April 2009
Securities lending weathers the storm
While 2008 was a challenging year for securities lending, the industry was able to weather the storm and deliver many plan sponsors record-setting revenues. Among the obstacles faced by the industry last year, two significant events stand out above the rest:
- The default of Lehman Brothers
- Short selling bans imposed in various major markets including Canada
In relation to the Lehman Brothers default, safeguards in securities lenders’ programs worked as designed to protect the securities’ owners. Legal contracts performed effectively and, in the vast majority of situations, collateral was adequate to facilitate the timely return of borrowed securities. The safeguards worked exactly as they were set up to work.
The short selling bans introduced in September across various major markets were initially greeted with enthusiasm. However, the effectiveness of the bans is now being questioned by market participants and academics around the world.
Securities lending demystified
Before exploring the mechanics of securities lending transactions, it is important to understand that the global securities lending market has significant scale. At the end of October 2008, assets available for lending in Canada were approximately $902 billion, according to the UK-based securities lending consultant Data Explorers. Of these assets sourced from Canadian institutions, approximately $109 billion was on loan. By comparison, there were $11 trillion of assets available for lending globally, with $2.3 trillion on loan at the end of October.
In general, the securities lending process is quite straightforward. Plan sponsors lend their securities to borrowers – typically through intermediaries such as custodian banks acting as securities lenders or as agents – to generate incremental returns. In securities lending, plan sponsors (or beneficial owners) transfer the title of their securities to qualified borrowers against collateral (which is held by the securities lender or agent) in amounts which are in excess of the value of the lent security. Beneficial owners receive any equivalent dividend payments or interest earned on lent securities during the term of the loan.
In Canada, collateral requirements for borrowing pension plan securities range from 102 to 105 per cent of the value of each lent security. This collateral requirement has been felt to be appropriate to protect lenders against borrower default. Collateral may include cash, equities and fixed income, and is marked to market on a daily basis to ensure adequate coverage of outstanding loans.
Securities lending resilience
The securities lending industry in Canada and abroad has weathered various unexpected and high profile events since the credit crisis began in August 2007. In 2008, the Lehman Brothers’ bankruptcy and restrictions on short selling of financial sector equities had a particularly strong impact on the securities lending market.
Borrower defaults are extremely rare. Before the Lehman Brothers bankruptcy, I am not aware of any cases of any Canadian custodial lending programs being impacted by borrower default. In addition to Lehman Brothers, other institutions defaulted on their securities lending obligations in 2008, including AIG and Washington Mutual – although the impact of these defaults was less significant in Canada than in the U.S.
The Lehman Brothers default tested the resilience of the industry and, in turn, each securities lender. Lenders quickly acted to recall beneficial owners’ securities and to quickly and efficiently liquidate collateral to buy in any unreturned securities. Due to this decisive action, securities lenders were able to return lent securities to clients without any adverse impact on their portfolios or trading activity.
Restrictions on short selling also drew attention to securities lending. On September 19, the U.S. Securities and Exchange Commission (SEC) elected to halt short selling in almost 800 financial sector companies in an attempt to stabilize the financial markets. The Ontario Securities Commission (OSC) followed suit by banning short selling in 13 inter-listed TSX-traded equities to prevent regulatory arbitrage. These bans expired on October 9 after an extension on October 3.
Although the SEC applied the ban to “restore equilibrium to the market,” many industry analysts agree that the restrictions on short selling had a negative effect on the marketplace, rather than a positive one as intended.
Restrictions on short selling
The rationale behind restricting short selling was to limit additional downward selling pressure on troubled financial services companies. This action was taken to help restore confidence in the credit markets and to encourage financial services companies to continue lending to their clients in order to stimulate the economy. In the cases of Lehman Brothers, Bear Stearns, AIG and others, rapidly declining equity prices had an appreciable impact on confidence in these institutions among their largest trading counterparties.
It appears, however, that short sellers were not the cause of fundamental weakness in these companies or the financial sector itself. First, these financial services companies were already reeling from the shock of the global subprime mortgage meltdown, weakened balance sheets, and record-breaking asset write-downs. Second, long-term holders of these securities exerted strong selling pressure as the value of their long-term investments became increasingly vulnerable to severe decline.
Commenting on the outcome of the short selling bans, SEC chairman Christopher Cox anecdotally remarked to Reuters that: “while the actual effects of this temporary action will not be fully understood for many more months, if not years, knowing what we know now, I believe on balance the commission would not do it again. The costs appear to outweigh the benefits.”
From a Canadian standpoint, the Investment Industry Regulatory Organization of Canada (IIROC) released an analysis on October 6 outlining evidence of further unexpected consequences resulting from the bans. Among other things, surveillance data showed that the bans brought “no appreciable impact on the price of [these] securities” and a “significant increase” in volatility of restricted shares.
Greater market volatility
Academic research echoed these observations, arguing that short selling was not the ultimate cause of failing financial services firms. Arturo Bris, professor of finance at IMD in Switzerland, has closely examined the impact of short selling bans and is one of the most vocal supporters of the value of short selling to financial markets. He argues that the recent short selling bans contributed to greater market volatility, less efficient price discovery, and slower reaction to market news.
Bris demonstrated that short sellers were not the cause of steep market declines and they were merely reacting to what was already happening in the market. He examined short selling volumes on September 9, 2008, when rumours of a Lehman Brothers bankruptcy were widely discussed. On that day, short sellers sold well after long investors began selling mass quantities of Lehman Brothers stock.
Considerable academic evidence suggests that short selling contributes to stronger financial markets by providing efficient price discovery, less volatility and greater liquidity. In addition, short selling creates new investment opportunities for institutional investors, efficient derivatives market-making among dealers, and the chance to generate further portfolio income for beneficial owners.
Looking forward
Although 2008 was a challenging year, the Canadian securities lending industry remains strong, having successfully navigated the storm. Securities lenders demonstrated they can manage risk and protect the interests of their clients in the face of major systemic shocks. From this position of confidence in the industry, pension plan sponsors are encouraged to initiate deeper dialogue with lenders. Securities lending remains a safe and valuable way for plan sponsors wishing to support sagging portfolio values.
In a future article, we will look at opportunities to enhance returns from securities lending and explore how plan sponsors can measure and attribute the performance of their securities lenders.
By James Slater, senior vice president, capital markets
Reprinted with permission from Benefits and Pensions Monitor, February 2009 edition
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Trade Talk® is provided for general information purposes only and CIBC Mellon Global Securities Services Company, CIBC Mellon Trust Company, CIBC, The Bank of New York Mellon Corporation and their affiliates make no representations or warranties as to its accuracy or completeness. Readers should be aware the content of this publication should not be regarded as legal, tax, accounting, investment, financial or other professional advice nor is it intended for such use.
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