate structure. Therefore now the opportunity is for many in the industry that manage their assets through existing stable value cash collateral vehicles to at least consider the benefits of moving to a floating NAV structure and for their cash re-invest program.

ROBERT ZEKRAUS: We have benefited from a five year trend in upward market appreciation but as Craig mentioned earlier, volatility does create other opportunities within our respective businesses and the markets have experienced more of that recently. Therefore investor sentiments where there were not as many shorts, and investment decisions were very much one-sided and directional, could now potentially change. Last year saw an abundance of M&A activity in the marketplace, the highest levels since 2007, with a lot of cross border activity in which people were able to trade around and transact. Companies flush with cash on their balance sheet may continue to make investments and/or distribution decisions back to shareholders. Couple that with a changing macro environment and the US Federal Reserve Bank’s decision on interest rates and there could be momentum going forward, and opportunity for the securities lending business to be more successful. However, I would add a note of caution: firms will have to pick and choose where they intend to be involved, potentially developing more of a specialist mindset while working very closely with clients across the investment management spectrum.

CHRIS VALENTINO: Just to back up what Craig was saying with some statistics, spreads in the U.S. equity market in Q4 were quite strong and demonstrated a healthy upward trend. In fact, if you look at the whole year, spreads on average were up approximately 30% from January through December. As Robert noted, in 2014 M&A activity was a catalyst for several securities lending opportunities. In 2015, potentially rising interest rates are at the forefront of many discussions we are having with clients. Volatility has injected itself back into the market, and we have already seen evidence of that within the energy sector. With the fall in the price of oil, you see a lot of opportunities in that particular sector starting off the year.

SUSAN PETERS: It certainly is a demanding environment that requires active management. It is also an environment that produces very interesting anomalies, as we saw with Tesla over the past year and a half. The prevailing theme that we have been discussing so far is that the beneficial owner and, indeed, whoever they partner with on either securities lending or other types of value-added products really has to be an active manager. When I first began in the securities lending business, securities lending revenue was viewed simply as a method for offsetting custody fees and little attention, if any, was paid to the process. That is now very much in the past. Now we see asset managers in large programmes making daily decisions on whether to allocate assets to a securities lending strategy or, indeed, to some other type of value capture strategy that captures additional revenue, such as corporate action optimization strategies. One could argue that this is now a beneficial owner’s fiduciary obligation, to find where the best value at the lowest possible risk and play a very active role in how they manage that opportunity.

CRAIG STARBLE: That is a great point. We are seeing a lot more interest from the beneficial owner to make sure that the portfolio managers, whether external or internal, are actively involved in the securities lending process. Years ago that was not the case. It was largely kept within the beneficial owner community and they did not give securities lending agents access to the underlying portfolio or the portfolio manager (PM). Therefore to Charles’ point earlier, he needs better information so he can communicate with his investment managers and his PMs about opportunities. It is a trend we are seeing among many of our clients and market players and we think it is a very good thing. It attempts to leave less money on the table for pure securities lending activity or alternatives, such as the services Susan’s firm is offering. To do this effectively however, you must have an active engagement with the portfolio managers, who are in charge of the portfolio. We have noted a genuine interest amongst beneficial owners to get us, and other folks like us, in front of their portfolio managers.

DAVID GURTZ: That is definitely how we approach securities lending at PRIM. This is a terrible analogy but I like to use it. We think of the beta of the market as the cake, the alpha by our managers as the icing and securities lending really should be the sprinkles on top of it. The sprinkles are additive, no doubt, but we do not want it to taint the icing on the cake. We do not want it to taint our managers’ alpha. Therefore, establishing effective lines of communication between our managers and our securities lending agent is the best way we ensure that securities lending, while additive, doesn’t negatively impact our managers, which are the primary source of alpha.

CCPS: DO THEY ADD VALUE TO THE SECURITIES LENDING MARKET?

