# The Calpers Model

Source audio: `audio\raw\the-calpers-model.mp3`
Compressed audio: `audio\compressed\the-calpers-model.mp3`
Model: `large-v3`
Language: `en`

[00:00:00.000] Hello, this is Brooke Gilman, and I want to welcome you all to the first podcast episode
[00:00:05.740] for the Global Peer Financing Association, which is GPFA. And Global Peer Financing Association
[00:00:12.120] is a new association in the securities financing market for both lending and repo,
[00:00:17.440] focused on the member base of the beneficial owner asset owners. This is a association that
[00:00:23.700] was created by a group of beneficial owners and initially by four large pension plans in North
[00:00:29.140] America that is now growing its membership globally, both with other pensions as well
[00:00:34.380] as other asset owner types, including insurance companies and asset managers.
[00:00:38.960] And today we have as our first guest, some of the original founding members of GPFA,
[00:00:44.800] CalPERS being one of the four pension plans that first founded GPFA.
[00:00:48.820] And with me from CalPERS today, I have both Dan Kiefer and Mike Johnson.
[00:00:54.100] Welcome, gentlemen.
[00:00:55.620] Thank you, Brooke.
[00:00:56.560] Pleasure to be here.
[00:00:57.040] Thank you, Brooke, for having us.
[00:00:58.160] Yeah, definitely. So Dan, your history at CalPERS is now 28 years in the making, which is quite some time. I know that you're an investment manager at CalPERS and maybe for both of you sitting within the securities lending function, it would be helpful just to let people know where that group resides within CalPERS, which is in your execution services strategy group.
[00:01:20.320] And I know, Mike, you also had a very long tenure at CalPERS, being there 14 years, an investment officer today, and prior to your time at CalPERS had been with State Street. So Dan and Mike, thank you both for joining. And what we wanted to talk today about was just to get a sense of the type of program strategy that you employ at CalPERS for your securities lending activities.
[00:01:43.420] And I think that it's helpful perspective, not just for other GPFA members, but other beneficial owners in the market globally to understand how each pension can differ slightly or each asset owner beneficial owner can differ and how their philosophy is on securities lending and how they approach the program and would love just to hear more about how your program operates today, but maybe also some of the history behind it and how you ended up where you are today.
[00:02:08.620] Sure, Brooke. Thank you. You know, when you take a look at any program, you have to play the cards
[00:02:14.360] that are dealt to you. Working at CalPERS, we have some unique cards. We're a large asset owner.
[00:02:20.320] We own assets of, you know, stocks and bonds worldwide. And we've got large positions that
[00:02:25.980] are indexed positions, so not a lot of trading in and out of those positions. And we've got a lot
[00:02:31.540] of stability being a state fund. So those attributes kind of lent themselves to our
[00:02:37.780] current model. It's been over 20 years ago, we were taking a look at how to best exploit our
[00:02:43.160] position in the market. Because traditionally, we were a custodial only lender and had a couple
[00:02:48.920] third party agents involved in our program. And we wanted to try to figure out how to lock up some
[00:02:55.440] premium for segmenting our pools of assets, especially internationally. We saw different
[00:03:01.880] values in different countries. So we approached our custodian at the time and asked if we could
[00:03:07.480] segment or kind of lot those out and have different people lend those assets. Well,
[00:03:13.120] we were in a commingled fund of one at that period of time. And our custodian wanted to
[00:03:19.340] charge us quite a bit of money in order to allow us to segment our own assets. So at that period
[00:03:26.660] of time, we decided to go a different direction and we created the ability and partnered with
[00:03:32.540] ESAC Lending at the time and created that functionality for ourselves and became an
[00:03:39.020] exclusive lender. So we started auctioning off portfolios, which really lent themselves to
[00:03:45.500] our both our asset base and our management style. Yeah, at the time I was with the custodian that
[00:03:52.500] was going to charge him to unco-mingle from a single fund. So obviously Dan doesn't hold
[00:03:57.300] grudges against me as he hired me a couple years later. But yeah, that is exactly correct. And
[00:04:01.880] to step it back, he did a complete summary of what happened, but we definitely started with
[00:04:05.720] baby steps there. We started with a smaller fund at the time, an equity fund, and kind of eased
[00:04:10.380] our way into the program from an auction model but the very first auction was extremely successful
[00:04:16.540] we just took one of our equity funds that we currently had available and we discontinued the
[00:04:21.740] custodial lender and we rolled it off into an auction and this is back in the day quite a bit
[00:04:26.220] so dan still got a copy of the facts he made it into a little plaque on his wall but that first
[00:04:30.860] auction itself was improved our lending 63 for the year for the very first auction was just a portion
[00:04:37.100] of our assets that we did. So to say the least, that it was extremely successful right off the
[00:04:43.000] bat, even when we just dipped our toe into the water to start. Yeah, I think we made more in
[00:04:48.200] that auction on that portfolio than we did the previous year on all of our assets combined.
