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Finding A Route to Market:
An Institutional Guide to the Securities Lending Labyrinth

© Securities Finance International Limited

INTRODUCTION

Finding the most suitable route to market and the issue of selecting a counterpart are at the heart of the securities lending business. In this chapter, we discuss these issues for the benefit of institutions whose core businesses do not include securities lending. We focus on the lending of international equities with regard to both lending and non-lending institutions.

How do explorers plan expeditions? Do they first choose a destination and then plan the route? Or, do they plan a route and thus reach a destination by default? Explorers have doubtless done both. How do institutions approach lending? Do they first decide to lend and then find the appropriate route to market? Or, do they become seduced by the proponent of a particular route and slip into the decision to lend? Historical precedent suggests that it is ultimately possible to reach a satisfactory conclusion in whatever order these decisions are made. Continents are discovered whether people sail off looking for them or not.

Today, when we want to explore a known place, we usually identify the destination and perhaps the motivation for embarking on the journey, before we select the route. So how should institutions approach the lending market? Before we tackle this question, let us explore whether a "market" exists and whether it is accurate to call it such. If it does exist, institutions should understand the kind of market that it is. What are its characteristics? What drives it?

For most institutions securities lending is a peripheral activity and therefore requires a cautious and patient approach. Navigating the labyrinth is not easy but nor is it impossible. Despite what any marketer of the business may tell you, it is no more a "rocket science" than it is a "free lunch".

Any market can be defined as a meeting place for supply and demand. Given that definition, the securities lending business qualifies as a market in its own right. Lending institutions and a wide variety of intermediaries provide the supply to meet the demands of other intermediaries or principal borrowers.

When we look at the source of the demand, the status of securities lending as an independent market is somewhat less obvious. The core market driver is a demand for securities that comes from proprietary traders selling the cash market short, frequently to hedge long derivative positions. If we accept this fact, we see that the securities lending market is subordinate to and dependent on, the cash and derivative securities markets.

The securities lending market is also tied closely to other securities financing markets in the form of the repo, swaps and prime brokerage products. In Europe, the recent use of repurchase agreements ("repo") for equity securities as well as bonds, is a case in point.

In the repo market, the equity lending desks of brokers, dealers and banks finance their long equity inventory as if they were bonds. Of course, many of these positions exist either as a result of financing customer strategies or because securities have been borrowed in anticipation of making onward deliveries. Which comes first, the borrow or the repo?

Securities lending is part of the broader securities financing business. The number of firms renaming departments is clear evidence of this fact.

If the derivatives market is the engine, then securities lending is the oil. It brings much needed liquidity to the marketplace but at a price. This oil is expensive. Some estimate that international securities lending revenues (i.e., excluding those in the U.S. domestic market) exceed $1 billion per year. It is the search for a share of this revenue that draws institutions from their core activities toward the less familiar world of securities lending.

Securities lending is a specialist activity with its own conventions, practices and rules. As in any business, it is most rewarding to be an expert. Pension funds hire experienced managers to invest assets to meet the demands of their pensioners. Insurance companies manage assets to meet their liabilities. Securities lending experts focus upon matching the supply and demand of lendable securities.

The key factor distinguishing securities lending from many other areas of the financial services sector is its almost complete lack of transparency. This benefits the experts.

The securities lending market is so opaque that it reminds some observers of the bankruptcy business in the United States during the 1980s. Information and experience are highly concentrated in the hands of a relatively small number of firms and people. There are very few screens on which prices are displayed and fewer still where you can get more than an indicative quote.

The market remains this way because it is in the interests of the dominant players to keep it so. More transparency is not in their interest, or so they believe. The lack of clarity does more than restrict the number of institutions bringing supply to the market. It also hampers the speed of any institutional entry.

Most service providers would agree that an informed customer is a better customer. This is not the widely held view in the securities lending business. Such an attitude has not only held the market back but also led to the development of numerous myths.

We can dispel some of the more popular market myths.

"Everyone should lend" – As our examination will show, this business is not for everyone. That being said, everyone should be an informed observer. Portfolios and trading strategies change. What was, from a lending perspective once an unattractive portfolio, may become attractive in the future.

"Lending is risk-free" – While it is true that the risks can be identified, managed and minimised, no one should expect to be rewarded in this business without accepting some risk.

