There was a time when securities lending was a little-thought-about, back-office, tacked-on service that institutional investors bundled into their custody contracts, the revenue from which was a reliable way to cover the fees they paid to their custodians. Today, it has the attention of everyone in the investment chain, and regulators too, all of whom finally considered the risks inherent in the $1.8 trillion industrythat securities may not be returned or recalled on time, or at all; that counterparties may default; that losses on invested collateral could take placefollowing the default of Lehman Brothers in 2008 and the financial crisis that followed. It remains a lucrative and growing activity for many funds, but some now see the risks as too great to get involved.
At the Data Explorers Securities Financing Forum in New York this week, industry participants described the recent evolution of the securities lending industry, one contrasting pre-2008 complacency with securities lending risks with present-day terror. Many pensions, endowments, foundations and other funds dropped out of the securities lending industry following the Lehman default, particularly small to mid-sized funds, for whom even minor losses from securities lending could have a vast impact on overall performance. Many have since returned, while others are still playing wait-and-see.
The consensus among industry participants at the forum, which featured panelists including agent lenders, prime brokers, beneficial owners, hedge funds and consultants, was that securities lending will remain an attractive activity for the largest funds but that the resources involved in operating a lucrative securities lending program may be too great for smaller funds, the ones earning perhaps a few million dollars a year from the activity, to be worth the risk of loss.
How beneficial owners that do engage in securities lending approach the activity, however, will undoubtedly change as the industry gains awareness of the risks (and rewards) involved, agrees on best practices and conforms to pending regulations.
One changewhether more bundling or unbundling of custody and securities lending will take placehas been hotly contested, especially as third-party (i.e., non-custodian) agent lenders, such as eSecLending, continue to gain traction in the space. That custodians are facing lawsuits from pension fund clients suing over securities lending losses has placed more attention on the question. In an unscientific poll of 32 industry participants conducted on Global Custodians LinkedIn group recently, 43% believed there will be more bundling of securities lending and custody while 46% believed there will be more unbundling of the two. Just three individuals, 9%, believe there will be no change in light of recent industry trends and increased regulatory involvement.
Cost pressure will drive more bundling; however, the regulatory environment will continue to force greater transparency in the cost/revenue associated with each service provided, commented John Miller, a Boston-based financial services executive.
Similar points were made, albeit with a different conclusion, by Robert Almanas, member of the executive committee of SIX Securities Services: The trend could be more towards unbundling in the long term, as regulatory pressures on SLB [securities lending and borrowing] have an impact on high-volume, low-value business, and increase the higher-margin business, which can more easily be detached from a custody arrangement.
Whoever beneficial owners choose as their agent lenders, it is clear regulatory pressures will be the key consideration beyond overall costs and revenue. Regulators around the world are implementing legislation impacting securities lending, from Title IX in the U.S.s Dodd-Frank Act, which mandates increased transparency in the securities lending industry but which is yet to be written; Europes Basel III, whose leverage ratios and capital confidence ratios have a direct impact on beneficial owners; and short-selling regulations, including the various definitions of what constitutes a short sale, across Europe and around the world, to name a few. J.P. Morgans global head of securities lending, Judith Polzer, outlines the regulations impacting securities lending in more detail in this video on GCTV.
The uneasiness in the industry surrounding securities lending as well as the lack of clarity from pending regulations has led several organizations to help spell out best practices for the business and shed some light on securities lending for funds considering whether or not to participate. Two recently released reports, one by the Mutual Fund Directors Forum (MFDF) and the other by eSecLending, offer guidelines for mutual funds engaging in securities lending.
In its report, MFDF says the first consideration is whether or not the fund should engage in securities lending at all. Further, boards should review and approve the contracts between the fund and agent lenders; it should understand the risks involved; written policies should be developed spelling out which securities may be lent and which collateral accepted; it should implement recall policies that enable the fund to vote proxies; it should monitor the program with regular reports and review the programs performance; and the funds chief compliance officer should be involved in overseeing the program.
eSecLending makes similar recommendations in its report, noting that many funds are returning to the business as they learn lessons from the past. Recent market events have reminded securities lending participants that securities lending has a risk/return profile and should be evaluated based on the risks inherent to each lending programs specific structural characteristics, just like any other investment decision, the firm wrote.
In other words, securities lending is back, but it is a whole new game now for those who are still playing.
Christopher Gohlke