Hu Liang, CEO of Novellus

Ashby and Dane welcome Hu Liang to the TTI podcast. This episode unpacks how Novellus is modernizing securities lending market and empowering institutional participants to transact directly, principal-to-principal, on a technology-enabled platform. 

Transcript

SPEAKER_03 0:14

Good morning, and welcome to the Technologize Podcast. I am Ashby Monk. I am one of the hosts of this podcast, which is delivered to you by the Stanford Research Initiative on Long-Term Investing. My co-host on this podcast is my dear friend Dr. Dane Rook, who's a senior research engineer with me at Stanford University. And Dane, what do we do on this podcast? What are we doing here?

SPEAKER_01 0:40

Well, we're trying to spread a little more information to the world about what the nexus between long-term institutional investing and technology is and can be. My goodness, it sounds so good when you say that. We're we're like date brokers in a way.

SPEAKER_03 0:52

We are date brokers. This is like uh this is uh Tinder for pension tech. We're hoping at the end of this you swipe, I don't know which direction because I'm too old to I've never used Tinder, but you swipe the direction that means you like the technology. It's wild out there, Dane. I'll tell you, every single day. We should add this as the sixth question to our normal routine, Dane. Here's what it is. Isn't Claude just gonna do that? You know, I feel like every single day when I'm talking to somebody about a piece of new technology, won't ChatGPT just do that? What do you think, Dane? Depends on that. Good question, good answer.

SPEAKER_01 1:30

There are some things that these technologies are just perlitive, and we are falling further and further behind as wetware rather than their approach to things, but I think that there are some things that are just still so distant. There are some things I think that aren't necessarily distant, but for structural reasons, regulatory reasons, institutional investors will not be touching for a while. Mixed bag answer.

SPEAKER_03 1:50

I wish it could be clear-cut, but by the way, as investors, we're used to having, you know, a lot of uncertainty and probability rather than certainty. But I will tell you, I saw a very interesting story about a team that modeled all the Y combinator cohort right now. And they went through and tried to understand every one of their products and every one of their TAMs, and they used all these systems to simulate their future. And the companies that relied on things like creativity actually did not have a defensible moat. The companies that operated inside bureaucracy that had a lot of human-to-human dysfunction or politics emerged as the winners. And so I take comfort that we are operating in an industry that seems like AI won't quickly replace simply because we have a lot of politics, dysfunction, bureaucracy, and governance is in, you know, is a work in progress. I don't know if that resonates with you, Dane.

SPEAKER_01 2:55

I mean, red tape as a bot killer sounds pretty uh reasonable.

SPEAKER_03 2:59

Exactly. Well, today we're gonna talk about one of those industries that you would think you can build tech around that. This is the securities lending industry. It's a huge industry. Every pension plan usually gets some securities lending revenue. And we've brought my friend Hugh Liang, who is the co-founder and CEO of Novellis. And Novellus is an institutional fintech network that is focused on re-imagining securities lending, if you can believe it. Can you believe we can actually reimagine something so foundational to the entire capital market system? I guess that's what we're doing these days with AI. But Hugh, welcome to the technologized podcast. It's great to be here, Ashby. Thanks for uh having me here. Well, we're gonna ask you five questions. And the first one is a doozy. It's who are you? And so you're gonna get the chance to just tell us who you are. But why don't you also tell us your bio and a little bit about novellas so we can start to put an understanding around why we invited you to this podcast.

