Securities lending generated over $8bn of revenue globally in 2016 – the best result in four years – as shock political outcomes, market volatility and economic growth concerns elevated shorting activity and helped beneficial owners achieve better pricing for their loans.
As a result, a number of firms have been selectively reentering the securities lending market, according to Bob Hollinger at Barrington Partners, a firm offering securities lending advice to asset owners.
“The market dynamics have been favorable and most of the vendors that offer lending services are mature, capable and highly competitive,” Hollinger noted in a recent whitepaper. “While lending has slowly been making a comeback since the 2007-2008 downturn, the opportunities in securities lending have changed.”
As Hollinger points out, lending opportunities are almost always associated with the borrowing of specials, those specific holdings for which there is a high demand and generates an attractive spread over the overnight bank funding rate (OBFR) or other benchmark.
While general collateral lending is still available, the loan spread relative to benchmark rates has compressed. “For firms with holdings in selected European domiciles with attractive tax benefit structures, dividend arbitrage opportunities continue to exist but at a lower rate than previously,” Hollinger adds in the study The Changing Face of Securities Lending.
David Martocci, Citi’s global head of agency securities lending, has noticed funds that have not lent previously, or perhaps had only a modest prior involvement, becoming far more interested and engaged.
“In our view, securities lending is increasingly viewed by asset owners as
“So far in 2017, the specials market has come off somewhat due to less conviction on the short side. However, this is a markets-based business and we remain positive. There are plenty of opportunities, especially in fixed income lending given the current rising rate environment.”
RISK VS RETURN TRADEOFF
A New York-based executive working for an agency securities lending desk adds that interest rates should not be a huge factor in re-starting a new programme.
“Many pension funds that suffered cash collateral losses during the credit crisis eventually came back but with programmes focusing on intrinsic value lending,” says Martocci.
“In fact, many insisted on only non-cash collateral or ultra conservative cash overnight guidelines and, in some cases, clients even set minimum lending hurdle rates of 100bps insuring a specials-only programme.”
Bo Abesamis, manager of Callan’s trust, custody and securities lending group, says decisions are ultimately boiling down to costs and oversight resources.
“We educate our clients on the full range of programmes, risk/reward outcomes and opportunities available to them – from a de-risked, pure intrinsic value lending approach to the maximum risk Callan believes is prudent to pursue,” he says.
“Based on those options, it’s up to the plan sponsor to assess the risk/reward trade-off that they are willing to live with. Once they have the information, they have to make the decision.
“There’s no such thing as risk-free in securities lending. When there is a risk, that risk needs to be managed and requires the plan sponsor to take an active role in oversight.”
Abesamis adds that the ability to do this by allocating resources often dictates whether a fund will pursue a specific strategy, or indeed lend at all.
Regulation, the macroeconomic environment and new ways of doing business are changing the economics of the securities finance. The cost of providing indemnification (essentially insurance against counterparty default) to clients, for example, is rising for agent lenders while the borrowing prime brokers have become more selective with counterparties and trades due to balance sheet constraints.
Citi’s Martocci says there are undoubtedly added costs involved in providing indemnification today, primarily due to regulation. “The need for indemnification depends on the organisation, board representation and experiences with securities lending the past.”
Callan’s Abesamis notes that if clients want to pursue a programme without indemnity because of added cost, it means they have to take a larger role in risk management, particularly counterparty risk management.
“As well as a layer of protection, borrower default indemnity provided by a custodian bank or a third-party agent helps lenders manage their assessment of borrowers.
As financing markets mature, certain beneficial owners are continuing to monitor non-traditional lending routes such as peer-to-peer & CPPs. The Teacher Retirement System (TRS) of Texas is one beneficial owner that is interested in this option.
“TRS is following developments in this space, and we will continue to evaluate them in the future,” says Mohan Balachandran, senior managing director of asset allocation, adding that the fund has no plans to lend without indemnification against borrower default.
According to Abesamis, certain Callan clients are actively looking at alternative routes to market, but they are not yet embracing new options such as CCPs and peer-to-peer.
“We do have a few clients that are conducting peer-to-peer types of transactions on an opportunistic basis, but they involve a large inventory of securities with sophisticated, disciplined risk management regimes. However, I don’t think peer-to-peer or central clearing for securities lending have yet evolved to a point where our clients are totally comfortable with them.”
