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ISSUE 2 |
The Growing Prominence of Non-Cash Collateral
MARCH 2014
In View Series
As one of the world’s most experienced
Over the last five years, the securities lending marketplace has experienced
lending agents providing both custodial
significant growth in the amount and types of non-cash collateral pledged. In this
and third-party lending, State Street
article, we explore some of the driving forces behind this expansion, including
offers the individualized service, client-
changes in regulatory requirements and the follow-on impact to prime brokers’
facing technology and commitment to
balance sheet management. We also look at the increasing importance of non-cash
transparency you’re looking for.
collateral as a means to expand lenders’ opportunity set and in managing lending
Whatever the market conditions, our
program risk from the perspectives of the lender and the lending agent.
dedicated team can work with you to
design a program within a framework
tailored to your return objectives and
risk appetite. The In View Series
A CHANGING LANDSCAPE
The use of non-cash collateral for securities lending transactions varies markedly
around the globe. In Europe, Canada, and Australia, for instance, non-cash has
highlights topical issues for today’s
securities finance market.
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always been the dominant form of collateral, while in the U.S. loans of securities
State Street Global Markets provides
have traditionally been transacted primarily versus cash. In fact, even though
specialized research, trading, securities
qualifying securities collateral, or non-cash, has grown in popularity in recent years,
lending and innovative portfolio
roughly two-thirds of outstanding securities loans in the U.S. are still collateralized
strategies to owners and managers of
by cash. In part, this is due to U.S. regulatory (e.g., U.S. ERISA law or 1940 Act
institutional assets.
statutes) or other legal and/or policy restrictions.
Author
Despite regional and client program variations, however, most if not all lenders
Tobias Krause, CFA, FRM
participate in agent lending programs that incorporate some form of non-cash
+617 664 2536
collateral. Given that, we think that the growth in the non-cash market merits a
[email protected]
broader discussion of both the underlying drivers of change and the risk and return
considerations that go along with non-cash collateral. Further, for those lenders with
the potential to broaden their existing non-cash collateral guidelines, we hope the
following may help them to assess the potential benefits of a more flexible collateral
schedule and provide a framework for evaluating their prospective risk-return
profiles.
The growth of non-cash collateral usage both in absolute terms and as a
percentage of total outstanding collateral within the securities lending marketplace
is occurring in conjunction with and as a result of a number of macro developments.
Broadly, expected and actual changes in liquidity requirements have actively driven
prime brokers to manage their balance sheets more closely.
Jarrod Polseno
+617 664 2513
[email protected]
STATE STREET’S DIGEST OF TOPICS IN SECURITIES FINANCE |
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More specifically, we believe the following factors have contributed to the growing use of non-cash collateral:
1.
Many borrowers hold on their balance sheets large amounts of equities and investment-grade corporate bonds that may be
eligible for posting in non-cash securities lending transactions. A typical example would be a broker/dealer that can use
equity and fixed income securities that are re-hypothecated from customers’ – primarily hedge funds’ -- margin accounts.
While historically the cost of using cash held as collateral may have been viewed as relatively low, regulators’ and market
focus on liquidity coverage has changed that calculus forever. Many borrowers are optimizing their assets to reduce leverage
and are doing so in part by collateralizing their borrows with pledged securities. Such transactions may be netted and taken
off balance sheet while permitting the borrower to upgrade into high quality liquid assets and/or obtain term financing.
2.
With regards to term financing, regulators have been pushing firms to extend their liabilities in an effort to reduce market
strain related to possible future short-term liquidity pressure. That push has resulted in borrowers seeking more term trade
opportunities, typically structured for at least a month’s duration and frequently versus non-cash assets. For those clients
willing and able to participate in term trades, our experience indicates that such trades can present a real opportunity to
enhance lending returns.
3.
Improved information systems permit prime brokers to see, access and optimize across their various divisions the full array
of collateral available for use within their margin accounts.
4.
Most borrowers worldwide use the services of third-party custodians to pledge non-cash collateral. Over the past two to three
years, third-party custodians have significantly improved their collateral allocation and optimization abilities. One important
result is that borrowers can now direct their non-cash collateral to many destinations such as lending agents, derivatives
clearing houses and other central counterparties through a single third-party custodian.
Most borrowers in the securities lending markets, though they may differ in their ability to pledge various forms of non-cash
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collateral due to regulatory or other reasons, must satisfy a variety of different collateral needs to support their transactional
businesses. Over time, as they have sought to optimize their collateral usage, the proportion of non-cash collateral has been
steadily increasing. State Street’s agency lending program, for instance, has seen an increase from 13 percent at fiscal year end
2009 to 37 percent at fiscal year end 2013, as illustrated in the chart below.
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In the U.S., for instance, broker/dealers are subject to the Securities and Exchange Commission’s Customer Protection Rule 15c3-3, which, among other things,
prevents U.S. broker/dealers from posting equity securities as collateral while allowing other assets including certain corporate bonds, asset-backed securities and
mortgage-backed securities to be used.
