Many investors are quite rightly asking questions about the inherent risks in the securities lending business. While typically sold to investors as a business that is low risk and generates a modest return, events of the past fifteen months have caused a spotlight to be cast on securities lending as a whole. The risks for lending ETFs are the same as for another other equity instrument and I will examine these below.
Why engage in securities lending at all?
First, it is revenue generated from otherwise static assets. The decision to buy the asset has already been made, and securities lending provides a way to improve returns from holding that asset. The investment decision itself has dramatically greater scope for gains and losses, whereas under normal circumstances, securities lending returns are only positive.
Second, lending activity is fully collateralised and is marked to market on a daily basis. Lenders can choose acceptable collateral types, margin and enforce concentration and diversification limits.
Third, and in my view the most important issue, your primary risk is counterparty selection. The importance of sound credit analysis and risk management practices cannot be underestimated, nor can it simply be outsourced to credit rating agencies as the sole arbiters of credit worthiness.
Fourth, stock loan transactions are almost all conducted on an “open” basis, meaning that either side can cancel any or all outstanding transactions without penalty with a minimal notice period of a few days at most. In a deteriorating credit environment a lender can reduce exposure or even cease trading with a counterparty in very short order.
Finally, it is also possible to have further counterparty protection through indemnifications issued by many of the top agent lending organisations.
A quick comment about the Lehman situation. Obviously I can’t go into specifics as I am not privy to any such information. Many former Lehman clients have well-publicised concerns over access to cash and securities held by Lehman or used by Lehman in the conduct of its business. However, I can’t find any evidence of losses that have impacted beneficial owners through conventional stock lending business transacted with Lehman as a borrower of equities.
It is important to remember that in the event of counterparty default, your sole objective is to replace the stock you have on loan. You achieve this by selling your collateral and buying back the stock on loan. Replacing an ETF is somewhat easier in that it is possible to create the ETF as opposed to the requirement to buy a specific stock on the market.
Clearly a stock’s liquidity may impact the market maker’s price in creating the ETF, but it is less of a concern when replacing an ETF. The only time an investor suffers a loss is in the event the sale of the collateral is not sufficient to cover the repurchase cost. It then needs to rely upon any indemnification from its lending agent; otherwise it would become a creditor of a defaulting borrower.
ETFs can be involved directly or indirectly in securities lending in one of two ways:
An investor in ETFs (or its agent) lends the ETF itself.
- The issuer of the ETF holds the underlying constituent stocks in an ETF and lends these shares into the market.
In the first scenario the ETF investor has the most control. After all, the investor can choose which counterparties with which it will trade, the terms and type of collateral it will accept, the provider of lending services and by implication in this choice, the further indemnification it could receive.
The second scenario is where the ETF issuer itself is lending the underlying stocks within the ETF or in fact the ETF itself. The motivation for the issuer to engage in lending may be twofold: to reduce the expense ratio for the ETF and, if there is a split of the securities lending revenues between investors and the issuer, to generate additional income.