Continued from page 25tionally, from the supply side, demand is generated by the need to generate incremental income on portfolios, and increase portfolio liquidity by generating cash."
Another custodian adds: "As more markets open to cross-border investment, and as these markets stabilize and provide adequate liquidity, securities lending opportunities continue to grow. Securities lending is part of the securities activity that facilitates foreign investment vis-a-vis the inherent risks in worldwide investment/portfolio risk diversification."
Said Terry Toth, senior vice president-securities lending at Northern Trust: "Securities lending is a dynamic business, and the characteristics of the financial marketplace - including random volatility, the desire for high-volume, high-speed operations and the need for liquidity - will continue to support securities lending."
An important issue, said another custodian, is that "legal and tax barriers that have impeded borrowing in certain markets are being reformed. In line with Group of Thirty recommendations, regulators around the world are recognizing that securities lending improves market liquidity."
Most custodians reported an impressive growth in business. Said one: "International securities lending has grown at an average annual rate of 57% since 1990; international lending volume, with an annual increase at the 50% for last year."
Custodians must anticipate the demand for services, especially with new business - requiring significant lead times - in the emerging markets. As one custodian commented: "When markets begin to demonstrate consistent demand for securities lending, a tax, legal and regulatory review is performed to determine the viability of a lending program. Evidence of significant growth in international securities lending is expected in five countries, namely Austria, Finland, Norway, New Zealand and Thailand."
Returns for the investor
Most custodians were shy about disclosing returns an investor may expect from securities lending arrangements. All were inclined to provide individual quote estimates based on the lending characteristics of a portfolio and the amount of risk viewed as acceptable by the investor.
A sample comment: "Returns depend to a very large degree on the asset allocation of the lending portfolio. In general, the most attractive lending portfolios hold positions of at least 25,000 shares for equities and $5 million par value for fixed income, and have overall assets of at least $1 billion. The distribution among countries is important as well as the individual securities held. For U.S. domestic programs, U.S. Treasuries and small-capitalization equities are highly attractive for lending. For international equity lending programs, EAFE-type portfolios as well as certain emerging market issues are generally good lending candidates. For international fixed-income programs, Italian and Spanish bonds are currently in demand."
One custodian provides a fair industry benchmark: "As a general statement of non-U.S. lending, in our experience, most portfolios will typically return gross spreads in excess of 100 basis points (annualized) for a reasonably diverse portfolio."
Another custodian said: "Spreads vary by individual security and current demand."
A table was supplied by another custodian that listed average spreads in a tight range of 30 to 45 basis points for fixed income and 95 to 110 basis points for equities with some emerging markets yielding more than 200 basis points.
A modest estimate was provided by another custodian: "Investor returns vary according to the market and type of instrument loaned. In general, however, portfolio returns can be enhanced by 20 basis points of more."
"Investors' returns completely depend upon the composition of the portfolio. Typically there are higher spreads in emerging markets, although there is significantly lower volume than in mature markets.
"Therefore, an investor may earn 200 to 300 basis points in an emerging market but probably only has 10% of the lendable amount outstanding on loan. In European markets such as Germany, an investor may be able to lend up to 50% of his portfolio during peak dividend times, but the spreads may only be 50 to 100 basis points."
"Securities lending commissions vary considerably between securities' domicile and the actual issue. It would be impossible to give any indicative quotes as to the amount of commission which could be earned from a particular portfolio without having a full breakdown of assets held," said another custodian.
One custodian said a "lending client receives between 60% to 40% of negotiated securities lending fees. This variation in client share reflects individual differences in indemnification and contract arrangements. In all cases, the custodian absorbs the costs of operating the securities lending program.
"On average, an investor client can expect to earn about two basis points to 10 basis points on securities, depending on the market. These figures reflect the rate earned on the outstanding balances averaged 'across the entire portfolio.' Moreover, the actual returns can vary markedly, depending on the actual composition of a client's particular portfolio and market conditions."
Securities lending guarantees
Most custodians do not guarantee returns from a securities lending program, and with good reason.
"Securities lending revenue is based on a number of factors beyond our control, such as portfolio composition, borrower demand and the short-term interest rate environment. Therefore, it is inappropriate to guarantee portfolio income," said one custodian.
