• Welcome
• Multiple Choices
• More Consolidation – More Competition
• Regulatory Reform
• Central Counterparties
• Lender Sentiment – Three Camps

Welcome

Jervis Smith
Managing Director, Global Head of Client Executive
Global Transaction Services, Citi

To complement last month's Spotlight on short-selling, our March edition examines the extensive change that the securities lending market has undergone, which is nothing short of a metamorphosis, over the past few years. Today, many expect this transformation to continue as our industry adapts to the ever-shifting dynamics of an increasingly complex marketplace.

At the same time, our view at Citi is that our industry is primed for a period of growth, based on the market-altering developments we believe will become increasingly evident during the next year and beyond. This article addresses the recent changes in the securities lending market and how Citi expects the industry to adapt to these changes.

We will analyze the plethora of choices facing future beneficial owners that have arisen due to events that have shaped the market in the past half a decade. We will also examine the future market trends that we at Citi believe will lead to increased consolidation, and thus competition. We will also look into the wide-ranging regulatory reforms that will be coming into force in the upcoming years as well as the proposed adoption of a central counterparty model. Finally we will outline the future of securities lending following on from the turbulence in the market post-Lehman’s collapse.

Multiple Choices

Rajen Shah
Managing Director, Global Head of Collateral Management
and EMEA Head of Securities Finance

By far, the biggest change that has occurred in the securities lending industry – and one that will continue to affect the collective future of all market participants – is the growing number of choices beneficial owners now have available to them to participate in securities lending.

Five years ago, the great majority of securities lending was done via the lender’s custodian, the institution that looked after the custody of assets for that particular lender. Now, lenders have many options. They can select their custodian to conduct the lending program or, at their preference, choose one or more third-party agent lenders. At Citi, our approach is flexibility and to provide choice via an open architecture.

More Consolidation – More Competition

Going forward, we foresee that the trend toward industry consolidation will continue. Over the past five years, there has been a considerable amount of contraction among banks, among agent lenders and among direct lenders, which lend their own portfolios.

A number of direct lenders have outsourced the securities lending activities to an agent because why carry the responsibility to continue with the investment needed to run a program or take the risk when it can easily be outsourced? It can be reasonably expected that any direct lender must be reassessing their business model now.

A great deal of investment is needed to run an all encompassing securities lending program and unless direct lenders have critical mass the economies of scale would be difficult to achieve. This means there will be fewer lending providers but the competition between them will be intense.

Under these survival-of-the-fittest conditions, service providers like Citi will need to offer more feature functionality and deliver more and better capabilities to lenders – all at a competitive price.

But price will not be the sole criterion for a service provider to win new lending business or retain current clients. Just as important will be the flexibility a service provider can demonstrate in its approach to lending. More and more, sophisticated lenders will no longer be asking, “How does your lending program work?” Instead, they will want to know, “This is what I want from lending. Can you handle it?” In this environment, service providers will need to exhibit a high level of adaptability to tailor both their service offerings and their delivery to meet a client’s specific requirements.

Regulatory Reform

The extensive array of regulatory reform initiatives that are being circulated around the world – too wide-ranging to treat in detail here – are expected, if implemented, to have a major impact on the securities lending industry.

Basel II and Basel III, for example, aim to change the way banks are regulated from a capital treatment perspective. The new regime will be increasingly driven by the credit ratings of assets, using the rating agency credit assessments of assets and therefore the capital treatment of them. If, as an illustration, the government debt of some OECD countries no longer receives the top credit rating, lenders could be very selective in the government debt they want, and banks that indemnify lenders against borrower defaults may also be careful about the type of government debt used as collateral.

In addition, because providers of securities lending services employ some of the bank’s capital to provide their services, these providers will also have to be compliant with the rigorous rules that are eventually implemented under Basel II and III.

Central Counterparties

After two years of debate on the prospects of adopting the central counterparty (CCP) model in the securities lending market, the overriding question the industry is now pondering is: “How do we integrate a CCP into what we are doing and how do we replicate how we do things now in a CCP?”

The CCP structure offers market participants a number of advantages: trade anonymity when brokers demand it; potential efficiencies in terms of process flow and last but by no means least balance sheet relief. At some point, probably by the end of 2011, the structure – either a single CCP or a multiple CCP market – will be a part of the securities lending business.

The adoption of the CCP model in the securities lending space is not a regulation – yet – but it could be. A regulatory mandate is a possibility because regulators view a CCP as a way to reduce counterparty risk because a lender’s risk is with the CCP and not with any of the borrowers.

Our view is that the securities lending market will not evolve into a pure CCP model, but there will be a certain percentage of business – perhaps as much as 30% – that flows through a CCP.

Lender Sentiment – Three Camps

Today and going forward, securities lenders can be placed into three camps. The first includes those with a long history of lending and who went through the Lehman default without suffering losses. They were able to suspend their lending program at that time, have since reengaged and are now generating revenues.

The second camp also includes longtime lenders. But when Lehman defaulted, they were in a very difficult situation with respect to the reinvestment of their cash collateral. They did not realize the extent of the risk they were bearing. Then suddenly, when they wanted to suspend lending, they were being told that they could not because their cash had been reinvested in a commingled, illiquid fund that was worth considerably less. If they were to pull out of lending, they would have to realize a loss on the fund.

The lenders in this camp are very disgruntled and are trying to exit the securities lending relationship with their agent lender. They realize there is a way to lend without taking that risk, and will reenter the marketplace once they have severed the relationship with their current agent lender.

Finally, camp three consists of a much smaller group. They have not done much, if any, securities lending before, amd are considering launching a program, but are being ultra-cautious given the market conditions over the last two years.

They recognize the benefits of the lending market, but are entering it in a super-conservative way. Of important note, not one of the prospects we have spoken to has told us they will never do lending because they are terrified of the risk. What they said is, “We understand the risk; we would like to lend, but we will do so in a very conservative way.”

Citi has built up a significant track record in the securities lending market, and continues to help lenders adapt to future market trends. We can work with lenders and help them react to not only the wide-ranging regulatory reforms, but also the proposed changes in the central counterparty model, as well as the predicted increased competition in the market. We also connect with future beneficial owners as they seek to better understand this rapidly changing market with the solutions they need to succeed.