Custodians Fight Back Against Securities Lending ‘Disintermediation’

With recent mandates seemingly on the rise for third-party securities lenders, custodians – the traditional bastion of the business – are fighting back.

(May 5, 2011) – Custodians are not going down without a fight in the renewed battle over beneficial owners in the securities lending space.

 

Recently, firms such as Deutsche Bank, eSecLending, and Credit Suisse have been touting success in breaking the age old distribution chain of securities lending – traditionally, beneficial owner to custodian to prime broker to hedge fund and back again. The Frankfurt-based Deutsche has been particularly active as of late: the firm recently secured a five-year mandate from the $25 billion Employees Retirement System of Texas to execute its securities lending program, which builds on similar mandates from the Colorado Public Employees Retirement Association and the Missouri State Employees' Retirement System.

 

They and other third-party lenders claim that this activity is a result of various factors: the financial crisis as it relates to securities lending, service levels, fee transparency. Of course, talk of securities lending and custody decoupling has been occurring since earlier in the last decade: In a report from 2002, New York-based ASTEC Consulting “…analyzed the securities lending programs of 10 large US public pension funds between 2000 and 2002—and found that, in 2002, public funds with at least one non-custodial provider earned 40% more, on average, than funds that used only their custodian for securities lending,” according to sister publication PLANSPONSOR.

 

However, regardless of whether this is a trend or simply anecdotal, what do custodians – the traditional center of the securities lending industry – have to say in their defense?

 

The one thing about the crisis is that it probably helped foster a better understanding of the true value of securities lending,” says Bill Kelly, global head of securities lending client management at BNY Mellon. “Clients came away with absolute clarity about where risks were – from both the borrower side and the cash-collateral side. This doesn’t mean they’re leaving in droves, though, for third-party lenders.”

 

“For years before the financial crisis, the ends of the securities lending distribution chain were under pressure from the middle to switch their business,” says Nicholas Bonn, head of securities lending at State Street. Prime brokers wanted to go directly to beneficial owners to get securities, skipping the custodian; custodians wanted to lend securities directly to hedge funds, skipping the prime broker. “In the crisis, this disintermediary action was suspended as everyone tried to stay alive, but it’s reemerged. Primes are trying to reinvigorate that process.”

 

Mandates such a Deutsche’s speak to this reinvigoration. However, custodians – in public, at least – seem nonplussed. BNY Mellon’s Kelly, for one, sees the financial crisis not as a weak point for custodians, but as an opportunity to see who is truly committed to the securities lending business. “I think there are aspects of third-party lenders thinking custodians are weak – which I disagree with – but I also think what has changed post-2008, in this regulatory landscape, is that you’ll see who is committed. A lot of prime brokers are now bank holding companies, and that puts a different view on the cost of capital, and the cost of doing these types of things. Where securities lending is a core business, you’ll see that commitment – but I think you’ll see a lot of people question whether they can be in this space.”

 

Of course, talk is cheap – for both sides of the debate. In the final calculation, the true winners will be determined by only one thing: the pitter-patter of institutional feet.



To contact the <em>aiCIO</em> editor of this story: Kristopher McDaniel at <a href='mailto:kmcdaniel@assetinternational.com'>kmcdaniel@assetinternational.com</a>

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