SPEAKER_02 4:03

Well, great. Um, well, you made it uh sound pretty intriguing what novellas does. So we'll dig into that a little bit more. A lot more, actually. Myself, I'll skip the first 20 or so years to make this a little brief for us all. Yeah, so I I have a technical background. I have my undergrad degree in electrical engineering later on with the business degree, but I was one of these guys just I was born that way. I love technology. Both of my parents were electrical engineers, so I started my uh career at the IBM Almondin Research Center, not too far from here in San Jose, doing uh software research and uh distributed systems. But as I said, I was also one of these guys that are that is just very uh I had a keen interest in business and finance. So pretty early on, after a cute few um moves here and there during the dot com time group of us in the Bay Area, we started on an idea for the FX market, another very old and foundational market in the world, perhaps that even if not the largest, but certainly the oldest there is. And and even in terms of users, many of the users are very similar to the users that I'm going after now. These large real money funds, corporate treasuries doing business directly with investment banks. So all the times that you see on TV where people got multiple telephones on their necks, a lot of them are doing FX-related voice trading. So we started going after this because around the 2000s there was this really neat technology called the internet. And we thought, hey, if you pair this on a system that is voice broke on a daily basis, and maybe you can add a lot of efficiency and speed, and things will be great. That was the idea, but it was tough to get the banks, particularly the investment banks, to accept something like this. Our fortune came along in the mid-2000s when a lot of these electronic trading firms, the hedge funds that were electronically trading equities and futures, found this FX market. And they say, wow, now you do have this huge, large market that's 24 hours a day. It's not regulated in the spot market, it's so deep. Let's turn some of these algorithms and trade this stuff. The interbank market didn't want them in. They didn't accept hedge funds, and we had this alternative pool on the side. So we started bringing hedge funds on board, they can trade with each other. Later on, we were able to work with uh JP Morgan FXPB and bring a central counterparty cleared model as well. And when the technology race really took off, there weren't any FX platform that can handle microsecond trading. We had built this really cool kit in the early 2000s that really wasn't getting used from the voice world or even just clickers on the screen. And all of a sudden, we were one of the largest and deepest routing networks for institutional FX, to the point where we're doing close to 100 billion a day of routing. In 2007, we were acquired by State Street Bank and Trust. So that's how I became part of this large institutional bank. I ran various different businesses. I was with State Street for 10 years. The last two or so years, I started a unit within State Street called Emerging Technology Center and had the opportunity to really look at a lot of different technology, things like blockchain, things like RoboAdvisors. I was really big at the time, machine learning, the precursor for a lot of the AI stuff for reconciliation. Did that for a few years and then realized how sometimes it could be slow in the large institutions to really do things like that. I ventured out on my own again to start a different platform that we don't have much time to talk about in the institutional digital asset space. After that period, we were able to kind of finish off in a good note between 2018 and 2022. I just had some time to really catch up with a lot of the contacts I had in the past. And actually, my current co-founder, Marty Tell, who and I uh overlapped in Stage Street. And when we started discussing about what other large institutional markets out there that could perhaps use some reimagining, I started learning about securities lending. We actually overlapped in Stage Street during 2016, testing some of the blockchain technology and looking at how can digitized collateral potentially sit on a blockchain and make it more efficient. What we're doing today is not blockchain related, but that's kind of how the Genesis started, how we met, and that was 10 years ago, believe it or not, right? So when we started really looking at the space, a lot of similarity to the FX, foundationally important in uh in institutional finance, and really hasn't changed in 34 years. So here we are. We started this company, Novellus. Uh, the idea is to reimagine security slending, which we'll get into more in a second. We hope to have a similar impact in what we've done in the past to bring efficiency, transparency uh into a world that is uh perhaps really hasn't changed in many decades.

SPEAKER_03 8:52

Fascinating background to hear you touching all of that. And I love that you started with the traders with phones wrapped around their neck.

SPEAKER_01 9:00

Yeah.

SPEAKER_03 9:01

Um I I think people don't quite realize that that's what the fixed income markets often look like, even today. That there's if fax machines are running in the world, it's probably for a fixed income trader. You know, if you've got a corded phone, it's probably related to something uh loan related. Okay, so thank you for the onboarding. And and you you said a term in there that was real money investors, that you were working to solve problems for real money investors. What are real money? Uh doesn't every investor have real money?

SPEAKER_02 9:35

They all have real money. Some have more real money than other hedge funds, perhaps. It's a really good question, perhaps for the audience. It took me, I think, many, many years until I really understood all of that. So in the FX world, when we're talking about real money, well, anybody when we're talking about real money, these are primarily Fordiac funds that perhaps the easy way to explain it is they cannot take other sides of trades. They cannot use leverage. They really have to use the funds that they've raised and what they have, your mutual funds in particular, pension funds and such. So back in the time in the early 2000s in the FX world, these were the funds that as they shift their portfolios around, they end up having a large FX residual of some sort. If a pension is going to shift from European to Asian or back and forth, that's what they were doing in the FX world is to shift these currencies around, and that's where they're using our product at the time.

SPEAKER_03 10:26

Okay, got it. So we might define real money today as kind of asset owners, but actually it's a real money is a is a bigger thing than that because you are you could be a 40 act, you could be a mutual fund. Correct. You just have a trading, you can't take a short position or you, you know, something like that. Correct.

SPEAKER_02 10:44

Much more regulated in terms of what you can do.