CRAIG STARBLE: Well, first of all, we are very positive and encouraging of the CCP model and the future of CCPs as far as being an intermediary. I am a big believer that it is a route to market, just like a lot of other types of transactions or appropriate routes to market. Eurex has done a good job in pushing the CCP agenda forward in Europe and they are far closer to doing pure securities lending, stock loan with client assets, than we are here in the States. It is evolving here and hopefully, one day we will get there, but we are some way behind Europe in this discussion. A couple things we should note: as agent lenders, we cannot advocate a CCP model to our clients unless we fully understand the impact of it. We know, for better or worse, the effects of a default in a traditional bilateral securities lending trade. We understand how to manage through it, based on the Lehman crisis. We understand how to manage our clients’ business and we know how to indemnify that risk. We understand all that. As for CCPs, how does it work if there is a default? And what are the processes involved? As I said, Eurex has done a great job of explaining these elements. Therefore, we now better understand the waterfall and the impact of potential defaults and we can then communicate that to our client. That is the first issue. CCPS are also great from a capital perspective as they provide huge capital relief for the borrower. Therefore as an opportunity, I am in favour of it. I also believe, however, that it should be financially beneficial to our client. I am hopeful that in the US, the OCC will have a model that works for clients over time, and I do think it is an appropriate route to market, but it will not involve all of the securities lending business. Instead it will involve a portion of the business, just like discretionary lending and exclusive lending, and all the other things that we do today in the marketplace. Regulation is helping CCPs; it is mandating their use. Borrowers should want to borrow through the CCP and agent lenders should benefit from it and clients should therefore benefit from it as well over time.

CHRIS VALENTINO: CCPs are certainly a topic that comes up often. We are conducting all of the necessary due diligence. After all, we are a partner with the industry, so when the industry feels that the timing is right, we will move in tandem with it.

FRANCESCA CARNEVALE: Charles, have providers spent time explaining effectively what, if any, benefits CCPs can bring to the securities lending market?

CHARLES RIZZO: Sure. We have had ongoing discussions. I can tell you today there aren’t any allocations of our loans going through a CCP. There are still areas that beneficial owners have some concerns about. I’m not sure that the counterparty risk has been entirely eliminated compared to the bilateral trade that we do today and we still have to interface with a clearing house broker. On the positive side, it is clear that you do get transparency, so I guess if you were to allocate, a portion of your loans on a clearing house type platform, you would be comfortable that you have a market price. Therefore, there is a good discovery mechanism when you trade through the market between a willing borrower and buyer and that is a positive. However, I also think that one of the benefits of an agency type relationship is the strong relationship that exists with their borrowers and that could be very beneficial to a beneficial owner during times of market stress particularly if there are instances of margin calls, where agent lenders can work with the portfolio manager to help manage the performance risk of having to sell securities in a bad market. Clearly then, that opportunity exists and the duration of loans can be perhaps managed more effectively in a bilateral type trade. There are definite benefits to the clearing house type model. However, it hasn’t really caught hold yet. We will just have to keep monitoring it but right now we do not really feel that there is a tremendous advantage of moving off our existing model.

ROBERT ZEKRAUS: For the right book of business it may make sense to progress and move forward using a CCP such as the OCC for a portion of your balances to mitigate counterparty exposures, potentially minimise haircuts, help with the capital structure regime of your bank and potentially reduce margin posted. To date I know a few tier one firms on the broker dealer side, prime brokers, who are actively engaged but at the same time others of similar size are not engaged or not pushing the envelope forward on that. Overall, from an OCC perspective, since the early 1990s the stock loan/hedge programme has expanded in terms of volumes and increases in operational efficiency. As a result the CCP continues to attract more participants for a variety of reasons.

FRANCESCA CARNEVALE: David, for PRIM is an initiative such as the establishment of a central counterparty as an intermediary between yourself and the other side of the trade, is that important to you? Is the saftey element important to you?

DAVID GURTZ: Not really. We rely on our advisor lending agent to keep us abreast of these market changes. To Charles’ point earlier, counterparty risk still exists, whether it is a bank or another entity, and there still needs to be a process in place to monitor your counterparty risk and understand who the counterparty is and the risks that they have and what measures are in place to mitigate those risks. We are agnostic at this point as we have a very plain vanilla programme, so we are probably not at the forefront of this issue. We are just monitoring at this point without considering any actions or any opinions on it.

