Something has started changing: the cost of securities lending indemnification can no longer be ignored

Hi, friends. Welcome back to another episode of Peer Connections, the podcast series brought to you by the Global Peer Financing Association, also known as GPFA. These podcasts offer our GPFA members and global beneficial owner friends a forum for information sharing and discussion on topics most important to them. And we hope you, our listeners, appreciate the insights, best practices, and transparency offered from our members and industry friends about securities, finance, or related investment areas. Now let's get into the episode. Welcome to another episode of the Global Peer Financing Association's Peer Connections podcast series. I'm Brooke Gilman, and I'm the GPFA Secretary. I also work with ESAC Lending. In this conversation, I'll be representing GPFA, though, for this hopefully very interesting conversation with two industry veterans. We have Matt Brunette with us today from Norges Bank Investment Management, as well as Mr. Mark Faulkner from Credit Benchmark. And I guess first, let's just do quick intros for folks that might not be as familiar with the both of you and your roles and organizations. So Matt, would you like to introduce yourself? Yeah. Hi, Matt Burnett, Global Head of Financing for Norgus Bank Investment Management. We are a government-owned pension fund. And for perspective for this conversation, we run an unindemnified lending program. Hello, everybody. Mark Faulkner, pleased to be with you. Thank you, Brooke. Looking forward to the conversation, Matt. I'm a co-founder of Credit Benchmark. And as a longstanding member of the securities financing community, People might also know me from working at the prime broker businesses of Goldman Sachs and Lehman Brothers, or setting up Securities Finance International, or establishing Data Explorers, which still today provide intelligence and data in the securities financing space. Pleasure to be with you. Great. Thank you both. Thank you. And so, Matt, you already alluded to the topic of our conversation today, which is centered around indemnification. It was your idea really to get together in this conversation for a few reasons. And so I thought we could just set the stage in terms of why we're gathering today, why we think it's relevant to share these thoughts with the broader GPFA community and others in the securities financing marketplace. And so, Matt, maybe I could ask you to just position the conversation today, and then maybe Mark will turn it over to you to let us know what your thoughts have been on this, what you've shared in the marketplace more broadly, and where we go next in this conversation. So, Matt, thank you. Yeah, sure. So for folks that don't know, I think Mark took a bold step in, I believe it was June earlier this year, and published a paper that either predicted or prompted some what I think are quite major changes in the industry in the securities lending market. Over to you, Mark, if you can summarize that in a couple of minutes. Thank you. Well, I'm very glad to step into this role as unofficial soothsayer for the securities financing business. I've had lots of roles in that business before, but never this one. So I wrote a paper called Something Better Change in June of 2022, and the sort of subtitle banner was Securities Lending Indemnification is Unsustainable in its Current Form. Something Better Change. And I think the catalyst for this conversation is the fact that I think we are starting to see things changing. I'd like to say and be recognized as predicting the future. I'd like to be interested in being part of the conversation. But I think the basic problem for the agents active in the securities lending marketplace is that not all beneficial owners are as knowledgeable as you may be in your organization, Matt, about the risks inherent in the business. And they become addicted to something that they thought was necessary to be in the business, namely an indemnification. Indemnification is an insurance policy basically protects them against the unlikely event of the borrower they're lending to go bust. And the positively margin collateral that's marked the market every day and held in possibly a third party environment being sufficient to make them whole should that happen. And it's a tail risk. It's not something that in the decades of doing business that most of the agents have ever seen losses associated with. The losses come from cash reinvestment, which is another altogether different conversation. And the big problem has been that for many institutions, they've chosen to get into this business protected by this comfort bracket. That's a sensible thing. Why? Because they don't get charged for it typically. and the agents haven't successfully differentiated an indemnified program from an unindemnified program. And the problem for the agents is that over the years, successive regulatory changes have meant that the regulatory capital cost of providing an indemnity has risen. Its utility hasn't really changed. Its economic benefit hasn't really changed. But the economic capital cost of doing this, providing it by an agent, by a bank, has risen dramatically to the extent that it now dramatically exceeds the profitability of most securities lending transactions other than specials transactions. And that's why I think we've seen the change. That's where I felt the pressure was building and why banks have started to react in a different way. Some in a more explicit, one could call it big bang manner. Another way in a more stealthy repricing, repositioning of their book way of doing it. But something it