The introduction of single stock futures on U.S. exchanges later this year may deal a blow to the stock lending business, cutting off one potential revenue stream for pension funds looking to offset market losses.
Single stock futures proponents say the new instruments, which could begin trading in the United States as early as April, will cost short-sellers less than traditional shorting, which involves borrowing stock and then selling it. By using single stock futures, the short seller would not have to put up the hefty collateral often required by stock lenders or pay broker fees, and would have lower margin requirements.
Single stock futures also eliminate prime brokers as intermediaries, allowing short sellers to buy futures contracts directly, potentially cutting off a revenue source for the prime brokerages.
For this reason, prime brokers may not be looking forward to single stock futures, said Robert G. Fitzsimmons, president and chief operating officer of Nasdaq Liffe Markets.
"The institutions most threatened by this are brokerage firms with prime brokerage and stock lending business," Mr. Fitzsimmons said. "We're eliminating the intermediary. Pension funds would also be losing those fees."
Not total agreement
But not everyone agrees. Lending stock to brokers for short-selling purposes is only a small part of the overall securities lending business, which includes not only stocks but all securities. Worldwide, there are between $600 billion and $800 billion in securities on loan, according to Morgan Stanley & Co. Inc., New York.
The Risk Management Association, Philadelphia, estimates there is roughly $627 billion in securities on loan worldwide. Of that, about $262 billion is in equities; and nearly half of that total, $123 billion, is in U.S. equities.
Lesley Hodgson, head of international client services for Northern Trust Co.'s London office, said her company has about 400 public and corporate pension clients in the United Kingdom that lend securities. One is the L1.3 billion (US$1.8 billion) P&O Pension Scheme, for which Northern Trust does securities lending.
In its March 2001 financial statement, P&O reported that during fiscal year 2001, the fund loaned L408 million in securities through Northern Trust.
Ms. Hodgson said pension funds generally choose to lend securities they own for one simple reason: "It makes money for them."
In its annual report, The L4.7 billion West Yorkshire Pension Fund, West Yorkshire, England, reported earning L1.2 million from stock lending in the fiscal year ended March 31, an increase of 14% from the previous year. That helped offset a loss of L280 million in investment value in 2000-2001, according to the fund's report.
On average, U.S. pension funds in 1998 earned $1.5 million in revenue from securities lending, according to an annual survey by Greenwich Associates, Greenwich, Conn. Public pension funds, on average, reported earning more than $2.2 million in 1998 from securities lending. Corporate funds earned $1.4 million, and endowments reported earning $309,000.
Here's how: A pension fund owns shares of a company stock as part of its investment portfolio. The fund lends the stock to, for instance, Northern Trust, which in turn lends it to another broker-dealer that needs the stock to cover a sale or a hedge fund manager looking to sell a stock short. In return, the broker-dealers put up some type of collateral, the value of which exceeds the market value of the securities on loan. Northern Trust charges the broker-dealer a fee for borrowing the stock and, after subtracting its own fees, passes the fee along to the pension fund.
"It gives money back to the fund to offset other fees and costs," Ms. Hodgson said.
The popularity of domestic and international securities lending by U.S. pension funds has remained fairly consistent. In 2001, 33% of 1,146 U.S. pension funds surveyed by Greenwich Associates said they loaned domestic securities. That compares with 34% of funds surveyed in 2000 and 29% in 1999.
Public pension funds are more likely to loan securities, according to the Greenwich survey. Half of the public pension funds surveyed in 2001 said they loaned domestic securities. That compares with 26% of corporate funds and 24% of endowments.
Far fewer pension funds loan international securities. Only 30% of public funds and 14% of corporate funds reported to Greenwich that they loaned international securities in 2001. The numbers are roughly the same for 2000 and 1998.
Northern Trust's Ms. Hodgson said she doesn't think the availability of single stock futures will significantly affect stock lending and will hardly make a dent in securities lending.
"I don't see it changing too much, to be honest," she said.
In its December 2000 newsletter, the Federal Reserve Bank of Chicago noted that industry experts, speaking at a conference in Chicago, said they expected single stock futures to offer a more efficient alternative to stock borrowing and be "particularly appealing both to the arbitrage community and to hedge funds as an attractive alternative to borrowing stock. It is expected that the majority of hedge fund participants will roll their equity loan books into single stock futures."
John J. Lothian, president of the electronic trading division at Chicago-based Price Futures Group Inc., said single stock futures may well reduce pension fund and broker-dealer income from stock lending, but not because demand for borrowed stocks would dry up. Rather, Mr. Lothian said, it's possible that if single stock futures become popular, they could increase equity trading volumes and opportunities for arbitrage and drive up the demand for borrowed stock.
However, he said, more efficient trading mechanisms, including electronic trading and T+1 settlement, may drive down the margins on stock lending.
Making up fees
Nasdaq Liffe's Mr. Fitzsimmons said both pension funds and broker-dealers with prime brokerage business could make up the lost stock lending fees through single stock futures. Pension funds would take long positions in the single stock futures market, and then lend futures contracts to hedge funds, which would borrow the futures contracts and sell them short. The pool of potential short seller counterparties would be larger with single stock futures than with stock lending, Mr. Fitzsimmons said, because single stock futures engender fewer concerns about counterparty creditworthiness. That's because the futures contracts are cleared through a central clearing organization, which guarantees the trades.
That means pension funds could deal with a broader range of hedge fund managers, some of which would not have a high enough credit rating to allow pension funds to lend them stock for short selling. The enlarged market means more potential deals and more potential revenue from lending the futures contracts for short selling.
All of which is dependent upon single stock futures being attractive enough to pension funds that they elect to buy them. As a man whose company's success depends on the success of single stock futures, Mr. Fitzsimmons is understandably optimistic on this point.
"I feel that once we get up and going, there will be demand for them (single stock futures)," he said.