Funds take stock of lending
The securities lending market has matured into a global €1trn business, driven largely by hedge funds and banks’ proprietary desks. Global custodians can earn good commissions as agent lenders (acting for beneficial owners of stock who do not want to participate directly) and lenders, such as pension funds, can earn substantial revenue by lending out their stocks.
Rob Coxon, ABN Amro senior vice-president and head of international securities lending says securities lending is now an integral part of a pension fund’s business and can “easily pay for custody fees as well as delivering a handsome profit”.
ABP, one of the Netherlands’ largest pension funds generated more than €70m from its securities lending programme during 2005, says Mark Linklater, head of securities lending desk at ABP. “Our returns from securities lending have increased greatly. ABP sees it as a fiduciary responsibility to obtain as much as we can from the programme with the least amount of risk for our participants.”
Along with the UK, says Coxon, the Netherlands is the most mature pension fund market in Europe. Dutch pension funds are heavily involved in securities lending and have a very sophisticated approach to it, he says.
Roeland de Groot, head of treasury at KAS Bank, says securities lending is a growing business. “Until 2000, many clients were doing it but it did not represent much money compared to the overall investment business. When stock markets fell, interest in securities lending grew and now almost all of our clients participate in it. It is very profitable for our clients.”
While the securities lending business is growing, there are some issues that might have an impact on that growth, says de Groot. “There is concern about the dividends paid out on securities that are lent. Some pension funds have gone to court because in European law pension funds cannot be discriminated against. The rulings may hinder the profitability of securities lending. However, in the long run the advantage of differing dividend payouts across Europe will disappear – it is just that these court cases may make it go faster than was anticipated.”
Linklater agrees that the current discriminatory tax treatment of cross-border interest and dividend payments is an important issue in the market. “In many EU member states interest and dividend payments to domestic pension funds are treated differently from payments to foreign pension funds,” he says. “The European Federation for Retirement Provision has recently lodged complaints with the European Commission on this subject. ABP has filed reclaims based on similar arguments. The procedures should result in legislative amendments aimed at equal taxation of domestic and foreign pension funds.”
Stephane Haot, managing director, RBC Dexia Investor Services Netherlands says the cases in the European court “are of concern to all of the market and will be observed closely”. Tax harmonisation across Europe is unavoidable, he says, and will have some impact on the return enhancement possibilities of securities lending. “However this is only one aspect of the business. Margins will be squeezed more than in previous years but we believe clients are looking at the sustainability of their securities lending programmes.”
The Financieel Toetsingskader (nFTK), the new financial assessment framework for the Dutch market, which focuses on marking liabilities to the market, could have an impact on securities lending, says Coxon of ABN Amro. “All securities lending is done on a collateralised basis, using either non-cash or cash collateral. The cash side of the equation may be affected by the nFTK legislation.”
The nFTK aims to provide an instrument to determine the financial position (solvency etc) of insurance companies and pension funds, particularly the relationship between available assets and the liabilities.
“Securities lending transactions have been treated as an off-balance transaction meaning to say that on the asset side of the balance sheet the straightforward equity/fixed income positions would be reflected regardless of whether the securities are out on loan or not,” says Coxon. “With the nFTK regulation this off-balance treatment of securities lending transactions is being revisited. The question arises whether cash that is taken in as collateral shouldn’t be capitalised and offset by a short-term liability to the borrowers. It can be questioned whether this would only lead to pumping up the balance statements without any additional information given to external parties.”
As the cash is invested in a short-term investment fund, additional risk is taken on, says Coxon. “Through the new NFTK rules, risks lead to additional capital requirements. The question now is whether re-investing cash and its effect on the duration of the total portfolio should require any capital requirements. It remains unclear at this stage.”
Coxon also predicts that the Basel II Capital Adequacy Accord will have an impact, particularly as Dutch clients are very conservative in their non-cash collateral and tend to use sovereign debt. “It may become more expensive for prime brokers and borrowers to collateralise, so there could be a trend towards lower grade collateral.”
Basel II and nFTK are “unlikely to rock the boat too much” or force people to pull out of securities lending, however. “In the specials market, where there is more demand than supply, broker dealers will always be looking for specials and will have to supply them whatever the collateral demands of the pension funds,” says Coxon.
For ABP, securities lending is now viewed as an investment strategy with its own alpha targets, says Linklater. “Securities lending used to be regarded as back office function. We changed that and it is now a front office function.”
Linklater says ABP is dealing with securities lending in a more intelligent way using sophisticated risk management tools to analyse and track our exposures. “We are also demanding more from the agents we choose to do business with. I think 2006 will be a good year for the industry.”
Pension funds are closely scrutinising agent lenders to ensure they are getting top quality performance, says Coxon. “There is a trend towards greater transparency and pension funds are signing up to independent benchmarking firms so they can look at performance and how it stacks up against the industry.”
One way to improve transparency is to auction out a portfolio on an exclusive basis – one of the options taken by ABP, for example. There are pros and cons, however. An advantage is that a prime broker will pay a premium for locking up the supply of stock from the pension fund, says Coxon. “However, it seems likely that merger and acquisition activity will continue to grow in 2006. This activity fuels arbitrage activity in which hedge funds are involved. The specials that come out of that command a greater price in the securities lending market, but if you have locked into an exclusive arrangement as a pension fund, you have capped out on the earnings you can gain from your portfolio.”
RBC Dexia’s Haot says in a well-managed securities lending programme clients will gain good returns for extremely low risk from an activity that can run transparently from core activities. “Transparency is very important because pension funds are coming under more pressure to demonstrate good corporate governance,” he says. “Proxy voting has become an important issue for funds that do securities lending. If funds have large positions they want to demonstrate their commitment to the companies in which they have invested by voting.”
Coxo of ABN Amro observes that corporate governance is an issue when markets perform poorly but now they are improving that has lessened to an extent. “When the markets were down, pension funds had to be seen to be voting on certain stocks that were perceived to be from companies with bad management.”