“It’s been viewed as an administrative decision,” says Lisa Laird, practice leader in the Los Angeles office of Watson Wyatt Investment Consulting. “But we’ve seen in the last year that securities lending can have real risks, and needs to considered part of the investment process.” Earnings on lending have fallen with interest rates, and the seizing up of credit markets has led to losses.
“The risks in securities lending have been there for 20 years, but recent market events have opened our eyes,” says Charles Millard, director of the Pension Benefit Guaranty Corporation (PBGC). This past week the agency issued a request for information from securities lending providers (see PBGC Looking for Securities Lending Partners ), the first step toward developing best practices for the business – as the PBGC did earlier in 2008 when it promulgated a set of standards for portfolio transition management (see PLANSPONSOR September 2008, “A new track for transitions “). “PBGC needs to bring to its securities lending program a view of proper risk-adjusted return on capital, as we do with any other assets,” he explains.
Many institutions – pension funds, mutual funds, and others – lend portions of their long-term holdings to other players in the market. (US institutions tend to lend about 20% of their holdings, according to the Risk Management Association.) The borrowers give provide the lender with collateral, often in the form of cash, and the lender agrees to pay them a “rebate rate” on the collateral, determined by the scarcity of the security being lent. During the lending period, the collateral is generally invested in some type of short-term investment fund, which is, in turn, composed of high-quality short-term instruments. The difference between the STIF earnings and the rebate rate is split between the lending institution and the agent that carries all this out, typically a custodian bank.
The problem lately has been that with interest rates at such low levels, the cash has underperformed the rebate rate, and there have been principal losses on the assets in the STIF funds. "There are three risks in securities lending," says Laird: "Income risk, principal risk and operational risk, and today the first two are front-and-center in the market."
"The whole point is that all this time you were collecting all those nickels and pennies from securities lending, at what you thought was no risk, because you had the collateral," says one market observer. "The risk is not enormous, but agents weren't telling clients that there was, say, a 1-in-40 chance your $100 bond would drop to $97." STIF funds typically are invested in high quality instruments, but the credit crunch has caused brought a halt to trading and a markdown of even A-rated bonds.
In some cases, lenders have not been able to access the STIF funds, and leaving the securities lending market altogether. "That has really put an onus on the management and trustees of these funds, to raise their hands and say 'I understand these risks,'" notes Rich Marin, CEO of GSL Advisors, New York, one of the securities lending providers responding to the RFI.
"We see now that securities lending contains real risks, and needs to be treated like any other part of an investment policy, and institutions need to know whether they are being compensated for the risks they take," says Millard. The PBGC's program is substantial: at the end of September 2008, PBGC had loaned about $ 3.6 billion of securities, , and earned $35 million for the year then ended.
"It's become clear that this is a segment of the financial services industry that does not have a best practices standard," Millard notes: "It's a complex part of the business, and through this request for information we want to get the industry's best thinking on the subject."
Providers can answer the RFI until December 22, after which PBGC staff will prepare a report from the different firms' views. PBGC's chief investment officer, John Greenberg, is also closely involved in the project (see PBGC Turns to MD's Greenberg as CIO ).
"We want to ensure that the PBCG and other institutions are getting the most from their securities lending services," he adds. "We want to explore whether competition among providers would be beneficial to us as a client. And we want to see what people suggest about reporting and monitoring, post and pre-trade analytics and the correct investment of collateral. We're looking at every part of the business to be sure that it is transparent to us, and help the industry too."
- John Keefe
The RFI can be found on the Federal Business Opportunities Web site here. Responses must be received by 10:00 a.m. EST on December 22.
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