The securities lending industry has long suffered from an image problem. But, as Frank Vogel, global head of global securities lending and arbitrage at Fortis Bank in the Netherlands, argues, it’s an image that has stuck despite a lack of incriminating evidence.
“What is bad for the industry is the continuing discussion about the impact that a hedge fund has on the price of an equity on an exchange. Worse than that though is what happened recently in the Netherlands, where a couple of large pension funds announced that they would stop their securities lending programmes because they believe hedge funds have a negative impact on the markets overall.”
“I think it has been made clear now though that the real impact of stock lending is negligible and that the impact on market levels is virtually non-existent. Without securities lending there would be a lot less liquidity and the possibilities that people have to do transactions would be greatly reduced.”
Vogel explains that every time a pension fund or insurance company takes a decision to hedge their downside risk, then someone has to provide that hedge – meaning that they have to borrow securities to sell the underlying stock. It is possible to hedge this trade with options, but he points out that if the deal involves a large block trade (as they often do) there is always someone who will sell the underlying assets to make sure there is no market exposure.
Significantly though, on a broader level, for the securities lending industry a lower market is not necessarily a worse market. According to Vogel, diminishing spreads mean that institutional investors need securities lending to boost income. “The big pension funds have started lending again. In a bull market there is a tendency not to lend out securities as the return you make is pretty minimal in comparison to the returns you’re getting. In a bear market the income represents a lot more, but if people start stock lending in a bull market then they will probably continue simply because it has become a kind of programmed trading.
“No-one wants to receive an audit report that shows they are leaving e3m–4m on the table because they are not involved in securities lending.”
In terms of risk exposure, Vogel also argues that the first type: counterpart risk, is today covered by collateral, while the second major concern for investors: operational risk, is something which he believes has almost been rendered negligible by the quality of the large houses involved in the industry.
Why then the continued bad reputation for stock lenders? Says Vogel: “The first reason, I think, is that the industry needs a scapegoat for what is happening at the moment. The second reason is that the securities lending industry has done nothing in the last 10 years to better its profile within the market. I think this has a lot to do with the fact that it is a completely unregulated market, but demand for regulation is going to increase and I think you will find that there is a lot of pressure that will come from the regulators on this.”
However, Vogel says he favours self-regulation rather than outside intervention. “Legislation could be damaging if it is drawn from a protection perspective. In Hong Kong, for example, after the crash in 1997 many rules were introduced and Hong Kong is now no longer the centre of financial power in Asia. Short-selling rules are damaging and yet short selling does not mean that you are doing something wrong.”
An important issue of self-regulation, he notes, is to increase transparency by creating a platform where people can see what the amount of liquidity going around in the securities lending market. “I think you would find that 95% of the total securities lending volume effectively involves neutral transactions. Short selling only has an impact on the price where there is a distressed stock. And why is the distressed stock there? Is it because of the short selling or because the company is not good….”
In a bid to boost market transparency, Fortis is working with a number of partners within the sec lending arena to create a lending platform that is a front- office rather than a back-office function.
“We are trying to create a front-office platform that will provide transparency and also hopefully be the starting vehicle for self-regulation. We are in trial phase at the moment, which should be over in four months and with a bit of luck it will be accepted and give everyone a better idea of what we are trying to do, which is to get a better and higher profile for securities lending. If you look at securities lending, equity finance and arbitrage activities, and so on, then in all fairness we should be at the high end of the front office, instead of at the low end. We have to admit though that the position we are in at the moment is of our own making!”