Until recently, securities lending had all the hallmarks of a ‘free lunch’. It was modest, but easy money for superannuation funds. Securities were usually lent through a principal program, in which the custodian took on the counter-party and collateral risk, and provided that custodian was reputable, very little could go wrong.

The custodian on-lent the securities to borrowers, including hedge funds, who sometimes used the stock for short selling, but in a market where prices were continually going up, it was very hard for hedge funds to make money in that way. Even if it was obvious a company was in trouble, private equity frequently rode in and turned it around.

Now some of the stocks that are on loan are being returned at a fraction of their former values. Hedge funds and lending agents argue that short selling improves market efficiency – that those borrowed stocks were bound to plummet in price eventually anyway. And, if over-selling is occurring, it only creates value opportunities to buy.

Long only managers agree, but contend that the opacity of the lending industry creates an opportunity to circumvent the ASX shorting rules, and makes it impossible to tell whether price falls are actually due to genuine problems within a company.

With such a large proportion of the nation’s assets locked up in superannuation, superannuation funds lending stock has become an essential part of creating market liquidity. But if it is possible that the funds are facilitating a huge devaluation in their own portfolios through lending, a few basis points a year or half-price custodian fees hardly seems worth it anymore.

Because of the lack of transparency in the lending industry, to what extent the falls in prices are due to short selling, no one knows. One lending agent estimates the market size for lending Australian equities is probably about $70 billion. But they admit nobody has any real figures. You are likely to get as many different answers as people you ask.

Some superannuation funds have already decided to err on the side of caution. Equipsuper ceased its lending program last month. The fund’s chief executive, Robin Burns, says in a bear market environment where shares prices are under pressure, it appears that securities lending is exacerbating that downward pressure, and Equipsuper plans to stop lending until there is more clarity in the market. “We just think it is a matter of principle,” he says. “It is no longer in our members’ best interests. We are not against securities lending or short selling, and I don’t believe for one minute that short sellers were acting in collusion, but in the current environment, with the lack of transparency, the risks are no longer worth the return.”

According to David Bryant, chief investment officer at Australian Unity, neither stock lending nor short selling are inherently bad. “Short selling with transparency and within limits I have no problem with – I agree that would aid liquidity and allow people to take different views. “But I don’t accept the rationale that short selling helps to find the real price of a company, I think it finds a very different outcome, and we need transparency around what the loan positions are.”

Bryant argues that the lack of transparency creates an uneven playing field between long and short managers. “A short seller can borrow stock with a five per cent margin in, short sell it and take the sale proceeds, so the net capital out is 5 per cent. That’s 20:1 leverage. With no transparency around the net lent position, the long managers don’t know how much of the selling is coming from people that own the stock and are saying ‘that’s a fair price to sell at’, an important piece of information, versus people that don’t own the stock – have never owned the stock – and are simply trying to push the price down to a particular level. People are trying to tell me that this gives us an efficient market… I don’t accept it.

“We’ve got a credit squeeze, a nervous market, limited capital available, and the short sellers are not balancing the stock out,” he says. “Companies with sound underlying assets are being pushed against the wall. Prices have been driven so low that it’s triggering restructuring elements. Normally a company in that position could refinance, but in a global credit squeeze it can’t. It is a combination of market issues and economic issues. It’s not to say these companies haven’t made mistakes, and there shouldn’t be some price adjustment, but should they be pushed to the brink?”

Simon Bonouvrie, portfolio manager at Platypus Asset Management agrees there is no problem with securities lending and short selling – as long as it takes place within the ASX rules. The rules on short selling are designed to stop manipulation in the market and to stop deliberate bearing down of a company. “Through stock lending and unreported short-selling, these rules are being circumvented,” Bonouvrie says. “Hedge funds are probably out there hunting for margin loan levels deliberately to trigger more margin calls.

The ASX shorting rules, which are similar to the US and Canada shorting rules, are there to protect both issuers and investors. However, hedge funds and proprietary trading desks are not always transacting within these rules.” Don Williams of Platypus AM adds “you don’t have to be Einstein to realise there has been some serious price manipulation over the past few months”. The ASX monitors naked short-selling daily, but it is no secret that this accounts for only a fraction of the short selling actually taking place. Part of this is to do with the misnomer “stock lending”. Several years ago, a law was created that allowed the transfer of legal ownership of securities from a lender to a borrower for up to 12 months. As the “owner” the borrower does not have to abide by any short selling rules, or report to the ASX because they are deemed to own the stock.

Bonouvrie says that when short selling is combined with stock lending, it all goes unreported. “It’s a vicious circle: a stock gets lent out by a custodian, hedge funds short it, super funds say great, the share price has got cheaper, buys some more, it goes back into the custodian, gets lent again, the hedge funds borrow more, short sell it, super funds say great it’s even lower, buys some more, gets lent out again, and its just a big spiral –there’s no restrictions on it at all.”

Williams says it is the same as the profiteering that had been going on the long side with the private equity. “The surveillance is not working. People dealing in insider information and misinformation are not being prosecuted.” Greg Clerk, a consultant with JANA Investment Advisers, doubts transparency will involve disclosing the positions of individual short sellers. Large short positions are extremely risky, he says, and if you knew which hedge funds were holding them, it would be too easy to squeeze them. It would have to be disclosure around the aggregate position, but he admits he is not sure how much that information would be helpful.

