It is not surprising that regulators are still evaluating the risks associated with securities lending as part of their on-going scrutiny of the shadow banking market. The securities lending market is certainly smaller than what it was pre-crisis. However, securities lending is being increasingly embraced by asset owners as a means to generate fixed revenues, but this could cause some issues for investors and regulators alike.
More asset managers and pension funds are lending securities to market participants such as hedge funds to enable them to short. Others are lending out cash or high-quality collateral to banks looking to bolster their regulatory capital or those that are caught by mandatory clearing who need to post initial and variation margin to central counterparty clearing houses (CCPs). Given the desultory returns in asset management and growing liabilities at pension funds, many see securities lending as a potentially profitable activity. Concerns about the finality of title transfer on collateral have reduced but memories of re-hypothecation troubles at Lehman Brothers will still deter some potential stock lenders.
“Some institutional investors and asset managers have a long history in securities lending. However, we are seeing additional new investors lending out their securities for the first time. Since the financial crisis, regulators have concluded that short-selling activities are conducive to market liquidity, as are the securities lending activities that facilitate for the short-selling to take place. Regulators have simply said that as long as securities lending is properly managed and prudentially regulated, it is a perfectly legitimate enterprise. The performance at many investors and asset managers has been impacted by market volatility and low interest rates so these organisations are looking towards securities lending as a mechanism by which to accrue incremental returns,” said Roy Zimmerhansl, global head of securities lending at HSBC Securities Services.
Simon Lee, managing director for EMEA business development at eSecLending, agreed. “Beneficial owners – whether it is asset managers, pension funds, insurance companies, sovereign wealth funds or Central Banks, have always had involvement in securities lending. My one observation is that asset managers who may have historically not lent securities or ceased lending securities post-Lehman Brothers, are reconsidering that decision not to lend. We are certainly seeing more interest from asset managers looking to participate in the securities lending space,” said Lee.
Analysis by Finadium found 54 US public pension funds loaned securities continuously between 2006 and 2013 earning an average cumulative 34 basis points (bps) on total Assets under Management (AuM). Even during 2008, these pension schemes earned an average 6.6 bps from securities lending. Finadium’s analysis of 10 large asset managers, which included Blackrock, Fidelity, Franklin Templeton, J.P. Morgan, Vanguard and T. Rowe Price, found securities lending earned them a cumulative 19 bps over the same time-frame.
“The number of asset owners who engage directly in securities lending is relatively small in number. Organisations need to have scale to lend out securities. Securities lending can be a lucrative business if the asset owner is able to lend out a special stock. We are also witnessing an emergence of a high-quality-liquid-assets (HQLA) fixed income market whereby asset owners with pools of HQLA government bonds are lending securities to broker dealers and banks who need these assets for regulatory reasons such as capital requirements,” said Andrew Dyson, chief operating officer at the International Securities Lending Association (ISLA).
Blackrock has been an enthusiastic proponent of securities lending. The asset manager recently expanded collateral requirements on its equity loans while scrapping a 50% limit it had on securities lending on European domiciled funds. Reports in the Financial Times said Blackrock made $477 million through securities lending in 2014. Nonetheless, some fear securities lending is exposing asset managers to undue risks. The biggest risk would be if the counterparty to the loan experienced a major credit event or default. Investors could face losses particularly if the collateral posted by that counterparty is of insufficient quality or liquidity and volatile. This is a major issue and something that investors ought to be cognisant of.
While securities lending is fully collateralised, there have been cases of organisations expanding their collateral requirements. A handful of organisations permit units in exchange traded funds (ETFs) to be posted as collateral. “As with any form of collateral, lenders must assess the suitability of that collateral from a risk management perspective including criteria such as the liquidity of the collateral, price volatility and the ability to liquidate that collateral in the event of a borrower default. Consideration of ETF collateral is no different in that regard,” said Lee.
Experts highlighted ETFs must be liquid if they are posted as collateral. Zimmerhansl acknowledged ETFs were diverse and their quality would ultimately be determined on the basket of securities to which they are exposed. “Fixed income ETFs may have exposure to government bonds but also hold tranches of high-yield corporate bonds as the underlying assets. An equity ETF tracking the S&P 500 will simply replicate the index and the underlying assets are exchangeable for the ETF. So in a worst case scenario – say a counterparty default – the holder of the ETF collateral could deconstruct the ETF following the S&P 500 and redeem the securities. The quality of assets underpinning the ETF is crucial,” he said.
Regulators take note
There has also been some investor criticism of asset managers about the amount of money they make from securities lending. Guidance introduced in 2012 by the European Securities and Markets Authority (ESMA), require proceeds from securities lending to be returned to the fund after direct and indirect costs are taken into account. However, asset managers can retain the fees from securities lending.
