Gazes Also.

Written by Scott Fulton, Co-CIO and Co-Host of Keanaissance

Two point five trillion dollars. That was the value of the market in securities lending in September 2020. It is likely to have increased since then.

Context. The market in securities lending is larger than the GDP of all but the seven largest economies in the world. It is larger than the Italian, Spanish, and Canadian economies, for example. It is three times the size of the Saudi Arabian and Swiss economies. It is one of the largest markets in the world.

Anyone who has read the book, or watched the film, The Big Short (2015) should have a working idea of securities lending. However, while not complicated, it is shrouded in acronyms (e.g. CDOs), misnomers (e.g. hedge funds), and one seemingly illogical practice. The securities lending market supports and makes considerable sums of money from the practice of selling instruments, be they shares or bonds, without owning them.

Short selling was “invented” by Isaac Le Maire, at one time the largest shareholder in the Dutch East India Company. Regularly in dispute with the Company (VOC in the original Dutch), Le Maire sold stock in the Company which he did not own in order to depress the price. It was effective and, according to certain accounts, may have precipitated the practice of “naked short selling” which was explained by a less than fully clothed Margot Robbie in The Big Short film. Naked short selling occurs when the seller has not borrowed, or has no indication that borrowing is available, stock which is sold subsequently. Literally, selling nothing for something: a strategy which was developed in a fit of pique.

The ability to borrow shares or bonds is at the heart of this practice: the market in securities lending. The Financial Conduct Authority (FCA) has this to say:

“the lender transfers securities to the borrower otherwise than by way of sale and the borrower is to transfer those securities, or securities of the same type and amount, back to the lender at a later date. In accordance with good market practice, a separate transaction by way of transfer of assets is also involved for the purpose of providing collateral to the “lender” to cover him against the risk that the future transfer back of the securities may not be satisfactorily completed.”

FCA Handbook, COLL 5.4 Stock Lending

Thus, stock lending comes in two parts:

• The lender “transfers” the securities to the borrower. It is not a “sale” but a “loan”:

• The borrower deposits “collateral” for the life of the loan to protect the lender’s risk.

Critically, the extent of collateral was often defined by the dividends and the result of any other corporate action, paid by the issuer (company) but forgone by the lender during the period of the loan as economic rights, equally often, rest with the borrower.

The cost of borrowing is critical, and we will return to it later.

However, let’s look at these transactions from the fund holder’s point of view.

You are an investor in a pension fund or, perhaps more likely, your employer invests on your behalf and as part of your remuneration. In the latter case, you are more likely to take a passive view of this investment, particularly when you are years or decades away from the investment having a value to you (retirement).

The concept of time is critical. Pension funds have long time horizons. Receiving investment from a 30-year-old pension fund holder today creates a liability for the Pension Fund in over 30 years’ time. According to an OECD report in June 2021, the global OECD pension fund asset pot is $35 trillion. For the sake of balance, the pension pot outside the OECD countries was $0.8 trillion.

The United States makes up over two thirds ($20 trillion) of the OECD total with Australia, Canada, the Netherlands, Japan, Switzerland, and the UK accounting for a further $11 trillion, or just shy of a third.

The pension fund industry is one of the largest markets in the world. It is dominated by just seven countries.

In terms of the market capitalization of the equity capital market (ECM), the same demography persists. Indeed, within the top 10 ECMs by market capitalization, 6 of them are larger than the GDP of the country in which they operate. In 2020, the US ECM was worth $40.7 trillion, almost twice the GDP of the US. In the same year, the value of the Hong Kong equity market was almost 18 times that of its GDP. Interestingly, the combined market value of the ECMs in France and Germany was only 70% of their combined GDP. The thrill of equity is clearly enjoyed more fully by non-European countries.

Back to pension funds. They are mandated to manage the retirement savings for pension holders over decades and are not “day traders”. They have the benefit of taking the long view and playing the long game. They are specifically asked to not care about the short term.

Enter the short sellers, often referred to as hedge funds. These funds, in this regard, are designed to take advantage of volatility. They target issuers (companies with shares traded on a stock market) whose financial performance or sector classification suggests that their share price will fall in the short term.

An economic transaction is often characterized as “the coincidence of needs and wants”. The pension funds need to generate a return from their holdings but cannot be seen to be trading actively as this would cost money and may indicate that they do not have a consistent strategy. Hedge funds want to make money but do not need to hold shares and incur the associated costs of so doing.

