Jeff Kearny, a principal with Mercer’s Sentinel Group (the investment operations consulting team within Mercer), agrees. “A lot of lending has gone on historically without anyone giving much thought to it,” he says. Kearny says some boards have opted to withdraw and educate themselves about lending before re-engaging in the practice. “A number of these institutions are in the public space and certainly don’t want to be seen to be supporting the short side of the market,” says Smit. While there haven’t been many cases of Canadian plan sponsors withdrawing from securities lending, they are approaching the practice with more caution and asking more pointed questions of their custodians.
Kearny says, however, that lending promotes efficiency and liquidity in financial markets, and will continue. Smit agrees, adding that additional regulation in the form of increased requirements around disclosure and reporting is likely. “But we certainly don’t think securities lending is going to disappear, by any stretch of the imagination.”
Custodians will also need to review the sub-custodians and counterparties they’re using, says Sharma. “Look at Citigroup, where they’re selling their trust business in Japan. Who would have thought a year ago that you’d be talking about Citibank in terms of, Are they going to survive or not?” she adds. Sharma notes that these counterparties are reviewed on an annual basis, but she believes there’s going to be increased pressure to review these relationships more often and more closely. Placido says that RBC Dexia has been monitoring its counterparties and collateral levels more frequently than in the past. “We have very stringent rules in terms of the companies we do business with, the counterparties we’re reviewing,” he says. Still, with the average global custodian offering sub-custody services in roughly 80 to 107 markets, says Sharma, that is a lot of counterparties to submit to a thorough review, adding more pressure to the monitoring of sub-agents.
There’s also some confusion around short-selling and securities lending practices. “[The] general consensus is that the overwhelming amount of lending that goes on is for settlement coverage, market making, financing or arbitrage strategies,” says Kearny. “Securities lending does not necessarily equal shorting.” Furthermore, Kearny and others are quick to point out that historically, and as academic research has uncovered, shortselling serves a valuable function in the market. “It helps ensure liquidity and can avoid price bubbles,” says Kearny. “If you have a situation where securities become grossly overvalued and there’s no function or ability to short that security, how do you bring the market back into equilibrium? It’s very difficult to do.”
While securities lending has received some bad press lately, MacMillan sees the current scrutiny of the market as a positive. “It’s perfectly reasonable that people are looking at it to identify the risk,” he says. “Is their agent any good? Did the agent have problems with Lehman Brothers?” For MacMillan, securities lending is a conservative activity. “I think most people are going to say [they’re] satisfied with it. We’re seeing that already.” Both CIBC Mellon and State Street say they have had minimal movement from their securities lending programs.
As for market conditions, whatever the impact will be down the road, Baillie believes that the more efficient custodians are going to be well positioned going forward. “Historically, settling trades, the whole back-office notion of processing, was the focus,” he says. “While this is still very important, the business has become all about operating efficiently and adding as much value as we can through technology to help clients interpret their data.”
Yet custodians can’t forget about the bottom line. “We have to manage our business well [and] control expenses, just like every business,” says Baillie. “Clients want good value for money, but they also want their custodian to make money.” And, most important, to feel confident that their assets are secure.
Brooke Smith is associate editor of Benefits Canada.
brooke.smith@rci.rogers.com
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