Business as usual for securities lenders

While there is increased scrutiny on institutional investors to mitigate their risk—which includes high amounts of leverage exposure—the securities lending business doesn’t appear to have been adversely affected by the market conditions of the last year.

The market for borrowing securities—which are usually to take short-positions—remains strong, according to a global survey of 86 major institutional market participants conducted by RBC Dexia.

Seventeen per cent of all survey respondents suspended participation in securities lending over the last year, while the majority, 60%, made no changes at all to their security lending programs.

“Despite some concerns over the short-term outlook for securities lending in the midst of market turmoil, our survey indicates that lenders have continued to customize programs to match their risk/reward tolerance rather than withdrawing from the market,” says Susan Pike, global head of market products at RBC Dexia. “It is critical that beneficial owners and asset managers know what they want and expect from their programs. The key to success is to actively manage, monitor and review policies and procedures on an ongoing basis.”

While most lending programs for funds remains intact, there is an increased focus on ensuring security lending programs don’t come at the cost of unnecessary added risk.

Given the financial turmoil caused by meltdowns at Lehman Brothers and the credit default swap unit at AIG, nearly two-thirds of respondents (65%) expressed less confidence in counterparty stability on their borrowing transactions.

Eighty per cent of respondents identified risk management and capital preservation as a “highly important” priority for their funds. Almost the same proportion (77%) ranked indemnification and provider strength/stability as a highly important priority.

The study explains that indemnification, which are the guarantees associated with a lending agreement and counterparty strength, is one area which plays a huge role in the risk management of a securities lending business.

“Indeed, indemnifications are particularly helpful in serving to mitigate risk in a number of circumstances, such as credit/counterparty risk and market risk,” the study says.

More than 38% of those who did make program adjustments altered their relationships with borrowing counterparties. More than a third of the same group of respondents made changes to the type of collateral they accept to lend a security.

Compared to other aspects of investment firm business, securities lending as a revenue generator remains quite low with 77% of respondents rated securities lending as average or of less importance to their overall performance.

Only 10% of respondents identified securities lending as an important part of their overall business.

“While revenues may not be of critical importance from a portfolio strategy perspective, they arguably still play a fundamental role in supporting an organization’s overall profitability (e.g., securities lending revenues have traditionally been viewed as an offset for custody or other administrative costs),” the study says. “In today’s environment, generating a return, any return, with low associated risk is a particularly attractive proposition. But assuming additional risk for marginally higher returns, is not.”

Many mandates, even in the retail fund space, do engage in securities lending to offset operational costs. In fact, there is an example of an exchange traded fund in Europe that tracks The DJ Euro Stoxx 50 index and has a management expense ratio of 0.00%. It makes all of its revenue through a lending program of the highly-liquid large cap stocks in its portfolio.

(09/21/09)