Not too long ago in securities lending, the operational expertise of the lending agent was the primary value added. It is now understood that operational expertise is simply a prerequisite skill.
Today, the sources of value added are: a) reduced search costs of finding the borrower with the greatest demand for a security; and b) enhanced valued from investing the collateral received subject to a well-defined risk constraint.
Everyone these days seems to have an opinion, and for good reason, about what securities lending is supposed to be. Some plans have incurred losses from their securities lending agent's activities. Others have come close, only to have their agent step in to make them whole for losses they otherwise would have incurred.
As an increasing number of plan sponsors investigate the likelihood of suffering similar fates, one observation is made repeatedly - securities lending is an investment management activity because of the critical value-added service of investing cash collateral. This investment management analogy extends well beyond the actual management of cash to the fundamental principles of agency, i.e., client and agent relationships, underlying investment management.
In my experience, securities lending clients clearly understand their objectives when participating in securities lending. They believe their plans benefit from securities lending because it extracts the scarcity value of the securities held in their portfolios. They also are quite clear about their risk tolerance. With some limited exceptions, securities lending clients want to earn the scarcity, or liquidity, value from the portfolios, as opposed to a risk premium from aggressive cash management.
While their objectives have not changed, plan sponsors' perceptions of securities lending agents' ability to deliver on these objectives have changed. Plan sponsors have increased their communication with lending agents seeking assurance objectives and risk tolerances are captured within lending program guidelines. Sponsors have focused further attention on compliance practices of lending agents to gain further assurance that agreed-upon guidelines are explicitly translated into action. This increased focus of sponsors and the resulting focus of lending agents on these issues has been the silver lining in the clouds recently shrouding the securities lending market.
It is critical that the incentive structure between securities lending clients and their agents supports the objectives and risk tolerances of the lending client. The market convention for compensation has been to share the revenue from lending activities between client and agent.
In his Sept. 4 commentary, "A better way than high-cost securities lending," Todd Tibbetts asserts there is a "moral hazard" resulting from this fee structure. Incentive fees are not new to investment management. In fact, much consideration has been given to the actual vs. desired incentives created by incentive fees. Clearly, absent risk constraints, a moral hazard may exist in an asymmetric incentive fee structure, with the manager motivated to take more risk than might be appropriate for the client. Beyond securities lending, ERISA acknowledges this moral hazard generally through restrictions on asymmetric incentive fee structures, allowing them only in combination with a cap on the fee paid. The cap serves as a proxy for a limit on the risk level allowed within the investment strategy.
Securities lending clients, however, have much more than a proxy to govern the activities of their agents. For example, pre-established guidelines between the lending clients and the lending agent regulating cash collateral management discretion serve as the key risk control of securities lending clients. With the risk constraint of cash collateral guidelines and effective compliance oversight ensuring these guidelines are followed, lending agents' incentives are aligned with their clients' objectives - maximizing securities lending while not exceeding a specified level of risk. As a result, the incentive fee structure does serve clients quite well.
Successful, client-centered securities lending requires clearly stated objectives linked to appropriate guidelines, oversight and incentives. Applying these fundamental principles of agency, well established in investment management, help ensure securities lending agents deliver on their commitments to clients.
John E. Martinez is chief executive officer, Capital Markets Group, Wells Fargo Nikko Investment Advisors, San Francisco.
