The Markets March 22, 2017

Securities Lending Seeing Higher Demand from Institutional Investors

Higher interest rates, changes in collateral used and other trends can result in higher revenues for institutional investors, such as DB plan sponsors.
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Securities lending is a way for institutional investors to generate incremental revenue for their portfolios by lending out their securities for collateral. George Trapp, head of Client Relations for North America at Northern Trust, Global Securities Lending, who is based in Chicago, describes it as “sort of like renting an apartment where you are an owner, but lending it out because there is demand for it.”

He says with the transaction, institutional investors should make sure they take all steps to price map correctly, do a mark to market valuation to make sure it is properly collateralized and investors are charging the right fee.

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According to Trapp, there are a combination of reasons institutional investors, such as defined benefit (DB) plans, are interested in securities lending, with the primary reason being it generates incremental revenue. But, securities lending also provides liquidity in the financial market, and sometimes DB plans use other products securities lending supports—for example, a long-short strategy using hedge funds. Securities lending provides DB plans more liquidity than other securities. “And institutional investors can vet the program to meet their list of parameters,” Trapp says. “It is a low-risk investment, but investors can set parameters based on their risk tolerance, for example, using only U.S. Treasuries as collateral.”

There are a few trends Trapp and Northern Trust are seeing in the securities lending space. Higher interest rates are driving demand for clients. There are better spreads on cash collateral since service providers can charge a higher rate for borrowing securities.

“Overall as rates move up from a very low nominal rate, we’re seeing clients have the opportunity to make additional income if interest rate moves are well-predicted and transparent. If you don’t know an interest rate increase is coming or when, it dampers earnings,” he says. “The longer-term impact is positive. In a low interest rate environment, institutional investors are battling for every basis point they can. Higher interest rates are not a major issue in the securities lending market; institutional investors can charge more for loans.”

NEXT: Collateral changes

Those to whom institutional investors lend securities post collateral. If clients were beneficial owners, lending agents help clients define what they deem as acceptable collateral, Trapp explains. For example, Employee Retirement Income Security Act (ERISA) funds and mutual funds cannot accept equities as collateral.

One clear trend over last three year period—borne from Basel III requirements, an international regulatory accord that introduced a set of reforms designed to improve the regulation, supervision and risk management within the banking sector—is acceptance of securities as collateral versus cash, according to Trapp. He says it plays out globally as well as in the U.S. The market has moved to 70% accepting cash collateral five years ago, to now 40% to 50%. Clients are beginning to pledge lower quality or less high quality securities as collateral, causing an increase in securities collateral. Those lenders willing to accept a broader range of collateral are likely to be well-positioned to maximize revenue within their acceptable risk parameters.

It is important for institutional investors to accept a wide set of securities as collateral because cash is not accepted as before. However, Trapp reiterates that an ERISA fund may not be able to accept a wide variety of securities as collateral; they cannot accept equities, but can accept sovereign debt and corporate bonds.

But, clients are rewarded for using cash as collateral. “We have two competing trends,” Trapp says. “It is important for clients to be able to take cash but be flexible about securities collateral.”

NEXT: Concentrated demand and ETFs

Last year, three stocks represented a sizable chunk of the securities lending market, according to Northern Trust. The $220 million generated by lenders of Tesla shares, alone, was responsible for 3% of the securities lending industry’s total revenue, generated for lenders in the marketplace. Trapp explains that for DB plans lending out Tesla shares, assuming normal asset allocation across the plans, Tesla would have represented a large portion of overall earnings.

Trapp says he can’t name specific companies that will generate high revenue for securities lending this year, but generally, Northern Trust is seeing demand continue for securities lending products, and clients are coming from all different market segments. He says securities lending is working its way in the defined contribution (DC) plan market, as Northern Trust is seeing interest from DC plans. “Lenders should identify hot areas they think will see continued concentration,” Trapp says. “Retail and energy securities are in high demand, but it is hard to predict that one company that will drive revenue.”

According to Trapp, an interesting trend continues to be the use of exchange-traded funds (ETFs) by institutional investors. Northern Trust sees increased demand for lending of ETFs. Clients are using ETFs and holding more to get greater exposure to more areas of market. When it comes to lending, he says, it is a good area for clients who want to hedge positions for exposures they have—buying and selling ETFs is a quick way to do that. Trapp says emerging market and high yield bond ETFs are seeing the most demand.

Trapp notes that U.S. Treasuries have been very quiet over last three to five years, but as seen in the past year, especially in the fourth quarter, interest rates are starting to creep up. He says there is a natural demand for U.S. Treasuries to hedge against interest rate moves. As rates move up, Trapp believes the securities lending market will see more demand.

“Securities lending is absolutely good idea for DB plan sponsors. It is a way to get some incremental revenue,” Trapp concludes. “What is important is working with a lending agent to set up a program to reflect the lender’s risk appetite. They can set up a program for specific needs, deciding how much to lend and a minimum spread, or they can throw all that to the wayside and try to earn as much as they can.”

Compliance March 22, 2017

Bank of America Prevails In ERISA Challenge After Bench Trial

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An opinion handed down by The United States District Court for The Western District Of North Carolina, Charlotte Division, rules in favor of the defendant, Bank of America, which had been accused of profiting from imprudence and disloyalty in the management of a cash balance plan.

The case has had a lengthy and complicated procedural history, stretching back to a time before Bank of America even existed as such and calling out cash balance plan design/administration decisions made by then-NationsBank leadership. Most recently the case was revived and remanded by the 4th U.S. Circuit Court of Appeals, leading to the current decision.

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Plaintiffs originally filed their cash balance plan lawsuit in 2004, claiming the way their employer created a cash balance plan by essentially transforming an existing 401(k) represented impermissible benefit cutbacks. After that, in 2005, an audit of the bank’s plan by the Internal Revenue Service (IRS) resulted in a technical advice memorandum order, in which the IRS concluded that the transfers of 401(k) plan participants’ assets to the cash balance plan between 1998 and 2001 violated relevant Internal Revenue Code provisions and Treasury regulations.

According to the IRS, the transfers impermissibly eliminated the 401(k) plan participants’ “separate account feature,” meaning that participants were no longer being credited with the actual gains and losses “generated by funds contributed on the participant[s’] behalf.” The IRS determination led a federal district court to move the participants’ case forward. However, the bank entered into a closing agreement with the IRS, paying a $10 million fine and setting up a special-purpose 401(k) plan to restore participants’ accounts. The district court determined that, following the closing agreement, the participants no longer had standing to sue.

The appellate court then determined that the plaintiffs in fact had standing to sue under Employee Retirement Income Security Act (ERISA) Section 502(a)(3), which provides that a plan beneficiary may obtain “appropriate equitable relief” to redress “any act or practice which violates” ERISA provisions contained in a certain subchapter of the United States Code. The court found that the transfers violated ERISA’s anti-cutback provisions, as determined by the Internal Revenue Service during a plan audit, and that the relief the plaintiffs are seeking—the profits Bank of America made from the assets transferred—is “appropriate equitable relief.”

On remand, the current decision comes down in favor of Bank of America. The full text of the decision outlines substantial expert testimony and other evidence marshaled by both sides, arguing whether or not the company ultimately benefited or suffered from the way it managed the plans in question. Ultimately greater deference was shown to Bank of America’s arguments that it actually suffered greater financial losses, rather than undue profits, as a result of its improper behavior than it otherwise would have. This was in no small part due to the fact that the bank’s retirement plan investment returns were dramatically impacted by the Great Recession. 

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