The heads of investment operations at QSuper and Sunsuper, plus representatives from NAB Asset Servicing and senior consultants from Deloitte and Dymond Foulds & Vaughan met in July to answer the most common questions on securities lending.
What is the additional workload created by an extensive securities lending program?
The prognosis of both the head of investment operations at QSuper and Sunsuper is that the hardest work in running a securities lending program is the initial set up. Once it is running it is relatively light work.
Kyle Ringrose, head of investment operations at QSuper, says: “When we first put it in, we were all over it every minute of the day, shaping everything. Once you got the process, the policies and the systems all ironed down it is a matter of monitoring it and making sure there are no breaches.”
Making the investment case was also lengthy and “not straightforward”, in gathering information that could convince the board that the returns would outweigh the risks, says Ringrose.
Lounarda David, head of investment operations at Sunsuper, has a similar account. “A lot of effort goes into getting the approval to actually do the due diligence before you go into the program,” she says. “The amount of time and effort and scrutiny that is required to prove the rewards outweighs the risks.”
As far as resources go both agree that a fund may need a full time employee to look after the role, though Ringrose caveats this by stating: “It is fair to say that FTE does have a lot of time to spend onother things as well as a securities lending program.” In this context he says the costs are “small and easy to justify.”
He adds this is not a role for a fresh graduate. “You need someone who has been in the industry long enough to really understand the mechanics from the front to the back,” he says.
By common consensus the reporting requirements created by Stronger Super were small and not a disincentive. Vaughan said these requirements meant trustees need to understand how much has been lent, who it had been lent to, what collateral was sitting behind the arrangement and what the returns were.
What are the largest misconceptions about securities lending?
Drew Vaughan principal at Dymond, Foulds and Vaughan felt strongly that investor misconceptions of securities lending were common, but a general lack of transparency was partly to blame. He says: “Many clients have told me they do not participate in securities lending and fail to realise the unit trusts they invest in have in turn lent to securities lending agents.”
The roots of these misunderstandings started when custody services were offered to investors for free if they agreed to take part in securities lending programs.
Similarly, he says, agents such as custodians have not always been clear who the counter parties were in transactions. He speculates that if regulation was introduced to drive greater transparency it would drive much greater uptake of securities lending. Hypothetically, if this did happen you would get so much uptake that the value of securities lending would decline, as there would be more supply than demand.
Lounarda David agrees this issue of transparency was holding securities lending back. “Trustees are becoming a little bit more aware. They do not feel comfortable when you give them a half-baked answer. A number pulled out a few years ago and have not gone back, because they have not been able to have those questions answered properly. The responsibility level is getting higher and they get uncomfortable.”
Tony Gregorio, head of financial market services at NAB Asset Servicing, agrees: “Over the last five years there are far more intelligent questions coming from clients because they are investing in people who understand securities lending.”
For Ringrose, the biggest perception of risk of those uninitiated in securities lending is that they will not have their securities returned, but that this was actually one of the smallest risks. He explains: “You always hold collateral over securities, so when Lehman Brothers went down the lenders had more than enough collateral to buy back their securities and nobody lost anything. You also have indemnity with an agent if they should fail to recover the securities.”
What is the difference between a principal lending program and an agent?
Broadly speaking an agent will act on an investor’s behalf and match them to borrowers of securities, often in tailored arrangements. A principal lending program is more likely to lend on pools of securities from a group of investors and will take on much of the work and the legal responsibility. With an agent the investor has an exposure to the borrower and the agent, but with a principal lender, the exposure is to them alone. NAB operates a principal lending program for the Australian market.
Gregorio says: “Our program tries to take some of that burden away from clients. We acknowledge they may not have a credit assessment team the size of our credit assessment department. So we can lift that burden from some of the smaller clients or clients who do not want to have the FTE impacts of a securities lending program; those that want to receive reports and get oversight but do not want to control the whole process themselves.”
He adds the legal agreements are simpler for principal lenders, with standardised arrangements.
Lounarda David says: “The onus is on the client who is negotiating the contract to find the gaps in the contract, trustees cannot delegate these processes.” And she questioned how much information investors in a co-mingled principal lending program would get on their particular exposure.
Gregorio answers that principal lending programs had evolved to now offer greater visibility and for the last three years NAB have used a UK provider to benchmark the returns for clients against the market. They offer monthly reports including exposures and earning statements and can drill down to allow them to request further details such as the mechanics of the program. “The reality is, many clients do not utilise those reports or marginally use them,” he says, adding that if they over engineer the process there is a danger costs will increase and impact on returns.
