'Sweating assets for sweet fees'
Securities lending, the temporary transfer of a security from its owner to another investor or financial intermediary, is one way that a pension fund can add value to its investment operations at relatively low risk. In other words, it is a good way for a fund to ‘sweat its assets’.
Typically, securities or stock lenders are large pension funds or other institutions holding securities that can be loaned out for a period of time. Borrowers are typically investment banks, broker/dealers, intermediaries or hedge funds that need the securities to satisfy short positions. The lender receives fees from the borrower for the loaned securities.
Over a year, these fees can add up to a useful amount, as Ireland’s e10bn National Reserve Pension Fund (NPRF) has demonstrated. Stock lending earned the NPRF fees of e2.5m in 2002 and e3.2m in 2003. This was a net gain that, in terms of performance attribution, represented between 3 and 4 basis points.
The NPRF, which invests 1% of Ireland’s GNP annually to meet part of the cost of future pensions, aims to maximise its returns within prudent risk parameters. Its investment mandate requires that it should “operate on a commercial basis so to secure the best possible financial return subject to prudent risk management.”
With this in mind, the NPRF Commission, which controls and manages the fund, decided to lend securities through the fund’s global custodian, ABN Amro Mellon. The intention was that income from securities lending would at least offset the cost of the custodian’s fees, and perhaps earn some useful additional revenue. The securities lending programme began in April 2002.
John Corrigan, a director of The National Treasury Management Agency (NTMA) which acts as the manager of the NPRF, explained the thinking behind the move at the Irish Association of Pension Funds’ annual investment conference in Dublin earlier this year.
Securities lending was already within the remit of the new pension reserve fund, he says. “The National Pensions Reserve Fund Bill of 2000 allowed the fund to invest in two ‘added-value’ services – brokerage recapture and securities lending.
“When we sat down to draft the legislation with the officials of the Department of Finance, the departmental officials had the prescience to allow us to include these two particular services into the legislation. So they’re expressly provided for in the legislation. So as soon as the fund was up and running, and as soon as the investment programme commenced in 2002, we put these in place fairly smartly,” he says.
Corrigan says the attraction of securities lending is that it is a low risk strategy for adding value. “The securities are temporarily utilised. The beneficial ownership doesn’t change. It is simply a loan by a pension fund to another market participant and the fund continues to receive all the economic entitlements. It continues to receive a dividend in the case of equity, the coupon in the case of a bond. There’s no change in the actual value of the portfolio, notwithstanding the fact that the securities have been temporarily lent.”
Most important, he says, the securities lending programme operates independently of the fund managers, who retain the right to sell the assets at any time.
“The fund manager doesn’t have to worry about what securities are lent from the point of view of trading those securities, because the intermediary who is operating the programme for the fund, as part of the standard agreement, would undertake to ensure that at any time the manager wishes to trade the securities they are made available for delivery in the case of a sale.”
All loans are fully collateralised and that collateral can take the form of either cash with a margin for price variance, cash deposited with the intermediary, or a bank letter of credit. Collateral is typically between 102% and 105% of the value of the security lent and protects the lender in the event of default.
Alternatively, collateral can take the form of acceptable securities such as government bonds. The NPRF has chosen this course, says Corrigan. “In our own case we have adopted the approach whereby securities with an amount to allow for price variation are lodged with the custodian.”
Pension funds can participate in securities lending either directly or through an agent lender, which will act on their behalf where the lender does not wish to participate directly.
The common characteristic all securities lenders share is the possession of long-term assets, Corrigan points out. “What all securities lenders have in common is that possibly with the exception of banks who might have trading operations – they are all long-term holders. They have the ability to lend the securities, but in the event that they want the securities back, the securities can be returned immediately or substitute securities made available at literally no notice.”
But should pension funds and other institutions be lending securities at all? One view is that stock-lending fuels short-selling by hedge funds and this destroys asset values in periods of extreme volatility. In this view, the revenue to be earned from stock lending is far outweighed by the damage that short-selling activities does to the assets held on behalf of pension fund members.
The alternative view is that securities lending is a key component of liquidity in the market. Since the short-selling activities of hedge funds and other market players are a major contributor to liquidity, any limitation on securities lending - which is the reverse of short-selling - will be counter-productive.
The NTMA and NPRF Commission takes the latter view, says Corrigan. “There is a debate in the US around whether in fact pension funds should lend or not because they encourage the activities of hedge funds, which is deemed by some market participants not to be a healthy activity.
“The view that we have taken in the agency, and the view that the NPRF commission has taken as trustees of the fund is that securities lending is a good thing because it adds to market liquidity. If you can add to market liquidity and if you can pick up a fee in the process, why not do it?
There is a precedent to the NPRF’s decision to enter securities lending, Corrigan says, in the NTMA’s repo programme. “When I ran the debt side of the business in the agency we in fact operated a repo programme which is similar to a securities lending programme. Here we were quite happy to lend to people who wanted to go short of Irish government securities.
“Maybe that’s an activity that some people might argue we shouldn’t encourage. But we took the view that if it added to liquidity it was a good thing and, if the agency could earn a fee in the process, that was a double bonus.”
The market needs to borrow securities for two basic reasons, Corrigan says. The first is for settlement. “This would be where there has been a failed trade and somebody needs to borrow a security in order to deliver it against payment.”
The second is for reasons of arbitrage. For example, investment managers who need to implement a market-neutral strategy will use ‘pairs trading’. Pairs trading involves going short with one security and long with another in the same sector. For example, going short Shell and long BP enables a manager to remain market neutral within the oil sector. “Because you would be going short on one you would need to borrow the security in order to deliver it when you sell the security that you haven’t got.”
There are two methods of mediating between the lenders and the borrowers in a securities lending transaction. Most securities lending programmes are operated through custodians, and this is the method the NPRF has chosen. Alternatively, there are specialist intermediaries who will operate securities lending programmes.
Usually there is a fee sharing arrangement between the lender and the intermediary. Setting a fee is largely a matter of supply and demand, Corrigan says. “The fee is quite simply driven by the demand for the security in question. Obviously, the greater the demand the higher the fee. In the securities lending jargon, if a security is on special – in other words, if there’s a huge demand for that security – the fees can be very sweet.”