Nicholas Pratt looks at the level of activity in the securities lending market and the implications of an increasing gap between supply and demand.
The Lehmans default in 2008 led many institutions to reassess certain practices and securities lending was one of the first to undergo such scrutiny. In the immediate aftermath of the default, the concern centred on a potential lack of supply. Lenders became wary of their involvement in an industry where such large-scale defaults could occur and which had become unfavourably associated with short-selling, which many viewed as a principal cause of the market volatility and plummeting equity values.
Various regulators introduced temporary bans on short-selling and fund managers, pension funds and insurance companies suspended their lending programmes pending a comprehensive review of counterparty risk management practices, collateral requirements and lending arrangements.
Two years on, these reviews are complete and most lenders have returned to the market. There are even some newcomers. The UK’s Pension Protection Fund (PPF), which provides compensation to members of defined benefit pension schemes that have become insolvent, announced in November that it is to extend its hedging activity to include securities lending.
“The PPF has looked very closely at the risk factors surrounding stock lending, in particular in relation to cash collateral reinvestment, which was where stock lending came under stress during 2008,” says a spokesman for the PPF. “The PPF will not accept cash collateral in order to maintain a very low risk level.”
The PPF has also addressed the issue of recalling stock for voting purposes, which became a concern for many beneficial owners in the last two years. “The PPF has put in place a recall policy for voting purposes where it has significant holdings and on a case-by-case basis. It is important to note that the PPF considers its greatest impact on company practices to lie in the engagement with companies through its voting and engagement advisor (F&C Investments). These activities will not be affected by its stock lending. The PPF publishes its voting record on its website and will continue to do so.”
The PPF has not yet appointed a lending agent but is in the process of looking for one and will make an announcement in due course. And although it has opted for a programme “at the conservative end of the risk spectrum in order to achieve a very low level of risk”, the PPF’s decision to enter the securities lending market underlines that most lenders now recognise securities lending as “a way of increasing revenue by lending securities in a controlled way to help us gain better value from them”.
Lack of demand
So the lenders are back. The problem though is the lack of corresponding demand. According to figures compiled by Data Explorers, the gap between supply and demand in the securities lending market for US equities is at a two year high. The LongShortRatio, which contrasts the value of securities made available for lending with the value of the securities on loan, stands at 10.8.
The reason for such a wide gap is not, however, due to a collapse in demand. The figures show that the short sale value (or value of securities on loan) has remained relatively flat over the last two years, rising from $284bn in December 2008 to the current value of $331bn in December 2010. In the same period, however, the value assets made available for lending has increased significantly from $2.3trn to $3.57trn.
“The value of equity has increased but the demand to borrow has stayed steady,” says Will Duff Gordon, senior research analyst at Data Explorers. “There has been no big increase in hedge fund assets under management and while there are still plenty of hedge funds engaged in short-selling, it is nowhere near the levels we saw in 2007 and 2008.”
This was not a normal period of short-selling says Gordon. “I think a lot of hedge funds saw the credit crisis coming and started to short sell bank shares and property shares. The question now though is whether the same level of short-selling and consequently the demand for securities lending will ever return. Is this the new normal?”
The key pillars to ongoing borrowing demand are the offshore hedge fund market, alternative Ucits funds, exchange traded funds and convertible bond issuance, says Gordon. And on the regulatory side, the Dodd-Frank Act in the US will see the emergence of more independent hedge funds no longer allied to investment banks which could encourage more short selling.
There are, however, the EU proposals on changes to short-selling which call for greater disclosure around short-selling positions which will not appeal to many hedge funds and could see many either refrain from this activity or stick to low levels which fall below the threshold set by the EU. But the industry is energetically lobbying for less stringent guidelines in this area. “Ultimately we need the regulatory environment to settle down and people’s confidence and risk appetite return before we will see any significant increase in the demand to borrow securities,” says Gordon.
But how serious a problem is the widening ratio between supply and demand and who is it a problem for? “It is not a great concern for the asset owners because they are not solely relying on the revenue from lending these assets. It is the intermediaries such as the securities lending agents that are relying on more activity to support their securities lending divisions.”
Just eight years ago the gross revenues being earned from securities lending was around $20bn and this figure now stands closer to $8bn, which is a significant drop and one felt by intermediaries such as lending agents and prime brokers who take a fee for each agreement they facilitate.
Aviva Investors is one of the few asset managers to manage its own securities lending house business and acts on a pure agency basis for the beneficial owners of funds within its own portfolios. Like most asset owners, Aviva unilaterally increased haircuts across all of its securities lending programme and terminated business with those counterparties at the riskier end of the investment spectrum.
Obviously the bigger the haircut, the bigger the capital implications for any potential borrowers and, according to Mick Chadwick, head of trading, securities finance at Aviva Investors, there has been a selective reduction of haircuts for certain asset classes and for certain counterparties. “One thing that the Lehman default demonstrated was the relative robustness of certain asset classes and counterparties so we have now taken a more asset and counterparty-specific approach to risk and collateral management.”
And while there may be less leverage in the system than there was three years ago and certain parts of the market such as the long-short equity funds and prime brokerage are far less active than in 2007, other asset classes and other participants have fared well, says Chadwick. “A good proportion of our portfolio is in government bonds and the demand for these assets has actually gone up. Prior to 2008 liquidity was cheap and abundant and now it is scarce and expensive. And the equity market is not all driven by hedge funds and prime brokers. There are plenty of institutions engaged in tax arbitrage strategies based on equities where the level of risk is not being ramped up and these are still very active areas.”
For the securities lending agents, the lack of demand and resulting decrease in revenue may be viewed as more crucial to the various intermediaries and securities lending agents that are wholly reliant on securities lending revenue unlike asset managers and beneficial owners. But, says Chadwick, this does not mean that buy-side firms see the securities lending market as merely a nice-to-have function.
“We have always taken the view that securities finance is a fund management discipline in its own right and not merely a back-office function bolted on to the investment process, but we are now seeing this view being more widely adopted by other institutions. For example, a lot of our insurance clients have Solvency II on the horizon and see securities finance as a way to monetize the liquidity embedded in their asset portfolios.”
“In some quarters securities lending was understood by some beneficial owners to be a risk-free source of income and a way to offset custody costs, but the last two years have demonstrated that it is not a risk-free business and you have to go into it with your eyes open,” says Chadwick.
The complacency of previous years was fuelled in part by the fact that some custodians offered indemnity on securities lending but this indemnity did not extend across the board, especially concerning the cash reinvestment side of the business, and it is in the reinvestment of this cash that many of the losses were incurred and where a number of lawsuits have ensued between beneficial owners and their agent lenders, says Chadwick.
“Our clients tend to be at the more sophisticated end of the spectrum and have always had an awareness of the risks inherent in the securities lending business, but for some of the smaller clients in other programmes it is possible that they did not appreciate the risks to which they were exposed. So in some regards I think the Lehman default has been a healthy development in that it has led institutions to review their programmes, and while some have left the market others have decided that, provided the necessary risk management and operational infrastructure is in place, this is still a good business to be in."
©2011 funds europe