Most global custodians agree the business is too volatile - with interest rates, changing regulations, maturing markets and other factors - to consider an income guarantee.
However, three custodians had a differing view.
One said: "We are able to offer a guaranteed return in securities lending negotiated on an individual basis by client."
A second said: "We may be willing to discuss guarantees of annual lending income or performance based fee schedules following a review of a portfolio's specific holdings."
And a third claimed: "(W)e might guarantee that lending revenue will cover custody fees."
Foreign securities prices
The securities pricing nuances in the emerging markets continue to be problematic for both the custodian and the investor wishing to value an international portfolio in a timely and accurate manner.
Custodians satisfy the growing demand for additional price information by working with vendors and various local sources familiar with the market.
The enormity of the task is illustrated by another custodian: "Clients can designate their own sources. We maintain a real-time, in-house pricing system that receives 280,000 unique securities quotes daily from 130 exchanges worldwide. In addition, the following external services are utilized as principal sources: Telekurs, Bridge Data, Reuters, IDC, Morgan Stanley, Bloomberg, Merrill Lynch, Kenny-S&P, Extel, FRI Corp. and Muller. Other pricing sources include Standard & Poor's, NYSE, AMEX, NASDAQ and financial journals. Pricing is done daily, weekly or monthly based on client requirements. All prices are tolerance tested."
Specific problems mentioned included:
African markets. All African securities types were mentioned by one custodian as problematic. Generally, the market has limited vendor or exchange coverage and no accepted security identifiers. This custodian manually priced securities based on phone calls to brokers, traders and underwriters, or if available, downloaded prices available from Reuters contributor pages.
European shares. New ordinary and coupon shares received from corporate actions are difficult to value where the market price supply is very thin and unreliable. A methodology to estimate a value for the shares was instituted by one custodian; the price of the ordinary shares and the latest dividend amount or call amount are used.
South Korea. "Foreign investment limits imposed on equity shares has created a separate 'foreign registered' market where all trading is done on an OTC basis. Pricing data for this market cannot be obtained from either vendors or brokers, but we have recently introduced a sophisticated internal 'price estimate' system for foreign registered Korean shares, where broker estimates of premiums applicable to these shares are used to produce estimates on a daily basis," said another respondent.
Another custodian mentions foreign board-traded equities. "Pricing is often inaccurate as vendors do not take into account the price premium applied to foreign shares over the price of local shares." To correct the problem, this custodian sends daily, weekly and month-end faxes from its agent bank or local broker/dealers in these markets detailing premiums. The correct price is manually input for each security.
India. The main exchange - Bombay - is the only exchange supported by most data vendors. Pricing is very infrequent and prices for any stock trading on any of the other Indian exchanges are very difficult to get at all.
Latin America. Feeds from vendors were said to be late or missing for all securities types. Custodians in general work around the problem by downloading prices available from Reuters contributor pages.
Mexico. "Many of the Mexican securities - such as tesobonos - are difficult to price if set up incorrectly; they should be set-up with a uniform unit of quotation, par value, etc. Normally, too many are issued to fax out regularly for prices and set-up changes," said one respondent.
Another custodian agrees: "Government fixed income (cetes, bondes, tesobonos) are problematic because of the lack of vendor or exchange coverage. We either download prices available from Reuters contributor pages or mark to model."
Thailand/Indonesia. As with Korea, foreign investment limits create a separate market, although price information for Thai foreign registered stocks is available from vendors. Prices can become out of date, for example, if no trades are effected for a period of time. "An internal system is used to manufacture estimates in cases where conditions deem it sensible to do so," said a custodian.
Additional pricing deficiencies
"Any truly emerging market can present pricing difficulties until data vendors establish a reliable and regular supply of data," said Bankers' Mr. Dwyer. "In certain cases, we will bypass existing vendors to try to set up price supplies with brokers based in or specializing in the area concerned.
"Prices in emerging markets are problematic at times, requiring manual intervention," said another custodian, echoing others' comments. For example, it is difficult to price fixed income (e.g., Brady bonds) in Brazil, Chile and Argentina. To overcome that difficulty, the custodian uses the Reuters' contributor pages service to secure prices daily in these markets.
