An author affiliated with the National University of Singapore and one with Goethe University Frankfurt, Germany, have co-authored a paper on the structure of the securities lending market: specifically, on the fact that this market is an oligopoly, and on the implications that has for pricing.
The general outlines are what one would expect, knowing the term “oligopoly.” Etymologically, that term means “few sellers.” “Few” represents a middle ground between “many” and “one,” — between textbook open competition on the one hand and monopoly on the other. Thus, each of the few sellers in an oligopoly has more discretion over pricing decisions than it would have were it a truly competitive market, but less discretion than it would have were it a monopoly. This is broadly true whether the item being sold is a widget, a printing press … or the service of acting as intermediary in the lending of securities.
The study, by Singapore’s Zsuzsa R. Huszar and Germany’s Zorka Simon, looks specifically at the securities lending market for German treasuries between 2006 and 2015, and the long maturity segment of that. Further, it looks at the markets not from the point of view of the borrower of securities, the hedge fund (for example) seeking to make a short sale, but from the point of view of the beneficial owner, who is often a conservative passive investor such as a pension fund or insurance company.
Your Own Trading Desk
Their conclusion, in a word, is that in this particular market the oligopolistic service providers are taking advantage of those conservative institutions. Those institutions could improve their results by cutting those oligopolists out of the loop entirely by managing their own trading desks. Or they could press for “more regulatory oversight and greater transparency to improve their bargaining power.” Either way, they should become more proactive in order to generate returns from securities lending.
In response to the global financial crisis, the European Central Bank, and a number of the national central banks of the continent, started buying sovereign debt assets, especially the lower risk ones. This in effect put the central banks in competition with the conservative private institutions, both chasing the same safe bonds, and that raised the danger that the conservative private institutions, and through them pensioners and the insured, were going to end up bearing some of the costs of the economic stimulus programs of those central bankers.
Faced with this possibility, many institutions entered the securities lending market as a way of raising additional income to offset the higher costs of securing high-quality liquid assets (HQLA).
Huszar and Simon, in studying the market in German sovereign debt, report that through the period under study there were high relative price spreads on lending contracts. That is, the difference between the highest and lowest fees on all contracts on a specific date for a specific International Securities Identification Number (ISIN) can be considerable. This suggests that lenders without their own active lending desks don’t get to extract “real” rents because the prime brokers upon whom they depend can capitalize on their market power and informational advantages.
The conclusion of the empirical study of spreads is this: “In the long maturity segment some less connected beneficial owners receive a persistently low-fee income, while some special clients with greater bargaining power receive higher fees.” This confirms the hypothesis that “fees are not only slow to incorporate lending market information [they] are also dependent on the market power and connectedness of lenders.”
Globally, securities lending is typically an OTC transaction. This means that agents and/or prime brokers are the typical intermediaries between the beneficial owner and the borrower, and the market can be opaque.
Efforts have been made to establish a more transparent market in the area, but as these authors say (in something of a scholarly understatement), “we have yet to see this becoming the norm.”
The equity side of the securities lending market (which is similarly OTC and opaque) has received a good deal more scholarly attention that the fixed-income side, in part because of the drama of short stock sales and of constraints thereon.
Huszar and Simon cite CalPERS as an example of a pension fund that has made a success out of lending its securities prior to the GFC. This was, they say, a “well-developed … program with struct guidelines,” although even CalPERS’ program “was not resilient to the 2007-08 mortgage crisis.” Their agent purchased Lehman notes, and CalPERS suffered from the Lehman default.