In 2003 the two biggest Dutch pension funds pulled out of stocklending because they feared that short selling was contributing to market instability. Five years on, some are suggesting that European pension funds should do likewise
The issue of stock lending and its links with short selling has become a hot topic in recent months. Short selling is the practice by which a borrower hopes to profit from falls in share prices, usually by borrowing a stock, then selling and buying it back in the market at a lower price.
Short selling is also used as a hedging strategy. In this case, the seller is merely trying to protect itself against the risk of loss from a fall in share prices.
In both cases, an essential part of this strategy is stocklending and the borrowing of shares.
Many leading European pension funds participate in stocklending, lending shares which are then used to short stocks. In the recent market turmoil, this practice has come under fire. Hedge funds have been accused of driving down the share price of key financial institutions by shorting borrowed stock.
Regulators in the Anglo-Saxon economies have responded by putting constraints on short selling. The UK Financial Services Authority (FSA) now requires hedge funds to disclose a 0.25% short position in a company that is the subject of a rights issue.
In the US, the Securities and Exchange Commission (SEC) has introduced a rule that prohibits ‘naked shorting’ - selling shares without borrowing them first - in mortgage lenders Fannie Mae and Freddie Mac and a dozen New York brokerages.
Hedge funds and other investors in alternative investments have reacted angrily to these moves, suggesting that constraints on shorting are panic measures and arguing that any constraints on shorting will limit the efficient operation of the market.
Have the regulators panicked or are they right to try to restore some stability to markets? And what should pension funds do in this situation? Should they continue to lend stock, or withdraw from the market temporarily, as the Dutch funds ABP and PGGM did in 2002?
Most of the pension fund managers, administrators and trustees who responded to our survey on the subject feel comfortable with shorts.
There is little support for intervention by the regulators. Only one in four respondents (27%) think there should be more regulatory constraints on the short selling of securities.
One of the strongest argu-ments in favour of short selling is that it promotes efficient markets - for example, price discovery. It follows that constraints on short selling will reduce market efficiency. This view has overwhelming support, with four out of five (82%) in agreement.
Yet there is support for recent regulatory interventions. Two out of three respondents (68%) agree that the Financial Services Authority are justified in requiring disclosure of ‘significant’ short positions in companies that are the subject of rights issues. Three out of four (76%) think that regulators in other European countries should follow the example of the FSA.
The SEC intervention has far less support, however. Only a third (37%) think that the SEC was right to temporarily ban ‘naked shorting’ of certain financial stocks.
Opinion is fairly evenly divided on what pension funds should do in this situation. Rather more than half (56%) think that pension funds should continue to lend stock to hedge funds for the purpose of shorting, although a small majority (54%) think that pension funds should withdraw from stocklending temporarily if they believe that it is creating instability in the market.
Most think that they should have nothing to do with hedge funds’ efforts to sink a rights issue. Two thirds of respondents (63%) think that pension funds should recall stock that they have lent if they believe that borrowers are using it to undermine a rights issue.
It could be argued that stock lending, far from being an undesirable activity, is something that all pension funds should engage in. The International Securities Lending Association, the representative body for the industry, says that “beneficial owners who choose not to lend their securities miss out on potential lending revenue, availabe at low risk.” It has even been argued that pension funds have a fiduciary duty to lend stock, and so add value to the investments in their portfolios. This gains lukewarm support, and fewer than half (45%) agree.
It seems that pension funds eschew extremes - a prohibition on stocklending or an exhortation to lend stock are both seen as equally unacceptable.