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STATE STREET’S DIGEST OF TOPICS IN SECURITIES FINANCE |
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Collateral Breakdown, State Street Agency Securities Lending
Source: State Street Securities Finance Division
Over the same time span, a shift towards equity collateral can be observed within the non-cash portion:
Source: State Street Securities Finance Division
As a result of regulatory changes such as the recent mandatory clearing of many swap transactions under the 2010 Dodd-Frank
Act, there is a widely held expectation in the market that demand for U.S. Treasury securities and other top-tier sovereign debt
will increase. Estimates of the additional amount of cash and high quality collateral needed vary greatly; however, the Treasury’s
Borrowing Advisory Committee forecasts additional demand for cash and U.S. Treasury collateral of $2.6 trillion to $5.7 trillion by
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2020 as a result of mandatory swaps clearing under the Dodd-Frank Act and other changes . While this demand has yet to
materialize to a meaningful extent, we fully appreciate that the new requirements increase the attractiveness of posting equity,
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Treasury Borrowing Advisory Committee, Report to the Secretary of the Treasury, dated 4/30/2013. Available at: http://www.treasury.gov/press-center/press-
releases/Pages/jl1922.aspx.
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STATE STREET’S DIGEST OF TOPICS IN SECURITIES FINANCE |
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corporate bonds and other non-cash asset classes as collateral and expect that more of the demand will percolate into the
lending market over time. Moreover, we anticipate that borrowers will continue to explore additional asset types that may become
eligible collateral for loan transactions. Equity ETFs are one relatively recent example of expanded collateral opportunity. While
volumes are still low, significant growth potential exists given the asset class’s large market cap, liquidity and price transparency.
Simplified trading flows for a typical cash and non-cash transaction are depicted in the following two diagrams. At a high level, the
use of non-cash collateral in securities lending transactions simplifies the operational trade flow when compared to the use of
cash collateral combined with reinvestment.
Traditional cash collateral transaction:
Lender/
$100 ABC
ABC
Lending Agent
Beneficial Owner
$100 ABC
ABC
Borrower
$102
Investment Reporting
(units/shares)
$102
Cash
Cash
Reinvestment
Portfolio
Traditional non-cash collateral transaction:
Lender/
Beneficial Owner
$100 ABC
$100 ABC
Borrower
Lending Agent
$108 XYZ
Cash
$108 XYZ
THE LENDER’S PERSPECTIVE
With respect to potential borrower default, the risk of the two transactions depicted above is equivalent from the lender’s
viewpoint and any exposure therefrom is usually assumed to be low in light of daily marks to market and excess margin
requirements. The cash-collateralized transaction adds reinvestment risk for the lender, or the risk that the value of the invested
cash may be less than the principal invested. The lender’s return in a cash collateral transaction, ignoring fees and transaction
costs, is a function of the cash reinvestment return net of the rebate paid to the borrower for providing the cash collateral. In a
non-cash transaction, the borrower pays an outright fee instead of receiving a rebate. By choosing to accept different types of
non-cash collateral, the lender can refine the risk/return profile of its lending program while at the same time increasing the
attractiveness of its portfolio to prospective borrowers. That choice is thus analogous to a lender’s implementing an investment
policy in a cash reinvestment portfolio according to its risk appetite.
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STATE STREET’S DIGEST OF TOPICS IN SECURITIES FINANCE |
IN VIEW
Lending agents vary widely in the types of non-cash collateral types supported in their programs. For lenders, it is important to
consider whether their lending agent supports a sufficiently wide range of non-cash collateral to both maximize lending utilization
and possibly improve borrower diversification, all within the context of a well-developed risk management framework.
THE LENDING AGENT’S VIEWPOINT
The lending agent has a keen interest in its program risk management at the borrower, client and aggregate levels. This holds
true whether transactions occur on an indemnified or un-indemnified basis. The nature of risk in securities lending is that of
market risk contingent on borrower default. To protect the lending program and individual clients from potential losses after a
borrower default, the lending agent implements oversight procedures to address the two major risk components, borrower credit
risk and collateral (market) risk.
State Street conducts fundamental credit analyses of all borrowers in its program, including internal credit ratings and an ongoing
credit due diligence effort.
On the collateral risk management front, State Street continuously reviews margin levels, diversification and liquidity limits, stress
tests and other controls to mitigate potential market risk exposure. In the event of a borrower default, the lending agent or its
client needs to repurchase loaned securities with proceeds generated from selling the matching portion of collateral. During such
a liquidation event, collateral that maintains good liquidity and easy price discovery is highly desirable, especially when it is also
generally positively correlated to the securities on loan. Equity collateral, in particular, has consistently demonstrated all the
aforementioned characteristics and is often highly correlated with the assets on loan. We believe that, with the right margins,
concentration, and eligibility criteria, an increasing share of non-cash collateral in the lending program has a welcome, riskreducing effect. We have a longstanding commitment to excellence in collateral management and we welcome further discussion
as to how we may help you optimize your lending program and/or better understand our oversight practice.
The information and charts contained herein are for illustrative purposes only. The views expressed in this material are the views of State Street Securities Finance, through the period ended
March 31, 2014, and are subject to change based on market and other conditions. This document contains certain statements that may be deemed forward-looking statements. Please note
that any such statements are not guarantees of any future performance and actual results or developments may differ materially from those projected.
State Street Global Markets is the marketing name and a registered trademark of State Street Corporation used for its financial markets businesses.
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