SPEAKER_03 10:46

Okay, perfect. Let's talk about novellas, but did but not just the product. Like what was the problem you observed with the securities lending space that inspired you? So you did this deep dive on these ancient markets, not ancient, but these old markets that hadn't been disrupted with technology. What did you find? And then why did you build Novellus to solve it?

SPEAKER_02 11:06

So I think the first thing when I really started learning and understanding how this market works is a realization that it's heavily intermediated. So for listeners who are not too familiar with um security slending, which is probably most everybody out there, these are ultimately hedge funds that need to borrow securities for whatever reason. Sometimes they're shorting it, sometimes they're just simply hedging the market. They want to take a short position in the market, so they need to borrow this from someone that has a long position, which is ultimately on the other side, long security holders, your pension funds, your sovereign wealth funds, your large asset managers, but they don't go directly. Right? In the middle, they're generally, traditionally speaking, two intermediaries. The lenders work with large custody banks that are agent lenders. They pool these together and make it take over a lot of the operational processes and lend these out on behalf of the lender portfolio that they have. On the other side, the hedge funds generally work with prime brokers who provide various other benefits other than just securities lending, trading, research, capital introductions, and so on and so forth. And the prime brokers and the engine lenders work with each other on the needs and the supply. So ultimately, the lenders and the borrowers never meet each other directly. Now, what we think about right now is yes, it is heavily intermediary, intermediated. But we do want to say is that in capital markets in particular, there's a lot of reason why intermediaries exist. They add a lot of beneficial services, right, than just extra connections. So that is in itself is not the major issue, right? The other issue that we discovered is that particularly since the global financial crisis, regulatory rules have become increasingly burdensome. Not just for no reason, right? This is to give us a better uh sense of security and oversight in the financial markets. Right. But the byproduct of that is that with large intermediaries, regulated intermediaries like agent lenders and prime brokers are in the middle, being party to the trade, these kind of transactions heavily affect their balance sheet. So even though a securities lending transaction is fully collateralized and over-collateralized, so if someone is borrowing, let's say, 10 million worth of some security, they're most likely pledging 120 to 125% of collateral.

unknown 13:34

Okay.

SPEAKER_02 13:35

So you're not doing this on credit. This is this is not like some kind of credit market. But the intermediaries are still hit with a balance sheet requirements as well as RWA rules. That, in our view, adds a lot of tax rent to this transaction. Got it. Right. And at the same time, there's a lot of pain felt by intermediaries as well. Again, for listeners that are not too familiar with this market, securities lending is generally broken up to two markets, one called the GC market, the general collateral. These are assets that are really easy to borrow, right? Your Apple's, your Google, low volatility, rack rates, very, very low margins. Then there's a special stocks, maybe like your Teslas, AMC during the pandemic, GameStop during the pandemic. These are specials because the rate changes daily. And the difference between a GC and a special could be thousands of times difference in terms of annualized rates that the lenders would charge. And intermediaries love the specials. But the large balance sheet constraining GCs that have very low margin are they might not necessarily be very interested in that. They might not even clear the internal hurdle rates on some of these, but you got to do it in order to support your clients to get the specials. So our view is that for these large balance sheet constraining low margin trades, why not create a different kind of structure? One that you can connect the lenders directly to the borrowers and remove all of the capital constraining intermediation in the middle. If we can do that with technology in a new market structure, then we feel like it's kind of a win-win situation, right? Because the ultimate lender meets the ultimate borrower and they do it.

SPEAKER_03 15:26

I just want to have ask a question about this market that relates to the share of call it profits or revenue distribution of the of making this market. Can you help me understand? I can understand the economic value to an hedge fund and needing a stock to short because they're going to make money off their own trading. I can understand what a pension fund gets for lending their security into this market. But what I don't quite understand is like how much does a pension earn and how much of that is eroded by intermediaries. You said it was highly intermediated. So which of these intermediaries are earning what? Basis points, percentage points, transaction costs? I'd love to hear all that.

SPEAKER_02 16:12

Yeah. Um, a lot of these numbers, as you can imagine, are not very transparent.

SPEAKER_03 16:16

Yeah, that's right. That's why I'm asking.

