Sec lending in the spotlight

After the annus horriblis of 2008, the securities lending industry is under new scrutiny on both the lending and the collateral reinvestment sides of the equation. While the Lehman Brothers collapse exposed counterparty risk on the lending side, volatility in the returns on collateral reinvestment are causing a rethink on how collateral should be handled in the greater context of portfolio risk adjusted return.

The gestalt on both sides of the transaction – the operational issues on the lending side, the risk management issues on the collateral reinvestment side – will continue to lead beneficial owners to question their arrangements with providers. This will most likely increase a trend to unbundle securities lending arrangements from custody arrangements. 

It might very well lead beneficial owners to separate the operational management of securities lending from the investment management of the collateral, both cash and non-cash. 

The evolving nature of securities

Furthermore, industry professionals say that securities lending is increasingly viewed as a separate investment mandate, much in the way the perception of transition management has evolved. This will require more due diligence before selecting a provider, plus increased reporting and oversight while lending securities.

“I think the market events of the past year have shown that securities lending is an investment business and not an adjunct to custody,” said Brown Brothers Harriman, managing director, global head of trading and asset liability management for securities lending Mark Payson, “There can be great returns, but there is a certain amount of risk if not done correctly.”

This view is manifest around the world.

“We have a view that securities lending is an investment activity. If you’re appointing an investment manager, that investment manager is thoroughly reviewed, investment guidelines are appropriately drafted and included in the IMA, and the risk and rewards are weighed accordingly,” said Sydney-based Mercer Sentinel regional director, Lounarda David. 

“Sec lending should be given the same status as those mandates, because it is about the appropriateness of the program and its investment guidelines for each client, and the risk and reward of the programme relative to the client’s risk profile. 

“It may not be suitable for every organisation, plus there are different types of programmes that may suit some clients but not others – clients, requirements and programmes need to be properly matched. 

“Clients must do a thorough evaluation of all aspects of the programme at the outset, and then establish a monitoring framework and review these arrangements and their exposure on an ongoing basis to ensure they are still sound and appropriate”.

This kind of due diligence may not have been a common practice in the past, particularly in Australia’s superannuation industry, where securities lending has traditionally been handled as part of the custody relationship and as a means to offset the overall custody costs.

“Traditionally, particularly in the custody world where custodians cross-sold the securities lending programme, the main motivation for clients entering these programs was to use the lending revenue to offset the custody costs, often without clearly understanding how the lending programs worked,” David said. “A lot of trustee boards didn’t really assess the securities lending programmes carefully or ensured the lending guidelines were appropriate for their circumstances. More importantly, often the risks associated with these programs were understated or misunderstood.” 

But at a global level, the larger, more sophisticated pension funds have come to view securities lending as an investment mandate, rather than a back office function. 

This trend will only increase in the next few years. Although the collapse of Lehman Brothers did reveal the catastrophic impact of counterparty risk to the securities lending industry, a pension fund would not bear that default risk, as their securities – or the value therein – is overcollateralised. What was revealed to be of greater risk was the nature of the collateral reinvestment – particularly cash reinvestment.

“Responsibility for securities lending is moving more from the back office to the front office,” said JPMorgan Worldwide Securities Services, global head of sales and client management for financing and market products, Paul Wilson. “However, with many pension funds, that can be one and the same person. On a positive note most industry participants come through the Lehman bankruptcy relatively well”

Reassessing risk

While pension funds might have known by rote that their securities were overcollateralised, the fact that the cash reinvestment might be at risk was discounted, according to Denver-based Wilshire Associates managing director Michael Schlachter.

“I’m not sure pension funds overlooked collateral risk, but they didn’t recognise the amount of risk,” he said. “People are focused on the wrong part of the equation. There was a lot of conversation about defaults in the lending portfolio, with long explanations to the clients about how they were overcollateralised, and if a security is not returned they will be 103%, 105% overcollateralised. The other side was, we’re invested in cash, so no worries. Lending as a whole has been scrutinised, but the problem was that nobody expected cash to have a problem.”

Additionally, there have been widely differing definitions and perceptions of what exactly the beneficial owner has been indemnified against, according to Zimmerhansl Consulting Services founder Roy Zimmerhansl.

“There are different degrees of indemnification,” Zimmerhansl said. “The default of Lehman Brothers and various problems with cash reinvestment has shown that. Your agent might say that cash reinvestment is something we’re not on the hook for. Another pension fund might have an arrangement where they are indemnified. 

“I think this has definitely come to the fore. It’s also a question if custodian banks went so far as to offer indemnification on cash reinvestment, those banks didn’t actually have to reserve capital against that – that’s as definite contingent liability. Banks have been able to get away with getting approval from being exempt from capital reserves. “They may still be on the hook for the cash, but they haven’t had to reserve for it. A reserve is important, but it’s a cost on the business.”

This is a fundamental misperception – and one that may have proved costly to pension funds when evaluating a securities lending arrangement with one provider handling both the operational lending and the collateral reinvestment thereafter.

“Lending securities against cash collateral is a leveraged mandate,” said Mercer Sentinel’s Stacy Scapino. “There is nothing to say that an agent custodial bank is the right provider to manage that transaction. There’s nothing to say they’re not the right provider, but a custodian skill set does not necessarily translate to managing a leveraged investment.”

There is no technical barrier to having three parties at the table – a custodian, a lending agent and a manager for the collateral, noted Payson. Indeed, firms such as auction platform provider eSecLending have won mandates because of technical advancements and the ability of pension funds such as CalPERS, and New Zealand Superannuation Fund to manage a relationship with a separate lending agent.

eSecLending president, Chris Jaynes noted that lending volumes for 2008 and into 2009 are lower than in past years, but also stated that the firm “conducted four auctions in January for over US$50bn in lendable assets and are encouraged by both the strong levels of intrinsic bids received and by the breadth of participation across borrowers.”

Improved management

Going forward, pension funds will have to scrutinise operational due diligence before awarding a mandate, plus increase oversight once the process of lending is under way. All the industry professionals that spoke to Global Pensions stressed the arrangement would need to be reviewed at least quarterly. 

“Operational management has not been overlooked, but the importance has been underrated by the beneficial lenders,” Payson said. “The importance has been discounted. I would say that what we’re seeing is a ‘back to basics’ approach to lending which includes a heavy  focus on risk management. The points to stress when looking at securities lending are adding value, emphasis on lending over income reinvestment gains, strong risk management discipline, prudent collateral management – that fits with the client’s risk profile – transparency in reporting and also in information and relationship management from the agent, plus flexibility – the ability to change the parameters of their programme to fit with the changing market conditions.”

In the short term, pension funds and institutional investors will take a more conservative approach with regards to cash collateral reinvestment, said Wilson of JPMorgan.

With respect to cash collateral, pension funds and institutional investors will be more conservative, with cash invested more in the short end.  There are typically two approaches regarding the structure of cash collateral reinvestment.  Cash will either be managed as a single large money market fund for multiple clients or in separate accounts tailored to the individual needs of each client.  In the future, we think given the increasing demand for customisation and transparency, there will be more desire for separately managed structures.

The criteria for measuring the success for a securities lending programme will shift from a pure measure of revenue generated to more of a risk-adjusted return measure.

“Revenue is important, but it’s going to be less critical than it was previously” Wilson said. “The focus will first be on getting risk management right, secondly on customisation and transparency and then within this realm, the amount of risk adjusted return. The market is going through a period of contraction with some institutional investors withdrawing coupled with lower asset values and interest rates  leading to reduced volumes and lower spreads.  The areas of future differentiation will be around product innovation and seeking out new low-risk opportunities, like emerging markets and different trade structures.”