Cutting Out the Custodian, in Lending Securities
November 11, 2011
What if a fund manager could eliminate the custodian bank when it lends securities to a broker overnight?
Would the asset manager’s clients—the holders of the assets—get a bigger bang for their shares?
Custodian banks say they try to maximize returns for lending the securities held by the fund manager. The results all depend on the type of securities lent, the type of collateral received and market conditions.
But what if the ultimate owner of the securities controlled their destiny, then it might earn more. This may sound like a pretty dramatic change. But it’s a concept proposed 11 years ago, by a new type of securities securities lending agent.
“Many concepts that had been employed for years in the investment management industry were largely absent in the securities lending market,” explained Chris Jaynes, co-chief executive officer and co-founder of eSecLending, headquartered in Boston.
Those concepts were best execution, performance measurement, competition, use of multiple managers and benchmarking. Plan sponsors—the owners of the assets—were simply taking the word of fund managers and custodian banks they were getting the best returns for their assets. Among the largest lending agents are State Street; JP Morgan, Northern Trust and Bank of New York Mellon.
ESecLending’s answer: act as a securities lending agent, albeit not in the same way as a custodian bank. How? By offering an automated auction model in which the plan sponsor has the ultimate control over just who borrows its assets, what amount of assets and for how much.
Here is how an auction-based model works: The owner of the assets or plan sponsor agrees that eSecLending can post the book of assets it wants to lend on its secure website. An approved list of borrowers will be able to participate in the auction and each one will state the amount they wish to pay to borrow a certain segment of that client’s securities. None of the borrowers know the identities of the others.
At the end of a designated period – typically a few hours – eSecLending will collect all of the proposed bids. It will then present them to the beneficial owner which makes the ultimate decision. That decision will be based not only on the price that is offered but also the plan sponsor’s exposure to a particular dealer and its creditworthiness. Because of the blind nature of the auction process, if a borrower really wants to gain exclusive access to a segment of assets it is willing to offer a significant premium.
That premium is often a lot higher than what the plan sponsor would earn through a custodian bank-operated process, according to eSecLending. The beneficial owner will receive the guaranteed bid price which is typically in basis points.
Case in point: A U.S. small cap portfolio could garner a bid of 30 basis points. With that bid, the borrower is obligated to pay that amount which gives them exclusive access to borrow those assets at anytime during an agreed upon term. Within that term the beneficial owner retains the right to recall securities from loan at any time and the borrower is contractually obligated to return the securities within the standard settlement cycle.