SPEAKER_02 16:18

Don't really go out there. Yeah. What I'll leave it at is this. The prime brokers work with the hedge fund borrowers, right? That's working in a margin structure. There's a lot of services provided there that the fees come from essentially banks internalizing some of the longs and shorts together and what they need to cover in terms of their own balance sheets and such. I would say a large amount of the profit is between the borrower and the prime broker. When the prime broker goes back out to the market to the ultimate lender side, lenders are working with agent lender banks, generally their custodian that's working with them. That's another layer that gets taken away through the agent lending bank for the services that they provide. Pulling all of this together, managing the risks, doing the identifications, uh, the which is the essentially the insurance. So there you get these two layers of uh of costs that are sitting in the middle.

SPEAKER_03 17:16

Got it. And the the demand for these securities is, I would imagine, is fairly inelastic in the sense that a hedge fund has a trade they want to put on. So they need to go get that security. That's correct. The supply of these securities probably fairly elastic. Like it's not like the pension fund is sitting here saying I need to lend my GameStop, you know, to somebody. And so is that how the why that hedge fund side with the prime broker costs more, or my kind of misunderstanding?

SPEAKER_02 17:44

So there's a lot of services, like I said, the prime brokers provide to the hedge fund. Part of it is going out to source all of these, right? Some of the more difficult ones in particular, where everyone wants a short. The reason why its cost is so high is because it's high in demand. Right? The apples and so forth, if you want to strategically short it for a quarter or two because of earnings, those are very easy to find. And that's why the prices between these can can differ by thousands of times on an annualized rate.

SPEAKER_03 18:14

So we have an opaque market, costly market, highly intermediated, which sounds like there's a lot of humans in this kind of process of going and asking people if they would lend a certain security. What will or what is Novellus doing to solve some of these challenges?

SPEAKER_02 18:35

So, what Novellus is trying to do is that we're trying to put and create this network and platform that allows the borrower and the lender to transact with each other directly. Cool. Two various different value propositions comes out of this, right? I think if you look at it from a lot of your sponsors and your research group, the concept of being transparent, the concept of having control, control of your own destiny, your risk, is very important. When you're laying this off with an intermediary, you lose a lot of that control. So there's already kind of a push within the market for pensions and other investors to retain that control and doing this on their own. So our view is that if you're able to do this and in-source some of these activities yourself, that is that's what you're getting. You're getting the control, the transparency, the ability to control your future. And along with that, economic upside, even though if it's not your primary focus. So that's how the value proposition is expressed in the uh the lender side.

SPEAKER_03 19:37

Am I right in thinking you're probably a hundred billion or more pension fund? Or do some of the smaller pension funds actually seek to own their own risk and securities lending or or even endowments, foundations? Like, or is this for a big pension game?

SPEAKER_02 19:54

So very good, very good question. As you know too, every startup we have to have our initial go-to-market. To really make this work, for the economics of all of this to work on a unique economic scale, you we do need to start with the larger pensions. They have the portfolio. And you know, one other statistic that's really interesting to understand is that you know, of all the available securities to lend, the actual lend supply utilization is only around somewhere between 7% to 10%. So most of the supply available for lending is actually not. So even for a large sovereign or one of the largest pension funds in the US, you have a small utilization. So you gotta, it's it's gotta make sense for the size of portfolio, especially when you're talking about 10, 20, 30 basis point level and getting some increase on top of that. So, yes, we're starting with the largest fund. And also the operational side, even in a system like ours, which is quite automated, allows you the ability to in source. It's amazing that these large pension funds actually have fairly small operational teams. So we want to make the burden as least as possible. There's a lot of automation going on here, um, a lot of integrations to make this kind of as transparent as possible. So, therefore, in the beginning, right, the scale does matter. And we're talking to the larger funds that actually have the ability to in-source this on their own.

SPEAKER_03 21:15

And what is the tech? Talking about integrations. Is this a digital platform? Is it software to tell me what we're talking about?

SPEAKER_02 21:26

Yeah, we're fully cloud-based platform. There is no high frequency trading requirements here in this market just yet, right? So it's not something that that's latency sensitive. But what is really interesting here is that if you look at, again, going back to the ecosystem that we're talking about, which is the large lenders working with the agents in the middle and the large hedge funds working with the prime brokers, these ultimate borrowers and lenders never had the technology to be able to do this on their own. They're always dependent on the intermediary to have the technology. So essentially, what we're what Novella's Is and what our platform and technology is, we are a network that connects the lenders and the borrowers together and provides them all the operational services that they can leave their current intermediaries and handle the operations on their own.

SPEAKER_03 22:15

Dane, you go. I saw you were going to say something.

