The modern pensions industry has become increasingly competitive and any low-risk source of added value can be worth pursuing as funds battle to outperform their benchmarks. Most attention focuses on strategic and tactical active management decisions, however, there is another way to add value which relies on putting the assets to further use in order to maximise overall efficiency. This is the process of securities lending.
Securities lending brings together those who are willing to lend their assets with those who wish to borrow in order to take advantage of market asymmetries. The process is fully collateralised, with the borrower providing collateral in excess of the assets being lent (typically 105%). This collateral is marked to market daily and leads to an arrangement which, from the lender’s perspective, all but eliminates risk, provides anonymity and permits him to retain flexibility over the assets. In return for lending the securities, the owner of the assets is entitled to a fee for the duration of the loan.
Securities lending is no longer a new idea. Over 2,200 participants lend over $1,000bn (€920bn) worth of stock in 44 markets globally. It provides benefits not just to the borrower but also to the lender and the markets as a whole. To the lender, the principal benefit is the fee which he earns, which can significantly reduce or eliminate costs incurred elsewhere in his operation. For example, an investor active in emerging market equity who lends his assets under a securities lending program can often pick up an incremental 75 basis points on that segment of his assets. A competitor who does not will be at a significant disadvantage in terms of performance, whether or not their strategies are otherwise identical.
To the market, securities lending improves liquidity and reduces overall transaction costs. Theoretically, the role of securities lending in efficient capital markets is to minimise the cost of failed trades and to enhance liquidity. Much in the same way that retail banks provide liquidity in the money markets by lending multiples of their capital base, so securities lending increases liquidity by increasing the effective market capitalisation of the securities loaned out. Given that bid-offer spreads are a direct transaction cost for fund managers, and given that the spreads will tend to be narrower with higher liquidity, the existence of the securities lending market serves to reduce these direct costs.
An example of this is again found in the emerging markets where the cost to borrow is potentially very high. The fund manager who is looking to purchase inventory from a market maker will pay a price inclusive of the market maker’s cost to borrow – one far higher than the 10 basis points typically found in the highly developed US market for instance. This will be necessarily reflected in a wider bid-ask spread and have a direct effect on the fund manager’s overall costs.
Finally, securities lending is also an important factor in the maintenance of arbitrage-free equity markets and is critical in ensuring smooth settlement cycles in the equity markets around the world. If one party fails to deliver to a market maker from whom the fund manager has bought, securities lending enables the market maker to make good delivery to the fund manager.
The downside is very little, provided the programme is managed properly. In general, the risk and consequences of default by the borrower tend to be overplayed. Remember that the assets being lent are over-collateralised and marked to market daily and that, in addition, it is often possible to purchase default insurance against a
particular counterparty. That said, there is no substitute for carrying out adequate due diligence in order to ensure that borrowers are of sufficient credit quality.
Other concerns which are sometimes raised centre on a fear of losing control, or that securities lending facilitates huge short activity which depresses the price of the securities which the fund manager is long to begin with. In reality, the hypothesis that securities lending detrimentally perpetuates short activity has no basis in academic financial research. To the contrary, as we pointed out earlier, the ability to maintain short positions is central to a successful and efficient capital market. Indeed, many sophisticated models of capital market behaviour require this as an underlying assumption.
There are several methods of implementing a securities lending program: in many ways, the ‘lending through a custodian bank’ is the traditional route, with the custodian acting as an agent, whereby the assets are pooled with assets of the bank’s other clients. These securities are then offered out to the borrowers as a block, with the proceeds then shared between pool participants after the bank has taken its split. The benefits typically include free or cheap custody of the assets, reduced movement costs, a high standard of reporting and, probably most significantly, little operational input by the lender. There are, however, several disadvantages. The investor has little control over where the securities are loaned, he or she has no certainty of revenues as these are based on expected value only, and he has to split the fee with both the agent and the other clients. Since the shares are pooled together, it is far from certain that all the assets will be utilised.
Then there is ‘securities lending through a dedicated in-house facility’. If the size and diversification of the assets permit, the investor can set up a dedicated facility and ‘do it himself’. Recently there has been considerable interest shown by some of the largest funds in such a move, motivated by the attraction of retaining 100% of the lending revenues. By being independent, the fund gains total control of the asset utilisation process, choice of counterparties and relevant price advantages by dealing directly with the end users. Clearly, by removing the stock lending function from the custodian, the asset owner is likely to face higher custody costs but this can be more than compensated for by the benefits.
Finally, the recent trend has been for larger pension funds to orchestrate deals with a preferred lender, who, for a guaranteed fee, will make use of the fund’s assets – ‘third party lending and exclusive deals’. The fund makes the decision as to whom the securities are lent, but the operational side may be handled by the custodian for a split of the fee. The attractions of this include better pricing (including a guarantee) and maximum utilisation of the assets. The investor will retain choice of counterparty yet be free from operational concerns. The investor may face higher custody fees than under the agency route, but if the custodian is involved in the administration – and therefore remunerated for this – it is quite possible for both parties to be better off.
The choice of securities lending program will clearly be based on a cost benefit analysis of the alternatives. Independence is usually more feasible for the larger funds, while exclusive deals may be attractive to even the smaller funds. Whichever route is chosen, it is important to put in place suitable documentation. Agreements are typically based on one of two standards: the Overseas Securities Lender’s Agreement (OSLA) and/or the Bond Markets Association Securities Lending Agreement (BMA). In both cases this documentation is drafted to protect the interests of lenders.
Once put in place, securities lending is an efficient, flexible and market neutral method of extracting value from the assets owned. The amount of potential added value may be modest by comparison with the impact of strategic and tactical asset allocation decisions, but for many investors it does provide a low-risk means of adding value and, in particular defraying the costs associated with running a medium-large pension fund.
Gareth Derbyshire is vice president, European pensions group and Phillipe Lopategui is executive director, equity financing services at Morgan Stanley, in London