Securities financing remains an important source of revenue for pension funds and other institutional investors, and should not be shunned due to its association with short selling, says Jerome Nunan

The background to the credit crisis is now well known. In 2007, the share prices of institutions believed to be most exposed to sub-prime risk began to sink.

Meanwhile, in response to growing rhetoric about short selling, the UK's Financial Services Authority (FSA) introduced measures in June 2008 requiring institutions that held net short positions greater than 0.25 per cent of a listed UK company undertaking a rights issue to report them and any subsequent changes. With markets suffering the extreme dislocation seen in 2008, it became a popularly held belief that short selling was to blame. Short selling bans of varying degrees of severity were introduced in many jurisdictions. These measures reinforced the view that securities lending was at the heart of the crisis.

Unsurprisingly, beneficial owners became concerned about their association with an activity that attracted almost universal opprobrium and that, following the collapse of Lehman Brothers, was no longer seen as low risk. These concerns were compounded by stories of beneficial owners suffering unanticipated losses in their cash reinvestment programmes, though this primarily affected US lenders. Many responded by suspending their participation in lending programmes, with some yet to re-enter the market.

The case for securities lending
In light of these concerns it is worth revisiting the case for securities finance. In contrast to the popular perception that equates securities financing with short selling, approximately 50 per cent of all lending relates to financing of fixed income. Primarily, this takes the form of government or credit repo, the purpose of which is to enable institutions to manage their liquidity requirements.

Of equity loans, the vast majority of activity is used to support some form of arbitrage. Without the ability to short sell, many widely practiced activities that support efficient markets, such as convertible, index, or merger arbitrage, would be impossible.

It is estimated that only four per cent of equity lending activity is used to support pure directional shorting. Furthermore, studies have established that lending equities delivers a range of benefits to markets, including improved liquidity, tighter spreads, improved price discovery, mitigation of market bubbles and support for derivative trading and hedging.

Despite this, some professionals believe that securities lending, and associated short selling, damages their interests as 'long' investors.

Fears tend to focus on the idea that short selling is predatory, linked with abusive behaviour, and misaligned with the goal of long-term capital appreciation. Certainly, regulators acknowledge such concerns – the FSA recognising that short selling could "contribute to disorderly trading, increased short-term price volatility and be used in manipulative trading".

And indeed, some academic evidence suggests that short selling can make price discovery less efficient in certain circumstances. However, the FSA also states that the risks outlined above are already addressed by existing regulation – relating to market abuse, for example.

While many studies demonstrate that short selling can impact prices negatively, this is interpreted as contributing to efficient pricing by allowing negative information about stocks to be expressed in the market.

It is in this context that regulators in all sophisticated markets have long endorsed securities lending as an integral element of the efficient functioning of markets. Indeed, as recently as in January 2010, Paul Tucker, deputy governor of the Bank of England, described it as "absolutely vital to effective market making, and thus to efficient capital markets".

Evaluating the regulatory response
Notwithstanding regulatory support, the events of 2008 inevitably meant that the industry would come under review once markets normalised – and so it has proved. At a macro level, regulators charged with market supervision have been looking at what needs to be done to facilitate orderly, efficient markets.

This has been coordinated by IOSCO (the International Organisation of Securities Commissions), whose technical committee produced high-level recommendations in relation to short selling with a view to introducing greater transparency and control.

More pertinently for beneficial owners, at a micro level, regulators have been examining how to protect the interests of lenders more effectively. In the UK, this has taken the form of guidance notes issued by the Pensions Regulator (TPR). These are meant to provide a framework enabling trustees and their advisors to better understand the nature of their lending programme.

Building on this, new guidelines on securities lending are being drafted under the auspices of the Bank of England's Securities Lending and Repo Committee. These are expected to be issued in Q3 2010. This consultation process is in its early stages, but it is clear that TPR is encouraging greater levels of understanding and involvement on the part of trustees.

In light of this new found focus, beneficial owners should re-examine securities finance, recognising it for the overlay investment strategy that it is. Potentially it unlocks the full intrinsic value of their assets, and should be reviewed alongside other investment decisions – ensuring that while generating additional revenue, it does so in alignment with the client's risk adjusted return objectives.

Paradoxically, though, while owners undertake detailed selection processes for investment managers, they commit billions of assets to lending programmes almost as a footnote to their selection of custodian. In redressing this, owners should review the key programme elements; return, risk appetite, and compatibility with the lender's broader investment objectives.

Forecast returns are inherently unpredictable. However, to the extent possible, beneficial owners should examine the features of an agent's programme that underpin revenue forecasts. Cash collateral introduces an additional layer of risk, albeit one that historically has served to actually enhance returns.

Insurance
Many owners with indemnities from their agent lenders have deemed their involvement to be risk-free. However, as events showed, the insurance these provided has varied widely – notably in respect to losses on cash reinvestment, which is precisely where owners appear to have been hit. It is, therefore, important that indemnities are scrutinised carefully to clarify what protection is on offer.

Equally important is the creditworthiness of the indemnity provider; an indemnity from an agent lender who defaults is of little value. In the final instance, it may well be preferable for the beneficial owner to take a higher fee split and no indemnity rather than surrender current revenue for an indemnification that, when required, proves inadequate.

Finally, beneficial owners should ensure their lending programme is compatible with their broader investment management activities. This not only relates to corporate governance, but to other areas where seamlessness between fund manager and lending agent can enhance overall portfolio returns.

Good corporate governance is perfectly compatible with participation in a lending programme, and governance-focused owners should select an agent whose programme offers the flexibility to determine on a vote-by-vote basis whether the owner's interests are best served by voting or by leaving the securities on loan.

Similarly, beneficial owners should investigate whether their lender can work with their investment manager on a case-by-case basis in respect of corporate actions. Such flexibility is also likely to help deliver enhanced returns.

The credit crisis has vindicated the securities finance operating model, and that it remains an important source of additional revenue for pension funds. However, it should be a focus for front office decision makers, who should routinely assess routes to market and the relative merits of custodial and third party programmes.

Jerome Nunan is a client portfolio manager at Aviva Investors

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