Choosing collateral and counterparty wisely will help to mitigate substantially against the future risk of default in securities lending, finds Iain Morse
To lend, or not to lend? This is a question that is currently on the minds of many sponsors, trustees and pension boards. “We have seen some pension funds withdraw from the market entirely or review and cut back their lending programmes,” notes Wayne Burlingham, global head of securities lending for HSBC Securities Services. A perceived risk of counterparty default looms large over the lending industry. Last year’s default by Lehman Brothers was a ‘Long Term Capital Management’ moment, so unforeseen and cataclysmic that it is now a caution for the unwary.
Whether so much anxiety about securities lending is justified seems in doubt. The key issue for stock lenders should lie in their choice of collateral and counterparty. “Get these right and risk is minimal,” argues Chris Angell, senior consultant at Mercer Investment Consulting. “Lending with non-cash collateral has worked quite well for our clients.”
Lending is not complex. Securities are temporarily transferred from lender to borrower, with a clear contractual agreement to return these on demand or at the end of an agreed term. For the period of the loan, the lender is secured by acceptable assets delivered by the borrower to the lender as collateral.
There is no fixed set of contract terms for this relationship. Borrowers will usually pay a basis point fee for use of each stock borrowed but in some cases they may pay a fixed fee for access to a portfolio with or without further use-based fees. These fees aggregate into an income stream split on a ratio between the lender and intermediary custodian.
The more the intermediary does the higher its share of the income stream. “This split is case specific,’ depending on a variety of factors including the overall value of the lender to the custodian,” warns Angell.
“Choice of collateral and margin are vital,” observes Simon Lee, senior vice-president for EMEA at eSecLending. “Common practice in the US has been to use cash collateral, in the UK and Europe the use cash collateral is less prevalent,” Lee says.
Cash collateral sounds safe but in practice this type of collateral has proved risky, depending on the way cash is held. Cash collateral losses have resulted where cash was invested in, for example, as mortgage bonds and other securities which subsequently became illiquid. If the borrower also becomes bankrupt then lenders risk losing all they have lent.
This has had unforeseen consequences. “If you can’t sell something for cash, what is it really worth? Some lenders are trapped in an existing contract with their custodian because collateral of this kind has been used,” notes Burlingham.
It also raises some uncomfortable questions about the way that counterparty risk as measured in the lending industry before the credit crunch. Excessive reliance on the credit rating agencies left some lenders badly exposed.
There has been change here among both custodians and consultants, with far greater use made of credit default swaps to price counterparty risk. “These give us the current market view of the credit worthiness of a borrower and we can price this risk on an intraday basis,” adds Burlingham.
Greater risk aversion among lenders is having an impact on the terms under which non-cash collateral is offered. Non-cash collateral may typically comprise a basket of shares, very high-quality investment grade bonds, government bonds and other liquid securities.
These are always set at a margin in excess of the value of the securities borrowed. But the size of these margins has been substantially increased by many lenders from 105% to 110%, 120% and more. This margin increase costs the borrower money pushing down the fees they will pay on some securities.
A growing number of intermediaries in the market, such as eSecLending and HSBC Securities Services, now offer lenders indemnity against loss on non-cash collateral, and against the bankruptcy of a counterparty. Indemnity levels are negotiable; some lenders will accept less than 100% at a reduced cost.
Either way, indemnities will usually be paid for by an adjustment to the revenue split in favour of the intermediary. Some intermediaries, particularly in the US, are now also offering indemnity against cash reinvestment risk on cash collaterals.
In the past, lending has been promoted by custodians and consultants as a low or no-risk means of offsetting some or all the costs of core custody services. Indeed, most lending programmes are run by custodians for their existing custody clients. This can be an opaque and complex set of relationships, more so because no two portfolios are identical.
Depending on borrower’s demand, one may be far ‘richer’ or more in demand from borrowers than another. This makes comparison difficult, but the temptation to lend will remain strong if the resulting income stream pays most or all the cost of custody services.
Auction model challenges traditional lending route
Auction specialists like eSecLending, which is a full service third party securities lending agent, are challenging custodian banks, traditional providers of stock lending programmes, which aggregate lenders’ securities into a common pool. eSecLending, for example, is an independent, specialist securities lending agent rather than a custodian. The key difference is that eSecLending auctions portfolios in return for fixed fees from the borrowers. If a portfolio is rich enough to tempt bidders, eSecLending organises blind bidding in an auction which will usually attract several institutional bidders.
“This creates a market value for these portfolios. Hedge funds, particularly equity long/short funds, are very interested in gaining the use of the right portfolio over, for example, six or 12 months,” says Simon Lee, senior vice-president for EMEA.
The appeal of this approach is that the firm can optimise lending returns without increasing overall portfolio risk. eSecLending uses a three-stage approach. “First we customise on client specific basis, creating a bespoke solution which reflects the lenders risk appetite,” Lee explains. The next step is to prepare the portfolio for auction. This might include splitting it into lots designed to sell at the best price possible. eSecLending then organises a blind auction but gives lenders discretion over which borrowers they select.
“Our approach better exploits inefficiencies in the lending market place,” adds Lee. “Bids made by borrowers for the exclusive use of portfolios nearly always exceed the income to be made from going the traditional pooled route.” This approach may change attitudes among the traditional custodian banks on how best to run their stock lending.
“We are also prepared to offer lenders an exclusive, auction-based process,” says Wayne Burlingham, global head of securities lending for HSBC Securities Services. “But the cost of accepting a fixed fee bid for the free use of a portfolio may not always be optimal.” Auctioning for a fixed fee is likely more profitable for lenders with larger, richer portfolios. There are no hard-and-fast rules but most of the portfolios successfully auctioned will be worth at least about €1bn.
They will also have exposure to mid and small caps, as well as direct holdings in areas like emerging markets. A little caution is also needed: lenders that decide to rebalance their portfolios midway through a lending programme may have to repay some of the initial fee.