Securities lending has been called an “invisible business” and a “shadow market”. There are no screen quotes, no mandated disclosures and no balance-sheet reckonings. The daily trillion-and-a-half dollars traded in this market are only noticed when there’s a crash or a sudden surge in interest rates.
But securities lenders and repo traders say proudly that their business rode out the recent turmoil with no loss of money and only minor adjustments to market practice. “We’re spending more time with our risk managers,” says Mark Katzelnick, head of global equity finance at ING Barings in New York, “looking at volatility and counterparty risk.”
In 1994 there was more general panic, triggering intraday calls for margin, as lenders scrambled to adjust the level of collateral to volatile market prices. In last year’s Asian meltdown such frequent margin calls were ruled out by the time zone difference but lenders seemed to have sufficient cushion. Nevertheless, at least one firm has put two people full-time on margin management.
The credit quality of the counterparty is the bigger priority. “Counterparty risk is even more of a concern than market risk,” says Bill Foley, an equity repo trader at ABN Amro in London. And counterparty quality cannot be improved by better-class collateral or a demand for higher amounts of it per dollar lent. In a bear market the response is “probably to reduce the number of counterparties”, says the head of sales and trading at an investment bank in Hong Kong.
While this suggests the mainstream business is developing prudently, at the frontier, securities lending is venturing into new areas of risk, for a higher return.
Securities lending is a spread game, with returns measured in basis points. It’s also a form of leverage. “It’s not like one and one equals two. In securities lending, it could be 11,” says Mark Whitehead, a director at Merrill Lynch in London. “The return on equity is infinite,” says Gerry Tamburro, the managing director heading UBS’s new US securities lending operation.
With that sort of earnings potential, it’s hardly surprising that European institutions such as UBS, Swiss Bank Corp and Deutsche Bank, and US brokerage firms such as Goldman Sachs, Lehman Brothers, Donaldson Lufkin Jenrette, Bear Stearns and Merrill Lynch, are trying to muscle in. During 1994, stiff rises in interest rates battered many traditional securities lending programmes and many lenders retreated from the market. But, the competition has hotted up again. Players are implementing new strategies that take on credit risk, often using complex instruments such as floaters or equity repurchase agreements (repos). Moreover, they are adopting structures that hide rebates given to borrowers. These developments imply new sorts of risks that will become particularly apparent in anything more than an emerging markets crisis.
The most innovative strategies have been developed in London, where market participants say US institutions are quickly being left behind. But they should catch up soon. To help them square up to the competition, the US Securities & Exchange Commission has recently relaxed rules on the use of equity repos by broker-dealers, who want to use them to finance their long equity positions. Equity repos were introduced by Lehman in London three years ago as a way to avoid paying the relatively high funding rates its low credit rating would otherwise demand. Now equity repos are viewed as the up-and-coming securities-lending product and are being promoted aggressively for the extra 10 basis points in return they offer.
Concern has been expressed, though, that many potential suppliers of securities to the market don’t understand or are ignoring the risks involved in many of the new strategies. “Neither the lenders nor the agents have spent a lot of time talking about what the risks are,” says Donald Hodgman, senior vice-president at State Street Bank & Trust, which has long been considered the leading global securities lending agent. State Street wants to bring a value-at-risk analysis to the industry.
US pension funds, followed by mutual funds and other institutional owners of securities, are the main suppliers of securities. And most of the demand comes ultimately from hedge funds. It is somewhat ironic that even though many securities owners’ bylaws prevent them from investing directly in such risky vehicles as hedge funds, they are indirectly funding their activities. Hedge funds, through their brokers, need to borrow securities to cover their short positions as well as to engage in arbitrage strategies. In between are the so-called lending agents, which traditionally have been the big US custody banks such as State Street, Bank of New York and Chase.
The original pitch to institutional securities owners was straightforward and appealing. With all that paper lying fallow with custodians, why not pick up a few dollars by lending it out, often just overnight? “It’s a chance to earn some additional income,” says R Rick Moos, a co-founder of Metropolitan West Securities (Met West) and a securities lending pioneer who started out at Security Pacific National Bank. Met West is renowned for offering high returns to pension funds. For a big fund, the earnings can come to millions of dollars a year on its portfolio – or 10bp to 20bp. “Everybody has such tight budgets about expenses, offices, staff and salary, and all of a sudden you have a securities lending programme that covers that. It’s pretty significant,” says Moos.
However, the opaqueness of the market means that owners of securities aren’t always aware of what’s going on. “The way it has been structured has been a good business for a lot of people, it’s a cosy business so there’s naturally resistance to major change,” says a securities lending veteran.
