While the particulars of the suit are interesting on their own—and a second complaint alleging similar issues was filed separately this February—they also point to a trend: Greater expectations are coming to stock lending, and the broader family of securities finance functions, including fixed-income repo, margin lending, and other collateralization activities. Whether considering the dearth of neutral venues out there to execute these arrangements, or the unavailability of data about how they are matched and priced, participants are becoming frustrated with the current dynamics of intermediation, a lack of transparency, and what they see as limited opportunity to negotiate on fair terms. Indeed, some are now frustrated enough to throw their weight around in court. And at the center of this drama lies technology.

Mutual Benefits

Securities lending contains a complex and often arcane jumble of processes to manage, much of which is done via over-the-counter (OTC) transactions, which is why sell-side prime services and cross-asset financing units, and custodians’ agency lending arms have invested significant financial engineering and effort into cornering this space. 

At its core, though, lending is straightforward. A beneficial owner lends assets to a borrower, typically collateralized at slightly above 100 percent of the assets’ value, for a certain term and under specific conditions. In stock lending, the borrower—which is usually a prime brokerage, hedge fund or proprietary trader—can use those assets to facilitate trading operations like covering short sales or arbitrage pairing. Meanwhile, the lender—institutional investors, insurers, mutual funds and, more recently even exchange-traded funds—can deploy equities they weren’t going to move off the books anyway, and grow additional fund income as a result. Mutual benefits abound.

Yazid Sharaiha, global head of investment strategies at Norges Bank Investment Management, says pension fund giants like Oslo-based NBIM increasingly see the positive advantages securities lending can have for market function, “including aiding efficient price discovery and valuation, income on portfolio inventory, and maintaining good relationships with corporates.” Therefore, an asset owner’s role in the market in 2018 is ideally active and growing. But while capital-constrained banks dig in, and other intermediaries like custodians fill the breach, Sharaiha says the “search costs” associated with the market have risen. “Transparency has improved over time in the market,” he says, pointing in part to greater availability of data in recent years—though matching up lending supply and borrower demand at a reasonable cost remains the challenge.

With those costs and interest each on the rise, attention has turned to quality of transaction information. Stock lending has gradually evolved from a “mostly administrative or operational activity” focused on generating marginal income to offset investment costs, to the status of an investment product—enhancing returns with stock lending strategies, says Robert Levy, head of business development at specialist analytics provider Hanweck. 

But this new approach requires more data for analysis and benchmarking—a tough ask in an OTC market with significant customized activity. “Beneficial owners (lenders) have different risk and collateral preferences and counterparty credit constraints,” Levy says. “This will lead to different types of securities lending transactions with different rates, transaction sizes and results. Therefore, it is challenging to define a generic stock loan trade, and difficult to know what constitutes a discrepancy unless you have very comparable conditions for comparison.”

Conversely, for stock borrowers, the problem is often insufficient supply. According to one industry veteran, “The banks have perpetuated a model where the only price is coming from the supplier, so there is no room to negotiate—say for a better price in exchange for more size. Hedge fund borrowers are left asking, ‘Why can’t we simply borrow more from a big asset manager who is deeply long stock?’ At the same time, the biggest beneficial owners, who would be happy to lend more to those same hedge funds for 108 percentage points in collateral, only see a small percentage of lendable inventory going out. They’re sitting on $15 trillion to $20 trillion to lend, and only $2 trillion makes it through. All of this, the banks claim, comes back to managing agency lending pools and relationships—to unavoidable complexity. But the fact is, it works for Goldman Sachs and Morgan Stanley, and not for anyone else.”

‘Still in the Stone Age’

This asymmetrical relationship came into clearer view with the antitrust suit brought Iowa Public Employees’ Retirement System, Orange County Employees’ Retirement System and Sonoma County Employees’ Retirement Association in August. Though certainly only part of the larger securities lending story, the matter has, more than ever before, exposed the extent of intermediary influence in the space, and stoked calls for change.

“Most stock lending transactions today can be traded in a standardized way and on electronic platforms,” says Dan Brockett, counsel to the plaintiffs and partner at Quinn Emanuel Urquhart & Sullivan. “Right now, this market is still in the Stone Age—and we see the banks as certainly putting up a big fight to keep it that way.”

