30th Anniversary

Securities Lending at a Crossroads

As practitioners look to the 30th edition of RMA’s Conference on Securities Lending this fall, the industry faces one of its most challenging environments ever.

Each fall for the past three decades, practitioners of the specialized field of securities lending have gathered to network and become educated in the latest opportunities and trends. Working as they do at an endeavor that can be arcane to the general public, the RMA Conference on Securities Lending has been a welcome chance to converse with like-minded professionals on the issues of the day. Between seminars and speeches by keynoters who have ranged from money maven John Bogle to “Money Honey” Maria Bartiromo, the group has discussed solutions to the big issues and taken stock of the big crises. 

Topics have included the fallout from the 1982 collapse of Treasury note short seller Drysdale Securities, the needed switch from next-day to same-day settlement of funds, and the effort to have traders know exactly who they were trading with—rather than just who the broker was. Christopher Kunkle, RMA’s director of securities lending and market risk, was at the 2008 conference, which was held during the depths of the financial crisis. A senior securities lending executive at the time, he remembers “a pallor” and a feeling of “what just happened?” More importantly, he remembers lenders coming together and discussing solutions around liquidity and reinvestment.

But as difficult as the financial crisis was for the industry—activity is down by nearly half from pre-crisis levels of over $3 trillion in securities on loan at any given time—the upcoming 30th edition of the conference comes as the industry faces perhaps its most difficult era ever.  

Reforms being proposed for the financial industry as a whole could take a particularly heavy toll on securities lending, which relies on the thinnest of margins—basis-point spreads can be as low as the single digits—for its survival. In rules and regulations spanning Dodd-Frank, Basel III and various regulating bodies in the U.S. and internationally, the industry faces changes that could at the least further reduce activity, and at worst threaten the practice’s very existence, some say.

“We’ve had steadily progressing issues regarding the regulation of securities lending but they never reached the level and volume and potential effect to this business as today,” Kunkle said. “We’ve had hiccups but they would have just cost us money.”

Kunkle said, “We now we have language in Basel III and Dodd- Frank 165 that could devastate this industry.”

It could also affect the financial system as a whole, securities lenders say, because the practice boosts liquidity by increasing the supply of securities. Conversely, cutting securities lending would take away some of that liquidity. Meanwhile, the short selling for which some borrowed securities are used is  said to lead to pricing that more accurately reflects the reality of the markets.

Some proposals would target short selling in particular by forcing hedge funds to disclose short   positions if those positions rise above certain percentages of company ownership. It is assumed that such requirements would lead firms to curtail short strategies. And while shorting is often seen as a destructive force, many say it is necessary because it can keep prices from getting over-inflated, and  can serve as an avenue to express suspicions or pessimism about a company’s fortunes.  

“Short selling can foster investor confidence, as investors can be confident that securities prices reflect both optimistic and contrarian views,” said Troy Paredes of the Securities and Exchange Commission at a 2009 appearance. Speaking at the Practicing Law Institute of the Harvard Law School Forum on Corporate Governance and Financial Regulation not long after the SEC’s temporary move to halt short sales in financial stocks, Paredes said: “Short selling can buttress buying by allowing investors that go long … to hedge their positions. Investors may be more reluctant to buy if the more pessimistic views of short sellers are not fully reflected in the securities prices.”

A steep drop in securities lending would hurt Main Street investors: The pension and mutual funds that invest for them are among the big securities lenders, and are able to boost returns and reduce  costs through gains from lending stocks and bonds.

Kunkle said institutional investors that lend are generally able to increase their returns by 20 basis points through the practice. That’s a particularly important figure “in a market that’s flat,” he said. “That adds up over time.” The Economist, citing numbers from Markit, said securities lending generates $11 billion a year in income, including a recent average of $100 million a year for the Teacher Retirement System of Texas alone.

But the spread on each arrangement is so small that the proposed 10-basis-point Financial Transaction Tax in Europe, if applied to securities lending, could effectively wipe out much of the activity there. Timothy Keenan, head of sales and business development at Quadriserv, said the FTT “could be the biggest killer” of securities lending in Europe.

“Already, a few beneficial owners have gotten out of the international business,” said Jan Price, managing director of securities lending at Wells Fargo Advisors.

Regulators and lawmakers say leaving securities lending regulations as they are could play a part in another financial crisis. The margin on deals may be small, but regulators say the exposure they create can be large, and they want lenders to put more reserves aside, limit exposures to individual trading partners, and take various other measures.

The first securities lending deals go back to the days when a trade was not settled unless the actual paper security was delivered. If a dealer could not deliver a promised security—a happening that was quite common decades ago, before electronic systems were developed—a penalty was enforced. To avoid costs associated with such “fails,” brokers would borrow securities from each other and then repay the lender with similar stocks or bonds later. 

It was a fairly casual arrangement.

“You cut a deal and you lived up to it,” mused long-time trader Thomas Kirdahy, senior vice president-head of North American sales at Sungard Securities Finance. “Everything was done on a handshake.”

Soon, other uses for borrowed securities eclipsed the covering of fails, which became less common as technology progressed. Fran Garritt, RMA’s associate director of securities lending and market risk, said the European business around yield enhancement also dropped off. This was mostly due to tax efficiencies in the local markets.

