From the desk of Roy Zimmerhansl
Practice Lead, Pierpoint Financial Consulting
I’d like to wish readers a Happy, Healthy and Prosperous New Year and welcome you to our first post of 2020. Just as a reminder to those that have been following us for a while and as an introduction to new readers, we established Pierpoint to bring more transparency and clarity to the securities lending business. Japan’s Government Pension Investment Funds’ December decision to suspend its foreign equity lending programme ensured that the spotlight would be on securities lending and short selling as 2019 wound down and the stories have continued into the new year. Followers can expect us to explore many of the issues raised by that decision and the surrounding commentary regarding it.
Today I look at one phrase that has come up again recently and over the years I have heard it applied to securities lending from time to time. The suggestion is that securities lending generates paltry revenue and the pursuit of it is “like picking up pennies in front of a steamroller”, equivalent to a "Taleb distribution". For those unfamiliar with a Taleb distribution, it is credited by Wikipedia to journalist Martin Wolf and economist John Kay who coined the phrase to describe investments with a "high probability of a modest gain and a low probability of huge losses in any period.” The allegation from those using the "pennies" label to describe securities lending is that the returns are regular but small and investors are subject to huge losses. This blog examines whether that assertion holds up.
Apologies for all those readers that are already familiar with this, but for the sake of completeness and for those less familiar with lending, I’d like to start at the beginning - risk.
What are the risks of lending?
Investors get paid to temporarily lend securities to borrowers. In doing so, they take on the risk that the borrower may not return shares in future due to insolvency, breach of contract or other reasons. The lender has various mitigants against this risk. First, the lender has complete control over which borrowers with which it will take on lending exposure and is able to cap that gross loan exposure per borrower at whatever level it chooses. Second, the lender is over-collateralised by the borrower with differential exposures marked to market daily with same-day settlement of collateral adjustments to maintain the over-collateralisation. Third, transactions are typically open-ended and subject to close-out tied to the relevant local market settlement time – so in the event of a rapidly deteriorating situation at an individual bank or securities firm, positions can be wound down quickly. Finally, many intermediaries that service institutional lenders provide further protection against counterparty loss through the provision of an indemnification, conceptually equivalent to an insurance policy.
Consequently, for an investor to lose out due to a borrower default, the following combination of factors has to occur: 1) a borrower the investor has continued to be comfortable having exposure to must default, with 2) a concurrent adverse movement in the value of assets on loan versus the value of the collateral and 3) for those benefiting from an indemnification, their service provider must also default on its contractual obligations.
Even so, one would expect a prudent investor to lend to a range of borrowers, so given a sensible diversification requirement placed on service providers by the investor, the potential scope for loss is limited. In the unlikely event of this combination of factors, the loss would not be the full value of the securities on loan, rather it would only be the difference between the proceeds of any collateral sales versus the replacement cost of repurchasing the loaned assets (as well as any unpaid dividends, interest and fees owed by the defaulting entity) for a single defaulting counterparty (such as Lehman Brothers).
Now let’s examine the revenue side. According to IHS Markit Securities Finance, an aggregator of securities lending data, fees paid by securities borrowers to institutional lenders and their agents amounted to just over $10 billion USD for 2019, down approximately $600 million from 2018. The chart below shows that while fees for any given year vary, they make a positive contribution each and every year. That's correct - cumulatively there has not been a net negative year - ever.
Source: IHS Markit Securities Finance
I have included below the Asset Class Quilt of Total Returns which I took from NBR with the data credited to BoA Merrill Lynch and Bloomberg. As you will see there is not a single asset class that does not experience a down year, aside from cash (somewhat ironic given my comments later in this post). Similarly, if you look at the MSCI World Index annual performance for the 15 years from November 2004 – November 2019, there were 4 down years, the worst year of course in 2008 with a -40.33% decline, followed by the best year +30.79 (2009). Higher reward opportunities usually carry higher risks.
People often think of a counterparty default as the reason for securities lending losses and at one stage I calculated that 17 different firms that have been engaged in securities lending have either defaulted or were rescued in the face of impending insolvency. While I am aware of individual lending firms that have suffered losses where they have had exposure to these entities, they have been very much at the margin rather than being representative of mainstream lenders. In my own experience I have dealt with firms that subsequently went out of business, but in each case, we wound down our exposure entirely prior to the default or were so over-collateralised we were protected and returned excess collateral to liquidators. Typically, rather than counterparty-triggered losses, cash collateral is usually at the centre of losses tied to securities lending.
Securities lending is often categorised and regulated as a technique for Efficient Portfolio Management. As with all investment activity, there is a risk of loss and of course there have been losses experienced by lenders. When cash is provided as collateral by borrowers, lenders or their agents make investments in the money market. At key moments in time, market disruptions can lead to losses on investments and this has resulted in some losses for securities lending related cash investments as well. Without going into too much detail, publicly disclosed losses occurred in:
1982: Resulting from flawed mark to market industry practice for accrued interest rather than cash reinvestments. Market practice changed and this has not been a risk since that time.
1992: Some investors purchased commercial paper from an issuer that went into bankruptcy protection and did not redeem the paper until it emerged from protection. Not so much a loss, instead a funding cost and an opportunity cost for a handful of large investors.
1994: Some investors used securities lending cash to purchase instruments called “inverse floaters” which carried interest rate risk. Interest rate rises caused losses for those investors. In some cases, investors suffered the losses; in others the agents absorbed the losses in several ways including compensation payments, taking the investments onto the agent’s own balance sheet through outright purchase or other arrangements.
2008: The market disruption that started with sub-prime mortgages in 2007 affected money market liquidity and was exacerbated by the Lehman Brothers’ default. The combination of declining markets, strained liquidity, ratings downgrades of some issuers and in some cases poor investment decisions by investors or agents created conditions that led to losses. Lawsuits and private settlements ensued and while losses occurred, these were not even close to the estimated $13.2 billion USD earned in 2008 by lenders and agents.
Today, cash collateral represents a much smaller proportion of securities lending collateral and its market share has been declining for many years. Approximately one-third of securities lending collateral is currently cash and the majority of that is taken against loans of US equities and corporate bonds. Some of that change is as a result of regulatory changes, some of it due to prevailing interest rates and investment options.
To be clear, I am not comparing securities lending returns to those available from outright investments as it is like “comparing apples and pears” as we say in the UK. Investments carry higher risks and investors should therefore expect to receive higher returns over time to compensate for that risk. Securities lending generates relatively small returns – the “pennies” part of the phrase. I think that these returns are commensurate with the relatively small risks involved. While I can't predict the future, I don't see the steamroller anywhere in the history of the business - in other words, no single year has resulted in a cumulative loss for lenders. The results and experience for individual lending participants may vary, just like individual investors’ experiences in the stock/bond markets don’t necessarily reflect market-wide returns due to individual choices and timing.
To me, the continuous, cumulative annual positive income effect of securities lending is more akin to the “miracle of compound interest”. Small, incremental, positive-only returns, which may vary year on year in absolute terms, that accumulate over time to have a meaningful impact. Given that the typical lenders are pension funds, sovereign wealth funds and retail funds such as mutual funds, UCITS and ETFS, this longer-term perspective seems particularly appropriate.
So rather than “pennies in front of a steamroller”, a more appropriate description might be “dollar bills in front of a tricycle”. It’s worthwhile to collect the money and while there is still the chance of an accident, you should be able to see it coming, but if the worst happens and you miss it, it’s unlikely to kill you.