Securities Lending and Borrowing: International Trends and Influencing Factors

Arguably the hottest topic at the International Securities Lending Conference held in Monaco this year was active extension strategies and their effect on securities lending and the industry’s operational landscape.

One of the major sources of portfolio management inefficiency is the long-only constraint. Restricting the investment managers’ ability to only express views on possible underperformers diminishes the potential for return. Active extension strategies redress this inefficiency by incorporating both long and short positions into portfolios in order to increase the opportunity set for potential returns.

Originally developed in the US hedge fund community, extension products are a means for institutional investors to take a more aggressive view on underweight investments. As an alternative to investing money in an index and leaving out stocks expected to underperform, 100% is invested in the index and a portion (say 30%) is sold short in stock anticipated to do worse than the market. The proceeds from the short sales are then used to go long on stocks expected to outperform.

Internationally, the demand for extension strategies from Pension, Retail and Hedge Funds has doubled over the last nine months, resulting in consequential growth in the international securities lending market, and a convergence of investment strategies and the offerings of custodian and prime broker businesses.

Hedge funds want to diversify their revenues by winning institutional business whilst asset managers want to offer absolute return alternatives. As the investment landscape changes, so the competition between custodians and prime brokers to service these new customers heats up. The new money is largely from investment managers looking to take more aggressive strategies. They are the custodians' existing clients; but prime brokers are seen as the natural home for covering shorts. Custodians need to connect different parts of their business if they want to offer services for these new strategies; prime brokers need to introduce systems to deal with the whole spectrum of custody. Institutional business is starting to compete head on with hedge funds to secure the cheapest and best securities lending coverage and may gain ground since many lenders might be more comfortable lending to a regulated extension structure rather than to an unregulated, secretive hedge fund.

Brokers are seeing a lot of interest among hedge fund clients looking to provide extension products. But perhaps the biggest playing field is among the asset managers, and the battle between brokers and custodians to service them. International custodians have been enhancing their business models to cater for extension strategy business by ensuring a convergence of or integration between custody, lending, collateral management and trading systems. Dealing with existing clients is a big advantage for the custodians. Many suggest that long-only institutions would probably prefer to keep their assets with their custodian.

Moving to a prime broker requires a whole new assessment of counterparty risk, a sizing up the competition in that market, and the need to satisfy investor questions on service levels and confidentiality of information. Any investor working with a prime broker for the first time is going to have concerns over Chinese walls and to what extent their trading strategies will be kept away from the broker’s trading operations and the rest of the investment bank.

For the custodian, a lending client just becomes a borrowing client, but for many beneficial owners the way this is handled and the costs involved are important. For example, if they are already a lending client, can the custodian look to the beneficial owner's pool of securities first for borrowing, rather than the general queue? Additionally beneficial owners want to know how much demand will be satisfied that way, how much will be in the wider lending pool, and how much the custodian will have to source specifically from other sources.

f the barriers to entry are high for brokers, why are they bothered then? The answer lies in the potentially massive volumes. Prime brokerage houses are piling into this space because there will be such a large amount of demand. Also, it's a way to increase assets under management that can be used elsewhere in the business. Brokers are fairly confident they will win the business to cover shorts under 130/30-type strategies. And possibly even the custody business. For them, it makes perfect sense that asset managers go to those with the greatest specialty in this area, the broker.

Custodians, on the other hand, are fairly adamant that anything relating to custody will just take too long for the brokers to introduce. For example the ability to handle corporate actions. They also have the resources to transfer to new products, they have all the service areas covered and they have the largest lending spread to service new alpha-hunting strategies. They can move faster, despite the size of their operations, and have prospective clients in custody already, as well as the necessary supply of securities. Boutique lenders may well find it hard to develop this product because of the need for breadth of supply and operational integration.