Securities Lending

The long term impact on capital markets

Originally published in the February 2008 issue

The Hedge Fund Working Group [HFWG] has recently released the findings of its consultation with the hedge fund industry, encapsulated in a set of voluntary standards. Much of its emphasis is on the conflicts of interest between managers and investors, and the improvement of governance within funds themselves. Compliance with the hedge fund standards will be voluntary, working on the basis of a 'comply or explain' scenario.

Sir Andrew Large, announcing the results of the consultation on 22 January, said that it was now time for "investors to help take this forward. This is a voluntary, market-led initiative based on disclosure. It is the investors who can provide the market discipline to ensure these standards are widely adopted."

The HFWG's composition is also interesting, made up as it is of 14 leading hedge fund managers, mostly based in London (the acknowledged capital of European hedge fund management with over $400 billion currently being managed by UK-based hedge fund operations). It was established last year as a response to ongoing fears being voiced by politicians (rather than regulators) about the threat posed by hedge funds to global financial stability. From an industry perspective, it is a shrewd move, as it stands as a practical answer to criticisms levelled at the sector by European politicians, amongst them German Chancellor Angela Merkel, and Peer Steinbrück, her finance minister.

What's in it for investors?

One of the big selling points being aired by the HFWG was that its work would be of greatest help to investors, providing them with a set of principles and best practices which will help them to understand how hedge funds should be managing risks. These standards focus on the key areas of governance, disclosure, valuation, risk management, and activism. Each of these areas was 'mapped back' to the original set of principles articulated by the FSA.

Brad Ziff, a member of the HFWG and Director of the Hedge Funds Advisory practice at Oliver Wyman, a management consultancy, reckons that hedge fund firms will only have to make "minor adaptations" to meet the new standards. "Many hedge funds already have a number of these practices in place in some manner and will only need to sharpen them or be more careful in the manner in which they apply what they already do," he says. "Others will need to make certain investments in resources, technology, additional models or approaches to risk, to meet the best practices."

Ziff says it is perfectly likely that some firms will find that the new practices will not suit them, and will explain why they are not complying. He argues the standards are "market friendly and flexible," and that it is up to individual firms, and their clients, whether or not they are adhered to.

Much of the onus in this new regime lies with investors. Ultimately, they will be the ones who will have to go out and encourage managers to adopt the practices. "The practices are only valuable to investors if there is support for the initiative," says Ziff.

Tom Brown, Head of the Hedge Fund Services practice at KPMG in London, thinks that the response to the report from investors has been positive thus far. The only point of weakness he sees is the self-certificating nature of the regime, which "is only as good as the honesty of the people participating." If the code is seen to be breached on one or more occasions, it will inevitably be devalued in the eyes of investors. Independent verification, for instance via GIPS and SAS 70 standards, still provides a more credible way for hedge funds to promote their credibility to investors.


The new standards also tackle the issue of valuations. The HFWG is calling for an independent process for the valuation of all complex financial instruments, and for higher levels of competence amongst the staff being tasked with these valuations. It is easier said than done, however.

According to Jérôme de Lavenère Lussan, Director of Laven Partners, "Agreements between managers and administrators are usually worded in such a way that nobody is held ultimately responsible for inaccuracies. If an asset is hard to value, it is currently permissible for the administrator to rely on information from the fund manager or the prime broker, which can lead to conflicts not fully addressed by the 'new' standards."

Laven Partners is suggesting that the standardisation of agreements between fund managers, administrators and prime brokers would help to tackle the issue.

Dermot Butler, Chairman of Custom House, the Dublin-based hedge fund administrator, believes that administrators that were already following the practices laid out by AIMA, and had a satisfactory SAS 70 Type 2, will already be largely adhering to the HFWG principles.

"A hedge fund administrator needs to be ready to provide information to investors or counterparties as requested by the fund's governing body, for instance the board," he says. "None of the potential information requests [in the code of conduct] look too daunting. Indeed, most hedge fund administrators would be used to these requirements," he said.

Butler does not see a challenge on the valuations front either, so long as the firm is following AIMA's recommendations on hedge fund valuation, as issued last year. On risk management, he thinks administrators will need to keep an eye on the investment risk reports that may be generated in future, and see if any of these are to be provided by the administrator rather than the fund manager. "In my view it is not the hedge fund administrator's responsibility to provide risk reports on the investments, and indeed that could represent a substantial uncompensated risk to the administrator," he says.

Will it be enough?

Hector Sants, the new CEO of the FSA, is known to be in favour of some form of code of conduct that the hedge funds industry can sign up to, rather than a regime that the regulator would be tasked with enforcing. In a statement to The Hedge Fund Journal, the FSA said: "We welcome this initiative, and consider that its recommendations are a constructive addition to the material which hedge funds can draw upon."