SUSAN PETERS: What interests me about central counterparties is that they are founded on the notion that risk is better managed from within a counterparty backed by a larger group. Not all risk is predictable; risks that are well understood and managed may not be the risks that ultimately cause losses. It is the risk that was overlooked or not well understood or comes from a confluence of unlikely events. I would caution overreliance upon central counterparties as a substitute for active management and it sounds like the mood in this room is that people are not doing that. My fear is that CCPs will bring about a form of complacency.

CRAIG STARBLE: The issue with the CCPs, though, is that every other market has gone towards a CCP model or has been mandated to do so. I do not disagree with what you are saying; I like being able to manage it and touch it and I have been challenged by trying to understand the CCP model, but the reality is every other financial instrument has been mandated to clear through it. Therefore, we probably are going to have some role in that going forward. I do not think it is going to be mandated or legislated, but I do think that there is going to be an effort to move us there. At the very least, as an industry, we need to understand it better because right now, many of us do not understand the model. We have to get comfortable with the nuts and bolts of exactly how the waterfall works, how you get paid, how the operational structure works in a default and we must get down to the real details. We understand how a bilateral default works now because we have all experienced it in the industry before, but we do not clearly understand how it works as it relates to securities lending in a CCP. All the CCPs were greatly impacted by MF Global and others. Therefore they know how it works, we just have to apply it appropriately to what we do, and it is, I believe, incumbent on the CCPs to educate us on what it means to clear and transact through the CCP. It will certainly be an interesting path.

CREATING VALUE IN A COMPLEX MARKET: DOES SEC LENDING HELP?

ROBERT ZEKRAUS: Over the short term, when you look at the impact and the challenges that everyone seems to be faced with, a positive consideration is that people now have to recalibrate and figure out where they can create value for their client base and for their book of business in order to differentiate themselves. Therefore an area of continuous growth opportunity is around collateral expansion. That being said, there are market initiatives and discussions ongoing in the US around the use and expansion of equities as an acceptable form of collateral in relation to rule 15c3-3. The growth of collateral expansion, in particular out of the US, is quite important for the marketplace. In Europe, it is more the norm and an established practice which has been documented and evidenced throughout the financial crisis and the post crisis period. In other markets/other jurisdictions traders have continued to use non-cash collateral in a trades to meet margin requirements, funding needs and newer regulatory demands. In the US we still have an opportunity to develop this aspect. The redistribution of balances based on the impact of balance sheet constraints and, standardisation of capital calculations could be helpful for smaller firms to win market share. Then there is the furthering of the relationship between the broker-dealer and the agent lender where changes in the market can create unique opportunities in financing as a consequence to the shift in prime brokerage balances and regulatory shifts. It could be anything from white labelling to funding structures to exclusives. Therefore we really think the theme is around collateral expansion, the redistribution of balances, and the partnership with clients and counterparts around market initiatives.

DAVID GURTZ: We have a very plain vanilla programme, so in the immediate future I see us continuing to grow the programme only ever so slightly. We focus 100% on specials. We do not have any general collateral lending at this point in time, and I do not see that changing in the foreseeable future. We do have a large hedge fund portfolio, so we do have players on the other side of the table, and speak with them about their views. If volatility increases over the coming months/quarters, I expect an uptick in the borrowing of securities by hedge funds in general. I do think it is a good time to be in securities lending. In regards to our reinvestment of collateral, while we have heard and talked a little bit about doing equity for equity, we are going to focus on low-risk securities and continue down that path. Because we have a very vanilla programme, our risk appetite is very low. Therefore we are going to stick with very traditional reinvestment of collateral but I do think the overall environment for sec lending should improve over the next coming quarters.

