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
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
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.
The point of all this is that there is some counterparty risk to securities
lending, but nothing to get anyone excited. Two rather more significant and
related obstacles standing in the way of pension fund trustees getting involved
in securities lending is short-selling and the reputational risk to the fund,
which boils down to thinking short-selling is simply a bad thing, or the concern
that your pension fund is in any way associated with that bad thing. It is a
case of education.
That said, once securities lending has been explained, there is a good chance
many trustees would opt not to pursue it given the relatively paltry rewards on
offer. Is an average return of say, five, six or seven additional basis points
worth any kind of effort, or worth running even the most modest of risks for?
After all, trustees are supposed to be prudent.
Ed Oliver, a director at Data Explorers, points out that the average return
to beneficial lenders amounts to around £1m. Take a pension fund grappling with
a shortage and ask the trustee board if it would like an extra one million
pounds for doing nothing, and the board should leap at the chance if the risk
profile is right.
Sonja Spinner, senior associate with pensions administrator Mercer, points out
the National Association of Pension Funds view on securities lending. It says
there is no evidence making assets available for securities lending in any way
compromises a pension fund’s goals. That is worth emphasising since one of the
arguments against trustees giving the go-ahead to securities lending for their
scheme is that securities lending is a major assistance to short-selling – and
short-selling drives down the value of assets in the fund’s portfolio.
Data Explorer’s Oliver argues his survey shows that supporting directional
short-selling – whatever the merits of short-selling might be – amounts to only
a very small percentage of securities lending demand. “Some 50% of securities
lending is about lending fixed-income securities and not about equities at all,
which means that short-selling doesn’t come into it in any shape or form. Of the
remaining 50% of equities lending, Oliver adds that the vast bulk of this is
directed at activities such as covering arbitrage opportunities or market
failure, leaving only around 4% of the total volume being used to support
directional short-selling. The Credit Suisse Tremont Index, a comprehensive
index of hedge fund strategies, shows just 0.7% of hedge fund strategies are
about pure directional short-selling.
Nevertheless, Data Explorers’ charts show a marked decline in securities
lending volumes since the fall of Lehman Brothers, undoubtedly due to some major
funds stepping back from securities lending. Mercer’s Spinner points out that in
the UK, Hermes, looking after the BT pension fund, was the most high-profile
fund to withdraw totally from securities lending.
“Our view is, provided a pension fund’s securities lending programme is
properly collateralised, with the kind of securities that are taken as
collateral being clearly in line with the fund’s risk profile, then securities
lending can be a useful additional source of revenue for a fund,” says Spinner.
What she means by the collateral “being in line with the fund’s risk profile”
takes us into another terrain, namely what constitutes sufficient collateral. A
conservative approach, which Spinner suggests should logically be the approach
adopted by trustees new to securities lending, would be to accept only G7 nation
government securities as collateral. “We tell funds that accepting 102%
government bonds as collateral (102% by reference to total value of the bundle
of securities being lent) is sufficient if there is no currency risk involved,
and 105% is sufficient where there is a currency risk. This is the industry
standard,” she says.
One form of collateral that pension funds accept is cash, though it is
something less common among European or UK funds. It might be thought that cash
would be the safest form of collateral for pension fund trustees to accept.
However, as it turns out, it is one of the riskiest. When the borrower gives the
lender a large sum of money, standard industry practice is for the lender to
agree to pay the borrower a set amount of interest at the end of the lend. This
puts an investment risk on the lender, since the lender has to invest the money,
make a set return to pay the borrower and then an additional return to make the
whole deal worthwhile.
Moreover, while custodian banks will indemnify lenders, the beneficial owners
of assets, against counterparty loss on trades collateralised with fixed income
or equity securities, they won’t indemnify the lender for losses resulting from
investment failures around cash. So if you take cash, you’d better be able to
make it work for you. This is why the vast majority of UK securities lending
programmes use securities as collateral and not cash.
Mark Tidy, head of international business development for global securities
lending at Bank of New York Mellon, points out that Lehman’s was a major
borrower of securities in Europe as well as in the US and when it crashed, that
default stress-tested the securities lending system. “What the failure of
Lehman’s showed was that securities lending worked, the collateral system worked
and lenders were protected,” he says.
Tidy adds that it is well worth funds having a debate about whether to lend
or not to lend, because, ultimately, that helps trustees to be clearer about the
whole concept. Essentially, he points out, it is about making idle assets work
that bit harder.
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