To lend or not to lend?
05 September 2017
Securities lending is a relatively low-return product, but any well-managed programme can be customised to mitigate the risks down to a level that justifies those returns, according to Simon Waddington of State Street
Image: Shutterstock
Of the adverse responses we hear when approaching new clients to enrol in our securities lending programme, there are two which are the most common by far.
The first is that returns are not high enough to justify the risk of the types of losses that occurred post-2008. The second is that securities lending supports short sellers and undermines the value of long-only portfolios.
Both of these arguments can indeed be valid, but only under very specific circumstances and neither should be an impediment to lending in today’s market.
Regarding the risks of securities lending, the crucial point to bear in mind is that the only major losses resulting from the financial crisis were related to cash collateral reinvestment.
More specifically, they were related to cash collateral reinvestment into higher yielding asset types such as mortgage-backed securities, which both significantly dropped in value and also became mostly illiquid. For many years, these types of cash collateral investments generated extremely high returns for beneficial owners, but with hindsight the balance of risk versus return was weighted too far towards the latter.
What would stop this happening again today? Firstly the industry in general has changed immensely over the last 10 years. Today, the industry is significantly smaller—around $2 trillion of loans versus over $3 trillion globally in 2007, according to IHS Markit June data—and much more sophisticated in monitoring market exposure.
Agent lenders have more advanced risk frameworks that include stress testing versus numerous extreme scenarios, daily value-at-risk analysis and more detailed liquidity limits.
Beneficial owners are much better educated about the risks of lending and most have tightened their cash reinvestment guidelines to remove higher risk investments and reduce average maturity. Reinvestment guidelines that allow less liquid asset types such as mortgage-backed securities are very uncommon.
Cash collateral returns are also no longer driving the industry the way they were 10 years ago. According to IHS Markit, cash reinvestment was generating around $4.6 million per day for the industry at the end of May 2017 versus a peak of $44 million per day in 2008. Of course, that is partly due to the recent low interest rate environment, but it is also due to heightened risk management and tightening investment parameters.
Secondly, every client has the ability to tailor their programme parameters to meet their own requirements. There are many collateral options that allow clients to participate fully while removing components they are not comfortable with, as shown in the list in the next column.
Any of these options would allow clients to benefit from securities lending returns while mitigating, or in some cases completely removing, the risk of the losses which occurred in the financial crisis. A non-cash collateral policy creates a very simple securities lending programme that captures the majority of the intrinsic lending value in clients’ portfolios, while the other three options offer the benefit of also accessing the 37 percent of the global industry, which is versus cash collateral, according to DataLend, and potentially generating additional returns.
The second common argument against lending is that it supports short sellers and thus undermines the value of long-only portfolios. It is true that short selling would not be possible without securities lending, but those flood gates have long since opened. Consider the IHS Markit statistics on the market in the graphic below.
What the graphic is saying is that the available liquidity in the average main index stock is massive. In general, around 95 percent of lendable equities in the market are not lent, according to IHS Markit, so in regular market conditions, anyone who wants to go short will have no problem at all borrowing stock. Market liquidity in these stocks is so deep now that the decision of any one client to lend or not to lend, however large they are, is very unlikely to have any meaningful impact.
This is clearly a generalisation and it will not be true for every asset type and market, but agent lenders are sophisticated enough to allow clients to choose which assets can be lent down to a security level.
Liquidity for the FTSE Smallcap Index in the UK, for example, will be much lower than the FTSE 100, but if a client held a large position in a FTSE Smallcap stock, their agent lender could review market liquidity in that stock to assess if their holdings would likely have an impact or not. If it was a concern, the agent lender would simply restrict that stock from being lent and that issue is resolved.
It is fairly common for active fund managers to either restrict or limit loans in securities in which they hold a significant percentage of the market capitalisation.
Managing limits such as these is part of standard day-to-day business for agent lenders, as is approaching these clients to let them know if there is a significant revenue opportunity on these stocks so that they can make an active decision on whether to benefit from it or not.
In conclusion, these are two of the factors that potential clients should consider before joining a securities lending programme, but they are far from insurmountable.
Securities lending is a relatively low-return product, but any well-managed lending programme can be customised to mitigate the risks down to a level that justifies those returns.
1: A non-cash collateral policy
Non-cash collateral such as government bonds or equities has no reinvestment risk at all, and none of the major losses post-2008 were related to non-cash collateral.
2: Cash collateral invested in reverse repo
A reverse repo trade collateralised by equities or government bonds has almost exactly the same risk profile as a non-cash collateral trade versus the same securities, and agent lenders may indemnify reverse repo trades in exactly the same was as they would indemnify a non-cash collateral trade.
3: Cash collateral invested in money market funds
This is a common choice for cash collateral reinvestment and allows clients to invest in regulated short-term funds such as State Street’s UCITS-compliant AAA-rated liquidity funds. Global money market fund reform such as the move to low volatility NAV funds in the EU will arguably make these even safer options for cash collateral reinvestment.