“It won’t allow the ASX to see who is circumventing the rules, but it has to be better than the opacity we have now. “If you knew that zero stock was on loan and the price was diving, then something is definitely wrong with the company. But if there was a lot out on loan then you could say maybe there was some nefarious action going on.”

Baked-in opacity

According to lending agents it is not that the securities lending industry is intentionally withholding information; it is the nature of the industry which makes the information difficult to gather. Mark Faulkner, managing director at Spitalfields Advisors, a UK consultancy, says it’s an over-the-counter industry – it doesn’t have a central exchange either in individual markets or globally. “It’s not an industry where historically it’s been easy to understand what’s been going on,” he says. Securities lending developed from an operational base many years ago and is yet to find a central way of dealing on an exchange or electronically, where all the information might be available.

“While it’s an enormous business generating billions of dollars on a global scale, it’s quite difficult for people to believe that it is broadly done by the exchange of telephone messages, Excel spread sheets and lists, it’s still got some way to go to be in the 21st century,” Faulkner says. “There are initiatives, electronic systems, around to address that, but they don’t get global traction easily. It’s only in the past decade that front office people have really been focussing on this.”

This information vacuum has created a lot of confusion and rumour around the role securities lending has played in some of the spectacular company devaluations over the past few weeks. Faulkner says he is supportive of greater transparency – that is one of the things his business was founded to achieve. Spitalfields attempts to pull together information on global activity in the lending market so that practitioners in the industry can better understand their relative performance and market share. But rather than curbing the activity of recent weeks, Faulkner believes that greater transparency will only remove the blame from the securities lending industry.

“Take ABC Learning for example,” he says. “In January 2007, 86 per cent of the available stock was on loan, at which time the company had seen no negative impact on its price. Is it possible that the volumes associated with short selling took six months to work through? Or is there another reason that the price has fallen? If something is structurally wrong with a company, it doesn’t always manifest itself quickly. Some of the people who were short ABC Learning last winter may have sat on that short position, and taken the pain of the cost of borrowing and sat it out and really have been vindicated in the last few weeks. This idea that borrowing a stock to sell it short drives the price down – if life were that easy, everyone would be a hedge fund manager.”

Tom Elliot, managing director and co-founder of MM&E Capital, a hedge fund, agrees. “If you look at the companies who have attracted a lot of shorting, it is companies who are in trouble, whose business models aren’t good. Shorting may get the share price to where it was going to quicker than it might otherwise do, and might exaggerate the share price movement a little bit, but a short seller or even a group of them by themselves can’t create a false value for a stock.

“People say short selling should be disclosed. Fine, it wouldn’t make any difference if it was disclosed. If we lived in a world where everything was disclosed, say ‘okay, 30 per cent of this company is being shorted’. How would that help anyone? It wouldn’t tell them anything more than what the lowly share price does – that the company’s in trouble.”

Long-only managers argue that if every short position had to be reported, it would be possible to see short positions building up over time. It would help balance out the market. However one manager, when asked why he would want such information, simply replied: “It would tell me if someone knows something I don’t.”

Elliot says he wouldn’t have a problem if short selling levels were disclosed because by the time people get to know about them, they’ve already happened. “Short selling is a symptom of something being wrong, it is not a cause. Short sellers go where there are problems, but they don’t create the problems, they don’t make a company vulnerable. “With ABC Learning, people wanted to understand the margin loan, how much it was, and Eddy Groves refused to tell them. As a result people got fearful about it and assumed the worst, and in fact the worst turned out to be correct. Second, what caused it was not the fact that he had a margin loan against his stock; it was the fact that the company produced a six-month result that showed it had negative cash flow. That is what made the shares go down. Short sellers look for companies whose business models are unsound.”

Jonathan Little, chairman of BNY Mellon Asset Management (of The Mellon Group which owns 13 different funds manager brands, and also provides securities lending through its Bank of New York/Mellon custody arm) says he can understand both the pro- and anti-securities lending arguments. “A big case for the ‘against’ recently was Northern Rock – a bunch of shareholders basically had their stock confiscated by the Government, it’s worthless, and it was some hedge funds deliberately bottom-feeding and making a nuisance of themselves that helped create that situation,” Little says.

Indeed, between the end of June and end of July last year, the proportion of Northern Rock shares that had been shorted rose from 7 per cent to 15 per cent. By September, that short position had passed the 20 per cent mark (with a single hedge fund said to have been behind almost half that position), before the nationalisation announcement from the Bank of England. “One of Mellon’s managers, Newton, will obviously allow stock to be lent if clients direct them to, but they reserve the right to veto. For example if they are standing beside a board they rate highly, defending them against a hedge fund that is aggressively short-selling the company, they don’t want to facilitate that. It’s a part of their investment view, they’d just be acting against themselves to allow that stock to be lent in that instance,” Little says.

