Pension funds still keen on securities lending despite market volatility

The financial markets of 2011 have been marked by one thing – volatility. Whether as a result of crisis in the eurozone, political infighting over the US debt ceiling, or the unprecedented outburst of revolutionary fever among Arab states, the last nine months have seen markets jump all over the place.

But according to Paul Wilson, managing director, global head of client management and sales for financing and markets products at JPMorgan Worldwide Security Services’ this increased volatility has not resulted in pension funds pulling their lending programmes. The reason for this stoicism in the face of economic uncertainty is the post-financial crisis focus is an improved understanding of reinvestment risk. 


 “We have spent a considerable amount of time over the last few years improving the education of our clients. We have worked with them to develop programmes that meet their risk parameters, across both the loan book and the cash re-investment side, in the eye of a financial storm.”

The result is that as investors have had reservations over the strength of previously dynamic economies such as Ireland or Spain, pension funds have kept faith with securities lending.

“We lend for one of the largest portfolios of clients worldwide and we have seen a minimal number of new restrictions and changes to lending programmes this year. In fact, there is a trend towards programme expansion,” says Wilson.

Weak demand

Indeed according to Wilson, the firm has seen an increase of 30% in the supply of securities its clients have to loan since 2008. Given the number of mandate wins JPMorgan has made during this period it is difficult to differentiate between the real, and nominal, growth in its supply of lending assets but nevertheless it provides anecdotal evidence of pension funds’ comfort with securities lending.

This story is echoed by BlackRock. According Stefan Kaiser, an investment strategist in the securities lending group at the firm, it has also increased its available pool of assets. However, as with JPMorgan, organic growth at the firm is the main reason for an increase in the amount of lendable assets. 

“Even at the height of the crisis in 2008 we only saw a very small number of clients pull out of lending. And following the merger of BGI and BlackRock, we have actually increased the supply pretty significantly,” he says.

But Kaiser says that despite supply side growth, profits from securities lending haven’t experienced similar fruitfulness. “We are actually pretty close to a low in revenue-to-clients at the moment”, he says.

The reason for this difference is that while supply is strong, demand is weak.

“Demand has recovered slightly from the lows we saw in 2010. But we are still pretty close those and the main reason for this is Dodd Frank regulation in the US moving proprietary trading out of banks,” says Kaiser.

And despite 2011 being characterised by record inflows into hedge funds this has not resulted in an increase in borrowing demand, according to one senior source in the securities lending industry.

Short trades

“Hedge fund interest is still subdued, despite the inflows that we have witnesses this year. There is still not much leverage or conviction about short trades by hedge funds”, say the senior source. 

Despite the much publicised problems of some pension funds in 2008/9 over their securities lending programmes (see box) the increasing supply of securities from pension funds has come as part of a reassessment of the way these activities are viewed by funds.

According to Bill Pridmore, a Chicago-based consultant who advises pension funds on their securities lending programmes, clients have become much more active in identifying and managing the risks entailed with securities lending.

“I have conversations with clients where I ask them, ‘what do you want from a securities lending programme? Do you want the pure rental value of your securities, or do you want some additional return by taking some risk in the short-term investment market?’

“And when you put it like that they tend to reply, ‘I may take some of the short-term investment risk, but I don’t want a lot of it’.”

The key point is that while some firms may have experienced unrealised losses on their securities lending programme, all these losses came from way collateral was reinvested and not from the lending activity itself.

Reinvestment risk

“No lender in the States that I’m aware of has ever lost a dime due to borrower default. And I’ll take that further: no lending agent – be that a custodian or a third party lending agent – that I am aware of has ever lost money by having to pay out on an indemnification of a securities lending programme,” says Pridmore.

Pridmore’s comments were echoed by all interviewees for this feature who all pointed to the good safety record of lending itself.

The recognition of where the risk lies with lending programmes is now fully understood according to Keith Haberlin,  head of securities lending (EMEA)  at Brown Brothers Harriman. He says that pension fund clients have reacted to the issues of 2008/9 by moving securities lending from the operational to the investment management part of the fund.

And in accordance with this greater investment awareness has come a reappraisal of pension funds’ approach to managing their collateral reinvestment programmes.

“We have always had an intrinsic value driven programme, rather than an aggressive approach to collateral reinvestment, so these comments are related to the industry in general. We’ve seen pension funds, and other beneficial owners, generally change their investment guidelines that make capital preservation and liquidity the two main issues when reinvesting cash, as opposed to really aggressively chasing yield.”