Beneficial owners taking cash collateral have always understood (or should have been well informed by their lending agents) that they are exposed to losses from the investment of cash collateral. However, it was a rare money market fund that didn’t hold some form of Lehman Brothers paper or the Sigma Structured Investment Vehicle, the default of which resulted in material losses. Many beneficial owners accepting cash collateral saw substantially increased revenues during 2007 and 2008 as cash spreads widened—but now they’ve seen the risks associated with the revenue opportunity.
Many cash programs also had assets reinvested in asset-backed and floating-rate securities that are worth less than par. In this case, the value of the assets purchased with the cash collateral is less than the value of the cash collateral that ultimately needs to be returned to the borrowers. Effectively, it is an unrealized loss that would be realized if any of the underlying assets had to be sold.
One of the most important developments is that beneficial owners with unrealized losses in their cash pools are now tied to their lending agents while they wait for the assets to mature or the market to normalize to the extent that the assets can be sold. In some cases, this could take a few years to occur. This could have a bearing on such activity as custody request for proposals, since some beneficial owners can’t change custodians (which are also the lending agents) without realizing losses in their cash reinvestment pools.
However, all of the negative news about cash collateral and reinvestment doesn’t mean that cash collateral programs are dead in the water. It is possible to structure a conservative cash collateral program that will provide a less risky offering. Obviously, this has an impact on revenue, but a cash program that is invested in overnight government repurchase agreements will give the beneficial owner a better night’s sleep.
Impact on indemnification
It is fair to say that lenders now have a better understanding of the value of their indemnification (the insurance from the lending agent that covers part of the costs in the event of a counterparty default). They will certainly have a better appreciation of the small print and where there may be gaps, as indemnities vary substantially from one lending agent to another. Many lenders will be focusing on the indemnity language—and who does what in the event of a default—when they next draft their securities lending documentation.
However, recent market events are leading many to question the value of any indemnity. In an environment where the market capitalization of a company can halve in a matter of minutes, the wider market may be questioning the resilience of such an institution. The focus is now directed at the relative strength of a bank’s balance sheet and its ability to meet any calls under the indemnities it has provided. Not unexpectedly, as market sentiment shifts, those banks with sizable balance sheets and reserves will be obvious choices in the securities lending market if the surety of performance under an indemnity is key to the decision-making process.
Today, there are very few institutions that will readily provide a full replacement indemnity product. Yet beneficial owners want to be sure that, when called upon, their indemnification will facilitate a speedy unwinding process. As markets return to some form of normalcy, many will evaluate their entire approach to securities lending, including the role of indemnification during the unwinding process. Banks and custodial agents will also have to reassess the relevance of indemnification to their clients and, where necessary, update their product offerings. There will also be an increased focus from beneficial owners on understanding the execution process in the event of a counterparty default.
The one area where indemnification doesn’t normally apply is the reinvestment of cash collateral—the main area for which beneficial owners would now like some protection. The costs of this protection are prohibitive, but beneficial owners should explore it, as it is part of the revenue/risk equation.
Fee splits
Lenders may be able to obtain the insurance they need, but they should understand that this might affect the fee splits they enjoy from their agents. If a lender would like an indemnity against counterparty default leading to the lending agent liquidating non-cash collateral and purchasing the lent securities, then it is possible to achieve this (though perhaps not for all forms of non-cash collateral). Repo indemnification is also possible, and some lending agents may consider indemnifying outright reinvestments, although this will come at a substantial cost. Whereas lending agents typically only share in the upside, with no downside loss possibilities, a better focus would be on sharing the revenues and the losses in the same percentage to ensure that the interests of both lender and agent are aligned.
Beneficial owners that incurred losses during the last few months are seeking assistance from their lending agents to cover these losses. Some agents are arranging this by adjusting the fee splits in favour of the beneficial owner for a period of time. In other words, fee splits are in a state of flux: lending agents can demand more of the revenue split if they provide a solid indemnity product while potentially giving up a greater portion of the revenue to the beneficial owners that have suffered.
A word of warning here: over the last few years, fee splits have been reduced to the point where some lending agents receive a very small part of the revenue. If the Lehman default and the experience of the last year tell us anything, it is that lending agents must be able to invest in resources: technology, people, risk systems, reporting and credit management. Beneficial owners should continue to test the market but focus on the service and product first, since squeezing fee splits could ultimately have the effect of increasing risk.
