November 2007


Despite recent credit woes, securities lending hasn’t taken a nosedive. Sarah Coles finds that it’s a low risk strategy, which generates reasonable returns if your portfolio is managed well

07_11_securities.jpg THE CREDIT CRUNCH that hit the markets this autumn made everyone a bit more nervous about their lending and borrowing strategies, and institutional investors who have had securities lending programmes for years have been looking at them afresh, wondering what the new environment means, and whether the market is really right for them.

The result has been a vote of confidence in the industry. David Rule, chief executive of the International Securities Lending Association, says despite the extra scrutiny, lenders aren’t pulling out. “Lending volumes haven’t declined. There have been increases, particularly in the bond market. I’m not aware of any pension funds having withdrawn from the market.” So what makes securities lending so attractive?

It’s certainly doesn’t offer particularly impressive returns. It usually nets an average of between three and six basis points a year. This return is free of capital gains tax and stamp duty, because there’s no buying or selling of securities involved. It may offset some of the running costs of investment, such as custodian charges, but it remains relatively small potatoes.

Income boosters
Some lenders boost this income through various means. It can be more rewarding, for example, if a lender has particular assets to lend. Mark Tidy, securities lending product manager for ABN Amro Mellon global securities service, says: “Lending is always a question of supply and demand. It depends on what you have to lend.” As Rule points out: “If you have something a bit rarer like Japanese, Korean and Indian stocks, you’ll get a much larger return from lending those than if you have a FTSE tracker fund. It depends on the value of your assets to the people who want to borrow.”

Lenders can also be more flexible about the collateral they will accept against the loan, in order to boost returns. Rule explains: “In the past you wouldn’t get a higher return depending on the collateral you accepted. You may have found it easier to trade if you were flexible, but you probably wouldn’t get a higher rate. Now it appears to be changing. Dealers may be willing to pay a higher spread if lenders will take collateral such as equity.”

There is also room to make additional returns if the lender can waive the right to recall the loan during the fixed loan period. This appeals to borrowers, who can make better use of the asset if they have the certainty they can hold onto it. However, this isn’t possible for most institutional investors. An active investment policy and voting requirements mean it’s virtually impossible to lend for a fixed term, as institutions need to recall securities in order to sell them or vote. Rule says: “I’m not aware of any institutions giving up the right of recall.”

Most lenders aren’t particularly worried about boosting their returns. They prefer to accept modest gains in return for protection against the risks inherent in the securities lending market. Where there’s a return, there is always a risk, whether it’s structural like tax and legal risks, or market-driven like the risks of lending in one currency and taking collateral in another.

The risk that concerned the market most during the credit crunch was less to do with the loans themselves, and more to do with the collateral. Over the past few years there has been a trend towards using cash as collateral in European markets. This is then reinvested in the money markets, at which point it becomes exposed to the credit crunch.

This isn’t necessarily a bad thing, as lenders are offering liquidity at a time of scarcity. Ed Oliver, a senior business consultant with Spitalfields Advisors, says: “Lenders benefited from the returns from cash because liquidity funds have done very well in this period. If you were able to invest for 30 days and hold the investment to maturity you made good returns.” However, others took more risks. Rule explains: “If lenders were stretching for extra return, they may have allowed themselves to get into riskier areas. So some lenders have been examining their strategy, and cash managers reduced the maturity of the assets to increase their liquidity.”

The risk that is uppermost in the majority of lenders minds is counterparty risk, and whether the person they lend to is going to be able to repay the loan. The market is complex. The borrower gains absolute title to the securities, so they are usually lent or sold onwards. Often there’s no way to tell where your securities will end up, so you are relying on your counterparty to repay.

To safeguard against this risk, the lender will, of course, receive collateral. This is worth more than the securities originally lent – standard practice is 102% when you are lending in the same currency as the collateral, and 105% when the currencies are different. However, if the market changes, you will need to make calls on the margin, to top up your collateral, and you need your borrower to be robust enough to be able to guarantee they will be around to pay.

There are particular risks when the counterparty is a hedge fund. The concerns with some hedge funds are the very high borrowing sometimes involved, and the possibility that not all of them will be around for the long term. This is the main reason why most lenders don’t get involved directly with hedge funds, instead they use a third-party broker, who lends on to reputable dealers.

The broker may be their custodian. Oliver says: “First-time lenders may feel more comfortable lending through their custodian. They have a long relationship with them, and, in general, they take a very conservative approach.”

Alternatively, lenders may use an investment bank. Whichever they pick, the third party will usually indemnify them against the risk of default, in return for taking a portion of the return.

As they are taking this risk on, the third parties have very robust systems to reduce the dangers of loss. Tidy says: “We don’t lend directly to hedge funds. We have a set list of approved borrowers, which is rigorously managed. We set high hurdles on credit quality and risk management and take into consideration the overall relationship with the bank. Firms we lend to are highly rated and capitalised, they include major investment banks, prime brokers and broker dealers.” These firms act as brokers, who are borrowing on behalf of their clients, reducing the risk involved on both sides of the deal.

It’s up to the lending agent whether or not to lend to hedge funds. Oliver says: “Some of the larger hedge funds’ status is more in line with a typical counterparty. Some are well capitalised and information about them is relatively publicly available, so some do borrow directly from lending agents. But that’s only the very top tier.” This shouldn’t affect lenders, however, as their indemnity still stands.

Aside from the protection offered by third parties, there are also regulations providing an extra layer of safety. Securities lending is a regulated activity and, as such, it is governed by the laws, regulations and statutes in the countries where the borrower and lender are based. Many participants also adhere to a recognised code of practice. In the UK this may be the Stock Borrowing and Lending Code of Guidance, which is published by the UK Stock Lending and Repo Committee, an industry body chaired by the Bank of England.

These protections mean that securities lending can be a relatively low risk activity – as long as lenders are willing to accept relatively modest returns. So is it worth the time and money to lend out securities?

This will vary for each potential lender, as the costs involved vary. There’s an infrastructure you’ll need if you are lending in-house or running complex lending structures like auctions. There are also monitoring costs regardless of how you do it. If you have a larger portfolio this cost can, of course, be spread further, making it more worthwhile. However, smaller lenders may still be able to lend cost-effectively through a third party, who can pool assets and provide some economies of scale, so costs can be kept under control.

The gains funds can balance against these costs vary too, depending largely on what they have to lend. If you have a diverse portfolio with unusual assets in it you are more likely to be able to do a deal and get a good return, says Tidy: “It depends what is in your portfolios, how you invest, and what asset classes you hold, your appetite for risk, and fiscal or regulatory impediments that may exist. Beneficial owners will usually request a revenue simulation to be run and will then decide what course of action to follow."

However, Rule emphasises that pension funds with a duty to get best value from the fund have to at least consider the option, saying: “You’re missing out if you’re not lending. There are some risks involved, but if you are reasonably conservative and deal through high quality intermediaries there’s not very much risk and you are getting a return. Any fund of a reasonable size would have to be able to explain to their investors why they are not doing it.”

© fe November 2007