29 Mar 2011
SLT: Firstly, could you tell me a little about Rule
Financial?
Nelson:
Rule Financial started out as a technology focused consultancy
back in 1997, but we have been increasing our business consulting
capability over the last six years or so by recruiting people who
have worked for the banks in business roles - in Securities Finance
our collective experience exceeds 150 years. We now have four
business solution groups offering advisory and change consulting in
Securities Finance, Prime Services, Risk and Legal. And we continue
to offer strong technology "execution" and "managed support"
services, able to provide project teams or individuals skilled in
all mainstream technologies. This enables us to offer full
end-to-end solutions to clients.
SLT: So how have you seen the business and technology
change?
Nelson:
I think securities finance as a business is interesting. No
single part of it is particularly complex, but there are so many
parts involved - it's like a 1,000 piece jigsaw puzzle, or a
"fractal" - with ever more detail the closer you look; this is
where the complexity lies, which makes it a challenging business to
fully understand from a process and technology perspective.
And of course it continues to change and evolve, always increasing
in complexity.
Most of the banks use vendor systems, with only some of the
larger ones having made the investment to build their own in-house
systems. Having built Morgan Stanley's securities lending systems
back in the early 90's, I fully appreciate how much time and money
is required to go down the in-house build road; back then vendor
options were limited so the decision was easier; today there's a
lot more choice - a number of vendor's offer solutions covering
differing parts of the securities finance landscape. But none cover
it all, so a bank will need to integrate multiple systems and
components in order to get the technology that it needs to
operate.
The challenges for the technologists - both in-house and vendor
- are how to keep up with the endless stream of changes; the
demands arising from the last three years have required quite deep
changes to the core of many systems - greatly increasing both the
costs and the risks involved in making it all work 100% of the
time.
SLT: Who make up the majority of your clients?
Nelson:
We focus mainly on the broker-dealers but also do some work with
the agent lenders and custodial lenders. We also work with the
buy-side.
SLT: It's been a tough financial market but securities lending
actually hasn't fared too badly. How have you seen the last couple
of years develop?
Nelson:
Last year ended up being pretty tough for the market. By the
middle of 2010, most banks had a fairly negative outlook for the
rest of the year and it was a case of keeping the ship afloat and
positioning it for 2011. The new year started well, but caution has
returned as Q1 has progressed.
Neville:
One of the difficulties with judging whether it was a good or a
bad year is that 'specials' within securities lending can carry
most of the revenue stream for the entire year. And, it doesn't
take too many 'specials' done in sufficient size to turn a bad year
into a very successful one.
Because 'specials' are so key, it doesn't require many takeovers
or other market events to make a big difference. I think this year
is going to be a lot better; as Alec has said already, we have seen
more optimism about 2011, even if that has softened of late.
SLT: How has the trust within the market changed?
Neville:
I don't think anybody fell foul over the last couple of years;
very few people lost money as everything was collateralised; so the
trust has always been there in the collateral and in the system.
It's more to do with fear, and I think people are getting less
scared. But some people we speak to are still standing back, and
stories about the New Orleans fund is still having an effect.
SLT: Do you think most people on the fund side understand
securities lending?
Nelson:
I think they understand it to a point. Reinvestment risk of
collateral is one area that was misunderstood. The general
assumption was that it was an easy, safe way to generate extra
earnings on a portfolio - receive cash collateral, reinvest the
cash and get a return on that - it couldn't be simpler. But falling
interest rates and volatility increased the risks of these
investments; turning (easy) profits into real losses.
Neville:
We don't do much cash collateral in Europe, so it's a US-centric
view on the market, but there are still risks with non-cash
collateral. There's a story about one bank taking convertibles as
collateral for a stock - they thought it was great, it's a
one-to-one trade. And then when things went wrong, it turned out
the bank didn't have a convertibles desk so they couldn't trade it!
What seemed to be reasonable collateral turned out to be something
they couldn't get rid of when they needed to! There are still these
complications; not so much about the loan, but about what you do
with the collateral.
SLT: How have your clients changed their approach to
collateral?
Nelson:
If you go back three years or so, there was generally a lack of
specialisation on the collateral management side of trades, with
securities lending probably more advanced than OTC derivatives for
instance. The Lehman default dramatically changed this, raising
awareness of the importance of stronger management of the
collateral being taken or given against trades and
transactions.
There has been a tremendous amount of change to processes and
procedures as the whole industry got to grips with the internal and
external demands for more transparency and understanding of the
risks and exposures they faced.
The banks have of course complied with all of the new demands -
regulatory or internal - but I think a lot of this compliance has
been achieved by tactical "band-aid" measures because their systems
cannot be changed fast enough to provide the support needed in a
more strategic way. My concern is that as and when business and
volumes pick up, these tactical solutions will not be able to cope
- it is a fragile part of a banks infrastructure at the moment.
SLT: How do you feel about the new regulatory
environment?
Neville:
I don't think there is too much regulation at all. Many people
are bleating about central counterparties but I don't have a
problem with that - why shouldn't we be able to have visibility of
what stock is on loan? Currently there is limited reliable analysis
of stocks on loan by data-providers - but in most other markets you
get that information on a tick-by-tick basis. In the modern world
we should see pretty much everything that goes on. So I'm a fan of
greater regulation, with the more visibility the better.
The only issue I see is that if you regulate in the wrong way,
people will just try to arbitrage the regulations. So if it is too
prescriptive there will be a problem. But making people more
accountable is utterly understandable.
Nelson:
I agree that regulation is a good thing, but I do worry about
the cost that it imposes on the industry - that cost has to be
carried somewhere. Securities lending in particular is a very
'thin-margin' business, and I imagine there are lots of banks
wondering if they can continue to make money from it going
forwards.