[00:04:55.460] The 63% is based on year-to-year comparison, and we had it for a little bit less than a year that
[00:05:00.280] first year. So the income actually was, on an annualized basis, did definitely double.
[00:05:05.200] So we knew we had something at the time.
[00:05:07.820] And it was basically we were capturing kind of a time value premium.
[00:05:12.300] So the prime brokers were able to lock up assets directly to the hedge funds.
[00:05:17.400] So they were able to lock up inventory, which they needed.
[00:05:19.820] And there was value there.
[00:05:20.920] And we were one of the first ones to capture that value.
[00:05:23.220] Instead of being at the spot market or what they called in the kind of the custodial queue.
[00:05:27.620] So you're waiting for another person to get their assets off.
[00:05:30.900] And then they have to treat everyone equally.
[00:05:32.880] Well, CalPERS is not equal to other asset owners because we have different types of assets.
[00:05:38.660] So to be treated equally when you have large, chunky assets, we weren't getting the value that we should have been receiving in the marketplace, both on a spot basis and for this term premium that we kind of unlocked.
[00:05:51.000] So we did take baby steps, as Mike indicated.
[00:05:54.880] Once you start turning an exclusive program on, there's a lot of monitoring that we had to do.
[00:06:00.820] we had all of our counterparties, then we had to pre-approve. So everyone that we traded with,
[00:06:06.820] we didn't allow the custodian to pick our counterparties. We picked our own counterparties
[00:06:11.960] and monitor our own counterparties. And that had to go through a process at CalPERS. So that was
[00:06:17.400] all part of a system and a monitoring system that we ended up doing. I think I would add,
[00:06:22.500] not only did we pick and monitor our own counterparties, but I think we actually
[00:06:26.180] increased our counterparties, which helped benefit the model as a whole. Not only were we seeing
[00:06:30.380] price transparency from the bids that we were able to see, but just getting feedback from the
[00:06:34.880] marketplace on what was of interest from the marketplace. We were able to slice and dice and
[00:06:40.120] present these. As Dan said, we were able to sublot our assets, which something was completely
[00:06:45.760] different than anything we had done before. So we're able to present the assets. We're able to
[00:06:50.940] slice the pie and sell off pieces of pie instead of the whole pie. The sum of the parts wasn't
[00:06:56.280] equal selling off the pieces we made more money than we'd sell off the pie previously but yeah
[00:07:00.440] increased price transparency we saw in the bids increased our counterparties and you know the
[00:07:06.080] uniqueness and the customized slots we were able to create present to the marketplace just worked
[00:07:11.200] well for us and just added to increased revenue not only increased revenue a better functioning
[00:07:15.840] program as a whole the other perspective brooke just to kind of chime in on what mike was saying
[00:07:20.340] that I think was really unique about the program or the shift is we went from being the customer
[00:07:27.300] in kind of a custodial model. We were receiving, we're a customer to viewing the bidders as our
[00:07:34.540] customer. So now we are delivering a product to them. And part of the product was operational
[00:07:40.060] ease. We wanted to have good relationships with all our bidders because it's easy to get somebody
[00:07:45.560] to bid on a portfolio the first time, but you don't want to have buyer's remorse. So all of
[00:07:51.940] the buyers, we wanted that key customer experience that if they had a problem or if let's say the
[00:07:58.740] portfolio went away or there was a shift in the asset base or a stock got brought back,
[00:08:04.740] we were able to communicate in advance or on the back end of any type of move.
