Alpha Bytes Short-Selling
Modern Lending
Gregory DePetris failed fifth-grade math and dropped out of college. Nevertheless, at 32 he has two thriving start-ups behind him and is knee-deep in a third. As a co-founder of New Yorkbased Quadriserv, a broker-dealer specializing in securities lending, he is helping to create a technology platform to automate the lending process hedge funds rely on for short-selling. The launch is targeted for early this year. If things go as he plans, Quadriserv’s platform, which will also introduce price transparency between lenders, could revolutionize stock lending.
“If we succeed with this, there is $6 billion to $7 billion in revenue we could take from the prime brokers,” says DePetris, who was already working part-time on the floor of the New York Mercantile Exchange when he was a 17-year-old freshman at Fordham University. He dropped out of college to become a full-time trader, coheading a foreign exchange arbitrage operation before deciding to apply his market knowledge independently.
Hedge funds rely on shorting -- selling borrowed securities in hopes of buying them back later at a lower price to return to the lender -- as a cornerstone of their investment strategy. Prime brokers have acted as intermediaries, aggregating securities from mutual fund firms and other big owners looking to lend them for a fee.
During the past five years, technology advancements have allowed prime brokers to furnish their clients with more-sophisticated services. They now use real-time information on supply and demand for lendable securities to automate the matching of borrowers with lenders, and detailed market data to provide pretrade and posttrade analysis. But although some of the benefits of these technologies have been passed on to hedge funds, prime brokers have been the main beneficiaries.
“Hedge funds have no idea where the marketplace is for borrowing securities,” says Joseph Weinhoffer, Quadriserv’s co-founder and CEO. “They borrow only from their prime brokers, and they pay whatever their prime brokers charge.” But as such service providers as Quadriserv look to bring automated matching technologies for lending to borrowers and lenders directly, hedge funds will no longer rely solely on prime brokers for their shorting strategies. Although Quadriserv already offers real-time information about lending supply and demand online, trade orders are still placed entirely by phone.
Securities lending can be extremely complicated. When a hedge fund borrows shares for shorting, it must post collateral -- usually cash, which is put into a short-term, interest-generating account based on the intended federal funds rate -- currently 5.25 percent. If a fund doesn’t have the necessary cash for collateral, it can borrow the money -- a practice known as buying on margin. When a short position is closed, a portion of that interest is paid to the lender, part is returned to the borrower, and the rest -- the spread -- goes to compensate the prime broker. The cost of borrowing is affected by the difficulty of finding available shares. Add to that the exclusive agreements prime brokers have with lenders and the brokers have all-but-free reign over the spreads they get as middlemen.
Charles (Brad) Hintz, an analyst with Sanford C. Bernstein in New York, estimates that the average spread prime brokers make off U.S. securities is anywhere from 25 to 50 basis points, and about 100 basis points for non-U.S. stocks. More-accessible stocks can be borrowed for as little as the fed funds rate plus 10 basis points. Spreads on hard-to-borrow securities can exceed 250 basis points -- fees that are partially offset by the rebates borrowers receive on the cash collateral they post. Margin finance and securities lending is estimated to generate roughly 60 percent of the $8 billion to $10 billion consultants predict the prime brokerage industry will reap this year.
Hedge fund managers have noticed, and begun questioning, these lofty fees. “There is no one central marketplace in securities lending, so the rate you get isn’t the rate your neighbor is going to get,” says Joshua Galper, managing principal with Vodia Group, a consulting firm based in Concord, Massachusetts. He estimates that funds borrowing from prime brokers typically overpay them by 75 basis points, on average. For a $500 million short portfolio, that translates into $3.75 million annually in lost profits.
Galper believes that as products such as Quadriserv’s new platform make their way to hedge funds, the lending process will change dramatically. Within five years he expects to see a transparent, centralized electronic communications network for securities lending where hedge funds can access fast, accurate, transparent rates for any security, with pricing based on their individual credit profiles.
In the past, information about whether a particular security was available for borrowing -- known in the industry as a “locate” -- was gleaned through calls between a buyside trader and a broker-dealer. Since automated systems were introduced five years ago, prime brokers have been electronically providing hedge funds and other borrowers with real-time inventories of available securities, what the securities trade for and whether the trade can be completed with a single keyboard stroke.
Real-time information has allowed hedge funds to make more-efficient decisions, translating to more-frequent shorting. Paul Busby, the New York-based head of North American securities lending for Deutsche Bank, says his group processes roughly 185,000 to 200,000 equity locates a day.
Technology has also improved prime brokers’ ability to manage their inventories of lendable securities and to obtain new supplies, helping them guarantee that their hedge fund clients have access to shortable securities. Electronic lending platforms like Bostonbased ESecLending and New Yorkbased EquiLend expand availability and transparency, providing prime brokers with screen-based auctions of lendable securities portfolios directly from the mutual funds and pension funds that own them.
