In a broadly challenging environment for asset managers, securities lending has become a go-to tool for many asset managers to help boost performance. The numbers tell the story: Global revenue generated from securities lending reached $9.96 billion in 2018.1 While revenues dropped in 2019 and 2020 (due in part to regulations banning short selling in some regions outside the U.S., the global pandemic, and the “meme” stock phenomenon), revenue in 2021 has shown an uptick compared to 2020: Nearly $7 billion has been generated through Q3 of this year.2 What is looking like a bounce-back year suggests reason to be optimistic about the future of securities lending.
Institutional investors globally expect heightened volatility well into 2022,3 and may well look to securities lending to cushion any market dips and facilitate short selling. This brief report looks at how institutional investors might take advantage of potential opportunities in securities lending, including:
- Awareness that, widely speaking, the agency lending service provider market is contracting from consolidation and retrenchment.
- Knowledge that what investors require from an effective agent partner is changing.
- Partnering with technology-driven agents that enable them to customize their programs at scale to provide more efficiency, improved connectivity and adaptability compared to what has historically been offered.
Securities lending is an appealing option to generate income for many institutions. But with ongoing consolidation in the industry, and some agent-lender firms likely to reduce their presence in the business over the next few years, choosing an established partner to customize and implement a lending program is an increasingly important part of a securities-lending strategy. II spoke to Justin Aldridge, Senior Vice President, Head of Agency Lending, Fidelity Investments, for insights on how securities lending is evolving and what risks institutional investors must navigate to maximize their lending income going forward.
Are you seeing more investors considering securities lending as an integral part of their strategies?
Justin Aldridge: Yes, absolutely. We are seeing more institutional investors coming into the lending markets to participate as they look to optimize returns. Some very large asset management firms who were adamantly against lending in the past have entered the market over the last few years seeking opportunity. In the first half of 2021, the lendable inventory has grown to over $34 trillion.4 The significant growth is attributed to new entrants and market gains.
Income from securities lending can be meaningful and help offset management fees. In a world where investors are hyper-focused on returns and fees, funds that participate in securities lending can differentiate their investment strategies and potentially gain additional assets.
Aldridge: How did Fidelity get into securities lending?
Fidelity Capital Markets has been a significant participant in the securities lending markets as borrower, principal lender, and prime broker for over 20 years. Our business units have thrived and are providing unique and meaningful solutions for our clients. Fidelity began lending on behalf of its institutional and retail clients in 2001. In 2003, we launched our prime brokerage offering, Fidelity Prime Services, by leveraging our captive supply base and our strong credit profile as a large privately held institution. Today, the prime brokerage group services some of the largest and most sophisticated managers in the world.
In 2012, building on that success, we identified a gap in the marketplace for transparency and asset managers’ ability to effectively evaluate the performance of their prime brokers and lending agents. Our solution to this need was PB Optimize℠, which is a proprietary portfolio finance and treasury management solution for institutional investors that provides unique data, benchmarking, custom analytics, and streamlined workflow solutions that maximize revenue and performance for asset managers.
Given the success and experience we’ve had in our securities-lending businesses it made sense for us to round out the offering and build a best-of breed lending capability for our affiliated mutual funds. Fidelity successfully launched our lending platform in June of 2019 and we have delivered on our goal of meaningfully improving the overall returns to fund shareholders while creating operating efficiencies and customization. Since agency lending is a scale business and Fidelity has had strong success in this space with over $2.4 trillion in attractive assets (as of September 30), it was logical for us to offer Fidelity Agency Lending® to the marketplace. This year, we took this well-built capability and made it available to asset managers, insurance companies, pension plans, and other institutional clients.
What market conditions present the best income opportunities?
Obviously, bull markets with a healthy number of IPOs and deal activity are most conducive. Today’s zero interest rate environment is challenging because there are two sides to a lending transaction: you are lending a security and you are collateralizing it with a security or cash. About 50% of the market is collateralized with cash, and the cash needs to be reinvested. The maturity spectrum that most agents invest in is relatively flat right now and has been for the last 18 months, so yields are a bit lower. But, in a healthy market, you would have better opportunities with higher interest rates that can boost lending returns.
That said, one of the most profitable years from a lending perspective occurred during the 2008 financial crisis. In a bear market, lending can help an investment manager offset some of their market losses.
Aldridge: What are the risks associated with securities lending and how do you manage them?
Three risks get the most attention. One is reinvestment risk. If you're taking cash collateral, what reinvestment risk are you taking by investing that cash? In 2008, investors suffered losses due to the reinvestment decisions they were making on the collateral. The investment manager decides where to invest, and I think more investors understand those investment risks today. Regulations and investment risk appetite has generally become more conservative since 2008, as it relates to investing cash collateral.
