A rough guide to securities lending
Loaning shares to other investors can be a lucrative income stream for pension schemes. How can trustees make it work for them? Maggie Williams explains
Pension schemes are long term investors. They tend to buy and hold shares for years, possibly decades, rather than selling them for short term gain.
As a result, those shares can sit idle in trustees’ portfolios for a significant length of time.
Securities lending – loaning shares to a third party – means they can put their investments to extra use.
When trustees loan shares, they receive an equivalent amount of cash, bonds or other assets as collateral. In addition to the collateral, the lender also receives a fee for the loan of the shares.
The fees gained from securities lending can be a good way of generating some extra income from those otherwise ‘idle’ assets. Trustees are more likely to lend shares than to borrow them.
Typically, organisations such as investment banks would borrow shares from trustees. Sometimes – but more rarely – trustees might also lend shares to other types of investors such as hedge funds. The securities lending process is usually carried out by the scheme’s custodian.
The custodian will manage transfers of the shares to the borrower, handle the collateral and ensure that the shares are returned safely at the agreed time.
Corporate governance Shareholders’ management of the companies in which they hold equities. This could include voting at shareholder meetings on issues such as executive pay
Counterparty The other party in a loan or a swap transaction. For example, if trustees loaned shares to an investment bank, the investment bank would be the trustees’ counterparty
Custodian An organisation that physically holds assets such as shares and bonds on behalf of trustees
Mark to market The process of valuing assets according to the current state of the markets
ALL ABOUT COLLATERAL
Getting the level of collateral right is essential, as this money is the compensation that trustees will receive should a borrower be unable to return the shares.
Generally, it will be greater than the value of the shares being loaned. The additional cost is to allow for changes in the value of the shares over the course of the loan, and is termed a margin. Even with a margin in place, sometimes the value of the collateral has to be adjusted.
The custodian (or whoever is acting on behalf of the trustees) should agree the terms under which the collateral should be changed between the borrower and the lender when the loan arrangement is first set up.
Reasons for changing the value of the collateral could be:
■ A substantial change in the value of the shares that isn’t covered by the margin;
■ Fluctuations in exchange rates if the shares are in a currency other than sterling.
Generally, the relationship between collateral and the value of the underlying shares is tracked on a daily basis, using market prices under what is known as ‘mark-to-market’ accounting.
The type and variety of assets used for collateral will also need to be agreed between the custodian, the borrower and the lender.
While cash is the most common asset used for collateral, trustees may feel more comfortable with a mix of different assets, such as equities and bonds as well as cash. They may also want to put limits on the quality of assets that are acceptable as collateral – such as triple A rated bonds only.
WHAT ARE THE RISKS?
For many schemes, securities lending can represent a healthy income stream. In theory at least, there are few financial downsides – trustees retain income from dividends, for example, and won’t lose out if the value of the shares increases while they are out on loan.
The most obvious risk in securities lending is that the borrower becomes insolvent, cannot return the shares and that the collateral it has posted does not cover the value of the loan. In that instance, trustees could lose some or all of the value of the loan. This is termed counterparty risk.
Voting rights are another consideration. Trustees relinquish voting rights associated with shares once they lend them to a third party. This could affect schemes that have a strong corporate governance code and want to use their shareholder voting rights actively. However, it is usually possible to recall shares for voting purposes.
There are other governance concerns that can be associated with securities lending. For example, once the borrower has received the shares, unless otherwise specified in the loan agreement, they can pretty much do what they like with them.
That could include lending them to another borrower in turn. In this instance, trustees might not know what sort or quality of collateral has been posted by the second lender to the original lender, what length of time their shares have been lent for, or under what conditions.
In the past, there was often very little clarity around how a borrower could use the trustees’ assets. This had serious ramifications when markets collapsed in 2008. Since then, trustees and custodians have become far stricter about the rules they set for securities lending. Trustees have also become much more demanding about the quality and regularity of reports that they want about their lending deals.
■ Securities lending means loaning shares to a third party, in exchange for collateral
■ Trustees also earn an additional fee from the party that has borrowed the shares
■ Securities lending is usually managed by the scheme custodian
■ Trustees will need to decide what is suitable for use as collateral
IT’S ALL IN THE DETAIL
Some of the important details to define when drawing up a securities lending agreement with custodians and counterparties are:
■ Who the trustee board is prepared to lend to. For example, they might be prepared to lend to investment banks, but not to hedge funds.
■ What the borrower can and can’t do with the equities while they are on loan. For example, are they able to lend the shares to others?
■ What is meant by a ‘business day’ for the purposes of returning shares and marking market prices if the borrower is in a different time zone from the lender. Generally, the business day is set as the time zone in which the shares are traded, so, UK time if they are traded on the London Stock Exchange.
■ How often mark-to-market measurements are made. Typically this would be once a day, but more frequent marking-to-market may be required in extreme circumstances.
■ Acceptable collateral – including how any top-ups to the collateral will be managed and how the custodian will manage/ invest the collateral.
■ The circumstances in which owners can and can’t recall their shares.
IS IT RIGHT FOR MY SCHEME?
■ Trustees retain most of the benefits of share ownership when they lend them, but lose voting rights
■ Trustees need to define carefully how the shares can be used by the counterparty once they have been lent
■ In certain circumstances, trustees can recall loaned shares before the term of the agreement is up
Most schemes hold significant amounts of shares for long periods of time and are therefore in a position to carry out securities lending activities should they wish. However, there may be restrictions on what they can do and there are a number of points to bear in mind:
■ The relationship between the risks of securities lending and the scheme’s overall risk budget or risk appetite.
■ Whether the scheme’s rules allow securities lending.
■ Possible limitations on what proportion of assets can be lent out at any one time.
■ How the custodians handle securities lending if there are fees involved and its effect on the overall value of the deal for the pension scheme.
■ Implications on voting rights for loaned shares – particularly in exceptional circumstances such as emergency shareholder meetings.