Last updated:July 25, 2012 8:26 pm

Shake-up looms over securities lending

By Chris Flood and Brooke Masters

All asset managers will have to return to investors in their funds any profits made from lending out securities in Europe under new rules that threaten to wipe out a lucrative source of revenues for some of the world’s biggest investment firms.

The rules set by Europe’s main market regulator aim to to ensure that fund investors gain the benefit from securities lending, a common practice across the fund management industry.

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Typically shares or other assets held in a portfolio are lent to a party such as a hedge fund return for a fee, usually to aid short-selling transactions – where a speculator sells a borrowed security in the hope of buying it back at a cheaper price before returning it.

The new rules from the European Securities Markets Authority are expected to come into force from next February and are likely to hit big asset managers, particularly those with large index tracking funds or exchange traded funds business such as BlackRock.

Some industry analysts say the rules could reduce short-selling activity if asset managers decide it is unecomic to carry out securities lending.

Fund managers argue that securities lending improves returns and reduces costs for investors. But estimates for how much revenue is generated by securities lending are rare as market participants are notoriously secretive about their activities

Around $132bn in European equities is currently out on loan, according to Markit, a consultancy. Fees earned for lending out stocks vary considerably. Lending out constituents of the FTSE100 might only generate a few basis points of revenues but hard-to-borrow stocks or “specials” from less liquid markets can earn significantly more.

BlackRock which earns significant revenues from securities lending transactions undertaken by its iShares exchange traded funds operations in Europe.

It currently retains 40 per cent of the revenue generated from stock lending by iShares while 60 per cent is returned to the fund to reduce charges.

BlackRock said it intended to work with Esma and national regulators to understand the application of the new rules “to preserve the benefits of securiities lending for our clients and the broader capital markets”.

Steven Maijoor, chairman of Esma, said the new guidelines were “an important step in the development of the regulatory framework” of Europe’s fund management industry.

Esma’s move was welcomed by economist and Financial Times columnist John Kay who recommended that all income from stock lending should be disclosed and rebated to investors as part of a government-sponsored review of UK equity markets published on Monday.

“This is a step in the right direction,” said Mr Kay.

Kevin McNulty, chief executive of the International Securities Lending Association, said that ISLA supported the disclosure of revenues and fees generated by securities lending transactions.

But he said that Esma’s new rules could act as a deterrent to some managers engaging in securities lending if they were deemed to preclude the manager from charging a commercial fee for doing so.

Roy Zimmerhansl of Zimmerhansl Consulting Services, said securities lending fees were an important source of revenue for fund managers and some might feel it better to withdraw from the market if they were not being adaquately compensated for the risks involved.

Mr Zimmerhansl said manager would look this issue on a fund by fund basis and it was unlikely that the new rules would make a substantial difference to the overall amount of stocks available for lending in Europe