In collaboration with Global Pensions, Data Explorers brings you the latest global trends and analysis on securities transactions. John Arnesen reports
Securities lending is a huge industry. Our latest data shows total outstanding loan value of US$1.9trn, albeit down from a high of almost $4trn in July 2007. Despite this correction, the industry’s growth since the late 1980s has been truly phenomenal.
In its simplest form securities lending creates a fee by lending a specific security at the request of a borrower in exchange for a form of collateral. Whether that collateral is in the form of another security or cash is where lending really deviates into two differing disciplines. A non-cash transaction is collateralised by another security that will meet pre-determined permissible forms as directed by the lender. No interest rate or yield volatility is introduced; revenue is generated by a basis point fee for the life of the transaction. Naturally there are other issues to consider such as counterparty credit worthiness, the strength of any agent indemnification against counterparty default and a host of other operational and risk factors.
The introduction of cash as collateral however requires the cash to generate a yield over and above the rebate paid to the borrower, at which point it becomes an asset and liability management business. Some programmes operated by large custodians and third party lenders total hundreds of billions of dollars in outstanding cash balances.
For many years cash reinvestment produced significant returns for participants. One would imagine placing cash on deposit with a highly rated bank (or even a government supported bank?) was a sound move. As long as the interest received was higher than the rebate paid to the borrower, the transaction would generate a return. However, one cannot place cash on deposit daily and expect not to be subject to interest rate volatility. This in turn could require adjustments to the rebate in order to keep it below the yield on deposit but that might not be possible due to a market practice of not adjusting rebates daily, particularly when lending equities.
While deposits are an option, placing cash unsecured in the current climate is considered less attractive and secure than it once was. Therefore the majority of cash collateral ends up being reinvested in other securities from reverse repurchase transactions to commercial paper, floating rate notes, corporate bonds and yes, asset backed securities.
While there has been an almost universal withdrawal of placing cash in anything other than reverse repo transactions of specific government debt in recent times, it is only a matter of time before these other asset classes are again considered suitable investments. (See chart: A pick-up in reinvestment return)
At our recent forum in New York, 40% of beneficial owners in the audience expressed an increased appetite for risk in the face of challenging market conditions. This time however, that risk appetite is likely to be accompanied by far greater credit analysis and issuer specific considerations.
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