[00:08:10.960] And the other thing that we did is that we had a very active and still do corporate governance
[00:08:16.400] program.
[00:08:17.820] So we stated what we needed to do on a corporate governance perspective up front to everybody
[00:08:23.180] and said, we're going to be pulling these securities back over this period of time.
[00:08:28.100] And then there were certain securities we weren't going to lend as part of our governance
[00:08:31.920] process.
[00:08:33.020] And I think when you're opening it up front with people, they know what they're buying.
[00:08:37.460] our legal documentation was posted on the auction sites. So everybody had full transparency. I mean,
[00:08:45.080] we had transparency of the pricing, but all of the bidders had full transparency into us,
[00:08:50.580] into our legal, into our operational, into the custodial charges that they were going to be
[00:08:55.180] hitting on the back end. And that's something we also spent a long time on and kind of was a
[00:09:00.160] precursor for the Global Peer Financing Association. Because when we started taking a look at the
[00:09:05.560] charges that our custodian was charging for different movements in the securities lending
[00:09:10.060] process. We started reaching out to other peers and we started going to conferences and having
[00:09:16.060] breakout discussions with those peers so we could have visibility on it. And that was one of the
[00:09:20.780] things Mike spent quite a bit of time on was negotiating and getting full transparency into
[00:09:26.240] the charges that were being charged by the custodian. I think you summed it up pretty well
[00:09:31.620] there but yeah that was kind of the start of getting together with other beneficial owners
[00:09:36.040] if you would to talk about things like this and this is something that based on my history you
[00:09:40.460] know was able to start having conversations with other people and open I have candid conversations
[00:09:44.740] about some of our other concerns some of the things that we do in our programs and why we do
[00:09:49.280] our programs and it really opened the box for I don't want to say thinking outside the box but
[00:09:55.040] it was able us to have a forum with other folks who deal with stuff with us we see way what were
[00:10:00.660] their experiences like? What's it like with their custodian? What are they seeing out there? And
[00:10:04.800] again, it's all information that's made available to us that we can use to all our benefit and come
[00:10:10.900] share, discuss, and, you know, might lead to changes within your program. That's kind of how
[00:10:15.360] we looked at it. And that's how it was specific for some of our stuff that we put on the auction
[00:10:19.560] early on on our platform. I have a question. You're talking about a 20-year time period or so
[00:10:25.140] roughly. We've obviously gone through a lot of market cycles in the past 20 years, broadly in
[00:10:31.000] the global financial markets, but then specifically in securities lending, there's also been a lot of
[00:10:35.900] market changes in terms of where demand has been, where opportunity has been for different asset
[00:10:42.020] types over the period. How would you summarize that this model that you've been running now for
[00:10:47.840] 20 or so years has performed and played out over that time horizon? I know that there's a lot of
[00:10:54.260] people out there that would comment, well, exclusives used to work really well or auctions
[00:10:59.040] used to work really well. I mean, first they probably started out by saying they don't work
[00:11:02.080] at all. And then they might've said that they work, but now the market's changed and whatever
[00:11:06.960] it is. But you guys have been living and breathing it this whole time and seeing the results and
[00:11:12.260] seeing the benefits to your plan. What's your commentary on how CalPERS has fared during that
[00:11:17.720] period of time? As I said before, we're able to get price transparency through the counterparties
[00:11:22.820] when they come in and bid. And not only do we just say, have them price it, we ask them for some
[00:11:26.800] color, both before we have the auction and during the auction, whenever they're like, well, you know,
