The explosion of new hedge funds, particularly in Europe, is the main driver of change in the equity finance landscape. And of all the products that make up equity finance, securities lending - the loan of stock in exchange for collateral often marginally greater in value than the underlying loan - is one that is undergoing its own revolution. Securities financing is the bridge between hedge funds, one of the main borrowers of stocks, and institutional investors such as insurance companies, mutual funds and pension funds, the dominant lenders of securities.
As the increasing number of hedge funds, particularly those following event-driven strategies, all hunt for certain securities, they drive up the price of those stocks during periods when corporate event take place. Event driven strategies are often defined as equity investing designed to capture price movement generated by an anticipated corporate event such as mergers, acquisitions, leveraged buy-outs, corporate re-organizations, spin-offs or tender offers.
Slowly, lenders are beginning to realize that as holders of the assets they are able to dictate better terms for the portfolios that they lend out. Although securities lending itself has little risk, the potential risk comes in the re-investment of the collateral.
Collateral re-investment too is coming out of the darkness as an important value added service. At UBS Warburg collateral management underpins all the securities financing and securities lending efforts in both equities and fixed income. At Dresdner Kleinwort Wasserstein's new equity finance business, collateral management is important and has an influence of the pricing of nearly every trade, while at State Street Bank, the collateral is invested in dedicated funds run by State Street Global Advisors.
Servicing the financing requirements of hedge funds is a lucrative business and many investment banks have been gearing up to attend to their needs. The bridge between equity finance and the lending market is highlighted by the trend to hire former custody marketers, such as Dick Feehan, Scott Dickinson and Clive Rickards, to market equity finance and securities lending. The links with the end lenders are as important as an understanding of securities lending, so banks such as Lehman Brothers, Rabobank International and State Street are among those that have hired former custody veterans in this capacity.
Securities lending, equity swaps and contracts for differences (CFDs) are among the products that equity finance and prime brokerage divisions are building to cement relationships with the actively traded and highly lucrative hedge fund fraternity. Headhunters have been scrambling to place traders in equity swaps and contracts for differences at the talent hungry investment banks and these positions command high salaries.
The move from plain vanilla stock borrowing and lending into equity repos, equity swaps and CFDs has led a few banks to structure their business so that equity finance umbrella falls under a derivatives unit. At Credit Suisse First Boston (CSFB), equity finance is part of the equity derivatives and convertibles unit so that the offering is fully conversant with derivatives.
This has also happened at Dresdner Kleinwort Benson, where the equity derivatives business built in 1999 offers clients one face but access to the group's entire range. This includes equity finance, alternative investments, convertible bonds, structuring and financial engineering, structured products, securitised products, listed and over the counter derivatives.
But having the sophisticated instruments is only part of the equation. The difference between a successful hedge fund strategy and one that fails is accessing the hard to borrow stocks on time. As the numbers of hedge funds increase, competition for "hot stocks" is also increasing and many believe that access to them is going to be one way equity finance and prime broker desks are going to differentiate themselves.
To make sure supply is available, investment banks have always been trying to negotiate deals to borrow certain equity portfolios on an exclusive basis with lenders. But this phenomenon has hit the headlines with USD177bn California Public Employees' Retirement System auctioning the exclusive rights to borrow certain pension fund assets. According to its annual report to June 2000, CalPers could gain incremental returns of USD50m annually, with minimal risk, via the efficiency of the auction process.
CSFB won the first bid for CalPers' US portfolios totaling USD57bn, and both Goldman Sachs and CSFB won the exclusive rights to four international portfolios at the second auction. Although many criticize the amount CSFB is believed to have paid for this exclusive right, the deal can be seen as beneficial in two ways.
Firstly, if stock supply is going to be a key differentiating factor between one prime broker and another, then CSFB has only invested in its future equity finance business. CSFB's recent exclusive deal with SEI Investments for mutual fund portfolios worth some USD200bn is another example of its strategy to build supply.
Secondly, the lender - in this case CalPers - is earning the most money for its portfolio. This is perhaps the issue that is going to have the greatest impact of the lending industry. Until now, stock lending has not been considered a core activity of a fund manager or pension fund, but the revenues generated cannot be ignored. According to research carried out by Mark Faulkner at Securities Finance Systems last year, the securities lending market generates revenues of more than EUR5.5bn annually.
Most lenders have been participating in the lending market in a safe and seemingly secure way via their custodians. But now that owners are beginning to learn that some stocks are worth more than others at certain times, depending on the corporate M&A activity, they are looking at options that will allow them to make more money for the securities out on loan.
One way for a lender to make more money is to lend directly. Until now, only fund management giants such as Barclays Global Investors and Prudential M&G have had the critical mass to lend directly. The new trend is for third party direct lending. Third party lending allows even smaller groups to make more money on lending.
