During the past few decades, institutional investors of all sizes and types have participated aggressively in the growth of the worldwide securities lending markets. At times, investors could be forgiven for viewing their securities lending activity as a “can’t miss” proposition — a nearly automatic way to capture incremental return with a manageable level of risk. By making certain assets of their investment programs available to borrowers in an over-collateralized manner, investors were able to achieve an added level of return in what was perceived as a risk-controlled fashion. Of course, the securities lending process was never designed to be risk-free, and the industry as a whole received a wake-up call in the midst of the global financial crisis of 2008, when many of the risks simultaneously emerged in unexpected ways. This became most evident when short-term credit markets went into a deep freeze, global equity prices plunged and one major industry counterparty, Lehman Brothers, failed.

As credit markets show signs of thawing, institutional investors are retooling their investment strategies and recalibrating their perceptions of the risk/return tradeoffs of securities lending. In late June, Point of View assembled a roundtable panel of securities lending participants to assess the future of this strategy and investors’ uses of it. The panel featured Adam Tosh, chief investment officer for the Kentucky Retirement Systems; and Mark Faulkner, founder, and Len Welter, chief technology officer, at Data Explorers, a supplier of securities lending and short-selling data and analysis. They were joined on the panel by Northern Trust’s Sunil Daswani and Christopher Doell, CFA, who serve as the heads of client relations for the international and North American securities lending businesses, respectively.

Point of View: What is the current state of the global securities lending industry?

Mark Faulkner: The securities lending industry, as a whole, is much smaller than last year and deleveraging continues. Hedge funds, for example, are more focused on risk management and staying in business than at any other time in their history. That said, the hysteria has subsided, and there is a much more rational discussion as more institutions calmly consider coming back to the market.

Len Welter: Our research shows that short interest has fallen since March, with lending down year-to-date 7.7% across the New York Stock Exchange and down 2% across the NASDAQ. We also have seen a decrease in the quantity of stock made available to borrow even as we have seen signs that lending programs that were closed are opening again. We can infer from this that some institutional investors remained on the sidelines during the recent rally.

Sunil Daswani: We have found that the utilization rate — total assets lent as a percentage of total assets available to lend — remains similar to levels seen before the credit markets tightened. This stability in utilization rates can be explained as follows: Even though there has been a reduction in supply, there has been a corresponding reduction in demand. Demand has fallen for several reasons. First, a series of short-selling regulations were imposed by financial regulators around the globe, though it’s worth noting that most of those restrictions have since been revoked or relaxed. Second, hedge funds were facing heavy redemptions until recently, so they were reluctant to deploy capital and take risk. Third, the borrower community began facing higher financing costs, so they consequently borrowed only what they needed and were reluctant to hold much excess inventory. Supply was reduced through general market factors such as falling equity markets, foreign exchange impacts to valuations and, of course, about 10% to 20% of clients who elected to suspend or slow their lending activity, many of which have since resumed their lending programs.

Chris Doell: We have been living through a massive global deleveraging phenomenon that has impacted all aspects of the financial spectrum. This clearly resulted in significant declines in short interest and borrower demand for securities loans, as Mark and Len have quantified. We confronted this pressure from falling borrower demand at the same time that short-term credit markets remained frozen solid, so the need for higher-than-normal liquidity in cash collateral holdings was key. Although we wouldn’t claim today’s market to be operating anywhere near a normal functioning environment, we at least feel, for the first time in many months, like there is a bit of stability to the markets. On the demand side, we have hopefully approached a floor level where borrowers will finally wish to vigorously re-engage in risk-taking and thus increase their level of borrowing. As for the short-duration credit markets, our portfolio managers report small signs of recovery in trade flow, which allows them to find opportunities to take advantage of liquidity and invest cautiously in small increments out on the yield curve. It is notable that most securities lending participants, despite these dual sets of challenges, have been able to take advantage of the intrinsic lendable value of their assets and have thus continued to record healthy earnings throughout the last several quarters.

Point of View: What factors might delay an improvement in the securities lending environment?

