Securities lending

Over the last few months there has been a significant increase in the level of media coverage in relation to securities lending and its impact on the Australian share market. This has gained added impetus more recently with the demise of some small retail brokers, such as Opes Prime.

Securities lending involves transferring some of the stock held in a portfolio (by the ‘lender’) to external parties (the ‘borrower’). In return, the lender receives a fee from the borrower. Whilst ownership of the securities transfers to the borrower, the lender retains all rights and entitlements associated with those shares (e.g. dividends). The only exception is that the voting rights pass to the borrower (although as a matter of policy, UniSuper recalls all relevant stock prior to voting periods such that voting rights are retained by the Fund).

There are a number of ways that lent stock can be used, but recently concerns have been growing around the use of ‘short-selling’.

Short-selling refers to the practice whereby a borrower sells a stock on the market with the expectation that the stock’s value will fall in the near term. Assuming that this fall eventuates, the borrower can then take advantage of the lower price to buy back the stock – thus achieving a profit for themselves before delivering the stock back to the lender.

One of the concerns raised is that short-selling can reduce the value of shares held by investors. The concern is that when investors such as UniSuper lend their stocks, borrowers are able to sell them, putting downward pressure on the shares that the super funds own.

It is important to remember though that stock prices can change for many reasons, and it is not generally as a result of securities lending or short-selling. Most recently, individual listed companies such as ABC Learning Limited and Allco Finance Group Limited experienced sharp drops in their share value primarily as a result of fundamental issues such as high debt levels and refinancing issues, not simply short-selling.

There are however legitimate concerns where market prices are being manipulated either to increase or decrease stock prices in ways that are considered unfair. The Trustee believes that improved regulation is required to prevent such cases, including increased disclosure of short positions and greater disclosure of the personal financial exposures of company directors. This is currently being considered by the relevant Australian regulators, and the Fund has written to both ASIC and Treasury regarding these issues.

Nevertheless, securities lending is an established feature of the market providing increased liquidity (i.e. greater volumes) and market efficiency (i.e. increased speed in incorporation of news and events), but is not considered to be a key driver of stock price returns, particularly over long periods.

The Trustee must ensure the prudential management and investment of UniSuper’s assets and as such makes and implements decisions about the investment of those assets, as well as carefully monitoring their performance.

All investment activities must be carried out in accordance with the requirements set out in the Superannuation Industry (Supervision) Act 1993 (SIS Act). In particular, the Trustee must ensure that the strategies for the investment of UniSuper’s assets comply with:

• the “sole purpose test” (i.e. the requirement that investments are made for the sole purpose of providing retirement income for the Fund’s members);
• the investment rules. This includes any rules relating to particular types of investments such as instalment warrants and derivatives;
• any investment restrictions, including the prohibitions on borrowing, lending to members, placing a charge over a member’s benefits or fund assets except in certain limited circumstances; and
• the general trustee covenants set out in the SIS Regulations.

Within these parameters, the Trustee is generally free to make properly considered investment decisions consistent with the prudential management of UniSuper’s assets for the benefit of members and their beneficiaries.

The Trustee has operated a securities lending program in relation to UniSuper’s equities and bond portfolios for many years. The program operates fully within the boundaries of the Trustee’s legal obligations in relation to investment activities. In implementing this program, the Trustee has carefully considered the risks of participating in securities lending, and believes that the Fund is appropriately rewarded for these risks.

A securities lending program has operated under a principal agreement between the Trustee and National Australia Bank Limited (NAB) (the parent company of the Fund’s custodian, National Custodian Services, NCS) for many years. As part of this agreement, NAB is obliged to re-deliver lent securities, as well as reimburse the Trustee for any monetary benefits (e.g. dividends) earned over the loan period.

In terms of any on-lending of stock by NAB, NAB assumes all associated risks (such as counterparty credit risk, entitlement default, collateral deficiency and delivery risk). This means that it is highly unlikely that UniSuper could suffer any loss from a failure of the securities lending program with NAB.

In terms of the operational risks with NCS, UniSuper has sought to mitigate these by ensuring the custodian:

• has significant assets under custody;
• is experienced in running securities lending programs; and
• has proper risk management techniques in place to ensure the appropriateness of any securities lending being undertaken and the protection of the program from losses.

The NAB securities lending program is conservative and strongly protected against losses. Only small proportions of the equities portfolios are lent out (typically around 20% for Australian shares and 5% for international shares). Somewhat higher lending levels are undertaken in the bond portfolios (typically around 20% for Australian bonds, 55% for Australian index linked securities, and 36% for international bonds). Investment managers engaged by the Trustee to manage the underlying portfolios are able to request a security be recalled should they consider it inappropriate for the security to be lent. In all instances, stocks are recalled prior to voting periods in order for UniSuper’s proxy voting policy to be fully implemented.

In addition to the NAB program, both of the Fund’s core Australian bond managers, Macquarie and Perennial, are permitted enter into repurchase agreements (repos). Currently, only Macquarie uses this discretion. Repos can only be entered into with a counterparty from a pre-approved list, who acts as a Principal, primarily for the purpose of providing additional market liquidity. All repos are fully cash collateralised, with the collateral marked-to-market daily. In the unlikely event of a default by any borrower, the cash collateral can be used to repurchase the relevant security. As such, the risk of loss in this arrangement is considered to be extremely low, while adding incrementally to the returns of the bond portfolio.

Overall, the Trustee believes that securities lending is an important means of providing greater liquidity and efficiency in markets, as well as providing an appropriate source of additional, low risk, income for UniSuper. However, the Trustee acknowledges the need for improved regulation and increased disclosure in relation to short-selling as well as the personal financial exposures of company directors.

Published: 15 May 2008