SPEAKER_01 22:18

I'm assuming for right now the securities covered are larger listed securities, correct? Do you offer any sort of services for, say, private market assets? Because I can see, given the explosion of interest in secondary markets in that field, that this is potentially something that could be very interesting and helpful to that side of the financial community.

SPEAKER_02 22:39

Absolutely. So we'll come to that maybe in the 10-year plan. So sticking to what we're doing now, right? We have the thing that we talk about internally, is you do have to crawl, run, uh, well, crawl, walk, then you run. So what we're starting with right now is equity to equity. You're borrowing securities and you're actually pledging securities as well, pledging shares. You can pledge traditionally, you can pledge all kinds of collaterals. Cash is a big part that's used in the US, less so in Europe, more so in the US. But even that, the regulatory changes, uh particularly one that actually happened uh just earlier this week, uh, could change some of that. But what we're starting with is your large public, uh, publicly traded equities, US against US uh public listed um collaterals.

SPEAKER_03 23:29

I bump into this when a pension fund says, Oh, I might be interested in switching from custodian A to custodian B, or it's come to that time every five years we do an RFP for custodians, and so now we got to go and look at all these custodian contracts. And that is actually when pension funds say, well, how what's our share of the securities lending? And that feels like that's the extent to which securities lending bumps into my like day-to-day is in that custodian moment. How much would a, and I'm gonna put a random number so we don't anchor on any pension, but a hundred billion pension fund, of which there are many in the world, how much would they make from one of those deals with their custodian on a yearly basis? Is it a big number? Like are we talking about material differentiation and performance? Or is it a small number where it's going to be hard to get people's attention?

SPEAKER_02 24:28

It depends on sort of what kind of assets they're lending out and the size, obviously, that they're lending out. But if you look at a large top-tier pension, you're talking about a decent amount of percentages, single digits that could have a material effect, right? Even for even for some of the funds, mutual funds and such, or ETFs that are also doing securities lending, cutting some of the costs that you have in your operational side, it's a big deal. So in terms of your own securities lending profit based on our estimates right now, we're talking probably in the 20 to 30 percent range.

SPEAKER_03 25:00

Okay. So you put 10 billion equities up to your custodian to say we're ready to lend. Are you telling me you would earn 1% on that 10 billion, just the fact that it's out there being borrowed? That's a big number. No. No. Okay. 30% increase on what you would get today. Yeah. So what I want to know is what is that return profile? So 20 to 30% tells me what you would improve if we used your tool, which is awesome. We like that. Disintermediation happening. But what is that total number of profit that a plan normally makes? What is the quantum of money moving?

SPEAKER_02 25:38

So if you look at GC, so again, these numbers vary wildly depending on your relationships, the type of shares, the revenues that you have, and so forth, right? So this concept of through the middle is how people kind of look at the aggregate cost of a loan, right? So on a borrow, uh, on a GC borrow, you're looking at somewhere in that 50 to 60 basis point return for GC, general collateral GC.

SPEAKER_03 26:04

So these are the standard assets.

SPEAKER_02 26:06

Standard, easy to borrow, yeah, low volatility asset, your Apples and your Google.

SPEAKER_03 26:11

I give you $100 of Apple or Google as a pension fund, I get 50 cents back.

SPEAKER_02 26:16

On an annualized basis.

SPEAKER_03 26:17

Okay.

SPEAKER_02 26:18

That's serious. That's half a percent. When you get into your specials, like I said, yeah, the borrowing time generally becomes a little bit shorter, right? Because they're more volatile. But those can go up to hundreds, if not thousands, of basis points on the borrow raise.

SPEAKER_03 26:33

Wow. And so this negotiation for a pension fund with their custodian, you know, this could be a very lucrative deal for custodians. For everybody around. By the way, isn't the retail market kind of screwed here? Like if I'm a retail investor, nobody's paying me and my Fidelity account or Vanguard account or Robinhood account for securities lending, even though I'm just buying and holding. You're saying you're you're offering some pretty big numbers. Why aren't we yelling to the sky about these retail players not paying me?

SPEAKER_02 27:07

So retail players are paying if you opt into the program. So everybody that you just mentioned right now, yeah the Delphi's, the Robin Hoods, the Schwabs, all provides retail programs as well. There are various different differences there on how retail can be pulled together versus large institutions. The other really interesting dynamic here, too, is that the retail side actually has a lot more special inventory, as you can imagine, right? Especially movements that we had during the COVID period.

SPEAKER_00 27:41

Right.