Borrower default risk is another risk that needs attention, but this risk is usually borne by the agent lenders and not the investor through indemnification. If the borrower defaults, then the agent lender must repurchase those securities with the collateral they have and they are expected to make up the shortfall if the securities are worth less than the collateral.
In 2008, during the financial crisis, the unwinding of lending activity with Lehman and Bear Stearns was orderly in the securities lending market and clients likely didn’t suffer losses due to being undercollateralized. A popular misconception is that lending clients lost money due to the collateral shortfall when it was caused by reinvestment of the cash collateral. Even though clients are indemnified, clients should still understand the risks their agent is taking as it relates to the approved counterparties, given that a default could require the agent to have sufficient capital to cover a shortfall. At Fidelity, our lending program has real-time data from the counterparties we lend to and with the custodians our clients use, so we are always aware of the exposure we have to borrowers. To reduce the risk of a default, Fidelity has chosen to lend to a short list of high-quality borrowers utilizing our Adverse Stress Loss model to set our exposure levels.
Thirdly, there’s operational risk that is borne by the agent, but it can create friction for the client. It’s something that clients really need to consider when they're choosing an agent lender; it is essential to choose a firm with high operational standards. That means strong reporting and modern automation and a commitment to investing in new technology to make sure shareholders have a seamless experience.
At Fidelity, operational excellence and sophisticated technology are key standards for our program. Our job as an agent is to make the experience completely seamless so shareholders are getting good risk-adjusted returns while reducing operational friction. This allows the investment management company to focus on what they do best, which is managing their clients’ investment.
Aldridge: How does your team help optimize transparency?
Historically, securities lending has been thought to be opaque and nontransparent. The industry has made great strides with data and transparency, and it continues to evolve. Fidelity Capital Markets has always been a proponent of transparency and has built proprietary technology such as Service Bureau and PB Optimize to help improve clients’ returns and transparency. However, benchmarking continues to be opaque in this industry, as every agent seems to outperform benchmarks. Fidelity’s goal is to help clients get better insight into their actual performance. The Fidelity Agency Lending team has been developing unique benchmarking tools that are designed to improve investment decisions, corporate governance, and program oversight. In October of 2021, Fidelity released a proxy management tool in collaboration with our colleagues at PB Optimize. This tool will assist institutional investors with the management of their lending program and ESG standards
Aldridge: What trends are you seeing in securities lending?
Current market dynamics are necessitating that institutions take a more active role in their securities-lending programs to find a competitive advantage. Clients have stated they need their agents to be technology driven and allow the firm to customize their programs at scale. They also need a program that provides more efficiency, better connectivity, and adaptability—more so than what lending agents have typically offered. The importance of securities lending to a fund’s returns has only grown in the highly competitive asset management industry.
We’re also seeing the proliferation of asset managers utilizing lending data to inform their investment decisions on whether to buy, hold, and sell securities, and they want this data in real-time. With respect to ESG, proxy voting seems to be at the top of the list for our clients, and providing clients with real time, consumable, and actionable data is key to helping them make the best decisions for their investors.
Aldridge: In addition to extreme customization, what other advantages in securities lending can Fidelity offer institutions?
We believe Fidelity’s lending program is at the forefront of automation and real-time connectivity. We’ve automated over 90% of our lending transactions with our street-side counterparties and six global custodians. Our ability to transmit, receive, and process this information in real time gives us an advantage over other agent lenders. It allows us to minimize operational risk and potentially generate additional returns and that may put us at the top of the queue with our borrowers.
We’re utilizing AI loan-decision functionality to effectively price and distribute our clients’ assets in a highly automated fashion, which allows our traders to focus on high-value trading decisions and provides borrowers with the liquidity they need instantaneously. Finally, we have scale with over $2.4 trillion in inventory in our lending program (as of 9/30/21), which makes us relevant and stable with borrowers. Most importantly, we typically have attractive assets that the borrowing community want, which may drive demand to Fidelity Agency Lending. All clients may ultimately benefit as we bring more clients with attractive assets to our platform. The marketplace needs an agent with new technology and the proven ability to serve large complex institutions in a highly automated and customizable fashion that is backed by a large and reputable firm known for putting its customers first.
Aldridge: What is Fidelity doing to support lending clients with ESG needs?
The primary areas in which securities lending intersects with ESG involve proxy recalls, proxy record dates, and voting. Clients can’t vote on shares they’re lending out, so they must get those shares back to participate in a vote.
To make this easier, we launched a proxy tool in October that will aggregate a client's program and all their securities—both on loan and not on loan—along with all relevant lending and proxy data. The tool will alert them well before proxy record dates and help them decide what actions to take.
