Stock Lending Today - An Industry Under Siege!

Short on Facts

Earlier today one of the GSL journalists sent me an email entitled “Big Seclending News” and referred to an article in today’s FT.  I am really lucky as I am now editor in chief of Global Securities Lending magazine (www.gsl.tv) and we have had people digging into the story all day long.  Now back in my office, I thought I would give you my personal views.

Norma Cohen, the FT article’s author advised us that the UK Pensions Regulator is urging retirement scheme trustees to review their stock lending arrangements.  Nothing wrong with that, trustees are required to know what is happening with the assets they oversee and they should maintain stringent controls on the safety of the funds.

However the regulator’s advice seems to have arisen as a result of information it had received from a member of the UK Parliament, Frank Field.  I checked out his blog which raised the issue yesterday.  

Early on in his post Mr Field raises the spectre of Robert Maxwell employing stock lending and the negative impact on the Maxwell pension funds.  Just to clarify, Maxwell did those movements of securities without collateral and without an agreement.  That is more appropriately called “fraud” not “stock lending”.  That’s like referring to the Madoff scandal as “fund management” instead of fraud.

Now to the meat of his article.  Frank Field alleges that “a medium size pension fund that was using a high street bank as the custodian for its pension funds” and that bank was lending “both shares and gilts owned by this pension fund” without the knowledge of the Trustees.   He goes further to suggest that the collateral was “gilts from third-world countries which, while they had the nominal value of the UK gilts, would have proved almost valueless had the bank gone under and the pension fund tried to sell the replacement assets.”  Mr Field also writes the fund was earning miniscule amounts of money quoting “a return of £900 in every £1M pounds lent” and that he believed that the bank was pocketing practically the whole of the fee it gained from lending out the pension fund shares.

Wow!  That’s a pretty heavyweight set of allegations and it raises some interesting questions that we can now examine.

Was the pension fund lending activity being carried out directly as part of the fund, or was the fund part of a pooled pension fund?  If part of a pool, then the pooled fund documentation should have made it clear that it would engage in lending.  If the pension fund didn’t want to be part of the lending business it should not become part of the pool.  By agreeing to be invest in the pool, the pension fund would have been deemed to accept the terms and conditions outlined by the fund including lending.  No specific Trustee approval of lending would be sought or required.

If the pension fund was acting as a stand-alone fund and not part of a pool, then the question is simple: “Did the Trustees allow its custodian to lend out the pension fund’s assets?”  A simple Yes or No will suffice.  If yes, then skip to the further points below.  If no, then why was the custodian lending the assets?  The only time that I have ever come across anything remotely similar is where an institution is a creditor of a client and uses that client’s securities in its normal trading operations.  Even in this scenario though, there would be documentation in place advising the client of those conditions and setting out the parameters of access and utilisation. 

It is a very serious situation if the custodian didn’t have the client’s approval and I suspect there could be a legal case in such a scenario.

Further, if the custodian is using the securities without the client’s permission, and it is trading under the standard industry documentation, it would also likely be in breach of contract with its borrowing counterparties.  The warranties given within the document include reference to being duly authorised and empowered to enter into the transactions which would patently not be the case.

Let’s turn to the collateral.  I will leave aside the easy cheap shot that given our government debt level, many would consider the UK a third-world country.  If the fund had approved the lending activity, it would also have been asked to approve the collateral profile.  This is somewhat less clear-cut as some beneficial owners have claimed ignorance and lack of understanding of collateral choices while custodians and other lenders maintain that they expend significant time and energy discussing collateral implications with their clients.  Assuming the client said “yes” to lending, did it also approve the collateral profile?  (If the fund didn’t say yes, then collateral is irrelevant as it should not be legally exposed to the transaction).  If lending was approved, but the collateral profile wasn’t approved, then the custodian has another case to answer and would then appear to be in breach of contract here as well.   [There is also a point on the collateral in the event “the bank went under”, but I don’t want to be distracted from the pension fund issues.]

Mr Field’s comments on fees are a bit confusing.  If the pension fund hadn’t approved lending, then why did it think it was collecting fees?  Surely that should have been an early indicator that something odd was going on.  If the pension fund hadn’t approved lending then why are the fees relevant?  Moving on from that, the nature of securities lending is that properly conducted, it is a low-risk, low reward business.  The fees Mr Fields quotes – 9 basis points – can’t be judged as high, low or somewhere in between without further information on which assets were being loaned out, the collateral being held (third-world gilts being not particularly helpful) and margin levels (the extent to which the collateral held exceeds the value of the securities loaned out).   It also doesn’t explain whether the 9 b.p. was before or after the bank’s share.

As an aside, I don’t know how Mr Fields defines high street bank, but given my understanding of the term, there aren’t many that engage in custody for pension funds.

He makes a couple of other allegations, but this post is already about three times as long as the experts say a blog post can be .... so I will come back another day with those items ... and watch for the full story on www.gsl.tv !