SPEAKER_02 27:42

The retail investors can actually loan out a lot more hard-to-borrow stocks. You can imagine your large pension is probably not going to be holding on to the AMCs and the GameStop.

SPEAKER_03 27:53

No, exactly.

SPEAKER_02 27:53

And your portfolio. Where does that come from? Part of the dynamic is that people do want to hedge funds in particular. Do you want to borrow that? So both sides, both those institutional funds as well as the retail aggregated broker dealers, all provide these kind of services. Our first entry is on these easy to borrow, low margin products, right? But the one thing I want to step back and talk about this, and people ask this all the time when we talk to customers is that, oh, how are you going to change this market? How are the intermediaries going to want you, or let's not definitely don't want, how do they allow you to actually play in this market, right? Really? What we're coming here to say is that we're not challenging necessarily the current market structure. As I said very early on, there's a lot of reason why capital markets are intermediary. There's a lot of values to this. What we're really trying to do is just provide a differentiated option to the market today. If you are a large pension fund and you want to loan out your securities, there is no other way other than what exists today. What we're saying is here's another option. It's not mutually exclusive. The two can be had in parallel. The other really important thing here, too, is that I also mentioned earlier, very small percentage of the inventory actually gets loaned out. If you have another avenue, it's not about shifting one to another. It's about increasing the utility of your asset. So we're starting with the equity to equity, large public market US to public market US. And part of the reason is that this simplifies the whole operation as well. Pricing of special securities changes on a daily basis. Tesla's moving, GameStop is moving, whereas Apple stocks are not really moving. So that operationally, this becomes much easier for the pensions to handle something than it is for them to get into these special stocks. And for the intermediaries, this leaves the high margin products to them. And in some ways, we actually talk about this as we're the release valve for the intermediaries on the low margin, high balance sheet utilizing products that they probably don't want to have on their balance sheet. So hopefully, I don't know if everybody interprets this way, but hopefully it's a win-win situation for all of us here.

SPEAKER_03 30:16

Yeah, I love it. I want to think about this 10-year world. I feel like I've asked you each of the questions like partially, but uh, but we're, you know, I don't want to make a three-hour podcast. So I want to talk about the 10-year world if you're wildly successful. I think it's hard for me. This is a this is a market. I've been doing this for 25 years now, Hugh. Like, this is a market where like I'm learning things. You know, you and I have talked for hours in our life. Even on this podcast, I'm learning things. This is like not a market we learn a lot about. And so it's hard for people to understand like, okay, so we improve this market. What happens? What happens to the world? Do we just give hedge funds easier access to stocks to short? Do we put more return in the pockets of teachers and firemen? You know, help me understand 10 years from now how the world looks different if you're wildly successful with novellas.

SPEAKER_02 31:10

You actually hit some of these already, just by sort of your high-level summary of what it is, right? We're talking about the institutional capital markets world. We're not talking about some sort of major revolution here that we want to completely upend, right? This foundational infrastructure of securities, lending, securities, finance will continue to be here because it's necessary. Right. So the changes that we're talking about is incremental. First and foremost, we would like to see this model of a more direct interaction between the borrower and the lender to become a much bigger share of the market. We've seen this happen in the more consumer space in almost all markets in the last 20 years, right? No change has really come to this market in the last 40 plus years. So 10 years from now, which isn't a huge amount of time, we think this direct principle to principle, so we're calling it the direct principle-to-principle model, right? Where the borrower and the lender come directly. First and foremost, we want to see this adopted, and we think this will be adopted in the long term, uh, and the certainly the 10-year stretch, partly because it is, it does add transparency and control to the lender side, which is what they're specifically asking for. Number two is we want to see this truly side by side. Even in the long term, we don't see the intermediate model going away. We want to see this to be a healthy, viable option where the market is looking at when and what do they need and choosing the right model, not only because it's actually just there. The third one is it is interesting, is right now, even in our current introduction of this direct principal to principle model, this is still a bilateral model. This is still bilateral contracts between somebody, the lender, and somebody else, the borrower. Many of the other products, most of the other products out there are on an exchange model. So the DTCC actually has a clearing infrastructure to make this happen. So in the 10-year life cycle, if you're talking about going down that path, we do think that instead of a just purely bilateral model, we could go through probably a CLOB, a central limit order book, CCP cleared model for securities lending as well, where the pricing becomes truly transparent. Um, and ultimately, how does that affect the broader infrastructure? Probably more than we can think of today.