That fight, as detailed in a wide-ranging complaint, involves an alleged collusive push by Goldman, Morgan Stanley, JPMorgan, Credit Suisse, UBS and Bank of America to steer stock lending away from centralized clearing, electronification and standardization—thus preserving their OTC foothold in the business. To do so, the complainants say the banks’ consortium-owned Equilend technology platform was used to buy up and shelve or undercut upstart platforms’ intellectual property, and even—in the case of Data Explorers, later known as Markit Securities Finance—their data services, as well. Bank of America and Equilend declined to comment for this story. The remaining defendant banks did not respond to requests by press time. 

QS Holdco Inc., the successor to Quadriserv, the firm behind one of one of those upstart systems, Automated Equities Finance Markets (known commonly as AQS), filed the second suit in early February of this year, arguing that the same collusive activities alleged by the pensions stifled competition and ultimately tanked their company’s chances to survive. The backers of yet another platform, SL-X, are considering a suit of their own, sources say. 

Though Equilend was originally built to serve as a common back office for lending, the banks eventually used it “as a front-end to manifest decisions about the evolution of the industry collectively—what technology, products and entrants they would support and would not—when in reality they should have been competing vigorously against each other,” Brockett says. “It became the primary vehicle for collusion.” 

In that sense, the alternative systems were not only important competition; their presence would also produce transaction data and shine a light on the market that had never been there before. “From an innovation perspective, stock lending had been a pre-crisis backwater,” says Michael Eisenkraft, Brockett’s co-counsel and partner at Cohen Milstein. “Bessemer Trust, Deutsche Börse, Renaissance Technologies—big players were backing AQS in 2009 and sunk $100 million into it. There was enough demand to fund AQS at that level.” 

Yet AQS struggled and neared collapse within a few years before selling its IP to Equilend in 2016. “The collusion started well before that, with a roadmap of identical decisions, strategy and even statements across several banks we’ve documented over a number of years,” Eisenkraft says, claiming that this collusion is designed to obfuscate that while certain trading strategies that hedge funds engage in, and stock lending supports, are complex, banks’ ability to profit by sitting in the middle of the borrowing is easy. “These are standardized loans of publicly traded shares. Transparency is the enemy of conspiracy, and you have clients paying the banks as much as 65 percent of the revenue on a fully collateralized transaction to perform what is a simple matching function. They can charge that because participants simply don’t know what they’re paying—there’s no price transparency,” he adds.

Preparing for Progress

The growing wave of litigation is a flashpoint, a kind of painful retrospective on the stakes still at hand. But in the present, Basel III-driven capital constraints on tier-one institutions have begun to bite, making it harder for banks to dominate stock lending, opening cracks for new intermediaries and even possible structural reform. And as that plays out, many borrowers, beneficial owners and technology builders alike are learning lessons of the past, and mulling ways to make their own chances in securities lending better. 

Unsurprisingly, this starts with data. One approach might be called smarter estimation; the other is more like radical transparency. But both align with the reduced “search cost” noted by NBIM’s Sharaiha.

On the supply side, beneficial owners are becoming more informed. Reporting and analytical services like those provided by FIS Astec Analytics and IHS Markit allow lenders to monitor the performance of their agents historically over time. Without this, “investors who are in control of the supply side of the market cannot effectively compare and contrast the various routes to market that are available to them,” says FIS senior vice president David Lewis. Being flexible in terms of the collateral that a lender can accept, or durations that they can commit to lend against, also helps make them more attractive to borrowers. “But every lender should bear in mind that they cannot create demand,” he adds. “They can only do their best to be the preferred choice when it comes to borrowers borrowing from the market. An efficient route to market, whether via a central counterparty (CCP), or other platform, can help make a lender more attractive. For example, novating trades through a CCP can translate into capital-cost savings for the borrower, which can then be reflected in better fees.”

