Thursday, 24 January 2019

Stock-lending and shorting, again

I've been thinking a bit more about the potential conflicts of interest around stock-lending and shorting in light of the RD:IR paper I blogged about a couple of weeks back. It suggested that passive managers are in part able to offer lower fees because they make money through stock-lending.

I was initially interested in the way that this might facilitate shorting on the cheap by the active side of the same business. If you're managing passive assets on a large scale on an AUM-based fee then I think you can probably lend to your active side safe in the knowledge that even if they call it right the decline in one stock isn't going to rock the boat (NB - I'm not saying shorting makes share prices decline!). I think that is still worth digging into, just to find out a) how extensive lending by passive managers is b) how much the passive clients make out of it and c) if cross-group lending is done, and, if so, if it's charged at a cheaper rate than to external clients.

But what interests me is what other issues might arise. I am reminded of this bit from an old Takeover Panel paper about the conflicts created for counterparties to derivatives in bid situations:
First, the Code Committee believes that, notwithstanding the contractual arrangements between them, a counterparty will usually know the derivative investor’s likely wishes and therefore it would be na├»ve to assume that the counterparty (who has no economic interest in any hedge securities it holds but who does have an ongoing client relationship with the investor) will act without having some regard to those wishes. In addition, as indicated in paragraph 3.3 of PCP 2005/1, the Code Committee understands that it is frequently the expectation of a long derivative investor, notwithstanding the terms of the documentation, that his counterparty will ensure that the securities to which the derivative is referenced are available to be voted by the counterparty and/or sold to the investor on closing out the contract. If the counterparty does not hold any such securities (because, for example, its book is balanced by an offsetting short derivative), the investor would normally expect the counterparty to acquire the necessary securities, even if that resulted in a cost to the counterparty.…..the Panel continues to encounter situations where holders of long derivative positions behave as if they were shareholders and, more importantly, situations where investment bank counterparties enquire of investors with long derivative positions as to their preferences in terms of bid outcomes in order that the counterparties may take those preferences into account;
Do similar issues arise for passive managers who stock-lend? Say you're a regular lender to funds doing the merger arbitrage trade. Say a big contentious hostile bid comes up and your lending clients have taken a big punt shorting the acquirer in the expectation that the bid succeeds. Is there any tension in how you decide to respond to the deal? Big passive managers are going to be long in both target and acquirer. I'm pretty sure there must be an optimum outcome in this situation, but if your positions are passive (so you're not being judged on performance) I suspect you've got freedom of movement to decide how to respond.

If you oppose the bid, and it fails, it's quite possible that stock-lending clients will lose a bundle. If so, will they come back to you as a borrower next time? I have heard anecdotes about borrows being sniffy about lenders who want to recall to vote, so I could imagine some conflicts / client pressure.

Another area to dig into...

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