Many strategies get around US Erisa (legislation governing pension fund operations) rules on prudent investments by moving securities offshore, where European banks and the global arms of US securities houses can offer a few extra basis points. And higher returns are what everyone is looking for these days. “There’s increased pressure from clients to get earnings up,” says Ralph Vitale, executive vice-president in charge of State Street’s securities lending operation. Vitale believes institutions don’t currently weigh the risk exposure of widely differing returns. Other market participants reckon they close their eyes to this problem as long as the money is good – and the markets look like remaining calm.
When a fund in the US lends out its securities, through an agent custodian bank or a third-party agent, the borrower typically puts up as collateral cash equivalent to more than 100% of the securities borrowed. (Erisa requires that the collateral be either cash or government securities.) Agents usually indemnify the securities’ owners in case of borrower default, and they also require borrowers to post more collateral, through margin calls, as market movements demand.
These market practices are designed to protect securities owners from market turmoil, as in Malaysia this summer when the government temporarily prohibited short selling. The government decreed that if a security was to be sold it had to be at the depository in the seller’s name the day before the trade. So if a security was out on loan, its owner would be stuck with it during a market meltdown.
Having collected cash collateral, the next step for the lending agent is to reinvest it. And that’s where the return to the owner – and much of its risk – comes in. Many consultants have been focusing on reinvestment as the biggest area of obscurity in the securities-lending market. “There’s very little reporting on the reinvestment of the cash collateral of the programme,” says Ed Blount, executive director of Astec Consulting Group. “Very few agents report all the information a lender should have to fairly assess the degree of exposure. There is also little reporting of the amounts of securities out on loan exposed to different levels of risk.” As a result, says Blount, owners of securities “don’t know whether 98% of the securities are put out on loan for small spreads or just a little bit for high spreads”.
Securities owners got the answers to some of these questions the hard way after the 1994 interest rate rise. The most common reinvestment strategy used until the early 1990s had been a short-duration mismatch. In such a programme, the cash is invested in money-market instruments or treasury securities with a duration of less than 90 days. The spread is typically between two-month Libor and overnight rates, or about 25bp. But when the yield curve went flat in 1993, many lending agents started going out longer on the yield curve – to six months to two years.
When interest rates rose early in 1994, those strategies blew up. Some lending agents, such as Mellon Bank, reported losses amounting to hundreds of millions of dollars. First Capital Strategies, which had taken on extra leverage by investing in derivatives, went bankrupt. Losses incurred by the funds that owned securities lent out went unreported because lending returns are folded into their overall performance.
After the interest rate-induced disasters, credit mismatching emerged as the hot new approach. Securities lenders offering such strategies promote them as having no interest-rate risk. They’ve been selling them as “the best thing since sliced bread”, says Vitale. But he adds: “The idea that there’s no risk in a credit programme is folly.”
Two institutions reputed to be the most aggressive in employing credit-mismatch programmes are Metropolitan West and Swiss Bank Corp. SBC securities lending officials did not respond to requests for comment. Met West’s Moos acknowledges that his firm does use credit mismatch but says the programme does not go far down the credit spectrum. “The clients we talk to are very sophisticated, they understand the type of work we do,” he says. However, because most of the credit mismatches have not been tested during a market correction, many observers fear that their risks are being underestimated.
A simple credit mismatch might be to take the cash raised from lending out government securities (still the bulk of what is lent) and reinvesting it in A1 commercial paper. But other credit mismatches are more risky, even though they too may involve an A1-rated corporate security.
Orrin Bargerhuff, a former securities lender with Northern Trust and now a pension funds consultant, says that such securities are typically floating-rate notes, which have become a big part of the market and increasingly risky. While interest rate resets take the interest-rate sensitivity out of the investment, long maturities of up to seven years create greater vulnerability to other types of event risk. “If you’ve got a five-year final maturity, and some credit deterioration occurs, that’s going to get whacked and pretty big. It’s not a piece of 90-day commercial paper. You’re talking about years to deal with this,” says Bargerhuff.
Another area where volumes at risk are ballooning is the equity repo, which has gained wide acceptance in Europe but received regulatory approval in the US only a few months ago when the SEC allowed broker-dealers to finance their inventories by using such trades, which are similar in structure to government securities repos. The demand for equity repos comes from the big US brokerage firms, which view it as a low-cost funding source to finance their inventories of equity securities every night.