Chris Doell: While we believe we have a more stable environment for lending securities today and one that is poised for expansion, there remains the possibility that additional market “shocks” could occur and delay a broad-based improvement. Based on our dialogue with the borrower community, we are convinced that a large number of hedge funds and other traditional securities loans end-users have for months been aggressively preserving cash. We expect that those hedge funds remain anxious to put some of that cash to work, so any external factors that cause them to further delay their risk-taking would obviously delay a return to higher borrowing levels. On the collateral reinvestment side, there have been waves of government intervention efforts globally to get the credit markets functioning again. For the most part, those efforts have proven to have a neutral or slightly positive effect, but there is always the possibility of unintended consequences whereby well-meaning intervention efforts might actually provoke new levels of uncertainty and fear among investors, which would obviously be counterproductive. At this time, we don’t expect that to occur, but these are the types of factors that could slow the pace of recovery across the entire securities lending industry.

Len Welter: Anything that would cause demand for securities lending to fall or continue to remain depressed, such as negative hedge fund returns and hedge fund redemptions, could delay the improvement in the securities lending environment. The good news is that over the past few weeks, we have seen a small increase in the short base across the NYSE and NASDAQ, but there is still a considerable distance to go before we are back to the level of demand seen back in the beginning of 2008.

Sunil Daswani: Regulators play a role in this process, too. While global regulators have actually been relaxing some of the rules implemented in the middle of the crisis — think of short-selling restrictions as an example — any decisions to enact further barriers to borrowing could also slow the recovery of the securities lending business.

Point of View: What are some of the short-term challenges of securities lending?

Adam Tosh: We tightened our collateral requirements as the downturn occurred last summer, shifting mostly to all Treasuries from asset-backed securities. That took some of the risk off the table.

Sunil Daswani: The uncertain regulatory environment promises to remain challenging. The short-selling bans provide one example. Studies found that short-selling restrictions had little to no impact on stock market returns. We need more certainty.

Chris Doell: Today, one of our greatest challenges as a lending agent is building the tools to accommodate the demand for greater transparency surrounding securities lending activity. Our clients and their consultants are beginning to view their participation in securities lending in the same manner they would treat any one of their externally managed investment strategies. We have built and expect to continue expanding our array of technology tools to help clients understand the interplay between risk and return in their lending activities. On another front, our team is currently hard at work recalibrating the risks embedded in a number of existing cash collateral pools. This will allow us to operate under new investment guidelines to recognize the evolving understanding of risk and liquidity among short-duration fixed-income instruments.

Point of View: How has risk management changed since 2008, and what challenges do these changes present?

Adam Tosh: It amazes me how many people didn’t understand what they participated in. Securities lending is not just nickels and dimes lying around waiting to be collected. It was not without risk. Gaining greater understanding of these risks of liquidity, of counterparties and of the potential for default, is a considerable challenge for the industry. Better education and understanding can help institutions and providers overcome this challenge. As with every other investment opportunity, securities lending involves a risk-reward trade-off, but proper risk controls can help it remain a valuable part of an investment program.

Chris Doell: Let’s face it — this liquidity crisis has delivered a shock to the system for anyone involved in short-duration fixed-income management, an important ingredient to the securities lending equation. This credit crisis episode reminds us all how risk can simultaneously bubble up on multiple fronts, and it provides the opportunity to learn from this experience and look at additional ways to control risk. Going forward, we expect that risk management efforts will also be heavily focused on managing interest rate risk and maintaining positive spreads between cash collateral reinvestment yields and the rebates owed to borrowers.

Mark Faulkner: Imagine a grandfather clock that swings from risk to reward, risk to reward. The mechanics of this clock — the markets — were way off toward reward. Now, the pendulum has swung all the way over to risk, which is fundamental again on every level. There has been a growing demand from institutions to quantify the risk taken in their name so they can make better decisions about where they are on the risk-reward matrix. Everyone is interested in measuring risk. It may be overdone — maybe the pendulum has swung totally to the other side — but I see some form of normality coming.

Sunil Daswani: Participants in the securities lending market needed to step back and fully understand what they were engaged in. Some left the market and haven’t come back. Others have come back into the market with a much more active management style, looking at risk and reward by asset class, and even examining the borrowers they lend to in the wake of Lehman Brothers. Clients know they need to review their lending strategies regularly and understand how risks relate to potential rewards.

Point of View: Do you see changes in the types of collateral required given this recent focus on risk management?

