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Impact Investing

IPE special report May 2018

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Stock lends puts 11 September behind it

Post 11 September, one rather closeted segment of the investment market came under particularly close scrutiny in a way rarely seen before. Commentators first set their sights on the activities of hedge funds – accusing them of dangerously shorting a market that looked on the verge of collapse. Their gaze eventually shifted to the custodians that market the securities lending services to pension funds. These provide the equity that allows hedge funds to call the market.
The talk of the time was that custodians might suspend securities lending to ensure the markets focused on the long-term rather than any gains that might be picked up on the back of tragedy.
In the end, few did. Instead, custodians rallied to defend their corner and explain what they felt were the advantages in ensuring that stock lending remained strong in a time of potential crisis.
Nine months on, has there been any fall-out from the brief but sharp spotlight on securities lending?
One of the most vocal defenders of stock lending since 11 September has been Bob Ash, senior vice president at State Street Securities Finance.
Ash recalls the criticism at the time: “There was some debate, mainly in the UK press and not elsewhere in the world, as to the role of securities lending in capital markets.”
He claims that there were significant misconceptions about the value that securities lending adds to the market. “If you look at the successful, sophisticated capital markets in the world and the role that securities lending plays then it’s clear that the practice adds much-needed liquidity.
“Some people say it adds volatility also, but it actually does the opposite. What it enables is greater pricing efficiency and price discovery by enabling both sides of the opinion of the market to be expressed simultaneously. If people think a certain stock is overpriced they have the ability to short it and you can only do that if there is liquidity in the securities lending market.”
Ash also believes that stock lending can help to curb the bubble effects seen in the dot-com boom and bust. “You can see elements of this in the dot-com explosion. Many of the stocks were really quite illiquid and the price got ramped up out of all proportion to the fundamentals.
“Suddenly people think ‘woaaahh... this doesn’t make any sense at all’ and then the price comes crashing down. However, if there is liquidity in the securities lending market, then when some people are chasing purchases, other investors will be expressing a contrary view, thus giving a balancing effect.”
Ash adds that one of the effects of 11 September was what he says may be a “realistic change” in the fundamentals of a couple of market sectors, such as airlines and insurance. “This has been a ‘real’ effect on the market and in fact if you then try and control the market you almost create a false market.”
One positive aspect, he believes, is that the market – lenders, borrowers and agents, weathered the 11 September crisis well. “It showed a mature and robust market place. The only people that pulled out were peripheral players or fund managers lending small amounts of stock. When you look at the importance of liquidity in the market, particularly in times of crisis, the worst that you can have is people pulling liquidity from the market.”
In terms of the knock-on effect of the bad press post 11 September, Ash is keen to point out that the impact has been minimal: “The press coverage certainly didn’t help at the time and the level of debate was very disappointing. It only happened in the UK though – we didn’t see this anywhere else. It was a UK press phenomenon.
“What we have been doing since is reiterating the arguments. Securities lending is an investment product. It is a risk/reward game and I think the risks are well known and proportionate. The risk/reward ratio actually looks very attractive and it is a very good return for the risk you take on.
“Securities lending is a continuing trend globally – there have been strong sales both before and after 11 September, so it hasn’t really affected the market.”
Roeland de Groot, head of securities lending at Amsterdam-based custodian, KAS Bank, draws the same conclusion and adds that the current market gloom has in fact boosted business. “We don’t see any difficulties in selling securities lending services to pension funds – it’s more or less the other way round. What you see at the moment is that it is becoming more and more difficult for pension funds to add money and that is the reason why they are looking towards stock lending.
“A few years ago pension funds were not on the whole interested in securities lending because the small amount that they could make on returns was more than they could make on securities lending in a whole year. That is no longer the case.”
Where previously pension funds had been worried about the hassle of entering into stock lending arrangements and issues of collateral etc, De Groot says they are now focused on issues of cost and earning extra money. “The pressure on us now is a lot higher because they really want us to perform.”
De Groot notes that while there was little criticism in the Dutch market, one or two pension funds asked themselves questions such as whether shorting the market was something they wanted to be involved in. “We haven’t seen anyone that stopped securities lending because of 11 September. I think in the UK there is still the legacy of Maxwell, so UK pension funds look at securities lending a little differently than the rest of Europe. As we are also involved in the UK market I think it is a little more difficult to sell securities lending there than it is maybe in the Netherlands.”
One important security factor for Dutch funds, he points out, is that the Dutch insurance and banking chamber lays down strict criteria for custodians to develop lending products: “Collateral issues are very important as is risk. In Holland the regulators don’t really like to talk about risk in the same sentence as pension funds.”
One issue though, post 11 September, he concludes, was that hedge funds became less active and demand waned. “The market has picked up again, so the demand is very high for European shares in the well-known markets. In Germany, France and Italy, for example, you can easily lend out all you have.
“The Netherlands has always been a little more difficult because all the equity is in the hands of the pension funds that participate in securities lending and there is never enough demand to place everything – like in the US and the UK.”
John Burgess, global head of global portfolio management at Deutsche Bank Securities Services, also believes the market is back to business as usual, albeit with a caveat.
“I think the view that the preponderance of lending goes to support outright short selling of equities is a false one. A lot of the work we do is on relative value, risk arbitrage and shorts, not people speculating on directional bets.”
Burgess says Deutsche is seeing continued growth in its European securities lending business, but acknowledges a “slowness” in the market, which he notes has more to do with the lack of current corporate activity and M&A business that would normally drive greater equity volumes in the market.
“Couple this with some of the changes in dividend tax reclaim that have been going on this year and the market is a little damp.”
However, the direct effects of 11 September, according to Burgess, merely led to a “hiccup” in market activity for a few days. “For most clients lending is an adjunct basis point to add to their underlying portfolio and most are sensitive to not taking extraordinary risk for the gain.
“In a perceived meltdown of financial markets lending is an easy thing for a client to suspend for a short time until the market settles down. We didn’t really see that happening though. We certainly had a lot of meetings and hand holding with our clients in the period after 11 September. But once the equity markets rebounded we saw that slack off immediately.”
Burgess notes though that, while there are more participants in the stock lending industry, overall borrowings are down because the markets are down.
“In terms of available lenders our market has grown and continues to do so, but as a lender we’d like to see better market conditions. This is happening going forward with the greater proliferation of equity hedge funds and the increasing sophistication and growth of prime brokers.
“Volumes are up, but as a percentage of the lendable base they are down year over year and that is due to market functions.”

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