Other tools, like Hanweck’s recently designed Borrow Intensity Indicator, similarly focus on optimizing term-rate curves for stock lending, in this case by using proprietary methodology and unbiased data from exchange-traded options markets to project implied borrowing demand over a maturities time-series. In both examples, beneficial owners are using alternative methods, overnight data and a methodical approach to get their inventory out. In short, trying to beat the spread by being smarter. And for his part, Brockett at Quinn Emanuel sees this as a realistic objective for most participants, even if the calculations remain imprecise.

“If you can use past bids and offers and don’t have to call your prime and take their quote simply out of hand, that price transparency—even without a neutral platform to transact—gives you leverage and would put pressure on spreads by itself,” he says.

Unfinished Business

Of course, the operative words to that approach include “historical, overnight, and estimate.” For some, especially among the borrower community, there is more to do. They argue that borrowing demand is there for the taking—assuming open competition, a willingness to execute, and mutualized cost for the technology and post-trade on the back end. Build it, give them transparency and they will come.

Just as it was 10 years ago, that is the theory behind a small but growing set of all-to-all platforms for securities finance that use tri-party clearing to skip an intermediary altogether, like Tradition’s Elixium (a multilateral trading facility, or MTF, currently focused on repo and collateral management activities) and Aquila, an independent peer-to-peer venue about to launch that proposes, among other things, to provide a ticker of real-time, anonymized market data to its active users. 

The objective isn’t revolutionary so much as a “reasonable” drive, as one source puts it, to carve out new liquidity, rather than standing in line with one’s prime broker and paying a premium for the privilege. In short, a genuine market for securities lending, rather than an unnavigable mess.

An area where these systems could especially flourish, says the industry veteran, is hard-to-borrow and high-demand “specials” stocks—lending situations that require visibility into both sides. “Sophisticated analysis programs are able to pass the litmus test when scarcity or difficulty of borrowing isn’t high. For instance, they are pretty good in index stocks. But beyond that, they’re nothing more than an educated guess. It’s like trying to derive the offer price on a swap only from the bid: you can try, and on a 10-year dollar fixed-versus-floating, a liquid market with lots of notional comparables, you’ll get pretty close,” he says. “But take a cross-currency yen-dollar swap with mismatched maturities and try to figure that pricing out, and you might not get closer than 30 percent off, one way or the other. The same thing holds here. In some situations, having those real basis points and actual borrow costs in front of you is much better than an algorithmic estimate.”

Regulatory Unknowns

Whether these concepts take off depends, in part, on the willingness and ability of beneficial owners to free up supply—and straying from their prime relationships is not without discomfort or cost. But more importantly, every source interviewed for this story mentioned another missing aspect that may finally be required to nudge progress along: regulatory influence.

When “detrimental variability” hits lending, it is a legacy of a market design that lacked necessary “contributions from lenders, intermediaries and regulators,” says NBIM’s Sharaiha, adding that for all the complexity that has grown up around securities lending, the priority should be simple from an asset owner perspective. “Increasing the available information on price and quantity available should be a goal. And this is a task for both data providers and regulators who can encourage increased transparency.”

Agreeing, FIS’ Lewis notes talk from some quarters of “a regulatory plateau” after Mifid II—a calm after the storm. “But I would suggest otherwise,” he says. “[Pan-European regulator the European Securities and Markets Authority (Esma)], through the Securities Finance Transactions Regulation (SFTR) reporting regime expected to go live in the second quarter of 2019, will be gathering vast amounts of detailed intraday information. This will form part of the global drive for data arising from the work of the Financial Stability Board (FSB) and its inquiries into shadow banking, which has led to the Transparency Directive. I would suggest that the market should expect the data that is being gathered will be analyzed over time, leading, inevitably, to additional regulations to manage and control the market.”

Other markets could follow the European lead, and indeed the alternative—litigation—has proven far less palatable, and even destabilizing. One source suggests that “three or four” post-trade service providers are considering a bid for Equilend, on the assumption that it may not survive the ongoing suits against it.  

If nothing else, though, the state of play has demonstrated just how bizarre securities lending currently is: rightly considered an ascendant investment product in its own right, but not transacted like one, not (yet) regulated like one, with participants on both sides asking only for a fair shake—and feeling around for data in the dark. 

Something has to give. As Eisenkraft says, “This market’s ripe for it.”