4: A separately managed cash collateral account
The definitive option for any client is to have a separately managed cash collateral account which is invested based on their bespoke guidelines only.
The first is that returns are not high enough to justify the risk of the types of losses that occurred post-2008. The second is that securities lending supports short sellers and undermines the value of long-only portfolios.
Both of these arguments can indeed be valid, but only under very specific circumstances and neither should be an impediment to lending in today’s market.
Regarding the risks of securities lending, the crucial point to bear in mind is that the only major losses resulting from the financial crisis were related to cash collateral reinvestment.
More specifically, they were related to cash collateral reinvestment into higher yielding asset types such as mortgage-backed securities, which both significantly dropped in value and also became mostly illiquid. For many years, these types of cash collateral investments generated extremely high returns for beneficial owners, but with hindsight the balance of risk versus return was weighted too far towards the latter.
What would stop this happening again today? Firstly the industry in general has changed immensely over the last 10 years. Today, the industry is significantly smaller—around $2 trillion of loans versus over $3 trillion globally in 2007, according to IHS Markit June data—and much more sophisticated in monitoring market exposure.
Agent lenders have more advanced risk frameworks that include stress testing versus numerous extreme scenarios, daily value-at-risk analysis and more detailed liquidity limits.
Beneficial owners are much better educated about the risks of lending and most have tightened their cash reinvestment guidelines to remove higher risk investments and reduce average maturity. Reinvestment guidelines that allow less liquid asset types such as mortgage-backed securities are very uncommon.
Cash collateral returns are also no longer driving the industry the way they were 10 years ago. According to IHS Markit, cash reinvestment was generating around $4.6 million per day for the industry at the end of May 2017 versus a peak of $44 million per day in 2008. Of course, that is partly due to the recent low interest rate environment, but it is also due to heightened risk management and tightening investment parameters.
Secondly, every client has the ability to tailor their programme parameters to meet their own requirements. There are many collateral options that allow clients to participate fully while removing components they are not comfortable with, as shown in the list in the next column.
Any of these options would allow clients to benefit from securities lending returns while mitigating, or in some cases completely removing, the risk of the losses which occurred in the financial crisis. A non-cash collateral policy creates a very simple securities lending programme that captures the majority of the intrinsic lending value in clients’ portfolios, while the other three options offer the benefit of also accessing the 37 percent of the global industry, which is versus cash collateral, according to DataLend, and potentially generating additional returns.
The second common argument against lending is that it supports short sellers and thus undermines the value of long-only portfolios. It is true that short selling would not be possible without securities lending, but those flood gates have long since opened. Consider the IHS Markit statistics on the market in the graphic below.
What the graphic is saying is that the available liquidity in the average main index stock is massive. In general, around 95 percent of lendable equities in the market are not lent, according to IHS Markit, so in regular market conditions, anyone who wants to go short will have no problem at all borrowing stock. Market liquidity in these stocks is so deep now that the decision of any one client to lend or not to lend, however large they are, is very unlikely to have any meaningful impact.
This is clearly a generalisation and it will not be true for every asset type and market, but agent lenders are sophisticated enough to allow clients to choose which assets can be lent down to a security level.
Liquidity for the FTSE Smallcap Index in the UK, for example, will be much lower than the FTSE 100, but if a client held a large position in a FTSE Smallcap stock, their agent lender could review market liquidity in that stock to assess if their holdings would likely have an impact or not. If it was a concern, the agent lender would simply restrict that stock from being lent and that issue is resolved.
It is fairly common for active fund managers to either restrict or limit loans in securities in which they hold a significant percentage of the market capitalisation.
Managing limits such as these is part of standard day-to-day business for agent lenders, as is approaching these clients to let them know if there is a significant revenue opportunity on these stocks so that they can make an active decision on whether to benefit from it or not.
In conclusion, these are two of the factors that potential clients should consider before joining a securities lending programme, but they are far from insurmountable.
Securities lending is a relatively low-return product, but any well-managed lending programme can be customised to mitigate the risks down to a level that justifies those returns.
1: A non-cash collateral policy
Non-cash collateral such as government bonds or equities has no reinvestment risk at all, and none of the major losses post-2008 were related to non-cash collateral.
2: Cash collateral invested in reverse repo
A reverse repo trade collateralised by equities or government bonds has almost exactly the same risk profile as a non-cash collateral trade versus the same securities, and agent lenders may indemnify reverse repo trades in exactly the same was as they would indemnify a non-cash collateral trade.
3: Cash collateral invested in money market funds
This is a common choice for cash collateral reinvestment and allows clients to invest in regulated short-term funds such as State Street’s UCITS-compliant AAA-rated liquidity funds. Global money market fund reform such as the move to low volatility NAV funds in the EU will arguably make these even safer options for cash collateral reinvestment.
4: A separately managed cash collateral account
The definitive option for any client is to have a separately managed cash collateral account which is invested based on their bespoke guidelines only.
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