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The Benefits of Collateral Diversification in your Securities Lending Program
One of the key mitigants to reducing risk in a securities lending program is collateral. In managing a securities lending program, both the collateral, including the haircut and marking to market the loans and collateral on a daily basis, as well as a combination of the counterparty and collateral mix, are highly important. But what is the current market trend for collateral?
Notwithstanding the fact, we have seen a continued recovery in loan volumes over the past 3 years. Demand remains suppressed despite a healthy appetite from beneficial owners to lend securities (indeed we have seen a positive trend in new beneficial owners lending their securities for the first time). This is in part driven by over supply in the fixed income market, lower hedge fund activity in the equities market and impending regulation which is impacting all market participants. Regulation, in particular, is really changing and driving the way in which borrowers manage their balance sheet and capital, which in turn is driving the cost of borrowing and the manner and way in which borrowers collateralize loans from beneficial owners. Basel III, Dodd Frank, EMIR and FSA Liquidity Rules are just a few of the specific regulations that are impacting the borrower side of the industry. This is manifesting itself in the ways we see different borrowers prefer to collateralize loans.
If we look at J.P. Morgan’s overall program, cash collateral now accounts for approximately 50% of all collateral . However since 2008 the largest growth has been in equities, while overall there is a more balanced breakdown of the types of collateral we have been receiving. As noted this has been driven by the individual funding needs of borrowers. Additionally we have seen many borrowers undertake internal collateral/funding optimisation which has led those borrowers to have contrasting preferences to the type of collateral they wish to provide. This is in contrast to the market several years ago, where we tended to see market shifts in waves with either cash of fixed income being more or less favourable. Today, there is no such consistent shift – each dealer has clear preference to the type and term of collateral they want to deliver. It is possible that for the same transaction, in terms of collateral and duration of the loan, that four different dealers have four different requirements. Term loans v. cash collateral, open loans v. equity collateral, or term loans v. fixed income collateral are just examples of the different types of loan and collateral structures that might be seen. The impact of this can be quite significant for beneficial owners. Balances can be built, or lost, simply because of a borrowers collateral requirements. As we have stated previously, while collateral is a prime risk mitigant, a beneficial owner who has a broad range of collateral flexibility, will benefit significantly in terms of balances and revenues. Collateral flexibility does not imply increased risk – in fact, risk can be reduced by diversifying collateral to several asset classes, differing or by higher margin levels. |
J.P. Morgan's Division of Asset Classes |
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Equities is a good example, whereby beneficial owners can benefit from increased utilizations and spreads, but also by diversifying collateral, can benefit from higher haircuts (7-10%), and have highly liquid and easily priced collateral.
J.P. Morgan undertakes a strenuous review of acceptable collateral, conducting stress tests and analysis and applying appropriate haircuts based upon asset class and currency of collateral. In order to maintain greater control, given increased complexitities of collateral management, we have a preference to use J.P. Morgan’s market leading tri-party collateral services
If you would like to know more about current trends in collateral or how you could benefit from collateral diversification, please contact your securities lending relationship manager.
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