December 2009

Securities lending in a post-Lehman world

Historically, securities lending has been viewed as a low-risk way for beneficial owners to earn incremental revenues on otherwise idle assets.  Central banks have promoted securities lending as a key ingredient of efficient markets, assisting in aiding price discovery and in providing liquidity.

After the Lehman Brothers default, securities lending moved from the back-office to the headlines as some media reports depicted short sellers as significant contributors to the Lehman collapse. Consequently, various jurisdictions throughout the world introduced short-term bans on shorting. 

In response, some lenders put restrictions on their securities lending programs or ceased lending altogether.  It is estimated that globally between 10 and 25 per cent of funds restricted or exited lending in the months following the Lehman default.  In Canada, this figure was approximately 10 to 15 per cent, and half of the plans that exited their lending programs have subsequently returned.

On counterparty default

Since the industry’s inception, agent lenders such as CIBC Mellon have spent significant time and effort putting in place controls and tools to help mitigate the risks associated with securities lending.  A few of these measures include:

• Implementing industry standard documentation that provides remedies in case of a default or breach of contract.
• Making significant investments in securities lending and risk systems.
• Creating appropriate program guidelines for credit limits and for the amount and type of collateral required to protect lenders.

The Lehman default tested the effectiveness of these risk mitigants.  During this extremely challenging time, legal contracts held up, collateral was seized and sold, and lent securities were bought and settled efficiently.  The risk model performed as designed. 

From a counterparty default perspective, the Canadian securities lending industry has moved from a message of “there has never been a counterparty default affecting Canadian securities lenders,” to one of “there has been a default, but there were no resulting securities lending losses incurred by CIBC Mellon or by any lenders in CIBC Mellon’s program."

Since the Lehman default there has been a lot of on-going media coverage concerning losses in cash collateral re-investment programs.  While re-investment results varied from market to market and between providers, CIBC Mellon's results have been impressive: there have been no re-investment losses, there are no "bad" assets and the daily valuation of all of our re-investment pools is at or just above C$1 (priced to the bid).  Revenue performance for our cash collateral lending clients has been significantly better than those in non-cash collateral only programs. In addition, there are no gates or restrictions on exiting our securities lending program.

On feeding the shorts

Post Lehman, academics wrote papers that were overwhelmingly in support of short selling.  They argued that stocks subject to the bans suffered a severe degradation in market quality as measured by spreads, price impacts, and intraday volatility.

In Canada, IIROC found that restricted stocks had lower trading volumes and more volatility than did non-restricted stocks.  In the U.S., former SEC chairman Christopher Cox said that agreeing to the three-week ban on shorting of 799 financial stocks was the biggest mistake of his tenure.

Short selling is just one driver for securities lending and executing pure shorts represents a small amount of borrower demand. The majority of  borrower demand comes from hedging and financing strategies.  

Why do participants continue lending?

While the latter half of 2008 and the beginning of 2009 was a stressful period for securities lenders, it is clear that the Canadian securities lending market has emerged significantly stronger and with a greater profile, which is good news for all practitioners.

So, why do beneficial owners lend in a post-Lehman world? Because there are tremendous benefits for the marketplace and for lending participants. Lenders generate additional revenues on assets that would otherwise sit idle.  They lend to generate alpha.  They lend because it is a relatively low-risk activity.  And by all of us participating in lending, we aid price discovery, provide liquidity and make markets more efficient.

By Rob Ferguson, vice president, product & client service, global securities lending

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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.