For example, the data can help answer key questions such as, how important is this vote? If we continue to lend the securities, how much income will they generate? Do we forego revenue to participate in an important shareholder vote? The feedback from prospective clients has been overwhelmingly positive for this proxy tool, and we believe it will be the first product of its kind in the market.
Reinvestment strategies can also involve ESG issues. Clients may want to avoid doing business with certain companies due to ESG standards. And Fidelity can provide that level of customization to ensure they're meeting their ESG requirements.
Learn more about technology solutions in securities lending at: i.fidelity.com/agencylending
The inherent issue for asset managers that use securities lending is that it introduces other impactful challenges and pressures. Here are three key issues many asset management firms see as hurdles that must be cleared.
The proliferation of ESG and Sustainable Investing, especially with proxy voting and collateral exclusions.
- Proxy voting: Lending a security renders the asset manager unable to participate in proxy votes for that security while it’s out on loan. Not every vote is relevant to ESG priorities, so asset managers can maintain both ESG and securities lending programs. A challenge remains, however, regarding how a lender can effectively distinguish relevance within upcoming proxy votes, including how much expected revenue that they would forfeit if they recall their shares and cast their vote.
- Collateral: Securities loans either use cash collateral that gets reinvested for the benefit of the lender or non-cash collateral in the form of marketable securities. In either approach, lenders with ESG requirements need to be able to exclude certain securities from their collateral investments. With manual processes and significant variation among ESG policies of different asset managers, customizing restrictions for each lender can be a challenge for agents.
The perception of short selling.
- “Meme stock” investors put a short squeeze on hedge funds in 2021 and reduced short selling in the market, which depressed demand for securities lending.
- The global Covid pandemic, saw 17 countries ban or restrict short selling in some form to help bolster market stability and confidence. In addition, many policymakers have implemented new rules to enhance the transparency of short positions by increasing requirements around speed and frequency of reporting.
Outdated technology and manual processes.
- Firms need the ability to customize their programs at scale. They also need more efficiency, transparency, connectivity, and adaptability than lending agents have typically offered.
- Securities lending solutions are built on legacy technology and infrastructure, and extensive customization of older platforms for each lender have made it very difficult for most agents to meet new challenges with scalable solutions.
- Older platforms can make even small enhancements challenging, expensive, and risky. Lending agents are often forced to patch flaws in their systems with people-driven manual processes, such as uploading spreadsheets.
For many asset managers it would be inefficient from a cost and time perspective to attempt to manage their own securities lending programs. Unfortunately, some agent lenders have fallen short of making the necessary investments to achieve efficient execution and provide the resilience lenders need to face new and emerging challenges.
By working with the right partner, asset managers can access the tools they need to effectively participate in securities lending without placing additional burdens on the firm. Here’s what managers should look for in a prospective partner:
AI-driven trading: AI-enhanced lending algorithms can be applied to better match borrowers to lenders according to their needs. Additionally, systematic and consistent pricing through AI may increase demand and deliver higher fees (compared to inconsistent manual pricing methods).
Customized/automated programs: Beyond greater efficiency and commensurate returns, this approach allows lenders to set parameters on criteria such as ESG, ownership level restrictions, trading volume limits, minimum return thresholds, and any number of potential requirements from the lender’s board. In addition, with borrowers also seeking efficiency in automation, lenders that can accommodate automated trading are expected to see higher demand and returns.
Performance benchmarking: Better connectivity and technology allows for better benchmarking across lending providers. The ability to benchmark the performance of multiple lending agents against each other on similar securities helps lenders to evaluate their agents and inform decisions around which agents they use, which assets they allocate, and how much business they give to each agent.
Custodian choice and connectivity: Real time, automated connectivity to any custodian offers lenders the flexibility to use the best custodian(s) for their needs, with assurance that their lending program will operate efficiently regardless of their choice. It also provides real-time buy and sell notifications from custodians to quickly identify lending opportunities and recall requirements. This approach allows lenders more time than they typically have with end-of-day notifications, to issue recalls, deliver sold securities, and avoid costly trade fails.
Powerful custom reporting: From new disclosure requirements to performance analysis, lenders can get a lot of value from strong reporting capabilities. Better technology and connectivity can also offer improvements in cash forecasting accuracy to improve financial operations.
Get Fidelity’s latest insights “The Arrival of Modern Securities Lending: How Technology is Propelling the Industry Forward.” Key topics discussed are: “Meme stock” investors’ impact on short selling, the proliferation of ESG and Sustainable Investing, and the anticipated shift to T+1.
3 Institutional Investor, “Managing Market Volatility in 2021,” January 2021
4 IHS Markit, “Securities Finance H1 2021 review”
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