Is This How Securities Lending Wins Back Investors?

(May 21, 2012) — eSecLending has released a list of best practices for the securities lending industry, which suffered a blow to its reputation in the aftermath of the financial crisis of 2008.

With the balance of securities on loan at the end of January exceeding $1.8 trillion globally, securities lending — a collateralized transaction that takes place between two institutions — has evolved from what 20 years ago. The practice has evolved from a back office, operational function to an investment management and trading function worthy of greater focus and attention, eSecLending said in a paper this week. 

However, the market events of 2008 and 2009 created an array of challenges that affected all short term cash markets including most cash collateral pools, the paper said. “The default of Lehman Brothers tested the unwinding procedures of the lending and collateralization processes at agent and principal lenders alike.” 

“In 2007 and 2008, people realized that there was an aspect of securities lending that they hadn’t looked at before, which really brought liquidity risk to the forefront,” Paul Sachs of Mercer added at an industry conference in New York last week, noting that despite the hardships securities lending has endured, it is a vital function of capital markets that will not go away anytime soon.

The following is a sample list of industry best practices when it comes to securities lending, as outlined in the paper.

1) Lenders should ensure that the person responsible for corporate governance is part of the securities lending oversight group internally.

2) It is important to understand what is driving the demand for the lenders’ securities. Lenders should be receiving market color that discusses the strategies and interest for individual securities and asset classes. 

3) In considering the route to market, the lender should ensure it understands the fee implications. For example, in a custodian program the custodian typically covers the fees associated with the security movements, how will this work in a third party program?

4) Lenders should ensure that their agent understands the lender’s preferences regarding proxy voting and security restrictions.

5) If there is one essential area of due diligence, the collateral management process is it. Understanding how an agent collateralizes loans, what happens operationally to ensure loans are not released before collateral is received, and how exceptions are reported is critical to a sound securities lending program.

According to the paper, short sale bans and negative press added to the negativity around securities lending products, with an increased focus being centered on the investment management and risk management practices of lending programs.

“The practice improves overall market efficiency and liquidity, provides a critical element for hedging, acts as a useful tool for risk management for trading and investment strategies, and helps to facilitate timely settlement of securities,” the paper said.

Read the full paper on securities lending chaired by eSecLending here.