At London fund management consultancy Kinetic, partner Andrew Shrimpton thinks this is a new high water mark for the industry. "There is mounting evidence each week that hedge funds are not a threat to financial stability, and this will help to dissipate that," he says. "It is a best practice standard that has been introduced here, one that goes beyond the minimum standards enforced by the FSA."

The launch of the Hedge Fund Standards Board in the wake of the report is another shrewd move, as it ensures that current enthusiasm of the code of conduct does not go 'off the boil' in years to come, and its existence remains a suitable counterpoise to any further political criticism coming the hedge fund industry's way in the months ahead. The hope that there can be some degree of convergence with the President's Working Group Study on Hedge Funds in the US holds out the prospect of one day having some kind of set of globally recognised standards, although commentators like KPMG's Brown suspect any US response will take into consideration the more litigious environment that prevails there.

We now await with interest the appointment of the permanent trustees of the HFSB, with Christopher Fawcett, AIMA's Chairman, already named. If other individuals of similar calibre join him, it should provide the Board with plenty of credibility and much-needed political muscle going forwards.

The kind of quantitative screening approach to identify securities for Short-Extension Portfolios such as 13030 might include those listed in Table 1. The lack of short interest data drives many of those wishing to adopt a more quantitative approach towards the securities lending markets. As referenced before, the securities lending market (once one has adjusted for statistical noise) is a good proxy for the level of short selling that is going on in a security.

Putting theory into practice

So much for the theory, what types of securities might fund managers employing a 13030 strategy actually buy and which ones might they sell? Many of the funds established to follow this strategy focus on well known indices such as the S&P 500. The securities that are the most and least borrowed in the S&P 500 are just the kinds of securities that might make up the overlay components of an S&P 500 13030 fund. Sears Holdings Corp was the most borrowed security in the S&P 500 based on Utilisation on 18 October 2007. All of the top 10 exceed 59% Utilisation ie. more than 59% of the securities available for lending are out on loan. Fig.2 shows the trend for borrowing Sears Holdings Corp over the last twelve months. Aetna Inc is the least borrowed security in the S&P 500, based on utilisation. All of the bottom 10 securities exhibit less than 1% utilisation ie. less than 1% of the securities available for lending are out on loan. These are just the kind of securities that could be viewed as 'good quant securities' and are therefore liable to have been sold during times of recent liquidity driven duress.

With more funds established to take advantage of shorting one of the questions that investors quickly ask is how much more shorting is likely to take place and what is the likely impact upon the market going to be? Before we address these questions let us reflect on the numbers today.

13030 strategies have attracted US$140 billion to date. This needs putting into context within the lending market. This means US$18 billion of short positions in total. If it were all in the S&P 500 (which it is not) that would equate to about 5.7% of the US$316 billion of shorts in the index. If it were all in the Russell 2000 (which it is not) that would equate to about 9.7% of the US$185 billion of shorts in the index. Put another way, US$18 billion of shorts equates to 1.2% of global equity borrowing which totals US$1,447 billion. As a percentage of hedge fund shorting of USD 600 billion overall USD 18 billion represents 3%.

If 13030 attracts US$1 trillion AUM in a five year period that would equate to US$300 billion being shorted (we are not taking the more aggressive estimations on board for the purposes of this estimation). Using the same analysis as the one conducted above, if we assume that securities lending balances grow by 25% over five years we come up with the following percentages1:

  • Hedge Fund 50%
  • Overall Equity 33%

It is very clear that should the 13030 strategy grow as predicted – it will be a major driver of the securities lending business.

Shorting on the increase

To return to the questions asked previously we can predict that the overall level of shorting will rise, but the percentage of the overall market accounted for by this source of lending demand would be 5%. At an overall level this is not that significant.

However, this macro level perspective misses the impact that increased crowding of shorts will have upon individual companies and the demand for borrowing them will have upon the securities lending marketplace. Whilst it is true that certain financial institutions have, at times, developed a unique investment strategy and generated extraordinary returns, the majority of strategies and returns look remarkably similar – particularly over time. Thus it is likely that the majority of 13030 fund managers focusing on a particular universe of securities will short the same securities and go overweight the same securities. This raises capacity issues that could restrict the possible returns, the success of the fund and the growth of this strategy.

Understanding what these constraints are and ensuring that the fund will be able to achieve its objectives will be a major determinant in the success of a fund. The need for accurate reliable data to research the securities universe will be vital as will the selection of a counterpart to provide access to the inventory necessary to support the proposed shorting as well as the execution capabilities for both selling and buying securities in active markets. The selection of the prime broker to support a 13030 fund is therefore a fundamental and critical decision. There are many capabilities that are commoditised and accessing securities lending supply is not one of them.

The art of shorting

The research suggests that short position takers are typically well informed and that securities with significant short positions are vulnerable to underperformance. The difficulty a new fund manager faces is getting short at an acceptable price in the first place, and making sure that they are not vulnerable to being the victim of a short squeeze should the security be recalled and no more supply be available.

