Following an excellent comment made from one of the Brewin Blog’s readers, we have decided to post this piece on stock lending and, as a more direct response, discuss what happens to the revenue generated from such operations.
For those unfamiliar with the term stock lending, it refers to a process of lending out stocks held within a fund, to a third party, for a fixed period and in return for a fee. In that respect, lenders are actually benefiting from loaning out assets that don’t really belong to them. A common, real life example of this morally grey area would be a dog sitter lending out their cutest dog (for a fee) to a ‘friend’, so that they may take it for a walk around the park in the hope of attracting some ‘attention’. Clearly the dog sitter is earning two sources of income. The borrower is also benefiting as they do not want to retain possession of the asset for a sustained period. However, unless the owner of the dog gives their permission, and is rewarded with a fair share of the borrowing fee, the arrangement lacks integrity. There could be more obvious examples, but this one seemed fresher in the memory.
The protagonists of this activity are Exchange Traded Fund (ETF) providers, given their requirement to hold a significant number, if not all, of the stocks within an index. Stock lending is not exclusively reserved for the ETF universe, active fund managers also participate. However, given that they are less likely to hold a specific stock, fewer requests come in.
Other than concerns over fees, given the potential for borrower default, stock lending also creates credit risks. However, the process of collateralisation can help mitigate much of these risks and is discussed in more detail here.
As stated, stock-lending is a revenue generating activity and, therefore, the distribution of these fees plays an important role in deciding whether a product is ‘value for money’. Our analysis has found that the least competitive provider takes 40% of revenues, with the remainder going back into the fund, whilst the most competitive is probably taking only 15%.
The July 2012 publication of ESMA (European Securities & Markets Authority) guidelines has sought to put an end to this rather lucrative but controversial area of business. In this paper, ESMA require that an ETF provider’s revenue share of stock-lending operations should only cover 'costs'. We do not, however, expect this to result in a dividend from the least competitive providers. 'Costs', unfortunately, is a term that allows for quite some degree of flexibility. Some will claim, for example, that their credit analysis of borrowing entities is more thorough and should command a higher fee. But this room for 'creativity' may yet bring about a response from ESMA, which may dictate a more strict code of conduct. And we would encourage such moves as a greater level of transparency allows for more accurate cost comparison.
Authorities should take note, however, a potential outcome of over regulation and trimming margins is reduced activity. Those who borrow stock are either using it to go short (more information here) or to hedge another position. We believe that these operations improve both price efficiency and market liquidity.
In regard to the total cost of ownership of ETFs, investors should include in their analysis, not only management fees and bid-offer spreads, but the offsets from stock lending revenues. Those providers offering a more generous share of stock-lending fees are not necessarily the 'cheapest' option however; as they may conduct less stock-lending activity i.e. the fund receives a larger amount of smaller pot.
Regardless of any benefits of scale, we are repeatedly applying pressure on providers to move the dial in our clients' favour and, given Brewin Dolphin’s size, our voices are being heard. However, we suspect it will be a little while yet before the larger providers allow their margins to fall. Perhaps ESMA can shout a little louder.
Divisional Director - Research