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Aon Retirement and Investment Blog

Securities Lending: Considerations for Investors

Many pension schemes and institutional investors invest in index tracking, or passive, funds and commonly these funds engage in securities lending. Similarly, securities lending may also be undertaken by active funds and segregated mandates.

Aon Hewitt is supportive of securities lending due to the benefits of offsetting transaction costs, lowering administrative fees, and providing incremental returns. Borrowers of securities perceive index funds as a stable and predictable supply of assets, and will pay a premium to access that supply.

However, we feel that it is important not to overlook a fund manager’s capabilities in this area when conducting due diligence. Securities lending is not a risk-free endeavour, and we believe that it should be viewed as an investment strategy, requiring a certain level of skill, experienced traders, technology, and operational infrastructure.

Index fund providers will either engage an affiliate to act as lending agent on behalf of their own index funds or hire independent third party lending agents. The diagram below depicts the typical arrangement.

Transparency of securities lending practices is modest, at best. Pooled funds do not face any obligation to disclose underlying arrangements to investors. Furthermore, lending is not restricted within funds to the same extent that applies to exchange traded funds (ETFs).

Given the lack of transparency, Aon Hewitt believes that investors could benefit from a refresher on how to evaluate an index fund provider’s securities lending program. The list below provides key items that investors should consider:

  1. Types of collateral. Both cash and non-cash collateral can be pledged in a securities lending transaction. Both types of collateral have risks and should be evaluated appropriately. With regard to non-cash collateral, clients should evaluate how the collateral accepted by the index fund might alter the risk/return profile of the fund, how it might behave relative to the securities lent in a distressed situation, and the overall liquidity of the security should the agent need to sell it to buy back securities in a default situation. Cash collateral raises questions as to how the lending agent reinvests the cash collateral and whether that is done in a risk-controlled manner.
  2. Level of collateralisation. Over collateralisation of security loans is a primary risk mitigation technique. The extent to which a security loan is over collateralised varies, and understanding why one loan may be 102% collateralised and another 105% is important.
  3. Utilisation. Should index funds cap the allowable amount of each security, and of the total fund, out on loan? Operational risk associated with recalling loans and managing liquidity may increase as utilisation rates increase.
  4. Approving and monitoring borrowers. Counterparty exposure is another key risk in securities lending. Low quality borrowers expose a securities lending program to possible borrower defaults. High quality collateral, over-collateralisation, and strong credit review and monitoring of borrowers can reduce the impact of a borrower default.
  5. Third party vs. affiliated lending agent. These are the two primary methods that index fund providers use for implementing a securities lending program. Are there conflicts of interest with an affiliated lending agent? Are there inefficiencies and increased operational risks with a third party.
  6. Revenue splits. Typically, the lending agent will share in the revenue earned from securities lending. This includes intrinsic income and reinvestment income. What is an appropriate split for the lending agent? Is sharing in both intrinsic and reinvestment income appropriate?
  7. Type of loans. Over what terms are securities being lent? Longer “term” loans can be acceptable but may alter the liquidity profile of a fund and may limit the ability of the manager to exercise voting rights. Callable “open” loans can be recalled at any point, but may not command as high a fee as a “term” loan.
  8. Governance. When a lending agent (either an affiliate or third party) is selected by an index fund to manage its securities lending program, what type of due diligence is conducted? Lack of a strong governance structure around selecting and retaining a lending agent would be cause for concern.Securities lending is an activity to which many investors are exposed, but which generally receives little attention despite not being a risk-free endeavour. We have specialists who can assist clients evaluate securities lending, whether through their index fund exposure or elsewhere.

This article provided by Aon Hewitt’s Trust & Custody Team. 

Aon Hewitt Limited is authorised and regulated by the Financial Conduct Authority. 
This content prepared for U.K. and Canadian subscribers, but available to interested subscribers of other regions. Personal objectives, needs or financial situations were not taken into account when preparing this information. Accordingly, you should consider the appropriateness of any general advice provided in this post having regard to your own objectives, financial situation and needs before acting on it.

The information contained above is intended for general information purposes only and should not be construed as legal or investment advice. Please consult with your independent professional for any such advice. The blog content is intended for professional investors only.


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