Equity repos enable a broker to sell his long position and get cash, the agreement being that he will buy back the security the next day. In the past, equity-trading desks had to borrow from their firm’s treasury for such positions or from banks at the broker-dealer call rate of 50%, the margin required for loans on equities.
Equity repos got a big boost in London about three years ago in large part to meet the technical legal requirements associated with dividend arbitrage strategies employed by the trading desks of investment banks. “A lot of people take stocks ahead of dividend dates. In the past, a regulatory ‘purpose’ test stated you [a broker] couldn’t borrow the security if you weren’t going to relend it,” explains Merrill’s Whitehead. “Once people started repoing the equities, they were going to relend it and so had a need to borrow, meeting the purpose test.”
The use of equity repos – either as part of a reinvestment strategy or as a form of collateral – could put pension fund owners in the dual position of both lending securities and buying them back. In fact, securities lending and repos have almost the same economic outcome. A repo is a sale with an agreement to buy it back, whereas securities lending is a loan with an agreement to get it back. That creates a certain amount of circularity already. “We may lend a treasury security to Goldman Sachs and they do a repo on the other side. It may go all the way around. We might end up with the same security,” says State Street’s Vitale.
Much of the hedge funds’ demand for non-domestic equity repos is driven by tax-dividend arbitrage strategies. Hedge funds want to borrow stocks of companies in such countries as Germany and France because if they are holding the stock when the dividend is paid, they receive a tax credit. The stocks’ owners, usually pension funds, receive the dividend income back from the borrower and most aren’t aware why their securities are being lent out, or who is the ultimate borrower. Since pension funds are not taxable entities, they don’t have a need for the tax credit.
Consultants to the pension fund industry worry that even in its simplest form this sort of trade carries the risk of being disrupted. “What happens if the German tax authorities clamp down on this?” asks Bo Abesamis, vice-president of US securities-lending consultancy Callan Associates. “Will they use a pension fund plan sponsor or a broker dealer as a guinea pig to teach the lesson?” But it gets even more complicated if the pension fund is also in the position of repurchasing the equity it has lent.
That is only one of many reasons why US securities lenders are cautious in using equity repos. Unlike government securities repos, there are no standardized repo agreements.
In the US, tax and legal issues pertaining to government securities repos are still murky. The identity of the true owner is a thorny issue. When it comes to tax, the original owners of the securities don’t have to incur capital gains taxes, which means it doesn’t amount to a sale. But when equity repos are used, the new holders do receive dividends, which they return to the original owners and tax credits. In that sense, the repo is a sale.
The identity of the owner becomes an issue if there is a bankruptcy (in the case of most financial institutions an insolvency) of one counterparty. The other counterparty will press ownership claims so that it can liquidate the collateral. Courts and regulators have been reluctant to agree to this without a lengthy review of the economic reasons for the transaction. As a result, assets are often frozen at a time when markets are moving rapidly, further lowering the collateral’s value.
The possibility of this happening creates further problems for equity repos, since equities are more volatile than many other investments. There seems to be little agreement on the appropriate level of margin. Many agree that it’s less than the 50% required on broker call loans, but more than the 2% on other types of securities lending collateral.
Moreover, some in the market view equity repos as simply a way around Erisa prohibitions on taking collateral other than cash for pension fund securities lending. “When you lend out equities, a pension fund typically gets cash and 102% of collateral,” says Bargerhuff. If that cash is then invested in an equity repo, it’s the same as taking that repo as collateral. “If it’s a fund lending to a broker-dealer, they’re taking in the more volatile piece and giving the pension fund the more stable piece,” he explains. “You’re reversing roles. It puts the pension fund in the position of taking in the more volatile piece.”
Equity repos become a credit trade when the collateral is being reinvested in a repo secured by a lower-rated credit than what was lent. State Street’s Hodgman gives the examples of a lender lending government securities and taking equity repos, or lending US large-cap equities and taking repos secured by a triple-B credit. The risk, he says, would materialize if the purchaser of the repo had to liquidate the collateral because the counterparty defaulted. If the collateral is equities, and the market has moved against the holder (which is usually why the counterparty defaulted in the first place), there will be problems getting adequate cash.
Although many traditional US securities lenders and consultants to the industry are wary of using equity repos, the brokerages that are the borrowers are actively promoting them. Merrill Lynch’s Whitehead says he recently met with consultants who asked him how much more business his bank would do with their client, a traditional US security lender, if it were prepared to take non-cash collateral, such as equity repos. “My balances with them would probably triple,” he says. “At the end of the day, people are giving cash up, but they are being fully collateralized and then they get a return they wouldn’t get anywhere else in the market.” The market is largely untapped, too, since about 80% of US equities owned by institutions are not lent. Equity repos would facilitate that business.
