Div-arb strategies not beneficial to market or society, says Norges Bank

Div-arb strategies not beneficial to market or society, says Norges Bank

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Crafting dividend arbitrage strategies in securities lending programs is detrimental to the market and society overall, according to the asset management arm of Norway’s central bank.

In a recent note to clients, experts at Norges Bank Investment Management say they do not believe that dividend tax differential based strategies are a net benefit to the industry or the economy overall, even though they may be favourable to a stock lender.

“We believe that differential tax treatment of investors does not contribute to well-functioning markets,” notes the whitepaper, entitled ‘The Role of Securities Lending in Well-Functioning Markets’.

“Asset managers should conduct their stock lending activity in a way that complies with local tax rules, and seek to avoid entering into securities lending transactions for the purpose of improving their tax position.

“Similarly, they should not lend the benefit of their favourable tax characteristics to third parties. They should also not lend out shares if they are solely sought for voting purposes.”

Norges Bank Investment Management runs the $885bn Government Pension Fund, the biggest sovereign wealth fund in the world by assets under management. 

It invests in 9,000 companies across 78 countries and appointed Citi as one of its global custody and securities lending agents in 2014.

Trades known as dividend-arbitrage, or 'div-arb', take advantage of inefficiencies between tax rates to generate a return.

Often transactions involve large foreign investors lending out their holdings of stocks, engineered by banks, so they are not on their books at dividend time.

The practice isn’t illegal but is increasingly under the media and regulatory microscope, particularly given the public focus on tax avoidance in a time of austerity. 

Advocates of the practice argue it is legal and has been commonplace because tax authorities failed to harmonise their rules. 

Others point out that the extra revenue generated by div-arb ultimately falls into the hands of shareholders or retail and retirement savers.

"It’s still part of the business but it has shrunk dramatically," one agent lender, who wished to remain anonymous, told Global Investor/ISF earlier this year. "The industry has to move on. Certain trades have a certain shelf life.”

Regulation

Norges Bank Investment Management's note added that a well-thought-out regulatory environment rather than ad-hoc intervention is crucial for the securities lending market.

For example, rules specifying the constraints under which borrowers must operate would be beneficial rather than off-the-cuff legislation.

“For regulators, their key contribution should be predictability in regulation,” representatives from the firm wrote.

“We believe the current regulatory environment is generally well-designed in this regard and helps to foster a robust stock lending market.”

“Designing robust securities lending markets involves contributions from lenders, intermediaries and regulators."

Well-functioning markets

Overall, securities lending markets contribute to well-functioning markets in important ways, the firm added.

"This is particularly true when ownership of the securities is concentrated, as is the case for most of today’s stock and bond markets. 

"Price discovery is improved significantly when the inventory of securities held by long-term, large institutional holders is made available to actively trading market participants through securities lending."

"For intermediaries, whether prime brokerages or agents such as custodians, the focus should be on providing increased transparency into the state of the securities lending market. 

Increasing the available information on price and quantity available should be a goal, Norges Bank IM concluded. 

"This is a task for both data providers and regulators who can encourage increased transparency."

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