PS...These are exactly the sort of questions that we expect Beneficial Owners will be asking at our Nordic Securities Lending Summit next week in Stockholm.  It is also why there has been demand for the Securities Lending Seminar I am running the day before the Summit,

Securities Lending Summit this Friday!

This Friday 27 November I will be chairing the GSL End of Year Summit.  It will be our fourth event of 2009 and we are taking the opportunity to look forward at the prospects for 2010 and examine how the past two years have shaped our future prospects.  The events have been extremely popular as they combine excellent content that is concentrated into a single afternoon of focussed discussion and debate, followed by a networking opportunity after the summit.

The objective of the Summits is to stimulate lively debate and discussion in order that the audience can walk away with ideas and issues to think about and discuss with peers and providers.    I am confident that this End of Year Summit will make an excellent contribution to the series.

Given that our first Summit in January was held to coincide the removal of the short selling ban, it is fitting that we close this event, and the year, with a politician.   Political and regulatory influences are more important than ever, and I am particularly pleased to welcome Mr Greg Hands, MP, Shadow Treasury Minister.  Mr Hands will give us the Closing Address on the day.

For the main body of the conference, we will be looking at both the demand side of the business as well as issues surrounding collateral.  Some of the questions that I have asked panellists to address include:

• Which hedge fund strategies have been successful in 2009 and what is the outlook for next year?
• Which markets, regions or sectors have captured traders’ attention?
• What demands are hedge funds making of their Prime Brokers?
• How have corporations been raising money recently, how does that compare in historical terms and where is funding likely to come from over the coming year?
• What role do Exchange Traded Funds play in the securities lending business?  Do hedge funds use ETFs, and what are the trends? 
• Collateral is a more important subject than ever before.  To some, it is the source of securities lending cash reinvestment losses, for others it was the safety net that protected them against the Lehman default.  What are the issues, trends and challenges for the collateral?
• This year saw the emergence of the first central counterparties for securities lending activity.  While they may be new to our business, they are an integral part of the investment world.  We are fortunate to have Marco Strimer, CEO of SIX x-clear as one of our panellists.  Marco will give us an explanation of what a CCP is generally and help us tie it into its role in this business.

I try to bring you an interesting and fresh group of speakers at each summit, and I think this group will continue to set a high standard of discussion and debate.   While there are some recognised industry commentators, I am pleased to say that there are several new faces that will be appearing on the day. 

There are some places still available and I hope you will be able to join us.  You can register here.

Some sense & some rubbish - Must be Silly Season!

ETFs Hit the Mainstream

As all my regular readers know, I love ETFs.  They are the obvious tool for building an investment portfolio.  Punters like me can't possibly know which stocks to buy, but we can have views on which markets, sectors or regions are likely to do well.  The launch of the self-branded ETFs by HSBC marks another important step in the evolution of ETFs.  HSBC has been working on this project for some time and I know several people that were involved in the process.  There was a lot of debate, discussion and disagreement, but in any case, it is now the real thing! Needless to say HSBC Securities Services will be pleased with the additional supply and no doubt the Global Markets group (that has recently announced plans to enter into the Prime Brokerage business) will have played their part in the development of the business at HSBC.  

There is an interview with Farley Thomas of HSBC by Paul Amery of IndexUniverse.com that you can read here.  Also, read Paul’s follow-up comments here.  I won’t reiterate Paul’s observations, but I have a couple of my own.  The fact that one of Paul’s first questions was about securities lending shows how closely intertwined the two activities have become.  The second is that the readers of IndexUniverse.com are not typically knowledgeable about securities lending, but are more exposed to the subject than ever before.  This can only be a good thing in the crusade to build secondary market liquidity through the expansion of both the supply and demand side of securities lending for ETFs.  

Myners Voting Madness  

I couldn’t believe when I read recently that Lord Myners was promoting the idea of shareholders selling voting rights.  I guess the idea is that if a shareholder isn’t interested in actively participating in the management of a company by exercising its vote, it should sell that vote to someone who is interested.  I think this is one of those things that sounds good over a couple of glasses of port in the evening, but in the cold light of day is rather bizarre.  It particularly strikes me as odd given the furore (unnecessary in my view as it rarely happens) over the idea of hedge funds and other firms borrowing shares with the sole objective of obtaining voting rights.  Regulators, politicians and CEO’s have all railed against such actions.  And now one of that group talks about selling the rights?  I assume the idea was floated in August so that most people would be on holiday and not notice.  

Tut-tut on the Tobin Tax, Mr Turner  

While on the subject of silly season commentary, I can’t believe that a former banker has suggested a transaction tax on banks.  Yet Adair Turner, Chairman of the FSA has proposed a “Tobin Tax” on banking deals.  The idea is to assess an additional tax on banking transactions and in so doing, limit profits of the banks and thereby stopping mega bonuses.  Are you kidding me?  If I hadn’t already used the word “bizarre” in the blog already, I would be using it now.  (Oh, I DID use it again.  Bad editing.)  Most of the trading activities that would be looked at are incredibly easily transferred to another jurisdiction and would just leave our fine British soil.  Along with all those who are already planning on leaving with the upcoming 50% tax rate and the emergency preparations being made by some hedgies to flee proposed EU Alternatives regulations.  At least the traffic coming in to the City will be reduced.

