Securities Lending, Market Liquidity and Retirement Savings: the Real World Impact November 2015 ______

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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

Josh Galper Managing Principal

PO Box 560 Concord, MA 01742 USA Tel: 1-978-318-0920 http://www.finadium.com

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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.

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

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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

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(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

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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

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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 or to post as collateral for OTC derivatives.

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Securities Lending, Market Efficiency and Economic Growth

Securities lending is a direct contributor to market efficiency. This has been found across multiple analyses using 2008 short selling bans as a case study. The more buys and sells in a marketplace, the more that spreads compress and market participants know that they can easily reverse their positions at a later date. This leads to lower transaction costs for investors. As a contributor to market liquidity and operational efficiency, securities loans help create a reliable, trustworthy marketplace (see Exhibit 4).

Exhibit 4: Securities lending contributions to market efficiency and economic growth

Source: Finadium

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Evidence on Equity Market Liquidity and Short Selling

Securities lending is tightly linked to short selling in every market where shorting occurs. Absent “naked” short selling, an illegal market practice where a stock is shorted without a corresponding securities loan, there can be no short sales past settlement date without a securities loan of some kind. As a result, securities loans directly contribute to increased market liquidity and improving price discovery.

Securities loans and short selling are widely recognized as a beneficial activity in financial markets. In a June 2009 report, the International Organization of Securities Commissions (IOSCO) noted that “short selling plays an important role in the market for a variety of reasons, such as providing more efficient price discovery, mitigating market bubbles, increasing market liquidity, facilitating hedging and other risk management activities.” 2 Further, short selling is an important factor in the construction of major investment indices.3 While the risks of abusive short selling have also often been cited, few market participants or regulators want to curtail legitimate short selling in todayʼs markets, barring an extreme market event. Even then, support for short selling bans may be limited.

Academic studies have demonstrated the benefits of short selling and therefore implicitly the benefits of securities lending. In an August 2011 paper in the Journal of Finance, authors Alessandro Beber and Marco Pagano produced the most definitive study of the impact of short selling bans during the 2007-2009 crisis. They found that short selling bans:

2 “Regulation of Short Selling, Final Report,” IOSCO, June 2009, available at http://www.iosco.org/library/pubdocs/pdf/IOSCOPD292.pdf

3 MSCI’s Global Investable Market Indices Methodology considers “Existence of a regulatory and practical framework allowing short selling” as part of its Market Classification Framework. Available at https://www.msci.com/index-methodology

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(i) were detrimental for liquidity, especially for stocks with small capitalization and no listed options;

(ii) slowed price discovery, especially in bear markets; and

(iii) failed to support prices, except possibly for US financial stocks.”4

After UK short selling bans were enacted from September 19 to October 30 2008, a study by Matthew Clifton and Mark Snape found that spreads on London Stock Exchange securities with short selling bans increased by 140% compared to 56% for stocks with no bans.5 In the US, Robert Battalio and Paul Schultz conservatively estimated that institutional and retail investors paid an additional $505 million in increased options transaction costs during US short selling restrictions initiated in September 2008.6 These costs were directly attributed to increased bid/ask spreads.

Similar findings have been presented in a series of research reports from the EDHEC-Risk Institute in Europe7, by industry associations8 and in a September

4 “Short-Selling Bans Around the World: Evidence from the 2007-09 Crisis (August 19, 2011),” Alessandro Beber and Marco Pagano, Journal of Finance, available at http://ssrn.com/abstract=1502184

5 “The Effect of Short-selling Restrictions on Liquidity: Evidence from the London Stock Exchange,” Matthew Clifton, University of Technology, Sydney, and Mark Snape, University of Sydney, commissioned by the London Stock Exchange, December 2008, available at http://www.londonstockexchange.com/about-the-exchange/regulatory/effect-short-selling- restrictions-liquidity-evidence.htm

