The game’s afoot for stock lenders
24 Oct 2011
Pension funds that are managing and investing money on behalf of members should be prudent. But they have engaged in securities lending for years – a practice that has been vilified by regulators, who claim that it played a significant role in the 2008 financial crisis. While they showed prudence by sitting out during the crisis, the majority quickly returned to the market, but this time with very different demands.
Securities lending is the temporary lending of securities to a third party. The lender is given collateral as protection against the borrower defaulting, either in the form of shares, bonds or cash, and a fee for lending the equity. Being long-term investors, pension funds have securities sitting idle in their portfolios, and by offering them out on loan they can make a steady stream of income.
But securities lending is viewed by some as a facilitator of short selling, a riskier practice in which sellers borrow securities, sell them on and then seek to buy them back at a lower price in the hope of making a profit.
Regulators across Europe moved to restrict short selling in 2008 and securities lending suffered as a result. The market dropped from highs of more than $12.8 trillion of total lendable securities at the end of June 2008 to $6.5 trillion at the end of March 2009, according to data compiled by the Risk Management Association.
Stuart Catt, an associate within the Mercer Sentinel Group, said: “In 2008 there was a fair amount of shock when trustees realised securities lending wasn’t a risk-free activity.”
As the dust from the financial crisis settled, pension funds and other institutional investors returned to the market; the latest figures from the association show a recovery, with total lendable assets at $10.2 trillion at the end of June 2011.
But this time pension funds are demanding enhanced services from their custodians, who act on their behalf, to avoid a repeat of the crisis.
Simon Lee, senior vice-president at securities lending agent eSecLending, said pension funds are now, for the most part, lending their assets under more conservative parameters.
“They have, however, spent significant time and resources reviewing all aspects of their programmes, and have a better appreciation of their participation. One obvious change is that pension funds have better governance around programme oversight, and understanding of their ability to influence programme performance through change,” he said. Part of that is an increased focus on the specifics of their programmes.
John Arnesen, head of agency lending product at BNP Paribas Securities Services, said: “Pension funds have taken a far more proactive approach in understanding who they are lending to, the asset classes, the collateral – if the collateral is cash what is happening to it – and asking far more leading questions about the correlation between the two.”
One outcome is an ongoing programme of education for pension funds, said Bill Foley, director of securities lending sales, market products and services at RBC Dexia Investor Services.
Part of this is a focus on the collateral accepted from borrowers against loans. A pension fund accepting cash as collateral can reinvest it to earn a return. However, this exposes it to risk on interest rates and credit, and so custodians are being pressured to produce greater transparency on these investments.
They must also be ready to quickly liquidate collateral and replace loaned securities should the counterparty default.
Rob Coxon, head of international lending at custodian BNY Mellon, said pension funds have put more restrictions on the type of collateral they are willing to take, and are becoming much choosier about who they will lend to.
He said: “If they take cash collateral they want it to be handled on a segregated basis, whereas before they were happy with pooled arrangements.”
The result is that pension funds are gaining greater control over their lending future. Coxon said: “They now actively specify their own reinvestment guidelines resulting from their specific risk appetite.”
Greater education and control is encouraging new entrants to the market.
Paul Wilson, international head of client management and sales for financing and market products at JP Morgan Worldwide Securities Services, said: “It is worth noting that in 2011 we have seen new pension funds coming to market for the first time.”
This increase in supply would usually be in response to demand, but the custodians say that demand is lagging behind.
Wilson said: “We need to see some improvements and increased appetite from the demand side. In the short term, the demand side has been impacted given the market and regulatory environment, including the impending Dodd-Frank Act, Emir and Basel III.”
However there is a silver lining – in the form of investor demand for high-quality collateral as a result of Dodd-Frank. The regulation, which moves over-the-counter traded derivatives on to central counterparties, will require collateral of about $2 trillion to $2.5 trillion, according to Foley, of RBC Dexia.
He said: “This presents opportunity for lenders as the required collateral, typically highly rated government debt, will likely be sourced from the securities lending market.”
Coxon of BNY Mellon said this could increase the market even further. “That could induce pension funds to come to the market, especially if they start getting paid well for lending out their assets.”
And now is a better time than ever for pension funds to come to the market, as additional revenue is not the only attraction.
Arnesen, at BNP Paribas, said: “A lack of new business among custodians and agent lenders means that competitive pricing pressure is high and therefore for the pension funds considering entering a programme, they will be able to do so on extremely favourable terms.”
The original article is here.