CHARLES RIZZO: In a mutual fund context, we have a fiduciary responsibility to optimise value generation but also to balance risk and that, first and foremost, when we look at any opportunity and was one of the reasons that we are only lending specials today, because that equation got out of balance. We felt that there was more risk than there was opportunity, given the low spreads we were seeing on the GC side. Having said that, as part of that process to adjust our investment management strategy, we also increased our minimum basis points requirement. Therefore we will always earn a spread relative to Fed funds that is sufficient based on our funds’ risk. I could see a decision to lend general collateral again in the future if reinvestment returns increased. With regard to specials, we have a mandate that all specials in the markets that we have approved should be lent out. We have worked in certain markets between our investment managers and our agent lenders to provide pre-notification as early as possible in any securities sales so that we do not run the risk of causing fails in a no fail type market There is a lending opportunity in emerging markets but clearly there is a lot of risk too if you do not have that process built and controlled right. Therefore we may take a look at other markets and make decisions whether or not those markets are fit for purpose in terms of loaning securities. Therefore we’ll keep our eye on that. We’ll continue doing what we have been doing on taking advantage of earnings on foreign dividends. That has been a great value generator for our international funds. The other thing that we keep an eye on, quite frankly, too is there is a tax component when you lend, particularly when dividends are being paid. Those in lieu of payments aren’t qualified dividend income from a distribution standpoint under US tax law. For those funds that have, let’s say, more tax-efficient strategies, you have to pay attention to that, otherwise, the shareholders who are getting distributions will end up paying more taxes and so while there are opportunities, certainly, in the international markets, the tax impacts need to be considered. Sometimes it may make sense not to lend a stock in a particular market and take that stock dividend and file a reclaim on withheld taxes with that country, or sometimes it may make sense to take the income from the in-lieu of payment and not have to wait to get paid on the foreign reclaim which can take years in some cases. Therefore there are many dynamics in play.

SUSAN PETERS: Early on in this discussion we talked about how beneficial owners are being more careful about managing the sources of their revenue, and that level of coordination is exciting because asset managers are making active decisions about lending their securities or not or whether another route to market may make more sense.

THE INTERPLAY OF COLLATERAL AND SECURITIES LENDING

CHARLES RIZZO: In a mutual fund there are many instances where collateral comes into play. For example, repurchase agreements are commonly used for overnight investments and collateral is received by the counterparty, similarly on a reverse re-purchase agreement collateral is given to counterparty in order to offset the lending risks that the counterparty has. Derivatives that trade through a clearing house or that are bi-lateral require collateral as well. As we have noted earlier, collateral is a central feature of security lending constructs. Therefore you have all these collateral dynamics at play and many of them could be at play within the same fund strategy. I see opportunity, quite frankly, for a system that provides functionality and transparency to be able to more effectively manage all these different types of collateral so that optimal collateral strategies assets of the fund and collateral decisions can benefit the fund and possibly improve earnings. However, I haven’t been presented with that type of system yet and because of that, I would say collateral optimisation processes and systems remain manually intensive. It requires automation and it needs a system and a process but if we had some type of front end that allows us to see the different types of assets in play, we could make better decisions on collateralising the right type of asset, offsetting the right type of exposure that our funds have, optimising the assets in the fund with the objective of trying to maximize the earnings potential. I think it is a tremendous opportunity, given all the changes in regulation that have happened over the past few years and somebody will seize on that and it will be a pretty neat product.

CRAIG STARBLE: It is very challenging to come up with a collateral and liquidity management system and roll it out to the industry because everybody, including Charles, has different custody agents/custody banks, and he has different profiles. We might think that another asset manager looks a little bit like him, but in reality we find that he is very different. Therefore, this theme is really about clients and beneficial owners looking for more of a customised approach and when you look to build technology, beneficial owners do not want to pay millions of dollars for the very something they are looking for. You want to be given something that works for you, that is provided to you and the agent lender can create transactions as a result of that collateral transformation. That is really the optimised thing to do and, you are right, it has not happened yet. We think about it a lot and we think about how to create it and it is something that needs to be done from an industry perspective.

CHARLES RIZZO: You are also going to need regulatory support because in Europe we know that we can use securities lending as a means to get funding into funds to collateralise derivatives to support liquidity needs on margin requirements. I think securities lending could be a structure to leverage for those managers that have derivatives, have to clear and need collateral to post to counterparties. The cost of financing for cash collateral may be less expensive than the opportunity costs of holding cash and/or short term investments. I think that lending can present an opportunity in the right situations to facilitate the liquidity needs of funds.

