The July 2008 alert includes two articles that deal with the esoteric subject of securities lending by retirement plans. For those of you that are unfamiliar with securities lending, generally borrowers, such as hedge funds, use the borrowed shares for short selling purposes. While securities lending is commonplace it is more controversial today than ever due to concerns regarding the impact of short sellers upon the financial markets. The first article concludes that pensions and funds would be challenged (due to a lack of transparency) to fully understand the details of the lending agreements they have entered into or the fees borrowers are paying intermediaries (such as prime brokers) to borrow plan securities. The second article, by the CEO of OneChicago LLC, discusses use of single stock futures to accomplish the same economic result as securities lending, without many of the risks.
Securities Lending By Pensions: An Emerging Duty of Best Execution in Securities Lending?
The threshold question fiduciaries of retirement plans should consider is whether these plans as owners of securities should lend their shares to hedge funds and others for short selling purposes, incurring the risk that such shorting may cause the price of the portfolio securities to fall, default and other risks. Assuming plan fiduciaries determine that participation in lending programs may be worthwhile, despite the risks, then it is incumbent upon them to ensure that the owners are adequately compensated for the lendings. This requires not only a thorough understanding of the risks involved, but also the fees borrowers pay. Fiduciaries have a duty to maximize returns related to all plan assets, including securities involved in lending programs. We believe the parties owning the assets should receive the lion's share of the returns related to the lendings.
Our conclusion is that pensions and funds would be challenged (due to lack of transparency) to fully understand (1) the financial details of the lending agreements they have entered into (i.e., how much they are paying intermediaries); and (2) the fees the ultimate borrowers are paying to borrow their securities (i.e., market rates for borrowing). Few funds have the sophistication required for item (1) above and there is no readily accessible source for determining market rates for borrowing specific securities required for item (2). Consequently, the fiduciaries to these plans are incapable of determining whether the owners are being adequately compensated for lending portfolio securities. Disclosure by retirement plans of the details related to securities lending, including any discussion that lending to short sellers may contribute to a decline in the values of portfolio securities; the terms of the revenue split with any lending agent; conflicts of interest related to use of affiliated agents and information related to the market prices for borrowers pay, is absent.
The beneficiaries of this lack of effective oversight of lending programs or lack of "best execution" in securities lending are the lending agents and prime brokers. Our conclusion is that the lending agents and prime brokers receive the majority of the revenues related to securities lending. The owners of the securities that are on loan appear to receive less than a quarter of the lending revenues. Analysis of the actual percentages of lending revenues received by securities owners may reveal that certain lending arrangements are even more disadvantageous to securities owners.
Retirement plans do not generally lend their securities directly to the parties who are the ultimate borrowers of their securities, e.g., hedge funds. Some of the largest retirement plans and hedge funds may attempt to deal directly and thereby realize savings but this is rare. The argument in support of use of intermediaries, such as lending agents and prime brokers, is that they provide important services, such as review of creditworthiness of borrowers that justify their (huge) fees.
Generally plans lend their securities through a lending agent. Often the lending agent is affiliated with the custodian of the plan's assets. All the major custodians have affiliated lending agents as lending revenue can significantly enhance the profitability of a bank's relationship with a plan. The custodian offers or recommends the lending program as an additional service to its custody clients which will supplement the income clients derive from plan assets. A conflict of interest exists related to this recommendation by a party (the custodian) that has a pre-existing fiduciary relationship with the plan because the lending program will also supplement the custodian's income. There may not be adequate disclosure of the various risks and rewards related to lending. Clearly attention would not be drawn to the disparity between the fees borrowers pay and the fees lenders receive (described more fully below). Further, other lending agents not affiliated with the custodian may not be considered, even though they may offer more favorable lending terms or opportunities.
When the SEC allows mutual funds to lend through affiliated lending agents (which is common), the exemptive relief the Commission grants provides that the arrangement with the affiliate must be as favorable as with an unaffiliated lending agent. Yet the exemptive relief appears to leave room for fund boards to determine that using a higher cost affiliated lending agent may be in the best interests of the fund if other benefits are present to the fund. A recent Commission sweep examination of the lending practices of affiliated agents apparently found rampant abuses. The results of this sweep examination (i.e., the nature of violations uncovered) were discussed by Commission officials with the mutual fund industry at industry events, however, in what is emerging as a disturbing standard SEC practice, mutual fund investors were not advised that they had been harmed.