For the same security types, Singapore and Thailand have two different pricing structures: alien and local pricing. When prices differ, a problem occurs. In addition, in the alien market (into which many clients fall), some securities are not traded for up to a year. In cases when alien and local market prices differ, and more frequent pricing is needed, many custodians work with their agents to establish and secure the best prices for its clients.
Pricing difficulties do exist in some of the established markets as well. For example, in Germany, two sets of prices are published -the market close price and the kassa (midday) price. When kassa prices are used, closing prices are obtained manually.
Prices of fixed-income issues in Sweden are provided every Friday only. Because some clients require more frequent pricing, one custodian manually goes into Telekurs or Reuters to secure prices, instead of relying on the vendor to provide the pricing.
Pricing of issues in Australia and New Zealand may require manual intervention as well. In some instances, dirty prices (prices with accruals) are quoted; in others, clean prices (without accruals) are quoted. Dirty prices require manual intervention by the custodian.
One custodian listed examples of securities that are difficult to price accurately: Canadian government bonds; Ontario Hydro coupons, bonds and strips; Ontario provincial bonds, strips; Venezuela government bonds; Brazil government bonds; and Mexican cetes, tesobonos and adjustabonds.
"In all currencies, many derivative and structured asset products are difficult to accurately price," said Kevin Griggs, director, Investors Bank and Trust.
"Most derivative product prices are provided by popular services provided by either Bloomberg or Reuters. For prices that are not supplied by these vendors, Investors Bank will contact the client or the investment manager for a price source," he said.
"The most difficult prices to obtain in the major markets are mortgage-backed securities, guaranteed investment contracts and OTC currency options. In addition, emerging market securities are difficult to price accurately on a daily basis. Our subcustodian network is extremely helpful in pricing these assets, especially in South America," a respondent said.
"Derivatives pose special challenges for custodians," said Mary Taylor, vice president-sales and client relations, global securities services, Royal Trust, Toronto. "Royal Trust relies on a variety of electronic sources to price listed derivatives. However, unlisted or over-the-counter derivatives are less straightforward. Prices provided by the issuing dealer and investment manager are compared. As an auxiliary service, Royal Trust provides third-party price verification of unlisted or over-the-counter derivative instruments using reputable, proven systems," she said.
A proprietary system developed for Royal Bank of Canada Group values structured notes and OTC options. The majority of our clients are currently using 'vanilla' derivatives, which simplifies the verification process. As client requirements change, so will our service."
More information demanded
A custodian captures the essence of the insatiable drive for more information: "As investors seek higher returns, they often turn to immature markets and new products. Our clients' investment strategies are in many cases ahead of vendors' price feeds, requiring that we manually price more securities."
Another custodian said: "As client investments expand into new markets, we need to provide them with all the custody services they require in those countries. Pricing is one of the required components. Therefore, we will not 'open' a subcustodian arrangement in a new market unless we have a dependable, timely pricing service. We require daily prices on all securities held in a particular market."
Said Bankers' Mr. Dwyer: "Due to client requirements, we have further expanded our pricing system. In addition, clients are requiring more frequent valuation of securities in all markets as well as expanding their use of derivative products in the international market to hedge against risk."
Cash management is an important service for investors to effectively use funds for emerging markets settlement practices and the frequent requirement for a foreign exchange transaction. Our survey found most custodians are offering a wide array of cash management services. One of the more popular offerings is interest bearing accounts, offered in most foreign currencies, and in some case with no minimum balance requirements.
Most custodians offer other cash management alternatives, including call accounts, time deposits, money market funds, short-term investment funds, derivatives and short-term debt.
Generally, the offerings are available in a large number of foreign currencies, with varied parameters such as interest rates, investment cutoff times, minimum balance policy, and allowable currency pairs.
The global custodians are well in tune with the need for new cash management offerings. The competitive nature of these offerings promises to be an advantage to global investors wanting to capture returns on idle foreign currency balances. A sampling of developments under way by the custodians follows.
