At the Securities and Exchange Commission's roundtable last week on how to regulate the multi-trillion-dollar securities lending industry to avoid a repeat of the billions of dollars lost in the credit crisis, the focus was on conservative investment of cash collateral and a clearinghouse to create transparency, reduce spreads and keep stock pricing efficient.
Clearly, risks in the securities lending marketplace are high. The California Public Employees' Retirement System lost $634 million in securities lending in the past year, and Wilshire Consulting estimates that figure could reach $1 billion. State Street just revealed in a filing that the SEC is investigating its cash collateral pools.
Given the large amount of money at stake, the increasing use of electronic trading platforms, and the growth of hedge funds and short selling, experts said mutual funds and other beneficial owners that lend out their securities to boost earnings can no longer rely on outdated SEC no-action letters reaching back in time to 1972. They need clear-cut rules on appropriate use of collateral, contract fee comparisons and a venue where prices are revealed.
"For a long time, securities lending was regarded as a relatively low risk venture," said SEC Chairman Mary Schapiro, "but the credit crisis revealed it can be anything but low risk. This was particularly the case with cash collateral reinvestment programs which experienced unanticipated illiquidity and losses. Some institutions that lent their securities, and the beneficiaries relying on those institutions, were significantly harmed."
While it is true that some mutual funds, pension plans and other beneficial owners invested the extra cash they received from securities lending in structured investment vehicles and other mortgage-backed instruments, most-particularly mutual funds, which panelists said are best adept at securities lending due to a risk-adjusted approach-did not take on such credit default risk.
"However, due to the entry of third-party lenders focused on better performance, unbeknownst to many beneficial owners, they frequently took on liquidity risk without understanding that risk," said consultant William Pridmore. "The attention must be on collateral and reinvestment. If any weakness has been exposed, it has been that risk," concurred Christine Donovan, managing director with Brown Brothers Harriman.
SEC guidance on how cash collateral can be invested would be very helpful, said Bruce Leto, a partner with Stradley Ronon Stevens and Young. "The industry assumes it must be in conservative, liquid investments and not involve an affiliated lending agent. But greater flexibility might be warranted, and further guidance would be helpful to address market changes and proxy voting," he said.
Asset managers want detailed parameters on investment type, duration, credit quality, risk and direct or agency-led investments, as well as a requirement for total transparency and reporting on a daily basis from lending agents. Although most lending agents provide indemnity against borrower default, that, too, could be a SEC requirement. In addition, non-cash collateral deals are becoming more common, and the SEC could require that such collateral be properly diversified, valued and correlated with the item being lent, suggested Kathy Rulong, executive vice president with Bank of New York Mellon.
Another key failure is a disconnect in the compensation of securities lending agents and beneficial owners. Agents collect 20% to 40% of the returns on the cash collateral investments, but have no liability whatsoever should those investments turn negative, leaving the bill entirely up to lenders. The New Orleans Municipal Employees' Retirement System lost $500,000 in securities lending in 2008 because the bank improperly sold the program as "free money" and failed to reveal the "cross contamination that affected the stock and bond markets," said Jerry Davis, president of the pension's board.
"We desperately need to develop new due diligence practices for every relationship, including custodians," Davis said.
Because the securities are lent over the counter, there is no clearinghouse for prices, giving these opaque transactions and intermediary sales agents undue influence over stock futures, particularly when borrowers seek stocks that are hard to obtain, said David Downey, chief executive officer of OneChicago.
"Securities lenders are fragmented, and prices are inconsistent, especially for stock specials that become hard to borrow due to such episodic corporate events such as mergers and acquisitions," added Professor Adam Reed of the University of North Carolina. "That makes it difficult to short sell, which leads to market inefficiency."
"We do think that a central counterparty offers a solution to transact securities loans [transparently with] consistent risk management practices," agreed John Nagel, managing director at Citadel Investment Group.
However, not all are in favor of a central clearinghouse. Irving Klubeck, president of Pershing, said that securities lending brokers mark to market every day and called the industry an efficient "supply and demand market that follows basic laws of economics where prices move towards the proper efficient." To determine a fair price for a security its clients want to borrow, Pershing will make as many as 40 calls to counterparties, he said.
Downey of OneChicago countered that spreads on stock prices can be as much as 50 basis points, and Davis of the New Orleans pension plan said that while mark to market may be common practice, it is not required. "If the paper is becoming less valuable, there is no requirement for the lending agent to monitor that," he said. Lending agents must be required to spell out how they use ratings and track cash collateral investments, Davis said.
Another disturbing trend is the "retailization" of securities lending, which Schapiro called "frightening."
A year ago, as mutual funds and pension plans became wary of the risks of lending their securities, brokerages began turning to the inventory of stock held by retail investors in custodial margin accounts, testified Richard Ketchum, chairman and chief executive of the Financial Industry Regulatory Authority. Thus, FINRA is considering a net set of consumer protection rules that would require brokers to inform investors about the risks of securities lending, in terms of losing their proxy voting rights and insurance protection from the Securities Investor Protection Corp., as well as higher taxes on dividends.
To address concerns about properly pricing securities on loan, last week, Standard & Poor's launched the first public index series on the cost of borrowing U.S. equities in the S&P 500, S&P MidCap 400 and S&P SmallCap 600 .
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