The equities lending industry has generated between 6-8 billion USD in revenue per year for fund managers and investment service providers over the past decade generating significant extra returns to investment fund unit holders, pension fund members and the retail investor clients of brokerage companies. In the post-crisis years after 2008, the total revenue figures were close to 5.5 - 6 billion USD, while in recent years, the equity lending business has been more characterized by annual revenues of 7-8 billion USD. The vast majority of lending income nowadays still goes to mutual funds and pension funds being the most active players, but lending is also becoming increasingly popular among brokerage firms servicing retail securities account holders.
Yet in Hungary, this alpha generating activity is subtly underdeveloped or we could say there is room for improvement. More precisely, there is some modest lending activity in Hungarian equities, however this is not done by domestic fund managers and investment service providers but primarily by foreign investors. Some Hungarian players also have one or a few lending transactions in Hungarian and foreign shares per year but these volumes are rather small. According to the records of the market data company IHS Markit, for example, the value of Hungarian shares lent was on average USD 12 million this year which is insignificant compared to the Polish (USD 600 million) or Austrian (USD 1.6 billion) volumes even if we take into account that the stock markets of the latter two regional countries are larger.
Source: IHS Markit
In exchange for the fee paid the securities borrower investors can, among other things, implement their short strategies or avoid delays due to settlement.
According to the general market practice in a securities lending transaction the borrower must always place a collateral exceeding the market value of the shares on loan with the lender, thus securing the lender-owner of the equities.
Shares easily available to borrow can be classified as GC “general collateral”, these can be liquid shares of companies with large market capitalization or simply large amounts of the shares are available for borrowing or just the demand for these equities to borrow is low. These stocks typically generate returns of 0.1-1% on an annual basis. At the same time, there are so-called “Specials”, which are the harder to borrow stocks, providing outstanding returns to shareholders, which can reach an annual yield between 1-10%, but in extreme cases it can go as high as 20-30%. These shares can be of small or midcap issuers, but they can also be large companies with high borrower demand or just fewer lenders. For example in this Specials category in the second half of last year, Varta AG generated $ 84 million securities lending fee for shareholders, but Lufthansa’s $ 25 million or Total SA’s $ 22 million fee was quite remarkable too. Among the smaller companies $ 11 million lending fee from the German leasing company Grenke AG is also noteworthy. [1]
It is important to point out that these returns are constantly changing, daily, weekly or in some months time a given stock can generate different returns depending mainly on the borrowers’ demand but also on the lenders’ supply. The temporary nature of these returns is similar to the changes in market prices in case of the stock market traded equity transactions. While the later has a seller and a buyer, in the case of an equity loan, there is a lender and a borrower who follows a different investment strategy for a specific stock.
Redeemability is also an important consideration, a shareholder lender can in most cases decide at any time to recall their share from the borrower and similarly, the borrower can return the share if they no longer need it. According to statistics from the international organization ISLA (International Securities Lending Association), 90% of the securities lending transactions fall into the open- end category. [2]
The proceeds from the securities lending activity are partly earned by the fund unit holders, i.e.: mainly the private investors, and partly by the fund manager, who can reduce its operating costs, thus improving his business results. For example, in the case of the Dutch Aegon funds, 72% of the income is earned by their investors, 10% by the fund manager and 18% by the intermediary for the loan transactions. [3]
It is also worthwhile to look for the reasons why the spread of securities lending is delayed in our country.
If we are looking for a historical explanation then the size of the market and the accumulated assets are important aspects, i.e. in the case of Hungary their lack in the past. This is because domestic fund managers due to their size have been finding it difficult to join the large international clientele of London based investment banks accounting for the majority of equity lending transactions. However this may not be necessarily a problem anymore partly because the assets under management of Hungarian fund managers have grown significantly in the recent period and several fintech companies are also making securities lending available to smaller players and their custodian banks.
In addition it should be noted that although the legal environment is basically quite supportive compared to the countries in the region (for example in Poland, pension fund have been excluded from lending shares until recent reforms and many types of them are still incapable) there are uncertainties related to domestic legislation that require extra legal work and contractual administration for the parties involved in securities lending transactions, thus making it more difficult for Hungarian fund managers to enter the international lending market. All in all, we can conclude that compared to the developed EU markets, Hungary still has a significant room for improvement in the legal area.
Finally in many cases over the past few years regulatory compliance (MiFID 2, CSDR) or following market trends has shifted the focus from this activity and due to the small organizational size of market participants there has been no resource for business development.
Looking into the world of international brokerage firms we can see that the stock lending business is also developing dynamically among retail service providers. Similarly to the mutual funds, revenues are shared between these brokers and their clients the underlying investors. For example Interactive Brokers which also has a large presence in Hungary, generated $ 345 million in lending income for the company last year. [4] Based on its current conditions, Interactive Brokers makes a 50-50 split of it’s lending income with the customers. [5] Binckbank, a leading Dutch online broker has been offering it’s retail clients the opportunity to lend on similar terms since 2018. [6] However, Robin Hood follows a different model, retaining all of its lending income in exchange for free trading for its clients. For Robin Hood the securities lending income in the first 6 months of this year was more than $ 75 million. [7]
Some leading domestic retail investment service providers also offer the possibility of lending securities to their clients for a fixed % fee, regardless of the type of share but the average placement rate and thus the rate of return is very low.
Securities lending fintech firm Sharegain examined the assets under management of their customers and business partners and has found that portfolios of retail brokerage firms have higher-than-average securities lending income potential due to highly diversified portfolios and midcap stocks owned by private investors to a greater extent.
Source: Sharegain Ltd., income in basis points considering all type of assets (shares, bonds, funds…)
In addition, a well-developed local securities lending market supports the liquidity of the local stock exchange as well. When FTSE Russell and MSCI rate national markets, one aspect classifying a national market from an emerging market to developed status is how active and advanced the securities lending activity is. They do so because the availability of stock lending improves the price discovery function of a given market and the price transparency of listed companies. In markets where the volume of lending and thus the ability of investors to short strategies is limited the rating cannot be in developed category.
Given the potential for the outstanding extra revenue and the fact that the activity fits well into the existing processes of investment service providers and fund managers without requiring much human or financial effort, stock lending may be a possible way for many players in the future to improve business and financial results. The consequently improving local market liquidity can bring additional benefits to all market participants.
Sources:
1: https://ihsmarkit.com/research-analysis/securities-finance-h1-2021-review.html
2: ISLA Securities Lending Data sourced from SFTR reporting
3: Aegon Funds - Prospectus en Fundspecificaties 2021 august
4: 2020 Annual Reports Interactive Brokers (https://investors.interactivebrokers.com/ir/main.php)
5: https://www.interactivebrokers.co.uk/en/index.php?f=46957
6: https://www.binck.nl/zelf-beleggen/pakketten/securities-lending
| Author: | |
| Dániel Körmöczi, Advisor to the CEO, BSE | |