Lending agents have made efforts to revive interest in the securities lending industry. Nicholas Pratt looks at how their role is changing.
It is fair to say that the securities lending market has been quiet of late. The noise generated by the high profile withdrawals of pension funds and other asset owners back in 2008 and early 2009 has since subsided. There is still some distrust about the benefit of securities lending for beneficial owners. The US Senate’s Special Committee on Ageing has launched an investigation into the securities lending industry and some allegedly imprudent cash-collateral reinvestment program. But for most pension funds, their own internal enquiries into securities lending were completed some time ago.
“Anecdotally, almost all of the beneficial owners that were planning to return to the market have now done so and some are now starting to revisit some of the more conservative measures they put in place during the last two years,” says Richard Thompson, chairman of trade association the International Securities Lending Association (Isla). “Primarily lenders were reacting to market conditions in the money market space and were drawing away from cash in favour of government bonds. We feel there is now a conversation to be had about other collateral types including the use of cash.”
And what of the various concerns of beneficial owners around the apparent lack of transparency in the securities lending process and for what purpose the securities may ultimately be used for? Many pension fund trustees appeared to be uneasy about the perceived link between short selling and market volatility and the possibility that stock which they had lent had been borrowed by hedge funds and used for improper purposes.
“I would challenge the assertion that there was a lack of transparency around the use of stock,” says Thompson. “All of the quantitative data on securities lending should be available on a daily basis from a lending agent and while not every single trade can be annotated, an ongoing commentary on what stocks have been lent out can be provided by lending agents as part of a service update.”
The issue is not that securities lending runs contrary to good corporate governance and there is no evidence to suggest that the securities lent are ever acquired purely for their voting rights, says Thompson. The Global Master Securities Lending Arrangement – the contractual agreement adopted for cross-border securities lending arrangements – has been updated this year for the first time since 2000 and includes provisions such as a warranty from the borrower to the lender that the stock will not be used for voting purposes.
Alongside the updated master agreement, Isla has also helped, along with the British Banking Association, the National Association of Pension Funds, the Association of British Insurers and other bodies, to produce a guide to securities lending for trustees. And Isla has also produced guidelines on how lending agents should interact with beneficial owners. “The idea is to re-set the engagement between beneficial owners and lending agents,” says Thompson.
It is too simplistic, says Thompson, to merely see the agent’s role as acting as the intermediary between borrowers and lenders and trying to align their conflicting interests. “They are not caught between the borrower and the lender where the borrower wants to engage in a transaction that is somehow detrimental to the lender. Lending agents are a point of entry for beneficial owners and they can provide aggregation around the inventory and provide a level of expertise and acumen in the provision of services.”
The changes in the securities lending market have not been wholly down to the aftermath of the Lehmans default. The unbundling of custody and securities lending services has been a profound development, particularly in Europe, says Paul Wilson of JP Morgan. Asset owners are now viewing securities lending as a fundamental investment process and no longer a commoditised back-office operation and this has changed the kind of engagement that lending agents have with prospective lenders. “We are now dealing with chief investment officers and chief risk officers that are more actively engaged in the process and aware of the risk levels involved.”
This heightened awareness of risk may have resulted in some lenders leaving the market while the general increase in collateral demands and risk management requirements have not made the securities available any more enticing to the decreasing number of potential borrowers in the market. But, says Wilson, there are some positive developments as a result of this change. “The lenders that are still involved in the market are more aware of why they are in the market and what they are looking to get out of it.”
There has been a refocus from asset owners on the intrinsic value of the securities that have been lent, says Rob Coxon, international head of lending, BNY Mellon Asset Servicing. "Some lenders have decided that they do not want to increase the risk in their programme and want to focus on the securities with the largest spread. This means they want us to focus on lending in demand ‘specials’ and not on general collateral."
Nevertheless the demand to borrow securities has dropped significantly and is now more of a concern for the securities lending industry than the level of stock available to lend, particularly the lending agents whose revenue is driven by the level of activity. “The demand to borrow securities has increased at points during 2010 but is still well below 2008 levels,” says Coxon.
“A bank such as ours has massive supply but the market is very subdued, although we are hopeful that demand will pick up in 2011. We are responding to the demands of prime brokers and hedge funds but it is clear that the supply side of the business are not about to lower their risk tolerance and will not lend at any cost."
The stock available may come with more conservative guidelines around risk management and higher collateral demands but, according to Simon Lee, senior vice president at securities lending agent eSecLending, this has not unduly affected the demand to borrow assets. “What has affected demand, particularly from a hedge fund perspective, are a series of macro-economic factors – the reduction in leverage, regulation relating to the cost of capital for collateral use, the low interest rate environment, the use of quantitative easing and the lack of corporate activity such as mergers and acquisitions and pubic offerings.”
“In order to adjust to these market conditions, market participants will need to be as efficient as possible. Most lenders have already reviewed their programmes and now recognise that securities lending is an investment process rather than a back-office process and are subjecting the same level of due diligence in selecting their securities lending agent as they would with any other investment function.”
This has created opportunities for third party lending agents to win new mandates and acquire new business as lenders continue to review their programme and alternative solutions in the market, says Lee. “Not every provider has the same business model. And while the large custodial pooled programmes may suit those lenders that are happy with a standardised offering, others will look for a more customized approach.”
Technology is likely to play an important role in whether securities lending agents are successful in winning new mandates and this means significant investment for any new entrants to the market, says Lee. “We are seeing more custodians enter the third-party agent space. One important component to consider as they try to compete with the more experienced third party agents who have been offering this capability for over ten years is the level of investment required to produce an efficient operating platform.”
The investment should be worth it through, particularly as the industry is more cognisant of infrastructure and the benefits of automation, says BNY Mellon’s Coxon. "Previously margins in securities lending were very high and a lot of bodies were thrown at the operational side, but now margins are much tighter and there is a growing recognition that enhanced automation offers a much safer and less risky way to run a securities lending operation, particularly when the risk of default is still a concern."
The lingering concern over further defaults means that the spectre of regulation continues to hover ominously over the securities lending industry. Basel II and its imminent successor Basel III will have an impact on the borrower community and the capital cost of securities lending. But of more potential impact are the EU’s proposed measures on the use of short-selling have not been overly helpful says ISLA’s Thompson.
“One of the misconceptions around short-selling is that it purely involves directional shorts. It can also be a hedging mechanism that is market-neutral. Short selling brings efficiencies and appropriate price discovery and whilst regulators are right to stamp out market abuse in any form, singling out short selling for additional legislation seems disproportionate. The industry needs to have a grown-up conversation about what short-selling is and what it is not.”
As for the future of the industry, Thompson is hopeful that a continued common sense approach will prevail. “The demand for securities lending is still running at a comparatively low level so it is important that we keep a sense of perspective. Lenders could increase their revenue by increasing the level of risk but I don’t think that approach would be fit-for-purpose in these uncertain times. I would prefer to see revenue increase and demand increase because more participants – both lenders and borrowers – get involved and not because individual participants do something rash in order to bring a greater return.”
©2011 funds europe