The relative lack of excitement around securities lending in previous years embedded a certain sang-froid in the minds of beneficial owners: the monthly revenue cheque seemed a nice little earner for the minimal time and resources invested. Beneficial owners that adopted securities lending programs in the early 2000s gradually became more relaxed, assuming that the risks were benign and the revenues were good.
However, the events of the last two years have been a wake-up call. The industry experienced the default of one of its largest counterparts, and securities lending and short selling hit the front pages of the financial papers. Beneficial owners taking cash collateral got caught up in the general malaise affecting the money market industry as valuations fell and liquidity dried up. Legal suits were raised against some of the leading providers of securities lending services.
Beneficial owners reacted in different ways. Some were comfortable with the events, probably due to good communication with their counterparts or lending agents. Others struggled to get reliable and timely information. However, all were concerned with reassessing their strategies.
Over the last year, approximately 15% of assets have been taken out of the lending pool due to beneficial owners reducing their lending activity or, in some cases, stopping altogether. Initially, this was more than matched by the decline in hedge fund assets, but recent months have seen hedge fund returns improve and inflows result. As Figure 1 shows, the global assets available for lending are currently just over US$10 trillion, with Canadian-domiciled lenders (Figure 2) representing just below 9% of the total.
What is the outlook for securities lending going forward? Do the returns outweigh the risks and the pressures from those who have an opinion—or a fiduciary responsibility—regarding the program? How has the lending market changed, and what does this mean for Canadian beneficial owners? Is securities lending worth it?
Counterparty risk
The argument “If ABC bank goes into default, we’ve all got bigger problems than the lending program” has proved to be true. However, when Lehman Brothers filed for
Chapter 11 protection in the U.S. and went into Administration in Europe, the exposures had to be unwound.
For beneficial owners accepting non-cash collateral, the combination of falling equity prices (the lent securities) and rising bond prices (the collateral) helped to ensure that sufficient collateral was available. In Canada, the regulations that historically restricted beneficial owners to accepting non-cash collateral paid dividends, as most beneficial owners were quickly made whole. However, for those beneficial owners participating in a “collateral upgrade” trade—for example, lending bonds and taking equity collateral—there may have been a shortfall in the liquidation of collateral due to the falling equity markets.
Collateral cases
The nature of a securities lending transaction affords the beneficial owner a high degree of credit mitigation, in that the lending party receives collateral in the form of either cash or other securities against the loan position. In the event that the borrower is unable or unwilling to return the securities, the lender or its agent may liquidate the collateral to facilitate the purchase of equivalent or replacement securities. Beneficial owners also typically receive a level of over-collateralization—or “haircut”—of between 102% and 105% of the value of the original loan. This haircut provides an additional credit cushion during the liquidation process.
However, there have been problems with securities lending programs accepting cash collateral. In these cases, cash collateral (usually in U.S. dollars or euros) is taken and reinvested into money market funds or the equivalent, in the hope that additional returns can be made over and above the returns already made by the fee being paid to borrow a security. Some programs make the majority of their returns from the reinvestment of cash. Effectively, the securities are used to raise cash for reinvestment, and securities lending is the mechanism.