Stock lending for Regulated UCITS funds: getting the priorities right |
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November 2010 |
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Welcome
Jervis Smith,
Managing Director, Global Head of Client Executive,
Global Transaction Services, EMEA, Citi
In this issue of Spotlight we look at some of the issues facing Undertakings for Collective Investments in Transferrable Securities (UCITS) that participate and engage in securities lending. We will examine the:
- Parameters within which lending programmes for UCITS operate and analyse the market events that have led UCITS to review their programmes and their providers
- Various key collateral types available to UCITS and how these can affect a lending programme
- Benefits of using a third party provider to manage the risks of securities lending in a manner that does not dilute their ability to generate revenues
The regulations for lending activities by UCITS are based on the UCITS Directive, which was most recently restated in Directive 2009/65/EC of the European Parliament and of the Council of 13 July 2009 on the coordination of laws, regulations and administrative provisions relating to UCITS.
Although the regulations for lending activities by UCITS are prescriptive in a number of areas such as collateral, counterparty acceptance and cash reinvestment (i.e. these regulations give very specific requirements for these activities by UCITS), they leave enough room to allow the UCITS to adapt their lending strategies in order to earn good revenues.
Knowing the Rules
The rules governing lending activities by UCITS focuses on three key areas: the type of collateral that is acceptable, the way in which cash collateral is reinvested and the credit rating of the counterparties of UCITS. UCITS must also ensure that the level of risk they take on is consistent with its risk profile and complies with the principle of risk diversification, which UCITS must adhere to.
In Ireland, the Central Bank, which regulates the entire Irish funds industry, has drawn up specific guidelines for the use of repos, reverse repos and securities lending arrangements by UCITS. These guidelines provide UCITS which act as lenders with a detailed framework of what they are permitted to do as lenders in lending programmes.
We are aware of a number of active lenders who have also used these guidelines for non UCITS lending programmes. Irish UCITS are allowed to accept a variety of collateral; the main types being cash, government debt or other publicly traded securities, such as Supranational debt.
A1-rated issuers, letters of credit and equities traded on leading exchanges are also permissible as collateral for UCITS. Importantly the collateral must be marked to market daily, always exceed the value of the securities loaned and be immediately available to the UCITS in the event of a borrower default.
Stock borrowers who engage with UCITS must have a minimum credit rating of A2 or equivalent or ‘be deemed by the UCITS to have an implied S&P rating of A2’. Unrated counterparties are only permitted where the UCITS is indemnified for collateral shortfalls by its agent with an A2 or equivalent rating.
A Conservative Approach is Key
Stephen Sheehan,
EMEA Product Relationship Manager, Securities Finance,
Global Transaction Services, EMEA, Citi
Much has changed for UCITS lenders since the markets events of 2008, culminating in the Lehman collapse. Some UCITS lenders have suffered losses and many had suspended their programmes. We expect changes to continue as lenders seek alternate providers and as market conditions improve.
Lenders holding large portfolios of European securities are natural targets for both agent lenders and borrowers. Those lenders that fail to take advantage of the opportunities on offer are often sacrificing performance or at least not fully utilising their asset’s full potential.
One of the biggest issues for UCITS lenders is collateral security. Historically, many lenders were encouraged by their agents to accept cash collateral and engage in cash reinvestment programmes intended to boost returns.
Taking a Balanced Approach
In many cases client cash was pooled and invested in AAA money market funds. In the wake of the Lehman collapse, some lenders discovered that the underlying investments were in asset-backed securities where the liquidity had evaporated and some of the investments in the money market fund began to underperform. Citi’s lending and reinvestment programme did not run this type of investment strategy and our clients were not affected in the same way as clients aligned with other agent lenders.
As a result, there is now a great deal more analysis, detail and understanding of lending programmes that runs from the lender’s back office through to the boardroom. Many lenders are going back to basics: rightly insisting on high quality counterparties and only accepting collateral and the appropriate margin that fits their risk profile.
Overtime, lenders have become more sophisticated and are looking for assurances from their agents that their securities are protected and that cash collateral is being appropriately reinvested and that they can access their collateral upon demand. Interestingly the volume of loans collateralised by cash by UCITS funds has fallen sharply over the past 2 years, see attached graph, provided courtesy of DataExplorers.
The Right Selection
Importantly, the regulatory framework allows UCITS funds to choose their lending agent. This does not need to be their custodian. Increasingly, lenders that have found themselves locked in to illiquid, pooled reinvestment programmes run by their provider are now turning to alternative lending agents to manage all future lending along agreed lines.
The key decision for lenders in today’s marketplace who are tied to their provider is to pick a third-party lender with a proven track record of risk management and capable of delivering a UCITS-compliant programme in a thoroughly transparent manner.
Switching to a third-party provider need not be disruptive. Once appointed, the new lending agent will simply request a daily feed of available securities from the custodian to allow loans to take place. Sales activity will also be monitored where sales pre-notification will be provided. Both the agent lender and the custodian will report end-of-day positions to the client. There is no need to change banking contracts or install new systems.
Citi’s Capabilities and Ability to Run Lending Programmes for UCITS Funds
Brian Staunton, Managing Director,
EMEA Head of Securities Lending,
Global Transaction Services, EMEA, Citi
Citi is fully compliant with the UCITS lending requirements, both as custodian and tri-party lending agent, and continues to monitor and implement changes when alterations to the regulations arise. Our clients can be assured of a fully transparent lending programme that delivers all the flexibility required by asset and fund managers whilst maintaining a conservative approach that places asset security first.
We have consistently adopted and agreed a client first approach to the reinvestment of cash collateral, working with its lenders to agree specific guidelines. Given the strong seasonal demand for European equities that occurs in the second quarter of each year, UCITS funds can set the bar high with regards to collateral.
Whilst insisting upon government securities, for instance, UCITS can still expect to lend the bulk of their portfolio and maintain excellent returns. For UCITS with large European equity portfolios they need not consider accepting cash collateral. This is due to strong borrower demand irrespective of collateral type.
With a significant track record in this field, we are ideally positioned to assist lenders who are seeking an alternative provider and who demand their programme is run in line with the regulations. At Citi, we work with lenders who have suffered liquidity problems resulting from cash reinvestment and those who may be carrying unrealised losses, providing the appropriate expertise, market knowledge and solutions to assist in the transition of lending provider in a timely and efficient manner.
Conclusion
The moral of the tale is that the case for securities lending remains as firm as ever. Citi’s highly conservative approach to securities lending has placed its lenders in good stead through the events of the past two years. There are still plentiful opportunities in the core business for lenders to achieve a positive performance — provided they remain focused on risk management and collateral quality.
