The problem with securities lending–what makes it fundamentally fraudulent in the US and Canada–is that it is not a “buy-in” market. Let us imagine that Mr. Smith borrows stock from Mr. Jones to sell it short. The stock is in a developmental drug company. When the news is announced that the drug has failed its test Mr. Jones’ stock is sold away from him (by stop-loss or margin call). The stock lender always has the right to sell his stock, indeed, he has no idea that his stock has been lent and neither does his broker. There is no buy-in requirement that requires that stock be bought in to cover Mr. Jones’ sale of stock that he does not have. The float increases out of thin air and there is no upward price pressure from a buy-in. Some other countries do have, and enforce, buy-in requirements.

By Richard Haas on Jun 10, 2009

I have no experience with retail securities lending regulations in Canada, but I find Mr Haas’ comments surprising and possibly not correct. I have referred this to industry experts in Canada.
Otherwise, thanks for the reference to my blog, and a good series on the business.
With respect to Mr Zweig’s article the other day, the issues are more complex than can be explained in a single article and so while some comments he makes are true, they are not necessarily representative of the full picture.
One issue he raises that needs clarification relates to who is left “holding the bag” in the event of a problem. Mr Zweig is comparing “apples and oranges” in his two scenarios. If the broker is borrowing fully-paid-for securities the broker is the trading counterparty and where an investor’s risk lies. In that scenario, the broker probably isn’t giving the retail client any collateral and may not even pay the client a fee (but typically does). If the broker defaults then the investor is on the hook for any losses and has to recover losses from the broker’s liquidators. If a firm borrows from the mutual fund and defaults, then the fund has collateral and if the fund suffers a loss as a result of insufficient collateral then it too must go to the liquidators. As an investor in the mutual fund, an investor is on the hook for its share of any losses.

By Roy Zimmerhansl on Jun 10, 2009

I am anxious to see what industry experts have to say.

So far as I know, securities lending is governed by commercial contract rather than by regulation. In my example using Smith and Jones as borrower and lender I should have made it The Smith Hedge Fund and The Jones Pension Fund.

If one is a retail investor, however, it would be Mr. Jones. Mr. Jones would have a margin agreement with his broker which allows that his stock can be lent out if he owns it on margin. His broker has a custodial agreement with its custodian which allows the custodian to lend the stock in exchange for the offsetting of custodial fees. Typically, custodians are also lending agents. That is, it is they who actively seek borrowers for the stock that they hold in custody. The custodian/lending agent has a securities lending agreement with a short selling hedge fund. The borrower would not be a retail investor. All of the agreements mentioned here would be contracts.

My belief that the buy-in of stock to cover long sales of lent stock is simply not a concern is based on snippets like the following; with my annotations:

“The staff of the SEC (the “SEC staff”) issued guidance [Oct. 1,2008] providing that securities out on loan will be deemed to be owned by the lender for purposes of the SEC’s short sale regulations, and therefore can be sold long, …Prior to the guidance, lenders were concerned that they would not be deemed to own securities on loan for purposes of the various SEC short sale regulations, including Regulation SHO as amended by new Rule 204T, the SEC emergency short sale order banning short sales of financial stocks, and the new temporary Form SH short sale position reporting requirements. Prior to the SEC staff’s issuance of this guidance, [from Sept. 18, 2008 shen the short selling of certain stocks were banned] many brokers were marking sales of securities that were out on loan as short sales out of an abundance of caution due to uncertainty regarding the long-short status of the sales.” http://www.mondaq.com/article.asp?articleid=67030 Free registration required

Further, An Introduction To Securities Lending refering to Agent Lenders as “intermediaries” says,
“… intermediaries [...] take on liquidity risk. Typically they will borrow from institutions on an open basis – giving them the option to recall the underlying securities if they want to sell them or for other reasons – whilst lending to clients on a term basis, giving them certainty that they will be able to cover their short positions.”
http://tinyurl.com/4brnw4 page 20

They borrow on an open basis and lend on a term basis. That means they borrow for an unspecified amount of time while lending for a specific amount of time. If a pension fund sells stock whenever it wants, which it is entitled to do, it can mean that its broker cannot deliver it to the buyer in a timely way. The above mentioned intermediary is reluctant to recall the stock lent from a pension fund’s account because doing so could break the loan to the short seller.

