SLT: Firstly, could you tell me a little about Rule Financial?
Nelson: Rule Financial started out as a technology focused consultancy back in 1997, but we have been increasing our business consulting capability over the last six years or so by recruiting people who have worked for the banks in business roles 鈥� in securities finance our collective experience exceeds 150 years. We now have four business solution groups offering advisory and change consulting in securities finance, prime services, risk and legal. And we continue to offer strong technology 鈥渆xecution鈥� and 鈥渕anaged support鈥� services, able to provide project teams or individuals skilled in all mainstream technologies. This enables us to offer full end-to-end solutions to clients.
SLT: So how have you seen the business and technology change?
Nelson: I think securities finance as a business is interesting. No single part of it is particularly complex, but there are so many parts involved - it鈥檚 like a 1,000 piece jigsaw puzzle, or a 鈥渇ractal鈥� 鈥� with ever more detail the closer you look; this is where the complexity lies, which makes it a challenging business to fully understand from a process and technology perspective. And of course it continues to change and evolve, always increasing in complexity.
Most of the banks use vendor systems, with only some of the larger ones having made the investment to build their own in-house systems. Having built Morgan Stanley鈥檚 securities lending systems back in the early 90s, I fully appreciate how much time and money is required to go down the in-house build road; back then vendor options were limited so the decision was easier; today there鈥檚 a lot more choice - a number of vendor鈥檚 offer solutions covering differing parts of the securities finance landscape. But none cover it all, so a bank will need to integrate multiple systems and components in order to get the technology that it needs to operate.
The challenges for the technologists 鈥� both in-house and vendor - are how to keep up with the endless stream of changes; the demands arising from the last three years have required quite deep changes to the core of many systems 鈥� greatly increasing both the costs and the risks involved in making it all work 100 per cent of the time.
SLT: Who make up the majority of your clients?
Nelson: We focus mainly on the broker-dealers but also do some work with the agent lenders and custodial lenders. We also work with the buy-side.
SLT: It鈥檚 been a tough financial market but securities lending actually hasn鈥檛 fared too badly. How have you seen the last couple of years develop?
Nelson: Last year ended up being pretty tough for the market. By the middle of 2010, most banks had a fairly negative outlook for the rest of the year and it was a case of keeping the ship afloat and positioning it for 2011. The new year started well, but caution has returned as Q1 has progressed.
Neville: One of the difficulties with judging whether it was a good or a bad year is that specials within securities lending can carry most of the revenue stream for the entire year. And, it doesn鈥檛 take too many 鈥榮pecials鈥� done in sufficient size to turn a bad year into a very successful one.
Because specials are so key, it doesn鈥檛 require many takeovers or other market events to make a big difference. I think this year is going to be a lot better; as Alec has said already, we have seen more optimism about 2011, even if that has softened of late.
SLT: How has the trust within the market changed?
Neville: I don鈥檛 think anybody fell foul over the last couple of years; very few people lost money as everything was collateralised; so the trust has always been there in the collateral and in the system. It鈥檚 more to do with fear, and I think people are getting less scared. But some people we speak to are still standing back, and stories about the New Orleans fund is still having an effect.
SLT: Do you think most people on the fund side understand securities lending?
Nelson: I think they understand it to a point. Reinvestment risk of collateral is one area that was misunderstood. The general assumption was that it was an easy, safe way to generate extra earnings on a portfolio 鈥� receive cash collateral, reinvest the cash and get a return on that 鈥� it couldn鈥檛 be simpler. But falling interest rates and volatility increased the risks of these investments; turning (easy) profits into real losses.
Neville: We don鈥檛 do much cash collateral in Europe, so it鈥檚 a US-centric view on the market, but there are still risks with non-cash collateral. There鈥檚 a story about one bank taking convertibles as collateral for a stock - they thought it was great, it鈥檚 a one-to-one trade. And then when things went wrong, it turned out the bank didn鈥檛 have a convertibles desk so they couldn鈥檛 trade it! What seemed to be reasonable collateral turned out to be something they couldn鈥檛 get rid of when they needed to! There are still these complications; not so much about the loan, but about what you do with the collateral.
SLT: How have your clients changed their approach to collateral?
Nelson: If you go back three years or so, there was generally a lack of specialisation on the collateral management side of trades, with securities lending probably more advanced than OTC derivatives for instance. The Lehman default dramatically changed this, raising awareness of the importance of stronger management of the collateral being taken or given against trades and transactions.
There has been a tremendous amount of change to processes and procedures as the whole industry got to grips with the internal and external demands for more transparency and understanding of the risks and exposures they faced.
The banks have of course complied with all of the new demands 鈥� regulatory or internal - but I think a lot of this compliance has been achieved by tactical 鈥渂and-aid鈥� measures because their systems cannot be changed fast enough to provide the support needed in a more strategic way. My concern is that as and when business and volumes pick up, these tactical solutions will not be able to cope 鈥� it is a fragile part of a banks infrastructure at the moment.
SLT: How do you feel about the new regulatory environment?
Neville: I don鈥檛 think there is too much regulation at all. Many people are bleating about central counterparties but I don鈥檛 have a problem with that - why shouldn鈥檛 we be able to have visibility of what stock is on loan? Currently there is limited reliable analysis of stocks on loan by data-providers - but in most other markets you get that information on a tick-by-tick basis. In the modern world we should see pretty much everything that goes on. So I鈥檓 a fan of greater regulation, with the more visibility the better.
