Securities Lending Carries More Risk Than We Can See

My colleague Carolyn Hill just wrote on our US site that securities lending “is simply not all that risky”. Carolyn was responding to an earlier blog by our colleague Spencer Bogart.

I’m with Spencer on this, Carolyn, and think securities lending is quite a bit riskier than you imply.

In your words, “it’s not just anyone who can borrow securities from these ETFs—they have to be creditworthy.”

In the 2008 annual securities lending report produced by iShares in Europe (I can no longer find this report on the issuer’s website, but I’m pretty certain the following is accurate) the fund manager listed its top five securities lending counterparties in the previous year. Among them was Lehman Brothers, which went bust a few months later.

That this was a sensitive topic for iShares was proved by the fact that when the following year’s securities lending report came out, all mention of counterparties had disappeared. And even now, if you go to the iShares website and look in the securities lending section for a particular fund, it doesn’t tell you to whom securities are on loan.

Now BlackRock, iShares’ parent company, tells me it has various levels of defence in place against counterparty and collateral risk when securities lending is undertaken.

In particular, a spokesperson says that: counterparty and collateral oversight is undertaken by BlackRock’s Risk & Quantitative Analysis group (RQA); credit limits to counterparties can be reduced and levels of overcollateralisation can be increased if required; loans and collateral are marked to market on a daily basis; and BlackRock Inc. provides indemnification against a potential collateral shortfall in case of a borrower default.

It’s also fair to point out that we have no evidence of any loss incurred by iShares clients as a result of Lehman’s 2008 default, at a time when no across-the-board indemnification was in place. The securities loans in the ETFs were collateralised, and the evidence suggests that there was sufficient collateral in place to protect investors’ interests as intended.

“BlackRock’s clients have never suffered a loss as a result of a borrower default since our securities lending programme’s inception,” the firm tells me.

But that’s not to say that counterparty risk hasn’t been incurred in the past and won’t be in future; or that someone might get the collateral calculation wrong in future or take collateral that doesn’t safeguard investors when a default occurs.

To give an example of where things might have gone wrong for ETF investors in the past as a result of counterparty risk, take a look at the iShares Euro STOXX 50 (DE) ETF’s holdings at the end of April 2008, and note the near-6% weighting in bank certificates issued by Morgan Stanley and Lehman (at the bottom of page 8).

Such certificates have routinely been owned by ETFs as a way of picking up extra income over dividend payment periods. But a Lehman certificate (which represented the unsecured debt of the bank) would have been near-worthless just six months after the iShares fund accounts were produced.

This is not to point a particular finger at iShares, by the way: any asset manager’s accounts from early- or mid-2008 might hint at similar near-misses and close shaves. But my point is that these risks were incurred, that they didn’t have to be and that the investors in the funds, not iShares, were liable if things went wrong.

And when you say, Carolyn, that ETFs “invest collateral in short-term instruments—money market funds (MMFs)—which are simply not risky,” you are ignoring the fact that, according to the recently departed head of the US regulator, the SEC, over 300 money market funds have been bailed out by their sponsors since the 1970s.

Just because MMF investors lost out only once or twice because fund sponsors stepped in to cover up losses on the other occasions doesn’t mean that there wasn’t a great deal of risk involved—and, incidentally, not just to the MMF investors, but to the whole financial system, given the enormous sums at stake.

Understanding the real risks in shadow banking activities like securities lending and repo is not at all easy.

As Paul Tucker of the Bank of England pointed out last year, the risks involved in securities lending are second-order, and contingent in nature. It’s not necessarily the first loan of securities from a fund like an ETF—which is what we see—that is a problem.

“The first lender of securities might lend against securities collateral and do no more; that is relatively common in European markets,” Tucker said in an April speech last year.

“But the entity that has borrowed those securities could themselves repo out the borrowed securities for cash, and employ the cash in a lending or credit-asset business. And so on—i.e., at any point in the chain of securities lending, an intermediary can build themselves a shadow banking business. Such chains can prove fragile for all sorts of reasons – because many securities are at call, and because many secured lenders try to realise their collateral instantly upon default,” Tucker concluded.

Regulators in Europe have decreed that revenues from securities lending within retail (UCITS) funds now have to be returned in full to investors, after a deduction for the costs of operating the programme. This should reduce the incentives for an ETF issuer to run a securities lending programme for its own benefit. In the US ETF market—which Carolyn and Spencer write about on—there’s still no such rule, by the way.

iShares tells me it has a 12-month transitional period to comply with the new European rules and for the time being is still taking 40 percent of gross lending revenues as its share. We’ll have to wait and see what it claims as acceptable costs for operating a share lending programme in the future, something the firm says it’s consulting with national regulators on.

As I wrote a couple of months ago, offering ETF clients a blanket indemnification against losses will certainly allow BlackRock to charge more for offering the lending service. It may also worry regulators if the asset manager’s balance sheet—traditionally way thinner than that of a bank—is put at significant risk.

Securities lending—and the equivalent collateral swaps that take place within synthetic (derivatives-based) ETFs—allow issuers significant leeway to offset fund expenses and improve tracking performance

But there’s no free lunch and we should never forget that these practices are risky.

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