State Street's Craig Starble and Peter Economou examine the securities lending industry in the wake of the credit crunch
The current turmoil in the financial markets has had far-reaching implications for the securities lending industry; reflected most prominently by how beneficial owners now view and monitor their programmes. While media reports have focused on the negative effects of market volatility, some results have been very positive.
Beneficial owners who leveraged the Federal Reserve's interest rate easing and widening spreads within the confines of a prudent lending programme have earned significant returns this past year. Moreover, the securities lending industry as a whole is re-evaluating in earnest the meaning and importance of transparency and risk management.
The current state of the market and heightened awareness provide favourable conditions to build stronger programmes based on an increased flow of information and greater reliance on risk-based returns (the relationship between the amount of risk taken and the revenue generated from those risks).
The changing landscape of securities lending
Between 2004 and 2007, most credit spreads remained extremely tight and, in search of enhanced yields, new investments were formed with either direct or indirect exposure to sub-prime or asset-backed issuance (i.e., residential mortgage-backed securities, asset-backed commercial paper and structured investment vehicles). As a way of gaining a few extra basis points in returns, numerous lending programmes invested in these products - keeping short maturity at good spreads with presumably quality credit ratings. The issue was that the underlying collateral that supported these packaged instruments was not known due to a lack of transparency.
In the latter part of 2007, when credit concerns over the sub-prime assets continued to grow, anxiety in the securities lending marketplace also rose.
The problems that began with longer-dated securities quickly rolled in to affect shorter term instruments, many of which (noted above) were mainstays of some securities lending portfolios. Market participants then looked for ways to navigate their collateral reinvestments beyond the sub-prime crisis and credit crunch, triggering a 'flight to quality' toward low-risk cash products which - for both long term and short term credit markets - have remained on investors' radar.
The widening of credit spreads, easing of interest rates by the Federal Reserve and overall flight to quality precipitated by credit deterioration created the opportunity within the securities lending industry to benefit from this scenario, which agent-lenders leveraged to generate higher revenues for beneficial owners. While investors are happy with the returns, they also want a clearer understanding from a systemic perspective of the type of assets in their collateral portfolio and how those returns are being generated.
Investors sharpen their focus on transparency
The key effect of the credit crunch has been a general acknowledgement of the need for greater insight into collateral portfolios and a better understanding of how cash is being reinvested. Investors also want reassurance that the industry itself will safely emerge from the crisis and that agent-lenders are operating with clients' interests in mind.
Now more than ever, beneficial owners are increasingly requiring strong risk policies from their providers. It is critical for agents to report full details on their customers' programmes - from the securities they have loaned out, to the stability and trustworthiness of trading parties, to where the cash collateral is reinvested. Agents who are committed to good risk management practices must not only provide that transparency to clients, but also demand it in the assets purchased and from borrowing counterparties.
Without transparency, it is easy to become inadvertently exposed to less credit-worthy markets. Having a complete appreciation of the underlying assets that comprise a collateral vehicle is not merely important in managing a portfolio, it is essential to the risk management process.
Quantifying risk without being able to identify it is impossible. Agent-lenders must have the capability to define returns from a risk-adjusted perspective to ensure clients are comfortable with their programmes.
Beneficial owners are seeking agent-lenders who will spend time explaining the credit process, create diligence around cash reinvestment and demonstrate how liquidity is maintained within the portfolio. In addition, beneficial owners want detailed information about borrowers, including the in-depth analysis their agents conduct in relation to the counterparties with whom they do business.
There are some agent-lenders who have made transparency and access to daily reporting platforms a cornerstone of their service offering. In doing so, they work closely with clients to establish proper investment guidelines, offer a complete look-through to all portfolio holdings and provide consultation which includes insights into portfolio strategy and portfolio objectives. However, across the industry there are still vast differences in the type and quality of information available.
The shift toward implementing industry standards
With increasing demand from beneficial owners for greater information around their lending portfolios and collateral reinvestments, and the persistence of top agents who have long provided that clarity to their own clients, the rest of the industry is compelled to move toward improved information flows and better risk management.
To that end, there is a need for the market-wide indoctrination of a single, industry-accepted standard on reporting metrics. Independent, third-party data aggregators who use approved metrics will allow for standardised data provision and give lenders the chance to benchmark the performance and stability of their programmes and agents against others.
Industry standards on risk reporting and risk tools are also critical pieces of the puzzle. Benchmarking providers on risk-adjusted performance and demanding data on risk-adjusted returns help to confirm that risk management is a high priority for the agent-lender. Understanding agents' risk practices and how they measure risk and performance should be a key consideration when choosing an agent.
A beginning of a new order for securities lending
The securities lending industry is at a point of inflection. Those providers with global resources and scale, along with best-practice programme oversight and risk management will succeed and, in the process, help shape the future of securities lending.
Market-leading service providers have the means and expertise - professionals situated around the world dedicated to customer service, portfolio management, trading, operations, technology, legal and compliance, product development and, perhaps most importantly, risk training and risk management.
Those with 24-hour access, best-in-class technology platforms and a relationship with an independent third-party data aggregation provider that uses industry recognised metrics for portfolio risk assessment are well positioned to help customers effectively manage their lending programmes. In addition, these providers have the experience and resources to secure their continued existence, regardless of market conditions.
When the dust of the current market turmoil settles, it will be a different securities lending market landscape - one with fewer providers and higher standards.
As the market stabilises and beneficial owners re-examine their existing programmes and providers, they will want to partner with agent-lenders who have the data-gathering infrastructure, information provision policies and rigorous risk management regimes to ensure best practices across the life of a programme.
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