Too constraining?
Written by Peter Davy
November/December 2011
If pension funds share regulators’ concerns about short selling and the securities lending facilitating it, they’re doing a good job of hiding it.
Short-selling bans introduced amid market turmoil in August continue in France, Italy, Greece, Spain and Belgium. Last month, Italy extended its ban on shorting financial stocks until 15 January (and introduced a total ban of naked short selling covering the whole of the stock market from December); France rolled its forward for another three months the day before; bans in Belgium, Spain and Greece are indefinite. They’re becoming an accepted feature of the market.
“Unfortunately, it seems to be something regulators will look to do from time to time at times of market stress,” says International Securities Lending Association chief executive Kevin McNulty. That’s borne out by plans for pan-European regulation tackling short selling with new powers for the European Securities and Markets Authority (ESMA), recently agreed by the EU and set to come into force next November.
“Part of the problem is that if markets start doing things that people don’t like, there are often very few tools that regulators can reach for,” explains McNulty.
In one respect at least, it’s already proved a challenge for the market. At the height of the crisis in August, changes were coming so fast that law firm Simmons & Simmons took to putting out updates on Twitter – its first foray into social media for such purposes.
“It was becoming ridiculous,” recalls Simmons & Simmons partner Darren Fox. “We had almost hourly updates from the regulators as they changed their interpretations of what the restrictions meant.”
Nevertheless, it has done little to put off pension funds, who are major providers of the stock hedge funds, and others borrow to sell when shorting; a study in February by consultants Oliver Wyman found two thirds of the 50 largest UK funds lent stocks.
Their involvement in the market has not just continued, but, if any-thing, is growing, says JP Morgan Worldwide Securities Services inter-national head of client management and sales Paul Wilson.
“We’re actually seeing new pen-sion funds both in the UK and in continental Europe coming to lend their securities for the first time,” he says.
Back to the future
Of course, it’s tempting to take this as a rejection of regulators’ approaches. Certainly custodians are unconvinced by the bans.
“If the aim of the short-selling bans is to protect against a fall in share prices, they simply don’t work,” says RBC Dexia director of securities lending sales Bill Foley.
“There are a large number of respected, academic studies that all draw the same conclusion as to the effectiveness of short-selling bans in protecting prices as well as high-lighting the negative impact on market liquidity,” he points out.
In fact, you can argue the bans, by damaging liquidity, have the opposite effect to that intended. It’s notable, for instance, that French, Italian and Spanish banking shares, protected by a shorting ban, actually fared worse during the recent troubles than Portuguese banking shares that weren’t. Even if they did reduce volatility in the affected markets, however, one can argue about the benefit many buy and hold investors actually see since hedge funds shorting those sectors are likely to turn to alternatives in other juris-dictions as a proxy.
“They have simply moved to short sell banks that do not have restric-tions, such as those in the UK or Germany,” explains Deutsche Bank European head of securities lending Ben Sofoluwe. It has published papers with Oliver Wyman on both the impact of short-selling bans and of enhanced disclosure require-ments forcing investors to report significant short positions in stock. The conclusion from both is similar.
“From an investor’s point of view it is not good news. Nothing that artificially restricts the free flow of trading ever is.”
For all that, pensions funds’ continued involvement in the market more likely just reflects the gradual return that’s taken place over the last couple of years. In the aftermath of ehmans, many lenders, including pension funds, withdrew from the arket – but only temporarily. Almost all of them have now returned, say custodians.
That’s not to say nothing has changed. Many took the opportunity to tighten credit limits, restrict lending to certain groups, reduce concen-trations in exposures to individual counterparties, review the collateral they’ll accept from borrowers as protection in case of default, or otherwise test their lending para-meters against their risk and return objectives.
“We have seen people stepping back and looking at their program with risk management much more in mind,” says Mercer Sentinel senior associate Sonja Spinner.
She highlights collateral haircuts and the correlation in price valuation movements between collateral and the underlying securities as two particular concerns. Another has been what happens to cash collateral.
“When cash is accepted as collateral, it is reinvested to secure an added return for the lender. There’s now much greater clarity as to what risk the lender is prepared to accept with that cash,” says Northern Trust international head of client relations for securities lending Sunil Daswani. In some instances this has meant lower volumes being lent as tighter investment para-meters reduce credit and duration risk, and low interest rates have seen lower yields and lenders less willing to engage in low value trades – “part of a general shift from volume to value lending that has been seen across the industry”, according to Daswani Overall, though, it is just a much better informed market.
BNY Mellon Asset Servicing head of the international securities lending Rob Cox sums it up: “It’s not just a free monthly cheque anymore. Lenders have ensured they’re really familiar with the product.”
It has meant two things: first, that by August most had already considered their lending pro-grammes in the light of potential turbulent markets; and, second, most had reached the conclusion that, broadly, stock lending continued to represent a good source of extra returns at relatively low risk. After all, as Coxon points out, there aren’t that many such opportunities around.
“In these chastened times the risk-adjusted are appealing.”
Everything in moderation
That doesn’t mean regulatory inter-est has no bearing on the market. The EU’s proposed short-selling legislation is a concern – not so much for the restrictions on naked short selling (shorting without actually borrowing the securities in question first); nor even the powers proposed for ESMA to be able to ban shorting – which potentially have much greater scope than the bans in place presently (one reason the UK government is challenging their legality). Rather it’s the disclosure regime that could have the biggest impact. Those shorting equities of 0.2 per cent of the issued capital will have to disclose it to regulators (which few object to); those with short positions of 0.5 per cent or more will have to disclose publicly, so the whole market will see them, which is more of a problem.
“The requirements are going to be the most significant legislative restriction on the European market,” says Sofoluwe. “Hedge funds with reasonable assets under management allocated to Europe will not want that level of disclosure.”
There’s no clear evidence yet for how demand for shorting has been or will be affected by the disclosure regime, he says. “It’s the $64,000 question.”
However, two points are worth bearing in mind. First, the regulatory push isn’t all one-way. Dodd Frank, Basel III and the European Market Infrastructure Regulation (EMIR) all also pose challenges for shorting and, thus, securities lending. However, they also present oppor-tunities – in pushing over the counter (OTC) derivatives trading through central clearing, for example.
“Their impending implementation will mean a short-term negative impact, but when I look at the amount of collateral and securities that are going to be required to provide margin for those now centrally cleared OTC derivatives I think there are reasons to be more optimistic for the medium term,” says Wilson.
Foley agrees. As he says, the collateral that central counterparties (CCPs) will accept is typically highly rated government debt, and pension funds, along with insurers and other investment funds, are an obvious source: “That demand has to be met somewhere.”
But the other point is that demand is really the key, and puts the regulatory challenges into perspec-tive. Supply might have returned to the market, but hedge funds are still not nearly as active as in the past. The uncertainty and restrictions from the regulators don’t help there, but they’re not the deciding factor.
“It is tempting to blame the regu-lators for everything, but we can’t completely,” says McNulty. “They have an impact, but bigger factors are probably investors appetite for risk, hedge funds’ performance generally and the continuing hang-over we’ve been through.”
That might mean the short term for securities lending remains difficult, but it should mean the market can remain optimistic for the future – whatever the regulators decide.