Another advantage of a principal lending agent such as NAB is having in-house legal experts with sufficient experience of securities lending. “Our lawyer has engaged with legal people who really do not understand securities lending as well as they should and are advising clients,” Gregorio says.
What are the historical returns of securities lending?
The broad answer is that the returns depend on how the investor designs their program. So if a fund regularly pulls back shares for voting it will cut returns. Similarly, if they are prepared to invest the collateral received in high yield bonds rather than in overnight cash accounts, they have the potential to make bigger returns.
For those looking for a ballpark figure Gregorio says the average return for clients is 4.8bps, a figure seen as credible by Ringrose who cited 4bps as the average for Qsuper, which had met expectations for the fund. One variation to this average is that global securities have traditionally produced higher returns than domestic securities.
Siva Navarathnam, a partner in the the financial services advisory group at Deloitte, made the point that once interest rates rise again, the returns on conservatively invested collateral should rise for investors.
Does securities lending lead to market volatility?
The proposition that securities lending actually aids market liquidity and brings stocks closer to their fair value, rather than cause sharp volatility, was broadly accepted by the panel, particularly as there is widespread research on the topic. So why should an investor lend their stocks if this is going to lead to them falling in value? Ringrose says: “If you are a net buyer of equities, which most super funds are, this is a good thing.”
How will Basel III impact on securities lending?
According to NAB, Basel III will level the playing field amongst custodians that have acted as lending agents. Gregorio says NAB has always put aside capital provision for its securities lending exposures, but that custodians that have not yet complied with the treaty do not yet do this.
“In terms of the non-Basel III compliant providers, they have been accounting for indemnity as a contingent liability on their documents, so there is going to be an impact on those types of agents who have historically not allocated capital and not understood the risk-weighted asset complications. That will drive some push back to clients in terms of fee splits and indemnities that will be put in place.”
Navarathnam believes such custodians will pass on the extra cost to clients. “The challenge will be for agents to have a good hard look at their return on expenditure. Under Basel III they have to hold 30 days-worth of liquid assets for a stress period. This means that they will need liquidity which is going to cost money.”
Can proxy voting still take place in a securities lending program?
One of the decisions an investor will face with their securities lending program is whether they will prioritise using their voting rights on the companies whose shares they have lent out.
Habitually recalling securities to exercise voting rights would impact on revenues. Lounarda David says Sunsuper would always recall the securities to vote. “Voting is far more important for us than the revenue we make going forward from lending. We do not want to give the control of that decision to somebody else.”
Gregorio says that this was the situation for domestic equities. “Here we recall all securities for voting as the majority of our clients are super funds and they vote 100 per cent of the time.” Complications in international markets meant it was not always possible to vote.
“There are difficulties in certain jurisdictions,” he says. “What we have found with some clients is that they have accepted that they might not have the ability to vote in those markets where we cannot recall quickly enough to get the securities back.
“We encourage those clients, or their appointed fund managers, to instruct NAB of their intention to vote well before the standard settlement time of that market’s AGM record date, allowing a recall to take place.”
What is the best type of collateral for investors to hold while their securities are being lent?
In Australia the bulk of collateral held for domestic equities is in cash, however, increasingly borrowers are looking at lenders’ collateral flexibility, and equity collateral is increasing in popularity. Cash might appear the safest type of collateral to hold, but many got burnt and investors lost out in the global financial crisis. Ringrose recalls that when the GFC happened, the first people in the queue to take out cash from pooled funds were able to liquidate, but those that came later had to wait which was costly for some and has ultimately led to the end of pooled collateral arrangements. Even then this is still a risk where collateral is held in a long dated cash investment program and the lender needs to exit a lending arrangement early. Here the investor may also incur a loss.
Ringrose says: “To me the real risk is reinvestment of cash collateral because that is where you do not get the indemnity from the lending agent. One of the things you have to be conscious of is not having controls for black swan events. Do your controls work then in the GFC or the 87 crash? Because that is the only time it matters.”
David equally emphasised the importance of collateral. She described it as the area that should be focused on the most.
What is the appetite for investors to launch their first securities lending programs?
Christine Bartlett, executive general manager for asset servicing at NAB, is starting to see more clients showing an interest in securities lending. “They are under cost pressure and looking for returns,” she explains.
Vaughan says the take up of securities lending would depend on how risk averse investors were. Those that wanted all collateral in cash, to pull stock back to vote or to impose limits on how much was lent could find the returns did not justify the outlay on the program.
Bartlett concludes: “We encourage beneficial owners, current and new to securities lending, to engage in conversations with their custodian to learn more about the product.”