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Opportunities and Challenges for Hedge Funds in the Coming Era of Optimization
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of indemnification, this type of treatment will not be
possible in the coming years and a more deliberate
policy will be required.
The first option articulated by several survey
participants related to agent lenders assigning a value
to the cost of indemnification and for them expanding
their fees by this amount to cover the balance sheet
impact. This solution would allow agent lenders to
continue offering indemnification within the new
regulatory environment in a manner that also allows
them to maintain their program margins. Asset
owners’ response to this option was uncertain. While
many allowed that they may need to explicitly pay to
retain this service, they were unable to say whether
this would be an acceptable solution until they saw
the actual size of the charge.
Because of their desire to maintain large lendable
pools, another solution discussed by the agent lenders
interviewed for the survey related to them offering a
tiered service. In this model, the agent lender would
absorb the cost of indemnification for large clients
and cover the higher capital charge out of their
existing margin. This is an expensive proposition,
however, and any small asset owners wanting to stay
on the platform would have to pay a higher fee that
would cover the costs of indemnifying their portfolio.
There were several indications that these discussions
have either already begun with smaller clients or that
smaller clients are actually being asked to leave the
platform to avoid having to explicitly charge them for
indemnification.
A final proposal that surfaced during the interviews
was to offer the client the choice on whether or not to
have indemnification. Those clients that required the
added protection would pay a higher fee to be part
of the lending platform, whereas those clients that
wished to forego indemnification would be able to
maintain existing fees. Some lenders experimenting
with this approach have seen asset owners choose to
forego indemnification to keep costs down. In these
instances, the client’s comfort with the risk controls
they have laid out for their lending program and their
confidence in the agent lender’s collateralization
approach and transparency have allowed them to get
comfortable going without indemnification.
Experimentation with each of these models is likely
in the coming years and no one approach is likely
to be uniformly adopted. New options may also
Source: Citi Business Advisory Services
Chart 26: Options for Indemnification Under Emerging Basel III Regulations
Repo
Current
State
Charge
Explicitly
Align to Client Strategy
Cover Cost
For Larger Clients
Charge
Smaller Clients
Give Client Choice
Pay for
Indemnity
Go Without
Indemnity
Explicit
Cost
Implicit
Cost
Stock Lending Fee Split
Balance Sheet
Cost of Indemnification
“ If banks charge for indemnification it will force clients to evaluate
their programs. Some lenders will ultimately decide they are not
willing to lend especially if their portfolio mainly consists of GC.
Those clients with attractive portfolios may be willing to pay
for it,” — Agent Lender
“ Indemnification needs to be priced into the lending activity
and if clients want it they need to understand the price. This
is becoming the dialogue among the lending community,”
— Agent Lender
“ We would probably move out of lending without indemnification.
This is part of our bundled service, although we used to
parcel it out. The industry may go back to this model. We
would be willing to potentially pay for indemnification,
but if it is too expensive, we will pull out of lending,”
— Asset Owner—Money Manager