Is Your Securities Lending Portfolio Safe?

Despite the media attention on securities lending, not much has changed with regard to the practice save for public perception, explained Craig Gaskin, managing director with TD Asset Management.

Gaskin has noticed a sharp increase recently in client interest in the issue. “Securities lending would have been an area of very low discussion content a year or two ago, and it’s now one of the top two or three items discussed at meetings with any institutional client,” he said. “I think it’s more about awareness and education right now than the actual practices.”

Gaskin feels that the ban on short selling imposed on Sept. 19, 2008 by the U.S. Securities and Exchange Commission has had the opposite of the intended effect on the markets, and that naked short-selling—in which the seller shorts the stock without first borrowing the shares—was the real problem. “We’ve seen wider spreads, higher volatility and, certainly, higher transaction costs during the ban period,” he explained.

He added that while the ban had no net positive impact, it’s possible that there may have been a psychological affect that helped to calm people’s fears. “Part of the investor landscape has a lot to do with behaviour and psychology, and I think that short selling was seen in a negative light,” he said. “Curtailing it was probably needed, but it’s a necessary part of a healthy market.”

James Slater, senior vice-president and head of Capital Markets with CIBC Mellon, agrees. “While it may cause some short-term volatility, if you’re a long-term investor, what you’re concerned about is efficient price discovery and good value on that stock,” he said. “The recent bans were an excellent opportunity to look at the impacts of constrained short selling.”

According to Jeff Kearny, a principal with Mercer Sentinel, the impact on the Canadian market has been much less evident than in the U.S. or in Europe, and while there have been lower volumes, the returns on those loans have been very good. The main message from his clients, he explained, is that they want as much information as possible on the practice.

“We are hearing concerns from clients’ investment managers who are saying, ‘We’re not comfortable with this; is there something going on here?’” he added.

Kearny suggested that the recent attention given to shorting is overblown and pointed out that, within Canada, the lending related to shorting is a small percentage of the total lending that takes place. He also took pains to distinguish the two.

“Securities lending does not equal shorting,” he said. “It’s a misperception. The problem we’re having now is not the shorting itself but what’s driving it.”

Given the losses or marginal profits that many firms have incurred over the past six months, one would expect the attractiveness of securities lending to have diminished. Not so, according to the panel.

Kearny explained that instead of shying away from securities lending, many organizations are simply becoming more stringent about what asset classes they are willing to lend.

As with any investment activity, explained Slater, there’s a wide spectrum of risks and returns. Plan sponsors engaged in conservative, money market-type funds likely avoided significant losses. “On the other hand, AIG put $84 billion in securities out on loan and invested two-thirds of that in three-to seven-year mortgages,” he said. “They have taken massive hits on that.”

As competitive pressures have driven lending agencies to put more and more securities out, they are paying higher and higher rebate rates, which need to be supported by higher and higher cash reinvestment returns, said Kearny. When an organization encounters problems on the cash reinvestment side, it goes into a negative spread situation and does not make money on these loans.

Looking at future trends in cash versus non-cash collateral, Kearny explained that cash-based lending is growing quickly in Canada and in Europe. “The opposite is now happening in the U.S., where we’re seeing a move towards more collateral flexibility and increased use of non-cash collateral,” he added

Slater remarked that a unique factor for Canada is the size of the market, which constrains the growth of the cash reinvestment market. “There’s still room for it to grow here, but it’s not going to be the dominant form of collateral anytime soon.”

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To comment on this story, email jody.white@rci.rogers.com.