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Opportunities and Challenges for Hedge Funds in the Coming Era of Optimization
paid for long assets at a qualified custodian. Since
the supply already sits with these organizations, many
custodians developed lending programs and bundled
this high-value activity with other services, such as
fund administration, in order to create stickiness for
their client base. Custodial lenders act as the agent
for their clients in terms of arranging trades and
overseeing the operational processes, but they do
not engage in any principal risk. This is particularly
appealing to conservative pension funds that are
often the beneficial owner of these underlying assets.
The European lending market developed along a
different path. Unlike the U.S. that has a single central
securities depository for equities—the Depository
Trust Corporation (DTC) and the Federal Reserve of
New York for government bonds—there are multiple
central securities depositories (CSDs) in Europe that
handle the immobilization and dematerialization
of securities settlement. There are also two major
international central securities depositories (ICSDs)
that operate on a tri-party basis. With supplies moving
constantly across this complex landscape, there are
increased operational risks in ensuring a securities
loan program. As a result, more organizations have
chosen to pursue a principal lending model where
they take the risk of their securities loan onto their
own organization’s books so that they can more
readily understand and manage that risk.
Having this principal obligation gives lenders in
Europe more flexibility to accept different forms
of collateral. In Europe, where there was not the
same money market fund structure to support cash
reinvestment as there is in the U.S., this resulted in
many lenders preferring to take in non-cash collateral.
Indeed, many European lenders see cash as a difficult
type of collateral because of the need to reverse repo
that supply and turn it into usable securities and the
balance sheet impact of that reverse repo transaction.
Lenders interviewed in this year’s survey estimate
that about 80% of the lending being done in the U.S.
market is happening via an agency model whereas
only about 40% of the European business is being
conducted as agent.
Asset Owners Exert More Control and
Demand More Oversight
One of the most frequently heard descriptions of the
evolution of securities lending programs in the post-
GFC period is that the function has “moved from
being a back office to a front office function.” This
sentiment encompasses the increased importance
asset owners place on risk management and on the
seniority and experience of those individuals charged
with administering their program. Indeed, many large
asset owners indicated that their firm’s risk committee
is now responsible for their lending program and that
they monitor these portfolios side by side with their
trading risks.
“ The U.S. is much more of an agency lending model, partly in
response to them having more pension funds as underlying
asset owners. Europe emerged with a lot more of a principal
model from the get go,” — Agent Lender
“ Cash is less dominant in Europe. It’s hard to get your principal
lender to take cash because they have to reverse repo it, which
is double the balance sheet impact. Europe just hasn’t had the
cash vehicles to reinvest this supply,” — Agent Lender
“ People with non-cash collateral did not experience losses or the
losses were de minimis during the crisis,” — Securities Lending
Consultant
Chart 8: Breakdown of Collateral Postings:
End 2007
Euro Bonds
& Gifts
NAM
Bonds
European
Equities
0
100%
60%
40%
80%
20%
Source: RMA Q4 2007
90%
50%
30%
70%
10%
On Loan VS Cash On Loan VS Non-Cash
71%
29%
14%
86%
63%
37%
5%
95%
NAM
Equities