Seeking Alpha asks is securities lending starting to dry up a little?
(emphasis mine) [my comment]
Is Securities Lending Starting to Dry Up a Little?
December 04, 2008
It's fair to say that the hedge fund industry as we know it would not exist if it weren't for one critical, but often ignored function - securities lending [securities lending is a potentially legitimate practice which was severely abused in recent years]. Like the proverbial swimming duck, a steady flow of stock "borrow" used for short-selling hides the mayhem that goes on just below the waterline.
Through their custodians or on their own, institutional investors often make their holdings available for loan (although some argue that securities lending is not technically a loan). Doing so routinely produces a small revenue stream with
very little risk [enormous amount of risk (for example, see *****401(k)s Hit by Withdrawal Freezes*****)]. In other words, the closest thing to a free lunch that exists today [THERE ARE NO FREE LUNCHES]. According to the International Security Lending Association (ISLA), there was about $2 trillion worth of securities on loan at the beginning of 2008.
Short selling and securities leading together create demand for twice the worth of the security on loan. So, lending $2 trillion securities for normal short selling would create the demand for $4 trillion US bonds:
A) $2 trillion comes from the cash collateral given to securities lenders (pension funds, 401k plans, etc...)
B) $2 trillion comes from the collateral held in the short seller's margin account.
Total demand = $4 trillion
The graphic below shows how, when one short sale occurs, it creates twice the demand for US bonds.
But the credit crunch is starting to eat this free lunch. Demand has been hit by temporary short-selling bans around the world. Spooked by what they regard as new counter-party risks, and motivated by a sense of vigilante justice against short sellers, several major institutional investors have unilaterally curtailed their securities lending programs recently. The head of Citigroup's securities finance group recently told Global Pensions that:
"The supply/demand dynamics of the securities lending market have been disrupted...The long term effects on demand will depend on the broader impacts of the bans and their duration. Some players are restricting lending activity and the market needs to work through these imbalances to find a new equilibrium."
Last week Watson Wyatt urged its clients to revisit their securities lending practices. In a note to clients the firm recommended revisiting collateral requirements and potentially even suspend their lending programmes. The company said:
While [we acknowledge] that it would be an extreme chain of events that invokes indemnification and then for it to fail, Watson Wyatt recommends its clients be aware of the potential risks...
What risks in particular? Pensions & Investments explained one of the biggies in an October article:
Institutional investors thought the collateral was invested in safe, plain-vanilla securities. Somewhere after 2000, however, the range of permissible investments was expanded to include things such as asset-backed securities and home equity loans, which have been eviscerated by the credit crisis...
It really doesn't take much to disrupt the "supply/demand dynamics" of this market. Growing concerns over whether institutional investors would cease lending prompted the International Securities Lending Association to issue a joint statement with several securities associations in September pleading with lenders:
...we encourage lenders to continue to make financial shares available for lending in order to support market making and efficient settlement. Any wholesale withdrawal of financial shares would have highly unwelcome consequences for liquidity in the cash equity and derivatives markets that would be against the interests of investing institutions and contrary to the stated intentions of regulators in introducing these measures.
According to Spitalfields Advisors, a UK-based consulting firm, the actual amount of stock on loan at any given time actually pales in comparison to the total stock market (about 5% of global equity markets). The following chart constructed with data from the firm's "2007 Securities Lending Year Book" makes the case (values in US $trillions as of December 31, 2007):
Some of the world's biggest players in this market happen to be based in Canada (CIBC Mellon, RBC Dexia etc.). So last week, the Alternative Investment Management Association (AIMA) held a luncheon panel discussion for a packed room in downtown Toronto to get a handle on how the credit crunch was impacting the securities lending business. James Slater, a Senior VP at CIBC Mellon presented some new and sobering data from Data Explorer, a data vendor tracking the securities lending market. The following chart was constructed with data presented by Slater at the luncheon (shows US market only in USD).
