The acceptability of securities lending

Roy Zimmerhansl

While Roy Zimmerhansl notes a growing acceptance of securities lending, the general lack of understanding of the business still surprises him

Roy Zimmerhansl’s securities lending career began in 1987 when he moved to the U.K. with a Canadian bank and set up a securities lending function. It was just after the “big bang of 1986,” when the industry was based on “my word is my bond” and there were 14 different borrowers with no contracts in place with any of them. The technology used was a Lotus 123 spreadsheet, which Zimmerhansl himself built.

In ensuing years, events such as the Black Monday market crash of 1987 and the Maxwell pensions scandal would affect securities lending. “The issues around Maxwell largely surrounded the capacity to do securities lending, the authorization to do securities lending and collateralization, because a lot of securities lending then was uncollateralized.”

The business was evolving throughout the 1980s, with some of the large U.S. banks such as Lehman Brothers, Morgan Stanley and Salomon Brothers being at the vanguard of bringing more structure and more technology to the business. Back then, says Zimmerhansl, securities lenders were mostly U.S. institutional investors, as cross-border investing often had restrictions in countries such as Canada, and securities lending was not yet commonplace.

Even in North America, although securities lending was known, it was not pervasive. “Although as a practice, broker-to-broker, in the U.S. it had been around for a long time. That didn’t mean it had penetrated the institutional side of the market. And if you look at insurance companies and pension funds, they were much smaller back then. In Europe, firms like Prudential and Robeco were very much the exception back then as active lenders.

The way securities lending was viewed was very different back then, says Zimmerhansl. “Trading strategies that worked in one market were applied to new markets, but those that required stock borrowing were limited by the lack of available securities. The gratifying thing is to see the transformation in the general acceptance of securities lending. Back then emerging markets were new and exotic as straightforward investment markets, whereas today, in order to achieve promotion from MSCI Frontier Market status, which is the least developed category, to Emerging Markets, your market has to allow securities lending. In the old days when we were considering a new market we would see if securities lending or short selling was illegal. And if it wasn’t illegal we would deem it to be legal on the basis there was nothing saying we couldn’t do it.”

The financial crisis of 2008 brought many changes, specifically regulatory. “From my point of view, although it’s had a significant impact on the demand for borrowing securities because there’s less proprietary trading for banks and less leverage for hedge funds, it’s actually the thing that has enshrined the future sustainability of the business. In the period from 2008 to 2009, about 30 different countries had a short selling ban at some stage. After that, each market regulator provided reports to IOSCO (International Organization of Securities Commissions) about their experiences relating to the bans. IOSCO aggregated that info and in their reports of securities lending and said if prudently conducted and managed, securities lending needed to support short selling actually is beneficial to the market.”

Technology, which used to be almost non-existent in this space, has also changed: “While people have always had their own books and records (some of it in manual ledgers) we now have trading platforms like EquiLend, automated post-trade reconciliations and you can have more or less STP (straight-through processing),” says Zimmerhansl.

On the regulatory side it’s pretty much accepted in every market, and where it’s not, market regulators tend to be working towards implementing it. “In the last few years, many markets have approved securities lending to improve market liquidity, including the United Arab Emirates, Poland and Nigeria, as examples,” says Zimmerhansl.

However, in order for institutions to participate in securities lending, it has to be low risk. “Pretty much every institutional investor I have met considers themselves as conservative, and so the risks involved in lending are important. While there have been counterparty defaults, some reinvestment losses and a small number of lawsuits, the losses to clients over the past 25 years have been extremely low compared to the consistent revenue contributions,” he says.

Going forward, the opportunity for securities lending is aligned with pension funds’ and other investors’ investment return challenges, getting the incremental revenues from securities lending, supported by “the regulatory thumbs up.”

“If you look at the cash reinvestment problems in 2007/2008, I would have expected the market to be a little bit more sophisticated and to have learned lessons from 1994—[such as] the need for better contracts with more clarity on cash reinvestment guidelines. Customers that were lending in 1994 and still active in 2007 should have had better clarity and understanding, and banks should have done a better job educating their new customers post-1994 on the risks of the business.”

Zimmerhansl is still surprised, however, that 25 years later there is still often a general lack of understanding of the business. “I naively anticipated that this would be standard practice for investors. I don’t see many RFPs that don’t include securities lending, yet education is still the most important contribution we make to clients on an ongoing basis.”

The second issue facing the industry is lack of visibility, he says. “People don’t understand the business partly because the industry has been closed in terms information being publicly available. ISLA (International Securities Lending Association) is addressing this as a core objective.

“The other thing I expected was for this to evolve more into a competitive trading business, i.e., more like an exchange with pricing transparency,” he says.