“Of course there are many instances where activist hedge funds have been a great positive influence on company performance, using a position to demand change to lazy management or to a strategy which has been underperforming. The thing about securities lending is that it’s much more flexible now than it was 10 years ago – an owner is able to call stock back very quickly these days.

“Hedge funds have certainly had an influence but I think investors are starting to learn to see beyond the simplistic view, you know -‘hedge funds are shorting this company, it must be in trouble’. They are looking at the fundamentals and making up their own minds.”

Natalie Floate, head of securities lending at BNP Paribas Securities Services, says transparency will stop criticism of securities lending when there is a market event, but it won’t stop a market event from occurring. “If everyone had disclosed their short positions in the companies that have experienced massive price drops so far, the same thing would have happened,” she says. “These were highly leveraged business models with some key dependancies that caused the concerns and short selling sometimes speeds up the price discovery `process.”

Nevertheless, the ASX and ASIC are investigating anecdotal accounts of some short sellers acting in concert and possibly trading on inside information. Early last month ASIC was approached by a number of market participants concerned that some individuals were deliberately spreading false information about listed securities to artificially provoke sales and lower market prices.

Most custodians are sceptical. “That’s one hell of a conspiracy theory,” says one. “If they [long managers] believe so much of the market has been driven down, go in and buy it, you’re getting it at a bargain. But they know that that’s not really the reason the shares have fallen. There’s a bit more to it than that. There are macroeconomic factors. It’s not just short selling. I just don’t buy into this conspiracy theory, I just don’t reckon there’s a whole group of hedge funds who get together around the world and say this is what we’re going to do, we’ll nail these guys. Go back to anyone of these companies and you can point out some fundamentals no matter where they were. They would have got caught, they over-geared too much.”

In or out?

Equipsuper’s Burns doesn’t credit the conspiracy theories around securities lending either, but still thinks the lack of transparency is enough reason to temporarily halt his fund’s lending program. However, the lending agents don’t think it will make any difference.

Spitalfields’ Faulkner says two or three funds in the Australian market have stopped lending, but are having virtually no impact upon the securities lending business or market prices, because there is good liquidity in the securities lending business. “What those lenders are doing is forgoing the opportunity to generate revenue from securities lending, creating some smaller operational issues for their lending agents, and probably making it unlikely that they will be able to return to the lending market any time soon. To some extent one could uncharitably say they are cutting of their noses to spite their faces. They will make no difference.”

According to one lending agent, a superannuation fund that stopped its lending program three or four years ago found it couldn’t re-enter the market when it changed its mind six weeks later. The agent said it was “cheeky” for a fund to pick and choose when it would add its revenue and liquidity to the market.

“Custodians require a stable supply of stocks on loan, and a fund that pulls out every time there is a negative market move is not a desirable client,” the agent said. JANA’s Clerk said the asset consultant has received a number of queries from its clients wanting reviews of their securities lending programs. JANA’s advice has been for the funds to continue.

Superannuation fund Host Plus has had a securities lending program for three or four years, co-ordinated by custodian JPMorgan Worldwide Securities Services. David Elia, chief executive officer, says the volatility in the market at the moment means the fund is making more money out of the program now than ever, although in the context of a $7.2 billion fund it’s still pretty small. “We’ve never asked JPMorgan for information on the counterparties they intend to lend our stock to. What would we do with that information if we had it? I’m of the view that you’re either in [securities lending] or you’re not. That being said, we have asked [our asset consultant] JANA to have another look at the program in light of some of the recent events, just to make sure it’s still providing a net benefit to our members.”

Another lender say it won’t make any difference if the Australian funds stop lending. The final outcome will be the same because funds overseas will continue to put their stock up for loan. “That will continue to happen, and they are much harder to regulate,” the lender says.

In any event, the securities which funds hold will not be protected from volatility created by lending unless the practice is stopped altogether. And there are a lot of entities in the securities lending market, including the Reserve Bank of Australia.

BNP Paribas’ Floate also points out that if a fund decides to stop lending its stock, it effectively increases the demand for that stock which drives up the price – a market distortion similar to that which hedge funds are accused of. If the securities lending industry is to have greater transparency, it will be driven by the prime brokers. Patrick Liddy, director of marketing and strategy at NAB Custodial Services, says the brokers he has spoken to say they want to have a position of monitoring the naked shorts and the gearing. “They’re actually insisting that they do this and are going out on the front foot.” If you are a super fund or insurance statutory fund, your investment time horizon is long term.

It could be argued that the trading strategies thwarted by securities lending and short selling are by nature shorter term strategies, and to some extent what happens day to day doesn’t matter in the grand scheme of things if your investment time horizon is a long one.

Securities lending is basically a situation in which asset-owners with a long term time horizon can generate income on an annuity basis. If they believe that their stocks will appreciate over the long term, irrespective of what other people do in the very short term, it’s probably a good way of generating additional returns for funds.

But as Paul Fiani, founder of Integrity Asset Management, points out, while superannuation funds are long term investors, their members live in a series of short runs, and managers have an interest in performance being good at all times. “You can say that super funds are a long term investment, but the ultimate client, the member, wants the return to be good every year, therefore the manger does too.”

We may not have heard the last story of a super fund suspending its securities lending program.

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