Securities lending: Setting the record straight. Let’s address what may be holding you back
27 April 2021
Don D’Eramo, head of securities finance at RBC Investor & Treasury Services, offers an overview of why a securities lending programme can offer low-risk returns and support capital market liquidity
Image: Don D’Eramo
Securities lending provides a valuable opportunity for asset owners and managers to earn incremental revenue on otherwise idle assets without disrupting their day-to-day investment activities. Moreover, the practice is relatively low-risk, given that it is usually indemnified by agent lenders and fully collateralised by counterparties, with tailored parameters that can be applied to align with a client’s risk appetite.
According to the Bank of Canada, securities lending “plays an important role in Canadian financial markets” by promoting market liquidity, enhancing price discovery, preventing settlement failures, and supporting a variety of trading strategies — as well as providing security holders with access to funding.
Still, there may be misconceptions about securities lending that are influencing institutional investors’ participation in this core market activity. These include topics such as risk levels, short positions, flexibility, and alignment with environmental, social, and governance (ESG) investing.
We address these concerns in more detail for beneficial owners considering adding securities lending to their investment strategy in order to generate new revenue streams, offset and/or reduce costs, and improve portfolio returns.
Key insights
• Securities lending is an important contributor to well-functioning capital markets by promoting liquidity, enhancing price discovery and providing access to funding for security holders
• Securities lending is often negatively associated with short selling; however, securities lending goes beyond short selling and includes other market facilities such as market making, funding, prime brokerage and collateral optimisation
• Portfolio managers and beneficial owners can participate in securities lending without impacting day-to-day operations and investment strategies. For example, many beneficial owners strike a balance between repo activity and securities lending. Flexibility in parameter setting and consultation with agent lenders is key to supporting simultaneous functioning of market activities
• Securities lending can coexist with ESG principles. A survey from The Risk Management Association shows 95 per cent of institutional investor respondents believe that securities lending activities can coexist with ESG principles
It is not high risk
The view that securities lending is a high-risk activity is an idea that developed in part from the losses incurred dating back to the 2008 global financial crisis.
At that time, securities lending was considered higher risk when cash-collateralised transactions involved a high degree of maturity or liquidity transformation, according to a report from the Bank of Canada. It cites the example of insurer AIG, which ran a large in-house securities lending programme. “AIG’s strong credit rating combined with its large portfolio of in-demand securities made it an ideal counterparty for many borrowers,” the bank stated in its report. It noted that AIG lent out its securities for cash collateral, much of which was reinvested in residential mortgage-backed securities and other asset-backed securities, with only a small cash buffer retained to meet redemptions.
In September 2008, there was a run on the program as borrowers demanded that US$24 billion in cash collateral be returned. The Federal Reserve Bank of New York ended up borrowing US$38 billion of securities from AIG and provided it with cash collateral to satisfy borrower demands.
Those losses were tied to cash collateral reinvestment, primarily driven by market stresses impacting the invested assets (i.e. defaulting instruments) as well as the duration mismatch of the reinvestment portfolio, and not the act of securities lending, says Donato D’Eramo, managing director and global head of securities finance at RBC Investor & Treasury Services (RBC I&TS). Also, since then, he says the industry has evolved. The practice of cash reinvestment has changed to mitigate against that scenario recurring, and there is greater transparency on reinvestment strategies.
Fast forward to today, and Canadian and European securities lending markets are predominantly undertaken without cash collateral. “Although it can be done in a very risk-averse way, if it aligns with a client’s risk appetite,” adds D’Eramo.
The multiple layers of protection that surround typical securities lending transactions include collateralisation and indemnification, making it a relatively low risk-adjusted return activity. With strong risk mitigation protocols, securities lending remains an important part of a diversified portfolio strategy and can be a powerful revenue driver.
It goes beyond short selling
Securities lending is often associated with trading strategies that rely on short selling, a sometimes controversial and polarising market activity that is based on the expectation that the price of a security will drop. While short selling certainly has its share of critics, it is also considered a vital market mechanism.