"Cash is the only safe form of collateral" – Cash has to be managed and invested to produce a yield and cash reinvestment is not without risk. In Europe, fiscal regimes have historically encouraged the use of securities and letters of credit as collateral. Recently equities, convertible bonds and even equity warrants have been accepted as part of collateral portfolios along with the more typical government bonds. The significant losses in the securities lending business are associated almost exclusively with the taking of cash as collateral.

"Good collateral makes a good counterpart out of a bad one" – Collateral should be seen as insurance against counterpart default. An unrated counterpart with little capital should be seen for what it is, not what it gives you as collateral. Good collateral, in terms of the type of assets and haircut taken, can provide merely a degree of increased comfort.

"There is one route to market" – In fact there are several different routes to market, each with its own advantages and disadvantages. Despite what some may have you believe, the different routes are not mutually exclusive.

"Indemnification eliminates all risk" – Indemnities vary considerably in quality. Some will eliminate most of the risks associated with participation in this business; others are not worth the paper they are written on. Ultimately one has to recognise that this form of insurance and protection is not without cost. Furthermore, no matter what the indemnification says, one is always exposed to the risk that the indemnifier will not perform.

"A level playing field exists" – Irrespective of an institution's sense of fairness and desire to treat all counterparts equally, one has to recognise that they are not equal in all respects. Triple A-rated banks are different from single B-rated broker dealers and should be treated accordingly. The fact that they are not treated differently is a testament to good marketing on behalf of the disadvantaged and many institutions' unwillingness to make difficult decisions. In the money markets, a lender of cash explicitly differentiates between borrowers by setting different rates, margins, collateral requirements and duration limits. Such differentiation is rare in the securities lending business, with the result that an unlevel playing field is artificially leveled. This is not in the long-term interest of the lending community.

"The market is mature" – There remains a significant imbalance between international supply and demand in certain countries and for particular securities. Why else would any potential new lender be courted by so many borrower suitors? New firms continue to enter the market and certain intermediaries continue to operate profitably. The rise of third-party agent lenders is just the latest phenomenon in a market that continues to develop and change. Even where the market exhibits signs of maturity, such as in the U.S. equity market, there remains significant room for revenue generation.

"Standardised legal contracts fit all scenarios" – Standardised contracts bring the benefits of consistency and can save on legal expenditure but they should be seen more as a starting point than a solution. The vagaries of cross-border securities lending transactions mean that the decision to use a standard document, without amendment, should only be taken after careful consideration.

"Tax arbitrage drives the market" – Fiscal authorities around the globe are, quite rightly, fixated upon the collection of taxes due them. When it comes to securities lending however, their collecting zeal seems to know no bounds. Rather than see the cost of manufacturing a dividend for what it is — namely a cost associated with borrowing securities, that borrowers seek to minimise — the tax authorities see a dividend arbitrage behind every trade. This is certainly not the case. While it is true that the securities lending market plays a role in facilitating the tax arbitrage that does take place, it is equally true that the Japanese market — with its historically low dividend yields offering minimal borrower motivation — is the largest non-dollar lending market.

ORGANISATIONAL CHARACTERISTICS

Before expending any energy on securities lending, you need to spend some time considering the characteristics that your organisation and portfolios exhibit. Working on the assumption that an institution is unlikely to reinvent itself or adopt a new trading strategy just to facilitate the lending of securities, this approach could save significant resources and frustration.

To simplify the approach, we divide institutional characteristics into two groups — organisational and portfolio-specific. We acknowledge that all organisations differ but feel that some general characteristics are common across geographical and sectoral boundaries. For the purposes of this analysis, we make the — admittedly extremely simplifying — assumption that the regulatory situation affecting any lending decision is known and clear.

Every lender is in it for the money. Some may view lending as a peripheral activity to help offset custody and administrative costs and, whatever the merits of their portfolio, may never change this view. Others see lending as a valuable contributor to revenues and a potential source of competitive advantage and act accordingly.

It is important that the activity be sponsored by a wide cross section of the organisation and that the fund managers are motivated to provide support. As any operations manager will tell you, running a programme without the understanding and commitment of the fund managers is fraught with peril. Senior managers need to understand the motivation behind their organisation's potential involvement and then to move forward only when a degree of consensus is reached.