does seem has changed. So I think, Mark, you made a point in your paper that I thought was interesting, where the main point, I believe, is indemnification has been underpriced by agents or maybe not priced at all, right? But you make the point that if a good is free, that people will consume as much as possible. And my version of that in the securities lending industry is me as a lender, if risk is free, I'll put out my stocks as much as possible at any price. Would you agree with that? I think that quite a lot of the lending of general collateral business and the building of balances to secure some revenue at no meaningful cost to the beneficial owner is what's happened. I think you're right about that. And I think you say that's driven the price down of GC something on average of something like 15 basis points. And you use an example in there that says, okay, you actually put a cost to indemnification, which I think you say is specifically 10.3 basis points. And then you give us the average fee split for large lenders is something in the order of 10% to 15%, which means the agent on that transaction on average makes a bit over a basis point. So check my math here, but are you implying that to make this a break-even proposition for the agent lender that that GC fee needs to be, what, 80 to 100 basis points? I'm suggesting it needs to be materially higher than it is now, that the indemnification and the preciseness came from explicit plagiarization of Glenn Horner's work at State Street on the pricing of indemnification that was name checked in the paper. What I'm suggesting is that the agents get so little for acting as an agent and yet are insuring business at huge regulatory cost to them. So, yeah, for it to be profitable as a standalone transaction, GC business would have to be dramatically repriced. I understand some agents are starting to think and take action to reprice it, but they haven't gone as far as perhaps they need to because it isn't a standalone business. It's a basket of business. It's not just general collateral. There are specials transactions. The problems have been that there have been fewer specials transactions and also combined with the unprofitability of, say, the cash reinvestment world for so many years in recent years has meant that the profitability of being an agent with a preponderance of GC business has just hurt them too much and they've had to react. That's the pressure that I saw building. So everything that you've just stated is very focused on the agents and the profitability of the agents, the impact to the agents, and sort of how they can make their businesses more efficient to still operate in this environment, still provide services to the underlying asset of securities finance. And so what do you think, and maybe, you know, first to you, Matt, you know, maybe you can talk a little bit about your perspective at Norges and how you got to the point of getting comfortable managing the risks in a way where you don't feel indemnification is required for your program. But how do you translate that to other beneficial owners out there that they're coming at it from a different perspective and probably disadvantaged versus your position, at least as of today, in order to get to the same end place? Sure. We can reference a previous podcast to answer a big part of that. But the short version is what can beneficial owners do in the short term? What can they do in the long term? I would predict in the longer term that they would move more towards unidentified programs, but that's a long road. There's a lot of things that need to go into that. from my perspective that you have to have analytics in place. Of course, you need to measure risk in some way. You need a view on risk. You have to have systems in place to actually trade that risk at the end of the day because you own that. You have to trade that collateral. So you need competency and technology to trade that. And of course, you need to anchor it at the end of the day with your board. I think you need to be able to go to your board and say, this is our business proposal for unindemnified lending, we can either, if this counterparty defaults, we either have enough of the right type of collateral to make ourselves whole again, or we're going to make enough revenue stream off of this business to compensate ourselves for expected losses. I think that's where you need to be. I would agree that. And I would also agree, Matt, that there is a journey, a long journey to want to be better. I hate it when people talk about patronizing, they need to be educated because the people that own assets are not uneducated. They are educated. They just don't focus on securities lending, perhaps as much as the securities lending industry would like them to. But I think it's much more likely that in the medium to short term, there might be a price differential between indemnified and unindemnified lending. And that might be explored by agents in conversations with their beneficial owners, rather than the removal of indemnifications, perhaps entirely, there may be indemnifications that take into account the quality of the borrowers that you're dealing with and the quality and the margin of collateral that you receive, that people start to get a better understanding of what's going on. I also think that this is a shot in the arm to peer-to-peer activity where appropriate, and there's good balances there. I think it's also a shot in the to what I could call agency prime brokerage, which seems to be growing in scale. I would also think it would be an opportunity to sort of kick over the statues and start thinking about a model change whereby a custodian