Stock lending and short selling: resolving the needs and wants of the pension and hedge fund industries.

You will note that at no point in what is now eight hundred words have the needs and wants of the issuers (companies) been discussed. To a very great extent, they are irrelevant. Hedge fund strategies – essentially picking what is going to go wrong in the short term – do not need to spend as much time on corporate fundamentals as they do the technicalities of the market for the shares.

Example:

Hedge Fund A believes that the market for loungewear is about to be undermined by a Government backed initiative to get people back to work and not WFH. The fund’s analysts identify Company B which is highly exposed to loungewear and its shares are owned by a small number of large pension funds. One of these funds, Pension Fund C, has a stock lending, or repo, relationship in place with Hedge Fund A. The hedge fund borrows several million shares in Company B and, in return, places collateral with Pension Fund C.

Company B’s shares are trading at 100, buoyed by the refusal of the workforce to return, en masse, to the office. Hedge Fund A sells one million shares at 100, generating a gross consideration of 100 million.

Shortly after, the Government announces that, for a quarter, travel into the office will be free. A panel of significant employers, including banks, accountants, and lawyers, all support the initiative and promise more comfortable chairs and larger lifts for the returning masses.

The stock market assesses the risks that this initiative will have on listed companies. It concludes that Company B will struggle, and the share price falls to 75. At this point, Hedge Fund A buys one million shares in Company B at 75, paying out 75 million.

Thus, in a short period of time, Hedge Fund A has generated a gross profit of 25 million from selling stock it did not own. Pension Fund C has not lost out as the collateral placed by the hedge fund is sufficient to cover the associated risk (e.g. any dividends paid) and remember, it does not need to recoup any losses quickly as it has a long-term time horizon.

Company B, however, experiences a 25% fall in its share price. This prompts other shareholders to sell in order to put a floor on losses. The share price falls further, prompting calls for pay restraint and board-level departures at the next AGM.

Irony. Pension Fund A has its vote returned with the stock from Hedge Fund B and, owing to its shareholding, this vote is a significant proportion of the total. It can choose to support the board or vote against it. Yet, the reason for the vote against the board is the fate of the share price, which fate was the result of Pension Fund A lending the stock in the first place.

The development of corporate structures has long been criticized for the “divorce of ownership”. This concept states that company boards exercise greater control over its fortunes than the owners of the company (shareholders). Yet the development of capital markets has seen a subsequent divorce. One where the shareholders, long of time but short of patience, lend their shares to funds who can take a shorter view on prospects, sell without needing to own, and, more often than not, benefit from a self-fulfilling prophesy.

Securities lending, and the accompanying short selling, is regularly described as an efficient means of managing the returns from portfolios with long-term pension liabilities. It has become more efficient because issuers have refrained from paying dividends. The cost of borrowing stock is often set in the context of the dividends not received by the lender over the period of the loan. If the issuer does not pay dividends, then the cost to borrow is either lower or, in relative terms, a replacement for dividends.

It could be argued that the growth in stock lending and short selling has replaced dividends as the primary source of non-trading revenue for pension fund shareholders. The largest US companies by market capitalization (the oft mentioned FAANGs) do not pay dividends. High growth companies, likely in technology and recent entrants to the ECM, do not pay dividends.

Thus, the cost of not paying dividends to an issuer is the likelihood that the very pension funds it has assiduously courted to hold its shares decide to compensate for this lack of income by lending the shares to hedge funds who compensate the pension funds equivalent to the lack of dividend.

The providers and managers of capital are not disadvantaged. Indeed, the capital market enjoys higher traded volumes, higher commissions, and higher profits.

Issuers have viewed the ECM, increasingly, as a free source of funds. Listing shares in the company based on valuations derived from concept, fashion, and revenue projections leaves the issuer open to the vagaries of the very pension funds it has been advised to recruit. If the issuer does not pay a dividend the cost of lending the stock to the pension fund is diminimous. Pay dividends, and the opportunity cost of lending stock rises, possibly to the point where lending does not take place. Without lending, there would be no shorting.

A warning to issuers. “If you gaze long enough into the abyss, the abyss gazes also into you”. (Friedrich Nietzsche).

Or, to paraphrase the closing of Bob Roberts, PAY DIVIDENDS. It will pay dividends to your share price.

This is the last of the “Keanaissance Series” of articles before the event which they support and inform takes place. We hope that you have enjoyed our work and we look forward to debating these points in the convivial surroundings of Kea Island in June 2022.