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Securities Lending, Market Liquidity and Retirement Savings: the Real World Impact November 2015 ______ Securities Lending, Market Liquidity and Retirement Savings: The Real World Impact November 2015 ______________________________________________________________________________________________________________________________________ Securities Lending, Market Liquidity and Retirement Savings: The Real World Impact November 2015 Josh Galper Managing Principal PO Box 560 Concord, MA 01742 USA Tel: 1-978-318-0920 http://www.Finadium.com © 2015 Finadium LLC. All rights reserved. Reproduction of this report by any means is strictly prohibited. Securities Lending, Market Liquidity and Retirement Savings: The Real World Impact November 2015 ______________________________________________________________________________________________________________________________________ Table of Contents Why Securities Lending Matters ........................................................................ 1 Sizing the Market ........................................................................................................ 2 The Uses of Securities Loans ..................................................................................... 4 Securities Lending, Market Efficiency and Economic Growth ........................ 6 Evidence on Equity Market Liquidity and Short Selling .............................................. 7 Efficient Markets and Economic Growth ................................................................... 10 How Much Do Investors Earn from Securities Lending? ............................... 12 Where Is the Risk in Securities Lending? ....................................................... 15 Regulation and Credit Risk for Custody Banks .............................................. 19 Could Securities Lending Move to the OTC Derivatives Markets? ........................... 21 Securities Lending Is an Important Part of Financial Markets ...................... 23 About the Author ............................................................................................... 26 About Finadium LLC .......................................................................................... 26 This paper represents the views of Finadium LLC. Funding for this research was provided by State Street Corporation, which was not granted editorial authority over the paperʼs content, methodology, and findings. These are solely the responsibility of Finadium LLC. Funding from State Street Corporation has made this report publicly available. © 2015 Finadium LLC. All rights reserved. Reproduction of this report by any means is strictly prohibited. Securities Lending, Market Liquidity and Retirement Savings: The Real World Impact November 2015 ______________________________________________________________________________________________________________________________________ Why Securities Lending Matters Securities lending plays a relatively unknown but vital role in financial markets. Behind the scenes, it provides liquidity for trading and settlement, reduces volatility and greatly assists in the process of price discovery both on exchanges and in bilateral markets. It also produces helpful incremental income for retirement plans and other long-term investors, which is used to reduce costs and improve returns. Agent lenders, primarily large custody banks, play an important role in securities lending by facilitating access to pools of investment assets held by institutional investor clients. Their ability to continue to intermediate securities lending is therefore crucial to the health of financial markets. This, in turn, benefits domestic economies by facilitating capital formation, risk transference and the long-term accumulation of wealth. In an era of complex regulatory change, it is important that the benefits of securities lending are well-understood and appropriately preserved. This paper looks at the contributions of securities lending to financial markets with an emphasis on transaction costs, market liquidity and incremental revenue. We identify US$61 billion in increased annual investor costs that would result from a loss of securities loans on major international equity markets if securities loans, and hence short selling, were no longer available. As an important addition to market liquidity and operational efficiency, securities loans help create a reliable, trustworthy marketplace for investors. The annual reports of US pension plans and global investment fund complexes demonstrate that securities lending contributes consistent and uncorrelated basis point returns to investors, including during stressed market conditions. Policy makers should be aware of the broad © 2015 Finadium LLC. All rights reserved. Reproduction of this report by any means is strictly prohibited. Page 1 Securities Lending, Market Liquidity and Retirement Savings: The Real World Impact November 2015 ______________________________________________________________________________________________________________________________________ consequences of existing and proposed regulations on the ability of banks to continue to support securities lending activities. Sizing the Market There are between US$1.5 to US$2 trillion in securities loans outstanding, according to data from SunGardʼs Astec Analytics, Markit Securities Finance and DataLend, the three securities lending data providers. 56% of this volume is in equities with the remainder in fixed income (see Exhibit 1). 63% of transactions occur in North America, 28% in Europe and 10% in Asia. Exhibit 1: Securities loans by product and location Sources: SunGard’s Astec Analytics, DataLend The majority of this volume is conducted bilaterally, although in some markets Central Counterparties (CCPs) are now an attractive alternative. In May 2015, the Options Clearing Corporationʼs securities lending CCP recorded an average daily loan volume of US$196 billion in broker-to-broker trades. In January 2012, their average daily loan volume was only US$20 billion. There are four main participants in the securities lending market: beneficial owners, agent lenders, broker-dealers and end-borrowers including hedge funds © 2015 Finadium LLC. All rights reserved. Reproduction of this report by any means is strictly prohibited. Page 2 Securities Lending, Market Liquidity and Retirement Savings: The Real World Impact November 2015 ______________________________________________________________________________________________________________________________________ (see Exhibit 2). Each participant plays an important role in the process. Fees are paid by end-borrowers and are split between beneficial owners, agent lenders and broker-dealers. Exhibit 2: Actors in the securities lending market Source: Finadium Participation from beneficial owners in the securities lending market is broadly distributed, with asset managers and pension plan accounting for 45% of securities loans outstanding, according to data from Markit Securities Finance.1 Other large beneficial owner types include Central Banks and insurance companies. 1 ISLA Securities Lending Market Report, September 2015, available at http://www.isla.co.uk/wp- content/uploads/2015/08/ISLAMarketReportSEPT2015.pdF © 2015 Finadium LLC. All rights reserved. Reproduction of this report by any means is strictly prohibited. Page 3 Securities Lending, Market Liquidity and Retirement Savings: The Real World Impact November 2015 ______________________________________________________________________________________________________________________________________ The Uses of Securities Loans Securities loans are used for a range of activities, including facilitating short sales, ensuring timely settlement of securities transactions and assisting investors in meeting their collateralized trading requirements. Short sales can represent a substantial amount of market liquidity. In the week of June 8, 2015, for example, short sales contributed between 33% and 41% of total market volume on US equity markets as measured by shares traded (see Exhibit 3). Short sales must be legally supported by securities loans; otherwise they are bought in by settlement. These figures are representative of typical trading patterns and show that short sales contribute a large amount of market liquidity for investors. Exhibit 3: Short sales as a percentage of total equity market volume, June 8-11, 2015 (Percent) Sources: FINRA, Finadium analysis © 2015 Finadium LLC. All rights reserved. Reproduction of this report by any means is strictly prohibited. Page 4 Securities Lending, Market Liquidity and Retirement Savings: The Real World Impact November 2015 ______________________________________________________________________________________________________________________________________ Securities loans are used to cover settlement failures, ensuring the timely delivery of securities to buyers in case of operational incidents. While the percentage of securities loans for settlement may be small, this is an important functionality used in every major securities marketplace. Some Central Securities Depositories including Euroclear and Clearstream have automated their settlement process to include securities loans in case of a failed delivery. Securities loans are part of the growing collateral upgrade trade, where investors and financial intermediaries needing High Quality Liquid Assets may borrow those securities in exchange for an asset of equal or greater value. These types of transactions ease buying demand in the cash markets and give investors the flexibility to conserve assets for regulatory capital
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