Surviving the global storm

The securities lending industry has been facing its most rigorous test to date. The default of one of the biggest global players has drawn growing attention to the dangers of counterparty risk. At the same time, bans on short-selling have increased lenders' nervousness and artificially dampened demand.

The question for many lenders is whether current events will have a lasting impact on supply and demand, and what that means for their lending programmes. "The supply/demand dynamics of the securities lending market have been disrupted," Tim Douglas, global head of securities finance within Global Transaction Services at Citigroup, said. "The long term effects on demand will depend on the broader impacts of the bans and their duration. Some players are restricting lending activity and the market needs to work through these imbalances to find a new equilibrium."

Some of the largest pension funds, such as CalPERS, ABP and Hermes, have already stopped or restricted lending. Most smaller schemes don't have explicit arrangements, but lend stock through their index-tracking managers, often without knowing it. Ed Oliver, senior business consultant at Spitalfield Advisors, said: "Before recent events, securities lending was considered to be a very low-risk activity. It potentially still is if managed well, but there is a much better understanding of what the risks are. Going forward, lenders will look much more closely at areas like counterparty risk than they have in the past."

When things were going well, lenders focused on relative peer group performance. "At times like now, the conversation switches to risk," according to Jane Milner, market specialist, SunGard Securities Finance. "The question many players are asking themselves is whether to continue with lending and, if so, what kind of additional controls are needed to ensure their safety."

Collateral impact
Collateral has played a crucial role in protecting lenders from counterparty risk.

This system has been thoroughly road-tested by the Lehman Brothers default, which Douglas said had motivated lenders to re-evaluate their activites. "It is wise to reassess that risk," he said.

"Collateral is a key risk mitigant in securities lending and clients have been reviewing their guidelines and making adjustments. Some are leaning towards a more conservative approach." Some lenders have increased collateral coverage margins and have demanded higher-quality, liquid and transparent securities.

According to Milner: "Unusually, there seems to be more acceptance of equities as non-cash collateral given the higher degree of price visibility and liquidity. Concern has increased around transparency and the ability to quickly unwind positions." Peter Bassler, managing director of eSecLending, believed the positive outcome from the Lehman Brothers default was testament to the fundamentals of securities lending since the lending side is a collateralised transaction.

"Never before has such a big player in the securities lending market defaulted, and it has significantly tested the market. From what we've seen, most lenders have been able to recall and/or replace stock successfully," he said. Not everyone has had a positive experience however. KAS Bank said they recalled stock lent to Lehman Brothers as soon as they discovered potential problems. Not all of the stock was returned, however, and the collateral recovered was not enough to cover the losses.

Michiel Janssen, spokesperson for KAS Bank, said: "We would usually have asked for more collateral from a borrower in these circumstances, but this was not possible with Lehman Brothers. We therefore still have a claim against them. "We have made some changes to our securities lending process, which include raising the requirements regarding collateral and not lending any financial stocks."

Lenders have three layers of default protection: firstly, positions are always over-collateralised; secondly, they are marked every day so lenders can call for further collateral if prices move and more is required; and thirdly, lenders are indemnified against losses. Two of these back-ups proved insufficient to fully protect KAS Bank, highlighting the importance of indemnification. "This layer is also being tested and it will be interesting to see whether the language in the legal agreements has come through and provided the protection," Oliver said.

Bassler stressed the importance of using independent indemnifiers. "We use two highly rated insurers who hold capital aside for our policies and whose business is non-correlated to our franchise or that of the borrowers in our program. This non-correlation is a big benefit in terms of protecting lenders." He believed indemnification would also be more widely sought after when using direct or principal 'exclusives', which have predominantly not had this protection in the past.

Others questioned whether these agreements, where owners lend all, or a portion, of their portfolio to one borrower for a fixed period in return for a guaranteed income, would continue to exist at all. "Full portfolio exclusives to one borrower will be a hard sell in the short term," Oliver said.

Lenders would be more likely to spread their risk going forward, loaning smaller portions of their stocks to a larger number of borrowers. "The big advantage was guaranteed income, but now diversifying counterparty risk has come to the fore," he said. According to Bassler: "Some lenders only started paying close attention to their risk exposures when the credit crisis first began. They are now asking for more reporting, transparency and analysis to better understand how returns are generated and what risks are taken to achieve these returns."

Built to last
As lenders put increasing focus on risk, their reporting demands were likely to change, Milner believed. "Value-at-risk has not been a major focus historically, but is now gaining emphasis and lenders will require more analysis on this aspect going forward.

Transparency and risk awareness are the themes of the moment." But securities lending, the only entirely over-the-counter market left, is opaque, which has created problems around pricing and performance measurement, exacerbating counterparty risk. "Both of these require the availability of data such as the aggregate price being paid for stock and the volume out on loan," Milner said. "Historical views over dividend periods and other corporate actions also provide a useful insight." In the search for greater transparency, Thomas Dubbs, senior partner at Labaton Sucharow, said: "There will be a big push for a central counterparty for anything that can be centralised. The old-boy way didn't have enough transparency, which ran the risk of upsetting the whole system, as we have now seen."

LCH Clearnet recently teamed up with SecFinex to launch the first central counterparty services for stock borrowing and lending across the Euronext markets, including France, Belgium, the Netherlands and Portugal. LCH Clearnet and SecFinex said their marketplace, due for launch in June 2009, would eliminate bi-lateral credit risk and lead to significantly increased market volumes. "This kind of development has been coming for a while," Oliver said, "but recent events have sped up the process. Their success will depend on volumes. Signing up the big lenders and borrowers will be crucial for a successful launch." However, securities lending is a complex global market, Douglas warned. "It would be very difficult to standardise the ways of using a central counterparty. "Electronic trading is the means to an end of price discovery and is part of a broader evolutionary trend," he continued.

"The industry would benefit from more transparent price discovery in order to better compare pricing. This is an ongoing and necessary development and the trend is going to continue, but won't be accelerated by recent events." Meanwhile, the threat of increased regulation raised questions over the long term strength of demand for securities borrowing. Dubbs said: "The current short-selling ban may be rescinded after the market has quietened down, but I would be surprised if it was not replaced by the up-tick rule or other more drastic measures. The odds of no additional regulation are slim to none." Bassler expected to see potential new requirements for greater disclosure of short positions by hedge funds and additional enforcement on naked short-selling.

But, despite this, he believed demand for securities lending would remain robust in the long term, particularly from hedge funds, 130/30 strategies and other new innovations in asset management that will have a short-selling component. In the short term, the supply/demand imbalance could widen lending spreads, generating additional returns for owners.

However, securities lending represents a relatively small percentage of pension funds' revenue. Phil Page, client manager at Cardano, said: "Lending revenues are a nice-to-have for schemes," he said, "but it only adds incremental value. Counterparty risk and capital protection are higher up their agendas."

According to Clark McKinley, spokesperson at CalPERS: "The shorting ban may have some impact on our income from securities lending and, indirectly, on hedge funds. However, those potential losses would be more than overshadowed by further stock losses if current negative market volatility continued." "It is too early to tell what the outcome of the current turmoil will be," Douglas concluded. "In our long term view, the fundamentals of the securities lending business remain sound, but there is clearly a shift in the supply/demand equilibrium in the short term. The apparent strengths will emerge from this crisis intact and the industry will evolve and become stronger as a result."