Trends Increasing Demand for Securities Lending

Interest rate moves, changes in collateral and ETF usage is driving a higher demand for securities lending programs from institutional investors, such as DB plans.

Securities lending is a way for institutional investors to generate incremental revenue for their portfolios by lending out their securities for collateral. George Trapp, head of Client Relations for North America at Northern Trust, Global Securities Lending, who is based in Chicago, describes it as “sort of like renting an apartment where you are an owner, but lending it out because there is demand for it.”

He says with the transaction, institutional investors should make sure they take all steps to price map correctly, do a mark to market valuation to make sure it is properly collateralized and investors are charging the right fee.

According to Trapp, there are a combination of reasons institutional investors, such as defined benefit (DB) plans, are interested in securities lending, with the primary reason being it generates incremental revenue. But, securities lending also provides liquidity in the financial market, and sometimes DB plans use other products securities lending supports—for example, a long-short strategy using hedge funds. Securities lending provides DB plans more liquidity than other securities. “And institutional investors can vet the program to meet their list of parameters,” Trapp says. “It is a low-risk investment, but investors can set parameters based on their risk tolerance, for example, using only U.S. Treasuries as collateral.”

There are a few trends Trapp and Northern Trust are seeing in the securities lending space. Higher interest rates are driving demand for clients. There are better spreads on cash collateral since service providers can charge a higher rate for borrowing securities.

“Overall as rates move up from a very low nominal rate, we’re seeing clients have the opportunity to make additional income if interest rate moves are well-predicted and transparent. If you don’t know an interest rate increase is coming or when, it dampers earnings,” he says. “The longer-term impact is positive. In a low interest rate environment, institutional investors are battling for every basis point they can. Higher interest rates are not a major issue in the securities lending market; institutional investors can charge more for loans.”

NEXT: Collateral changes

Those to whom institutional investors lend securities post collateral. If clients were beneficial owners, lending agents help clients define what they deem as acceptable collateral, Trapp explains. For example, Employee Retirement Income Security Act (ERISA) funds and mutual funds cannot accept equities as collateral.

One clear trend over last three year period—borne from Basel III requirements, an international regulatory accord that introduced a set of reforms designed to improve the regulation, supervision and risk management within the banking sector—is acceptance of securities as collateral versus cash, according to Trapp. He says it plays out globally as well as in the U.S. The market has moved to 70% accepting cash collateral five years ago, to now 40% to 50%. Clients are beginning to pledge lower quality or less high quality securities as collateral, causing an increase in securities collateral. Those lenders willing to accept a broader range of collateral are likely to be well-positioned to maximize revenue within their acceptable risk parameters.

It is important for institutional investors to accept a wide set of securities as collateral because cash is not accepted as before. However, Trapp reiterates that an ERISA fund may not be able to accept a wide variety of securities as collateral; they cannot accept equities, but can accept sovereign debt and corporate bonds.

But, clients are rewarded for using cash as collateral. “We have two competing trends,” Trapp says. “It is important for clients to be able to take cash but be flexible about securities collateral.”

NEXT: Concentrated demand and ETFs

Last year, three stocks represented a sizable chunk of the securities lending market, according to Northern Trust. The $220 million generated by lenders of Tesla shares, alone, was responsible for 3% of the securities lending industry’s total revenue, generated for lenders in the marketplace. Trapp explains that for DB plans lending out Tesla shares, assuming normal asset allocation across the plans, Tesla would have represented a large portion of overall earnings.

Trapp says he can’t name specific companies that will generate high revenue for securities lending this year, but generally, Northern Trust is seeing demand continue for securities lending products, and clients are coming from all different market segments. He says securities lending is working its way in the defined contribution (DC) plan market, as Northern Trust is seeing interest from DC plans. “Lenders should identify hot areas they think will see continued concentration,” Trapp says. “Retail and energy securities are in high demand, but it is hard to predict that one company that will drive revenue.”

According to Trapp, an interesting trend continues to be the use of exchange-traded funds (ETFs) by institutional investors. Northern Trust sees increased demand for lending of ETFs. Clients are using ETFs and holding more to get greater exposure to more areas of market. When it comes to lending, he says, it is a good area for clients who want to hedge positions for exposures they have—buying and selling ETFs is a quick way to do that. Trapp says emerging market and high yield bond ETFs are seeing the most demand.

Trapp notes that U.S. Treasuries have been very quiet over last three to five years, but as seen in the past year, especially in the fourth quarter, interest rates are starting to creep up. He says there is a natural demand for U.S. Treasuries to hedge against interest rate moves. As rates move up, Trapp believes the securities lending market will see more demand.

“Securities lending is absolutely good idea for DB plan sponsors. It is a way to get some incremental revenue,” Trapp concludes. “What is important is working with a lending agent to set up a program to reflect the lender’s risk appetite. They can set up a program for specific needs, deciding how much to lend and a minimum spread, or they can throw all that to the wayside and try to earn as much as they can.”