Cutting Out The Custodian Bank

What if a fund manager could eliminate the custodian bank when it lends securities to a broker overnight?

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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.

Swimming against conventional wisdom wasn't easy for eSecLending. The firm took a big chance when it split off from its asset management company United Asset Management in 2000.

"When we tried to implement a securities lending program for our own funds we discovered there was little information on just how well existing banks were performing," recalled Jaynes, who previously served as senior vice president at UAM Trust Company before launching eSecLending.

ESec Lending also ended up with a little bit of luck. Old Mutual, a London and Johannesburg insurance and asset management firm who purchased UAM in 2000 provided an undisclosed amount of seed money. CalPERS, the largest pension plan in the U.S., also agreed to become its first external client that same year.

In 2006, private equity firm TA Associates bought the company from Old Mutual. By that point, eSecLending had already passed $200 billion in lendable assets and would pass the $400 billion mark the following year. As of today, it has auctioned more than $2 trillion of assets for 20 institutional investor clients. In addition to CalPERS, they include OhioPERS, SEI Investments and Schroders Investment Management.

"They have been very successful at proving that the auction process is sustainable," says Josh Galper, managing principal at Finadium, a Concord, Mass., firm which tracks securities lending.

Why? Beneficial owners, or lenders, have become are more comfortable with using third-party securities lending agents other than their custodian banks. Instead of viewing securities lending as a byproduct of custody services, asset holders believe it is an investment management and trading function.

Lendable assets are typically divided into two categories: general collateral ones are the most liquid and cheapest to borrow. Specials are far less liquid so they attract a higher price tag when lending. Custodian banks primarily operate a pooled program in which clients with the most attractive supply of assets – the specials– often subsidize the returns of clients with less attractive lendable assets or the general collateral ones.

"There is a practice inherent in traditional pooled programs whereby in order for a borrower to receive special securities it must commit to borrowing a certain amount in general collateral or less attractive securities," Jaynes said. "This reduces the returns on specials as borrowers are not always able to offer their best price when required on a quid-pro-quo to also accept assets for which they have little or no demand."

Just how much better is eSec Lending's auction-based model? Jaynes said that it typically outperforms traditional pooled approaches used by custodian banks. The improvement varies depending on the assets involved and the parameters of the securities lending program but eSecLending's said its clients can see returns increase by 30 percent to 50 percent.

ESecLending's clients don't rely solely on its auction based system to lend out exclusive securities. The firm also offers "discretionary lending," in which it actively trades the assets on a daily, best-efforts basis. Some of ESecLending's clients also rely on their custodian banks and ESecLending also relies on firms such as SunGard, Pirum and EquiLend to reconcile the books and records between the borrowers and the lending agents.

How is a plan sponsor to decide which venue to use when lending out its assets? "It all depends on the type of securities and its objectives – whether or not it wants borrowers to have exclusive rights to a pool of its assets as it would through an auction-based process," said Galper. "As a rule of thumb, auction-based platforms are more profitable for lending special securities than general collateral securities and lenders can still get multiple borrowers across pools of assets."