Given the level of borrowing already taking place today in the top ten most borrowed S&P 500 names, a model suggesting shorting these names might not be that attractive a strategy. The recent stresses in the US equity markets suggest that quantitative funds covering short positions drove up their prices relative to other investments. Therefore, this strategy will need careful consideration.

The increased demand for particular securities will manifest itself in a variety of ways. Prices will rise, allocation of supply will become more contentious, recalls will increase and the pricing models established by the securities lenders will come under increased scrutiny. When selecting a provider to support a securities lending dependent strategy the fund manager and his team will need to understand exactly how they will be treated. They will need to know the answers to the following questions:

  • What information can I expect to receive?
  • Where do the securities I am borrowing come from?
  • How reliable is that supply?
  • How big is your exclusive supply?
  • Will you lend my long positions? – If so, how will I be compensated?
  • How will I be charged for borrowing these securities?
  • What is your recall procedure?
  • How important is my fund to you?
  • How many competing funds do you service?
  • How do you allocate supply?

The answers to these questions will vary considerably and the clients will have to select providers that match them well in order to proceed. The prime brokers (or the custodians) will increasingly hold the key to successful asset management performance and this will bring increased responsibility to be seen to act responsibly, particularly concerning loan allocation and pricing. This may mean an end to the bundling of services and an increase in transparency. This will be met with some resistance – particularly from the dominant incumbents – but the market will demand this – particularly the clients and the regulators. The securities lending market, as already referenced, makes a big impact upon the capital marketsand to some extent this impact is under appreciated. The impact upon the money markets and securities markets will grow over time as the industry expands and the importance and profitability of this activity comes to the fore.

The development of asset management strategies dependent upon short selling and therefore securities lending is not new, but the involvement of the more traditional asset management community will awaken them to the importance of an activity that has typically been consigned to the back office.The gradual recognition of the fact that some strategies just will not work without access to securities to short, will drive clients and regulators alike along a path that will bring increased transparency of the processes and pricing.

The majority of managers that have started 13030 funds have focused on the established liquid indices and therefore are predominantly looking to short easy to borrow or general collateral ("GC") names. This focus makes sense as they and their investors are inherently conservative (or they would already be active hedge fund investors) and because they are often inexperienced in the borrowing and shorting of securities. As time goes by, the focus of 13030 fund managers will change as they gain confidence and experience. They will seek alpha by investing in the less liquid asset classes and need to start borrowing and shorting harder to borrow securities. This significant increase in demand from the new borrowers will cause a strain on the securities lending market and result in pricing and allocation pressures. Existing alternative managers (traditional hedge funds) will start to see more competition for the securities that they wish to short and the pressure will result in increasingly crowded shorts that are liable to recalls, buy-ins and rate changes. For the new entrants, despite their size in the traditional asset management space, the price paid to secure inventory will rise as competition increases.

The allocation to short side exposure will become increasingly important to managers and some will look to pay more to their custodian and prime brokers to ensure they get a better allocation. This payment could take many forms including higher borrowing fees – however, the full range of revenues paid by a manager will be taken into account. This will potentially be a sobering discussion for traditional managers who may not appreciate the importance of their smaller "alternative" competitors.

The long and the short of it

The impact of the 13030 funds on the long side is worth considering too. The traditional long only managers who may or may not have lent in the past may well wish to begin lending their long positions via their custodian or prime brokers. Some of them will lend their securities in the general securities lending market and others, regulations permitting, will direct their long inventory towards sibling short funds. Given the likelihood that the majority of these securities will be easy to borrow this increase in supply will offset some of the increased general collateral borrowing demand. The crowding and potential short squeezes will remain an area of concern in the hard to borrow securities.

Securities lending has been called the "oil that lubricates the capital markets machine" and we would not defer from this view. The more efficient and more easily available this lubricant the more output one can expect from the machine.

An extract from the report 'Why Securities Lending Matters to the 13030 Manager… and vice versa' by Mark C Faulkner and commissioned by Deutsche Bank for their Global Prime Finance clients

1. Assuming everything remains the same; ie. growth in supply could outweigh demand


A graduate of the London School of Economics, Faulkner has spent his career specialising in International Securities Finance. From 1987 to 1995, he held management responsibility at LM (Moneybrokers) Ltd, Goldman Sachs and Lehman Brothers. During this time he worked closely with the UK Inland Revenue and has represented firms at the Bank of England's SBLC and The London Stock Exchange's securities lending committees. In 1995 he co-founded Securities Finance International.

About Spitalfields Advisors

Founded in 2004 by Bill Cuthbert and Mark Faulkner, Spitalfields Advisors Limited ("SAL") is an independent consultancy firm specialising in the provision of securities finance advice. SAL specialises in the global securities finance marketplace which is a multi-trillion dollar market generating billions of dollars of revenue per annum. SAL takes no transactional involvement in the marketplace.