[00:11:31.820] Mike, Dan, I'm thinking about putting this bid. We're like, write a bid in, put a bid in, give us
[00:11:35.720] information. We have a front row seat to borrow demand here through the auction process. And by
[00:11:40.920] having them come in and put in their bids, you know, if we pay close enough attention, we can
[00:11:45.060] notice a change in behavior. And sometime in the mid 2010s, we started seeing a change in the
[00:11:51.300] behavior. We started seeing push towards this alternative collateral type. I'm hesitant to say
[00:11:56.680] the European lending model, but we did see before, if you looked at the market as a whole,
[00:12:01.440] cash as collateral was the majority of what loans were against. In the mid-2014, 15, 16,
[00:12:07.320] you saw that change. You started to see more non-cash collateral be taken. And then you started
[00:12:12.000] seeing the collateral types that were posted start to change a little bit there too. And I guess my
[00:12:16.520] takeaway is we've kind of adapted as we've seen the change in borrower behavior and by just paying
[00:12:23.120] a little bit of attention to what happens at our auctions and by talking, as Dan said, is
[00:12:28.240] gauging the borrower directly, having relationships with these guys, disclosing what our assets are,
[00:12:33.840] what might be some of our hurdles to borrow a certain set of our securities. Full disclosure
[00:12:38.560] and open conversation directly to the counterparty has helped us get in front of this and helped us
[00:12:43.880] be more informed and enabled us to make changes. Right now, we're more non-cash than we have been
[00:12:49.120] ever before. A couple of years ago, our on-loan balances, you know, I don't want to dive too deep
[00:12:53.800] into the numbers here, but we had just slightly over $10 billion on loan. Now today, you know,
[00:12:58.480] we expanded our collateral set, but now we're over $40 billion. So we've adapted as the market has
[00:13:03.400] adapted. We've changed as the market has changed. And I think we're able to do this in an exclusive
[00:13:08.200] environment through the auction platform. And like you said, we have front row seat. If we just pay
[00:13:12.620] a little attention, we can see what's going on. Yeah. And I guess the other thing about the model
[00:13:17.760] that we chose is when you have a custodial based model, you really have no flexibility to tailor
[00:13:22.940] anything toward you because if you're treating everyone the same, and if you're off the same
[00:13:28.980] technology, developing different technology for one customer or giving somebody something that
[00:13:35.280] no one else has, that's not in the best interest of the custodian or a third party lender, usually.
[00:13:41.460] When we went to the exclusive model, it was not just kind of the exclusives or auction.
[00:13:47.160] It was the whole system behind it.
[00:13:49.360] And I looked at it more as kind of a Lego model where you could build off of it and
[00:13:53.420] you have that flexibility.
[00:13:54.680] So when the market changed or we needed deeper transparency, we were able to get deeper
[00:13:59.480] transparency.
[00:14:00.400] We would just add it on to what we already had because we had a very flexible kind of
[00:14:04.800] open-based architecture, not a closed-based system.
[00:14:07.920] So you could go in and you could augment your program.
[00:14:10.360] And like Mike said, the non-cash collateral that came as a result of the big financial crisis in
[00:14:16.760] 08-09. So the regulatory reform after that pushed non-cash as a more viable alternative from a
[00:14:23.980] bidder standpoint. We were able to see that. The other thing that along the way, you see new market
[00:14:29.360] opportunities develop. So Mike has been instrumental in getting different markets approved.
[00:14:37.280] So we were some of the first lenders in certain markets.
[00:14:42.520] And we would go slow and we would make sure operationally we had things figured out and
[00:14:48.140] we would roll that out.
[00:14:49.200] So there was a lot of incremental value in just taking different security in a different
[00:14:53.800] countries, different security types, and figuring out the best route for that security type.
[00:14:59.620] So it's very customized around what you own.