A multicurrency STIF for investment of clients' available currency cash balances will be offered by one custodian; specifics will be announced sometime during the fourth quarter of 1995.
A second custodian is developing a similar offering for funds denominated in British pounds, deutsche marks and yen, to be available by year end. Additional currency balances are planned.
The World Wide Web
The general business community appears to be embarking on the exploration of a new technology - the Internet. The Internet is a vast array of computers networked worldwide for use by any individual or business. The technology and investment cost for entry are relatively low-hurdle barriers for most companies.
In the financial services industry, several major players are exploring the new area. And the technology would appear to be a natural for global custodians, who have a worldwide following of savvy international investors.
The results were surprising.
Initially, the survey plans called for participation from the major players through the use of the World Wide Web. The Web was used to distribute the survey questionnaire and announcements and to publish survey results. But only two custodians - of an original 18 - had an Internet e-mail address. Why wasn't the Internet more widely used in an industry that appeared to have the perfect application - global securities business? The following section presents the result of a two-page supplemental questionnaire.
(The Internet did provide a benefit in the case of two custodians. One custodian received the P&I questionnaire via the Internet. The second returned the completed questionnaire via the Internet, and in the process gained a few days to put the finishing touches on the submitted questionnaire.)
The first order of business was to determine Internet usage for current global custody business. The survey sample was 15 custodians; 10 completed the questionnaire, and five had no interest.
Only three are using the Internet for the global custody business, primarily for administrative messages and advertising. Reasons given for not using it ranged from business priorities to no time allocated for research to security concerns.
Of the three using it, one custodian is using the Net for client surveys. Another engineered its proprietary client workstation with the communication prowess of the Net to accommodate various elements of trade processing.
Of the areas custodians expect to develop on the Net in the next 12 months, the most popular were advertising, administrative messages and client surveys.
Various additional uses of the Net were mentioned - job postings, client inquiries, client advice/information, market data, market intelligence and educational articles.
Internal users of the Net are operations, relationship management, research, systems support personnel, analysts, marketing, sales and executive management.
External users include clients, treasurers, clients-custodians, custodians-agents, broker-custodians, consultants, government officials, domestic and offshore fund mangers, broker/dealers, insurance companies and banks.
The most frequently mentioned issue limiting expanded use of the Net was security.
Most survey participants indicated the need for improvements in security and restricting access to information. One custodian who uses the Net stated: "Until the security level of the Internet meets the stringent securities processing industry's requirements, we will not use the Internet WWW to support the communication of securities settlement activities."
Beyond the business considerations for using the Net, a series of questions was asked regarding its technical components. An in-house proprietary Web site is now used by only two custodians. By next year, two additional custodians will have their own Web sites; two others are considering it.
Although the Net is not widely used for the business of global custody, it is being used on a very limited basis - typically, internal to most companies. The most popular Internet technology now used is e-mail and bulletin board-type message groups. Planned for the next 12 months are additional e-mail use, file transfer protocol, Web browsers and gophers. Internet relay chats were given a strong "maybe" classification by the sample - outside the 12-month planning horizon.
Results of the P&I/Buttonwood global custody survey are available on the Internet on a Website, http: www.ios.com/bwgroup.
For U.S. clients43,200
The bank network covers 42 countries, of which 1 is a proprietary subcustodian.
For U.S. clients2,400
Bank network covers 62 countries, of which 21 are proprietary subcustodians.
Lloyds Bank Securities
For U.S. clientsn/a
The bank network covers 64 countries, of which 3 are proprietary subcustodians.
Total custody assets242,300
For U.S. clients*187,200
The bank network covers 62 countries, of which 2 are proprietary subcustodians.
Custody assets of North American clients
For U.S. clients8,000
The bank network covers 65 countries, of which 26 are proprietary subcustodians.
Royal Bank of Scotland
For U.S. clientsn/a
The bank network covers 61 countries, of which 1 is a proprietary subcustodian. ====================================================================
Investors Bank and Trust
For U.S. clients74,641
The bank network covers 60 countries, of which 1 is a proprietary subcustodian.
For U.S. clients67,000
The bank network covers 61 countries; there are no proprietary subcustodians.
Bank of Bermuda