While a variety of vendor systems can alleviate a significant amount of the technological strain associated with securities lending, successful participants commit significant resources to internal systems. Borrowers will want to receive available inventory as frequently as possible. Lenders will need to (1) avoid lending the same securities twice; (2) deal with sales of inventory by their fund managers; (3) process both recalls and returns; and (4) effect any "buy-ins" as necessary. These are not particularly difficult tasks but each needs to be recognised and addressed.

A lender's collateral flexibility, be it in terms of cash reinvestment parameters or the ability to accept lower-grade securities, will be rewarded. The securities lending market, like any other, is a meeting place for organisations with a wide range of credit quality and collateral capabilities. A borrower's credit rating may be inversely related to its propensity to borrow. If an institution has a cautious approach to counterpart selection and a low tolerance for risk, this must be recognised by management charged with researching securities lending. This is not to say that securities lending cannot be conducted profitably but rather that the chosen route to market has to be consistent with an institution's general risk profile.

Some organisations have a propensity to outsource services; others do not. Understanding this fundamental organisational trait prior to talking to potential counterparts, will enable managers to identify routes that are unlikely to be suitable and to focus on those that exhibit more of an organisational "fit?'

PORTFOLIO CHARACTERISTICS

Our analysis of the characteristics of the portfolio or portfolios that might be available for lending has the dual benefit of further exploring the viability of participation and, should one decide to take the next step, being a start on evaluating the portfolio's merits.

Size is not everything but it helps. Borrowers covet large portfolios more than they do small ones. However, a concentrated portfolio of even $50 million of the right securities is, of course, worth investigating.

Given that the average loan transaction size is in the order of $500,000, individual holdings of under $250,000 are of limited appeal to direct borrowers. Generally, holdings of less than $750,000 are likely to be best deployed through the lender's participation in an efficient pooled lending program.

Active trading which increases the likelihood of recalls, reduces the attractiveness of the inventory. It is often better not to borrow a security at all than to borrow it and then have it recalled. Recalls tend to come at the most inopportune times and can cause significant strain in a lender-borrower relationship. Passive portfolios are ideal for lending, although if you have the same inventory as everyone else, lending revenues are going to be low.

From a lending perspective, a broad geographic and sectoral distribution within a portfolio is a positive factor. The global securities markets are in a constant state of flux and at any given moment a particular country or sector may become a focus of demand. Borrowers like lenders who offer a wide geographic range of liquidity. Acknowledging that the profitability of lending in certain markets may be marginal, they direct compensating business toward lenders providing service in the less profitable markets.

Borrowers are responsible for "making good" any benefits of share ownership (excluding voting rights) that would have accrued to the lender had the securities not been lent. In the case of dividends, they must "manufacture" (i.e., pay) the economic value of these to the lender.

The manufacturing of dividends is a major cost component of borrowing securities. For example, a borrower with $100 million of German securities outstanding that yield an average of 3%, could save $450,000 if the manufactured dividend obligation could be reduced by 15% ($100,000,000x 3% x 15%).

An institution's tax position at a particular time is a given but understanding your status compared to that of your peers is valuable in researching the viability of lending.

By way of an example, U.K. pension funds would usually reserve 85% of the dividend on a Dutch equity. The U.K. Inland Revenue has decided, however, that if such a fund lends those securities over the dividend date then a borrower must pay 85% to the lender and 15% to the Inland Revenue. This rule means that U.K. pension funds are less attractive as lenders than, for example, U.S. pension funds.

The definition of a security's attractiveness is, like so many things in the securities lending business, made rather inaccessible by the adoption of simple jargon. "Hot" securities are those in high demand whilst general collateral or "GC" securities are those that are commonly available. Needless to say the "hotter" your portfolio, the more lending merit it has. "Hotness" is difficult to assess without approaching potential counterparts but as a general rule of thumb, non-Japanese Asian securities are hot, as are the less liquid and tax-advantaged securities worldwide.

Thus the lending case for a revenue hungry institution, domiciled in Bermuda, with good technology and passively managing a global inventory of large holdings of hot securities, would be particularly strong.

THE SIX ROUTES TO MARKET

Should the organisational and portfolio characteristics exhibited by an institution seem encouraging, the next step would be to assess the available routes to market. The key thing to remember is that there are options and, despite what anyone may tell you, the choice of route is not a straightforward decision.