In May 2006, ESecLending held an online auction of exclusive borrowing rights to about $76 billion of the California Public Employees Retirement System’s U.S. equities. Citigroup had the winning bid for $58 billion worth of Dow Jones Wilshire 2500 index and Dow Jones Wilshire U.S. micro-cap index assets; Goldman, Sachs & Co., JPMorgan Chase & Co. and Lehman Brothers won access to other portions of the funds.
EquiLend, an automated borrowing platform for financial institutions that is co-owned by 11 banks and broker-dealers, executes trades based on the defined set of rules and instructions users enter into the system for their searches. For example, a trader could ask the system to search every fourth day for stocks with less than $50 million in capitalization.
“A lot of the large hedge funds still don’t have their arms around the concept of portfolio finance,” says Jon Ottomanelli, the New Yorkbased managing director and global head of securities lending for Citigroup, which has aggressively ramped up its technology efforts. New systems, such as Citibank’s Web-based PrimeLocate, allow hedge funds to tap the firm’s $1 trillion global inventory of stocks.
Merrill Lynch has also aggressively responded to hedge fund managers’ desires to incorporate prime brokers’ services into their technology platforms -- such as their trade order management systems. Robert Bowers, a director of sales and trading for global markets financing and services in Merrill’s London office, says the ability to link systems together has benefited the firm as well as its clients, allowing each to reduce the hours spent on simple transactions and concentrate instead on more-difficult ones.
“Clients can take digital information, incorporate it into their systems, hit a button, and the transaction is almost executed,” says Bowers, explaining that, although a trader still needs to complete the transaction, the prime broker’s system is just a step from full automation. Merrill, he adds, has begun providing hedge funds with market analysis -- enabling sales traders to electronically flag the direction in which they predict a stock will move. “Our desk wants to be alpha-generating, via value-added sales trading,” he says.
Pretrade analytics allow a hedge fund that is considering shorting a stock to use the availability and cost of borrowing that security, along with its current trading price, to model the likely outcome of shorting it. Conversely, a quant firm could use the same information to determine whether additional shorting activity might put downward pressure on a stock’s price. As hedge funds have embraced such services, prime brokers and technology vendors have responded by developing others, such as posttrade analytics.
Deutsche Bank is doing just that. Anthony Byrne, the London-based global head of its securities lending operations, says the firm measures historical trend analysis against inventory to create demand, supply and fee profiles for clients. It can thereby forecast their future shorting activities within particular sectors and monitor for potential reratings by analysts or ratings agencies that could affect a security’s trading price and a hedge fund’s strategy. Deutsche feeds this data through its equity derivatives strategy research group, which looks at convertible bonds, special situations and equity derivatives. So far, the firm is the first to create a dedicated research arm within its securities lending group.
Prime brokers are also using technology to help hedge funds enhance their returns through synthetic lending. Managers can replace long positions, particularly in hard-to-borrow securities, with derivatives. Byrne says Deutsche Bank is using derivatives to create inventory, by buying shares for lending and hedging price moves by selling corresponding futures or options contracts.
Prime brokers’ efforts to add new services are also being driven by the awareness that as price transparency and automation reshape the hedge fund industry, the shift could cost them business and force them to lower their pricing.
“Prime brokers can borrow much more cheaply than they are willing to lend, and their clients are thinking, ‘Is this right?’” says Timothy Smith, president of Boston-based Data Explorers, a firm with five Web-based products that generate data on the performance and profitability of securities lending. The products provide mutual funds and pension plans with information on the volume of securities being lent and the borrowing rates prime brokers pay -- a bellwether for institutions to determine price points for their own lending. Data Explorers is also developing products that will feed similar rate information to hedge funds.
To help hedge funds negotiate better rates with their prime brokers, Quadriserv’s service generates data on the amount of stock institutions are willing to lend and the going rate for borrowing. In 2004 the company established a broker-dealer as the intermediary in a system designed to act as a netting facility for hedge fund financing -- a kind of Liquidnet for securities. Just as Liquidnet’s automated system lets buyers and sellers bypass brokers by anonymously executing block trades against one another, Quadriserv’s service allows hedge funds to lend and borrow shares directly, cutting out prime brokers.
Quadriserv began executing lending trades in December 2005 and now has 16 counterparties, including hedge funds, whose assets under management range in size from $400 million to $10 billion. The firm expects the number of counterparties to reach 50 within the year.
By directly matching borrowers and lenders, Quadriserv plans to undercut the spreads prime brokers charge. Its platform will also let hedge funds simultaneously lend shares they own long and borrow those they want to short. As hedge funds provide Quadriserv’s system with indications of the shares they are willing to lend and those they want to borrow, the system identifies matches and executes the trades.
“We’re moving pretty quickly from the Stone Age into modern technology,” says Quadriserv’s DePetris.
