Asset management firms that favour the risk-adjusted return characteristics of an intrinsic programme have every reason to stick to their guns, as BBH’s John Wallis, Co-head of securities lending EMEA, explains
Attend the recent conferences or read the latest industry commentary and you will hear stories of oversupply and falling revenues compelling beneficial owners to be more flexible in the collateral they accept, adopt term structures to lock in trades, or consider higher yielding cash reinvestment options. These changes would increase risk for the beneficial owner, and while that may be appropriate for some lenders, asset managers are asking if they also need to be making similar changes.
The first step in putting these developments into context is to recognise that securities lending is effectively two markets. The first — and by far the largest – segment is the General Collateral (GC) market where the overriding goal is to maximise revenue. To achieve this, large volumes are lent at low fees with a flexible approach to accepted collateral. Industry-wide, 90% of securities on loan are priced at 50 basis points or less1, so it’s easy to see why this part of the market occupies so much air time. However, very few asset managers are GC lenders. This type of lending is usually favoured by sovereign wealth funds, insurance companies and some pensions whose time horizons and liquidity constraints are dramatically different from a mutual fund.
The second securities lending market is the ”specials” space which focuses on the few stocks that command the highest fees (e.g. 200 to +2,000 bps). Often referred to as “Intrinsic Value” lending, this type of trade can generate 90% of its revenue from lending just a few stocks — often less than 5% of a fund’s AUM. Those stocks are in high demand, meaning lenders do not need to compromise on the quality of collateral they accept. In the US, this means cash, reinvested in short-term, highly liquid money market funds and, in Europe and Asia, collateral is typically G10 sovereign bonds.
Many asset managers prefer this nuanced approach that prioritises risk-adjusted returns as they balance revenue, daily liquidity, and risk. By lending a smaller proportion of their assets, it is easy to see how registered funds account for 40% of lendable assets across the industry, yet comprise just 15% of assets on loan2. This leaves 85% of the securities lending industry serving lenders who are not registered funds, so it is not surprising that so much industry commentary seems not to apply to them.
The market is seeing record levels of oversupply and lenders need to be more flexible with collateral and term structures to maintain balances and revenues. But, does this apply to asset managers? If they are a GC lender, yes, particularly if they are lending large volumes of HQLA (High Quality Liquid Assets, e.g. government bonds). The current fees of 15 bps anticipate lenders accepting main index equities as collateral and term structures of 1-3 months.
However, for the majority of asset managers, following an intrinsic value approach, collateral flexibility and term structures will add little value in terms of revenue or improved distribution. For example, look at the market utilisation levels of the stocks you have on loan and the percentage of your holding you have on loan. If market utilisation is high and your entire inventory is lent, then the stocks you are lending are probably in such high demand that you do not need to compromise your collateral standards to improve your loan distribution. If this is the case, your agent will have no excuse for not achieving the highest market fees.
Intrinsic value lenders are often encouraged to rethink their stance, ease their collateral standards, and lend more at lower fees.
Every lender should review their stance periodically. However, asset managers that favour the risk-adjusted return characteristics of an intrinsic program have every reason to stick to their guns — market noise to the contrary is largely addressed to a different area of the market.
1Markit, 2ISLA 2017 Market Report