Securities Lending: Managing Value Generation and Risk

Securities lending and its risk/reward profile have been in the headlines as the credit and liquidity crisis unfolded over the past 24 months. Market events focused attention on certain important aspects of the business for all parties involved. First, securities lending is a major driver of market liquidity, from both the lending of securities and the investment of cash collateral, through which the beneficial owner generates alpha. Second, with return comes risk. Beneficial owners typically lend securities through agents (financial firms who provide securities lending services). If the owners accept cash collateral, they can earn a return from reinvesting the cash. In doing so, beneficial owners also take on interest rate and credit risk from the investments; therefore, strong risk management coupled with transparency is an essential component of a successful securities lending program. Third, agent lender indemnification-the protection agent lenders provide to beneficial owners against counterparty default-

Securities lending monetizes the intrinsic value of a portfolio of securities. It provides an opportunity for incremental income (alpha) that can be used to increase portfolio returns or reduce portfolio expenses. In a basic transaction, securities are lent short-term, collateralized by either cash or securities, and should be marked daily. If securities are held as collateral, the loan transaction is complete. If cash is taken as collateral, there is another leg to the loan transaction, as this cash is reinvested, typically in short-term money market securities. The transaction is unwound when the borrowed securities are returned to the beneficial owner and the collateral returned to the borrower.

In a securities lending transaction, a component of the beneficial owner's return is affected by a particular security's available supply compared with aggregate borrower demand. When the demand for a particular security outstrips its supply, its intrinsic value increases, making it more profitable for the beneficial owner to lend the security in the market. When a transaction is collateralized with securities, the borrower pays the beneficial owner a basis point fee on the market value of the borrowed security. Again, this fee varies by how much the borrower is willing to pay to borrow the specific security. When a borrower pledges cash as collateral, a rebate rate or yield on the collateral is negotiated. The greater the demand for the security being lent, the lower the yield paid to the borrower on the cash collateral. Securities that "go special" or have an extremely high borrowing demand can obtain negative rebate rates, requiring the borrower to not only pledge cash, but also pay a fee to the beneficial owner. The cash received as collateral is typically invested in high quality short term instruments under guidelines agreed with the beneficial owner. The difference between the yield paid on the cash collateral to the borrower and the yield earned on the investment generates return to the beneficial owner.

Securities lending, like all market activities, creates a risk/reward trade-off for the beneficial owner, borrower, and agent lender. The three primary risks in securities lending are: borrower/counterparty default risk, operational risk and cash collateral reinvestment risk. Participants in securities lending can manage these risks through a variety of controls with the agent lender's assistance. Agent lenders typically provide indemnification against broker dealer default, which they manage by maintaining collateral at levels greater than 100%, and thereby absorb the counterparty default risk. Capital strength and effective collateral management are essential for agent lenders to fulfill their obligation under an indemnification. Beneficial owners that participate in securities lending programs look to align themselves with well capitalized, high-quality agents. The indemnification provided against borrower default was tested by the Lehman Brothers bankruptcy, and beneficial owners quickly realized that their lending agent must have the capital to deliver on the indemnification commitment, as well as the market skill to unwind and replace collateral positions as needed.

Operational risk management, too, is an important consideration when beneficial owners select an agent lender. Operational risk can be mitigated by agent lenders through a robust operating framework, global scale and a comprehensive understanding of transactional flows.

Cash collateral reinvestment risk-in particular-requires vigilant beneficial owner oversight and maximum transparency and control. Beneficial owners who accept cash collateral increase the leverage of their portfolio through the investments made with the cash collateral. For them, securities lending is an investment overlay strategy which generates incremental alpha in return for additional risk. When a beneficial owner accepts cash as collateral, investment professionals should be actively involved in decisions about the program, including the investment guidelines, the specific assets purchased under those guidelines, and the indicative market pricing of those assets on a daily or weekly basis even under a typical "buy and hold" strategy. Going forward, reinvestment portfolios will likely be of shorter duration with more standardized maximum guidelines, possibly along the lines of 2a-7 funds. When beneficial owners accept cash collateral, they should also understand how account types impact control and transparency-separate accounts provide more control and transparency for the cash collateral reinvestments, whereas commingled funds provide less.

Agent lenders directly contribute to strong risk management of cash collateral through the account structure, transparency, performance reviews and control the agents employ. Agent lenders should provide robust, frequent reporting to help beneficial owners monitor the performance of their securities lending program. An agent lender's ability to provide independent, detailed credit analysis, rather than relying on rating agencies alone, creates a valuable resource to a beneficial owner as they navigate investment decisions. Now more than ever, strong partnerships between agents and beneficial owners are needed as all parties focus on enhanced transparency and control.

This article was extracted from a white paper on securities lending published by J.P. Morgan Asset Management as part of its compendium of essays entitled Post-Modern Asset Management: The Credit Crisis and Beyond (May 2009). The full white paper was also published in Reserve Management Quarterly (April 2009).