“Liquidity risk” here refers to stock liquidity not monetary liquidity. It is my belief that if you combine the risk that this behavior is illegal with the risk that this illegality will be punished you get something that is called regulatory risk. And I think that regulatory risk is nil.

I look forward to correction.

By Richard Haas on Jun 10, 2009

It would be highly unusual for a broker to have a custodian to lend out margin securities, so if that does occur it would be exceptional rather than the norm. What a broker can do with margined securities is indeed regulated rather than solely reliant on contractual arrangements which generally govern the business arrangements.
The agency side of the business is almost without exception a relationship between institutional investors and their custodians which arranges loans on the institution’s behalf.
Where Mr Haas makes reference to intermediaries taking on liquidity risk, borrowing on “open” and lending on “term” this relates to dealers that choose to take that risk upon themselves and again represents a minor portion of the business for which they charge their hedge fund clients a premium. This open vs term trade has absolutely no impact on the lender or their ability to ask for the return of their securities, save in the case where the lender agrees to do so, taking its own fee premium at the time.
I misunderstood the comment on buy-ins. It is correct that buy-ins are not automatically generated as it would be expensive and unnecessary. Lenders retain the right to ask for their loaned securities to be returned within a normal settlement cycle. Practically speaking, when the lender asks the borrower to return the stock, the borrower seeks to substitute the securities by borrowing securities from another lender. If a lender does not received securities back within the contractual time frame, it is legally entitled to buy-in the securities. However, in the event that a borrower can’t locate securities elsewhere is more likely to buy the shares back on the open market rather than be bought-in.
This is a complex business that is difficult to research and understand without interpretation and context. Mr Haas has clearly done some investigation, but needs supplementary comment.

By Roy Zimmerhansl on Jun 11, 2009

Mr. Zimmerhansl says, “It would be highly unusual for a broker to have a custodian lend out margin securities, so if that does occur it would be exceptional rather than the norm.” Is there a brokerage that does not allow its custodian to lend stock? From Scottrade’s margin agreement, Scottrade is a retail brokerage:
Loan of Securities. We are authorized to lend ourselves, as principal or otherwise, or others any securities held by us in your Account and we shall have no obligation to retain under our possession and control a like amount of such securities. In connection with such loans, we may receive and retain certain benefits (including interest on collateral posted for such loans) to which you shall not be entitled. In certain circumstances, such loans may limit, in whole or in part, your ability to exercise voting rights of the securities lent. http://www.scottrade.com/formscenter/PDF/SF1011_Margin_Agreement.pdf

I would suggest that in general less than fifty percent of stocks are on loan but in the case of stocks-in-demand (for short selling) substantially all of them are on loan.

“Where Mr Haas makes reference to intermediaries taking on liquidity risk, borrowing on “open” and lending on “term” this relates to dealers that choose to take that risk upon themselves and again represents a minor portion of the business…” I should have said that I was referring to parties that engage in securities lending using the standard Master Securities Lending Agreement as their contract. Securities lent under the terms of this contract are measured in the Trillions of dollars, hardly a minor part of business.

When borrower is known to lender and vice versa (”disclosed” is the term used for this) then a custom agreement is possible. This is the exception.

“It is correct that buy-ins are not automatically generated as it would be expensive and unnecessary.” This is a value judgment from the point of view of the borrower who borrowed the stock hoping that it would drop in price. The lender and beneficial owner might consider a buy-in necessary to bolstering the price of his stock. If the automatic buy-in occurred say, on the day after Thanksgiving, when trading is light it might be very expensive. This would be bad for the borrower and good for the lender.

“However, in the event that a borrower can’t locate securities elsewhere is more likely to buy the shares back on the open market rather than be bought-in.” The borrower does not look for shares to replace shares that were sold away. This is the job of his lending agent. And, the lending agent is not going to buy shares on the open market since that would mean taking title to them which would lead to some sort of taxable event. If the borrower must buy shares on the market that he is short he is unwinding a short position. The short ratio for the stock in question may make that impossible.