and a clearing organization might choose to be a custodian and a clearing organization, where the beneficial owners that understand the value and the utility and have assets that have a material intrinsic value in the securities financing market or as collateral in the collateral market, trade that themselves and report trades to experts in clearing custody and reporting, i.e. custodian banks. And so there will be a variety of different responses. But I think we'll look back at this moment this week, this time when perhaps the cover is broken by one major agent and maybe soon be followed by others at a time much like we would look perhaps at the time when Bob Sloan at Credit Suisse did the CalPERS exclusive. It was the beginning of a different stage of the conversation, a different profile for the industry across the asset management community. And I think it's less predictable what will exactly happen, but I think a variety of horses will run. And I think there'll be, this is a moment that we'll look back and we'll say, this is perhaps when the industry started to address the indemnification issue. Yeah, I totally agree with you on pretty much all those points. From the beneficial owner perspective, my prediction would be that if people start thinking at least about an unindemnified world and start really thinking about what those risks are and how you trade out of that risk in your catastrophic situation, I think they'll probably decide that 15 basis points or 12 basis points or whatever it is, isn't the right price to underwrite billions of dollars in tail risk. They might also decide that, you know what, we've got other things that are more important to us and perhaps we should demur and maybe withdraw our participation in the securities financing business, because not everybody should be, could be, would be a lender. And I think that's something that many of the agents would like to see. In other words, a retrenchment from the volume of individual lenders that there are to those that really have inventory that makes sense and or those that self-qualify for really understanding the complexities of the business. Not everybody is prepared to put their thinking caps on and focus on lending in a way. And if they were to withdraw their portfolios, I'm not sure that that would be harmful to the markets at all. They wouldn't miss much revenue and it would perhaps accrue to those with a more sophisticated approach. It wouldn't be a bad thing. So being the right time of year, I'd like to, if I can, shift this conversation back towards speculation. And I did some back of the envelope stuff using S&P data, benchmark lending data for securities lending. And I apologize if I got this wrong, but I went back to a single snapshot. To back this up a little bit, it's come to our knowledge, the three of us, that a major agent lender decided to take a bold step and reprice their GC lending business. So I looked at what could the potential scale of this be, and I looked back to S&P data, not looking at the whole year, but looking at the 25th of November, which actually isn't that different from averages over the year. And if I just drew a line in the sand, took an arbitrary number of 25 basis points. There's a full 79% of the equity lending balances currently shown on their database, or $960 billion is priced at 25 basis points or less. The remaining $253 billion is priced at a weighted average fee of 276 basis points. So this is a massive, massive pool of liquidity that could potentially be repriced. And so I guess my question is, if we're looking to speculate, if this one agent is large, which they are, will other agents be happy recipients of this GC pool, or will they follow their lead? Challenge accepted. Are you ready to speculate? I'm always ready to speculate. So interesting statistics. And let's just take them as a snapshot. 960 billion at 25 basis points around there. In a year, it will be hardly changed. I do not see this as a ramping up to 35 or beyond for the bulk of the business that's done in the business. I think the general collateral trade will find a level that's roughly that level. I don't think this will be a catalyst for change. I think those balances will allocate and reallocate to unindemnified programs. It will oblige and force the broker dealers that haven't squeezed every pip in their kind of proprietary asset allocation and sort of in their efficiencies. I think it will encourage inter-dealing business of GC collateral. I think it will encourage peer-to-peer activity. I think it will encourage agency prime brokerage. But I would be very surprised, Matt, if we see a material deviation from 25 basis points for that volume of business. It's not quite a Pareto kind of business. It's near as dammit, quite frankly. 80% of the business at 25 basis points on average, 20% of it to 76. I don't think that's going to change. And I think it's going to change because I don't think the agents that are already full of this kind of in business and providing indemnities want it. I think the borrowers will have to go and find other takers for this kind of business. And I don't think that they will expect to pay much more. So you think there's enough creative other outlets to absorb what might be shifting away from at least those that are already taking steps to reprice and change? Unless you've got, if you're an agent and unless if you've got no sort of unindemnified capacity, why on earth would you take this business? I think the borrowers will try and push it back to 25 and resist as they can. And I think there is capacity in the industry to take this and there are enough routes to do so to stabilize. I don't