Academic research shows short selling enhances liquidity and price discovery and improves market efficiency. Furthermore, the strategy does not negatively impact long-term investment goals, with research suggesting that long sellers impact stocks more than short sellers.
“When investors have the ability to take both sides, the mechanism of price discovery is much more efficient,” says Kyle Kolasingh, associate director of securities finance at RBC I&TS.
Short selling is not the main driver of securities lending, he adds. “That’s a primary misconception. Short selling is one aspect of the industry but by no means the largest contributor.”
The European Securities and Markets Authority (ESMA) considered the impact of short selling and securities lending practices and its potential link with short-termism in a 2019 report. The report stresses that short selling and securities lending “are key for price discovery and market liquidity”.
The ESMA report further emphasises that it is “not aware of concrete evidence pointing to a cause-effect connection between these practices and the existence of undue short-term market pressures”.
It stated that “securities lending, if done in a controlled way, is an opportunity to add value for fund investors and [is] compatible with long-term investment strategies”.
It is not all or nothing
Securities lending does not require the commitment of an entire portfolio. In fact, portfolio managers and beneficial owners can restrict any security or asset classes they may not be comfortable lending. Recalls can also be initiated at the beneficial owner’s discretion.
Agent lenders develop programmes that are customised to suit a client’s particular requirements and preferences. For example, a client can opt to enroll its entire portfolio of assets but limit lending to a specific hurdle rate. This approach is referred to as an “intrinsic value” lending programme. In this model, clients can enter agreements that enable them to choose to lend only specific securities or “specials”. While this is a more concentrated form of lending, it provides some exposure and insight into the mechanics of securities lending before proceeding to make a full portfolio lendable, and may be more conducive to some investment strategies.
While securities lending is about scale, it is not only larger portfolios that have the opportunity to benefit from lending, Kolasingh says. “You can have a smaller portfolio that is concentrated in a very attractive asset class. That can generate the same return profile as a portfolio that may be 10 times as large but may have an asset composition that is less desirable from a lending perspective.” At RBC I&TS we have developed a tailored route to market where eligible beneficial owners can monetise securities lending opportunities on single securities, instead of lending their full portfolio. This can be advantageous for traditionally smaller portfolios, or simply a more suitable approach depending on risk appetite considerations.
It is ESG friendly
Another concern is that securities lending is incompatible with ESG investing, where investors seek to exercise governance responsibilities by screening companies considered to be more responsible in their corporate behaviour, or focusing on those where voting rights can be used to exert influence.
For example, investors may see short selling as inconsistent with ESG investing since sustainable investing is often viewed by some as a strictly long-term investment strategy. The Bank of Canada, through its opinion of price discovery and market liquidity, presents an alternative and broader view of what sustainable investing is by including factors such as price discovery.
Furthermore, beneficial owners do not need to give up their proxy vote when lending securities, as noted in a recent report from BlackRock.
“Questions have arisen regarding whether securities lending is additive to or detracts from sustainable objectives, particularly in relation to short selling and voting,” the report states, citing a common view that securities lending transfers the voting rights to the short seller. “The buyer of the security has the right to exercise proxy votes of the security not the short seller,” the report notes. “Additionally, brokers are prohibited from borrowing shares for the primary purposes of voting. Securities on-loan can also be recalled to vote.”
A recent survey from The Risk Management Association (RMA) shows 95 per cent of institutional investor respondents believe that securities lending activities can coexist with ESG principles. The survey says 18 per cent of respondents currently apply ESG factors to their programs, while 25 per cent said they did on a case-by-case basis. Another 18 per cent do not apply the principles but are planning to, while 39 per cent simply do not.
Canadian pension executives believe ESG issues are critical and eight of the country’s leading pension plan investment managers — representing approximately CA$1.6 trillion in assets under management — recently issued a statement calling on companies and investors to provide consistent and complete ESG information to strengthen investment decision-making and better assess and manage their collective ESG risk exposures. Interestingly, all of the pension plans that are part of the call to action participate in securities lending programs, further highlighting that securities lending can align with ESG principles.