There are two main duties of the lending agent, in addition to scrutinizing the creditworthiness of the borrower and operational details. First, the agent is responsible for generating the highest possible investment return on the collateral related to the lending deposited by the borrower, which is required to be reinvested during the term of the loan. (The borrower must provide the lender with collateral with a value of at least 105% of the securities lent.) Second, the lending agent is responsible for negotiating the most favorable rebate rate to the lender. (Of course, it's up to the retirement plans to negotiate the most favorable lending split with the lending agent. Where the lending agent is an affiliate of the custodian arguably the custodian or lending affiliate may have a special (fiduciary) duty, based upon the pre-existing relationship, to advise the retirement plan of prevailing lending splits between lenders and agents.)
At the outset of the loan, the borrower provides the lending agent with the collateral and the plan (through its lending agent) enters into an agreement as to the amount of interest on the collateral that will be rebated on the specific loan. The lending agent then invests the collateral in the highest yielding instruments permitted in his agreement with the lender. Thus, if the Fed Funds rate is 5.25, the lending agent may choose to instead invest the collateral in commercial paper earning 5.30, to provide additional income to the lender. (It is common, despite the limited range of investments generally permitted for collateral reinvestment, to earn a rate of return 5-7 basis points above the Fed Funds rate.) The rebate rates are set daily, regardless of the duration of the loan.
If, for any reason (such as the temporary spike in Fed Funds rates), the interest on the collateral promised to the borrower (the rebate) exceeds the interest earned on the collateral, the lender may actually experience a loss on the loan. In such a situation, it is often industry custom for the lending agent to reimburse the lender for the loss but this is not required. Larger retirement plans indicate that they do experience losses on specific loans and are not reimbursed by their agents- probably because they don't ask. (Since the lending agent may earn an investment management fee related to investing the collateral (as discussed below), it seems reasonable to ask the agent to compensate the pension in those few instances where a loss results from a loan.) Custodians and other lending agents have pooled funds for investing lending collateral and may each offer a more conservative and a more aggressive pooled fund for their lending clients to choose from.
The lending agent generally then rebates to the borrower, the agreed upon interest on the collateral and the lender and retirement plan keeps a portion. If, in the example above, the collateral earns 5.30, perhaps 4.75 would be rebated to the borrower and the cost to the borrower is .50, while the lender and his agent share .55.
The lending agent and the retirement plan share in the lending revenue (after rebate to borrower) according to the percentage split in the agreement between them. Retirement plan officials at best are aware of the percentage split they have with their lending agents and are not familiar with any of the additional charges described below. Today, typical splits between lenders and agents range from 70/30 to 85/15. Years ago a typical lending split was 50/50 and many retirement plans have failed to renegotiate their percentage shares upwards. Other plans have renegotiated but still are not operating at competitive percentage splits.
However, there are additional charges that apply prior to the split that reduce the amount paid to the pension. For example, the lending agent may be paid an investment management fee for investing the collateral of 2-5 basis points and custody and other expenses may amount to another basis point. Thus, 6 basis points may be paid to the lending agent before the split between lender and agent is applied. For example, if the lending fee is 20 basis points (after rebates to the borrower) and the revenue split between the pension and the lending agent is 50/50, the lending agent would receive 6 basis points for investment management and other expenses and then 7 of the remaining 14 basis points, for a total of 13 basis points. The lender would receive 7 basis points. The lending agent receives 65% and the lender receives 35%, assuming these additional charges apply. The retirement plan is, as a result of these incidental charges (that are also presumably subject to negotiation), receiving substantially less of a percentage of the lending revenue than it believes. It is common for pensions to lack full understanding of the details of their arrangements with securities dealers, custodians and others. Often fees and charges, not reflected in the written agreements between pensions and their vendors, are deducted without disclosure to the plan. (Since securities lending by retirement plans must be undertaken pursuant to a lending agreement between the plan and lending agent, scrutiny of the agreements for any reference to such charges, as well as review of statements related to lendings is necessary to determine whether charges have been imposed - even where there is no reference to such charges in the lending agreements.)