think this is a reason, but I don't think prices will change material, which is a shame. I don't think it's the right thing, but I think that's what will happen. I also think that other predictions I would make, I would suggest that there will be fewer lenders in the business than there are now. Because I think as people start to debate these kinds of things and understand that, yes, a year from now, I think that this will be a beginning of conversations the likes of, hello, beneficial owner, I'm your relationship manager. We've been lending you for a good zillion years and we provide you with indemnity. We've decided we're not going to do that for regulatory capital purpose. It makes no commercial sense for us. And we'd like you to move to either being an unindemnified lender over a period of time or a partially indemnified lender for certain types of counterparty collateral or stop being a lender. what would you like to do? And so you think underlying beneficial owners will exit in the coming year because of this. You're not suggesting agent lenders would exit in the coming year. I'm quite surprised that we haven't seen the consolidation that lots of people have expected for a while in the agency lending business, but I'm not predicting that. I'm predicting that beneficial owners will be encouraged by some of their agents to desist. Right. Their programs will be marginalized enough balances reduced enough revenue reduced enough to such that is it worth it should i continue i don't necessarily want to continue and identify they could shift out yeah i don't think you need to do this by a big bang but it was very brave to do it by a big bang and i think the ramifications that will be fascinating to see unfold over coming weeks and months but i think there are agents out there who've been taking action to reduce the scale of their business, most notably their GC business and repricing it and not suffering. I'll agree with a couple of those things, but I'll take the other side of the pricing bet. So I agree with you that there will be less lenders. So in the short term, until lenders can go down this long path and decide how they want to view and underwrite that risk, I think they'll be forced into probably one of two decisions. Either they have to enter a program with a very high minimum fee that makes it profitable for their agent, or go into a fee split that makes it profitable for the agent. That's probably your decision tree. And can I ask on that, Matt, though, what's the profile of lenders that you think will be forced into those types of decisions? Do you think size and scope of the potential of a program matters in those conversations? No, this is just risk and return. I don't think that matters at all. It's just, can the agent make a return off of the lending that covers their regulatory cost of capital? As Mark's paper says, it's quite simple. It's just not profitable for them. I just want to finish. I agree with you that other agents aren't going to want to take this because who wants unprofitable business? Who wants to underwrite risk and pay for it as well? But on the pricing, I'm going to take the other side of that bet and say pricing has to change because I don't think there is capacity to take these kind of numbers into unindemnified programs. But I will make an even bolder prediction and say that that also needs to be driven by the prime brokerage side. So hedge funds for many years now have been very successful at renegotiating pricing with their prime brokers and prime brokers have pushed that on the agents and agents have taken it and that pricing has come in and that's gone on for years. And I think that hit bottom and will reverse, is my prediction. And I think we're already seeing signs of banks accepting that. And I'm going to make a wild allusion to the largest secured lending market in the world, which is U.S. residential mortgages. 2022 is not the same year as 2021. Throw volatility and liquidity aside, but look at pricing in the secured lending markets for residential housing. So 30-year fixed mortgages versus 30-year treasuries, which is the benchmark in the hedging device, has moved from 1% last year on average to 3% this year. That's massive. That's tripled. I think there's no difference in our industry. We're not price takers at the end of the day, and it's gone too far. And so the prime brokers are facing the same dilemma as the agent lenders, as nobody wants to be first because they don't want to lose market share. But somebody has to be bold. One agent has done it and one prime broker just needs to break the mold as well. I think a couple of points. I'm not saying that the price shouldn't change, but I predict that the borrowers will find a way to arbitrage the lenders for at least another year. And I'd love to come back in a year and see who wins this bet. And we should make it interesting in some way to do with. But I think you're right that it should be possible to change. But I think there may be enough pressure coming from the principals to find ways to alleviate that. I think the other thing is the prime brokers have been living in this capital environment, this capital-sensitive environment for many years. And they've been feeling the heat. And one of the reasons why I think they've been incredibly exasperated by the agents and their inability to help them with agency lending disclosure, smart bucketing, RWA, and all kinds of things like that is because they were really feeling capital pressure. So they do understand why the agents are starting to feel the heat like this. And I don't think they would be disingenuous if they didn't say that they didn't understand. I also