A quiet but lucrative corner of the asset management industry will be thrust into the spotlight as policymakers finalise rules that will make securities lending more transparent.
The European Commission will soon release detail of the Securities Financing Transactions Regulation, which will force fund managers that loan out assets, such as stocks, bonds and cash, to disclose the deals in full.
This global market covers $2.3tn assets and produces $9.2bn revenue. Securities lending has surged in recent months as investors try to maximise returns.
“We have noticed a great deal of interest among US and European asset managers in securities lending over the past 12-18 months,” says John Wallis, co-head of securities lending for Europe, the Middle East and Africa at Brown Brothers Harriman, the investment bank.
He says much of the interest is driven by active managers that need to cut costs and whose profit margins are shrinking. They are trying to squeeze additional revenue streams— and stock lending looks to be a more viable option. Active managers are pitched against passive products and exchange traded funds that make heavy use of securities lending, enabling them to offer lower fees.
Andrew Dyson, chief executive of the International Securities Lending Association, a trade group, says an effective stock-lending operation can help a passive fund become a top-quartile performer. “The biggest passive managers deploy lending techniques very well and successfully,” he adds.
A survey of investors by DataLend and Funds Europe, a specialist publication, showed 59 per cent of respondents said their main reason for engaging with stock lending was to boost returns, compared with 36 per cent who said they did so to cover operational costs — the traditional reason for engaging in lending.
“A lot of fund managers that stopped lending stock after the financial crisis are looking to get back in,” says Mr Wallis. “That’s not to say that their historical concerns have gone away. They are trying to get data to understand how the sector has moved on.”
The global value of tradeable assets stood at more than $20tn at the end of 2017, according to DataLend. Of this, $2.3tn was loaned out, producing revenues of $9.2bn, a figure that includes $2.6bn from the European market. IHS Markit, another data provider, expects global revenues to top $10bn this year for the first time since the 2008 financial crisis.
BlackRock, the world’s biggest money manager, made $597m revenue from lending last year. The New York-listed group retains 37.5 per cent of the revenue through an affiliate that acts as its lending agent.
Regulators have been keeping a close eye on securities lending since the collapse of Lehman Brothers 10 years ago. Some investors suffered heavy losses through transactions linked to the failed investment bank. Stock lending dried up in the aftermath but it has returned gradually.
In 2011 the Financial Stability Board, the international body that monitors the world’s financial system, said securities lending could be classed as shadow lending. It recommended better oversight by global regulators.
The European Commission was first to respond. It unveiled its proposed SFTR in 2014 and final details will be published within weeks. Disclosures are likely to have to be reported from autumn 2019.
Under the regime, borrowers and lenders of stock are required to make daily disclosures on each transaction to an EU trade repository, including information of the collateral used.
A total of 153 data points have to be disclosed but not all are required for each transaction. “It’s quite a detailed reporting requirement,” says Mark Byrne, an SFTR specialist at EquiLend, a securities lending service. “The cost implications of meeting it are not insignificant.”
He says the new rules will not affect large asset managers too badly. Companies that work on tight margins, however, will be hit hard, to the point that some may be put off continuing to lend.
Mr Wallis does not expect the cost to be significant for most asset managers because a lot of the burden will be taken on by lending agents, such as his business. Who pays for additional disclosures, however, will be decided case by case, and large groups that lend internally, such as BlackRock, will have to shoulder the cost.
Rather than deterring asset managers from lending, the regulation is already helping bring investors back, says Mr Wallis.
“Asset managers can see the regulators have pulled up the carpet and floorboards — they’ve had a good look and given it a thumbs-up,” he says. “Investors can now have a degree of comfort that this has been looked at.”
Mr Dyson agrees that the rules will provide some security to fund managers, but not all will welcome the extra time and expense. “It legitimises lending in the eyes of people who stayed away since the financial crisis. But there are costs involved and someone in the value chain will have to pay for that,” he says.
Outside Europe, Australia and Hong Kong are moving towards setting new rules. The missing market, though, is the US, which produces more than half of global lending revenues. The Trump administration’s preference for a lighter touch has convinced regulatory experts that US legislation on stock lending will not appear soon.
Mr Dyson says this has created a regulatory imbalance. ISLA calculates that 60 per cent of lenders globally are based outside Europe. Under the SFTR, about a quarter of the data that borrowers need to disclose can be sourced only from the lender. If lenders are based outside the EU and not subject to the European regulation, it will be harder and more costly for borrowers to collect the information needed.
“It makes Europe a tougher and more expensive place to do business,” says Mr Dyson, who adds that if fund managers have not yet looked into the change and how it will affect them, they should do so quickly.
Empty voting is exceedingly annoying
A bitter battle between the boss of the maker of Mr Kipling cakes and Hong Kong hedge fund Oasis Management has reignited controversy over stock lending.
“Empty voting”, where activist investors borrow stock from long-term shareholders in order to use their voting rights, has been criticised as poor corporate governance. Public bodies advise against the practice but it still goes on.
In the case of Oasis and Gavin Darby, chief executive of Premier Foods, the hedge fund borrowed stock which it used to give it a vote at Premier Foods’ annual meeting this month.
Mr Darby’s re-election was opposed by shareholders controlling 41 per cent of the stock — an unusually high vote against a sitting CEO and at odds with last year’s backing by 99.5 per cent of investors.
In the weeks running up to the vote, a significant amount of Premier stock was lent out. Oasis increased its stake from 9 per cent to 17 per cent and told the Financial Times that the figure included 4.5 per cent of borrowed stock.
The issue of empty voting is highlighted every few years, especially when activist hedge funds exert pressure. In the high-profile battle between Melrose and engineer GKN this year, up to a quarter of the latter’s stock was lent, causing UK politicians and some parts of the media to berate fund companies for lending their stock and helping the activists.
Laxey Partners, the boutique UK manager, has used the trick several times. Famously it borrowed 42m shares from British Land in 2002. Embarrassingly for Hermes Investment Management, a champion of governance standards, it was revealed that the company had unknowingly loaned its stock to Laxey.
Regulators and public bodies take a dim view of empty voting. The Bank of England’s money market code, for example, says: “Securities should not be borrowed solely for the purpose of exercising voting rights.” The code is not legally binding.
John Wallis of Brown Brothers Harriman says empty voting is typically one of the biggest concerns for his asset management clients: “It’s something we have to give them a lot of comfort with.”
He says that for most companies there would be just one or two stocks they hold over the course of a year that are involved in activist campaigns. “They have a recourse mechanism to recall stock in these situations,” he adds.