While not going to the market will not endear a potential lender to the proponent of any particular route, this may indeed be the right decision for a given organisation. If however, the organisational and portfolio characteristics are favourable, there should be a route or routes offering the return expected for a given level of risk and effort

Using a global/domestic custodian is the least demanding route for a lender, especially one new to the business. Assuming the acceptability of any indemnifications and confidence in the custodian, this route poses few barriers to getting started quickly. Levels of both risk and effort are low but so too is the cost in the form of reduced revenues.

The custody business is intensely competitive and in securities lending, banks feel they have discovered a money machine — not unlike their old view of the foreign exchange business. If banks succeed at securities lending, they will not only generate significant revenues to support technological investments and cross-subsidise their core business; they will also retain their customers. No wonder they are keen to lend your assets!

If, while believing that a custodian cannot offer the service required, a lender decides not to lend itself, the answer may be to appoint a third-party specialist. In the United States the demand for this option stems from frustration with custodial performance. Elsewhere, it is typically a response to the increasingly competitive nature of the business and the propensity of institutions which could lend directly, to outsource to specialists.

Agent intermediaries are sometimes separately incorporated organisations but are more frequently parts of larger bank, broker-dealer, or investment banking groups. Third-party agent lending specialists represent the most fashionable and fast growing sector of the business. The low marginal cost of entry and significant potential rewards are two very good reasons for a firm already in the lending business to set up a specialist agent.

Many wholesale intermediaries have developed global franchises using their expertise and capital to generate spreads between two principals that remain unknown to one another. These principal intermediaries are again, sometimes separately incorporated organisations but more frequently, parts of larger bank, broker-dealer or investment banking groups. Acting as principal allows these intermediaries to deal with organisations that the typical institution may choose to avoid.

The classic principal intermediary is the prime broker, borrowing from institutions and banks to lend to "hedge funds". Given the opaque nature of these relationships however, the lender is unable to determine where the securities are going, in particular if they are being loaned or used by the intermediary’s own traders.

As institutions develop further understanding of the market dynamic, they may wish to consider lending direct to the organisations that are the final end users of their securities. The proprietary borrowers include broker-dealers, market makers and hedge funds. Some exhibit global demand while others are more regionally focused.

Just as there is no one right route to market, nor are the options outlined mutually exclusive. Deciding not to lend one portfolio does not preclude the lending of another, just as lending in one country does not force one to lend in all of them. Choosing a wholesale intermediary that happens to be your custodian in the United States and Canada does not mean that you cannot lend your Asian assets through a third-party specialist and your European assets directly to a panel of proprietary borrowers.

TYPICAL MARKETING STRATEGIES

The right route to market is that which meets your realistic objectives. The challenge of finding the right route is not made any easier by the different marketing messages that institutions receive from securities lending professionals. Besides marketing their own firm's merits, borrowers will adopt certain arguments to encourage an institution to take a particular route.

While it is impossible to detail all the potential marketing strategies available to a gifted professional, we can identify some of those more frequently used.

It might be expected to be most unusual to hear "don't go to the market" unless the portfolio in question was particularly unattractive but there are times when an attractive portfolio, with significant revenue-generating potential, draws this response. It really means, "We can’t do it, so you shouldn't". Such a reaction is often expressed as the taking of the "moral high ground" and most frequently comes from custodian banks.

This is not to deny the genuine instances when not to lend would be the best advice but rather to encourage an institution hearing this line to question whether it is getting good advice or merely an excuse.

Being administratively straightforward, the use of a custodian bank is the conservative option. Custodians will argue that they are perfectly positioned to clear, report and process your lending activity in as near a trouble-free and seamless manner as is possible. They will give you directed or discretionary options so that you can effectively select your own principals and will manage collateral in accordance with your investment guidelines. They will make a great deal of their indemnifications (but only to the extent that they offer them) and will stress their global reach, commitment and risk management controls until any thinking person would view any other option with extreme caution.

Custodians continue to reap the benefit of planting the seeds of doubt in many an institutional mind. They do so because it sells.

Fed up with being a small fish in a large pond? A large fish in a large pond? Fed up with dealing with Jacks of all trades who are masters of none? Want a partner to help you get fair value from your lending inventory? These are just some of the lines you might expect from a specialist agent.

They would argue that advances in technology have eliminated many of the administrative and communication barriers that once made this route difficult to navigate. They may suggest furthermore, that they can achieve a higher utilisation rate for securities and obtain more income per loan. They will attack custodial programs as inefficient and run by non-experts.