“The ESMA guidance is clear and requires managers to be completely transparent about their securities lending practices with investors in their prospectuses. Prior to the ESMA guidance, there was little uniformity over how securities lending fees were viewed at managers. Some firms took a fee while others did not. Some took more of a cut, others took less. It is hard to make a generalisation of practices at that time. Nowadays, while different managers continue to take different approaches to the treatment of securities lending fees, the transparency required of ESMA is apparent with managers having clearly defined protocols in place,” said Lee. However, there has been a lot of publicity with some investors claiming fund managers have been retaining more revenues from securities lending than they should be in contravention of the spirit of the rules.
Regulators have taken note. In July 2015, the International Monetary Fund (IMF) expressed alarm that pension funds could be creating systemic risk by pursuing securities lending programmes. The Securities and Exchange Commission (SEC) has proposed investment funds report details about their securities lending operations. The Financial Stability Board (FSB) is also evaluating securities lending at asset managers, having previously elected against designating large fund managers as being systemically important financial institutions (SIFIs).
The FSB and other governmental agencies including the Financial Stability Oversight Council (FSOC) have not fully absolved asset managers from their SIFI status. If the authorities feel asset managers are engaging in copious amounts of securities lending, they could be designated SIFIs. SIFI designation would be a terrible outcome for asset managers already saddled with heightened compliance and infrastructure costs. It could possibly subject them to Basel III type obligations including enhanced liquidity risk management, capital requirements, leverage limits, additional reporting, frequent stress testing and the even the introduction of living wills. This would be very costly, and maybe prohibitively expensive for some firms.
In response, managers should reassure investors and educate them about their securities lending activities. “A number of UCITS or mutual funds will use securities lending as a performance enhancement technique or cost reduction mechanism. It is crucial that this is disclosed up-front and in the prospectus. A number of managers make the information and potential risks about securities lending available on their websites as well. Equally, investors should conduct the necessary due diligence on managers to ensure they fully understand these securities lending practices,” said Zimmerhansl.
The decision to invest into a manager which engages in securities lending ultimately lies with the allocator. “Rules such as UCITS have introduced a significant amount of transparency to investors and regulators. Allocators are entitled to invest in funds which either lend or do not lend. I believe investors are comfortable with securities lending as long as the manager is completely transparent about what they are doing. In this low return environment, securities lending is an attractive proposition for end clients,” commented Dyson.
Securities lending could get more expensive for asset managers. European regulators are already pushing for greater transparency of securities lending. The Securities Financing Transaction Regulation (SFTR) took effect on January 12, 2016 and will require financial institutions to report information on their securities financing transactions (SFTs) to trade repositories on a T+1 basis. SFTs will include securities lending and borrowing, repurchase agreements, buy-sell backs, sell-buy-backs and collateral swaps such as total return swaps.
SFTR is a partial replication of the European Market Infrastructure Regulation (EMIR) which requires users of OTC derivatives and exchange traded derivatives (ETFs) to report details of those trades to trade repositories authorised by ESMA. The approved trade repositories for EMIR reporting are the Depository Trust & Clearing Corporation (DTCC); KDPW – the Polish trade repository; Regis-TR; UnaVista; CME Trade Repository and ICE Trade Vault Europe.
Data for SFTR will include information about SFT counterparties, the principal amount, currency and assets used as collateral and whether the collateral is available for re-use or re-hypothecation. As with EMIR, SFTR reporting will be dual-sided meaning both counterparties to a securities lending transaction must report. Dual-sided reporting has plagued EMIR with problems including inaccuracies and inconsistencies between different counterparties’ reports to trade repositories.
Nowhere is this more evident than in the generation of the Unique Trade Identifier (UTI), an alphanumeric code allowing repositories to reconcile reported ETDs and OTCs. Regulators failed to clarify which counterparty to the trade develop the UTI. As such, it was not uncommon for both counterparties to a transaction to report a different UTI. This means a significant amount of data is being reported but cannot be reconciled by the trade repository thereby undermining the entire premise of EMIR as regulators are unable to spot systemic risk build-ups in the derivatives market. Industry experts have recommended ESMA follow the example laid down by the Commodity Futures Trading Commission (CFTC) and allow for single sided reporting to trade repositories/swap data repositories.
Should SFTR prove to be prohibitively onerous for fund managers, they may avoid engaging in securities lending. As with EMIR, most fund managers sought third party delegated reporting at a reasonable price and this cost has not really been an issue. Lee doubted asset managers would exit securities lending because of SFTR reporting. “The additional disclosure obligations under SFTR can be delegated to a third party provider and I do not believe these extra costs will deter asset managers or any asset owner from participating in securities lending,” said Lee.
Regulators are increasingly scrutinising activities in the shadow banking system including securities lending. “Regulators in major financial centres have reviewed securities lending practices in detail and made a number of recommendations which have been taken on by agent banks and asset managers. That is not to say further regulation will not happen but a modicum of increased participation in securities lending by asset owners is unlikely to result in increased regulation in the near-term,” said Lee.
The growing proportion of asset managers and asset owners engaging in this practice does present opportunities such as a guaranteed fixed income in volatile markets. However, firms must be careful about how they approach securities lending.