think that your secured mortgage comment, very well taken. But I think what that points to is, ironically, the get out for GC businesses that are not profitable at low levels of cash reinvestment profitability. If there is a yield curve you can lay into and you can make money on the cash management side of securities lending, the cash reinvestment side, it's much less problematic for you to lose money on indemnification. And I think that's where the market might move. Rising interest rates gives them opportunity to make money off big balances where hitherto they may be suffering indemnification losses. The difficulty in the bet will be whether we talk about the implied fee or the real fee and the allocation of the revenue from securities lending and cash reinvestment. My sense is that securities lending will be more profitable for all next year, but that the proportion of revenue that will come that will be most incremental will be from the cash reinvestment linked to the money market rates that you've identified in the security and mortgage market. Yeah, we'll have to specify this bet in detail. Yeah, I'm taking notes. I've drafted a contract over on the side that we'll be reviewing. You see what I'm getting at, Matt. I agree that there will be more revenue in securities lending next week because in a rising interest rate environment, therefore cash reinvestment opportunities might persuade agents against their better judgment with their indemnification hats on to take this business because they think they can make more in the cash side of the trade. Point taken. And it gets to be a gray area when you talk about GC and you mix in cash in there, because are lenders lending in equity or are they borrowing cash? It's two different things. Right. Yes, but not every lender knows that. And they're indemnified for the easy bit, lending equities, but typically unindemnified for the more challenging bit. Well, there's a lot to talk about here, but I think in the interest of keeping our listeners wanting more, we probably should look to wrap up. But I do think getting the both of you back on at some future date, I don't know if we do it 12 months from now and go back to this contract that we're going to pen here in a moment, or whether we do an interim update just on how things are going. But I think it's a conversation definitely worth continuing. there's probably a lot of other market participants too that would have a lot to say on this topic clearly especially those that are being directly impacted I think hearing from both of the other beneficial owners on this other agents in the market the borrowing counterpart side as well there's a lot more to come and I know actually Matt will just preview the panel that you're participating on I'm actually going to join you as well for it but there is a panel on indemnification at the upcoming information management network conference at the end of January or towards the end of January in the U.S. and New Orleans that I think will be a month further on in sort of the time horizon. Maybe there'll be a little bit more directional wind to assess at that point. And maybe we can see if your predictions evolve or if you're sort of have any other information or data points that are informative between now and then as well. A lot to come here and well done, Mark, and positioning all of this for the market before it was something to really talk about. Thank you. Well, thank you for hosting the conversation. I hope it was informative for the listener. Indeed. Thanks for having me back again. Absolutely. And we'll bring you back on again in the future. And for our listeners, the paper that was referenced at the outset that Mark penned called Something Better Change that will be available. We'll put that link in our show notes and also other places where we promote this podcast. So if you do have more questions about the conversation that you just listened to, definitely we'd highly recommend reading that paper. There are a few pages to it, but it's very educational. It gives a good background, both on this topic, where it all stemmed from, the regulatory changes that led to this, and some of the historical perspective on indemnification. So it's definitely a helpful resource if you haven't already read it. And if you do have other thoughts or want to get involved in further follow-on conversations, please reach out to GPFA. You can reach out to GPFA either via the website or info at globalpeerfinancingassociation.org. And I know the group would welcome more input from the securities financing community. So with that, Matt, Mark, thank you both. I know you both are snowbound in your locations and we're here close to a weekend and close to the end of December. So I wish you the very best for the holiday period and hopefully staying warm and having fun in the snow at the same time thank you thank you very much thank you very much thank you all thanks for listening to another episode of peer connections by gpfa we hope you found the information shared in this podcast interesting and beneficial and as always please feel free to reach out to gpfa with ideas or interests for future episodes and if you liked what you heard today don't forget to subscribe wherever you get your podcasts now for the disclaimer the opinions expressed in this podcast are those of the presenters and do not necessarily reflect the views, or opinions of their respective employer organizations. This material is for your private information and does not constitute legal, tax, or investment advice. There's no representation or warranty as to the current accuracy of nor liability for decisions based on this information.