By Roy Zimmerhansl, practice lead at Pierpoint Financial Consulting
“Why should I lend my securities?” – I’m trying to think back to the first time I heard someone ask that question. It must have been in the early 1980s when I first became involved with the business. The simple answer then, as now is “to generate income from otherwise static portfolio holdings”. If you consider that the pool of securities available for loan has grown to at least €19.6 trillion, one could say “job done”. Securities lending is an accepted practice in almost every country that has an established capital market. Indeed, index providers often require a market to include short selling and securities lending in order for it to be considered “developed”.
Investors that lend span the universe from retail investors via mutual funds, UCITS and ETFs through to central banks. Data from the most recent semi-annual ISLA Securities Lending Market Report, using figures from IHS Markit, shows that mutual/retail funds have €9 trillion of assets available for loan, pension plans have €3.7 trillion, insurance companies €1.2 trillion and governments/central banks €1.2 trillion, clearly demonstrating the wide spectrum of investors participating in lending programmes.
Pension funds that lend accrue positive returns year after year, making meaningful contributions to portfolio performance. Sovereign Wealth Funds (SWFs) are huge investors that tend to outperform in this space, so it comes as no surprise that almost all the largest SWFs lend, adding to their investment performance. Many central banks initially engaged to avoid liquidity disruptions in secondary market trading but are now active in generating returns for their portfolios accumulated over the past decade.
The job isn’t done for either markets or investors. In several active securities lending markets there isn’t sufficient depth of supply beyond the primary index to facilitate trading and not all markets allow trading yet, but the direction is clear. Many notable investors in each category continue to abstain from lending, meaning the “Why” question isn't entirely answered. I spend an inordinate amount of time pondering this question and I have come up with five reasons:
Lending isn’t for everyone. There is a certain asset size required in order to be able to generate returns, while not all assets have borrowing demand. It can be a valid concern for managers of small cap funds as they could have disproportionately large holdings in small companies and are concerned about supply/demand imbalances.
In my experience, non-participants are less concerned about the ethics of securities lending, rather they focus on short sellers. “Why should I lend my securities to a short seller?” is a commonly asked question by non-lenders. I recommend that people read “Are short sellers ethical?” by Duncan Lamont of Schroders, which details short selling motivations. I've added two comments to Mr. Lamont’s overview.
1. Short sellers do not have magic dust. Where shorting for a directional trade, they are expressing a negative view on the company in the same way as a holder of the same stock has a different view. Over time, stocks have risen so there is an inherent bias against the short seller. And remember that every time an investor buys a stock, they are already expressing an opposite opinion to the seller (which may or may not be a short seller) and only time will prove which view is correct.
2. Regulators have recognised the value short selling brings to price discovery, market liquidity and its smoothing effect on market peaks and troughs. That is unlikely to change except for temporary periods that are scenario specific. Short selling dates back to the early 1600s and isn’t going away.
As with all investment activity, securities lending carries risk. The two primary risks are counterparty default and cash collateral reinvestment losses. The Lehman Brothers default provides a real example of the impact of the largest securities-borrower default in history.
Losses from securities lending are few and far between due to the collateralised nature of the business and indemnifications provided by agent lenders. Forced sales of assets purchased with cash collateral did cause losses which were exacerbated by the Lehman default, but the market conditions leading to those losses started gathering momentum a year earlier when the sub-prime market started to impact money markets and investments.
Critically, it is investors that determine how aggressive their reinvestment policy is, and of course, most have the option of accepting only non-cash collateral and avoiding reinvestment risk altogether.
I have come across product managers who differentiate themselves from competitors by promoting the fact that they do not lend. That is a valid position to take, but investors in those products should be cognisant of the likely underperformance or higher operating costs vis-à-vis products that lend. In the end, investors will vote with their cash, so if it is an important differentiator, then those funds will accumulate assets faster.
Over the years, securities lending education from service providers and outside observers has improved dramatically.
Yet there is still a gap and many investors that could benefit substantially from lending remain outside the business. It may be that these investors have taken an informed decision not to engage in lending and the matter has ended there. However, in our experience, it is also true that many non-lenders have questions which have not been answered satisfactorily and comprehensively or that investors remain unclear or sceptical.
Bottom line: I am encouraged by the tremendous growth in the 35+ years since someone first asked me “Why should I lend my securities” but recognise that there is still work to do.