Doubts over 'aligned interests' in sec lending market

Doubts over 'aligned interests' in sec lending market

Tougher capital rules placed on big custodian banks are leading to a misalignment of client interests when it comes to lending securities, according to a Boston-based lending agent.

Speaking at the Investment Company Institute’s (ICI) annual event in Washington D.C, eSecLending chief Craig Starble said regulatory change is resulting in the most profitable clients of some custodian banks getting the “lion’s share” of new loans.

“The concept of fairness is being called into question in the securities lending market,” said Starble, who previously ran State Street’s agency lending business.

“Custodians can’t do certain transactions anymore, so the most profitable clients take precedent. It’s not malicious, it’s just the reality of what regulation is forcing them to do.”

In a securities lending trade, securities are transferred temporarily from one party, the lender, to another party, the borrower, for a fee.

The borrower collateralizes the loan and is obliged to return them either on demand or at the end of the agreed term. Indemnification – an added layer of protection underpinning lending programs – is also present.

However, certain trades such as general collateral, depending on fee splits, are no longer economically viable for agent lenders due to added costs from Basel III and Dodd Frank.

Moreover, providing the indemnity, the insurance which often sits on the custodian bank’s balance sheet, is increasingly expensive.

“It’s a problem for our industry which has traditionally always been aligned with client interests, but I would argue large custodians aren’t as aligned as they used to be,” Starble added.

Speaking to Global Investor/ISF, one custodian bank disagreed and argued that there is in fact a greater alignment of interests occurring.

“I really can’t comment on other programs but I say that if anything with the avalanche of potential regulations hitting our business, we are seeing our clients getting more and more engaged with their programs,” said Tim Smollen, global head of agency securities lending at Deutsche Bank.

“Clients want to understand the regulations, the impact on their programs and if necessary what changes they can make to adapt their lending strategies. Clients want to talk about and understand things like capital costs and indemnifications. 

“Our job is to ensure that our interests are always aligned and in most cases we are viewed as a direct extension of our clients."

eSeclending is independently owned and, with around 100 staff, classes itself as a boutique.

That differentiates it from custodians, such as Deutsche Bank, providing similar lending services – i.e globally systemically important banks that are subject to the stricter capital rules.

Ultimately, according to eSecLending, there will be consequences for investors choosing to lend out securities.

The first could be a trend set by some agent lenders to change their fee splits as certain trades become uneconomical. 

“Custodians will be asking themselves 'how much money am I making on the total client relationship? How much expense am I creating? Then, what’s my return?'” Starble added. “Securities lending is going to be impacted by that.”

The second consequence, and one considered the most unlikely and unviable by Starble, could be the removal of indemnification. 

Although most beneficial owners, including large pension funds loaning out stock, still demand indemnification, are advised to take it and refuse to lend without it.

Another trend is the ‘cost calculator’ approach, which would involve the agent lender looking at the profitability of each client and transaction. 

This is perhaps the most likely scenario, according to Starble, and the one where he sees the misalignment of interests occurring. 

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