Background – what does securities lending involve?
The practice of securities lending is also often referred to as stock lending (although it can involve a variety of asset classes) and refers to the lending of securities by one party to another. The borrower provides the lender with collateral in the form of cash, government securities or a letter of credit which should be of a value equal to or greater than the value of the loaned securities. The parties then negotiate a fee for the loan. When a security is loaned, the title to the security transfers to the borrower. The type of scenario when stock lending typically occurs is when a securities lender (an investment bank) loans the stock and allows a short seller to borrow the stock and sell it. The short seller intends to buy the stock back at a lower price, thus creating a profit and at the end of the agreement, the lender (should) receive the same number of shares in the security as they originally lent to the borrower.
Why has the Regulator issued this statement?
The catalyst for this statement appears to be concerns expressed to the Regulator by Frank Field, MP in May 2009 that pension fund custodians were "gambling" with assets entrusted to their safekeeping. The particular example which came to Mr Field's attention, was a mid-size pension fund that used a high street bank as the custodian for its pension funds. Mr Field claimed that unknown to the trustees of the scheme, the bank was lending out both shares and gilts owned by the scheme. Mr Field stated that the collateral received in return for the loan took the form of gilts from third world countries which, although they had the same nominal value as the UK gilts, would have been inadequate had the bank collapsed and the pension scheme been forced to sell the replacement assets. Mr Field was particularly concerned that this practice could be widespread, that pension schemes were generally receiving very small returns relative to the risk and he believed the banks were instead keeping most of the stock lending fee.
The Regulator has now issued its statement on securities lending in response to concerns expressed in the pensions industry. The aim of this statement is to help trustees understand how securities lending operates and to help them understand and manage the risks involved. The Regulator also highlights the positive side of securities lending by referring to a recent Financial Services Authority (FSA) discussion paper noting that this practice allows market makers to increase liquidity, which then helps the financial markets operate more smoothly and efficiently.
A recent survey by Pensions Week demonstrates that securities lending is popular. Replies from the 50 biggest pension funds participating in the survey revealed that 68% currently participate in securities lending and that they make on average £2million per year from the activity. The survey also demonstrated that many schemes adopt a cautious approach to securities lending, particularly in relation to collateralisation.
The Regulator highlights that securities lending will not be appropriate for all schemes and that each set of trustees will need to decide whether it is suitable for their particular scheme. A number of action points for trustees of occupational schemes are included in the Regulator's statement and the key points to emerge can be summarised as follows:-
- Awareness – trustees must make sure they know whether their fund managers are lending assets on their behalf and, if they are, whether the scheme is receiving appropriate benefit for the stock lending – this also applies when scheme assets are invested in pooled funds;
- Understanding – trustees should have an appropriate understanding of the arrangements and the financial terms in place between the scheme, fund manager and any borrowers;
- Satisfied as to the risk – trustees must understand both the risk of securities lending and the collateral being given in return for the loan as well as being satisfied that what they are receiving is sufficient and appropriate in the circumstances;
- Controls in place – trustees must ensure that the controls they have in place allow them to monitor the appropriateness of this type of arrangement in the context of their overall investment strategy.
Importantly, the Regulator also suggests that trustees and pension scheme managers should review their current arrangements for management of scheme assets. The Regulator also sets out a number of key questions to be considered, including:-
- Arrangements with fund managers – are any agreements with fund managers sufficiently clear regarding whether (and which) scheme assets may be lent? If the assets may be lent, are the terms on which this may happen adequately set out?
- Legal Agreements – does the fund manager have appropriate legal agreements in place setting out the obligations of both the borrower and lender?
- Controls and expertise – are there appropriate controls and expertise in place to understand, monitor and mitigate the risks involved in lending scheme assets?
Clearly there are a number of important considerations for both trustees and those involved in the management of pension schemes when the option of securities lending is being explored to ensure the necessary checks and balances are in place. Equally important, of course, is that all parties must ensure they are at all times acting within the powers included in their scheme trust deed and rules. Investment powers are something that should be kept under regular review, particularly when stock lending or over-the-counter derivatives are being considered by pension schemes.