[00:15:03.340] recognizing that CalPERS and you Dan and Mike were really the instrumental folks at CalPERS
[00:15:11.860] to help found Global Peer Financing Association can you maybe speak to your own perspective at
[00:15:18.960] CalPERS and the benefit you spoke a little bit about the information sharing and everything
[00:15:24.140] from it originally started maybe around hey what transaction fees are you being charged here and
[00:15:30.500] how can we maybe learn from one another's experiences and share information and help
[00:15:35.540] one another. But I recognize today that's evolved into a much more robust conversation and actually
[00:15:42.520] now transactions with some of your peers. Can you maybe either one of you speak to sort of how that
[00:15:47.860] came to be from your perspective at CalPERS? Well, I think, you know, the genesis was the
[00:15:53.900] fact-finding around our custodian. So we had kind of some loose meetings of our peers, both insurance
[00:16:01.140] and pension fund peers, and we would get together and talk about operational issues, new market
[00:16:06.620] opportunities, and we had these closed-door sessions. And in the closed-door sessions, what
[00:16:12.880] ended up happening is there was always a group of three or four or five different funds that were
[00:16:18.600] kind of leading the pack in what they were doing. They were up to something new, they were
[00:16:23.400] approaching it, and usually it was around a personality, an organization that had responsibility
[00:16:28.760] for both sec lending or collateral management. So they had a unique scope within their organization
[00:16:34.340] and the ability to affect change within their organization. So those meetings allowed us to
[00:16:40.780] meet the change makers at certain places. And that's where we came across the Jerry Mays and
[00:16:47.860] the Rob Goobies, these individuals that were doing new things and looking at the world
[00:16:53.840] differently.
[00:16:54.940] Since we were augmenting our program and always are looking at new opportunities, the people
[00:17:01.120] that are doing new things in their organizations in the confines of their own limits.
[00:17:06.420] So I think creativity happens when you have constraints and understanding the constraints
[00:17:14.240] that our brethren are under and understanding our own constraints allowed for this kind of
[00:17:20.320] creative process flow. I think that was kind of the genesis of the founding of the Global Peer
[00:17:26.560] Financing Association. So what does it look like today for you without getting into the specifics
[00:17:32.380] of trades? How active is CalPERS with your peers? And broadly, what type of transactions or size
[00:17:41.040] does that look like? I mean, is that a couple hundred million in this type of transaction or
[00:17:44.760] that type of transaction, or is this much bigger than that? How significant is it within your
[00:17:49.320] broad-based program today? That's a good question, Brooke, and it kind of bridges where we're at
[00:17:55.560] as far as what CalPERS program looks like, an exclusive model, and what we're doing with the
[00:18:00.860] GPFA. On an exclusive model, we auction off exclusive rights to our lending base. So once
[00:18:07.320] that happens, a borrower's committed to a chunk of assets, whatever the lot is, and they own those
[00:18:13.300] things. So we can't touch them. They pay us a fee for the size of the assets and we can't touch
[00:18:19.500] those things. So the exclusive, we put out all our assets out on exclusive. We auction them off and
[00:18:24.780] try to get them committed and exclusive. So all our assets go out. We've probably got 90% of our
[00:18:29.300] asset base that's committed in exclusives, but well, with that other 10% we have, that's something
[00:18:34.880] that we can do, something we look to. And what initially first happened is we started having
[00:18:39.320] these conversations several years ago in these breakout sessions. And we talk and we started
[00:18:44.660] put together a deal where we did a deal with Hoops. That was kind of what started us out.
[00:18:49.120] And that was from an auction. We auctioned some assets off and through our traditional
[00:18:54.040] price transparency, we didn't see a value in a certain area. So we just kept that as basically
[00:19:00.300] an agency. We were going to lend that out kind of on a spot basis. And our peers were able to
[00:19:07.240] unlock value in that market. So then that was the period of time we saw one of our peers could
[00:19:12.860] unlock value. And we went back and we created a approval for that peer. So now we had got into
[00:19:19.620] kind of the counterparty approval process for a non-standard counterparty or an unrated counterparty.
[00:19:25.020] So once we kind of tackled that and defined what we needed and a way to monitor a nonstandard counterparty, we were able to go to one of the committees that approves our counterparties, and we got our counterparties approved internally.
