The death of sec lending in prime brokerages?

Dec 7th, 2009 |

The world is full of middle-men: Walk into a car dealership to purchase a car and you go through a salesperson, who takes a cut for showing you the car; walk through a house or apartment and the real estate broker takes a cut for opening the doors and closets.

Like it or not, and as counter-intuitive as it sometimes may be, it is the way transactions work.

So it’s been with the securities, or “sec” lenders: institutions that have access to “lendable” securities. Asset managers who have securities under management, custodian banks holding securities for third parties or third party lenders who access securities automatically via the asset holder’s custodian have for years taken a nice slice of the pie to lend back out stocks to others who need them.

In its most basic form, sec lending is where a loan results in a transfer of title/ownership to the borrower, who is obligated to return the same type and amount of securities. The loaned securities are collateralized, typically 102-105%, reducing the lender’s credit exposure to the borrower (as illustrated in the chart below provided to AllAboutAlpha.com by automated securities lending and borrowing marketplace Automated Equity Finance Markets (AQS) – click to enlarge).

When the banking and financial systems were functioning normally, all of this was considered par for the course. Indeed, for long/short and short-only hedge funds in particular, the ability to go to their prime broker for their sec lending needs was a value-added proposition not even questioned.

At least until Bear Stearns blew up, Lehman Brothers was allowed to go bankrupt and all H-E-double-hockey-sticks broke loose, bringing into question for the first time the notion of whether too big to fail – and too big not to be concerned with the physical securities your prime broker was lending back out to someone else at a profit – were going to get taken away from you.

It was this kind of talk that dominated the Securities Lending Debate produced by consulting firm Finadium and Markets Media and held in New York last week as part of Markets Media’s Global Markets Summit.

Among the many key points of debate: the use of multiple primes, the need for speed, liquidity and premium pricing in the form of new, accessible platforms, the notion of “bundled” services for hedge funds and the concept of “central” borrowing – literally going back to the old five-day settlement cycle, where all securities going through a central clearing house get settled within a specific period. Also of note, sec lending spreads are still at historically wide standards, meaning there is still profit to be made in lending out securities (as the data below collected by Finadium shows):

But by far the most contentious point of debate were projected changes in prime brokerage – in the sec lending food chain, that is – and what will inevitably mean fundamental changes in the prime brokerage business model.

“I think it’s going to be a significant trend for 2010,” noted Josh Galper, Finadium’s managing principal, who opened up the forum at the Waldorf Astoria hotel last week and hosted the event. “I can see at this time the development of two separate markets: hedge funds borrowing securities lending from prime brokers versus hedge funds engaging in borrowing from electronic markets and other non-prime broker dominated venues.”

Galper said that driving the anticipated trend will be hedge funds who want to go to lenders directly, rather than finagle with their prime brokers. Also driving the trend will inevitably be regulatory oversight of both sec lending and short selling, with the SEC and others recasting rules concerning leverage, margin requirements and how over-the-counter derivatives and other instruments are viewed and regulated.

Of course, speculating on how the sec lending and prime brokerage businesses pan out over the next few years is all about what part of the industry you reside in. For their part, the prime brokers aren’t going to walk away from something that provides both value-added and makes them additional money. At the same time, non-prime broker service providers, in particular custodians and others who are either getting into or expanding their sec lending game, aren’t about to throw away an opportunity either.

There are also new ways to skin cats, so to speak — ways of doing the long/short game that so far only third parties and less-known markets can accommodate.

One thing is for sure: the Lehman debacle – in particular the Lehman UK debacle – has made the entire alternatives industry re-think how it looks at sec lending, and how best orchestrate it safely, securely and cost-efficiently.

The prime brokers that offer it up as value-added service at competitive rates likely won’t have much to worry about. The only thing they’ll need to get used to is some additional competition.