Specialists may also argue that many custody programmes are the victims of their own success. How they do this will be determined largely by the size of your portfolios. If the inventory is small, the argument may be, "The custody lending pool that you are in is so large that you are never going to get the kind of utilisation that you might in our smaller pool. You will be relatively more important to us and while remaining a small fish, will swim in a smaller pond". Should the inventory be large, expect to hear, "Your lending inventory utilisation is being undermined by the custody bank's automated allocation algorithms. There are too many lenders in the custody pool who are getting their fair share of loans at your expense, loans you might be able to satisfy on your own. Why not become a big fish in our smaller pond?"

If you are looking for the wholesale distribution of your assets through a securities specialist who can co-ordinate the demands of many proprietary borrowers and take advantage of them as a principal, then this intermediary route is for you. This is a real departure point for an institution.

Wholesaling requires establishing a desk, incurring fixed costs and adopting a professional approach to the lending of your securities. However, such a commitment in following this route can be avoided if you sign an exclusive arrangement with one principal and outsource your collateral management function. This might make sense for an entry level institution wishing to earn while it learns for a specified period of time but it is less likely to be the optimal approach for a large and attractive portfolio in the longer term.

Intermediaries will make much of their captive demand, be it from prime brokerage customers or affiliated proprietary trading desks. When evaluating this route, the key trade-off is whether the revenue generated will justify the commensurate increase in commitment required and concentration of counterpart risk.

To identify the final end user of any product, one typically looks for the person whose need is the greatest and who is paying the most for it. The securities lending business is no exception to this rule. The proprietary borrowers will tell institutions that they will pay more to borrow securities and borrow from them as a matter of priority and for longer periods. If this sounds too good to be true, it often is.

The larger proprietary borrowers are frequently able to borrow at rates comparable to those of the principal intermediaries. They effectively eliminate the intermediaries' spread by keeping it for themselves rather than giving it to the institutions. Should an institution wish to gain spread by dealing directly with a proprietary borrower, it will have to fight for every basis point and recognise a fair market price. This means being an expert and having a number of counterparts or executing exclusives only after conducting an extensive bidding process.

An institution is unlikely to hear any combination strategy advice too often. Very few, if any, organisations active in the lending business have all route options available and fewer still are likely to recommend other options over their own. This is the kind of argument to expect from a specialist consultant, an experienced lender who has learned over time that a combination approach makes sense, or a representative of a professional counterpart that is taking a realistic long-term perspective.

There are many more marketing strategies that may be adopted to encourage an institution to follow a particular route. When confronted by what seem like logical, but often contradictory, arguments, institutions are not surprisingly bemused and some fail to make any decision for fear of its being wrong. Many institutions are led down a particular path by marketing professionals who could just as readily have argued in favour of a competing route.

The challenge for an institution is to distinguish between good marketing and good common sense. Whilst an examination of one's organisational and portfolio characteristics will be helpful in selecting the appropriate route, being prepared for marketing arguments and understanding the pros and cons of each approach are the best forms of preparation.

ADVANTAGES AND DISADVANTAGES

There are as many arguments to be made in favour of each route to market as there are arguments against. The goal here is to provide some objective perspective on each approach. Prior to making a route-specific analysis, we offer some general observations.

The choice of route to market brings with it the need to consider the institution's organisational and portfolio characteristics and, above all, its proposed level of involvement in this peripheral activity. An institution needs to determine whether it is going to embrace the business fully and set up a desk with all the resources that requires or take a more passive role and appoint an agent or exclusive principal.

The advantages of the former approach are primarily the degree of control and customisation combined with retention of all the revenue. However, these benefits are not without cost. Equipping a desk to be an efficient market participant is neither cheap nor speedy. An inefficient desk will fail to generate the revenue of an experienced desk from the same portfolio. Keeping all of a smaller revenue stream may well be less attractive than taking the lion's share of a larger revenue pool, particularly when one factors in the cost of establishing the desk in the first place.

The advantages of the latter approach are that the cost of entry is reduced and that an experienced desk lends the portfolio. While it is true that the selected counterpart will take some share of the revenue, the total revenue accruing to the lender may increase. Notwithstanding the revenue sharing issue, the main disadvantage of this approach is the potential sacrifice in terms of control and customisation.