Martocci says Citi is engaged in peer-to- peer type transactions. “We have been for some time. In many cases, this is simply an agent trade. If brokers no longer want to participate in certain financing transactions, the market will find a way to do business. Clients still need financing and leverage, so intermediaries such as ourselves are going to engage with them. The business is resilient.”
CASE STUDY: TEACHER RETIREMENT SYSTEM (TRS) OF TEXAS
Mohan Balachandran, senior managing director of asset allocation at Teacher Retirement System (TRS) of Texas, says risk remains paramount and lending has not necessarily become more relevant in the current low yield environment.
“We continue to manage our securities lending portfolio in a conservative risk-averse manner,” says Balachandran. “So far in 2017, our programme performance has been in line with expectations.”
TRS has had securities lending arrangements in place for decades. The fund has always made its securities lending objectives clear – risks are to be controlled and the impact on the broader investment activities of TRS minimised, while conservatively reinvesting collateral.
“We view securities lending predominantly as a way to offset some of the plan’s custody and other expenses, not as a source to add value to an investment programme,” TRS states in its investment policy.
“The focus of a securities lending programme should be on controlling risk, not maximising returns.”
CASE STUDY: SAN FRANCISCO CITY & COUNTY EMPLOYEES’ RETIREMENT SYSTEM
In April, investment staff at San Francisco City & County Employees’ Retirement System (SFERS) voted to end the fund’s securities lending programme.
A memo, seen by Global Investor, said stock loan operations will wind down over the next few months as the $20bn fund switches custodians from Northern Trust to BNY Mellon.
The pension fund has earned $118m through securities lending since the programme began in 1996. However the ride has not always been smooth; securities lending led to $80m of losses for the fund during the financial crisis.
A recent review, involving consultant Callan, found that SFERS could modify its programme to make it more conservative but doing so would reduce returns to $3m annually – compared to $4.2m achieved in 2015.
“Boosting our income from securities lending would require putting a greater volume of lower quality securities on loan, which increases the risk of incurring a large loss,” stated the memo, signed by SFERS chief investment officer William Coaker.
“We believe the retirement board, staff and our consultants need to focus our time and resources on the aspects of the portfolio with larger risks and expected returns than securities lending, whose risks can occasionally be surprising and whose expected returns are very low.”
In addition, Coaker noted it has less control of its liquidity due to securities lending, because it is not choosing which securities to lend. He recommended that securities lending be re-evaluated if short-term interest rates rise to the level seen before the financial crisis.
A senior New York-based executive working for an agency securities lending desk, speaking on the condition of anonymity, says the move was unexpected: “This is a surprise firstly because they went through the effort to hire a very good and experienced consultant in Callan and conduct a very thorough search looking at both third-party lenders and bundled solutions.
“Therefore, they already did the heavy lifting and the effort to implement a new programme that met their new conservative parameters. It should have been relatively quick and straight forward.”
Another US-based securities finance expert described SEFS’ decision as unique and isolated, adding that it goes against the industry trend of increasing participation in securities lending.
“If anything, we see things going in the opposite direction. Funds that have not lent previously are engaging and expressing interest. Opportunistically, with more of a yield curve, it’s a good time for clients to be engaged. However, it becomes challenging when clients haven’t grown or developed programmes. Invariably they become stagnated and, as a result, are not able to earn the revenue they once did.”
CASE STUDY: PIEDMONT FAMILY OFFICES
Jerry Davis, chief investment officer at Piedmont Family Offices and former chief executive of New Orleans Employees’ Retirement System, from 1986 to 2011, says the financial market is constantly evolving, in search of new and better sources of returns for both the sell side and the buy side.
“The erosion of returns on money market investments has continued to feed the trustees’ desire to generate returns from idle assets,” says Davis, adding that funds should look for balance in any agreement, and set realistic return expectations from lending programmes.
“Securities lending is unlikely to have any meaningful impact on your overall rate of return. Done well, it provides evidence of the fiduciary’s efforts to manage assets prudently. Done unwisely, lending may provide only embarrassing losses.”
Davis advises investors to lock-down the real value of any custody fee reductions; first consider the likely cost/benefit of forsaken loss-immunisation and then monitor the accuracy of your estimated returns.
“Securities lending is not a set-and-forget strategy,” he adds.