Global Investor/isf: There are a vast number of regulatory developments for the financial sector now - which is the most important for the securities lending industry?

Chris Kunkle: They are all important. The reason we decided to have a regulatory front-end to the conference is because there’s so much occurring in the US, Europe, and Asia at the moment. We’re looking at how regulations could negatively affect the securities lending industry, what could be misunderstood or misinterpreted, and how securities lending relates to various other industries such as the short selling and the prime brokerage industries.

With respect to the Dodd-Frank regulation, we have worked hard with the Securities and Exchange Commission (SEC), as has the Securities Industry and Financial Markets Association (SIFMA) and others, to help them understand securities lending so we don’t get an uninformed policy affecting the business. That has been very important.

Another concern is the Federal Deposit Insurance Corporation’s (FDIC) Orderly Liquidation Authority (OLA). If there is a default of systemically important financial institutions there are certain requirements for the liquidation of collateral. Securities lending may fall into this and OLA’s stay provision means a court, or creditor, could hold up the ability to liquidate collateral. The collateral could drop in value so you don’t want it held for a day or five days. That’s a fairly significant issue.

Is there a possibility that these developments will coalesce into a global regulatory standard?

Basel III is a generally accepted financial standard in the banking arena. And theInternational Organisation of Securities Commissions in Spain has representatives from various exchanges and regulators that participate on its board as part of a global regulatory process.

Global regulatory standards are not there yet, but various regulators do look at what is going on with other regulators. The Fed watches what goes on in London, London watches what goes on in the Fed, and Asian regulators look to see what the SEC is considering in terms of securities finance regulation. But I don’t know if they are perfectly correlating.  The Financial Stability Board is also an organisation that is also going to affect global coordination from a regulatory standpoint.

Are central clearing counterparties (CCPs) a positive development? Can they mitigate counterparty risk in securities lending?

We are all still learning about CCPS. You see a lot of a discussion about them, but are they driving away the bilateral securities lending arrangement? And will they fully replace that? I don’t think so.

It’s not that I don’t want them to succeed but I don’t think they have proven they mitigate risk yet. Some lenders have a relationship where they have to go to a participant that can clear on the central clearing counterparty and hence you are actually still doing a bilateral arrangement with the people that then trade into the underlying CCP. I think a lot of learning still needs to be done.

Also, the idea that both the borrower and lender provide margin to the CCP, in the form of additional collateral, does not make sense to the beneficial owner and will be a hard sell.

So beneficial owners are not too happy about it then?

They won’t do it if they have to provide an additional margin and their by-laws may not even permit that. They don’t have to do it in a bilateral arrangement right now. Go tell a large mutual fund or pension fund: ‘you are going to have to provide additional 102% collateral into the CCP’. It’s not going to go down well.

Also, prove to me in a massive default, or even a slight default, that a CCP is better at liquidating. A CCP doesn’t have capital so who are you going to go to? All of your participants?I am neither for CCPs nor against them. They had just better prove where they are going to mitigate risk and protect clients.

Is securities lending risky?

If you lend securities and take cash collateral, the cash collateral has to be invested. In the 2008 liquidity crisis problems occurred. You have several lawsuits going on right now because clients lost money. Many invested according to proper guidelines but if they had a portion of broker paper, such as Lehman or structured investment vehicles (SIVs) they took a hit. 

Remember that SIVs were in the portfolios of a majority of US money market funds under 2(a)-7 guidelines and they were acceptable investments in those vehicles. This was not a securities lending investment pushing some outer realm of quality.

Did people understand the risks at that time?

I came from a client relationship management background and I feel my clients and other agents’ clients were firmly aware of what they were doing. I know at several firms I have been at, we went out of our way to make people understand where their money was being reinvested.

How do you compare what happened in 2008 with the collateral reinvestment problems that happened in 1994 with the collar and cap mortgages?

I think it was drastically different. In the early 1990s there were sometimes not comprehensive investment guidelines in place and investments may have exceeded product guidelines. In 2007, these investments were clearly mandated in investment agreements and clients were aware that these investments were being made. 

In 1994 the securities lending industry learned a lesson. It got improved investment guidelines and, worked with clients to understand them. In 2007 to 2008 the liquidity crisis exacerbated the ability to liquidate investments, whereas in 1994 those investments that had issued guidelines were most likely too aggressive.

Is the prolonged low interest rate environment a problem for the securities lending sector?

It hurts US government lending. It hurts long bond government investing. With interest rates so flat it makes it hard to help clients make a profit in their government investments. However, it is more value-based, intrinsic lending than volume- based lending now. Back in the day many used to lend a lot of assets. Now you are lending assets that are intrinsically beneficial and I think that can be a good thing.

The world has woken up a little on the equity books. Equity lending is more driven because people are lending equities to cover for strategies or to cover shorts, not just to generate additional investment, and revenue, from collateral yield.

So equities are more appealing than fixed income from a collateral reinvestment perspective?

Well corporate bond lending has continued to do well but low interest rates do make equities more attractive from an intrinsic revenue standpoint. At the moment when you put out equity there is high demand for a specific trade going on. It is more lucrative for the client and you can help the client make more on their portfolio.

The scary part here is now you have a volatile equity economy and you have an interest rate that is very low, so the conundrum for any investor is where do you put your money? That’s why companies are hoarding so much cash.

Has market volatility changed the US use of cash in securities lending?

I don’t think it’s changed our use of cash. I think there is an extra eye on the safety of reinvestment but yields are so flat that you really have to find value in the demand of that security as opposed to the reinvestment.

Overnight repo is a safe investment for the most part but that has a low yield too. So you have to make sure you get your security priced well.  If you are not getting much on the loan, you are not getting much in the reinvestments, and it is sometimes not worth the risks of putting on the loan.

What other market conditions are affecting the demand for securities?

The short selling bans mean that there are stocks that are not being borrowed to cover shorts. So that’s something that is and could continue to affect securities lending income. The tough thing about short selling bans is – at least with the US ban after the financial crisis – it doesn’t work. The US short selling ban was a reactionary move and when you looked at the numbers afterwards, it didn’t help stock volatility that much.