The drop in total lendable assets wasn't just a result of the market falling however, the actual number of lendable securities also fell over this period. Data Explorers' Stock Lending Index (DESLI) shows a global drop of 15 % in the total number of stocks available for lending from September 1st to November 19th - perhaps reflecting how some institutions are beginning to pull in the reins in their lending programmes (chart right - click to enlarge).
Meanwhile, the total number of stocks of the world's largest (and most liquid) companies shorted has almost doubled during this time as the chart from Data Explorers' website shows. (This pop isn't apparent in the dollar-value data shown in the chart above, but we called Data Explorers and they confirmed that we were reading their graph correctly. CIBC Mellon's Slater hypothesizes that there is a divergence in the shorting activity in the largest stocks used to construct the DESLI and the shorting activity in the overall market.)
In any event, this increase in demand for shorting of larger names is bound to put upward pressure on their annual borrow costs (which were estimated by Spitalfields to be between 20 bps and about 50 bps at the end of 2007).
So like a swimming duck, lendable stock often seems to flow from lender to borrower with apparent ease. But just below the waterline, a complex marketplace reflects a constantly changing supply and demand for this lifeblood of the hedge fund industry.
HSBC reports about lending, borrowing and 130/30 funds.
Lending, Borrowing and 130/30
The securities lending industry is growing fast. Statistics published by Data Explorers show that, since the end of the three-year bear market in 2003, the value of securities available for loan in the global marketplace has grown at an estimated compound annual rate of 15 to 20% to $13.2 trillion. Of that sum, the value actually on loan in the spring of this year was $3.5 trillion. Yet, there remains ample room for further growth on the supply side of the market. The assets managed by the global fund management industry in pension plans, mutual funds and insurance funds at the end of 2006 were estimated to be worth $55 trillion. Merrill Lynch estimates a further $33 trillion is managed by the private wealth management industry.
This Lending $3.5 trillion securities created the demand for $6 trillion US bonds:
A) $3.5 trillion comes from the cash collateral given to securities lenders (pension funds, 401k plans, etc...)
B) $2.5 trillion (3.5 trillion — 1 trillion from 130/30 funds (see below)) comes from the collateral held in the short seller's margin account.
Total demand = $6 trillion
(I didn't worry about 130/30 funds when I calculated the 4 trillion in the first article because I wanted a round number.)
It follows that the value of securities for loan could double and still account for less than a third of assets under management. There are now forces at work, which mean that rapid expansion is likely to happen. Securities lending began in the back office of broker-dealing houses looking to cover trade failures or cover short positions by borrowing securities from custodians of the assets of long-only institutional investors. But the industry is now driven by the trading strategies of hedge fund managers, the proprietary trading desks of the major investment banks and a burgeoning group of traditional fund managers that are developing absolute return strategies that necessitate something entirely new for them: going short.
Market participants that go short need to borrow securities. What they want to borrow, and what is available to lend, is widening as well as deepening. As they scour the world for higher returns, the same broker-dealers and fund managers are buying and selling and holding a broader range of asset classes (such as emerging market debt and equities and asset-backed bonds) in a greater variety of markets (notably in Asia). They are also making greater use of synthetic alternatives to the cash markets. Since these assets need to be financed—and, increasingly in the OTC derivatives markets, collateralised—the range of instruments available for borrowing and for use as collateral is widening. The capital relief afforded by the Basel II regime to banks that lend on a collateralised basis is further fuelling the growth of securities lending.
All of these developments mean that securities lending has ceased to be a purely operational activity. It has become not only an integral part of financing, but a trading activity and an investment management discipline in its own right. So it is not surprising that borrowers have sought alternative sources of supply, or that lenders have sought to increase their returns by developing new routes to market, or that exchanges and inter-dealer brokers are developing electronic lending and borrowing trading platforms.