Have a great weekend - especially those of you having Monday as a holiday as well!

On the road to Barcelona

I am writing this as I sit on the plane, on my way to the 18th Annual ISLA/RMA conference on securities lending. I think that I have been to 15 of the 18 events, and I can't recall a more important nexus for the industry.

Hedge funds remain the single most important driver for the growth of the business.  Hedge fund data from May have finally shown a turnaround in fortunes for the alternatives industry. Performance is up virtually across the entire spectrum of funds, new investments have exceed redemptions for the first time this year and some sizable new fund launches are in the works. Yet one month's figures do not constitute a trend.  In addition to the natural challenge for performance, regulations loom large and ominous for hedge funds around the world. Regulators and politicians in practically every region want more controls, restrictions and reporting.  The impact of these forces is hard to predict at this time, but they will have an effect on the business.

On the morning of last year's ISF awards announcements in September, I suggested in my blog that the winners on the borrower side of the survey enjoy the celebrations but the lenders shouldn't take any notice of the rankings. My feeling at the time was that the past winners would perhaps for the first time not be a useful guide to future winners and that there would be a new order arising. I feel pretty good about that prediction.  I don't think there is a prime brokerage firm out there that isn't grappling with the after shocks of the Lehman default last year. Numerous hedgies have changed and/or added PBs, and many of the switches involved moving their relationships into the US offices of their PB. The original move to providers based outside the US was to take advantage of more commercially oriented leverage arrangements from non-US offices of the prime brokers. However, given the very low degree of leverage this is no longer an issue, and many funds feel more comfortable dealing with future potential insolvencies in the US as opposed to other jurisdictions. PBs are having to re-examine their service and funding models, coming up with different and innovative solutions for their clients. Any provider that hasn't added any new services, arrangements or features over the past 9 months or isn't working on them now is likely to be left behind by the end of the year.

Agent lenders have been on the firing line for much of the past two years as a result of the credit and liquidity crisis that has hit the cash reinvestment side of the business. The core challenge for these agents has been less about the selection of investments and more about their ability to keep the pools funded in a shrinking market. Forced sales generally have unfortunate outcomes. Agents who predominantly lend against non-cash collateral have had a growth spurt in business as their clients haven't had cash reinvestment losses and the collateral profile is attractive to the majority of borrowers. The debate about the purpose of collateral - safety net or alpha generator - is surprisingly still in its infancy. Borrowing demand is down from peak levels a couple of years ago so lenders have to work harder just to stand still.

Beneficial Owners that participated in cash programmes ... Hmmm.  Are they the victims in the cash reinvestment story or willing participants until the tide turned against them? Have they been ill-educated and uninformed by their service providers or were they only interested in the bottom line?  "Securities lending in five minutes a month!" Which Ben Owner wants to admit to this approach these days? For those funds that took non-cash collateral, they missed the best of the returns generated by their cash-oriented brethren, and with market volumes down are no doubt well off their best revenue years. I suspect however that this is the group that feels least stressed (depending on how much business they did with Lehman and the type of business).

Further, the issue of electronic trading and central counterparty is finally real rather than an abstract idea for the future. The question here seems to be more an issue of those fighting for the status quo rather than considering whether CCP is a valuable part of the future of the business. Indeed, individual firms have their own best interests in mind in their actions. However, a number of the arguments made against CCPs don't bear up under scrutiny.  Typically it is regulators that are tasked with determining what is best for the wider markets. I'm not sure this an issue the stock loan industry wants to leave solely in the control of the regulators.

Finally, the subject of short selling has never had so much focus as it has over the past twelve months.  Securities regulators, politicians, church hierarchy, day traders, pensioners, corner shop owners and cab drivers have all been given time to air their views, happily accommodated by a media fueled by frenzy.  We have almost emerged from the fog of fear and a more considered and thought-out regime will likely result over the coming months - although it is likely to be different on a country-by-country basis.

All in all, we see a securities lending business that is still huge, and recognised as a cornerstone of the capital markets.  But we also see an industry that is dealing with important fundamental issues that will shape the market for years to come.  What that final shape will look like however, is yet to be determined.

Should be an interesting conference.

(A long post - hope you made it to the end.  See what happens when the flight is delayed and I have too much time on my hands.)

SEC Proposes Five Short Selling Restriction Options

The SEC this week held a meeting to address the emotion-packed subject of whether short selling should be controlled or restricted.  They came up with five different alternatives and you can read the Press Release here.  There is a 60 day consultation period where people can contribute their views.  I'll revisit this subject in coming days, but for now, I'd like your views on which approach makes the most sense. 

So, give me your thoughts! 

P.S.  I am writing another article for Global Custodian Magazine.  I am interested in your thoughts on lessons learned for the securities lending industry as a result of the Lehman default.  Please email me your comments at roy@stocklendingtoday.com .  Don't be shy - there won't be any names in the article!  Thanks for your help.