The securities lending market is attracting closer scrutiny from its users, given the vast number of hedge funds now requiring to borrow stock to be used in shorting transactions. Earlier this year, institutional trading firm Electronic Trading Group filed a lawsuit against many of Wall Street’s securities lending businesses and individuals, accusing them of setting excessive fees and controlling the securities lending industry.
Law firm Entwistle and Cappucci, which is handling Electronic Trading’s action, did not return calls to confirm the status of the case, but some industry sources suggest that discussions with the defendants are under way. However, the case has highlighted what many hedge funds have been bemoaning for years: a lack of transparency in the pricing of lending fees, and the power that the prime brokers have obtained in the industry. According to recent research by Vodia Group, prime brokers set the rates that 95% of hedge funds accept. “The remaining 5% may be able to step outside of the prime brokers but they remain an exception,” says Josh Galper, managing principal at Vodia. According to his firm’s research, securities lending and financing generates about $10 billion in fees annually for Wall Street.
Prime inventory
Prime brokers are in a naturally optimal position to act as intermediary for lending stock, and borrowing on the behalf of hedge funds. “Primes get inventory from three main sources: from custodians (on behalf of their pension plan and mutual fund clients), from retail broker-dealers (on behalf of their retail account holders), and from their own hedge fund clients’ long positions,” says Galper.
By dominating access to inventory, prime brokers have the most control over setting the price of borrowing stock to meet the demand in the market. But how the level of such fees is set is extremely opaque. “In just about any market, you’ll find a Bloomberg screen of prices and rates. But when it comes to borrowing stock, you’re in the dark,” says a hedge fund manager. Prime brokers and custodians themselves do have central markets for securities lending activity, but what gets lent to hedge funds is always priced at a mark-up to that central price. “The central price may also go through multiple levels of mark-ups as it passes through layers of middlemen to get to the final borrower, the hedge fund,” says Galper. Since the business has been built up on a relationship-led basis, fees also vary according to the specific identity and characteristics of the hedge fund client. “The rates that a hedge fund receives are based on who that fund is, its assets under management and its value to its prime broker,” says Galper. “A fund with a notional short book of $100 million will always receive better rates and better service than a fund with a notional short book of $10 million.”
He continues: “A general collateral stock may be available to a large fund at a rate of Fed funds minus 20 basis points. However, a smaller fund would receive a rate of Fed funds minus 45 basis points. For hard to borrows, a large fund may pay a negative rate but a small fund might not be able to get the stock at all.”
Brian Traquair, president of securities lending software and service provider SunGard Loanet, says that pricing is being set fairly. “The securities lending industry is an OTC market and fees are decided on factors such as creditworthiness, ease of locate, terms, whether the stock is callable, for example. It’s much more complicated than it might appear, so people may presume that Wall Street is deciding the prices. There are initiatives to have transparency – we have order routing, for example, where borrowers can specify ‘this is what I’m prepared to pay’ and either they will find a match or not.
“My view is that most of what we call general collateral business is pretty straightforward, but when you get off that road into the country of hard-to-get-hold-of stocks, you have to negotiate a price – less information is available.”
Nothing illegal
Bear Stearns, Goldman Sachs and Morgan Stanley, the big-three prime brokers on Wall Street, either did not return calls or declined to be interviewed about their securities lending businesses. But one analyst with a different financial institution argues the case of the prime brokers. “It is a supply and demand industry,” he says. “No one is forcing hedge funds to use them. If they are making sure they are getting the inventory that their hedge fund clients need, then one can argue that they are acting in the best interests of their clients. Nothing illegal is going on.” He adds: “Even in the case that they are cornering the market and buying up stock they think will be hard to borrow, and therefore essentially making that stock illiquid and driving up hard-to-locate prices, are they not just doing so to fulfil the future needs of their hedge fund clients that will need that stock?”
It is a fair point, and one that Galper wholly agrees with. “The notion that securities lending desk are taking unfair advantage in marking up rates is itself typically unfair. Like any market, securities lending desks can only charge their clients what their clients will pay. No fund has ever been forced to short a security in their portfolio.
“In the case of securities lending, it is the hedge fund’s responsibility to know what appropriate rates are for their positions and either ask for those rates or change providers.”
Indeed, lack of sympathy with the hedge funds is understandable. It’s rather ironic that hedge funds are bemoaning the charging of what some might consider unreasonably high fees for an opaque product. Nonetheless, prime brokers should take cognisance of the fact that their money-spinning hedge fund clients are beginning to look beyond Wall Street for stock-borrowing services. One hedge fund manager says his firm prefers to go directly to custodians and other managers. And independent intermediaries offering transparent pricing are beginning to emerge as competitors to prime brokers.
One such intermediary is Quadriserv. It set up a broker/dealer arm in early 2004 to provide a fully transparent automated market for securities lending transactions. Quadriserv today borrows on the behalf of a range of hedge fund managers with as little as $400 million under management to some of the largest funds, from an inventory of other managers with long-only positions, broker/dealers and beneficial asset owners, which could include pension funds, endowments, mutual funds or others.
“We set it up because we believe in efficient markets, and securities lending is one of the least, if the not the least, efficient industries left on Wall Street,” says Greg DePetris, co-founder and chief strategic officer of Quadriserv.
“It resonates with public investors. On the lender side, it is naturally difficult to gauge performance when two intermediaries are involved and only one side of the transaction is known to the market. Fiduciaries are hard pressed to demonstrate best execution,” he adds. “On the other side, hedge funds have historically been constrained in their ability to lend long assets or borrow securities from someone other than their prime broker, and especially another hedge fund, so there was a natural opportunity there.”
Equality of treatment
Essentially Quadriserv acts as an exchange. “We publish every transaction anonymously with the rate it was loaned at and the quantity of shares that were loaned. We disclose this information to the borrower and the lender with indifference to their size so that everyone is treated equally,” says DePetris. Quadriserv’s facility also ensures that lenders are in effect paying significantly less on the cash that they borrow and receiving substantially more on the rebates they earn from short sales.
Since its launch in 2004, Quadriserv has enjoyed double-digit growth each month, indicating its popularity. Funded originally by Bessemer Ventures, Quadriserv is in the midst of a second round of capital-raising to allow it to grow further.
DePetris says: “Universally, markets have become more efficient. Securities lending hasn’t, but eventually it will, and our business model reflects a view of that evolution. History will show us, though, that current market participants will all continue to play a vital and constructive role in the market. We simply believe that those roles will evolve over time, and I think the question we’ve all been asking one another is ‘when’?”