6 “Regulatory Uncertainty and Market Liquidity: The 2008 Short Sale Ban's Impact on Equity Option Markets (January 11, 2010),” Robert H. Battalio, and Paul H. Schultz, available at SSRN: http://ssrn.com/abstract=1534932

7 The EDHEC reports include analyses from Professors Ekkehart Boehmer, Julie Wu, Charles Jones, Xiaoyan Zhang and Abraham Lioui. A list of reports is available at http://www.edhec- risk.com/about_us/Press%20Releases/RISKArticle1048860368688218576/attachments/Press_rele ase_Short_Selling_Ban_120811.pdf

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2011 research note from the Federal Reserve Bank of New York.9 Working papers from academic and industry sources around the world support the idea that the absence of short selling degrades market quality and that short selling promotes market liquidity.10

We have already observed that from June 8-11, 2015, the percentage of short sales ranged from 33% to 41% of total US equity market volume. While individual days will vary, these figures are indicative of general trading patterns on US markets. Academic research backs the conclusion that securities lending supports these transactions by affirming the ability of a trader to borrow shares to meet their short sale delivery obligations, which in turn enhances the price discovery process.11 At one point, academics stopped even discussing whether

8 The Alternative Investment Management Association (AIMA) response to recent European short selling bans, available at http://www.aima.org/en/media/press-releases.cfm/id/EAA34FCE-0036- 4D93-A6CE684CA77CA2CE

9 “Market Declines: Is Banning Short Selling the Solution?” Robert Battalio, Hamid Mehran and Paul Schultz, Federal Reserve Bank of New York Staff Reports, no. 518. September 2011, available at http://www.newyorkfed.org/research/staff_reports/sr518.pdf

10 “Shacking Short Sellers: The 2008 Shorting Ban,” Boehmer, Jones and Zhang, November 2008, available at http://www2.gsb.columbia.edu/faculty/cjones/ShortingBan.pdf

“The Impact of Short Sale Restrictions,” Ian W. Marsh and Norman Niemer, November 2008, available at http://www.afme.eu/WorkArea/DownloadAsset.aspx?id=195

“Does Short-Selling Amplify Price Declines or Align Stocks with Their Fundamental Values?” Curtis and Fargher, December 2008, available at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=817446

“Has the Short Selling Ban Reduced Liquidity in the Australian Stock Market,” Plato Investment Management, October 2008, available at http://www.plato.com.au/cmsupload/ShortSellingBan.pdf

“Short Selling and the Price Discovery Process,” Ekkehart Boehmer and Juan (Julie) Wu,” July 16, 2012, available at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=972620

11 “Price Efficiency and Short Selling (August 30, 2010),” Pedro A. C. Saffi and Kari Sigurdsson, AFA 2008 New Orleans Meetings Paper; IESE Business School Working Paper No. 748; Review of Finance Studies, Vol. 24, No. 3, pp. 821-852, 2011. Available at SSRN: http://ssrn.com/abstract=949027

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short selling bans were harmful and began trying to measure which types of bans were the least damaging.12

Similar to the equity markets, securities lending provides important liquidity for equity-linked options and futures markets. For long market makers, keeping a balanced book without purchasing more put options typically requires shorting equities, and a failure to hedge positions requires market makers to assume more risk in their portfolios. This risk gets translated into wider bid/ask spreads for investors. Securities loans facilitate short sales and act as the grease that reduces spreads and enhances market liquidity.

Efficient Markets and Economic Growth

A primary purpose of organized markets is to support economic growth. Exchanges serve as the meeting place for companies to find capital and for secondary market traders to determine a fair price of listed entities. According to the World Federation of Exchanges, regulated exchanges provide transparent price discovery and certainty of outcome.13 The ability to provide a transparent price and certainty of outcome relies on liquidity and operational efficiency. OTC markets across stocks, bonds and derivatives serve similar functions as regulated markets but without necessarily the same post-trade or regulatory infrastructure.

