It’s fair to say that the hedge fund industry as we know it would not exist if it weren’t for one critical, but often ignored function – securities lending. Like the proverbial swimming duck, a steady flow of stock “borrow” used for short-selling hides the mayhem that goes on just below the waterline.
Through their custodians or on their own, institutional investors often make their holdings available for loan (although some argue that securities lending is not technically a loan). Doing so routinely produces a small revenue stream with very little risk. In other words, the closest thing to a free lunch that exists today. According to the International Security Lending Association (ISLA), there was about $2 trillion worth of securities on loan at the beginning of 2008.
But the credit crunch is starting to eat this free lunch. Demand has been hit by temporary short-selling bans around the world. Spooked by what they regard as new counter-party risks, and motivated by a sense of vigilante justice against short sellers, several major institutional investors have unilaterally curtailed their securities lending programs recently. The head of Citigroup’s securities finance group recently told Global Pensions that:
“The supply/demand dynamics of the securities lending market have been disrupted…The long term effects on demand will depend on the broader impacts of the bans and their duration. Some players are restricting lending activity and the market needs to work through these imbalances to find a new equilibrium.”
Last week Watson Wyatt urged it’s clients to revisit their securities lending practices. In a note to clients the firm recommended revisiting collateral requirements and potentially even suspend their lending programmes. The company said:
“While [we acknowledge] that it would be an extreme chain of events that invokes indemnification and then for it to fail, Watson Wyatt recommends its clients be aware of the potential risks…”
What risks in particular? Pensions & Investments explained one of the biggies in an October article:
“Institutional investors thought the collateral was invested in safe, plain-vanilla securities. Somewhere after 2000, however, the range of permissible investments was expanded to include things such as asset-backed securities and home equity loans, which have been eviscerated by the credit crisis…”
It really doesn’t take much to disrupt the “supply/demand dynamics” of this market. Growing concerns over whether institutional investors would cease lending prompted the International Securities Lending Association (ISLA) to issue a joint statement with several securities associations in September pleading with lenders:
“…we encourage lenders to continue to make financial shares available for lending in order to support market making and efficient settlement. Any wholesale withdrawal of financial shares would have highly unwelcome consequences for liquidity in the cash equity and derivatives markets that would be against the interests of investing institutions and contrary to the stated intentions of regulators in introducing these measures.”
According Spitalfields Advisors, a UK-based consulting firm, the actual amount of stock on loan at any given time actually pails in comparison to the total stock market (about 5% of global equity markets). The following chart constructed with data from the firm’s “2007 Securities Lending Year Book” makes the case (values in US$trillions as of December 31, 2007):
Some of the world’s biggest players in this market happen to be based in Canada (CIBC Mellon, RBC Dexia etc.). So last week, the Alternative Investment Management Association (AIMA) held a luncheon panel discussion for a packed room in downtown Toronto to get a handle on how the credit crunch was impacting the securities lending business. James Slater, a Senior VP at CIBC Mellon presented some new and sobering data from Data Explorer, a data vendor tracking the securities lending market. The following chart was constructed with data presented by Slater at the luncheon – shows US market only in USD).
The drop in total lendable assets wasn’t just a result of the market falling however, the actual number of lendable securities also fell over this period. Data Explorers’ Stock Lending Index (DESLI) shows a global drop of 15% in the total number of stocks available for lending from September 1st to November 19th – perhaps reflecting how some institutions are beginning to pull in the reigns in their lending programmes (chart right – click to enlarge).
Meanwhile, the total number of stocks of the world’s largest (and most liquid) companies shorted has almost doubled during this time as the chart from Data Explorers’ website shows. (This pop isn’t apparent in the dollar-value data shown in the chart above, but we called Data Explorers and they confirmed that we were reading their graph correctly. CIBC Mellon’s Slater hypothesizes that there is a divergence in the shorting activity in the largest stocks used to construct the DESLI and the shorting activity in the overall market.)
In any event, this increase in demand for shorting of larger names is bound to put upward pressure on their annual borrow costs (which were estimated by Spitalfields to be between 20 bps and about 50 bps at the end of 2007).
So like a swimming duck, lendable stock often seems to flow from lender to borrower with apparent ease. But just below the waterline, a complex marketplace reflects a constantly changing supply and demand for this lifeblood of the hedge fund industry.