Blogs & Comment

Digging deeper into securities lending

One thing I left out of the June 4 columnon the investment-fund practice of securities lending is the role of incentives. Specifically, goes the argument, investment funds that take a large percentage of the revenues generated from securities lending may not be so bad after all since they have a greater incentive to expand securities lending andthat could end up providing a larger dollar amount to unit holders than if the fund did not take a big cut.
This is already the case, apparently. As reader FinanceProf mentions in the comments section of the June 2 post, Barclays takes 50% of the lending fees flowing from iShares portfolios, but the 50% left over for fund holders is still larger than the revenues Vanguard generates (after covering just its costs from securities lending).
In Vanguards case, the incentive of wanting to be the lowest cost supplier seems to be sufficient. Maybe fund holders should be happy with that scenario even though it may not generate as much revenue from securities lending. When lending agents are allowed to take a sizable cut of generated revenues, there is a risk they may push the envelope too far and lower lending standards (like mortgage lenders did in the run-up to the financial crisis of 2008). A few years ago, for example, borrowers of securities had to put up government bonds as collateral, but these days, riskier assets such as stocks and corporate bonds are also accepted.
Even if a fund were to take a large cut like Barclays does, there still is the question of how much of an incentive is enough to maximize revenues. Is 50% the commission that yields the optimal amount for fund holders? Couldn’t an unaffiliated agent, operating at arms length from iShares, generate the same amount of business with a smaller incentive?