By Matt Clay
Pension managers burned in the crisis are among those reshaping securities lending to avoid a repeat.
While the issues with money market funds grabbed the lion’s share of the headlines during the financial crisis, their troubles paled in comparison with the securities lending market, which suffered losses in the billions of dollars. Last month, a representative group of securities lending participants met in San Diego for the International Beneficial Owners’ Securities Lending and Repo Summit. The consensus thinking was that, although securities lending has been dealt a blow by the crisis, it can, when managed appropriately, be a valuable contributor to investor portfolios. Several trends that came out of the summit suggest a marketplace of more informed participants with a greater attention to risk management.
THE NEW PARADIGM
- Transparency. This business buzzword has been used to the point of overkill, but it does aptly describe the general trend in securities lending. Beneficial owners, some of whom were burned in this latest crisis, are seeking more detailed information about how their securities are lent, who the counterparties are and what credit risks are associated with those counterparties. They are also seeking detailed information on the cash collateral reinvestment risk that has accounted for nearly all securities lending losses. Lack of visibility shielded reinvestment in new and exotic security types and led to excess risk taking. Providing greater transparency across the entire securities lending spectrum will be crucial in avoiding these pitfalls going forward.
- Investment perspective. A second industry trend is toward viewing securities lending as a commitment of capital rather than an operational function. For the most part, professional investment companies participating in securities lending programs appear to have fared better during the most recent crisis than many other types of securities lenders including pension funds, corporations, and state and local municipalities. One explanation is that investment companies are much closer to the investment process and, as a result, have viewed securities lending as a fundamental investment and risk management exercise, rather than an operational function. Many other lenders with an operational focus took profits for granted and discounted the associated risks; in the end, to their peril. Market participants have since learned that securities lending is not risk-free and simply cannot be viewed as a back-office exercise or operational function. Greater attention to risk management resources and on tools designed to more effectively monitor the lending program will continue to be part of the re-calibrated role of securities lending in the future.
- Separate accounts. A third industry trend is toward separate accounts. Historically, beneficial owners have generally used commingled funds as cash reinvestment vehicles. Now, more are opting for separate accounts. These beneficial owners see value in setting investment guidelines and liquidity parameters and having daily visibility and transparency into their own portfolio.
- Reinvestment policies. A fourth trend is toward the segregation of responsibilities between collateral investment manager and agent lender. In securities lending programs where the agent lender is also managing the collateral reinvestment assets, there resides an inherent potential conflict of interest. This can create an asymmetrical risk relationship between the agent lender/investment manager and the client. Securities lending program earnings are typically based on some type of revenue split where, for example, the beneficial owner client receives 60 percent of the lending revenue while the agent lender keeps 40 percent. Lending revenue is primarily driven by the type of securities lent and the spread between what can be earned on the collateral reinvestment and what has to be paid to borrowers in rebates. Put simply, the higher the spread, the more revenue to the securities lending program. If the risk and return relationship is true, the more return that is sought on the collateral reinvestment (in order to increase the spread) the more revenue both parties will earn, but at an increased level of risk.
There is, however, one very important caveat to this relationship. The agent lender/investment manager typically does not indemnify the beneficial owner client against losses with respect to the reinvestment of collateral. With the client on the hook for losses, one could argue that the distribution of returns and risks is grossly imbalanced. While many agent lender/investment managers provided additional support to their collateral investment products, most of the credit losses in securities lending programs during the past crisis were borne by beneficial owners.
Many beneficial owners with in-house staff and resources are internalizing all, or a portion of, the collateral reinvestment process, giving them greater control and flexibility over the way assets and associated risks are managed. Others have engaged third-party collateral investment managers. They are able to evaluate the managers on a stand-alone basis and make their selections using a process similar to that used in selecting investment managers for any other investment program.
In the wake of the recent crisis, the money market fund industry has certainly seen a rash of new reform and regulation. In the end, the securities lending market may need strict revision and—even more so than money market funds.
Matt Clay directs money market fund and securities lending investment reporting solutions for Clearwater Analytics, a provider of leading web-based investment portfolio reporting and analytics.