David Taplin and Ilana Wald discuss the role of the adviser
Increasingly, pension fund investors are becoming comfortable with securities lending. The consultant is playing a key role in increasing client comfort via education and analysis from an unbiased perspective. However, investors remain unsure of the risks involved in securities lending programs and have not engaged in the activity. As the risks become better understood and the management /controls better explained, pension fund trustees appear willing to implement securities lending programs.
Increased confidence can also be attributed to recognised improvements in controls relative to those available in the 1980s. Thus, lower risk programs with convenient structures and increased revenue became an attractive proposition in the lower return environment of the 1990s.
Securities lending is a fairly simple concept. Investors lend their securities to borrowers for a fee. Borrowers offer collateral to minimise the exposure of the investor. Collateral is usually in cash, securities or occasionally letters of credit. Although the transaction appears to be a forward repurchase agreement, it is in fact a loan. Whilst the securities are on loan, entitlements usually accrue to the lender. However, the lender is exposed to market risk during the loan period.
There are several types of securities lending programs. The more common programs are agent programs or principal programs. In an agent program, an agent acts as an intermediary between the investor and borrower. The agent is responsible for negotiating the loans, receiving, investing and monitoring collateral, reviewing the creditworthiness of borrowers and distributing the revenue. This is the most common approach.
In a principal program the agent is the principal borrower and may sub-loan to other borrowers. The revenue is reduced however, so too are the risks in terms of reduced counterparties.
Understanding and managing the risks: Investors gain confidence when risk is well managed. The above table describes selected risks in a securities lending program. The consultant’s role is to interpret each risk and quantify the potential for the investor. In addition the consultant must be able to educate the client in how the risks are managed by the agents. These management tools/controls include:
Indemnification: the agent indemnifies the lender in the event that losses occur in the program in a range of circumstances.
Credit controls: the agent establishes strict guidelines in selecting its borrowers and then monitors the credit quality of each borrower.
Collateral:to reduce the impact of borrower default, a margin is required over the market value of the loaned securities (a "buffer" equal to say, 102% for domestic securities and 105% for global securities).
Intraday valuations: mark-to-market securities valuation several times a day. Additional collateral would be demanded where the security value increases to ensure that the collateral matches the security value.
Global agents have introduced risk controls. For example, one agent’s borrower network must meet the agent’s internal corporate lending criteria, ie. the borrower must satisfy the bank’s own corporate credit evaluation. Another example would be where a security is not returned at the time it is recalled. Global agents can make good the security to complete the trade instruction, for instance, putting forward the necessary funds to settle a buy transaction. In the meantime, it would continue to demand that the borrower return the security.
Generating Revenue: Cash collateral is invested and the margin (in excess of the rebate to the borrower) is shared between the agent and the lender. Where the collateral collected is in the form of securities, the borrower is charged a fee that is shared.
The revenue from securities lending is dependent on many factors. The primary factor being the security type/quality in a portfolio. The ability to loan securities is driven by demand in the market. Demand arises from the quality of the security, size of the pool, country demand, type of collateral sought and ultimately the fee.
The revenue also varies according to the arrangement in place with the lender. For example in an indemnified program, a lower split goes to the lender that in a non-indemnified program.
The Decision to Participate – Risk Versus Rewards: From a consulting perspective, the decision to participate is a matter of weighing up the risks versus the rewards. The revenue must be adequate to justify the potential risks involved.
In considering the risks and the rewards, it is important to be well informed. To make an informed decision, the agent must provide specific detailed information. A formal Request For Proposal is the best technique is this respect.
To obtain a revenue estimate, a full listing of each security in the portfolio is provided. Although only an estimate, it should be accurate to around ± 10% – 15%. However, it is important to remember that it is only an indication of the revenue and actual revenue can change with economic circumstances. If only used as a benchmark it is valuable in managing performance and expectations.
The validity of estimates has often been challenged. However by contrasting estimates from several agents, it is possible to assess whether adequate revenue is possible – a breakdown of the revenue by country and asset types equally important. The subtleties in various programs become apparent from this exercise.
The type of program to implement include options such as the custodian, a third party agent or an in-house arrangement.
There are benefits of using the fund’s custodian as agent. The custodian has direct, up-to-date access to the portfolio. A global custodian has wide market coverage, 24-hour activity and it has access to experts round the world. Automated administration systems are prevalent and critical to reducing operational risks. Custodian systems are usually fully integrated to enable the information to be automatically sourced from the data warehouse.
When dealing with a third party agent, compatible system links need to be established. An additional relationship must also be managed with an increase in operational risk. Third party agents are often specialists in certain types of securities, and so may not be able to generate the levels of revenue that a custodian may require. It is possible, however, to use a blended approach allocating selected assets /portfolios to specialist lenders.
Investors can also establish in-house arrangements. In setting up such an arrangement, the investor assumes virtually all the risk. It would not have an indemnity from an agent and be at risk for any potential losses. It would have direct control over its counterparties and reinvestment vehicles, however many agents are already giving lenders the control over these decisions via agent programs. System links would also need to be established with the custodian.
The attraction of an in-house operation is access to all the revenue, rather than sharing it with an agent. However the additional revenue needs to be carefully justified. Consideration should be given to the ability of an in-house operation to earn the levels of revenue that an expert could do and the costs of operating such an arrangement must also be included.
The Bottom Line: The risks and rewards need to be carefully considered in deciding whether to engage in securities lending and how to best structure the lending arrangements. The consultant will be keen to reduce the risk to minimal levels while gaining the investor a reasonable level of income. The investor will in the end need to decide how much risk it will take over and above the consultants preferred and usually conservative positions. In the end, the old adage is relevant – let the lender be aware!
David Taplin is head of custody consulting services and Ilana Wald is client director, both at Deloitte & Touche in Melbourne

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