Andrew Dyson, CEO of the International Securities Lending Association (ISLA), believes that “a well-run and prudentially managed securities lending programme can happily run alongside an ESG investment mandate”.
In a recent letter posted on the ISLA website, Dyson says many of the reasons cited for not lending securities in an ESG mandate “appear to fall away and not stand up to intellectual rigour”.
He notes that lending agents can help beneficial owners exercise their voting rights, while also highlighting the role securities lending can play in supporting short sellers.
“It has been confirmed time and time again through independent research and by the regulatory community that short selling in general is a force for good, allowing hedge funds and other short sellers to bring companies to account where their share price bears no relation to the facts behind that firm. As so-called ‘greener’ markets evolve, wouldn’t we expect that level of scrutiny from the buy-side of the investment spectrum?” writes Dyson.
He also discusses the market liquidity and efficient price discovery that comes with short selling. “Without the support of institutional investors for securities lending across ESG markets, these securities will trade less frequently and suffer from a lack of market liquidity which, in turn, will lead to a widening of bid-offer spreads,” writes Dyson, whose organisation is working on best practices and guidance to help institutional investors align their securities lending programmes with their ESG objectives.
He also underscores the argument that securities lending delivers relatively low-risk returns over time, “which can drive outperformance or lower fees where lending revenues are used to offset management costs”.
Securities lending as a viable investment strategy
Securities lending is a mature, resilient market activity that has persisted through macroeconomic events such as credit shocks, the sovereign bond crisis and now the pandemic. Furthermore, it is highly regulated and transparent, utilising risk mitigation tools that make it efficient and low risk.
The industry continues to evolve alongside the financial markets and the global economy. Participants benefit from digital innovation with tools and data that help them make more informed decisions and optimise results.
Overall, securities lending can provide beneficial owners with the opportunity to earn considerable low-risk adjusted returns. Given that interest rates are expected to remain low for longer, securities lending is an important market tool to help beneficial owners seek broader portfolio diversification to achieve sustainable future returns.
According to the Bank of Canada, securities lending “plays an important role in Canadian financial markets” by promoting market liquidity, enhancing price discovery, preventing settlement failures, and supporting a variety of trading strategies — as well as providing security holders with access to funding.
Still, there may be misconceptions about securities lending that are influencing institutional investors’ participation in this core market activity. These include topics such as risk levels, short positions, flexibility, and alignment with environmental, social, and governance (ESG) investing.
We address these concerns in more detail for beneficial owners considering adding securities lending to their investment strategy in order to generate new revenue streams, offset and/or reduce costs, and improve portfolio returns.
Key insights
• Securities lending is an important contributor to well-functioning capital markets by promoting liquidity, enhancing price discovery and providing access to funding for security holders
• Securities lending is often negatively associated with short selling; however, securities lending goes beyond short selling and includes other market facilities such as market making, funding, prime brokerage and collateral optimisation
• Portfolio managers and beneficial owners can participate in securities lending without impacting day-to-day operations and investment strategies. For example, many beneficial owners strike a balance between repo activity and securities lending. Flexibility in parameter setting and consultation with agent lenders is key to supporting simultaneous functioning of market activities
• Securities lending can coexist with ESG principles. A survey from The Risk Management Association shows 95 per cent of institutional investor respondents believe that securities lending activities can coexist with ESG principles
It is not high risk
The view that securities lending is a high-risk activity is an idea that developed in part from the losses incurred dating back to the 2008 global financial crisis.
At that time, securities lending was considered higher risk when cash-collateralised transactions involved a high degree of maturity or liquidity transformation, according to a report from the Bank of Canada. It cites the example of insurer AIG, which ran a large in-house securities lending programme. “AIG’s strong credit rating combined with its large portfolio of in-demand securities made it an ideal counterparty for many borrowers,” the bank stated in its report. It noted that AIG lent out its securities for cash collateral, much of which was reinvested in residential mortgage-backed securities and other asset-backed securities, with only a small cash buffer retained to meet redemptions.
