Effective Securities Lending Strategies
IN PRINT ARCHIVE CIR Fall 2008
Securities Lending Strategies
By James Slater, senior vice-president & head of capital markets, CIBC Mellon
The Canadian securities lending industry has evolved significantly over the last 10 years. This evolution has brought beneficial owners a broader range of program options, the potential for greater returns and the ability to measure and compare the performance of their securities lending agents.
The Canadian custodial securities lending market is large and growing. The market now boasts C$1.1 trillion in lendable assets and more than $170 billion in assets on loan—up 50% over the last four years, according to Performance Explorer1. This growth has been spurred by demand for trading strategies requiring securities borrowing among hedge funds and manufacturers of derivatives and other synthetic products.
Emerging from the shadows
In the past, securities lending did not get serious attention from the asset management community as it was buried deep within the back office. The market was opaque and lenders had limited reporting information. Beneficial owners were unable to compare their securities lending revenues with those of their peers, or with returns generated by other securities lending providers.
This lack of transparency had as much to do with a paucity of market data as it did with the disinterest of some institutional investors. As a case in point, a number of years ago a large U.S. pension fund representative in a panel discussion on securities lending reporting said something like: “I use an agent lender. They send me a pile of reports each month. I only look at the one that shows how much money I made.”
One sign of market maturity is greater transparency. Canadian securities lenders now have access to useful performance reporting, and they are increasingly likely to work with their clients to help them understand their portfolio performance, and attribution, in relation to their peers.
One thing is clear from a review of this performance reporting: not all securities lenders are created equal in terms of revenue generation for their clients. As clients achieve greater understanding of the impact of different program choices on alpha generation, we anticipate greater objectivity and sophistication in the selection of securities lenders, including an evaluation of the estimates provided by agent lenders.
In relation to estimates, many consultants overestimate the importance of the revenue split between lender and beneficial owner. While splits are an important factor, if an agent lender consistently underperforms the competition, then a more favourable split may not mean greater relative returns. Just as it is not prudent to buy investment management services based solely on the management expense ratio (MER), focusing only on the revenue split distracts beneficial owners from measuring and assessing the total revenue potential.
Securities lending returns are increasingly material contributors to alpha. Pension plans used to earn between two to four basis points from securities lending, and now a typical balanced portfolio is earning five to 10 basis points. For government fixed income and international equity portfolios, clients are currently earning revenues between two and three times higher.
One reason for superior returns is the growth of securities lending against cash collateral. In these transactions lenders earn revenue not only based on the intrinsic value of the security loaned but also income derived from the reinvestment of cash collateral. Over the past year or so, cash collateral balances grew 50% to more than $30 billion from approximately $20 billion, according to Performance Explorer.
Ten years ago, collateral for Canadian securities lending transactions was overwhelmingly securities collateral–typically government or bank paper and convertible securities. Now, agent lenders have more sophisticated risk monitoring systems at their disposal that allow them to administer a diverse mix of cash and securities collateral.
enhances returns in several ways. By offering more flexible collateral
options to borrowers, lenders capitalize on new opportunities to
do business. Accepting cash and securities collateral also offers
the opportunity to generate incremental returns through the cash
reinvestment process, in addition to returns based on the intrinsic
value of the security being lent.
The Canadian securities lending market has experienced a remarkable amount of change over the last decade. These changes have benefited beneficial owners as they now experience higher returns and greater interest from global borrowers. These positive trends are expected to continue as cash collateral becomes more broadly accepted in Canada. Finally, new transparency tools have brought beneficial owners the ability to gain greater insight into the risk and reward characteristics of their securities lending arrangements, and to objectively assess the impact of new program choices on their portfolios.1 Performance Explorer is a product of U.K.-based Data Explorers Limited.