BlackRock has started issuing letters to investors to bolster the degree of protection they have from the firm’s practice of securities lending in iShares, its exchange traded funds (ETF) arm.
The asset manager last year moved to indemnify its iShares range from the risk of borrower default, meaning that if a company borrows stock from the fund and goes bust, BlackRock compensates the fund and ensures there is no financial loss for investors.
But there are degrees of indemnification, and by writing to clients BlackRock's move has been regarded as innovative and something of a landmark, as well as mitigating fears about the extent issuers cover investors from the risk of borrowers being unable to return the stock.
One iShares investor said: ‘They used to announce the indemnity and never followed it up in writing with anything…now investors have a proper indemnity.
‘The indemnity is very good. It is an indemnity against loss. Not the same as the indemnity to buy back your shares,’ he said, the latter of which being a practice undertaken by some providers, that can still leave investors incurring losses.
It is the first time that BlackRock's iShares has written to its clients on the issue and in a letter to one investor it explained its decision.
‘With regard to such sub-funds participating in the BlackRock securities lending program, if a borrower defaults and the value of the collateral pledged by the borrower at the time of default is insufficient to cover the borrower’s obligations, the BlackRock guarantee guarantees the payment of and indemnifies the relevant sub-fund against such loss.’
Criticism over securities lending
BlackRock has come under fire for lending out securities and potential conflicts of interest, in that the firm has in the past taken 40% of the income from the stock lending but zero percent of the risk, while investors take on 100% of the risk, and only 60% of the income.
As a result, BlackRock – and other providers that undertook similar practices – were potentially incentivised, prior to the indemnity, to pile on the risk by lending to weaker counterparties, taking on poorer collateral, such as small cap equities or European banks, to generate a greater return.
With the indemnity in place, BlackRock is now taking on a much greater degree of the risk.
One investor said: ‘iShares and BlackRock were clearly profiting hugely from stock lending, clearly above and beyond their costs.
‘Now with the indemnity they are seen as providing an extra service and taking risk which may allow them to get away with their 40% profit share arrangement.’
There is some debate over this profit share arrangement, though, given the European regulator came out with its final guidelines last year stipulating that all profits generated from securities lending must be returned to the fund, net of costs.
The indemnification policy can also be seen as a way to protect what is an important profit stream for BlackRock shareholders, as a significant proportion of iShares’ profits comes from stock lending.
While the European regulator’s final guidelines potentially restrict such profit generation, the indemnification can help safe-guard the stock-lending income.