Much of this increased interest has been the result of more visible regulatory oversight and industry standards to improve transparency, and lenders introducing a more calibrated risk-management framework into their securities lending process. This increased oversight has pioneered a shift towards client focused innovation and the development of programmes tailored to client specific risk-return characteristics.
However, the role of securities lending has not fundamentally changed over time. What are the key uses of securities lending in the market and how can securities lending assist an asset owner better achieve its overall investment objectives?
Role in providing liquidity to the markets
It is generally considered best practise for markets to have a securities lending and borrowing facility available to support an efficient and orderly market. For regulators and clearing houses, the established fail coverage practice keeps the market moving and reduces domino fail risk. This has become vital in the current focus on reducing settlement cycles.
Securities lending enables market makers to hedge when offering or issuing futures, options, dual listed securities and convertible securities on behalf of clients. Broker dealers gain access to high quality liquid assets (HQLA) to lodge as collateral with central counterparties and to re-align their balance sheets with regulatory requirements.
Remember long/short funds? These funds require securities lending to execute their investment strategy. Our quiet achiever is often the one in the dealing room that no one notices – but watch him as he sits in the middle facilitating other traders’ activities.
In 2017, securities lending and borrowing was estimated at approximately EUR 1.8 trillion. Breaking this down into equities (49%) and fixed income (51%), this means that the global equity turnover is less than 2% of the daily turnover of the Dow Jones. Sounds small? Maybe so, but this is appropriate as securities lending is a facilitator. A decision will be made to trade, hedge, collateralise, cover a failed trade – whatever the reason is, it will trigger a need to borrow securities. This facilitation role means that securities lending is a background activity and without the ability to borrow or lend, these core activities could not occur as fluidly as they do.
Role in optimising performance
Increasingly the growing pools of stable assets held by beneficial owners such as pension funds, insurance companies and government entities which are suitable for lending are being enrolled in lending programmes. As a fully collateralised low risk transaction the additional liquidity has assisted the market, but the additional revenue has assisted the lender.
Take the case of pension fund holding a large portfolio of government bonds. Their underlying clients, albeit having a low risk profile, still expect returns in excess of the relevant benchmark. Securities lending is a way to generate additional revenues by lending out the fixed income via a fully collateralised transaction in which the fund manager determines the risk profile for the collateral. The pension funds retains full flexibility on how much to lend, who to lend to and when to recall the loan. As the owner of a buy-to-hold portfolio in a low interest rate environment – a securities lending strategy could generate an extra 5, 10, 15+ basis points towards performance.
What happens when you lend a security? Securities lending transfers full legal title from the lender to the borrower while allowing the lender to preserve all ‘economic’ rights of ownership. Collateral and fee terms can be established at trade date thus providing full flexibility for as long as possible. Should cash be accepted as collateral, this can create an additional source of revenue.
Role in reducing fees
In the current low return environment the focus is back on fees. A visiting portfolio manager to Australia found himself being quizzed about his fees before he was asked about his performance. Banks and fund managers are under ever increasing scrutiny on fees, and regulatory changes globally are introducing more transparency. Asset managers now ask themselves – can securities lending transparently show my clients how I am reducing their overall fees via the generation of revenue from assets that would otherwise be sitting dormant in their custody accounts? This was actually the traditional role of securities lending – generating incremental revenue to offset fees for asset owners.
And what about risk?
Beneficial owners now want to understand what drives the peaks and troughs in revenues, and what potential risks there are. They know about flexibility and about customising their guidelines in line with their overall risk-return profiles.
A careful selection of borrowers and collateral parameters is the most important risk management practices for an agent lender. Securities lending indemnification is an insurance policy that protects investors against borrower credit risk. In the event of a counterparty default, the agent will use the available collateral to repurchase a client’s securities or return an equivalent amount of cash.
There are a number of lenders in the market who lent throughout the market turbulence around 2008 and 2009 without issue and whom are still lending today – these are the lenders who have clarity over their risk profiles and manage their securities lending programmes within their standard overall investment risk frameworks.
How do I know if securities lending is for me and my fund?
Securities lending is like any investment activity – you need to be able to get a clear explanation of how it will work, what the key risks are and what can be done to mitigate those risks. Are there any elements that are unique to your fund that you should consider?
Start with a custodian programme where you have full flexibility and have someone experienced manage the activity for you. Do you want to lend one portfolio only? Restrict substantial shareholdings? Manage the programme electronically? Your agent lender can manage all of this for you in adherence with your core investment needs.
Like any investment decision, ask for an estimate of performance and weigh this up versus the risks and returns. And then see how you progress – you might start with one asset class such as fixed income, and gradually enlarge your programme.
Think about the role of securities lending in your overall investment profile. Speak with those who have a robust risk management framework, reporting tools in place and the local market knowledge. They can assess the best opportunities for your securities in line with your risk-return profile as they know that it’s in the best interest of their client - you.