There was a survey of US plan sponsors put out by a consultant last month that included some commentary on “unbundling”.  Unfortunately the survey is a subscriber only document, so I haven’t read it, but I have spoken with a number of people who are subscribers and of course there are the various media reports.

Virtually every news item focused on one specific area of the report – the suggestion that the trend for securities lending to be unbundled from custody was being/had been reversed.  I must admit that when I read the stories I was a bit surprised as that wasn’t what I had been hearing, or experienced in my consulting work with European beneficial owners but assumed that this was because the survey looked at only a small universe of US plan sponsors, and this wasn’t a community I was personally familiar with.

To put the survey figures into context, it is a small universe by numbers (96 pension plans), but not so small when measured by assets ($832 billion).  There are no aggregated figures published or even comprehensively compiled anywhere, but ISLA, the European trade association for securities lending suggested that its members represented 4,000 client lenders.  Clearly that doesn’t account for the global scope of underlying lenders, but gives a sense of scale.  The total universe of available securities has been estimated by several commentators in the region of $14-15 trillion.

The Illinois Teachers’ Retirement System made an announcement last week authorising a search for the TRS’s first third party lending agent.  So are they bucking the trend apparently identified in the report?

There is no question that in today’s securities services marketplace that custodian banks face a series of challenges.  Core custody continues to be a business requiring high on-going investment and quality people at a time when global investors continue to search for cost savings.  Value-added services such as foreign exchange are increasingly scrutinised and custodians’ performance benchmarked by any number of consultants.  Cash that sits in accounts awaiting deployment used to be a reasonable source of earnings for custodians, but sharper cash management and the dreadful interest rate environment has reduced spreads here as well.  So it is not surprising that custodians work hard to ensure they have the best opportunity possible to obtain and retain securities lending mandates.

First let me address pricing bundling as opposed to service unbundling.

When I use the words “price bundling” I refer here to the contractual arrangement whereby custody fees are discounted on the basis of a securities lending contract.  As long as this is after both services are independently evaluated and priced, how it is repackaged for pricing purposes is neither here nor there.  By "evaluated and priced", I mean the following.  Securities lending is an investment activity and in return for assuming a degree of risk, the lender earns a return.  As with any investment, there is a risk of loss.  Employing a global custodian on the other hand is an administrative activity that is a by-product of being a global investor.  Each of the two activities has a value and beneficial owners (“clients”) need to understand the cost of global custody and the risk/returns of securities lending.  It seems counter-intuitive to me that a discretionary risk-oriented activity should be used to offset an administrative necessity.  However, understanding and accepting the expected return for taking on securities lending risk generates a figure that can be used in contract discussions.  If, AFTER separately pricing and evaluating the two activities, it is more convenient, acceptable, attractive, etc. for one activity to cross-subsidise the other, well that is a contractual negotiation strategy.  By valuing the two separately, the client positions itself well to make rational decisions after the original contract negotiation.  If a client decides to curtail or suspend lending, they must understand that it will have an impact on custody pricing.  If the client decides to appoint a third party lender, then it will similarly understand that the original deal would no longer apply AND it would have a baseline for comparison purposes.

Now let me turn to the question of third party lending.

I haven’t seen the questions that were asked so I can’t really put any interpretation on the responses.  What I can tell you for certain is that a number of respondents will have had arrangements in place with their agents where cash reinvestment losses post-crash were mitigated to some degree.  Some deals continue on that basis and decisions to “re-up” with some providers will have been influenced by this factor.

In any case, a few other issues make me wonder about this supposed reversal of trends.

I don’t think that in such a diverse group of clients can truly have a trend either way.  Earlier I referred to clients as a “community” and I believe that they are anything but a community.  Every agent lender of every description will tell you that their clients are the most conservative clients.  OK … that’s like everyone’s performance is above average (think about it).  We know that some clients have suspended programs at times in recent years yet we similarly know that other investors have started lending for the first time over the same period.  Many have moved away from cash reinvestment, yet most that previously accepted cash have continued to do so (possibly with a changed reinvestment profile) and others have moved into cash for the first time.

Institutional investors choose multiple investment managers and when making alternative investments into hedge funds often require the hedge funds to use multiple prime brokers.  Similarly, most clients may use only their custodian as a sole lender, yet a significant universe of investors clearly use multiple agent lender providers.  No doubt they have numerous reasons for doing so, including performance benchmarking, provider expertise, spreading business for provider diversification and for other purposes as well.

Also, statistically I’m not certain that the view of 92 investors identifies trends or reversals of trends when the global community is several thousands.

The final point is a sell-side observation.  If in fact there wasn’t a significant desire for third-party lending from clients, then the actions of the agency lenders would be adjusted.  And on this basis, I have to tell you I don’t see any reduction in focus, attention or resource allocated by custodian lenders towards their third party business.  If any custodians reading this are cutting back, please let me know – I’d be interested in hearing about your thinking.

The bottom line is that investors engaged in lending, or considering it in future, have more choice today than ever before.  That is due to technology; a competitive variety of providers, each with a different focus and product structure; and a relatively static demand profile from borrowers with agent lenders competing for a bigger slice of the pie by increasing their pool of attractive assets.   One of the key strategies in improving their supply size and characteristics is by engaging in third party lending.  I don’t see anyone disengaging from the business and obviously there are also the focused third-party lenders themselves as an important force which continue to offer stand-alone securities lending programs.

In this case, the trend is not your friend because there isn’t one (or a reversal of one). There are just individual clients with individual needs and expectations.  Successful market providers will be the ones that satisfy those needs.