In the past when there was limited demand for securities lending, the revenue related to lending was limited to some portion of the interest on the collateral. Today, however, lending revenue can be exponentially greater than the interest on the collateral. In other words, the lender may not rebate any of the interest on the collateral; rather the borrower may pay substantial amounts in addition to the total interest on the collateral. For example, an additional 45% interest (annualized) is possible for certain hard-to-locate securities. Such a borrowing rate is referred to as "neg 45," i.e., a negative rebate of 45%, in addition to the interest on the collateral.
What are pensions and funds earning from lending their securities after payments to their lending agents? According to one lending agent, an S&P 500 large cap fund, could earn .5-4 basis points from lending its securities; a small cap fund could earn 10-100 basis points, with the majority of the Russell 2000 securities being lent at approximately 10-20 basis points; a corporate bond fund could earn .5-1.5 basis points and a high yield bond fund could earn 10-20 basis points (however, 50-500 basis points is possible); finally, an international equity fund could earn 10-20 basis points.
More importantly, what are borrowers paying to borrow securities from intermediaries (who have borrowed these securities from pensions and funds)? According to one knowledgeable insider, based upon what borrowers are paying, large cap funds could be earning 15-20 basis points; small cap funds, as much as 10%; corporate bond funds 15-20 basis points and high yield bond funds, as much as 10%. (Note that both of these sources agree that large cap and corporate bonds and small cap and high yield bond rates should be comparable. Also note the huge disparity between what ultimate borrowers pay and retirement plans earn from securities lending and the amounts they could be earning today.)
The president of one lending agent reluctantly acknowledged that prime brokers are capturing the greatest amount of the revenues related to securities lending, easily half. (In our initial interview, he indicated that lenders were collecting the lion's share of the revenue.) Another insider had always maintained that the prime brokers were profiting handsomely from the lack of transparency and inattention to lending by fiduciaries.
Retirement plans may have exclusive lending arrangements with prime brokers through their lending agents. For example, a plan custodying its assets at bank may have an exclusive arrangement with a Wall Street brokerage whereby the brokerage pays the plan a certain number of basis points (e.g. 10 basis points) annually on a portfolio for the right to borrow all the securities. The prevailing view at retirement plans is that this is income the plans would not otherwise receive so there is no need to question what the holder of the "exclusive" is earning from the arrangement. In our opinion, such exclusives breach the fiduciary's duty to maximize return on plan assets since the fiduciary up-front agrees to a fee that bears no relationship to the lending income the exclusive agent is earning from the fund's securities.
Based upon our recent conversations with the SEC, the Commission has not yet focused upon the issue of whether mutual funds receive their fair share of the lending revenue related to their securities. The Commission seems to have no idea of the magnitude of the lending rates paid by borrowers today. Commission officials are unaware that rates as high as 50% annualized are being paid by borrowers for hard-to-locate securities. Commission officials assured us that mutual funds they have examined are never receive income anywhere near the high amounts being paid by borrowers for hard to locate securities. We suspected as much and that, in summary, is the problem.
Single Stock Futures: An Alternative to Securities Lending
By David Downey, CEO, OneChicago LLC
Securities lending is primarily a back-office function that effectively is an over-the-counter derivative transaction. Mutual funds and pension plans (funds) lend (actually sell) assets today with an agreement that they will get the assets back at some point in the future. During the interim they will not lose economic exposure to the position and will receive additional compensation for participation in the lending. This transaction is substantially similar to an EFP (Exchange Future for Physical) transaction using Single Stock Futures (SSF) but with some very important differences:
The SSF EFP is a trade on a regulated exchange. SSF trade in a competitive environment where finance rates are established by multiple market participants. Transparency in pricing. No counterparty risk as all trades are cleared through the AAA rated Options Clearing Corporation (OCC). Securities lending is currently an operations function. However, it should be viewed as a trading strategy and therefore be included in the investment manager's responsibility. There are substantial profits being ceded to intermediaries that could accrue to the funds and their clients instead.
Securities Lending Overview
Securities lending markets have two sides or parts. The first part is cash driven whereby institutions finance their operations by borrowing cash in return for collateral. The second part is securities driven whereby hedge funds firms employing short delta strategies such as the 130/30 are required to borrow securities prior to shorting .This activity is increasing the demand for the available supply of stock to borrow. The hedge funds look to the brokerage firm to service the request. The brokerages can meet some of the demand from their own inventory but must look to the beneficial owners (the pension and mutual funds) to satisfy the total demand.
