With total lendable assets hovering at $16 trillion globally, according to market analyst Data Monitor, the securities lending space quietly has grown into a powerhouse -- fueling more trading and helping to increase returns for many investment funds. Major players such as The Bank of New York (BNY) and JPMorgan Chase, however, are becoming acutely attuned to the myriad of complexities involved with what was once perceived to be a hum-drum, relatively riskless business.
Securities lending involves a lender (pension funds, investment managers) that provides capital (securities) to a borrower (hedge funds, broker-dealers) in exchange for collateral. The borrower is required to return the identical securities to the lender at a specified date in the future, in addition to interest or other premium. For lenders, the process is a means to generate additional revenue on assets that otherwise would be sitting idle. Borrowers do this to cover transaction failures or for shorting purposes. Custodian banks, such as the Bank of New York and JPMorgan Chase, often serve as intermediaries within the process, enabling their pension fund clients to offer their assets as loans.
For pension funds and dealers, the growth in the market has been a boon, as the funds are able to generate additional revenues off their assets and the dealers are able to secure lower-cost loans. But as the market has grown at a faster pace than the technology that serves it -- most transactions still are initiated by fax and phone calls -- lenders are becoming more and more concerned with controlling the risks associated with lack of liquidity, poor credit, default by the counterparty and migration of credit ratings, among other risks.
But while automation and technology solutions can help mitigate securities lending risks, they also can provide a false sense of security, according to Brad Bailey, senior analyst, Aite Group. "Technology can be a double-edged sword," he says. "While it allows greater efficiency and more-accurate representation of risks through sophisticated models, players might be inclined to run their operations with insufficient excess capital should there be any type of problem."
Even the most-advanced technology cannot completely remove all of the risks in the securities lending market -- especially if a counterparty within the lending process defaults on a loan, Bailey stresses. "If we were in a situation where a major counterparty failed, it would be very scary and part of a very large systemic failure within the securities industry," he says. "This is very complicated stuff. The dynamics in the way that people are paid and the myriad number of risks that people need to be aware of are astounding."