Reviewing the Economist's article on securities lending

The Economist published an article on securities lending this past weekend. While a short piece, it attracted some attention with one correspondent of ours calling it an attack job. We read the article and didn’t think it so bad, but we would have preferred some things to be clearer. Here are our main points.

1) The article says that dividend arbitrage benefits everyone except for national tax collectors. Well, yes, we agree, and believe that this is well understood in the industry. The only thing we’d argue with here is that The Economist missed any comment on tax harmonization or tax coordination in the EU or the fact that the number of countries with dividend arbitrage opportunities has shrunk in recent years. The Court of Justice of the European Union’s May 2012 ruling on France’s taxation policies is also a big deal. All of this diminishes the excitement over tax avoidance from dividend arbitrage. For those who want to keep closer tabs on the matter, please see our September 2012 research report, “Regulation, Taxation and the Outlook for Lending in European Securities.”

2) We thought it interesting that Markit is quoting the securities on loan universe at US$1.5 trillion. This is down from the last figures we knew of US$1.8 trillion, then US$1.7 trillion.

3) We thought the article missed two points in its discussion on borrowers. One is that market makers are big borrowers, and that hedge funds are borrowing to hedge positions as much as they are to short stock on a directional basis. This point seems to get missed a lot in popular thinking about why investors borrow stock. We suppose it’s much more fun to think of the evil short seller trying to push down the price of a stock than it is to picture a quant keeping his or her Sharpe Ratio in line.

4) While we agree with the article’s write up of what can go wrong with securities lending, we are sorry that it didn’t distinguish more clearly between counterparty risk and collateral reinvestment risk. We also think that the relationship between AIG’s failed collateral reinvestments and new bank rules on capital exposure limits isn’t linear or for the reasons that the article alludes to. On the other hand, FSB proposals on Shadow Banking and required securities lending collateral investment types do address collateral risk concerns, but that wasn’t mentioned. (For the record, we are not supporters of the FSB’s ideas on required collateral reinvestment types.)

5) We liked the conclusion, which speaks to a major theme of ours for 2013: Securities Finance Meets the World. The article noted that regulations hampering securities lending will have negative ramifications for other parts of the financial industry and will in turn impact the real economy. “Regulators in both America and Europe now want all derivatives contracts to change in ways that will require much higher levels of collateral—and thus securities lending. Should such financial activity indeed be severely limited, nobody will much miss the tax-dodging holiday of European shares in springtime. Other benefits would be harder to replace.”

The original Economist article can be found here.

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