[00:19:42.120] And that led to us being able to trade with our peers. And we have a variety of peers right now on our approval list. And since that period of time, Mike, what was the number? It was in the billions of dollars that we've had out with our peers. And it added, you know, millions of dollars to revenue.
[00:20:01.460] And this is money that wasn't really available. It unlocked an opportunity. If you think about it, kind of the classic efficiency frontier curve in finance, this was off the curve. This was an opportunity that wasn't available. And by increasing your opportunity set, you shift up and right on the opportunity curve. And that's always a win-win.
[00:20:23.760] And the other thing that we were dealing with is we have peers that are better counterparties than the normal traditional counterparty. These are large asset owners. They're not going away and they're not getting called in. And if you take a look at some of the data out on some of our peers from a nonstandard credit perspective, they're some of the highest rated counterparties in the world. And you would expect that.
[00:20:48.960] So we were able to unlock value, create additional revenue, and take less counterparty risk and create a win-win situation with people that we understand very well, our own peers.
[00:21:04.900] Definitely a win-win for all involved.
[00:21:07.200] So, you know, just maybe wrapping up here. I'm curious what you guys would say if you were to answer the question, what is probably the first, second and third priority or goal of the CalPERS Securities Lending Program?
[00:21:23.800] I know that from all these conversations, you'd probably focus on being an intrinsic lender, but what do you think is most, especially maybe today here as we are in 2020 with your continued use of the auctions and exclusives, but clearly you've adapted your program style significantly over the years as the market has changed, as borrowers have changed, as behaviors have changed, and now you're growing and evolving even beyond that with your peers.
[00:21:50.160] How would you summarize all of this as things that you are most focused on for your program or the best way to describe your program?
[00:21:57.600] Our main goal at PERS is achieving an actuarial return in order to meet the goals for our beneficiaries.
[00:22:07.280] So in the end of the day, that's the first charge for everybody.
[00:22:10.700] And we have a 7% return target, which is a pretty lofty goal at this point, given where fixed income is.
[00:22:16.740] So the securities lending program is a return generator, and we're also not wanting to expose those that return to a lot of risk.
[00:22:27.940] So I'd say we're a very low risk, higher returning program through the use of some of these creative areas.
[00:22:37.260] So as we unlock creative new areas, we're unlocking new value that wasn't there before, but we're not exposing ourselves to a lot of incremental additional risk.
[00:22:50.280] So that, I think, is probably our number one and two goal is to basically derive return for the fund in a low risk, highly transparent and measurable manner.
[00:23:04.970] Yeah, that's correct from a lending perspective.
[00:23:07.210] We also have a mandate for leverage, which we kind of put in a separate silo and have
[00:23:11.650] a separate risk mandate for that, which also potentially could involve the lending team
[00:23:16.210] as far as doing financing trades and things of that nature.
[00:23:20.090] But like I said, that's a separate silo from securities lending, but we just do that for
[00:23:24.350] our own purposes internally as far as measuring risk.
[00:23:29.400] Okay, well, great.
[00:23:30.180] I want to thank you both for agreeing to do this first GPFA podcast.
[00:23:35.840] And I know that some of the topics that were discussed could be a more in-depth podcast
[00:23:40.920] topic going forward.
[00:23:42.260] Obviously, you spoke earlier about the non-cash collateral topic, and I feel like that's what
[00:23:46.900] we should maybe dive into next, Mike, when you mentioned that, but also even just recently
[00:23:52.220] trying to better understand how CalPERS looks at securities lending as one of the tools
[00:23:57.400] and solutions for maybe your broader leverage strategy also could be interesting to explore
[00:24:02.120] down the road. But thank you both. I really appreciate you doing this and it'll be exciting
[00:24:07.000] to hear more from you as GPFA grows and expands its membership. So thank you both.
[00:24:11.860] Happy to do it. Thanks, Brooke.
[00:24:13.320] Thank you, Brooke.