CPD: The state of securities lending told in fives

Roy Zimmerhansl, practice lead, Pierpoint Financial Consulting, uses five markers to explain securities lending under three headings

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The EU’s Securities Financing Transactions Regulation (SFTR) is the most impactful new regulation ever to affect the securities lending market. In a series of five markers, we will explore the drivers of the business, the contribution it makes to markets and, finally, how environmental, social and governance ( ESG) considerations are, or should be, driving investors’ securities lending behaviour.

Securities lending 
  1. What: Securities lending involves the temporary transfer of stocks or bonds from an investor to a borrower in exchange for a fee. The transactions are typically governed by one of several standard sector agreements and almost always require the borrower to provide collateral to the lender as a risk mitigant against the potential for a borrower default (think Lehman Brothers).
  2. Who: There are several participants in a conventional securities loan: an institutional investor that is the legal lender; an agent lender, usually but not always the investor’s custodian that acts on behalf of the investor; the borrower, usually a bank or securities firm; and the short seller that is the end user of the borrowed security. Recent figures from Global Custodian indicate the market has US$25tn as securities available for loan daily, sourced from over 20,000 institutional investors. According to the International Securities Lending Association, the amount on loan has been hovering around US$2tn for most of the past decade with an end-2019 split of 44% for equities and exchange-traded funds (ETFs), 47% for government bonds, 5% for corporate bonds and the remainder in other fixed income assets.
  3. Where: Securities lending is now actively practised in more than 40 countries around the world. Several markets have introduced securities lending since the financial crisis, which included a ban on short selling in over 30 countries as one of its milestone events. Today, the allowance of securities lending and short selling has become a baseline expectation for consideration as a ‘developed’ market.
  4. When: According to Don’t blame the shorts by Robert Sloan, the first recognised short sales occurred in 1609, but my guess is that people weren’t so concerned with lending securities to ensure delivery back then. For the first half of the 20th century, securities lending was less a business and more of a way to grease the wheels of settlement amongst market practitioners. The business aspect started to grow from the 1960s, and in 2019 was estimated to have generated around US$10bn in fees for investors and their lending agents, according to IHS Markit’s Securities Lending 2019 snapshot.
  5. Why: Institutional investors participate in lending to make money, whether using the proceeds as alpha capture or to offset expenses (as many ETFs do). End-borrowers need the securities to satisfy delivery obligations resulting from short sales. Short selling is part of multiple strategies that can be broadly categorised as directional (one-way bet that an asset price will drop), hedge (mitigating risk of loss from long positions), arbitrage (exploiting perceived price anomalies), and quantitative (algorithm-driven trend following).

    Norges Bank Investment Management explains ‘The role of securities lending in well-functioning markets’ on its website. Let’s look at the benefits.
The five market benefits of securities lending

1. Liquidity
Market making wouldn’t be possible without market makers having the option to borrow as well as buy securities they have sold to investors.

By allowing short sellers to participate in a market, there are more trades; both their short sales and their long purchases. For every share that is shorted there is a future purchase. Additionally, many proprietary traders operating market-neutral strategies avoid markets unless they can go both long and short.

More traders, able to trade in either direction, result in more liquidity, providing better conditions for all investors in a market.

2. Market efficiency
One of the original reasons for the development of securities lending was the need to borrow securities to avoid a failed settlement or to remedy a failing trade.

This is of increasing importance to regulators and the reduction in fails is a key goal for the Central Securities Depositories Regulation, which comes into effect in February 2021.

3. Constraint on short selling
One factor that also acts to restrict short selling volumes in most markets is the need for a would-be short seller to ensure there is a lender of the relevant security prior to executing a short. This ‘locate’ requirement effectively limits the number of shares and bonds available to be shorted.

4. Price discovery
This is the process whereby a current market price for an asset is set. Inevitably some traders will view an asset’s price as expensive, others may consider it cheap, with the remainder having no view or accepting it as a reasonable representation of the value. Short sellers are one part of that community and securities lending represents a necessary part of the plumbing, enabling short sellers to contribute to price formulation.

