Jumping Ship

Christine Senior asks whether the market is abandoning securities lending

The aftershocks of the Lehman collapse last September spread far and wide. While pension funds were struck by direct portfolio losses, other activities were not immune, and securities lending, which many pension funds had previously regarded with some suspicion, began to look even less appealing.

Regulators tried to bring some calm to markets by banning short selling of financial stocks. Speculators were accused of driving down stock prices of weak financial companies through shorting in order to make a fast buck. Regulatory bans forced pension funds to question their
own role in the market events. Were they contributing to plummeting markets through their own lending activities? Or were they exposing themselves to unnecessary risks? Lehman was a big player in securities lending, so many lenders were directly hit by their exposure.

According to Mark Tidy, head of international business development, securities lending at BNY Mellon, lenders were protected by the support mechanisms embedded in the securities lending market.

“Organisations such as ours stepped in, in accordance with our contractual obligations, and where we had loans out to Lehman we used collateral proceeds to purchase back lent securities. We protected our clients’ interests. I think you would hear that from all major custodial lenders. The essential pipework of lending performed.”

Currently short selling bans have mostly been lifted though some restrictions remain. Naked shorting (without borrowed securities to back the deal) in certain stocks is banned in the US, and the SEC is considering further measures to limit short selling. In the UK the short selling ban on certain financials was lifted in January, but a requirement for disclosure is still in force until further notice, and the FSA is currently consulting on disclosure.

Industry reaction has been mixed while consultants’ advice has been that pension funds should tread carefully and be aware of the risks. In the Netherlands Watson Wyatt’s advice varies across its client base.

“It depends on individual clients," says Luigi Leo, senior investment consultant at Watson Wyatt. “If you have the governance or feel you can handle the risk you might want to continue, others might not want to.”

To come to a decision on whether or not to continue pension funds must review various aspects of the lending programmes – the kind and amount of collateral to accept, the type of assets they are willing to lend and the counterparties they are willing to lend to.

But alongside this caution, pension funds are re-examining their investment strategy to reflect the change in markets. In tough times any way of generating extra return is worth a second look.
“While the appetite for lending dipped post Lehman interest, we’re seeing that it’s on an upward trajectory at the moment,” says Tidy. “We’ve seen enquiries pick up. In a low interest rate environment everyone is under pressure, and lending is a technique for generating income. Many who re-evaluated their participation, who maybe suspended what they were doing, have started again.”

Graeme Perry, head of agency lending at BNP Paribas Securities Services, agrees demand for securities lending has remained strong in 2009, though overall volume has decreased.
"BNP Paribas has still seen great demand for equities during the first part of the year, but with less corporate activity across many sectors, the actual volume of trades has fallen. We have therefore seen better spreads and returns over recent months, but overall revenue has decreased, due to lower equity valuations, less corporate activity and lower overall demand, due to borrowers not only tightening their balance sheet use, but also less demand from end-users like hedge funds.”

But some developments over recent months have pointed out less well-known risks for lenders. Problems that have given rise to legal action in the US relate to cash collateral. Unnamed Dutch pension funds, for example, have been reported to have suffered losses through their custodians’ investment of cash collateral into risky assets. This has driven lenders to scrutinise more closely the finer points of contractual arrangements with custodians.

“Pension funds are aware of the issues and that is rightly causing them to attach great importance to their discussions with their advisers and providers of securities
lending services,” says Tidy.

“In negotiations with clients before they even start lending there is always detailed discussion of how everything works and negotiations around the documentation that underpins what we do, how we do it and what our obligations are.”

There are specific problems related to accepting cash as collateral because lenders are not indemnified by custodians against losses, unlike with other types of collateral. Michael Robarts of the global investment practice at Hewitt Associates feels that custodians have a conflict of interest because they share in the gains from the investment of clients’ collateral.

“You hold cash as a deposit from borrowers to earn return,” he says. “You have to return that cash. It crucially depends what you have invested in. If you are not careful and give slack guidelines, custodians have an interest in maximising returns on that collateral because they share the revenue, but they don’t share the risk, the indemnity they give doesn’t extend to investment losses. I would argue when it comes to cash collateral custodians suffer from a conflict of interest in that they participate in the revenue but do not participate in the risk.”

Tidy at BNY Mellon adds: “A securities lending agent that acquired a reputation for taking unreasonable risks – even within the confines of agreed investment guidelines – would not long survive in the securities lending business.”

In order to protect themselves pension funds need to issue strict instructions on how collateral is invested, says Robarts.

“We don’t mind cash collateral as long as investment guidelines limit it to high quality securities. We have advised clients if they accept cash to limit investments to government securities of short date maturity and preferably to focus on non cash collateral where they get the additional security of an indemnity.”

In spite of the bad press that shorting has attracted, there is evidence it benefits efficient market function. It is widely recognised that shorting, and by association stock lending, is essential to oil the wheels of the market, by providing liquidity.

“The good aspects of stock lending are market liquidity,” says Robarts. “The ability of market makers to make two way quotes in size is completely dependent on their ability to cover their positions if they take on that price. If they can’t borrow stock to meet settlement obligations they will cease to quote. Pension funds need market liquidity enormously to get their business done.”

WRITTEN BY CHRISTINE SENIOR
A FREELANCE JOURNALIST