Both regulated and OTC markets are based on trust. The more confidence that investors have in price discovery and certainty of outcome, the more they are

12 “Which Short-Selling Regulation is the Least Damaging to Market Efficiency? Evidence from Europe,” Astrid Herinckx and Ariane Szafarz, January 2012, available at http://econpapers.repec.org/paper/solwpaper/2013_2f107635.htm

13 “Our Mission,” World Federation of Exchanges, available at http://www.world- exchanges.org/about-wfe/our-mission

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willing to invest in public sector institutions and private companies. A key component of this trust is that a security will have enough liquidity that investors can buy or sell at a time of their choosing and that securities will be settled on time and without errors.

Securities lending plays a critical role in building trust by generating liquidity, facilitating price discovery and helping to ensure operational settlement. This increases investor confidence, leading to more robust markets through capital formation and a strong secondary trading market.

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How Much Do Investors Earn from Securities Lending?

Retirement plans and other long-term investors are direct beneficiaries of securities lending revenues. Securities lending is intended to produce a consistent, incremental return for asset holders. This builds asset values and reduces operational costs, and is particularly helpful for public funds with no budget allocation for custody or other asset administration fees. However, securities lending is not intended as an alpha or beta asset class; it is an incremental revenue stream. The data show that securities lending accomplishes its revenue objective consistently across any time series, even the crisis period of 2008. Funds that experienced losses in 2008 from cash collateral reinvestment made up those shortfalls in later years and in some cases have come out strongly ahead.

Taking a sample of 90 US public pension plans, Finadium identified 54 funds that have loaned securities continuously from 2006 to 2013. These funds earned an average cumulative 34 bps on total asset under management from securities lending over that period, including the turbulent 2008 period where some funds experienced losses in cash collateral management accounts (see Exhibit 5). Even so, in 2008, these funds earned an average 6.6 bps from securities lending and typically made up collateral losses in later years.

Data from leading investment fund complexes show a similar pattern. From 2011 to 2015, lending portfolios from a sample of 357 investment vehicles run by 10 large firms returned a cumulative 19 bps over the period (see Exhibit 6). There are large distinctions between large cap index funds, which may earn just 2-3 bps annually from lending, and international and small cap funds, which can earn 20 bps or more annually due to demand for the assets and scarcity of lenders.

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Exhibit 5: Cumulative securities lending returns for 54 US public pension plans 2006 to 2013 (Percent)

Sources: fund filings, Finadium analysis

Exhibit 6: Cumulative securities lending returns for funds managed by 10 large investment complexes 2011 to 2015 (Percent)

Sources: company filings, Finadium analysis Note: funds analyzed were BlackRock, Dreyfus (BNY Mellon), Fidelity Investments, Franklin Templeton, J.P. Morgan, MFS, Putnam Investments, Schwab Funds, T. Rowe Price and Vanguard

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Securities lending returns have been compared to government bond funds. While bond fund returns will typically be greater, securities lending returns have generally been more consistent and can at times even outperform. As one example, while the iShares Core US Aggregate Bond Fund (AGG), returned 49 basis points from June 2011 to June 2015 (see Exhibit 7), in 2013 it suffered a drop in value while securities lending returns remained constant.

Exhibit 7: iShares Core US Aggregate Bond Fund (AGG) NAV 2011-2015 (US$)

Source: Morningstar, Finadium analysis

It is appropriate that not all funds lend, and this decision should be made according to the needs of investors and asset managers. Securities lending is a mixture of an operational function and an investment product. Investors and asset managers commit capital because they seek returns that are commensurate with the risk they assume. Likewise, securities lending fits into the risk/reward profile of some firms but not others. However, those institutions that have elected to participate in securities lending earn consistent returns.

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Where Is the Risk in Securities Lending?

The securities lending process is the result of decades of institutional proficiency made all the more robust in the mid-2000s, well before the global financial crisis; the market is characterized by and subject to well-developed risk controls. Institutional borrowers and lenders of securities are protected through Master Securities Lending Agreements that specify what may happen in the event of default. In addition, securities loans are over-collateralized at anywhere between 101% and 115% of loan value, depending on the collateral accepted and counterparties to the transaction, and are subject to daily re-margining based on changes in market value.