Third-party has started to emerge out of custodial lending banks, HSBC USA and State Street Bank, as a way to continue to compete in the growing securities lending market. Previously, lending was a bundled service included in custody. Brown Brothers Harriman, an established direct lender in the US, has opened its doors in the UK to capitalize on this growing trend in Europe.
All of this growing awareness in securities lending is also giving rise to industry initiatives such as benchmarks, risk measurement tools, online market places that offer partial price transparency. Unlike most revenue generating activities that pension funds engage in, the securities lending industry does not have enough data or benchmarks to measure performance and risk. Additionally, it is almost impossible for a pension or mutual fund to determine whether or not lending programmes are generating sufficient revenues.
Among the risk management initiatives is Securities Finance Systems' Riskexplorer, which measure and manage risk taken in collateralised lending and financing transactions. It is designed for beneficial owners, custodians, agents, principal intermediaries and
proprietary traders. Harry Markowitz, the father of modern portfolio theory and winner of the 1990 Nobel Prize for economics, is part of the advisory board to eSecLending, which is another initiative.
eSeclending is building what it believes will be the first securities lending benchmark. Developed in conjunction with Old Mutual, eSecLending, an advisory company, is also behind the auction process at CalPers. It is compiling a database of daily securities lending transaction information that it wants to become the definitive source of data for beneficial owners as well as the industry. The database, the basis for the benchmark, will use data provided by the pension and mutual funds - the owners, rather than custodians, of assets.
Reech Capital, a derivatives and securities financing consultant and service provider, is behind a third initiative. It has gone live with SLMark, an internet-based source of real-time fair-value lending and repo rates from overnight to 12 months. For the first time, the securities finance industry will also have forward prices and volatility information for the costs of borrowing.
DKW, Lehman Brothers, Merrill Lynch and UBS Warburg are the founding members of this first independent pricing tool for the securities financing industry. They will be the first to provide the raw data on individual securities from most of the big markets globally in return for access to two SLMark benchmarks.
One benchmark is calculated with prices for a large range of securities submitted every month end to give a time picture to which all members must contribute. The second benchmark is a real-time benchmark updated every time a member contributes a transaction price. Fair values are calculated using data contributed by these members on a confidential basis.
A market participant will lend out a portfolio for a specific period of time. For risk-management purposes, participants need to be able to calculate as accurately as possible the price of replacing a portfolio out on loan at any given moment. Until the launch of SLMark, there was no independent way to verify the market pricing and without such a tool there was increased potential for loss based on mis-pricing.
The securities lending industry is still in the Dark Ages in terms of a market place or exchange. But in just one year, two online market places have started to test the market. SecFinex, a global electronic transaction and information platform, is in the final stages of testing its independent online marketplace for securities finance. It promises to enhance access to securities and financing, increasing transparency and liquidity in the market and streamlining the trading and booking process.
The group's ultimate goal is to bring to the securities finance market its first exchange, but the first step for any marketplace is to ensure liquidity. Initially, 12 institutions, including Credit Suisse First Boston, GNI, Cogent and M&G Investment Management, have been testing the system.
The launch of SecFinex comes some six months after the inauguration of another electronic stock lending marketplace, StockLineOnline.com. Set up by Tony Brown, a Boston-based software design consultant. StockLoanOnline.com is currently being supported by three institutional lenders, a custodian bank, an asset manager and a pension fund manager, and is being trialled on the borrowing side by 12 broker-dealers.
SecFinex is split into two distinct parts. First a private platform that acts as a 'global portal', allowing lenders and borrowers to move their current business online while simultaneously simplifying the trading process. Secondly, there is an open marketplace where bids and offers can be posted and closed between participants with complete anonymity; identities are only revealed once a trade owner responds positively to a user's request for an exchange of names. An auction function will be added in the near future to expand this part of the service still further.
But something more revolutionary is believed to be in the pipeline. The equity finance heavyweights thought to include Barclays Global Investors, Goldman Sachs, JP Morgan/Chase Manhattan Bank, Merrill Lynch, Morgan Stanley and State Street Bank are understood to be among the 10 institutions that have set up Hubco, a securities financing initiative.
The consortium, which was formed eight months ago, is a closely guarded secret. All the participants - believed to be six borrowers of securities and four lenders - have signed strict non-disclosure agreements. At the time of going to press, the function of Hubco was still the subject of debate by participants in the securities lending industry. Among the possibilities is an exchange or a centralised clearing system, but it is understood that one of the most likely options is an internet-based automated loan transaction processing system. Post-securities lending transaction costs are currently high.
But all the developments in the equity finance industry will be based on technology. Many believe, however, that for most of the initiatives, the meaningful participation of the main players is more crucial than the development of the technology.
Niki Natarajan covers equity finance and alternative investments for Financial News and eFinancialnews.com.