5. Moderating peaks and troughs

Many people will be familiar with the phrase ‘irrational exuberance’ and short sellers play a role in regulating such excesses. When markets march uniformly in an unrelenting upward trend, short sellers assert themselves either as outright contrarians anticipating a market fall or as a hedge against a wider market fall. Amazon, for instance, is often shorted as a proxy to hedge against a wider market fall. It is a mega-cap stock, has huge daily trading volume and is widely available for loan (so cheap to borrow with low risk of an early close-out due to investor sales).

When market crashes occur, it involves investors of all types selling – long investors as well as short sellers. The difference is that short sellers need to repurchase the shorted stocks in order to book profits. Short sellers, therefore, help add buying substance to markets that might otherwise continue to have a selling bias and fall precipitously.

Securities lending is part of the investment ecosystem, but at an individual investor level, is an optional activity. It is, therefore, a prerequisite that wherever relevant, securities lending reflects investor ESG principles. There are five key aspects to the intersection of ESG and securities lending.
Environmental, social and governance

Roy Zimmerhansl

Roy Zimmerhansl is former global head of securities lending at HSBC. roy@pierpoint.info 

Securities lending is part of the investment ecosystem, but at an individual investor level, is an optional activity. It is, therefore, a prerequisite that wherever relevant, securities lending reflects investor ESG principles. There are five key aspects to the intersection of ESG and securities lending.

1. Collateral
When securities are lent, the investor receives collateral – either cash or other securities. Cash is invested into money market instruments such as commercial paper, money market funds or reverse repo. If securities are used as collateral, the title transfers from the borrower to the lender. In both cases, the collateral assets form part of the fund property so the same exclusions that apply to investments should be applied to the collateral. Not straightforward, but eminently doable.

2. Voting
Lending investors lose the ability to vote shares while on loan but can still exercise control over the process in several ways. First, they can exclude specific portfolios or assets from lending altogether. Second, they can exclude assets on an ad hoc basis if, for example, a contentious issue arises. Third, investors can put in place standing instructions requiring an agent to recall shares price to AGMs. Finally, on an ongoing basis, lenders retain the right to recall their assets from loan at any time and borrowers have a contractual obligation to return the shares within one normal settlement cycle. Accordingly, if an investor has not voted, it is a choice rather than a consequence of lending.

3. Tax
Clearly, prior to commencing lending, investors need to understand how various aspects of tax apply to securities lending. They also need to ensure they comply with their domestic taxation obligations while also satisfying the requirements in each lending jurisdiction where they are active. It is also critical that investors understand their agent’s approach to loan distribution and policy with respect to managing collateral over dividend and interest payment dates for the collateral, as well as the securities on loan.

4. Governance
Lenders should have clear policy guidance on how they participate in lending, risk profiles, including counterparty selection and collateral acceptability, and approach to voting. They need to demonstrate how they deliver on those policies and test the management responsible for their securities lending activity.

5. Transparency
Investors should provide transparency to their own stakeholders on their securities lending activity. This starts with the formulation and communication of the topics identified under governance, but then deals with the communication of that information. SFTR reporting requires market participants to provide regulators with an enormous volume and granularity of data surrounding securities lending and repo transactions. The information made available will feed increased transparency. While there are some shining examples of transparency, much work is required here.

Short selling and securities lending are the bedrock of the modern capital markets infrastructure. For a long time, it has been held out as a separate activity, exempt, immune or ignored when it comes to the process and thinking at the front end of investing. That needs to change – and it is.

As with all change, it will be uncomfortable for many and painful for some, but ultimately it will set the stage for a sustainable future for securities lending.

This article was originally published in the June 2020 flipbook edition.

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Published: 20 Jul 2020
  • Risk
  • Compliance
  • Capital Markets & Corporate Finance
  • Wealth Management
  • Bonds
  • securities lending
  • short selling
  • SFTR
  • Securities Financing Transactions Regulation

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