Creating New Best Practices in Securities Lending for Cash and Non-cash Collateral Management
Securities lending is experiencing a marked change in 2013, as lending and the collateral it generates are becoming more integrated than ever with other parts of financial markets. This is most readily apparent as banks adjust their balance sheets to optimize Basel III capital ratios and as other market participants begin to identify the collateral they need for OTC derivatives transactions that clear on CCPs. Regardless of how beneficial owners manage portfolios, participation in the securities lending market means engagement with a diversity of other market actors. The willingness of beneficial owners to accept cash or non-cash collateral, and how they choose to manage collateral once they have it, has started a new conversation with agent lenders and counterparties.
Data drawn from recent Finadium surveys of institutional investors, mutual funds and insurance companies help to identify trends that beneficial owners in securities lending programs will want to pay attention to going forward. While we find no "one size fits all" model in securities lending collateral management, there are some lessons that apply across the market.
As banks and OTC derivatives end-users work to manage their balance sheets and available collateral, securities lending has becomef an important part of how risk can be managed and assets distributed in financial markets.
Institutional investors and cash collateral
The majority of the institutional investor world, including pension plans and sovereign wealth funds, has gravitated to the most secure collateral for their securities lending programs. Cash has gone into government-backed repo or money market mutual funds, and government bonds are the most highly desired form of non-cash collateral. However, sophisticated investors recognize that these collateral types may introduce constraints to their lending programs and make mandates more difficult to achieve, even as cracks appear on the edges of what collateral institutions will accept. While still in the early stages, institutions recognize that the old order is changing, and that to run successful lending programs they too must evolve. The challenge now is in maintaining the safest possible risk parameters as cash collateral reinvestment opportunities expand and contract along with regulatory requirements and market conditions.
When it comes to cash collateral reinvestment strategies, following the herd is a safe policy but not necessarily the best policy, according to the executives at large global pension plans and sovereign wealth funds we spoke with for our January 2013 institutional investor survey.1 In our interviews with institutions accepting cash collateral, we found 63 percent putting cash into money market accounts that follow U.S. Rule 2a-7 or similar guidelines. These include money market funds as well as separately managed accounts that may extend in term or hold less liquid investments. In addition, 50 percent of respondents put cash into short-term repo and 19 percent invest for greater returns than these other two pools offer (see figure 1). Many institutions reported more than one option.
Some institutions with more aggressive collateral pools than 2a-7 funds discussed the idea of accepting term repo past 30 days, although this strategy is still in the planning stages. Institutions are most interested in overnight repo to limit their risks whether they are providing cash against government bond, agency, equity or corporate bond repo. However, very low returns and a periodic or potentially permanent lack of liquidity mean that some institutions are looking at longer term repo options.
Institutional investors on non-cash collateral
Among non-U.S. investors where non-cash collateral is the norm for securities lending programs, there is a similar conversation on risk versus reward regarding acceptance of securities other than government bonds as collateral. Government bonds are undoubtedly preferred but investors recognize the growing scarcity of those assets in the market. The alternatives are to accept a planned decrease in securities lending revenues or to take other asset classes, with higher margin levels. For example, equities may be accepted with up to 110 percent collateralization.
A small portion of U.S. institutional lenders see demands for cash in other areas and believe that non-cash will be the most viable collateral option for borrowers going forward. This is not entirely welcome as most U.S. funds either do not accept non-cash or do not like to advertise the fact. Several large funds that we interviewed said that they had not been asked to accept non-cash for loans lately, and U.S. borrowers were cash-rich in the first half of 2013. However, the expectation from our interviews is that non-cash use will grow as the U.S. economy enjoys a stronger economic recovery.
Across the sample of large institutional investors globally that we interviewed, 27 percent accept cash collateral only, 15 percent accept only non-cash and 58 percent accept both (see figure 2).
Mutual funds and insurance companies on cash collateral
In Finadium's August 2013 survey of the largest mutual funds and insurance companies in securities lending, we saw little change in cash collateral management practices since 2011.2 This year, 78 percent of our sample managed their own collateral internally while another 11 percent used an affiliated custodian, and several funds had more than one cash reinvestment vehicle (see figure 3). Only 19 percent of firms chose to have their cash collateral managed by an unaffiliated custodian.
We saw consistent interest in overnight repo only as a cash collateral reinvestment strategy; 41 percent of our sample used overnight repo alone or as one of two cash collateral reinvestment vehicles (see figure 4).