The only issue I see is that if you regulate in the wrong way, people will just try to arbitrage the regulations. So if it is too prescriptive there will be a problem. But making people more accountable is utterly understandable.
Nelson: I agree that regulation is a good thing, but I do worry about the cost that it imposes on the industry - that cost has to be carried somewhere. 麻豆传媒 lending in particular is a very 鈥榯hin-margin鈥� business, and I imagine there are lots of banks wondering if they can continue to make money from it going forwards.
SLT: What do you think about the short selling restrictions we have seen over the past couple of years?
Neville: I think it鈥檚 just nonsense. I always use the example of selling the Mona Lisa; it鈥檚 a long price, you can鈥檛 sell it short, it can only go up in value. Likewise, house prices always trend upwards because you can鈥檛 sell them short. And because you can鈥檛 sell them short there is no genuine price discovery process. If you sell, you do so because you need the cash - you don鈥檛 sell because it鈥檚 the wrong price. For price discovery, selling short is crucial.
Nelson: There seems to be a lack of understanding of the markets by governments and regulators. Enormous media pressure encouraged them to be seen to act, and restricting short-selling was an easy target 鈥� it feels like it was a knee-jerk response to the market situation at the time.
Neville: Poland introduced short selling when everyone else was taking it away and it had no negative effect on the market. Their stock exchange saw that short-selling is a key part of creating liquidity 鈥� it facilitates derivatives hedging, which in turn should enable and encourage more futures and options business, new products and more market makers.
SLT: What about the introduction of Central Counterparties (CCPs)?
Nelson: At the moment I鈥檓 fairly neutral about them. They will add another set of costs to the equation. I understand the pros, in terms of better balance sheet treatment, standardised clearing and settlement, theoretically no counterparty risk and so on. But I think they will reduce flexibility, especially with collateral, and I wonder about the level of trades that will still be completed outside of the CCPs.
Neville: You put equity trades through the exchange, but if you want decent volume in equity trades, you do that OTC, through a broker. Name me a market and I鈥檒l show you a very large voice market - FX is $2 billion on exchange and $200 billion on voice so there鈥檚 always an OTC market. But with most asset classes the reporting goes through the exchange so there is a certain visibility.
With securities lending, there is no clear visibility of what goes on - it generally means that if you can鈥檛 see the information then the price is skewed. And things like custodial services get offered for free because the custodian has the inventory and makes up the difference. So I think clearing fees will increase the cost, but it will also mean that custodial fees and the like, will also be charged. And I think that is right - the granularity of charging gets spread out over the classes of services.
SLT: Can an exchange-traded system work well with specials?
Neville: There are loads of specials that go on all the time in other markets - you get Notifications of Interest. There was one stock on the FTSE, DMGT, that never traded. So if you wanted it, you鈥檇 have to put a note up on Bloomberg asking if anyone had any of them. So it was exchange traded, but it was a special. I don鈥檛 see any reason why this can鈥檛 be the case in securities lending.
Nelson: I think one of the challenges about trading specials are the terms that are negotiated on them. Terms for trades in non-special General Collateral (GC) securities are largely consistent across the market, so they are well suited to the standardisation that comes with trading on an exchange. But trading in specials requires more negotiation and 鈥渟pecial鈥� terms 鈥� the limited trade-terms available on an exchange could limit the negotiation process, making it preferable to trade the special off-exchange.
SLT: Where do you think more growth will come from?
Neville: The Koreas of this world, the Philippines, China and India is where the growth will come from, and to an extent is already coming from. I don鈥檛 believe there will be phenomenal growth in the UK because as you increase high frequency algo trading, you鈥檙e just as likely to get in and out of a stock quickly as you are to stay in it. M&A activity is likely to increase and that will be great, but it鈥檚 South and East Asia where the opportunities lie.
China is a whole different ballgame. At some point that will open and the beneficial owners will have some fun there, as there is real investment potential; and if there鈥檚 real investment, there are real opportunities for shorts as well.
Nelson: You also need to consider that securities lending growth will depend on how easily the securities in those local markets can be accessed 鈥� if the brokers can鈥檛 physically borrow the securities, they cannot on-lend (physically or synthetically) to the investors. Volatile markets have traditionally been good for speculators and therefore securities lending; but there are so many variables it is difficult to predict.
SLT: Is there anything that could kick start the market, or is it slow and steady growth?
Nelson: There still seems to be a lot of caution and conservatism at the moment, with the markets still seeming to lack any particular direction. World events and media hysteria, rather than fundamentals still seem to have too big an impact on stock markets. Until the global economy settles down and recovery is more fully on its way, I think markets will remain fairly steady. There are also some significant events coming that will have an unknown impact 鈥� I鈥檓 thinking of looming regulations such as Dodd-Frank and Basel III, and the introduction of central clearing counterparties (CCP鈥檚) to the OTC derivatives world. If nothing else, these changes are all likely to affect the availability of assets used as collateral by the securities lending world.
Neville: Convertibles are on their way up, causing a bit of a stir. It looks like the environment is improving for corporates to go out and raise a bit of money and often they will do that through convertibles. Trading is cyclical anyway, so at any one time there are particular fund areas to be in and areas where investors are less interested. As stock borrowing and lending is dependent on a certain type of trade, you have to wait for that type of trade to become flavour of the month
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Stephen Casner
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