The securities lending industry is growing fast. Statistics published by Data Explorers show that, since the end of the three-year bear market in 2003, the value of securities available for loan in the global marketplace has grown at an estimated compound annual rate of 15 to 20% to $13.2 trillion. Of that sum, the value actually on loan in the spring of this year was $3.5 trillion. Yet, there remains ample room for further growth on the supply side of the market. The assets managed by the global fund management industry in pension plans, mutual funds and insurance funds at the end of 2006 were estimated to be worth $55 trillion. Merrill Lynch estimates a further $33 trillion is managed by the private wealth management industry.

It follows that the value of securities for loan could double and still account for less than a third of assets under management. There are now forces at work, which mean that rapid expansion is likely to happen. Securities lending began in the back office of broker-dealing houses looking to cover trade failures or cover short positions by borrowing securities from custodians of the assets of long-only institutional investors. But the industry is now driven by the trading strategies of hedge fund managers, the proprietary trading desks of the major investment banks and a burgeoning group of traditional fund managers that are developing absolute return strategies that necessitate something entirely new for them: going short.

Market participants that go short need to borrow securities. What they want to borrow, and what is available to lend, is widening as well as deepening. As they scour the world for higher returns, the same broker-dealers and fund managers are buying and selling and holding a broader range of asset classes (such as emerging market debt and equities and asset-backed bonds) in a greater variety of markets (notably in Asia). They are also making greater use of synthetic alternatives to the cash markets. Since these assets need to be financed—and, increasingly in the OTC derivatives markets, collateralised—the range of instruments available for borrowing and for use as collateral is widening. The capital relief afforded by the Basel II regime to banks that lend on a collateralised basis is further fuelling the growth of securities lending.

All of these developments mean that securities lending has ceased to be a purely operational activity. It has become not only an integral part of financing, but a trading activity and an investment management discipline in its own right. So it is not surprising that borrowers have sought alternative sources of supply, or that lenders have sought to increase their returns by developing new routes to market, or that exchanges and inter-dealer brokers are developing electronic lending and borrowing trading platforms.

The discovery and use of alternative routes to market have continued to put down­ward pressure on aspects of the lending market forcing innovation in order to increase profitability and retain market share. With revenue splits being weighted increasingly in favour of the lender and prime brokers taking a large proportion of the lending revenue stream by servicing hedge fund demand, il follows that the role of the custodian in the securities lending market has to change. Instead of treating securities lending as a proxy for a custody fee, agent lenders must transform themselves into asset managers, whose task is to maximise the value of the portfolios of a client, even if that means directing assets via a third-party lender or an auction platform, or indeed taking principal risk in lending to end borrowers as opposed to intermediaries.

This is why HSBC Bank pic (HSBC) offers clients a range of options for access­ing the lending market. As in any investment management activity, that choice depends on where the managers of the fund wish to strike the balance between risk and reward. But, nonetheless, for many lending clients the defining advan­tage of an agent lending program is the limited risk: Assets are part of a pool lent to a diversified selection of pre-approved borrowers, and transactions are under­pinned not only by eligible collateral but by indemnities against loss provided by the agent lender. Indemnities are highly sought after by lending clients—in aggregate, the top global custodians disclosed indemnities worth more than $1.7 trillion at the end of last year.

Historically, the market has been based on institutional clients lending stock; however, current trends see institutional clients expanding their investment mandates to include borrowing for short-selling purposes. Evidence of this on both sides of the Atlantic is the increasing popularity of 130/30 funds, which allow fund managers to run short positions as part of their day-to-day search for incremental alpha. Because they remain 100% net invested by being 130% long of favoured stocks and 30% short of unfavoured stocks, 130/30 funds need stock loan accounts. They need them to receive the proceeds of the short sales, which are then used to augment the long positions without the need to borrow money, and to facilitate the stock borrowing needed to maintain the position. This is why 130/30 funds are helping to drive the expansion of the securities lending markets. But they also impose novel service requirements. Because they need to go short, 130/30 fund managers require not only custody and fund accounting, but fully integrated securities lending/borrowing and collateral management, plus the execution services to effect the initial short sale and subsequent buy-back.

Not all custodian banks are well-placed to supply these services on an integrated basis. Securities lending is always an operationally intense activity, requiring tight coordination between the monitoring of the assets in custody and on loan, the marking-to-market or reinvestment of collateral received, the recall and substitution, and the asset-servicing functions. But 130/30 funds add further com­plexity, chiefly in their demand for execution services. With its global execution, asset and fund servicing capabilities, HSBC possesses all of the ingredients to offer fund managers a fully integrated, low-risk method of entry into the growing market for 130/30 investment strategies.

Low-cost absolute return strategies, which offer institutional investors downside protection as well as the upside potential of hedge fund investing, are one of the fastest-selling products in asset management today. For custodians reared on servicing long-only institutional funds, and offering securities lending as an alternative to charging a custody fee, they pose novel service challenges.

This is the eighteenth in a series of Talking Points published by Institutional Fund Services, HSBC Bank plc.

For more information:
Nick Thomas
Business Development
Institutional Fund Services
HSBC Securities Services
HSBC Bank plc
8 Canada Square
London E14 5HQ

Tel: 44 (0)207 260 6803
E-mail: nicholasthomas@hsbc.com