Already such European institutions as SBC, UBS and Deutsche Bank are said to be doing equity repo trades with US pension funds, through a third party or in their London branches. “They do it everywhere but the US,” says a London banker. “They are very aggressive. They realize this is where they’re getting their market share.” And while the business has blossomed in Europe in recent years, it has yet to be tested in an equity bear market.
To capture the business, investment banks are starting to bypass securities-lending agents. Instead the equity finance departments of such institutions as Goldman Sachs and Bear Stearns are going directly to pension funds. They are also buying third-party institutions. Two years ago Goldman Sachs purchased Boston Global Advisors and recently Donaldson Lufkin Jenrette bought London Global Securities. Both securities-lending operations had been owned by Paloma Partners, a US-based hedge fund. DLJ and Goldman consequently became both lenders and borrowers, which many view as a further risk to the system.
“One of the biggest issues facing all of us is the continued consolidation of the players on either side of the transaction and the movement towards larger, and fewer participants,” says William Smith, managing director in charge of securities lending at Bankers Trust, which is a custodian and agent lender. Now, with the purchase of Alex Brown, it has become a major borrower. “It will challenge people’s risk and concentration analysis.” Concentration may not be a risk in itself, he suggests, but as any investor knows, “diversification is a factor looked on favourably in portfolio management”.
At the same time, many participants believe it is the increased risk in the system that is driving consolidation, as smaller players find themselves squeezed out because of the credit concerns of the securities’ owners and their agents.
It is such credit concerns, which market participants say are growing as leverage creeps back into the system, that are being heavily promoted by such institutions as triple-A rated UBS and Deutsche Bank. “In an Armageddon situation, capital is a comfort to the client,” says the head of securities lending at a highly rated European bank.
Others worry about the intrusion of brokerages into the business, saying it is just a way for them to control inventory. Brokerages have complained that the consolidation of custodians in the past decade has made it extremely expensive to borrow from those lenders, who often control the amount of securities lent to any one institution under single credit-limit guidelines. They say it is often just a way to limit supply artifically to boost their returns.
“The reason brokers are getting into the business is to gain more exclusive supply than they had before,” says UBS’s Tamburro. Recently, however, the new competitiveness in the business seems to have been turning the tables. Now borrowers have the upper hand and are often demanding heftier rebates.
Bargerhuff thinks that increasing the rebate paid back to the borrower is one of the most aggressive tactics employed by lending agents in today’s competitive marketplace. Rebates are involved in almost all transactions, he explains. When a security is borrowed, the dividend or interest flows back to the entity that lent it out. Meanwhile, the borrower has posted collateral to meet the lender’s safety considerations.
If the borrower had invested that collateral himself, he would have been receiving the income. By accepting a rebate below what the cash is earning, he pays for the use of the lent security.
Typically, the risk-free rate of return, as measured in an overnight treasury repo, for example, might earn 5.5%. If the borrower gets only 5.25%, he is paying 25bp to borrow. If a lender is willing to pay, say, 5.55% to the borrower, the lender will have to invest in more risk to create a return which he will split with the owner of the securities.
“Borrowers will do that trade all day and night,” says Bargerhuff. “What the securities’ owners don’t know is how much of the 25bp to 30bp return is coming from the above-the-risk-free rate and how much is coming from below it.” In other words, the higher the rebate the borrower can negotiate, the higher the risk profile of the investment needed to achieve adequate returns. “The folks who own the security are not being told what rebates are being paid to generate the activity,” he claims.
Many securities lenders insist the scales aren’t that stacked and argue that clients have become much more sophisticated and demand information on investments, in part because of the vast educational efforts of the consultant community since the 1994 debacles. “We view it as one of our primary jobs to make clients aware of what their potential exposures are,” says Bankers Trust’s Smith.
A number of the new third-party lending agents say they are gaining business by farming out the reinvestment aspects to an independent asset manager. Furman Selz, a small US brokerage that caters to hedge funds and was recently purchased by ING Barings, has just gone into the business in a joint venture with money manager Brinson Partners, which is charged with the investment side of the business.
In the US, UBS has hired an outside money manager to manage the cash collateral received from the securities-lending operation, which got off the ground only six months ago. And it has gone one step further to assuage the fears of its clients. Tamburro says that the bank has a couple of accounts that manage their own cash collateral. “They can invest in whatever they choose to invest in at their own risk.” These days, that just might be the safest way to go.
