The regulatory solution to securities lending and short selling, if there is one, lies not with the ASX or the Australian Securities and Investments Commission, but with the Australian Prudential Regulatory Authority – the body that supervises super funds.
The funds that do it, or allow it, in the current market climate are probably breaching the covenants contained in section 52 (2) (b) of the Superannuation Industry (Supervision) Act. If APRA made an example of a fund over this issue, the securities lending business would grind to halt, and at least become more transparent.
That section of the act requires funds to exercise the “degree of care, skill and diligence as an ordinary prudent person would exercise in dealing with property of another for whom the person felt morally bound to provide”.
There are two reasons why a super fund trustee who allows his or her members’ shares to be lent out to short sellers may be in breach of that provision; firstly, the short selling tends to depress the value of the fund’s assets, and secondly, the interest rates are typically not high enough.
As I understand it, the interest rate on securities lending is based on the overnight cash rate. The stock lenders are looking to make an extra 30 to 40 basis points on the returns they would make from the shares they continue to own, so they don’t apply the same pricing to the loans as if they were lending cash.
But this is no way properly recognises the risks involved in the exercise.
Stock lenders usually don’t even know the identity of the borrowers, let alone know what their credit rating might be – if they had one, which they don’t.
In normal times counterparty risk in securities lending is not a big issue, but these are not normal times.
As the Australian Securities Lending Association says on its website: “Many complications can arise when a counterparty defaults on its obligations. A thorough credit assessment of all counterparties should initially be undertaken to determine their financial status. Reviews should then be undertaken regularly. In this context, it is important to keep in mind that the fortunes of many potential counterparties can rapidly change.”
Quite true, but the interest rates on these loans should also reflect counterparty risk. It should be at least double what it is now, in my view, if trustees are to exercise the proper “degree of care, skill and diligence”.
And then there’s the question of what the borrower does with what’s been borrowed. Is a trustee acting within his or her statutory obligations if the borrower “sells” the stock at a lower price than its previous market value – even if it’s just one cent lower?
Arguably, if the act of lending shares itself causes a price to fall, even temporarily, then the trustees have breached their duty to members.
In my (non-lawyer) view, a super fund that lends stock, or allows its custodians or fund managers to lend it, needs a full monthly report on the price movements of shares lent as well as the extra returns, in order to fulfil its obligations to members
This first appeared in Business Spectator