The discovery and use of alternative routes to market have continued to put downward pressure on aspects of the lending market forcing innovation [INNOVATION. How I hate that word sometimes.] in order to increase profitability and retain market share. With revenue splits being weighted increasingly in favour of the lender and prime brokers taking a large proportion of the lending revenue stream by servicing hedge fund demand, it follows that the role of the custodian in the securities lending market has to change. Instead of treating securities lending as a proxy for a custody fee, agent lenders must transform themselves into asset managers, whose task is to maximise the value of the portfolios of a client, even if that means directing assets via a third-party lender or an auction platform, or indeed taking principal risk in lending to end borrowers as opposed to intermediaries.
This is why HSBC Bank pic (HSBC) offers clients a range of options for accessing the lending market. As in any investment management activity, that choice depends on where the managers of the fund wish to strike the balance between risk and reward. But, nonetheless, for many lending clients the defining advantage of an agent lending program is the limited risk: Assets are part of a pool lent to a diversified selection of pre-approved borrowers, and transactions are underpinned not only by eligible collateral but by indemnities against loss provided by the agent lender. Indemnities are highly sought after by lending clients—in aggregate, the top global custodians disclosed indemnities worth more than $1.7 trillion at the end of last year. [Like FDIC insurance, these guarantees are worthless if the institution making them is insolvent]
Historically, the market has been based on institutional clients lending stock; however, current trends see institutional clients expanding their investment mandates to include borrowing for short-selling purposes. Evidence of this on both sides of the Atlantic is the increasing popularity of 130/30 funds, which allow fund managers to run short positions as part of their day-to-day search for incremental alpha. Because they remain 100% net invested by being 130% long of favoured stocks and 30% short of unfavoured stocks, 130/30 funds need stock l oan accounts. They need them to receive the proceeds of the short sales, which are then used to augment the long positions without the need to borrow money, and to facilitate the stock borrowing needed to maintain the position. This is why 130/30 funds are helping to drive the expansion of the securities lending markets. But they also impose novel service requirements. Because they need to go short, 130/30 fund managers require not only custody and fund accounting, but fully integrated securities lending/borrowing and collateral management, plus the execution services to effect the initial short sale and subsequent buy-back.
Not all custodian banks are well-placed to supply these services on an integrated basis. Securities lending is always an operationally intense activity, requiring tight coordination between the monitoring of the assets in custody and on loan, the marking-to-market or reinvestment of collateral received, the recall and substitution, and the asset-servicing functions. But 130/30 funds add further complexity, chiefly in their demand for execution services. With its global execution, asset and fund servicing capabilities, HSBC possesses all of the ingredients to offer fund managers a fully integrated, low-risk method of entry into the growing market for 130/30 investment strategies.
My reaction: Together with the derivative markets and repo markets, securities lending is one of the "innovations" whose use and abuse helped wreck the US financial system.
1) Since the end of the three-year bear market in 2003, the value of securities available for loan in the global marketplace has grown at an estimated compound annual rate of 15 to 20% to $13.2 trillion.
2) The growth in the securities lending industry was driven by new trading strategies necessitated shorting market. 130/30 funds exemplify the use of these new strategies.
3) The value actually on loan at the beginning of 2008 was between $2 and $3.5 trillion, creating the demand for between 4 and 6 trillion US bonds.
4) Somewhere after 2000, the range of permissible investments was expanded to include things such as asset-backed securities and home equity loans, which have been eviscerated by the credit crisis... The result is that Institutional investors were surprised by how many toxic securities they held as collateral, including long-dated MBS.
5) There was drop of 15% in the total number of stocks available for lending from September 1st to November 19th as some institutions pulled back on their lending programs.
6) Further wholesale withdrawal of lendable securities would have highly unwelcome consequences for liquidity in the cash equity and derivatives markets. (if securities lenders stop lending, it will another create a cash crunch)
Conclusion: Like the exponential growth of the global derivative market, the rapid spread of security lending helped create demand for US bonds and drive down interest rates. Also, as with derivatives, the security lending market has begun to shrink, which is now destroying demand for US bonds and helping drive up interest rates.