SUSAN PETERS: I’m sure Robert is smiling because he’s probably saying: welcome to my world. This has been the broker dealer challenge for years. I find it inspiring that asset managers are looking at value added methods from a similar perspective.

ROBERT ZEKRAUS: I agree, although it is a significant challenge in most banks and in most organisations. When you start looking across asset classes, it really gets down to the data, the quality of that data and where the data is warehoused. It is also about the clearing mechanics, the sophistication of your architecture and technology platform, that an overarching theme of a central collateral management business utility function within an organisation, that is not new by any means; it is been around for a long time and how people perform and how they execute that strategy in that plan, it has a lot of investment. It is not cheap, it is very costly but it is a very important part of the business. As Craig mentions, we need to solve this as an industry. It can either come out of an existing platform that someone’s already built or we start from scratch. As Charles says, there is a real opportunity out there.

CRAIG STARBLE: What has not been addressed is the internal transfer pricing that goes along with all this. There has to be a mechanism to transact appropriately between legal entities, at the right price. The right way to do that is with a third party player, right? It’s- such an obvious requirement that it seems impossible to believe that a third party has not been more actively involved; but there it is, it is clearly very challenging. For a public pension plan with one legal entity, the equation may be a lot easier than an investor with say Charles’ 200 funds. That may be a little bit more challenging right? However, that does not mean it should not be worked on and developed.

CHARLES RIZZO: There is an opportunity for a systems solution that can address some of these issues. It think it would be very well received in the industry.

CHRIS VALENTINO: The conversations that EquiLend has with its clients are somewhat of a leading indicator for the direction of the market and the opportunities that may exist. These opportunities include increased automation around equity for equity trading and fixed income trading via our BondLend product. An opportunity exists in synthetics and swaps where there is very little automation and standardization. New markets are also of interest. Australia, for example, is a new market for EquiLend. Brazil presents opportunities as well. Repo data and additional transparency in the fixed income space is yet another opportunity.

CRAIG STARBLE: Over the long term, access to collateral is going to have the biggest impact on securities lending. With that in mind, do we migrate toward a model that is focused only on specials lending, because specials lending will always be lucrative. How do we better source and use appropriate collateral? The reality is that regulators are mandating the takers of cash to take cash longer term, while the providers of cash want to invest that cash short term, which in turn creates a disconnect and a challenging environment. Some clients will respond with more aggressive reinvestment strategies, others will opt to remain with their current strategy. For our part, eSecLending will move toward being more of a utility in the marketplace. We want to be an advocate and provide solutions to our beneficial owner clients and also to the CCPs. CCPs require default management solutions, they need liquidity financing, and they need opportunities, just like beneficial owners need them, just like the borrowers need. Yes, we may use them as a conduit to do stock loan but they also have other needs in the marketplace as well. Therefore I see the market moving more towards providing the beneficial owners with more dashboards. We are going to have to give those who want to transact on their own the ability to transact on their own. For instance, we will have to give portfolio managers the opportunity to lend their own stock if they choose to do that transaction, or let them be a middle office, if they want to do that. The more tools we give clients, the more they are going to use them — but we have to do it in an appropriate risk-managed way, and everyone is going to have to be different. As is the case today, we will continue to see customisation in this business because everyone has a different philosophy, everyone has a different risk profile and you cannot run a securities lending programme as a programme anymore, you have to run it as a series of client accommodations. Clearly, the movement towards communicating with portfolio managers and asset managers directly is a huge change in the industry. It gives firms such as Susan’s the opportunity to talk directly to the decision-makers; it gives eSecLending the opportunity to make sure operational considerations, such as the timing of sell notification, are handled properly. If you do that, you can make more money in the emerging market space; but you cannot do that unless you have a risk profile in place that is going to allow that to be done in an appropriate way. Therefore, more transparency and communication will lead to a lot of interesting opportunities for beneficial owners and the industry as a whole.

EVOLUTION AND INNOVATION: WHERE WILL YOU FIND IT?

