A practice which underpins swathes of the financial system faces turmoil
IT IS one of finance’s odder rituals: every year come springtime around $100 billion in European shares goes on a little holiday. In the days running up to annual dividend payments of listed companies, many long-term shareholders, such as pension funds, lend their holdings to a third party. A week later, once the dividend has been paid to the temporary owner, the shares are returned safely to the pension funds’ vaults, where they remain until the following spring.
The brief excursion is not designed to improve the share certificates’ complexion. Its purpose is to circumvent withholding taxes on dividends, which some investors have to pay upfront and others do not. The tax-exempt borrower pays a rental fee equal to the dividend that the pension fund will now miss out on, minus a cut for itself and a clutch of banking middlemen. All sides are better off, bar the taxman.
The European dividend-arbitrage trade, as it is known, is just one facet of the “securities lending” industry. Globally, over $1.5 trillion in shares and bonds are out on loan at any one time, according to Markit, a research firm. A further $12 trillion is on offer. Many staple operations of high finance, such as the ability for investors to bet on falling share prices, depend on securities lending. But new regulation, in particular Europe’s financial-transaction tax, could make it much more difficult—even as other new rules may make it more necessary.
A wide coalition is defending the status quo. Long-term owners of stocks who agree to lend them, such as pension funds and insurance companies, are keen on the income stream that this generates: $11 billion globally last year, according to Markit. “We look at securities lending as a way of unlocking incremental returns for our investors without undue risk,” says David Lonergan of BlackRock, an asset manager. For a balanced portfolio which includes both shares and bonds, the uplift to overall returns is in the order of 0.05-0.10% a year, explains James Slater of BNY Mellon, a financial group which helps to arrange share loans. That is certainly worth grabbing in a low-interest-rate environment. The Teacher Retirement System of Texas, a pension fund, says it made an average of $100m a year in the past decade from lending securities.
HT: Abnormal ReturnsBorrowers of securities are a diverse bunch. Hedge funds are the most visible. Those bearish on a particular firm can borrow its shares, sell them immediately, and if the price does indeed drop replace them later at a lower cost. Brokers, for their part, borrow securities to plug temporarily the gaps between whatever securities they promised their clients and what they were able to source from the markets.
Stock lending is also used by firms that want to trade low-grade securities (such as equities) for better-quality assets (such as government bonds), a piece of financial alchemy known as “collateral upgrading”. Banks resort to this to help them meet regulatory capital requirements, or to get further financing from a central bank that requires high-quality assets to be posted as collateral. Multinationals also need safe assets to buy and sell derivatives, which they use, for example, to lock in interest rates or currency levels over time.
This points to a hazard inherent to securities lending: your counterparty has to be around to return what it has borrowed from you. Industry boosters say any risk is mitigated by stringent collateral requirements: borrowers have to leave ample cash (or other assets) with the lenders of the stock. They note the orderly resolution when Lehman Brothers, an investment bank, collapsed in 2008....MORE