Securities lending is often explained in terms of its use in short selling. In a successful short sale, an investor borrows, say, 1 million shares of a stock that is selling for $50 a share. The investor sells the shares and collects $50 million. If all goes according to plan, the share price later drops—to say, $40—and the investor buys the 1 million shares needed for repayment at the lower price. In this simplified example, the securities borrower makes $10 million—the difference between the $40 million purchase price and the earlier $50 million sale price. If the plan backfires, and the price of the stock rises by $10 a share, the investor is out $10 million.

That’s unfortunate for the trader playing the market.

But the owner who lent the securities makes money either way.

Here’s how: Lenders, or their agents, invest the collateral borrowers put up. The gain is the difference between the interest rate the lender is able to get by investing the collateral and the rebate rate that the lender pays the borrower for use of the collateral. Beneficial owners traditionally take a majority of the gain, with the agent taking the minority percentage. 

Kirdahy said he remembers when institutional investors started getting into securities lending.  “They thought, ‘This is a great way to make money,’” he said.

Years later, he said, with the financial world reeling, some owners realized you can lose money lending securities, too.

The many applications of securities lending and the related practices of repos and reverse repos include hedging, pairs trading, market-making and the covering of long positions to lock in profits.

Securities lenders say many of the proposed regulations are out of proportion to the risks of the arrangements. Those risks are 1) the possibility that borrowers will not return securities and will not have posted enough in collateral to cover the cost of repurchasing them, and 2) the possibility that money will be lost in the investment of collateral.

Take the proposed regulations that would serve to limit the exposure each bank would have to a counterparty, or trading partner. Or the regulations that would require lending agents such as BlackRock, State Street and the various brokerage arms of the big bank holding companies to take capital charges and assign heavier risk weights related to the amount of securities lending they do.
The industry says regulators are not properly accounting for collateralization.

When a borrower borrows a stock, it puts up collateral in the form of cash or securities. The industry standard is 102% or more of the value of the borrowed security. The collateral is used to purchase replacement securities if the borrower defaults and can’t return what was loaned.

A further protection is the daily mark-to-market in which the amount of collateral is adjusted to keep it tied to the market price of the borrowed security. 

Securities lending proponents say collateral makes another important element of securities lending currently under regulatory scrutiny—indemnification—much less risky.

Indemnification is when lending agents guarantee the beneficial owners of securities that they will not lose the loaned security if the borrower defaults. It’s a common arrangement in the industry, and many of the big institutional lenders insist on it. 

The new regulatory landscape that appears to be taking shape could affect the ability to provide the  indemnification agent lenders could offer.

A big concern is that a reduction in—or absence of—indemnification will cause lenders to leave the market, and “if you knock out a whole group of potential beneficial owners, such as mutual funds or ERISA plans, you knock out a whole supply of securities,” Kunkle said.

In an October letter to U.S. regulators regarding Basel III, the RMA Committee on Securities Lending said that, “in an informal survey of RMA members involved in the drafting of this letter: (i) many with the largest securities lending operations have never experienced any losses as a result of borrower-default indemnification; and (ii) none has incurred material losses as a result of the indemnification.”

The money that has been lost in securities lending, particularly during the crisis, has often been in the re-investment of that collateral.

The classic example is AIG and its famous bailout by the U.S. government.

AIG didn’t lose billions because borrowers didn’t return the securities it lent. It lost billions because when borrowers did return the securities, AIG had lost much of the collateral in risky investments and couldn’t return it. “They bought a variety of longer-term paper and then other investments that were riskier,” Kunkle said, and, for a time, made a much higher ROI on investment of collateral when the average fiduciary was making well below 0.75%.

Collateral management will be one of the many topics discussed at RMA’s Conference on Securities Lending, which will be held October 14-17 this year in Boca Raton, Florida. 

Regulation, of course, will be a major focus.

The first conference was held in 1983, when a call was growing for standardization and best practices in the burgeoning industry. In 1982, there had been the spectacular failure of Drysdale Securities, a firm that borrowed and shorted Treasuries but was not including accrued interest when it posted collateral. Prices rallied, Drysdale couldn’t make good when the accrued interest came due, and its counterparties were out $360 million. (They were later made whole by the agent lender.)

Other big moments in the 1980s included in 1981, when pension funds in the U.S. were allowed to lend securities for the first time. 

The conference has been a venue to talk about employing strategies and correcting problems, and is  organized with the RMA Committee on Securities Lending. Over the years, the committee has developed the original survey on securities lending statistics, and the quarterly aggregate composition survey. “In the mid-2000s,” Garritt said, “the industry as a whole came together to solve the agency lending  disclosure process requested by regulators.” Now the crucial issue is how to respond and react to various rules and regulations that could be on the horizon.

At the conference and elsewhere, RMA members will discuss proposed regulations “to see which make sense and what’s helpful, and what will restrict or remove liquidity from the market,” Kunkle said. 

Despite the challenges the industry is facing, Kirdahy said he is optimistic about the future. He said securities lending will get a boost from a rebound in interest rates—which seems inevitable—and that the industry will adapt to new regulations, if it comes to that.  

One possibility, said Peter Caruso, a partner at ITG, is lenders that are prohibited from certain deals because of counterparty limits will find different counterparties to lend to, perhaps ones with fewer assets that they wouldn’t have considered working with in the past.

Price said he can’t imagine an economy without securities lending.

“People sometimes tell me it’s going away,” Price said, “that stock loan is not going to stay around. But we haven’t written our doomsday scenario yet.”
 
To view the RMA Executive Committees over the past 30 years click the link below.

RMA Securities Lending Executive Committee Members 1983-2013