Securities lending is likely to remain an important activity among large investors in 2013, albeit with lower revenue expectations. At the same time, the impact of a regulatory pipeline on attitudes to securities lending is more significant than any of the individual regulations themselves, according to a new survey by research and consulting firm Finadium.
The study, 'Institutional investors on securities lending and collateral management in 2013', draws on a proprietary survey of institutional investors in North America, Europe and Asia conducted in late 2012, including public and private retirement plans as well as sovereign wealth funds, supplemented with information gleaned from the annual reports of US public plan sponsors.
While lending continues to be viewed as a worthwhile activity for most large institutions, divergences of opinion are becoming more pronounced. "Some investors continue to seek out securities lending revenues from an older business model that relied on leveraged hedge funds and market maker borrowing," the report suggests. "Others recognise that lending activities create an opportunity that combines the traditional business of providing inventory for hedging, shorting and operational needs with the regulatory requirements of new types of market participants."
Changes in the broader financial services marketplace have had a measurable impact on securities lending levels. The report cites the example of the UK, where Financial Services Authority (FSA) figures put hedge fund borrowing leverage from prime brokers at 1.3X in March 2012. While higher than the 1.2X level from October 2011, this is still down from 2007's high of 1.92X. Hedge funds continue to use leveraged products such as options and futures but this does not necessarily translate into demand for securities loans, says the report. A reduction in the ability of banks to maintain large general collateral balances has also reduced securities lending utilisation, as have European Union short selling bans and other regulations. "Estimates on the current size of the securities lending market are roughly US$1.7 trillion, down from US$3.8 trillion in 2007 and early 2008," the report adds.
The importance of indemnification
Along with expectations for future demand, indemnification is the most uncertain aspect of securities lending facing institutions today, said Josh Galper, managing principal, Finadium and author of the report. "Indemnification is to some degree an artificial construct, as collateralisation of 102% to 110% is designed to be the first and most substantial wave of defence against a counterparty default," he argues. In practice however, it is an important requirement for retirement plan boards and sovereign wealth funds. "Many beneficial owners see indemnification as something of a paper tiger; it may not have much worth in practice, but is critical to include in a legal agreement," Galper observes.
As far as future regulations are concerned, the Finadium survey suggests that institutions are not overly concerned about the final face of financial regulations, though ongoing uncertainties about rule changes, along with the potential for unexpected consequences, are creating an uneasy environment. "Institutions say they will manage around whatever regulators finally issue and either accept or reject risks and returns accordingly," said Galper, "but it is prolonged rule-making and lack of clarity on final rules that is causing difficulties."
The report notes that use of securities lending cash or non-cash collateral as a liquidity source for other purposes is in its infancy. "Today's conversation is about using cash collateral to fund margin positions for OTC derivatives or meet private equity capital calls," read the report. "On the surface this makes sense; cash collateral comes with no extra borrowing costs and is readily available. The securities lending departments of institutions could make loans to internal borrowers at little to no interest."
Using securities lending collateral as liquidity takes lending another step closer towards being an integrated function of investment activity. It also moves lending away from being a purely revenue-oriented activity to being a tool that institutions can leverage in their favour. "While relevant only for funds that require collateral for other products," says the report, "securities lending can now be considered more seriously as part of a fund's asset allocation structure."
Reporting by Richard Schwartz