Sunil Daswani: When we look across the global securities lending landscape, it’s important to remember that there are two types of collateral offered by borrowers: non-cash collateral and cash collateral. When using non-cash collateral, participants are typically insulated from the types of reinvestment risk seen over the past year during this recent liquidity crisis. As a result, we predict that usage of non-cash collateral will expand, as will the types of non-cash collateral considered acceptable in a lending transaction. On the cash collateral side, we anticipate a migration to new, more conservative cash reinvestment guidelines for many institutions. Clients have become more aware of the specific risks of each component of the lending transaction, and that includes collateral. It’s interesting to note that the usage of non-cash collateral may potentially expand and thus become less restrictive at the same time that cash collateral usage may decline and cash reinvestment guidelines become more limiting.

Mark Faulkner: There is certainly recognition by providers that non-cash collateral is a sensible alternative to cash and, as the Canadians have shown in recent years, can be safer. Data Explorers found that almost 98% of collateral in the United States is taken as cash, while that number is about 21% in Canada and 9% in the United Kingdom.

However, regulations in the United States encourage taking collateral in cash, as do the pricing and business models. Some participants can’t take non-cash collateral due to Department of Labor regulations. The United States just hasn’t embraced the non-cash collateral world, although some institutions have begun following the European model.

Point of View: As institutions look anew at their lending strategies, will separate accounts or commingled pools become the lending vehicle of choice?

Adam Tosh: We use both, using index funds to get the commingled exposure. We will continue to participate in both when doing so makes sense.

Chris Doell: Across the industry, there will be a healthy examination of the virtues of the separately managed account format versus the use of commingled collateral reinvestment pools. We see many of our commingled pool clients actively exploring the use of separately managed collateral accounts and believe some will indeed make the switch; in fact, a handful have already done so over the past few months. The biggest factors supporting this move are the desire for greater control and the ability to customize the degree of risk and types of investments in the collateral account. That said, we still expect commingled pools, given their efficiency, ease-of-use and huge economies of scale, to remain the vehicle of choice for the majority of our clients. It’s healthy for all beneficial owners to understand the advantages and disadvantages of both vehicles and then make an informed choice. Our job as a lending agent is to assist clients with that evaluation process and offer the best guidance possible. In the end, we are capable of operating both separately managed account and commingled pool formats, so we are indifferent and only want to help our clients find the best possible fit for them.

Point of View: What is your outlook for securities lending?

Chris Doell: There is no doubt that the securities lending market will remain a vital ingredient for genuine market efficiency and price discovery, so the overall outlook is strong. While some participants have recently opted to exit the securities lending arena, we observed that a significant number of these exiting investors did so as part of a short- to intermediate-term risk management exercise. I believe a large number of those institutions will eventually re-engage and ease back into the process with fully informed, deliberate decisions. Our job as a lending agent is to help beneficial owners re-establish a comfort level with the industry’s place today and where it is headed tomorrow.

The level of transparency has changed considerably, and we believe this is absolutely a good thing going forward. It will help reduce unease among investors who might have been less aware of how their securities lending programs operated.

In the end, this business is designed to generate consistent, incremental revenue for institutional investment programs in a risk-controlled manner. As a whole, the industry is definitely on a back-to-basics course. Institutional investors will continue to find there are borrowers willing to pay a premium to secure access to their assets. After carefully examining the risk-reward tradeoff and considering their fiduciary responsibilities, we believe most institutional investors should be able to find a comfort level with some degree of securities lending exposure.

Sunil Daswani: I’m positive about the future. We have already seen many larger institutions come back to securities lending, but with a realignment of risk in the new world that brings this product back down to low risk. With help from regulators, I expect we’ll see an added focus on liquidity, market efficiency and price discovery. I also believe we — and most regulators — have learned that short selling is not necessarily bad for the market.

Mark Faulkner: I’m also optimistic. The response of the industry has been broadly positive. The risk aversion of some clients will direct business to low-risk providers with great financial strength or control of their business. The profitability of lending also remains very sound; the rates of return for lending and reinvesting cash are still profitable — just on smaller balances. It will take time, but I believe the market will come all the way back. Securities lending is one of the least efficient markets in the world right now, but it has great scope for operation and pricing efficiencies. Uniformity will come when someone invents a better mousetrap. Institutions make some $20 billion lending securities annually, so the prize is big enough to encourage innovation.

In the end, the securities lending business is ultimately an asset management business. It’s an annuity and extremely good hedge in bear markets. The securities lending market is doing exactly what it is supposed to do.

The views expressed are those of the participants and not necessarily of the Northern Trust Corporation and are subject to change based on market or other conditions without notice. All material has been obtained from sources believed to be reliable, but the accuracy cannot be guaranteed.

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