While it is possible to negotiate with the agent or principal counterpart the exact type of service that you would like, it is unlikely that you will be able to achieve lending nirvana. However, one must not forget that nothing is forever and the options available can always be reassessed at a future date.

There are two main forms of inactivity to assess — not lending at all or choosing not to lend selected portfolios or parts of selected portfolios (e.g., those in particular countries). Nothing ventured, nothing gained. If you choose not to lend, the main disadvantage is that you may be forgoing revenue. The amount forgone depends on the merit of the portfolios concerned.

The opportunity cost of not lending is equivalent to the potential lending revenue forgone, minus a financial estimation of the effort and risk required to generate that revenue. If the opportunity cost is a significant positive number, then the decision not to lend might not be the right one. If on the other hand that cost is a small positive or even a negative amount, then the decision not to lend is justified on economic grounds alone.

The main advantage of using a custodian is administrative ease. You deal with an entity that you know and trust and custodians may provide some enhanced security by means of indemnification. There is no need to set up a desk and the levels of management involvement and resources required are minimised,

This is the convenient and conservative way to lend but convenience does not come without a price or conservatism without a missed opportunity. The share of the revenue given to custodians typically ranges between 20% and 40% but varies from account to account. The question an institution must answer is whether this represents value.

Custody lending is conservative or, to put it another way, lowest common denominator lending. Banks will be banks and should an institution hanker to be on the cutting edge or prefer a fully customised program, using a custodian is unlikely to be the optimal route.

Some custodians have been so successful at marketing their securities lending programs that some of their customers have become victims of their success. Small and large portfolios alike may be missing revenue opportunities by virtue of the way that the bank allocates loans. Both might lend more securities and generate higher revenues if they were to leave the massive custodial pool for an alternative lending strategy. This might involve appointing another custodian with a smaller pool or instead, taking a different route altogether.

Custodians will make much of their cash reinvestment capabilities. Yet did not certain custodians experience reinvestment problems in 1995?

When you choose this route to market, you are putting all your eggs in one basket — selecting a single organisation to be custodian, securities lender and to manage your cash. What is the likelihood that one firm will be superior in all disciplines?

Using a third-party specialist is the first step away from the custodial route. The principal advantage for the customer is that a securities lending-focused organisation and its personnel ought to lend effectively.

One reason we see increased use of this choice may be that specialists are newer operations without a lending backlog. As they become successful however, specialists' customers may suffer the same lack of attention about which some custodial customers complain. One consideration is that as every custodian trots out its agency lending programs, the customer may simply move to another custodian, although the assets remain immobile unless loaned. There may be situations where regional or product specialisation means that this is nevertheless the right decision.

The unbundling of this product is a double-edged sword. Separating lending from custody brings with it operational disadvantages if the technology is inadequate. Furthermore, being able to appoint an independent third party to reinvest cash (as some specialists do) allows a further degree of specialisation.

Taking this route is something like getting a tailor-made suit rather than one off the peg. Finding a good tailor takes some time and a store-bought option can fit just as well. Using your custodian may be a compromise but for many it works.

Now we're getting serious. Lenders wishing to receive gross lending revenues could choose to deal with an intermediary as principal. The potential gross revenue increase is the main advantage of this route. There are costs however. This route is essentially only for those for whom the fixed costs of starting a business are less than the variable costs of paying an agent to do it.

Perhaps the major disadvantage of this choice is that you need to establish a business with a desk capable of dealing with the securities lending professionals. Rather than getting a percentage of the earnings from a portfolio, a lender's counterpart is now rewarded by borrowing securities at the lowest cost. Moreover, there is a potentially combative relationship to be managed. Lenders taking this route need personnel who can extract "fair value" from lendable assets.

Where proprietary principals have similar credit quality to the principal intermediary group, those lending direct will presumably retain even more of the lending fees because they are closer to the market. Taking this route entails only marginally higher fixed costs because there are likely to be more counterparts. Little else changes, unless the proprietary borrowers are themselves "hedge funds". Dealing with these counterparts requires a sophisticated approach to risk management. For most lenders, the process almost inevitably means having a principal relationship with various "prime brokers". This is the same as having a relationship with a principal intermediary because lenders have no contractual relationship with the hedge funds themselves.