At the same time, 68 percent of our sample used a money market fund or separately managed account including U.S.-style 2a-7 funds. We see an increasing emphasis on leaving the strict 2a-7 confines and more attention on separately managed accounts. The 5 percent with collateral strategies that were longer in duration than a conservative money market fund remained an anomaly, but we see the potential for adding new categories in our data tables as U.S. money market reforms continue to constrict the definition of 2a-7 itself. We would expect then to expand our data choices to include an Old or Highly Flexible 2a-7 category that encompasses greater duration and more flexible credit qualities.
Whether in overnight repo or increasingly strict definitions of money markets, risk-averse mutual funds and insurance companies accepting cash in securities lending may be challenged in identifying reinvestment vehicles that provide enough supply to meet their needs. This is not chasing for yield; rather, this is finding investments that make sense in a conservative environment and for which there is sufficient supply relative to the risk tolerances of investors. In the end, not everyone really wants to hold bank certificates of deposit or government bonds that may dip into negative interest rate territory on occasion. Further changes in money market regulations may encourage the trend toward a relaxed or older 2a-7 style of money market fund guidelines for securities lending cash collateral investments.
Mutual funds and insurance companies on non-cash collateral
Mutual funds and insurance companies continued to expand their thinking about cash and non-cash collateral options in our 2013 survey. While U.S. mutual funds are limited in their acceptance criteria, European investment funds and insurance companies worldwide can engage in a broader conversation about collateral safety, returns and diversification. In our 2013 survey, we found 52 percent of our funds accepting cash only, and these were largely U.S. mutual funds (see figure 5). The 4 percent accepting non-cash only were European based. Where regulations are not a factor, we see the general industry preference as accepting both cash and non-cash depending on the circumstances.
Questions to ask for beneficial owners
Institutional investors, asset managers and insurance companies understand that the old world has changed. Cash collateral reinvestment vehicles can no longer rely on an unlimited supply of government-bond backed repo to produce returns, and increasingly tighter money market fund guidelines mean reduced risk but also lower returns. Beneficial owners looking to find supply and perhaps increase yield are looking at longer terms and lower credit qualities. Is this a safe option for investors? This is an important conversation to have in today's securities lending market in order to chart out strategies going forward.
In non-cash, the acceptance of equities or even corporate bonds creates new opportunities for beneficial owners. Borrowers are eager to provide blue chip equities as collateral because these securities are less desirable for bank Basel III Liquidity Coverage Ratios when compared to cash or government bonds. While beneficial owners accepting equities report right-way risk versus the correlation of their portfolios, ongoing sensitivities remain over how risky equities really are. There are also uncertainties about margin levels: is 105 percent to 110 percent the right margin or should black swan types of market events that could drop equity market values by 20 percent in a day be taken into account? For mutual funds and insurance companies, will investors view equities as too risky or do they make good sense?
A scarcity of government bonds as non-cash collateral, as well as government bond backed repo and similar investments in cash collateral, is as much a question of competitionbetween beneficial owners and other market participants as it is about the assets of borrowers to pledge as collateral. If all beneficial owners insist on government bonds as collateral then borrowers will be forced to oblige, albeit at lower lending volumes than today. On the other hand, if enough beneficial owners are willing to take corporate bonds and equities then lending revenues will flow to those institutions at the expense of others. This is the flip side of the challenge faced by cash collateral holders in securities lending; more risk may result in higher revenues, but insisting on current exposure levels may reduce revenues to undesirable low points.
Whether in overnight repo or increasingly strict definitions of money markets, risk-averse mutual funds and insurance companies accepting cash in securities lending may be challenged in identifying reinvestment vehicles that provide enough supply to meet their needs.
As banks and OTC derivatives endusers work to manage their balance sheets and available collateral, securities lending has become an important part of how risk can be managed and assets distributed in financial markets. While the potential of the collateral transformation trade both in securities loans and collateral reinvestments remains either out of reach or out of mandate for most beneficial owners, current participants report strong returns with acceptable risk parameters. Going forward, beneficial owners in securities lending may want to consider these options as important risk-managed opportunities for yield enhancement to their portfolios. The right first step however is knowing the questions to ask to ensure strong oversight and risk reduction in the lending program.
l "Institutional Investors on Securities Lending and Collateral Management in 2013: A Finadium Survey," Finadium, January 2013.
2 "Leading Asset Managers on Securities Lending and Collateral Management 2013:A Finadium Survey," Finadium, August 2013.