Most beneficial owners receive counterparty default indemnification from their agent lenders, which has been infrequently used in practice. The collateral received from the loan itself has been sufficient to cover virtually any default, whether to purchase back loaned securities in the open market or to return cash to the lender.

The mechanics of a securities loan mirror the risk profile of the transaction. In a traditional loan model, beneficial asset holders lend via agent lenders, who move securities and collateral on behalf of their clients but do not assume risk in the transaction with the exception of counterparty default indemnification (see Exhibit 8). The beneficial owner is directly exposed to a broker-dealer or similar financial intermediary, and this exposure is over-collateralized. Broker-dealers are exposed to both beneficial owners and their hedge fund clients. While this may seem a risky situation, the over-collateralization from the beneficial owner perspective and daily re-margining of the loan on both sides provides a strong defensive position in the case of counterparty default for any reason.

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Exhibit 8: Asset movements and collateral risk exposure in a securities loan

Source: Finadium

Counterparty exposure is the risk most often associated with securities lending. Lenders could have difficulties in getting their loaned securities back when needed if they choose their counterparties unwisely. For this reason, lenders are careful to choose whom they lend to at all times, and the majority of beneficial owners rely on agent lenders in substantial part to outsource counterparty credit analysis. This includes access to credit risk assessments for a wide range of borrowers, operations and technology expertise, and the active monitoring of supporting collateral positions. The potential future model of CCPs that accept beneficial owners in securities lending would have lenders face off against a CCP, rather than a broker-dealer; this is a new risk profile that will require evaluation.

There is also risk exposure when cash is received as collateral and then invested, at the direction of the beneficial owner, to earn a return. Cash reinvestments are typically overnight repo, money market funds and other short- term investment types. While specific reinvestment programs will vary according

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to the interests of the beneficial owner, Finadium data from 2014 show that only 16% of US pension plans elected to invest their cash in anything riskier than a money market fund, down from 18% recorded in 2013 (see Exhibit 9). Even so, a typical cash reinvestment portfolio profile for “risky” investments is 95% traditional money market fund and 5% equity repo, government bonds with a duration of up to one year, or similar type of asset. Cash collateralization levels are typically between 102% and 105% of the loan value. Some beneficial owners experienced losses in 2008-2009 due to counterparty default on reinvestment assets and/or widening credit spreads. Since then, reinvestment guidelines have become substantially more risk averse.

Exhibit 9: US pension plan investments from cash collateral in securities lending programs, 2013 and 2014 (Percent)

Source: fund filings, Finadium surveys, Finadium analysis

When securities are loaned against non-cash collateral, the same risk exposure applies as with a securities loan against cash. Collateralization levels may range from 101% (for government bonds) to 115% (for equities or corporate bonds). When beneficial owners receive non-cash collateral, these securities are held in

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segregated accounts, generally at their agent lender bank, and may be sold in the event of a default or simply held if they fit the fundʼs investment criteria.

While non-cash collateral has always been used in securities lending, it has become increasing popular in countries where cash has long been the industry standard. According to data from SunGard Astec Analytics, DataLend and Markit Securities Finance, the percentage of non-cash collateral used currently ranges from 55% to 60% of total collateral. This is an increase of 5% to 10% from September 2014.

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Regulation and Credit Risk for Custody Banks

Because of their proximity to pools of investment assets held by their institutional investor clients, custody banks play a prominent role as agent lenders in the market. As of November 2014, the three largest agent lenders, all major custody banks, had US$918 billion in outstanding balances, or roughly 51% of the global total. Furthermore, nearly all of the remaining agent lenders are also large banks with their own substantial custody operations. As a result, regulations that impact banks have important implications for the overall health of securities lending.

