By Roy Zimmerhansl, practice lead at Pierpoint Financial Consulting

Today I look at one phrase that has come up again recently and over the years I have heard it applied to securities lending from time to time. The suggestion is that securities lending generates paltry revenue and the pursuit of it is “like picking up pennies in front of a steamroller”, equivalent to a "Taleb distribution". The allegation from those using the "pennies" label to describe securities lending is that the returns are regular but small and investors are subject to huge losses. In this article, I will examine whether this assertion holds up.

What are the risks of lending?

Investors get paid to temporarily lend securities to borrowers. In doing so, they take on the risk that the borrower may not return shares in future due to insolvency, breach of contract or other reasons. The lender has various mitigants against this risk. First, the lender has complete control over which borrowers with which it will take on lending exposure and is able to cap that gross loan exposure per borrower at whatever level it chooses. Second, the lender is over-collateralised by the borrower with differential exposures marked to market daily with same-day settlement of collateral adjustments to maintain the over-collateralisation. Third, transactions are typically open-ended and subject to close-out tied to the relevant local market settlement time – so in the event of a rapidly deteriorating situation at an individual bank or securities firm, positions can be wound down quickly. Finally, many intermediaries that service institutional lenders provide further protection against counterparty loss through the provision of an indemnification, conceptually equivalent to an insurance policy.

Revenue

Now let’s examine the revenue side. According to IHS Markit Securities Finance, an aggregator of securities lending data, fees paid by securities borrowers to institutional lenders and their agents amounted to just over $10 billion USD for 2019, down approximately $600 million from 2018. This chart shows that while fees for any given year vary, they make a positive contribution each and every year. That's correct - cumulatively there has not been a net negative year - ever.

Also, if you look at the MSCI World Index, annual performance for the 15 years from November 2004 to November 2019, there were four down years, the worst year, of course, in 2008 with a 40.33% decline, followed by the best year in 2009 with growth of 30.79%. Higher reward opportunities usually carry higher risks.

Losses

People often think of a counterparty default as the reason for securities lending losses and at one stage I calculated that 17 different firms that have been engaged in securities lending have either defaulted or were rescued in the face of impending insolvency. While I am aware of individual lending firms that have suffered losses where they have had exposure to these entities, they have been very much at the margin rather than being representative of mainstream lenders. In my own experience I have dealt with firms that subsequently went out of business, but in each case, we wound down our exposure entirely prior to the default or were so over-collateralised we were protected and returned excess collateral to liquidators. Typically, rather than counterparty-triggered losses, cash collateral is usually at the centre of losses tied to securities lending. 

Securities lending is often categorised and regulated as a technique for Efficient Portfolio Management. As with all investment activity, there is a risk of loss and of course there have been losses experienced by lenders. When cash is provided as collateral by borrowers, lenders or their agents make investments in the money market. At key moments in time, market disruptions can lead to losses on investments and this has resulted in some losses for securities lending related cash investments as well. Without going into too much detail, publicly disclosed losses occurred in; 1982, 1992, 1994 and 2008.

Today, cash collateral represents a much smaller proportion of securities lending collateral and its market share has been declining for many years. Approximately one-third of securities lending collateral is currently cash and the majority of that is taken against loans of US equities and corporate bonds. Some of that change is as a result of regulatory changes, some of it due to prevailing interest rates and investment options.

Conclusion

To be clear, I am not comparing securities lending returns to those available from outright investments as it is like “comparing apples and pears” as we say in the UK. Investments carry higher risks and investors should therefore expect to receive higher returns over time to compensate for that risk. Securities lending generates relatively small returns – the “pennies” part of the phrase. I think that these returns are commensurate with the relatively small risks involved. While I can't predict the future, I don't see the steamroller anywhere in the history of the business - in other words, no single year has resulted in a cumulative loss for lenders. The results and experience for individual lending participants may vary, just like individual investors’ experiences in the stock/bond markets don’t necessarily reflect market-wide returns due to individual choices and timing.

To me, the continuous, cumulative annual positive income effect of securities lending is more akin to the “miracle of compound interest”. Small, incremental, positive-only returns, which may vary year on year in absolute terms, that accumulate over time to have a meaningful impact. Given that the typical lenders are pension funds, sovereign wealth funds and retail funds such as mutual funds, UCITS and ETFS, this longer-term perspective seems particularly appropriate.

So rather than “pennies in front of a steamroller”, a more appropriate description might be “dollar bills in front of a tricycle”. It’s worthwhile to collect the money and while there is still the chance of an accident, you should be able to see it coming, but if the worst happens and you miss it, it’s unlikely to kill you.

This is an abridged article. The full article was published by Pierpoint Financial Consulting on January 7.