By Richard Haas on Jun 11, 2009

Quite a lively debate. Just because something CAN happen, doesn’t mean it DOES happen.
Hence my comment regarding context or additional commentary. Brokers definitely lend out margin securities, but the assertion that they give it to their custodians to lend out without their knowledge or direction is simply wrong. The mismatch between open borrows and fixed loans also does occur using the quoted agreement, but the truth is that the number of mismatched transaction that occur are in fact a minority of trades. In addition to the potential risk for the dealer, the end borrower seldom wants to make a fixed commitment to borrow the securities for specified period of time, instead retaining the ability to close out the short position and return stock.
If you are speaking of institutional end-borrowers these firms do not use lending agents. Borrowers use prime brokers, clearing brokers, or trade as principals.
Mr Haas is taking a series of facts, truths, personal interpretations and potential events and weaving them into a story that doesn’t reflect the reality of the mutli-trillion dollar industry that is securities lending.
I do not know his background, but I suspect he has never worked within the industry and therefore is subject to the often incorrectly reported hysteria that often surrounds the business.

By Roy Zimmerhansl on Jun 11, 2009

“…the assertion that they give it to their custodians to lend out without their knowledge or direction is simply wrong.” Well, maybe…, here is a quote from an interpretive letter from the Comptroller of the Currency to some mysterious bank:

“The Bank now proposes to act in the capacity of a “conduit lender” to provide additional return enhancements to its securities lending customers. Currently, the Bank’s customer chooses various potential borrowers from a list of usual borrowers. However, the customer may decide not to “approve” all of the borrowers on the list, resulting in some customers that will not permit their securities to be lent directly to certain borrowers. Yet, a certain borrower may desire to borrow securities that only may be found in accounts of customers that have not approved the borrower.

To engage in the conduit lending services, the Bank would borrow the desired securities as principal from the customer that had declined to approve the borrower, and then on-lend those same securities as principal to the borrower. The Bank plans to accomplish this by listing itself on the list of potential borrowers attached to the agency securities lending agreement.”
http://www.occ.treas.gov/interp/may05/int1026.pdf

“…but the truth is that the number of mismatched transactions that occur are in fact a minority of trades.” I will interpret ‘mismatched transactions’ to mean a transaction with a borrow on one side without a corresponding loan on the other. I would agree that they are in the minority and suggest that this happens. And that this is what drives stock prices down.

“If you are speaking of institutional end-borrowers these firms do not use lending agents. Borrowers use prime brokers, clearing brokers, or trade as principals.” I believe that prime brokers and clearing brokers use lending agents to support their institutional borrowers. Unless they can source the stock borrowed from their own inventory. Institutional lenders use lending agents. If they do not lend to institutional end-borrowers then to whom do they lend?

“Mr Haas is taking a series of facts, truths, personal interpretations and potential events and weaving them into a story that doesn’t reflect the reality of the multi-trillion dollar industry that is securities lending.
I do not know his background, but I suspect he has never worked within the industry and therefore is subject to the often incorrectly reported hysteria that often surrounds the business.” Hmm, could be something vaguely ad hominem there.

But as our host says, “If industry members are the only ones making their voices heard in the public realm, then fund holders will likely continue to get what appears to be the short end of the stick.” http://seekingalpha.com/article/142293-the-organized-business-of-securities-lending-part-iii

My contribution.

By Richard Haas on Jun 11, 2009

The purpose in making the comment regarding Mr Haas’ background is not to question the validity of any of the commentary, rather it was to demonstrate my point that abstract investigations without an experienced-based context can produce misleading results.
I could continue to point out the continuing inaccuracies in the latest comments. For instance, Mr Haas has now reinterpreted my explanation regarding brokers using lending agents. In his initial comments “The stock lender always has the right to sell his stock, indeed, he has no idea that his stock has been lent and neither does his broker.” Mr Haas is alleging the broker doesn’t know that a custodian is lending the owner’s stock. I have pointed out that the brokers don’t use custodians to act as their lending agents. This has been twisted by Mr Haas into somehow me suggesting that prime brokers and clearing brokers don’t use legnding agents to support their business.
As another example, he can interpret my definition of mismatch incorrectly if he chooses, or he could read the start of the sentence: “The mismatch between open borrows and fixed loans…”. It is a fact that this type of transaction represents a minority of trades. However, unless someone was part of the day to day activity, it would be difficult, if not impossible for anyone to know this.
He is free to make incorrect assertions about the business, and question the motives of someone trying to rectify the errors, however that will be misleading for your readers.
I suggest that as with most pursuits, people do their own research, engage with experts to get more information and then make their own decisions.

