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ITEM PF13 - ANNEX 1

PENSION FUND COMMITTEE – 21 NOVEMBER 2003

STOCK LENDING

Report by the Head of Finance and the Independent Financial Adviser

1. Stock lending is the lending of securities by institutions such as pension funds to other market participants, such as market makers who may have sold stock but need to borrow temporarily to make delivery, or lend to other funds, including hedge funds, who may have sold stock they do not own (known as short selling) hoping to close their position (buy back) at a lower price level. The borrower provides collateral and pays a fee of around 0.24% (24 basis points) on the total value of the loan. Stock lending provides additional liquidity to the market, particularly at times of turbulence. The FSA has recently examined stock lending in depth and concluded that short selling is a legitimate investment activity, playing an important role in supporting efficient markets and that further regulation is not warranted, but they want to see increased transparency through more information being made available on the amount of stock lent.
2. Stock is lent either for a specified period or more generally at call. It is registered in the name of the borrower, but the borrower is required to pay the lender all cash benefits, such as dividends and rights issue. However, voting rights can only be exercised if the stock is recalled, which can easily be done provided the stock is lent ‘at call’.
3. In September 2001 officers and the independent financial adviser visited the then fund managers, Deutsche and Schroders, to discuss stock lending and subsequently in November 2001 the Committee gave authority for the Pension Fund’s custodians, being associated companies of the two fund managers, to lend stock, excluding Far East securities, on behalf of the Fund. In the event as an asset/liability study of the Fund was soon to made, followed by the development of a customised benchmark and a new fund management structure, with new fund managers, stock lending was temporarily held in abeyance.
4. Now that the new management structure is in place, Mr. Wheeler and the independent financial adviser visited the Fund’s new global custodian, ABN AMRO Mellon in London to discuss stock lending through them. Areas of risk were particularly focussed on being –
   
   

1. Collateral

ABN AMRO as agent for the lender will only accept sovereign debt (i.e. issued by a government or international organisation viz World Bank) in the same currency or FTSE 100 equities, plus a margin being 102% for sovereign debt or 105% for FTSE equities. Every day collateral is ‘marked to market’ and the amount of collateral adjusted. ABN credit assess every FTSE 100 stock and for instance did not accept Marconi as collateral. Also CREST (the security clearing organisation) require diversification of collateral with, for instance, no more than 10% concentration in any one FTSE 100 stock. Cash is not accepted as collateral as interest around base rate has to be paid on it to the borrower and to earn a margin over that would mean investment in lower grade securities. ABN’s stock lending agreement will list the types of securities eligible as collateral and clients are free to exclude any with which they are not happy.

2. ‘Daylight exposure’

This could in the past occur if stock was lent before collateral was received. However, now with CREST handling all UK traded securities, stock lent is only released when collateral is received. For all other stocks ABN require collateral to be deposited before lent stock is released. This also applies in the Far East where there could otherwise be daylight exposure, partly through time differences. There is very small scope for ‘daylight exposure’ if when collateral is ‘marked to market’ and the borrower does not provide extra collateral in time. In such a situation ABN confirmed it would be their risk as agent. When securities on loan are returned or re-called, they must be received before collateral is released.

3. Counterparties (i.e. borrowers)

ABN’s own analysts access the credit worthiness of all counterparties and keep them under constant review; they do not just rely on the international rating agencies, although they do take note of their assessments. Thus ABN as agents for their clients only lend stock to top quality names and so they do not lend, for instance, to hedge funds, although an investment bank to which they have lent clients’ stock may on-lend to a hedge fund; in this case the investment bank takes the risk. ABN’s stock lending agreement will contain their list of approved counterparties, but clients may remove any about which they are doubtful.

4. Default

If the borrower defaults by failing to return the securities lent, ABN will buy the same securities in the market and pass them to the lender. Afterwards it will liquidate the collateral. ABN do not provide clients with an indemnity, since if the collateral is insufficient when marked to market, they will cover any shortfall (see (b) above).

5. Fees

The fees of 24 bp earned on stock lending are split 60% to the lender and 40% to ABN as agent. ABN estimate that of the Fund’s total portfolio some £300 million is lendable. However; the Local Government Pension Scheme (Management and Investment of Funds) Regulations 1998 only allow local authority pension funds to lend 25% of their total funds, which for Oxfordshire would equate to approximately £150 million. On a sum of £150 million they would estimate total earnings of around £30,000, of which £18,000 would be paid to the Fund.

RECOMMENDATIONS

6. The Committee are RECOMMENDED to request the Pension Fund’s global custodian, ABN AMRO Mellon, to lend stock on behalf of the Oxfordshire Pension Fund.

CHRIS GRAY
Head of Finance

A F BUSHELL
Independent Financial Adviser

Background Paper: Agenda Item 14 - Pension Fund Committee Report – 16 November 2001

Contact Officer: Tony Wheeler, Loans, Investments Manager Tel: (01865) 815287

November 2003

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