SPEAKER_03 33:36

Dane, I see you chuckling over there. What are you laughing at?

SPEAKER_01 33:39

I mean, just some of the acronyms I'm still learning in the banking world about things like CLOB. Um it's not the most beautiful acronym I've ever heard, but what does it stand for?

SPEAKER_02 33:49

Club, it stands for central limit order book. Oh, okay. So you're yes, so your traditional exchanges are all central limit order books, right? So central limit order books are multi-participant uh markets that are centrally cleared by somebody and it's fully anonymous, fully transparent. You see the entire depth. Whereas if you look at FX, traditional FX, uh certainly on the securities lending world, these are all bilateral, low transparency, low depth of market, and just makes pricing um very difficult to uh to sort out. Go ahead, Dan.

SPEAKER_01 34:26

So I was um I'm curious about this. Which, in terms of the impact on long-termism in the financial markets, I can see this being as a blade that cuts both ways. Obviously, for the lenders, this is an opportunity for them to continue to hold on securities longer than they might otherwise do. But on the side of the borrowers, correct me if I'm wrong, oftentimes when a lender is uh surrendering a security for a period, they're also conveying voting rights with that. So in some respects, the borrowers can act much more short-termist than they otherwise would. Do you have a sense of what the net impact would potentially be? Is this going to actually drive more long-term decision making? Because I know there's been entities in the past that have been bent on trying to have long-term exchanges for securities holding, et cetera. Um, I'm just kind of curious. I can't make up my mind on it.

SPEAKER_02 35:17

You know, one thing I learned interesting about um security borrowing and such is that people will short securities because there's an economic reason to do it on a short-term basis. And some people that are you know very long-term viable businesses like an Apple will still get shorted because of just market structure movements and so on and so forth, right? So I don't think just having a more transparent uh infrastructure like this is gonna necessarily change people's view on you know how they take longer view of the market just because they have some extra information here on this. Uh, and then there's certainly a lot of trend, the uh a lot of data securities and so forth that goes along with something like this. Now, when we move into a fully claw-based central limit order book exchange model, how does that change market structure? That is something that's probably slightly harder to see today.

SPEAKER_03 36:10

I think I can see this plugging into TPA total portfolio approach. You know, these long-term investors, they're building these, well, first of all, it's nerve centers inside organizations to help them understand the risks they're taking and better manage those risks. You might call it close to real time. You know, which risks are being rewarded in the market and how should we move our book around to continue to get paid what we want to get paid on a risk-adjusted return basis? And being able to add securities lending into that portfolio from which you are running your TPA becomes very powerful. But you need to be able to find yourself talking to a chief investment officer of a pension plan to build your capability into their suite. And so I sort of skipped this question before, but now I feel obligated to ask it. How are you selling to pension CIOs? How are you getting in front of pensions around the world to pitch this as something that they should be managing?

SPEAKER_02 37:14

Our approach right now to pensions is, as you can imagine, this is a very much a relationship-based um process right now. I didn't talk too much about the team. And I think one of the things that's really special about us, it is the team makeup. So my partner, uh, Martitel, he spent 20 plus years at Morgan Stanley in the 90s and 2000s running the entire securities lending and equities division, as well as being um chairman of Echolend, which is the interbank um securities lending organization. And then he became part of Stay Street and built Stay Street's uh prime brokerage and securities lending infrastructure there as well. So a lot of these activities, uh, these meetings that we have are very direct based on the uh the relationship we have, and they're going directly to the securities lending group. Um, we've not had the approach of going directly to the CIOs yet at that point, at the current point.

SPEAKER_03 38:09

So you're not plugging into any of the, you know how pension funds have emerging manager programs? You're not plugging into any of the pension fund emerging technology programs.

SPEAKER_02 38:20

Not yet. And this is something that we talked about a little bit about the higher, the top-down versus the bottom-up approach.

unknown 38:26

Yeah.

SPEAKER_03 38:27

I I said that only those programs don't exist, Hugh. Um I wish there was emerging tech programs. I'm sort of uh laughing, laughing at the industry.

SPEAKER_02 38:39

I did listen to the other podcast series that you have, so I learned a little bit from there as well.

SPEAKER_03 38:43

You know, it's coming. This industry will have to have an emerging tech program because the real breakthrough tech connecting the foundational models to the pension fund investment decision making will run through startups that have the context, that have the governance, um, that understand these high-stakes decision environments. It's all people to people. The foundational models won't have that people-to-people part that you have right now. You know, 45 years from now, when we've wired your brain with um sensors, maybe we'll be able to rebuild that, but not today. Dane, any deep thoughts or wise words before I ask my final question?