By Roy Zimmerhansl on Jun 12, 2009

I worked on Wall Street for twenty years–’82-’02, albeit not in securities lending.

“I have pointed out that the brokers don’t use custodians to act as their lending agents.” This is a very fine point. All large custodians belong to companies that own lending agents. Respective lists are http://tinyurl.com/mff3vc and http://tinyurl.com/ktfwmc

But I see that in 1993: “1993 – Key Industry Event

* State Street separates its securities lending arm from its custody business, viewing it instead as an asset management function. This distinction starts an industry trend”

http://tinyurl.com/lsh8xo

My admitted confusion came from press releases like this one:

Boston, MA… —State Street Corporation (NYSE: STT), the world’s leading provider of services to institutional investors, announced today that it has been selected by Charles Schwab Investment Management (CSIM) to provide a broad range of investment services including accounting, custody and securities lending to the Schwab Funds and Laudus funds. The fund complexes represent more than 67 funds in total and $140 billion in assets. http://tinyurl.com/mbjud3

“Mr Haas is alleging the broker doesn’t know that a custodian is lending the owner’s stock.” I meant to assert that the beneficial owner’s broker has no way of knowing whether the individual shares of a particular beneficial owner have been lent. By beneficial owner I mean that person or institution who has bought and not yet sold his stock. And I stand by that. This is the reason that 1099div’s are mailed in March. Because the broker does not know whether to report dividend income from stock ownership or payment-in-lieu of dividend from the borrower of the shares until then.

” “The mismatch between open borrows and fixed loans…”. It is a fact that this type of transaction represents a minority of trades. However, unless someone was part of the day to day activity, it would be difficult, if not impossible for anyone to know this.” To know what? That there are settlement failures when a share is sold and cannot be delivered? Settlement failures are reported with a huge delay and it is certainly true that most people don’t know why they happen.

“people [should] do their own research, engage with experts to get more information and then make their own decisions.” I think that this is at least somewhat disingenuous. Look at the number of “closed door sessions” at the Beneficial Owner’s Conference. http://www.imn.org/2009/eej1195/post_event/index.shtml

And this quote from, I think, Frank Fabozzi (the link is broken so I will post the whole thing):
‘The securities lending market is so opaque that it reminds some observers of the bankruptcy business in the United States during the 1980s. Information and experience are highly concentrated in the hands of a relatively small number of firms and people. There are very few screens on which prices are displayed and fewer still where you can get more than an indicative quote.
The market remains this way because it is in the interests of the dominant players to keep it so. More transparency is not in their interest, or so they believe. The lack of clarity does more than restrict the number of institutions bringing supply to the market. It also hampers the speed of any institutional entry.
Most service providers would agree that an informed customer is a better customer. This is not the widely held view in the securities lending business. Such an attitude has not only held the market back but also led to the development of numerous myths.”
If people are misled about the securities lending business I would suggest that it is the fault of the securities lending business itself.

By Richard Haas on Jun 12, 2009

And can I restrain myself from commenting further? Not only do I feel the need to add one more comment, but I find myself dangerously close to agreeing with Mr Haas on several points. (But not all!)
Don’t mix the asset management/fund arms of brokers with the brokerage side. Regulations that work to protect investors from conflicts of interest between the two parts of the business often mean it is more difficult to deal “within” a firm than with another company.
The closed door sessions that Mr Haas refers to enables Beneficial Owners (Pension funds, mutual funds, insurance companies, – i.e. asset owners) to have open and frank discussions about their issues and concerns without fear of prying eyes of the brokerage community, custodians or agent lenders. Far from keeping issues hidden, it is a “safe” environment for them to privately air concerns which inform the public parts of the conference.
Before starting my consultancy this year, I set up an electronic trading platform for borrowing and lending securities as I believed (and continue to believe) that screen trading would be good for the market. It has proven to be beneficial for other markets so must surely be true for securities lending. Various initiatives are underway in both the US and Europe. Whether or not these become central to the business can only be seen in due course.
I completely agree with Mr Haas that part of the blame for the lack of understanding about the industry comes from poor communication, education and publication from within the industry. That is why I started my blog a year ago, why I have started writing articles for various magazines and why I tape free video updates for Global Custodian’s website. That is also why I have spent the time commenting here.

By Roy Zimmerhansl on Jun 12, 2009