Indeed, continued weakness in the securities lending market relative to its pre- crisis peak can be traced, in large part, to regulatory initiatives that require banks to measure their counterparty risk exposures in a manner that substantially overstates such risks. This inflates the cost to banks of serving as an intermediary for what remains a low-risk, low-return financial activity. If the costs are too great, then banks will be incentivized to diminish their role, and there are indications that this process is already well underway, with industry estimates suggesting that a reliance on risk insensitive methodologies for the measurement of exposures could result in a further decline of securities lending activities of between 30% and 50%, particularly in General Collateral lending.

Banks that are active in the securities lending market, including custody bank agent lenders, typically rely on simple value-at-risk (VaR) methodologies when calculating their risk exposures. While VaR methodologies are widely viewed as the most accurate means of assessing risk in securities lending transactions, large US banks are required under Section 171 of the Dodd-Frank Act, commonly referred to as the ʻCollins Amendmentʼ, to measure their risk-exposures using both advanced and standardized methodologies. As currently designed, these

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standardized methodologies require the measurement of exposures using a highly risk-insensitive haircut based look up table which ignores key risk parameters, such as the correlation that exists between loans and offsetting collateral, the impact of portfolio diversification and the offsetting price dynamics of certain securities, such as US Treasuries in times of stress.

This formula results in an exposure measure that is multiples higher that what is obtained using VaR methodologies and that bears little resemblance to the ʻmaximum possible lossʼ that a bank may incur. This significant overstatement of exposures threatens, in turn, the practice of banks providing counterparty default indemnification, a service that beneficial owners consider very important to their continued participation in securities lending programs.

Outside of regulatory capital, methodologies for the measurement of exposures to securities lending have important implications for the calibration of single counterparty credit limits (SCCL). These are currently under review by US regulators, including the prospect of a lower SCCL for transactions between global systemically important banks. Since the Basel Committeeʼs large exposure framework makes use of the same risk-insensitive methodology that applies to risk-based capital, it is difficult for US regulators to opt for an alternative approach. For US regulators to change, the Basel Committee will need to change as well.

The growth of non-cash collateral loans, particularly equities for equities, gives rise to new challenges for securities lending market participants. While the benefits of non-cash include the liquidity of the underlying securities, higher haircuts relative to cash and government bonds, and support for borrowers needing to manage balance sheet exposures, new regulations require greater capital to support these transactions.

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In the US, equity collateral is currently not permitted to be pledged by broker dealers under Rule 15(c)3-3. Additional restrictions on the acceptance of equities as collateral exists for ʼ40 Act funds and ERISA plans under Securities and Exchange Commission and Department of Labor rules, respectively. Still, as the market evolves and eligible market participants seek to use additional amounts of non-cash collateral for risk management purposes, they are finding that the prescribed haircuts for non-cash collateral are working against them.

Could Securities Lending Move to the OTC Derivatives Markets?

Further complicating matters for securities lending is the preferential treatment afforded to derivative transactions under the Basel Committeeʼs standardized approach for counterparty credit risk (SA-CCR). Compared to the haircut-based Comprehensive Approach, the SA-CCR creates a powerful and adverse incentive for market participants to substitute securities loans with economically equivalent derivatives instruments to obtain a better capital treatment.

A move towards synthetic finance using swaps in place of securities loans is already evident in prime brokerage. Prime brokers are actively encouraging their clients to engage in swap transactions over physical loans where possible due the highly attractive capital benefit. A move towards synthetic finance has not yet shown up in securities lending transaction data, and some synthetic transactions still require a physical loan as a hedge. However, market anecdotes are that swaps-based transactions mimicking physical securities loans have and will continue to increase.

A move away from physical loans under the Comprehensive Approach to swaps under the SA-CCR directly damages underlying market liquidity. Every trade conducted as a swap over the physical removes liquidity from buyers and sellers

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of securities, leaving wider spreads and fewer opportunities for price discovery. Like dark pools for equity trading, this causes little harm if one or two trades occur this way. However, as more trades move away from the primary market to secondary trading venues, in this case OTC derivatives, the impact is felt and magnified across both the underlying and swaps markets.

