Stock lending is definitely anathema to many governments and regulators across Europe. Countries forbid short selling at regular intervals. And now the European Securities Markets Authority has proposed rules to ensure that the benefits of stock lending accrue to funds.
Stock lending has had a bad name for many years, ever since Robert Maxwell raided his company pension fund in the late 1970s and early 1980s under the guise of lending stocks (in reality stealing them!). The Lehman affair was just another example of the problems caused by rehypothecation, the on-lending of borrowed securities in different environments. And the financial crisis saw the authorities blaming shorting as a major cause of market volatility.
Whenever those authorities propose regulation in this area, one has to question if the intended consequence is not really the elimination of the function. There will be many who support the view that stock lending creates liquidity in markets and limits volatility. Such views are intellectually satisfying to the extent that lending is the result of market activity and not the cause.
But what is likely to happen if managers cease to earn reasonable returns on stock lending? In theory, as long as they cover their costs (and the indications are that operational costs would be covered), it is probable that lending volumes would not be impacted. Quite simply, especially for index-linked funds, revenues from stock lending are key to performance and thus imperative to the fund.
But it is unclear how the rules will work. The stock lending market is not a tri-party arrangement between a fund, that fund managers lending desk and the borrower. There are several parties to the chain, and it is unclear how proposed regulation will impact each of them. Furthermore, some fund managers arrange loan and revenue-sharing deals with third parties, and it is unclear how these would be affected. Is the custodian or fund administrator considered to be party to any ESMA guidelines if they operate as lending agent?
If the rules are drawn broadly to capture all parties, there would have to be a close re-examination of the risks allocated. If the deep pocket philosophy of the authorities for risk attribution is maintained (with the illogicality proposed in UCITS V and AIFMD where custodians become liable for market risk and, to some extent, investment risk), we have a major problem. Stock lending is, of course, always collateralized. But collateral management is still a dangerous art rather than a precise science. There are chasms of risk around title in some jurisdictions. And market risk prevails to the extent that haircuts can never be guaranteed sufficient to cover all possible market volatility. Markets also all claim to have perfect delivery versus payment, but whenever I have seen a crisis, there has been uncertainty around this simple principle other than in environments operating real-time gross settlement in central bank money.
If the authorities require the revenue allocation to be changed, then the agreements will have to be revisited across Europe to ensure that liability follows revenue rather than the best balance sheet in the chain. It is not so much the challenge of a recalibration of revenues that could destroy the stock lending market, but such a recalibration without a simultaneous reallocation of risk.
And, if the authorities do destroy the stock lending market, my guess is we will then learn a lot about turbulence and volatility.