Securities lending took a major hit in the 2008 crisis. For those funds that stayed the course, Cécile Sourbes finds new regulation promising more activity, but threatening to raise costs
On 15 September 2008, when Lehman Brothers filed for bankruptcy, many pension funds woke up in shock, wondering what would happen to the assets they had lent to one of the largest borrowers of securities in the market.
But problems in securities lending were evident way before Lehman’s default, when the first tremors of the US sub-prime crisis in 2007 caused unexpected losses in, and a wave of redemptions from, some of the money market funds that pension funds’ agents used to re-invest the cash collateral they received in exchange for securities. Many pension funds alleged that those agents did not adequately inform them of the counterparty and cash-collateral reinvestment risks of their securities-lending programmes, and a number suspended those programmes as a result.
At the height of the market in early 2008, around $15trn of securities were available for loan. That fell to just $8trn by H2 2008, according to the Bank of England.
Since then there has been a recovery; around $13trn worth of securities is now on the market. Simon Lee, senior vice-president at eSecLending, explains that lending agents had to develop “very rigorous” default-management processes, given the size and scale of the Lehman default.
“Agents would have to liquidate any collateral held on behalf of Lehman and then buy in their lenders’ assets to cover the positions that were otherwise due to default,” he recalls.
“The default processes we engaged in worked exceptionally well.” This, he adds, brought a new wave of confidence to both the lending-agent community and the lenders – who, after all, value the additional income as an offset to the costs of maintaining large investment portfolios.
But another important factor is also re-awakening pension fund interest in securities lending.
Under the EU’s new European Market Infrastructure Regulation (EMIR) users of OTC derivatives will be required to clear most of their trades through central clearing houses that will demand both initial and variation margin – the latter exclusively in the form of cash. As pension funds tend not to sit on large piles of cash, most will need to transform some of their securities either via the repo or the securities lending market.
“Securities lending can be the right tool to raise cash,” says Lee. “It provides a lot of additional benefits on top of the repo market by way of the administrative support, reporting and servicing provided, as well as greater flexibility in creating tailored solutions for clients. We’ve had discussions with a number of institutions about structuring a securities lending programme that provides built-in collateral transformation and optimisation services.”
These incentives are not sufficient for all pension funds. Some, like Switzerland’s Caisse de prévoyance du personnel des établissements publics médicaux du canton de Genève (CEH), seem to have turned their back on securities lending for good. Director Jean-Pierre Steiner argues that the market suffers from a “misalignment of interests” between pension funds, which have longer-term investment views, and short-term-oriented hedge funds, which borrow securities for short-selling; but also between pension funds and securities-lending agents, which “participate in the earnings but not the losses” and often push schemes to take more risks than they wish.
“The use of securities lending would lead us to create risk-management solutions that come in direct opposition to what our scheme really wants to achieve,” he says.
Andres Haueter, head of asset management at the Swiss Post pension fund, also says that his scheme has not used the securities lending market since 2008 due to its unattractive risk-return profile. He reasons that as long as he seeks to avoid tail risks in asset classes such as equities it would be “inconsistent” to take similar risks – like those of a Lehman-style default or money-market crash – in securities lending.
Pension funds in the UK and the Netherlands that suspended programmes have been much more willing to return – but with tighter controls around counterparty exposure.
According to Emily Cates, principal consultant at Rule Financial, pension schemes are still willing to accept equities and lower-rated bonds as collateral, but the pre-crisis haircuts of 5% or less have been succeeded by margins of more like 10-20%. Those haircuts, moreover, tend to be dynamic, reacting to the level of risk-aversion and volatility in markets.
This is where recommendations regarding risks in shadow banking, published last November by the Financial Stability Board, are causing concern.
“There could be a policy but I think it will be a light policy with guidelines rather than absolute rules,” says Cates – while recognising that some market participants fear that policymakers could opt for set levels for haircuts, taking away the flexibility that allows for more cost-effective securities lending when markets are calm.
For Cates, the bigger problem stemming from the shadow banking guidelines lies elsewhere. She expresses concerns over the transaction reporting process – similar to the one introduced for OTC derivatives under EMIR – that policymakers could impose.
“At the moment, a lot of these trades are traded the same day and not on a T+1 or T+2 basis, as is the case for cleared OTC trades,” Cates explains. “So, if regulators were to implement something similar in shadow banking for securities lending [as they have for OTC derivatives], the sheer volume of reporting could be huge. This, in turn, would mean that the whole regulation would make securities lending economically unattractive to pension funds.”
This market has come a long way since the panic of 2008 – but that alone was enough to persuade many of the more conservative investors that the incremental gains from securities lending simply didn’t justify the risks or the perceived conflicts of interest. Now, as one set of regulations aimed at mitigating systemic financial risk promises to stimulate a new wave of lending activity, another set threatens those already tight profit margins. Pension funds will be weighing-up the costs and benefits for some time yet.