In September 2008, there was a run on the program as borrowers demanded that US$24 billion in cash collateral be returned. The Federal Reserve Bank of New York ended up borrowing US$38 billion of securities from AIG and provided it with cash collateral to satisfy borrower demands.
Those losses were tied to cash collateral reinvestment, primarily driven by market stresses impacting the invested assets (i.e. defaulting instruments) as well as the duration mismatch of the reinvestment portfolio, and not the act of securities lending, says Donato D’Eramo, managing director and global head of securities finance at RBC Investor & Treasury Services (RBC I&TS). Also, since then, he says the industry has evolved. The practice of cash reinvestment has changed to mitigate against that scenario recurring, and there is greater transparency on reinvestment strategies.
Fast forward to today, and Canadian and European securities lending markets are predominantly undertaken without cash collateral. “Although it can be done in a very risk-averse way, if it aligns with a client’s risk appetite,” adds D’Eramo.
The multiple layers of protection that surround typical securities lending transactions include collateralisation and indemnification, making it a relatively low risk-adjusted return activity. With strong risk mitigation protocols, securities lending remains an important part of a diversified portfolio strategy and can be a powerful revenue driver.
It goes beyond short selling
Securities lending is often associated with trading strategies that rely on short selling, a sometimes controversial and polarising market activity that is based on the expectation that the price of a security will drop. While short selling certainly has its share of critics, it is also considered a vital market mechanism.
Academic research shows short selling enhances liquidity and price discovery and improves market efficiency. Furthermore, the strategy does not negatively impact long-term investment goals, with research suggesting that long sellers impact stocks more than short sellers.
“When investors have the ability to take both sides, the mechanism of price discovery is much more efficient,” says Kyle Kolasingh, associate director of securities finance at RBC I&TS.
Short selling is not the main driver of securities lending, he adds. “That’s a primary misconception. Short selling is one aspect of the industry but by no means the largest contributor.”
The European Securities and Markets Authority (ESMA) considered the impact of short selling and securities lending practices and its potential link with short-termism in a 2019 report. The report stresses that short selling and securities lending “are key for price discovery and market liquidity”.
The ESMA report further emphasises that it is “not aware of concrete evidence pointing to a cause-effect connection between these practices and the existence of undue short-term market pressures”.
It stated that “securities lending, if done in a controlled way, is an opportunity to add value for fund investors and [is] compatible with long-term investment strategies”.
It is not all or nothing
Securities lending does not require the commitment of an entire portfolio. In fact, portfolio managers and beneficial owners can restrict any security or asset classes they may not be comfortable lending. Recalls can also be initiated at the beneficial owner’s discretion.
Agent lenders develop programmes that are customised to suit a client’s particular requirements and preferences. For example, a client can opt to enroll its entire portfolio of assets but limit lending to a specific hurdle rate. This approach is referred to as an “intrinsic value” lending programme. In this model, clients can enter agreements that enable them to choose to lend only specific securities or “specials”. While this is a more concentrated form of lending, it provides some exposure and insight into the mechanics of securities lending before proceeding to make a full portfolio lendable, and may be more conducive to some investment strategies.
While securities lending is about scale, it is not only larger portfolios that have the opportunity to benefit from lending, Kolasingh says. “You can have a smaller portfolio that is concentrated in a very attractive asset class. That can generate the same return profile as a portfolio that may be 10 times as large but may have an asset composition that is less desirable from a lending perspective.” At RBC I&TS we have developed a tailored route to market where eligible beneficial owners can monetise securities lending opportunities on single securities, instead of lending their full portfolio. This can be advantageous for traditionally smaller portfolios, or simply a more suitable approach depending on risk appetite considerations.
