As a rule, post-trade operations take place somewhat behind-the-scenes, and they most certainly do not make the headlines on the evening news the way daily stock market index movements do. One of the most critical elements within them is securities lending and borrowing, which bolsters secondary securities market liquidity, enables tighter transaction spreads, enables disrupted settlement to go ahead, and generates relatively low-risk recurring fee income for asset owners and their custodians.
What ‘Sec Lending’ is
Agent lenders, primarily large custody banks, a central client group for Thomas Murray, facilitate access to pools of investment assets often held for very long periods by institutional investor clients. For a fee, these securities can have an additional role to play when lent – but not sold – back into the market to those who are short these positions. The shorts occur when there are trade settlement problems, and far more frequently when an investor or trader takes a market view and chooses to go short on a particular position. Securities lending breathes new life into stocks and bonds that otherwise would be shut away in portfolios for the duration of holding.
The ability to intermediate securities lending is crucial to the health of financial markets by facilitating more accurate price discovery and regulating over-valuation and price bubbles. This, in turn, benefits domestic economies by facilitating capital formation, risk transference, and the long-term accumulation of wealth. In an era of complex regulatory change, it is important that the benefits of securities lending are well-understood and appropriately preserved. The Finadium research paper of 2015 looks at the contributions of securities lending to financial markets with emphases on transaction costs, market liquidity, and incremental revenue. Finadium identified US$ 61 billion in increased annual investor costs that would result from the elimination of these transactions on major international equity markets if securities loans, and hence short selling, were no longer available. As an important addition to market liquidity and operational efficiency, securities loans help create a healthier, more trustworthy marketplace for investors. Markets have to remain two-way to be more fair and efficient, and errors have to be able to be corrected at minimal cost and effort: securities lending provides both these benefits.
The annual reports of US pension plans and global investment funds demonstrate that securities lending contributes consistent and uncorrelated basis point returns to investors, including during stressed market conditions. Policy makers should be aware of the limited risks inherent in these transactions, and limit their regulatory oversight such that it does not needlessly constrain the ability of banks to continue to support securities lending activities.
What are these transactions worth?
Looking only at the use of securities lending and borrowing to cover short positions, a loss of market liquidity leads to wider spreads, and that invariably means higher investment costs for retirement plans and other long-term investors. A short-hand, very rough way of estimating the cost to investors of a security transaction is Investment Commission + Spread. If investment commissions are 20 bps and current spreads are 10 bps, investors pay an effective transaction cost of 30 bps to buy or sell a security.
Finadium’s study of markets during the 2008 short-selling bans on financial stocks showed that spreads widened by an average of 140% over the period. In a hypothetical example, this would translate to investor transactions costs of 44 bps a jump of 14 bps, or 46%.
If investors’ and traders’ transactions together turn over the stock market the equivalent of once each year in major economies, this gives a rough approximation of the value at stake. Using that rough calculation above, the elimination of lending and borrowing by regulatory fiat would translate into something on the order of US$61 billion per year in additional costs across just the seven largest equity markets. This is money taken directly out of investor returns.
Comparable figures in the fixed income market are less certain, owing to a variety of factors that cloud the relationship between short selling and market liquidity; the market structure is not at all similar to equities. However, it is very safe to affirm that in a global fixed- income market of over US$100 trillion, any widening of spreads will have a large and repeated impact on market participant returns.
With fewer securities loans, investors would also lose out on lending fees. While securities lending revenues of three to seven basis points over a short period of time will not make or break a portfolio’s performance, with constant renewal of loans they can add up, even – and perhaps especially - during crisis periods. These add-on returns are independent of securities portfolio performance, and can be important in paying for additional staff or services that retirement savers need most. Risk is most effectively managed by prudent collateral acceptance and, where applicable, in cash reinvestment policies rather than in exposure methodologies which dramatically overstate risk – it is this point that the regulatory authorities must most keep in mind.
Critically for the safety of these transactions, too, the International Securities Lending Association and its members have for some years worked off a common, widely understood contractual basis.
Worth watching in the sec lending field
- Adverse regulatory risk. As Basel III bank ratios continue to have their effect on bankers’ appetites for risk, it is worth constantly reviewing the true underlying risk to these transactions and the cost of capital that must be set aside against them. Did the global regulators settle on an appropriate weighting?
- Counterparty credit risk. The value of credit intermediation is changing: traditionally, securities lending was a bilateral market with banks and brokers being one another’s counterparties. Today, new platforms are emerging that allow asset owners and managers to deal directly with their counterparties.
- Pricing the loans. Most of the world’s securities markets publish little information on short positions, so it is rather hard to get a firm view on how tight the market is. Moreover, with trading platforms of various sorts more and more prevalent in the determination of securities pricing in North America and the European Union, market depth is ever harder to determine for the unwinding of these operations. Without these key indicators, it becomes hard to estimate a fair market fee to assign to any given loan transaction over a given period of time – and that uncertainty might well hollow out the trading in the underlying stocks and bonds.
In this regard, an interesting experiment is underway at the Deutsche Boerse group, which is putting to use its central counterparty clearing to take the bilateral risk of securities loans on to its book; and with its vertical integration, Clearstream gives it a better view on market conditions than any other actor could have in the German marketplace.
 This posting relies heavily on “Securities Lending, Market Liquidity and Retirement Savings: The Real World Impact,” a research paper published in November 2015 by Finadium. The author wishes to thank the Managing Principal, Josh Galper, for his help in preparing this article. The research paper is in the public domain, and is found at: http://finadium.com/wp-content/pdfs/finadium_seclending_real_world_impact.pdf.
 A very different and disruptive cost to the markets would occur if securities lending were eliminated as a tool to unblock administrative errors, which sometimes occur with final settlement of trade transactions. The ability to borrow missing securities adds considerably to market confidence.
The author, Thomas Krantz, is Senior Advisor, Capital markets, in the firm of Thomas Murray; and served as Secretary General of the World Federation of Exchanges (2000-2012). The views expressed are his own, and not necessarily those of the firm.