Securities lending, once considered a mundane middle and back office operational chore, is quickly becoming the target of scrutiny from savvier plan sponsors who want a far better understanding of the financial benefits and pitfalls.

"The plan sponsor is responsible for doing its homework and understanding the risks and rewards it is receiving," when lending or borrowing securities, says Josh Galper, managing principal of Finadium Partners, a Concord, Mass.-based consultancy. "It's not the custodian bank or third party agent's responsibility to provide complete disclosure of every potential risk nor is it realistically feasible."

Plan sponsors are no longer content with just knowing their lent securities are earning revenues and are being processed correctly. The market downturn and onslaught of lawsuits against some of the world's largest custodian banks - Northern Trust, State Street and JP Morgan to name a few - for not protecting them enough against financial losses incurred in cash collateral pools has raised the stakes in what investment funds must know before they take the plunge. In many instances judges have ruled against the plan sponsor in favor of the custodian bank.

"Plan sponsors now want a lot more information from their custodian bank lending agents on which of their securities are being lent, how much they are earning and just as important how much investment risk they are taking," says Virgilio Abesamis, senior vice president at Callan Associates, a San Francisco-based consultancy.

Plan sponsors - who own the assets - earn revenues when lending out securities to borrowers, typically broker dealers and hedge funds. The transactions are handled through their custodian banks or third-party lending agents and the plan sponsors split the income from reinvesting cash collateral posted by borrowers with the lending agent. In the case where cash is not used as collateral, there is a fee agreed upon between the borrower and the lender in a spread from a benchmark, typically the Fed funds rate. Most loans made by U.S. pension and other plans are collateralized with cash while loans made by foreign investment funds re most often collateralized with securities.

Sponsors also "need to verify the results (of lending activities) with third party data providers, do their own internal analysis or hire a third party consulting firm," says Abesamis.

But for starters, plan sponsors must understand the exact terms of their contracts with the custodian bank. "Custodian banks will protect the plan sponsor from the potential bankruptcy of the borrower by selling the borrower's collateral should that become necessary. If there is a collateral shortfall, the custodian will try to collect the difference from the borrower as a creditor unless the agreement states differently," says John Piccitto, managing director of John Piccitto Consulting, London. "However, the custodian bank won't provide much information on where the cash collateral is being reinvested unless pushed, and cannot guarantee against the loss of value in the collateral."

The warning sign: when a contract deviates too much from the industry norm.

Next in line - knowing just how much revenue your securities lending program is generating and from where. "Plan sponsors should ask the custodian bank for detailed reports on just which securities are being lent out, how much they are earning not only in aggregate-meaning for the entire portfolio but by exact security and counterparty which borrowed the security. Such reports also need to explain the number of securities out on loan and how many are left which are lendable." says Galper.

JP Morgan Chase, for one, offers more than 100 different daily and monthly customized reports which are broadly categorized in three categories - informational, performance and benchmarking. "The information reports include details on what is out on loan, who the borrowers are, and exactly where the cash collateral is being reinvested while the performance reports include details on how much revenue is being generated from which securities lent, which borrower and the cash collateral," says Paul Wilson, director of securities lending for the global custodian bank in London.

JP Morgan Chase and other banks also link their plan sponsor clients to securities lending data vendors such as SunGard Astec Analytics and Data Explorers to provide some form of aggregated monthly analysis as to what revenue other plan sponsors received for lending under the same circumstances. Plan sponsors can also sign up with the firms separately.

"The goal is to create some type of benchmarking based on the applicable variables including the type of securities being lent, the fees charged related to the relative in-demand qualities of the securities and the degree of utilization when compared to other lending institutions," says Tim Smith, executive vice president at SunGard Astec Analytics in New York.

Centralized electronic markets for securities lending transactions, such as the one operated by Quadriserv, also provide some comparative analysis. Gregory DePetris, co-founder of Quadriserv in New York, says its AQS market data service offers plan sponsors and hedge fund managers real-time information on the rate at which securities were lent on its AQS platform, the last bid and offer rate for the same securities, which securities are being recalled by other lenders and which securities are becoming more expensive or hard to borrow. Plan sponsors and hedge funds can purchase the AQS data directly from Quadriserv, but if they want to do business on the AQS platform they must be sponsored by their custodian banks or prime brokers.

The most significant bit of information plan sponsors want has so far also been the most difficult one to develop because of the lack of an industry standard in defining it. That is quantifying of just how much risk is the plan sponsor taking to generate the return it is receiving.

JP Morgan Chase, for one, does offer plan sponsors on demand a type of value at risk analysis of how much money the plan sponsor could lose under certain market conditions. The bank will develop a risk-adjusted return report for securities lending activities by year-end. Astec will release a similar product in early 2011,says Smith, with the help of SunGard's trading and risk analysis unit to crunch the relevant data.

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