It is ESG friendly
Another concern is that securities lending is incompatible with ESG investing, where investors seek to exercise governance responsibilities by screening companies considered to be more responsible in their corporate behaviour, or focusing on those where voting rights can be used to exert influence.
For example, investors may see short selling as inconsistent with ESG investing since sustainable investing is often viewed by some as a strictly long-term investment strategy. The Bank of Canada, through its opinion of price discovery and market liquidity, presents an alternative and broader view of what sustainable investing is by including factors such as price discovery.
Furthermore, beneficial owners do not need to give up their proxy vote when lending securities, as noted in a recent report from BlackRock.
“Questions have arisen regarding whether securities lending is additive to or detracts from sustainable objectives, particularly in relation to short selling and voting,” the report states, citing a common view that securities lending transfers the voting rights to the short seller. “The buyer of the security has the right to exercise proxy votes of the security not the short seller,” the report notes. “Additionally, brokers are prohibited from borrowing shares for the primary purposes of voting. Securities on-loan can also be recalled to vote.”
A recent survey from The Risk Management Association (RMA) shows 95 per cent of institutional investor respondents believe that securities lending activities can coexist with ESG principles. The survey says 18 per cent of respondents currently apply ESG factors to their programs, while 25 per cent said they did on a case-by-case basis. Another 18 per cent do not apply the principles but are planning to, while 39 per cent simply do not.
Canadian pension executives believe ESG issues are critical and eight of the country’s leading pension plan investment managers — representing approximately CA$1.6 trillion in assets under management — recently issued a statement calling on companies and investors to provide consistent and complete ESG information to strengthen investment decision-making and better assess and manage their collective ESG risk exposures. Interestingly, all of the pension plans that are part of the call to action participate in securities lending programs, further highlighting that securities lending can align with ESG principles.
Andrew Dyson, CEO of the International Securities Lending Association (ISLA), believes that “a well-run and prudentially managed securities lending programme can happily run alongside an ESG investment mandate”.
In a recent letter posted on the ISLA website, Dyson says many of the reasons cited for not lending securities in an ESG mandate “appear to fall away and not stand up to intellectual rigour”.
He notes that lending agents can help beneficial owners exercise their voting rights, while also highlighting the role securities lending can play in supporting short sellers.
“It has been confirmed time and time again through independent research and by the regulatory community that short selling in general is a force for good, allowing hedge funds and other short sellers to bring companies to account where their share price bears no relation to the facts behind that firm. As so-called ‘greener’ markets evolve, wouldn’t we expect that level of scrutiny from the buy-side of the investment spectrum?” writes Dyson.
He also discusses the market liquidity and efficient price discovery that comes with short selling. “Without the support of institutional investors for securities lending across ESG markets, these securities will trade less frequently and suffer from a lack of market liquidity which, in turn, will lead to a widening of bid-offer spreads,” writes Dyson, whose organisation is working on best practices and guidance to help institutional investors align their securities lending programmes with their ESG objectives.
He also underscores the argument that securities lending delivers relatively low-risk returns over time, “which can drive outperformance or lower fees where lending revenues are used to offset management costs”.
Securities lending as a viable investment strategy
Securities lending is a mature, resilient market activity that has persisted through macroeconomic events such as credit shocks, the sovereign bond crisis and now the pandemic. Furthermore, it is highly regulated and transparent, utilising risk mitigation tools that make it efficient and low risk.
The industry continues to evolve alongside the financial markets and the global economy. Participants benefit from digital innovation with tools and data that help them make more informed decisions and optimise results.
Overall, securities lending can provide beneficial owners with the opportunity to earn considerable low-risk adjusted returns. Given that interest rates are expected to remain low for longer, securities lending is an important market tool to help beneficial owners seek broader portfolio diversification to achieve sustainable future returns.
NO FEE, NO RISK
100% ON RETURNS If you invest in only one securities finance news source this year, make sure it is your free subscription to Securities Finance Times
100% ON RETURNS If you invest in only one securities finance news source this year, make sure it is your free subscription to Securities Finance Times
