Ten Steps to a Better (and Safer) Securities Lending Program
When lending out their assets, mutual funds need to spend some time evaluating and mitigating the risks involved, recommends a working group established by eSecLending which has just published a white paper on best practices.
There are plenty of reasons investment funds need to be more cautious as evidenced during the financial crisis. Borrowers can default, as shown by Lehman Brothers, and cash collateral could quickly lose its value if not invested properly. Misunderstandings between lenders and agent banks can also lead to the worst case scenario: financial loss and litigation. Mutual funds comprise about 22. 3 percent of the total value of securities out on loan as of January 2012, according to securities lending data provider Data Explorers, now part of Markit Group. Other lenders include global pension funds, insurance companies, investment funds, exchange-traded funds and sovereign wealth funds. Best known as a specialist third party agent who introduced an auction based process directly linking securities lenders and borrowers, the Boston-headquartered eSecLending teamed up with a group of representatives from 38 fund managers, legal firms, consultancies and trade associations to come up with a pretty exhaustive list of recommendations for mutual funds. Participating in the group were representatives from Pacific Life; Deutsche Asset Management; Alliance Bernstein and John Hancock Funds. The following represents just ten of the recommendations which were published in a white paper entitled "Securities Lending Best Practices: A Guidance Paper for US Mutual Funds." The Mutual Funds Directors Forum used some of the guidelines to publish a separate white paper on best practice guidelines for mutual fund boards. A full copy of eSecLending's white paper can be found under the "Thought Leadership" section of its website www.eseclending.com.
1- Be Clear: Lenders should be clear on the objectives of their securities lending programs and explain the objectives in their securities lending policy shared with the lending agent bank. In most cases, mutual funds lend securities for one reason only: to improve the performance of the fund for the benefit of its shareholders. The revenue from securities lending is returns to the fund adding additional yield to improve performance versus a fund's specific benchmark. Most mutual fund companies do not permit lending across all funds, as some portfolios hold securities that are not appropriate for lending.
2- Understand Demand: It is important to understand just what is driving the demand for the lenders' securities. Lenders should receive market color that discusses the strategies and interest for individual securities and asset classes. It is useful to provide this color to the fund's board of directors, highlighting the top revenue earning securities for each calendar quarter. Lenders should also monitor developments with respect to the use of central counterparties in the securities lending market and update their strategy accordingly.
3- Understand Alternative Routes to Market: Lenders can find borrowers themselves or rely on custodian banks or third party agents to do so. Therefore, they need to understand the fee implications of the route they take. In a custodian run program, the custodian will typically cover the fees associated with security movements. Lenders also should be given estimates of their revenues and understand the assumptions made by the custodian bank or third party agent. All agent lenders should be able to provide lenders with a Statement on Standards for Attestation Engagements (SSAE) 16 -- formerly known as SAS 70 -- detailing their lending controls.
4- Evaluate strategy: Each lender should ensure their lending agent provides a comprehensive lending strategy for their funds which includes the electronic tools used and whether or not exclusives are part of the mix. Lenders should also be aware of whether their lending agent has any affiliated borrower and ensure their agent understands their preferences regarding proxy voting and security restriction. In the case of a principal or exclusive lending agreement, the lender or its agent will negotiate an exclusive agreement with the borrower and the borrower will pay a guaranteed fee for exclusive access to borrow a portfolio of securities. Income is guarantee and lending fees are stable and consistent through the term of the exclusive -- typically a year. The lender is protected from a decline in revenues but gives up the upside revenue potential above the guaranteed revenue level. A lender can have multiple exclusives with a variety of borrowers for different parts of its portfolio of securities to be lent. By contrast, in the case of discretionary lending, the lending agent or principal will negotiate each loan with he borrower and pricing can fluctuate daily with market changes; lending is done on a "best efforts basis."
5- Know What Securities to Lend: Each asset class may require its own securities lending strategy which could relate to collateral options, route to market and security level restrictions. The extent to which a lender considers breaking out its strategy will depend on the size of the assets and its ability to manage multiple strategies with potentially different vendors. The mutual fund's board and portfolio manager should decide what securities are lent and what restrictions should be applied. Such restrictions should be programmed into the lending agent's systems and monitored from a compliance perspective.
6- Manage Collateral: Lenders must spend just as much attention to monitoring cash reinvestment programs as they do the securities lending transaction itself. In the US cash represents about 80 percent of collateral received in securities lending programs. It is typically placed in a commingled fund or separate account so the lender returns any income earned from the investment of the cash collateral less the rebate paid to the borrower. Lenders must understand how agents collateralize loans; what operational safeguards are taken to ensure loans are not released before exceptions are reported and how exceptions are reported. The lender must also know its rights to the collateral in the event the borrower defaults. If a third party cash manager is selected the lender must ensure that it gets frequent updates on cash forecasting; cash yields and rebates to prevent potential negative loans-- or losing money. When participating in a commingled cash fund lenders should ensure they know what will happen in the event an investor pulls out of the fund, particularly if there are liquidity or credit issues with the portfolio of securities the cash is invested in.
7- Consider Type of Loan: The dynamics of supply and demand drive how a securities lending transaction is negotiated. Lenders can tell their agents the type of securities lending transactions they want. Examples include "special loans only"; a combination of "special loans and "general collateral loans" or minimum fee criteria and loan balance limitations. General collateral securities are very liquid and widely available while "specials" are heavily in demand and hard to borrow so they generate higher fees but a lower volume of transactions. Lenders who allow general collateral loans will benefit from higher transaction volumes and asset values on loan but are more susceptible to operational and market risk so program controls and risk management practices become even more important. Most loans are "on open" or callable so securities can be recalled at any time.
8- Mitigate Risks: There are multiple risks in a securities lending program: counterparty risk; investment risk; market and liquidity risk; operational risk; and legal and contractual risk. The use of collateral and indemnifications by lending agent against broker defaults are valuable insurance policies but don't eliminate the need for the mutual fund to implement comprehensive risk mitigating policies, procedures and controls. Among those are knowing the operational procedures to be followed when a counterparty defaults, including the respective responsibilities of the lender and the agent and ensuring these procedures are consistent with the terms of the legal agreement. When it comes to lenders monitoring market risk, they should understand the potential exposure in certain past crisis scenarios as well as use value at risk models.
9- Establish Board Oversight Policies: The board of directors of a mutual fund is typically responsible for approving and overseeing their fund's securities lending providers. The board will play a key role in defining the parameters of the securities lending program and overseeing it. Some mutual fund boards have found it useful to form a small working group of fund directors and adviser personnel to monitor the key elements of the securities lending policy and report periodically to the board. These working groups are made up of independent directors and representatives from the investment adviser's operations, compliance, portfolio management, risk management, trading, legal and tax departments.
10- Establish Lending Policy: The fund should have written securities lending policies and procedures approved by the board and set parameters for risk tolerances. When lending is done through a lending agent, the agent should be aware of the written policy and the securities lending agreement should adhere to the policy. Elements of the policy may include the choice of route to market-- whether through a custodian bank; lending agent or directly; the fees to be paid; revenues to be earned; and the approved or restricted list of borrowers.
Written by Chris Kentouris, Editor-in-chief (Chris can be contacted through Chris.Kentouris@hotmail.com)