SPEAKER_01 39:28

I think I think about the value of this in the TPA world are significant. Um, that is still a space that is trying to find um a lot of the technology backbone that it's going to operate on. And I can see this being a very important component of that in the future.

SPEAKER_03 39:44

So it's a great comment. I I think truly this could be one of the levers that that rolls up into a TPA investment committee. Like, you know, if you're if you're talking about getting paid four or five percent for lending out one of these specials, that's a material amount of money. And and so that decision probably should roll up to an investment committee to think about, you know, what are we doing? Um, what are we doing with these assets?

SPEAKER_01 40:10

The evidence of for so far that we've seen, again, small pool, of TPA asset ownership, there in a lot of instances will be a higher fraction of optimal portfolios that do contain those special assets that are less standard. And this de-risks that somewhat. So this is an enabler I very much can anticipate. But that's just my view.

SPEAKER_03 40:31

Yeah, it's interesting when you think about an equities team recommending a microcap. Like I wonder how often in their models, or or let's call a special. I don't know whether that's your terminology, Hugh. I wonder how often the the model for an equity portfolio manager includes the revenue from lending.

SPEAKER_02 40:55

Revenue from lending, generally speaking, are not part of the return profile. It's part of the reduction of the operational expenses.

SPEAKER_03 41:03

That's where it goes? Okay. Interesting. So you would never say we've got equity appreciation, dividends, and lending revenue as our three kind of return drivers for this asset.

SPEAKER_02 41:16

Yeah, returns is returns. Um, you know, some of the conversation recently um in one of the conferences that um for securities lending that had an ETF component was specifically focused on how ETF fees today being so competitive could be offset through more enhanced securities lending, but it's not on the return, it's on the uh the fee structure.

SPEAKER_03 41:40

But is that because that's an intermediated product? And so now that you're going all the way up to the people who own the assets and facilitating direct, like aren't they primarily focused on the return profile?

SPEAKER_02 41:55

I think it's just how how they kind of categorize this, right? This is this is not your this is not because you chose your portfolio or or your or your stocks in a certain way, right? This is because how you used it for um another purpose.

SPEAKER_03 42:09

Got it. My last question. You're now operating in the world of pension funds. Welcome. It's fun. This is the parties are wild. Um what advice do you have to other founders as they start to navigate this space? We're trying to attract a lot of people like you, Hugh, that are gonna build tools to help pension funds achieve their goals. Um, what would you say to yourself five years ago before you got into this?

SPEAKER_02 42:35

You know, one of the things I mentioned a couple of times here is that um I had to learn a lot about this, right? This this is in terms of market structure, I can see this as something that needs change. But at the same time, I need to understand how this really worked. And it's through this understanding in the last year that's given me the ability to better articulate this, to be able to talk about this with investors, um, as well as the potential prospects coming in. I think in this space in particular, in institutional finance, it's very different than consumer retail type of product. You really have to know this. And I think for people that are trying to get into this space, you've got to have the team that can really, that can really understand this. And you know, I would say in the teams that we have right now, I'm still the one that's learning. If we bring other folks like my co-founder, like our head of um, our head of growth and our head of product, they know so much about this that can really give to give our prospects confidence and comfort when we start talking about this without really knowing the subject matter. Uh, it's really hard to convince folks, honestly, that you can make a difference in their daily lives.

SPEAKER_03 43:46

Well, I think you are. I think it's it's an important area. We need to continue to modernize these markets. You know, as a 40 year, it's interesting to hear this market emerged around hedge funds 40 years ago. And, you know, we're really just getting the the first. Major upgrade. Um you know, there might even be people with uh doing deals on phones today, it sounds like, rather than doing deals through exchanges or through technology. But you're gonna change that. That's what we're here to do. All right, my friend. Well, Hugh Leong, thank you so much for coming on. Dane, any final words before we let you go to your weekend?

SPEAKER_01 44:24

I've just appreciated this conversation. This has been one of my favorites so far on the podcast. So thank you, Hugh.

SPEAKER_02 44:30

Yeah, thanks likewise to both of you for taking your time. Ashby, Dane, it's been great.

SPEAKER_03 44:34

All right, and until next time, we'll be back with more technologists trying to improve the world of investing. I'm Ashby, and for Dane, we'll see you next time.