Investing March 22, 2017

Trends Increasing Demand for Securities Lending

Interest rate moves, changes in collateral and ETF usage is driving a higher demand for securities lending programs from institutional investors, such as DB plans.
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Securities lending is a way for institutional investors to generate incremental revenue for their portfolios by lending out their securities for collateral. George Trapp, head of Client Relations for North America at Northern Trust, Global Securities Lending, who is based in Chicago, describes it as “sort of like renting an apartment where you are an owner, but lending it out because there is demand for it.”

He says with the transaction, institutional investors should make sure they take all steps to price map correctly, do a mark to market valuation to make sure it is properly collateralized and investors are charging the right fee.

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According to Trapp, there are a combination of reasons institutional investors, such as defined benefit (DB) plans, are interested in securities lending, with the primary reason being it generates incremental revenue. But, securities lending also provides liquidity in the financial market, and sometimes DB plans use other products securities lending supports—for example, a long-short strategy using hedge funds. Securities lending provides DB plans more liquidity than other securities. “And institutional investors can vet the program to meet their list of parameters,” Trapp says. “It is a low-risk investment, but investors can set parameters based on their risk tolerance, for example, using only U.S. Treasuries as collateral.”

There are a few trends Trapp and Northern Trust are seeing in the securities lending space. Higher interest rates are driving demand for clients. There are better spreads on cash collateral since service providers can charge a higher rate for borrowing securities.

“Overall as rates move up from a very low nominal rate, we’re seeing clients have the opportunity to make additional income if interest rate moves are well-predicted and transparent. If you don’t know an interest rate increase is coming or when, it dampers earnings,” he says. “The longer-term impact is positive. In a low interest rate environment, institutional investors are battling for every basis point they can. Higher interest rates are not a major issue in the securities lending market; institutional investors can charge more for loans.”

NEXT: Collateral changes

Those to whom institutional investors lend securities post collateral. If clients were beneficial owners, lending agents help clients define what they deem as acceptable collateral, Trapp explains. For example, Employee Retirement Income Security Act (ERISA) funds and mutual funds cannot accept equities as collateral.

One clear trend over last three year period—borne from Basel III requirements, an international regulatory accord that introduced a set of reforms designed to improve the regulation, supervision and risk management within the banking sector—is acceptance of securities as collateral versus cash, according to Trapp. He says it plays out globally as well as in the U.S. The market has moved to 70% accepting cash collateral five years ago, to now 40% to 50%. Clients are beginning to pledge lower quality or less high quality securities as collateral, causing an increase in securities collateral. Those lenders willing to accept a broader range of collateral are likely to be well-positioned to maximize revenue within their acceptable risk parameters.

It is important for institutional investors to accept a wide set of securities as collateral because cash is not accepted as before. However, Trapp reiterates that an ERISA fund may not be able to accept a wide variety of securities as collateral; they cannot accept equities, but can accept sovereign debt and corporate bonds.

But, clients are rewarded for using cash as collateral. “We have two competing trends,” Trapp says. “It is important for clients to be able to take cash but be flexible about securities collateral.”

NEXT: Concentrated demand and ETFs

Last year, three stocks represented a sizable chunk of the securities lending market, according to Northern Trust. The $220 million generated by lenders of Tesla shares, alone, was responsible for 3% of the securities lending industry’s total revenue, generated for lenders in the marketplace. Trapp explains that for DB plans lending out Tesla shares, assuming normal asset allocation across the plans, Tesla would have represented a large portion of overall earnings.

Trapp says he can’t name specific companies that will generate high revenue for securities lending this year, but generally, Northern Trust is seeing demand continue for securities lending products, and clients are coming from all different market segments. He says securities lending is working its way in the defined contribution (DC) plan market, as Northern Trust is seeing interest from DC plans. “Lenders should identify hot areas they think will see continued concentration,” Trapp says. “Retail and energy securities are in high demand, but it is hard to predict that one company that will drive revenue.”

According to Trapp, an interesting trend continues to be the use of exchange-traded funds (ETFs) by institutional investors. Northern Trust sees increased demand for lending of ETFs. Clients are using ETFs and holding more to get greater exposure to more areas of market. When it comes to lending, he says, it is a good area for clients who want to hedge positions for exposures they have—buying and selling ETFs is a quick way to do that. Trapp says emerging market and high yield bond ETFs are seeing the most demand.

