Securities lending and short selling: What’s a responsible long-term investor to do?

David Crum looks at a decision by the world’s biggest pension fund to bring a halt to securities lending and how the LGPS should react.

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At the beginning of December last year, Japan’s £300bn Government Pension Investment Fund (GPIF) halted its stock lending programme, saying it was ‘…inconsistent with the fulfilment of the stewardship responsibilities of a long-term investor’.

Specifically, their press release cited concerns that ‘…the current stock lending scheme lacks transparency in terms of who is the ultimate borrower and for what purpose they are borrowing the stock’.

This announcement was effectively a large rock tossed into the securities lending pond from an asset owners’ viewpoint, and the ripples are still spreading out. From an LGPS perspective, what does it mean, and what—if anything—should the LGPS be doing in response?

Concerns

Securities lending is an activity which many LGPS funds have undertaken over the years. It’s essentially the process of lending out some of their existing investments (usually listed company shares or government bonds) to a borrower, for a period of time, in return for a fee, and with some collateral provided as security for the loan.

Most LGPS funds have their securities lending programme managed by their global custodian, if they are large enough to have segregated investment accounts. For funds whose investments are held as units of managed pooled funds, those vehicles are likely to have lending programmes in place.

Securities lending, while unlikely to generate large amounts of income, is generally viewed as a useful way to deliver income to offset some fund operating costs.

There are a number of reasons why someone would want to borrow your assets, but two main reasons are for brokers to ensure they have sufficient stock liquidity to support their daily buying and selling “market making” obligations, and for investment managers (including some hedge fund managers) wishing to have a “short” position on a company.

This second kind of manager borrows securities and immediately sells them, hoping to buy them back at a future date at a lower price. They’re looking to profit from a downward movement in the borrowed security’s share price over the period of the loan (so-called ‘short sellers’).

Looking again at GPIF’s actions, they have three current concerns:

• They believe lending is currently inconsistent with the fulfilment of their stewardship responsibilities as a long-term investor;
• That their current lending scheme lacks transparency in terms of knowing the precise identity of the ultimate borrower;
• They have no way of knowing the rationale behind the borrowing arrangement.

Let’s briefly touch on these concerns.

Stewardship Responsibilities of Long-Term Investors

A topic worthy of a book, by ceasing to lend their assets GPIF are implying they are now more closely aligned to what they believe their long-term investor responsibilities to be.

Without presuming to know their thoughts, it seems reasonable to suggest that responsible long-term investors should not necessarily participate in, or promote, activities that are short term in nature, particularly if such activities might result in some long lasting, or irreparable, damage to their existing investments.

Whilst the generally held “short selling bad” sentiment is, I believe, more nuanced than that, there is no doubt that it can result in significant negative outcomes for any short-sold company. By being a true long-term investor, avoiding activities that destroy value seems sensible.

Lack of Transparency

As the securities lending system currently stands, there is no way of knowing where your stock might end up.

It’s not currently possible to run a securities lending programme in which the lender can specify who the final borrower can be. You can agree to a list of counterparties with whom you will lend, but not what they might then do with the loaned position. Lenders cannot currently control the final destination of their loaned stock.

Borrowing End Uses

It follows that, if you can’t specify the final home for your loaned stock, it’s unlikely that you can specify how it can, and can’t, be used.

In a loan, the legal title of the asset is transferred to the borrower, who can use it as they see fit, and that includes selling it short if they wish. The outcome of short selling—aside from being a potentially profitable activity for the seller—could result in a company in distress, possibly even going out of business.

This has its own consequential impacts in terms of jobs lost, investors losing their money, and other associated wider economic and social costs. Not every stock sold short goes under, but some do, and in some instances there will be someone making money from the event using borrowed stock.

What to do?

Clearly GPIF have concluded that stock lending, as it currently operates, is not consistent with their long-term investor responsibilities. In their December statement they hold out the possibility of restarting their lending programme one day, saying: “The stock lending scheme may be reconsidered in the future if improvements are made to enhance transparency and address the inconsistencies cited…”.

So, what can long-term institutional investors do, when it comes to securities lending in 2020?

I believe there are four options:

• Don’t lend;
• Recall stocks on loan in time to secure the voting entitlement;
• Recall stocks only for companies where there are specific stewardship or ESG issues, using a provider such as Minerva to help screen holdings and identify such issues;
• If the idea of short selling is unpalatable, add an additional step to your lending programme to recall any loans where the stock is being shorted (again, something with which an adviser can help).

It’s inevitable that the greater focus being placed on sustainable stewardship by long-term institutional investors has turned its gaze to the securities lending function. Some, including myself, would argue that it’s long overdue.

Whilst it will require a significant effort from asset owners to bring about positive changes to the future shape of stock lending arrangements, the day may well come when transparency of ultimate borrower and borrowing purpose can be delivered, and GPIF will return to the securities lending fold.

In the meantime, LGPS lending participants can take pragmatic steps to make stock lending more sustainable. Whilst acknowledging the system’s weak points, funds can take action today, for example, by protecting their voting rights through monitoring potential controversies.

So, with the right help, there’s no reason why the LGPS can’t continue to lend, with the result of reducing overall running costs and providing vital market liquidity.

David Crum is managing director of asset steward solutions at Minerva Analytics.