A combination of a low-interest-rate environment over the past few years and rising equities valuations has spurred a return to the securities lending market, driven in part by funds’ increasing scale and global outlook, and reversing a pullback by superannuation funds during the global financial crisis (GFC) and later the share market turmoil during the COVID-19 pandemic.
The Australian superannuation system is now approaching $4 trillion in value and is growing quickly. Australian Prudential Regulation Authority data shows it grew by 4.2 per cent in the March quarter of 2024 alone.
As they’ve grown, funds have started seeking out a broader range of investment opportunities for their rising cash flows, presenting additional lending opportunities from mature markets such as the US, UK and Japan, but also in emerging markets such as Korea, Taiwan and China, where fees can exceed 300 basis points for particular securities, especially in the more volatile sectors.
Funds’ investment heads are seeing an increased benefit in making the operational side of their business work harder.
“It can put assets that are on the super fund balance sheet to work, to allow for an incremental alpha generation.”
Jo Leaper, JANA
“From a tangible perspective, it is able to deliver an operational return. It can put assets that are on the superfund balance sheet to work, to allow for an incremental alpha generation,” says Jo Leaper, head of operational consulting at investment consultant JANA.
“Usually it’s not humongous, but in a good environment a conservative program could recoup potentially their custody fee costs.”
The renewed interest by Australian pension funds tracks the trend that saw the global securities finance industry generate a record US$10.7 billion in revenue for lenders in 2023, an 8.6 per cent improvement from the previous year, according to market data service DataLend.
It was primarily driven by strong borrower demand for equities in North America and Asia-Pacific, while a 25 per cent jump in fees to borrow corporate debt translated into a breakout year for the asset class.
Return to market
The largest industry funds, including AustralianSuper, Australian Retirement Trust, UniSuper, Cbus and REST have been active in lending securities – namely repos and equities – in international markets for decades.
Domestically, though, some stepped back from lending to short sellers during turbulent periods for equity markets, such as the GFC and the Covid-19 pandemic.
AMP’s head of portfolio management, Stuart Eliot, says his fund restarted securities lending recently, partly facilitated by a reallocation of the active risk and fee budget within the portfolio.
“We have been moving the portfolio into much more reliable and fundamental drivers of return, so things like private credit and direct infrastructure but also securities lending,” he said.
With equities and fixed income now less actively managed in the portfolio, allocations are managed passively, he says, and all of those passively managed assets are available to the securities lending program.
“They’re in high demand, and the extra returns we get from that are adding meaningfully to portfolio returns.”
Stuart Eliot, AMP
“Most of the utilisation in securities lending has been on the government bond side of things. They’re in high demand, and the extra returns we get from that are adding meaningfully to portfolio returns.”
Lending involves owners temporarily loaning securities to borrowers, who can use them for settlement of trades, margin requirements, or for hedging or derivatives arbitrage purpose.
In exchange, borrowers provide collateral for the duration of the loan, which can be invested to generate returns. The borrower also pays a fee for the use of the borrowed securities and compensates the lender for rights and distributions accruing on borrowed securities during the loan term.
Given the complex nature of the transaction, securities lending comes with numerous inherent risks including counter-party risk, where the borrower defaults on obligations; collateral risk, where the collateral falls short of the value of the security; the risk of regulatory constraints; and market risk such as price volatility or exchange rate fluctuations.
Investment managers say most of these can be mitigated through the efficient use of a risk framework and indemnified programs.
“All those risks are managed very carefully internally through our investment platform, where we can look at every counterparty, see what our exposure is, see what internal and external rating agencies have,” says Aware Super’s head of income and markets, Michael Clavin.
The $170 billion fund uses tri-party arrangements to ensure collateral is priced and valued daily, and where it may have a shortfall versus the loan position, calls are made within 24 hours.
“Within the cash collateral, we have very specific investment guidelines that we manage to make sure we are achieving an interest margin that is in the benefit of the members, but also managing the risk associated with that investment,” Clavin said.
Other challenges specific to the Australian market include undue attention focused on short selling and social expectations around corporate governance, which often forces funds to break loans and recall securities around proxy season in order to vote on stocks they hold.
The regulatory focus on illiquid investments in the portfolio also prevents the use of evergreen loan strategies commonly used in more mature markets.
Evolving market
The expansion of securities lending programs is part of the recognition by funds of the potential for generating higher yields through better use of investment decisions in a competitive market that can help offset rising administrative costs and custody fees.
“There’s an increasingly better understanding of what it means, which obviously links to internalising parts of the securities lending process,” says Otto Vaeisaenen, director for clearance and collateral management at The Bank of New York Mellon Corporation (BNY), a global financial services company and one of the biggest players in the global securities lending market.
“Today, it’s part of the stated investment strategy of a pension fund to have securities lending integrated into the portfolios because it generates good extra yield.”
Otto Vaeisaenen, BNY
“In the last few years, it’s become more of a must-have than a nice-to-have. Today, it’s part of the stated investment strategy of a pension fund to have securities lending integrated into the portfolios because it generates good extra yield.”
Vaeisaenen says BNY is seeing “more global clients benefit from alpha returns both in equity and fixed income lending, aiding market liquidity as well as facilitating asset mobility that enables counterparties to optimse their balance sheets”.
“With BNY’s leading market share within global fixed income lending, funds are able to leverage BNY’s distribution capabilities to move assets verses an extensive set of collateral options, optimised by BNY’s tri-party solutions – it’s an incredibly nimble solution set,” says Vaeisaenen.
The take-up of securities lending has also been aided by funds boosting internal treasury capabilities to take advantage of strong cash inflows and better manage their growing offshore investments.
JANA’s Leaper says the internalising of treasury management is helping securities lending transition to securities financing, and becoming more of a front office function, rather than a back-office task. With front office teams now taking decisions on securities loans because of the bigger and more complex alpha opportunity, the sophistication of the way lending is being done is improving.
“Super funds now have more internal expertise than what they would have had previously. And so you are getting a change of lens,” she says.
“As we see the sophistication of those investment teams continue to evolve, we’ll see more of that treasury management function come in-house, which likely means, if not more securities lending, we’ll see more securities financing through more awareness of their collateral program and how it can be used.”
