March 2009


Activity in securities lending is picking up after last year’s short-selling bans. As lenders return to the market, Nicholas Pratt looks at how processes have changed...

The link between securities lending, short selling and the collapse of international stock markets created such a sense of panic and uncertainty that a number of firms suspended their securities lending programmes in the last few months of 2009.

For pension funds fearing borrowed stock could be used against their sponsoring employers, their securities lending programmes became untenable at a time when the value of pensions was plummeting and unemployment was rising sharply. The fact that regulators had imposed their own temporary ban on short selling added credence to these concerns.

But with the lucrative dividend season approaching, activity is starting to rise again and the last few months have seen various bodies in the securities lending industry launch initiatives to reignite the interest of pension funds and fund managers.

The first strategy was to discredit the notion that securities lending had been a contributing factor in the economic crisis by facilitating short selling among speculative hedge funds. David Rule, chief executive of the International Securities Lending Association (ISLA), believes that the short-selling accusations were largely unfounded and the temporary bans, which have now been lifted, were ineffective. “Now that there has been some calmer analysis it has shown that the evidence for short selling being the cause of the collapse is very sparse.”

Rule points to the recent FSA discussion paper released on 6 February in which the watchdog concedes that “the benefits of short-selling such as price efficiency and liquidity, normally outweigh the disadvantages” as an admission that it was mostly concerned about the potential for, rather than evidence of, abusive short selling.

The confusion and panic that has been created around short selling has been misleading for lenders, says John Belgrove, principal at UK-based pensions’ consultant Hewitt Associates. “There has been a fear of being associated with the negative connotations around short selling. I have to respect the wishes of my clients but I have more sympathy with the argument around the risk/reward profile for lenders.”

Belgrove also says there is lots of evidence that transaction costs will go up as a result of less securities lending activity. “We are in a credit crunch and a liquidity crisis, and suspending securities lending only exacerbates that.”

It was Watson Wyatt, another pension consultancy, that grabbed headlines back in November when it advised clients to suspend securities lending programmes if they were uncertain about the attached risks. Four months on and with these reviews underway or completed, many lenders’ programmes have restarted or are just about to.

Colin Rainbow, head of custody consulting at Watson Wyatt, says: “Fortunately the reviews have been very positive. Clients are now far more familiar with the mechanics of their securities lending activity and the guidelines are more in keeping with their expectations.”

The next step in the revival of the securities lending market has been to emphasise the need for more realistic expectations from lenders. Asset managers and pension funds are, of course, in a position of relative power right now as they are the ones holding the assets; however, any new arrangements cannot be skewed too heavily in their favour if they want to retain any business from expectant borrowers, says Rainbow.

A less risky business
Instead one of the main areas of focus is on improving the quality of collateral. “There has been a definite move away from the use of cash collateral and for those lenders that are still accepting cash as collateral, a lower risk cash investment profile is demanded. Gilts are the preferred collateral, and for lenders that are prepared to take equities as collateral we are advising that they restrict these to large cap stocks.”

Lending agents such as the global custodians have also played a part in reigniting interest in securities lending by stressing the changes that have taken place in the market. “We are seeing more oversight in lending programmes, more structure and a realisation that securities lending is a front-office alpha generator with some risk attached and not merely a back-office administrative tool,” says Paul Wilson, head of sales for securities financing at JPMorgan.

While this growing emphasis on oversight and risk management may be a reflection of the current market sentiment, some of the structural changes to the market will be more long-lasting, says Wilson, particularly in terms of the relationship between lenders and their lending agents. “The level of transparency and customisation that is demanded of agents is much greater. Agents with commingled funds may argue that liquidity is the important factor, but a customised approach gives lenders much more flexibility. Lenders will also find that they have greater or clearer choice when it comes to selecting an agent as we are all looking more different to each other than we have in the past.”

Overall the focus for lenders in this year and the foreseeable future is on risk management. “I think the overall theme is that there needs to be a return to the basics,” says Brian Staunton, head of securities financing EMEA at Citi. However, this emphasis on risk will mean that lenders must be willing to sacrifice some revenue in return for greater security, says Staunton.

“Funds have to look at the rationale behind their participation in lending and the parameters they operate in and see if these are consistent and within their own acceptable levels of risk. This could mean a scaling back of revenue, particularly for those lenders that were more tolerant of certain collateral types. The focus now is on risk tolerance and most lenders are prepared to give up some revenue for this.”

There is certainly a realisation among many fund managers that they now have to work harder to extract the same kind of returns they were receiving in more buoyant times, even if the level of disruption in the market has been less pronounced for some than others. “We normally run our securities lending programme from September to September, but in 2008 there was so much uncertainty that we suspended the auction and did it later in the year, which was beneficial for us,” says Carl James, head of dealing at Fortis Investments. “Once we got through the market uncertainty of September, we had a very successful auction. There were a few firms that decided not to participate but we didn’t see much of a change in the market.”

Must work harder
Nevertheless, James says that Fortis Investments has made a number of changes to its auction process, such as targeting specific counterparties. While he talks of the company’s desire to engage with “a broader group of counterparties”, James also says that Fortis Investments did not simply offer all of its assets to all bidders but was more selective. There has also been a review of collateral arrangements for securities lending which has been part of a wider project across the firm, says James.

“We have a global counterparty committee for all trading activity and we have the compliance and legal teams involved for
our borrowing and lending policy.”

The panic and uncertainty of September may have dissipated and the link to short selling has been disproved in many trustees’ eyes, but James says that fund managers will find more long-term challenges. “There was a time when the securities lending business was just a case of turning the handle but going forward I think firms will have to be a lot smarter in terms of how the assets are presented, who you engage with and how the lending programme is structured.

It’s going to get a lot tougher and firms will have to work a lot harder to get returns.”

©2009 funds europe