With a squeeze on traditional sources of return, pension funds are once again looking at securities lending, even as concerns grow over lending stock to short-term punters like hedge funds whose recent short bets on Deutsche Bank brought the bank to the brink last month as its shares nosedived.
Some leading investors admit securities lending can lead to a ‘balancing act’ between ownership rights and links with investee companies on one side and benefits such as efficient markets and income on the other.
Securities lending is defined (by Investopedia) as the “act of loaning a stock, derivative or other security to an investor or firm”. It requires the borrower to put up collateral, whether cash, security or a letter of credit. “When a security is loaned, the title and the ownership are also transferred to the borrower,” Investopedia says.
Some large pension funds like the Dutch pension fund ABP and the UK’s BT Pension Scheme have quietly ceased all stock lending, but with returns proving scarce in a low-interest environment a growing number of pension funds are now looking at generating returns out of securities lending.
“We are definitely seeing more interest from pension fund trustees who are exploring the opportunity to engage in securities lending,” said James Day, EMEA head of securities finance at BNY Mellon. “Some of these pension funds had engaged in securities lending before the financial crisis of 2008, and some of them are new to the process,” he added.
Data from Markit showed that lendable inventory rose by $1trn over the year, from $14.8trn at the start of the year to the current $15.8trn. According to Markit, some 55% of inventory came from pension funds and mutual funds.
This lending to short-sellers in Deutsche spiked to its highest level this year on October 4, when the percentage of shares out on loan hit 6.4%, according to the latest data from Markit. Deutsche shares have lost 50% of their value this year, and plunged to a 30-year low late last month, at one point below the key €10 level. Shares are now trading at just over €12.
Simon Colvin, vice president at Markit, said: “Even though there is shorting on the Deutsche stock, it’s not a high-conviction short as only 20% of the shares which could be short were out on loan during the peak of this year’s volatility. This compares to a level of 80% that we saw on some high-conviction shorts during the financial crisis.”
He added: “Pension funds have to be pragmatic about sources of revenue and in a low-return environment, if they can generate a couple of extra basis points, why not?”
Colvin noted that demand for stock lending always increases during more volatile times when there is a “better chance to get more revenues as an investor.”
Global revenues from securities lending are estimated to be €8bn annually, according to trade body the International Securities Lending Association.During the financial crisis of 2007-2008, unrelenting shorting was believed to have driven down many financial stocks. At the time, many large pension schemes said they would be suspending their stock lending programmes, including BTPS, CalPERS and CalSTRS. While the two US pension funds have reinstated their stock-lending programmes, BTPS has yet to kickstart its stock lending. BTPS declined to comment.
“The balancing act responsible investors have to perform.”
But while some pension funds make the “pragmatic” argument for stock-lending in their quest for returns, others are clear where the line should be drawn.
“Basically, you are lending money to someone who is going to bet against your position – so it’s a bit like getting someone else to take insurance against fire on your property,” said George Latham, managing partner and CIO, at sustainable fund manager WHEB Asset Management.
“So as a long-term investor, you are facilitating a part of the market that is driving more short-term behaviour and more short-term decision-making,” he added.
Latham, whose firm doesn’t offer stock-lending to its pension fund clients, said there was also a clear conflict of interest between fund managers and their clients.
“Fund managers earn a fee from any profits from stock lending, but it is not immediately clear how this fee is split,” he said. “So the fund manager has a strong incentive to actively promote stock lending,” he added.
In a paper on securities lending published last week, Norges Bank Investment Management, the arm of the Norwegian central bank that runs the assets of the Government Pension Fund Global, argued that even temporary bans on short selling by regulators as seen in 2008 had a negative impact on well-functioning markets, in both the short and the long term, which outweighed the short term benefit of “taming animal spirits”.
Norges says the market “as the ultimate arbiter of a firm’s value” can on balance be “credible protection against reckless corporate behaviour, better than regulations”.
The fund said it has to “balance” its ownership voting rights – and its relationships with companies – against contributing to well-functioning markets via securities lending and the income it gets from it.
While robustly defending the contribution of securities lending to well-functioning markets, NBIM said it also restricts its stock-lending when required by it corporate governance activities. It has a “robust process” for balancing its various objectives.
“The long-term investor’s key contribution to well-functioning stock lending markets is to provide a steady and consistent supply of shares available to borrow, while ensuring that the investor is compensated for the additional risks and loss of ownership right,” it says.
“This balancing act leads to the (generally temporary) emergence of a subset of ‘hot’ stocks, which are hard to borrow. This status as a hot stock is typically linked to some corporate action and, on occasions, to voting considerations. We view these stocks as an expression of the balancing act responsible investors have to perform.”
The Dutch pension fund giant ABP said it suffered a “significant loss” in 2008 on the reinvestment of cash from securities lending, leading to the board deciding to shut down its securities lending programme, which ceased operations in 2011. The fund declined to say what these losses were, or how big its securities lending portfolio was.
“There were elements of that even for larger funds in the UK – but the increased regulation especially around derivatives has strengthened the system,” saidJoe Dabrowski, Head of Governance & Investment, Pensions and Lifetime Savings Association, the umbrella body for pension funds in the UK.
He added that it was important that pension funds ask the right questions and have appropriate risk controls in place.
No doubt aware of some of the issues involved, the Securities and Exchange Commission (SEC) in the US has just called for greater disclosure around securities lending by mutual funds and exchange-traded funds (ETFs). The SEC wants funds to disclose “income and fees” from securities lending – and the fees paid to securities lending agents. So perhaps there will be a little more light on what can be an opaque practice.
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