Trapp notes that U.S. Treasuries have been very quiet over last three to five years, but as seen in the past year, especially in the fourth quarter, interest rates are starting to creep up. He says there is a natural demand for U.S. Treasuries to hedge against interest rate moves. As rates move up, Trapp believes the securities lending market will see more demand.

“Securities lending is absolutely good idea for DB plan sponsors. It is a way to get some incremental revenue,” Trapp concludes. “What is important is working with a lending agent to set up a program to reflect the lender’s risk appetite. They can set up a program for specific needs, deciding how much to lend and a minimum spread, or they can throw all that to the wayside and try to earn as much as they can.”

Investing March 22, 2017

State Plans Face Unique Investment Hurdles

Governmental plan sponsors are generally not policed by ERISA, but they face their own set of “old, obscure laws” that can apply many restrictions on how or how much they can invest. 

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During a recent conversation with PLANSPONSOR, George Michael Gerstein, counsel with Stradley Ronon Stevens & Young, made the frank observation that “there seems to be a significant and even increasing amount of fiduciary investment risk that exists in governmental plans that is not being addressed.”

“Think of state retirement systems like CalPERS or Texas Teachers,” Gerstein says. “These governmental plans have really a lot of money to invest and strong liability demands on that money, and so they are enthusiastically pursuing things like alternative investments, greater use of derivatives, and other areas and transactions that can, quite simply, go awry if they are not properly approached.”

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Gerstein believes there is lasting confusion arising from the fact that these big state-run plans are not subject to the Employee Retirement Income Security Act (ERISA)—they are expressly carved out in fact.

“But this cannot be taken as these plans having free reign to invest however they please,” Gerstein warns. “They are all subject to state law—and these state laws vary tremendously. Some are very strict and lay out very specific requirements as to how state money can be allocated. A certain fund might have a restriction that it cannot invest in more than, say, 10% real estate, for example. Many have at least some restrictions on certain vehicles or transactions.”

The real challenge for service providers is the fact that some of these restrictions have been passed in “old, obscure laws that have not, frankly, been thought about for some time by anyone.”

“And so it’s not hard to imagine the kind of challenge I’m talking about and that I’m seeing more and more in practice,” Gerstein continues. “Say, if the plan I mention above has 8% of its assets in real estate today and a consultant comes in an pitches an attractive new investment that would push it to 10.5% real estate, or even 10.1% real estate. The investment professional and the sponsor may believe they are making/receiving a prudent recommendation but in fact the consultant is recommending their client break the law.”

This line of thinking should serve as a warning to sponsors, Gerstein says, “but generally they are going to know what they can and cannot do with their money. It more so applies to cases, say, where the plans have delegated some amount of investment authority to an outside professional. It is always possible that an outside manager will be unaware of some more or less obscure restriction—especially if nobody thinks to warn them, which can happen a lot more easily than you might expect.”

NEXT: Getting ahead of the problem 

According to Gerstein, there have been cases in which “well-meaning but unwitting managers,” providing various services, fail to appreciate the risk that they are taking on serving these plans. The risk can result in many unfortunate consequences—anything from inappropriate transactions being ordered unwound, with fines, through to full-fledged fiduciary breach litigation naming individuals and alleging personal liability.

Something else to consider is that any legal challenges emerging will be tried in the local court system, “and you will see providers get dragged in front of very unfavorable jury pools in most situations.” As Gerstein puts it, “you will not find it easy to defend yourself if the local pension is accusing you of wrongdoing or negligence.”

In dealing with clients on the buy side and the sell side of this issue, there is some emerging awareness about these issues, Gerstein concludes. “But it’s really not a major focus, because everyone thinks of ERISA and the fact that these plans aren’t subject to ERISA. But these plans are still subject to state laws that are very similar to ERISA.”

In fact, some states have essentially incorporated ERISA’s prohibited transaction provisions directly into their own laws over the years, but they may leave out some or all of the accompanying federal exemptions that allow ERISA plans to even operate in the real world (i.e., under Department of Labor policing) without getting totally locked up by potential conflicts of interest.

“So the grounds are there for this issue to really become significant in some places,” Gerstien concludes. “Of course, this is all manageable with diligence and care. You need to know what you’re up against. Simply put, these plans present too much opportunity for providers to pass up, even with the risk.”

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