Exclusive deals
Exclusive arrangements (which give the borrower the exclusive right to borrow from a portfolio) have become de rigueur over the years, as beneficial owners like the guaranteed revenue stream. However, there are also negative aspects, such as missed opportunities, borrower concentration risk and high utilization of assets. Today, counterpart concentration is not a risk that many will be ready to take. That’s not to say that exclusives do not represent a good tool. They are a good way for beneficial owners to lock in value and, more importantly, borrowers will continue to require the exclusive supply of key assets and indexes to satisfy their marketing requirements to prospective hedge funds. However, the days of whole portfolio exclusives to a single borrower are likely limited, at least in the short term.
Borrowers will also be constrained by capital and will be more selective about the portfolios they bid for. While the quality of a portfolio will dictate interest from the borrowing community, collateral and trading flexibility are being weighted almost as highly. Portfolios that are similar from an asset perspective will be viewed against collateral and trading criteria. From the beneficial owner’s perspective, diluting collateral parameters could heighten risk and may require additional risk monitoring infrastructure.
Short selling restrictions
There has been much emotional discussion regarding the short selling bans put in place by regulators worldwide. However, it has also provided a real opportunity to analyze the effects of short selling and share price movement. For example, research conducted by London’s Cass Business School on behalf of a number of industry associations found no strong evidence that the short selling bans changed the behaviour of stock returns. Former Securities and Exchange Commission chair Christopher Cox’s comment that he regrets the short selling restriction in the U.S. demonstrates the regulators’ concern about bans that were, in many cases, driven by political influence.
The short selling bans—and the resulting headlines—caused problems for some beneficial owners concerned about reputational risk. These concerns have somewhat abated, in part due to reiteration from regulators that they welcome securities lending and the liquidity that allows market makers to fulfill their role. Also, the reminder that the majority of security loans by value are fixed income loans that are not required by hedge funds for short selling, but instead provide important liquidity as collateral for other financing activities, is useful in disconnecting securities lending from the short selling debate.
Clearly, there will be more disclosure on short selling activity in the future. In March 2009, Martin Wheatley, chair of the International Organization of Securities Commissions Task Force on Short Selling, said, “We believe that short selling should operate in a well-structured regulatory framework in the interests of maintaining a fair, orderly and efficient market. The objective of such regulation being to reduce the potential destabilizing effect that short selling can cause without exerting undue impact on its legitimate benefits in capital formation and volatility reduction.”
Lending in the future
Today, beneficial owners are returning to securities lending, as the revenue and returns are important to them. However, they are also revisiting these programs, confirming what they want to achieve based on their risk appetite. They are redrafting their legal agreements to ensure that they reflect their aims, and they are asking for reporting that analyzes performance—and, more importantly, risk.
Looking at the collateral environment in the future, we’ll likely see an increased use of haircut flexibility to manage and mitigate counterparty risk. There will also be a more positive view of using equities as collateral (particularly where liquidity and market depth is more reliable around main indexes) and a less positive view of cash collateral as a result of cash reinvestment difficulties. Borrowers will be more collateral-sensitive—particularly larger borrowers, which will increasingly dictate the terms of trade and want to trade with beneficial owners that are flexible on both haircuts and collateral mix. There will be a greater focus on the trade structure, so that lending equities against fixed income will be viewed differently from fixed income loans against equity collateral trades. Finally, haircuts and collateral mix will become increasingly borrower-specific, with larger, well-capitalized names enjoying better terms of trade than smaller, less well-capitalized institutions.
It has been a tough period for securities lending, but we are moving back to a flatter, straighter road, and beneficial owners have updated their procedures accordingly. Ultimately, this is a good thing. When a beneficial owner decides to take on securities lending, it must closely monitor the program, assess the risks and carefully examine the opportunities in order to get the best risk/return trade-off.
Ed Oliver is director of Data Explorers Consulting.
ed.oliver@dataexplorers.com
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© Copyright 2009 Rogers Publishing Ltd. This article first appeared in the October 2009 edition of BENEFITS CANADA magazine.