The beneficial owners make their supply of securities available by contracting with either a custodian or the brokerage firms for the wholesale distribution of all or a portion of their portfolio. For this they receive a guaranteed fee and/or a split of the reinvestment of the cash collateral the contracted party receives.
The disadvantages to this arrangement are the concentration of credit risk with a sole counterparty and the ceding of potential profits to these agents. The funds can achieve the same end of providing the market with the assets they need but not have to split the profits with a third party.
Funds will argue that the securities lending involves a variety of complex administrative, operational and accounting activities including credit evaluation and cash management which may be better handled by specialists in that field. Fair enough. However, with SSFs they can participate in this process and earn higher returns on the assets under their management.
There are financial products that have the same economic effect as securities lending that do not involve any securities being exchanged. These are off-balance sheet transactions such as equity swaps, total return swaps and Contracts for Difference. However, unlike SSF these products still entail some counterparty risk.
While SSF are a derivative product, they are the simplest derivative of them all. The value can be derived by using grade school mathematics. An SSF's price is the forward value of today's stock price which is derived by multiplying today's price by the risk free rate of interest out till expiration of the future and subtracting any dividend that is paid (if any) during that time period. The formulae are as follows:
For stocks that do not pay a dividend:
So for a $100 stock that pays no dividend in a 2% interest rate environment the six month SSF will have a fair value of $101. If the stock paid a 20 cent dividend then the six month future would have a fair value of approximately $100.80. (Approximate only because a higher resolution fair value could be obtained by taking the present value of the future dividend stream into consideration but for simplicity deducting the full value works.)
Now, a trader should be ambivalent about buying the stock at $100 today or receiving the same stock at $101 (in the no dividend example) in six months in a 2% rate environment. The physical settlement of the SSF means that upon expiration the fund holding the long SSF will receive the CUSIP as the future expires and the party holding the short SSF will be required to deliver. One of the most fascinating aspects of the SSF is that unlike all other futures products where the positions are offset prior to expiration more than 95% of the SSF positions traded on OneChicago actually make or take delivery upon expiration. So for funds who invest by buying and holding there is no difference in the two transactions of either buying today at one price or buying a SSF for delivery of the underlying at expiration except for the fact that they may be able to purchase the SSF at a lower net cost and therefore reduce the price they actually pay for the resulting position.
Pricing of the EFP
An Exchange Futures for Physical (EFP) trade allows for the substitution of a long or short stock position for a long or short SSF position. EFPs allow one to decrease finance charges for long stock positions or increase the interest received on short stock positions. That is because the interest rate built into the price of an SSF and hence its EFP is competitively determined by numerous market participants rather than by a single broker who can set less advantageous margin loan and stock borrow rates. Accordingly EFP's can be used as a synthetic stock loan transaction as funds can offer their long stock out in return for a SSF that will expire back into long stock at expiration but with returns that are greater than those currently being received for lending the stock to an intermediary.
An EFP is a combination order to sell (buy) an amount of stock and simultaneously buy (sell) a proportionate number of SSFs. Taking a long position in the EFP involves buying the SSF and selling the underlying stock. The stock position becomes flat due to the sale of the existing long stock position and the position now holds a SSF with the same economic exposure. The EFP is priced in interest rates as there is no underlying price risk since the stock and the SSF are equivalents but does involve interest rate risks as the two parties are simply engaging in a loan as they switch positions. Selling the EFP has the opposite positioning as the SSF is sold and the underlying is purchased. Hedge funds and other short sellers who are currently short and paying for the privilege would be able to lower their costs of financing this position by executing an EFP at a much more favorable rate without changing their economic position vis-à-vis the stock moves. Both parties will have the added benefit of removing their current positions from their balance sheets without changing their market position as SSF are off-balance sheet items.
Securities lending is where buyers and sellers meet to exchange an asset for a short term in return for basis points of compensation. Lenders can deliver the asset to the borrowers through an SSF transaction by either purchasing outright for future delivery or pricing the EFPs in such a way to increase the basis points received for the 'loan'.
Funds have a fiduciary responsibility to their participants to maximize the returns without exposing the assets to unnecessary risk. SSFs competitive trading in a transparent process without counterparty risk exposure is a viable alternative.