Top five things investment managers need to know about securities lending

February 2020

From the desk of Sakti Narayan, Margin Reform

Securities Lending has evolved from a back-office operational activity originating in the 1960s/70s – borrowing securities to cover settlement failures and supporting short-selling investment strategies – to a recognised investment management discipline that can be a source of additional alpha and revenue for beneficial owners and investment managers. Furthermore, it is widely accepted that securities lending can improve market liquidity, aid price discovery, potentially reducing the cost of trading and increasing market efficiency. For further insights on the contribution of securities lending to well-functioning markets do read this blog post, how OTC market liquidity is affected by securities lending, and lessons from AIG's collapse.

Given the cost pressures the investment management sector is facing, securities lending can be a significant source of alpha, and the incremental revenue1 can reduce the operating costs when the lending programme is appropriately executed with robust risk management and good governance. If you are an investment manager and are considering (re-) entering the market, here is a framework to help you evaluate your decisions:

1. Balancing your objectives as an investor – board room/management's motivations (price discovery, generate returns for the funds, reduce direct and indirect operating costs) for lending should be balanced with the need to act as a responsible investor (contribute to well-functioning markets, exercise voting rights, maintain active dialogue/engagement with the companies invested in, etc.)

2. Risk appetite – securities lending isn't risk-free. The business is OTC, and to a large degree, is still governed by bilateral agreements and is relationship-based. Management and internal corporate functions need to have a heightened awareness of the operational, counterparty and reinvestment risks associated with the business and the available solutions for mitigating those risks. Beneficial owners need to be informed of the additional risks, how the lending programme will monitor and mitigate such risks, and the compensation they are expected to receive for bearing those risks.

3. Lending mandate, policy and programme monitoring – these are necessary to align the investment manager's business objectives (Why do you want to lend? What and how much can you lend? Type of lending, route(s) to market, acceptable risk profile and controls, fees and costs) with the broader incentive structure between the beneficial owner and the investment manager. Transparency on fees, best execution, and ESG topics will continue to attract attention from policymakers, regulators, and the general public. The question remains whether securities lending can co-exist within a strong corporate governance2 framework, and the investment managers need to be able to evidence what their programmes do when they are in the spotlight.

4. Business processes – given the regulatory burdens (SFTR, CSDR) associated with securities lending, the cost pressures and the technological developments, the timing now is as right as it can be to set up a lean, efficient operation from scratch using trading and post-trade platforms automated to a great extent. If you are already lending, this is an opportunity to reassess your business objectives and improve your business processes. From a firm-wide perspective, as securities lending is part of the securities financing toolkit, the business process improvements need to be executed as part of a holistic collateral and liquidity management optimisation programme which are being undertaken at many firms in response to UMR.

5. Education – make informed decisions by accessing independent, unbiased insights and in-depth knowledge from market practitioners, including from us at Margin Reform (Mandy Rice-Davies Applies). We can guide you through your decision-making process and address questions specific to your business needs.

In the next article, we will draw on experience from recent engagements with investment managers and provide practical information on designing a bespoke programme and the various routes to market.