Structural Shifts Prompt Rethinking of Securities Lending Strategies

The ongoing bull market in equities has played a major role in depressing securities-finance revenue in recent years. Reddit “meme stock” traders fueled a temporary bump up in revenue early this year, but prolonged market challenges may prompt asset owners to reconsider their lending strategies.

Global securities finance generated $2.07 billion in revenue for lenders in the first quarter, 10% more than in the comparable 2020 period, according to DataLend. The increase was driven, however, by equity-trade financing - the largest portion of securities financing - and it may be fleeting.

“Revenue from equities increased by 8% year-over-year, to $1.65 billion, due to new entrants (via IPOs and special purpose acquisition companies [SPACs]) and short squeezes in January,” DataLend reported April 1.

The firm's May update showed April revenue for lenders, at $690 million, rose 20% from a year earlier and 9% from March 2021.

Market Turbulence

Securities financing revenue in all of 2020, at $7.7 billion, was down significantly from 2019's $8.66 billion and 2018's record-setting $9.96 billion.

Nancy Allen, global head of DataLend, a division of EquiLend, said that over the first half of 2020, declining equity market values led to lower on-loan volumes in the lending markets, while short-selling bans in Europe and Asia resulted in suppressed demand and general fee compression. As the pandemic hit, average fees increased, driven by a number of COVID- and non-COVID-affected names trading at very high fees to borrow.

Through the year, short positions in U.S. equities declined as markets rebounded and hit record highs. The DataLend Target 50 index, which tracks the top 50 stocks by borrowing cost, showed demand increasing in the early months, then dropping again over the summer.

The index rose again toward year-end as demand for specials - hard-to-borrow stocks - increased, Allen said. It fell toward the end of February 2021 as the markets continued to rise.

There are many drivers of demand for stock borrows, Allen noted, “but generally, when we see markets rise as they have, there tends to be fewer shorts in the market.”

Rates and Other Factors

Low interest rates have fueled the bull market in recent years, prompting investors to turn to riskier assets such as equities in search of better returns. That trend is likely to continue, given that central banks, including the Federal Reserve, have stated their intent to maintain low rates.

Other factors may also contribute to depressed short selling, when investors borrow assets and sell them with the intent of buying them later at a lower price to return to the lender. Traders coordinating over the Reddit social media website in late 2020 and early 2021 pushed up the prices of GameStop and other stocks heavily shorted by hedge funds, so-called crowded shorts. The resulting short squeezes required hedge funds to buy those stocks at inflated prices to cover their positions, driving prices up further and causing significant losses.

Short sellers' retreat from GameStop and other targeted names caused securities finance revenues from those firms to fall. Other short sellers, however, may have seen opportunities once stock prices rose to inflated levels, according to Josh Galper, managing principal of research and consulting firm Finadium.

“Similar amounts of shorting may be occurring, but the reduction in concentration among big players results in more defused demand for securities loans,” Galper said. “This in turn can serve reduce the rate that lenders can charge.”

Regulatory Prospects

Another consequence of the Reddit trades has been increased scrutiny by Congress and the Securities and Exchange Commission, raising the possibility of new rules impacting securities financing, perhaps similar to Europe's new Securities Financing Transactions Regulation that requires increased transparency. Simon Tomlinson, global head of securities finance trading at BNY Mellon, said the prospect of new requirements may further inhibit traditional short sellers until the political ramifications “shake out and we understand what it means for the industry.”

Subdued short selling of equities in the foreseeable future may prompt beneficial owners to consider other types of trades. Fixed-income appears to be one area lenders turned to in the first quarter, when, according to DataLend, revenue from lending those securities increased 20%, to $420 million.

“Collateral flexibility is key,” Tomlinson said, noting the growth in corporate and convertible bond issuance last year as well as ongoing growth of exchange-traded funds. “If lenders can finance those assets, they can make additional alpha for their clients,” he said.

Mergers and SPACs

M&A is picking up, and transactions that are a mix of stock and cash could provide additional financing opportunities, according to Tomlinson. He pointed to the $80 billion in SPAC transactions last year and record SPAC issuance of $88 billion in the first quarter.

“Depending on the structure of the fund, not every lender can do those or will want to,” Tomlinson said, adding, “Clients that are willing to expand their financing are the ones who will probably generate the best returns this year.”

Of the top 10 in 2020 in terms of securities lending revenue, four were new listings, either via SPAC (Quantumscape), IPO (Rocket Companies and Lemonade), or direct listing (Palantir), according to DataLend.

Other Openings

On the corporate actions front, exchange offers provide beneficial owners forgoing the opportunity to tender shares the ability to charge premiums to lend their shares. Sam Pierson, director of securities finance at IHS Markit, said beneficial owners may adopt strategies to lend shares only in specific situations that provide more lucrative rebates and fees, such as exchange offers, or more generally when the lending fee meets or exceeds a certain threshold.

“Events like exchange offers are good examples for why beneficial owners want to have some participation in lending programs, even if just to take advantage of those when they come up,” Pierson said. “This is facilitating a corporate action, so if you own the shares, why wouldn't you want to be there to participate in that?”

Pierson also noted a bifurcation in the securities lending market that can boost returns for lenders able to take advantage of it. He said prime brokers are now lending a large portion of highly liquid, easy-to-borrow stocks, reducing the need to borrow shares from beneficial owners. On the other hand, fees for lending the most expensive-to-borrow shares have increased in recent years, even as prices of those shares have generally outperformed over the last 12 months. Previously, their routine underperformance often led active managers to avoid them.

“You may start to see a behavioral shift in asset managers who want more exposure to some of the more speculative names, given the share price outperformance in addition to lending fee generation,” Pierson said.