SUSAN PETERS: Securities lenders should look to the future and expand beyond the mundane and partner with providers of value-added products that enhance revenue. If I were to look at it from the perspective of the beneficial owner, providers should look at securities lending in terms of not just simply providing one product that is intended to accommodate all routes to market but to acknowledge, enhance and facilitate routes to market that may even involve a decision to seek another route to market. The real winner among the lending agents will be the ones that provide the platform where this type of decision-making can take place.

ROBERT ZEKRAUS: We think the industry is very healthy and will continue to go through changes. We think an education process that explains those changes and what they mean for the various participants is vital. In terms of our own business, we will continue to look for partnerships (where it makes sense) either through technology solutions, through banks and broker dealer solutions or through our own proprietary solutions to make this business grow and maintain sustainability while managing the inherent risks. Securities finance plays an important and vital role in the marketplace. Market evolution is also pretty interesting right now. There looks to be a little continuum that is encouraging convergence between investment strategies, where long-only index managers will eventually look more like a hedge fund and a hedge fund will look more like a long-only manager and that will continue to create more business and opportunities in the securities lending and financing space, both for prime brokers and agent lenders.

CHRIS VALENTINO: The business itself is still day-to-day very manual, so in order to free up the resources to analyse these higher-margin type opportunities, there is a lot of manual flow that still needs to become more automated. There are still tons of spreadsheets, Bloombergs [sic] and emails going back and forth between lenders and borrowers. Our Next Generation Trading initiative at EquiLend looks to inject additional automation into this day-to-day flow. Our goal is to move beyond the traditional general collateral trade and create efficiencies in the warm and hot space.

DAVID GURTZ: Asset owners are better positioned than they ever have been. Even so, asset owners’ (and here I’m talking of the large endowments, foundations and middle to large public pension plans) portfolios are exceedingly complex. While these organisations are getting more sophisticated in an effort to keep up with the investment market space, quite honestly, to keep on doing that you need the right tools, advisors, systems and products to keep alongside the curve. At the end of the day, what are we trying to do? We are trying to maximise returns while minimizing risks and as you become more complex, you need better tools in order to achieve this. With that in mind, I believe securities lending will continue to evolve and become more complex, but I also believe the systems and tools will become that much better. Even so, going back to my original and horrible analogy, it is still the sprinkles on top of the cake. We do not want to harm the larger cake, or the icing because of securities lending. We realise that, like everything else, things will become more complex and the better systems and tools that we need will be required in order for us to continue with securities lending. If it does begin to harm the other work we do, we will again step away from the securities lending programme, as we have in the past. Being optimistic, for sure, as a business segment, over the long term securities lending will evolve and prosper. I hope we’ll have a very successful programme and the sprinkles will be abundant and delicious!

FRANCESCA CARNEVALE: How much will firms like yours Charles drive this move towards greater transparency? How important is to for you to fully understand your counterparty, to manage your collateral exposure more effectively? Or, are you dependent on the willingness of providers to anticipate and meet your requirements?

CHARLES RIZZO: One of the benefits of having a service provider offer collateral optimisation solutions is because of the scale benefits across multiple clients, which then can give beneficial owners like ourselves a commercially viable (or cost-effective) product. Now, we could spend a lot of money internally and try to build that system ourselves, but I’m not sure that that is the best use of shareholder assets, given the scale of our lending programme. Therefore, it is very important to have more automation to provide funds with additional capabilities. Certainly broad based industry solutions offer a more consistent approach and avoids large IT spend and development cost. Given the fast pace of technology and regulation, could mean many internally developed system would be out of date in a very short period of time. Regulatory change is a constant right now. It makes it more challenging to undertake effective forecasting, as it is not clear sometimes which way regulators are going to turn. Then, if you are a global business, regulation is not standardised around the world. So there are already many variables in the system to contend with. We also touched on areas where collateral optimisation solutions can benefit asset managers. Set against these considerations, some level of standardisation is good and would benefit all asset managers and shareholders alike, though it will to take some time

FRANCESCA CARNEVALE: Thank you for a very interesting discussion.