Tough economic times demand greater return on investment

In early October, Labour MP Frank Field wrote to Pensions Week warning that pension funds were running “alarming risks” by allowing their securities to be lent to third parties. Field’s letter drew a blistering response from International Securities Lending Association (ISLA) chief executive David Rule, who itemised all the points he thought Field had got wrong. However, politicians shrug off that sort of thing readily enough and Field’s subsequent responses showed him determined to uphold the position on this sometimes controversial practice.

But a lack of knowledge about securities lending is by no means unusual. It is an arcane topic well off to one side of the usual final salary ­ versus ­ defined contributions debates, and there probably are trustees in large schemes who have very active securities lending programmes that would find a briefing from their pensions advisors on this theme useful.

A basic tutorial would very briefly explain what securities lending is all about. A pension fund has a portfolio of assets, including government bonds and equities which it trades to achieve the fund’s objectives as laid down by the trustees. If it is a buy-and-hold fund, which pension funds tend to be, since they are trying to achieve a match of assets to very long-dated liabilities, once it buys the assets they sit on its books and gain (or lose) value under their own momentum. What securities lending does is to enable the fund to earn a handful of basis points from a borrower by assigning them a security for a defined period, in exchange for sufficient collateral.

One of the very good things to come out of the fuss Field kicked up was a collaboration between Pensions Week and Data Explorers, an organisation that gathers data about securities lending around the world. This collaboration resulted in a survey of the top 50 UK pension funds, conducted in the summer, which found that 68% were participating in a securities lending programme. All respondents said they were participating by choice ­ putting paid to one of Field’s major concerns that trustees of pension funds did not know their agent lenders (the banks who provide custodial services to the fund investment management team) were lending out their securities. Around 88% of the sample said they lent through their custodian, while 11% engaged a specialist third-party agent to manage their securities lending programme.

On whose authority
ISLA’s Rule made the point that there is no way a reputable custodian would indulge in a lending programme without the explicit authorisation of the beneficial owner of the securities. Who would it pay the proceeds to? Imagine the conversation:
Bank: “Excuse me, Mr/Ms Trustee, here’s £1m.
Trustee: “Eh? What’s this for?
Bank: Well, we’ve been lending your securities on your behalf, we thought it would be a good thing to do.”

A second major fear Field expressed was that, while securities lending is done on a fully collateralised basis ­ I lend you £1m of my portfolio of securities, you put up £1.05m worth of government gilts to cover the trade ­ there is still some risk. The risk he focused on is trading volatility, suggesting that markets sometimes lose 10% in a day and so the industry standard practice of accepting 105% collateral is, to his mind, risky. But this point missed the fact that it is standard practice, when taking equities as collateral, to mark-to-market on a daily basis, which means whoever is managing the lending programme would be automatically pulling more security from the borrower to bring the collateral up to the level specified by the lender.

Of course, if the borrower could not afford to meet the additional security call, then there is an insolvency situation where the agent acting for the lender would begin liquidating the borrower’s collateral to replenish the lender’s securities. Does this not still involve the risk of loss to the lender? No, not unless the custodian bank also fails: as the Data Explorers survey discovered, more than 82% of lending agents indemnify the lender against counterparty default.

It only takes a moment’s thought to see that if there is a market event of such cataclysmic proportions as to wipe out both a borrower and the custodian bank itself, sending both into default, then a glitch in its securities lending programme is likely to be the least of any pension fund’s worries. The global financial network would be in meltdown.