The Information Content of Securities Lending Along the Sovereign Risk Spectrum

By 2018, the securities lending market had grown to a 20 trillion US dollar global business. While the equity side of the market has attracted ample academic attention, the fixed income segment is largely understudied. Fixed income lending is similar to the equity segment in supporting various trading activities and market efficiency, but it also differs in ways it can help to reveal private information along the sovereign risk spectrum. In this project, we study the role of the securities lending market in conveying information relevant to the pricing of European sovereign debt. Ensuring liquidity and price-quality, we work with the largest and most liquid Eurozone sovereign debt markets with different sovereign risk profiles: Italy and Germany. We show the channels through which positive and negative information is revealed in this funding market, and how this provisional role of information can increase the systemic importance of fixed income lending.

We conjecture that positive information, i.e. increased demand and liquidity and realizable lending income, gives rise to a convenience yield in high-quality liquid assets (HQLA), identifiable from the cross-section of bonds. Moreover, the high demand and the expected lending income also benefit lenders, typically contractual savings institutions who are mandated to have large (long-term) HQLA holdings. We expect HQLA lending to be the most profitable around reporting dates when banks lock in HQLA in their balance sheets to managing the regulatory buffer requirements. Nevertheless, the size of the lending income depends on whether in the opaque and oligopolistic over-the-counter (OTC) securities lending market broker-agents exercise their market power and/or apply discriminatory pricing practices. We study this effect for both unexpected demand shocks within the lending market, as well as around year-end reporting dates. Additionally, to show potential price discrimination, we examine the spread on fees different lenders can earn for the same asset on a given day.

As for negative information, we examine Italian treasuries, to see whether lending market activity predicts negative economic outlook or downgrades, as well as large increases in the credit default swaps (CDS) spread. To do so, we run various panel regressions linking CDS returns to securities lending market activity, and survival analysis for the period leading up to credit downgrades. This aspect of information revelation is highly similar to how derivative markets lead the price discovery process.

• For the prime European benchmark securities, the German Treasuries, we show that despite the high demand pressure for pledgeable collateral in the near-zero interest environment, most lenders are unable to extract nontrivial market rents in the opaque, decentralized lending market.
• In the long maturity segment, where the marginal lender is likely to be a contractual savings institution with limited bargaining power, the inability of realizing material income from securities lending is likely to exacerbate solvency issues and lead to welfare losses in pension contributions for most European citizens.
• Consistent with the equity lending and short sales literature, we find that for risky sovereigns such as Greece, Italy, Ireland, Portugal, and Spain, securities lending can lead the price discovery around negative news events, e.g. credit rating downgrades.
• We observe lending market activity picking up before the downgrade announcement, while hazard models show that supply changes in securities lending supply affect distance to downgrade. In other words, changes in supply indicate market participants’ expectations about the next downgrade event.
• We also document how lending market variables, such as lending fees or demand, predict large changes in CDS quotes both in OLS and quartile regressions.

We urge the regulators, perhaps also the European Insurance and Occupational Pensions Authority (EIOPA), to consider introducing measures that protect smaller, less informed market participants. These are mostly smaller pension funds and life insurers who do not manage their own internal lending desk due to economies of scale and cost considerations. These institutions could either set up lending desks together as a CSI cooperative, in which case the pooled assets could increase their bargaining position in the market or start lobbying for regulatory oversight that would grant more transparency to reduce the information asymmetry and the subsequently arising market inefficiencies.