Most lenders will find the optimal solution to be some combination of the routes described. This can be accomplished in one of two ways. Lenders can make entire portfolios available for loan to both agents and principals on some kind of "first come, first served" basis. Perhaps a better alternative is to segment the lendable inventory, lending some segments of the portfolio through a custodian, some through an agent and some on an exclusive or panel basis to selected principals.

COUNTERPART SELECTION CRITERIA

Many lenders are now recognising securities lending as a stand-alone business and no longer as a peripheral activity. They are demanding access to the relevant business information on which to base securities lending decisions. There is a practical need to know one's counterparts and to understand both their capabilities and requirements.

Exhibit 1 identifies some of the key information that a lender should use to select a counterpart.

Source: The Register of International Securities Financing Counterparts

SAMPLE PORTFOLIOS

No two portfolios exhibit identical characteristics, even when controlled by the same organisation. The simplified portfolios we describe are designed to show that the route to market varies by portfolio as well as by organisation. Lenders may need to adopt a flexible approach having multiple routes available to them in order to do full justice to their inventory.

This portfolio is almost certainly unlendable on a direct basis. Apart from anything else, the individual holding size is just too small and unstable. Some percentage of the 100 lines of specials might be lent as part of a custodial or perhaps a third-party agency pool. It would probably be imprudent to lend more than 50% of any individual holding. On a lender/agent split of 60/40 at an average fee of 50 basis points (Bps), this route might generate $37,500 per year for the pension fund. This is about a 1½Bp contribution. If this were an organisation's sole fund, the lending case would probably be marginal.

This portfolio would have any agent or principal doing cartwheels. Assuming an 85% dividend entitlement and an average 3% dividend yield on the securities held, the lender could expect gross revenue estimates on this portfolio to be in the region of $2.5 million. This represents a 50Bp contribution. Even if the lender/agent split was 80/20, the "cost" of the agency route would be $500,000.

Some may believe this is too expensive. A direct route, perhaps even a guaranteed exclusive with a well-rated principal counterpart, might make more sense.

This is another attractive portfolio from a securities lending standpoint, although there are some operational challenges that need to be overcome. Every lender's first priority is investment performance and the lending of securities should not impede that objective. Fails, buy-ins and recalls are to be avoided if at all possible.

Given the passive nature of the portfolio, if a 25% buffer were considered appropriate and fees averaged 75Bp, gross lending income could be about $1.5 million. This represents a 75Bp contribution.

It is advisable to deal with a regional expert, be it agent or principal. An agency "cost" of $375,000 based on a lender/agent split of 75/25 might be entirely reasonable but only if the agent is an expert.

MAINTAINING PERFORMANCE

Things change. Just as an institution evaluates its suppliers of custody and asset management services, so we would contend that it should evaluate the lending performance of its chosen route and counterpart/counterparts. Having expended considerable effort in making the original selection, it is essential to allocate some resources to checking whether that choice continues to remain appropriate. (See exhibit 2 below, which provides recommendations for doing so.)

THE WAY FORWARD

What to do now?

Adopting a logical approach to the lending decision will save time, money and frustration. Lending is not for everyone.

Examine your organisational and portfolio characteristics before approaching counterparts. When gathering information from the market, do so in a structured manner so that results do not add more confusion than they resolve.

To ensure that your lending performance remains optimal, you should regularly revisit the lending route decision. Conduct this process with as open a mind as you approached the initial lending decision. The barriers to changing routes are less daunting than many counterparts would have you believe.

CONCLUSIONS

Navigation is not straightforward. There are often many routes to a particular destination and it is not always easy to find the best one. It is also difficult to determine what is meant by "the best". Does it mean "the quickest", "the easiest" or "the most profitable"?

Finding the best route to the securities lending market can be as difficult as embarking on an arduous journey. There are no maps and along the way various vendors will attempt to lure you down their favoured path.

The approach we have outlined in this chapter can be adapted to suit any institution's particular circumstances. Should the approach be adopted, it will enable an institution to achieve a better result quicker. The key thing to remember is that while there are many possible routes to take, you should set the pace and only embark on this journey if you believe it to be worth your while. We would suggest that institutions focus on the lending decision first and the route second. In reality, lenders are likely to be attracted to a lending decision because of the persuasive powers of a particular route proponent. We would advise taking an initial step backward to consider whether participation is really appropriate and what other routes are available. We would not discourage lenders from calling on an independent specialist's assistance in this endeavour. Then again, we would say that wouldn't we?

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