It makes sense for economically equivalent transactions to have economically equivalent regulatory capital regimes. A swap that replicates a short sale but has an improved credit risk formula will benefit over a physical transaction subject to a Comprehensive Approach-style formula. This unbalanced regulatory arrangement favors OTC derivatives over securities lending, and is anticipated to result in lost liquidity for underlying markets in favor of swaps that settle based on increasingly less liquid reference prices.

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Securities Lending Is an Important Part of Financial Markets

Securities loans play an integral part in reducing transaction costs, providing liquidity to financial markets and generating income for retirement plans and other long-term investors. Demand has, however, already been heavily constricted by global regulations that dramatically increase borrowing cost for loans that were previously viewed as low risk for both counterparties. If costs increase further and constrict both supply and demand, markets should expect increased volatility and wider spreads in a variety of asset classes.

A loss of market liquidity, which leads to wider spreads, means higher investment costs for retirement plans and other long-term investors. A simple formula for determining the cost to investors of a security transaction is Investment Commission + Spread. If investment commissions are 20 bps and current spreads are 10 bps, investors pay an effective transaction cost of 30 bps to buy or sell a security. During 2008ʼs short selling bans, spreads widened by 140%. In our hypothetical example this would increase investor transactions costs to 44 bps. This translates into an increase of 14 bps, or 46%:

Investment commission = 20 bps Current spread = 10 bps Total current investor cost = 30 bps

Investment commission = 20 bps Future spread with less liquidity = 24 bps Total future investor cost = 44 bps

Increased investor transaction cost = 14 bps, or 46%

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If investors in major economies buy and sell 100% of their domestic marketʼs capitalization each year, which is a rough estimate of trading based on large exchange and market statistics worldwide, this translates into US$61 billion in additional costs across seven equity markets (see Exhibit 10). This is money taken directly out of investor returns.

Exhibit 10: Impact of lower liquidity on investor costs (US$ billions)

Source: Finadium

Comparable figures in the fixed income market are less certain, owing to a variety of factors that cloud the relationship between short selling and market liquidity. However, in a global fixed income market of over US$100 trillion, any widening of spreads will have a large and repeated impact on market participant returns.

With fewer securities loans, investors also lose out on lending revenues and the opportunity to cover at least some of their operational costs. While securities lending revenues of three to seven basis points will not make or break a portfolio, cumulatively they can add up, even during crisis periods. These returns can be important in paying for additional staff or services that retirement savers need

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most. Risk is most effectively managed by prudent collateral acceptance and, where applicable, in cash reinvestment policies rather than in exposure methodologies which dramatically overstate risk.

Already impacted by a substantial contraction during the financial crisis, the securities lending market has not rebounded due to increased capital costs for major industry participants and is expected to further contract based on the requirements of prevailing regulatory standards. A constriction of supply due to increased regulatory costs will have immediate consequences for financial markets, domestic economies and individual investors. These implications should be carefully evaluated when considering the direction of further regulatory change.

© 2015 Finadium LLC. All rights reserved. Reproduction of this report by any means is strictly prohibited. Page 25 Securities Lending, Market Liquidity and Retirement Savings: The Real World Impact November 2015 ______

About the Author

Josh Galper is Managing Principal of Finadium and runs the firmʼs research and consulting advisory practice. He is a regular speaker at industry conferences and has been quoted in major mainstream and financial industry publications. He holds an MBA from the MIT Sloan School of Management. He can be reached at [email protected].

About Finadium LLC

Finadium is a research and consulting firm focused on institutional investments, treasury and financing. Finadium research is available on a subscription basis. Finadium conducts consulting assignments on product development, marketing and strategy. For more information, please visit our website at www.finadium.com and follow us on Twitter @Finadium. Finadium also produces the publication Securities Finance Monitor.