From the desk of Roy Zimmerhansl,
Practice Lead, Pierpoint Financial
I have been speaking with clients, presenting at conferences and writing about non-cash collateral since the early 1990s. For my sins, I was even invited by the RMA to present to the US Department of Labor in the late 1990s to present why, as a non-US borrower, I directed my business to non-cash lenders and that as ERISA funds were restricted essentially to US government securities, my business and likely that of my peers would be directed elsewhere, to the detriment of the ERISA lenders. This advantage for non-ERISA lenders was a fundamental driver to the growth of lending by non-US investors as we sought out less-constrained investors from which to borrow.
Since that time there have of course been notable issues with cash reinvestment losses on more than one occasion. The resulting regulatory changes have channelled demand in the direction of non-cash as well as the impact over the past decade of artificially low rates that have reduced the incremental returns available to investors that receive cash for securities loans.
Despite this, I have never suggested that investors should dismiss cash as an option, simply that they ought to recognise the differences in risk, indemnifications and demand outlook. If you follow our work, you will have seen the team here at Pierpoint encourages investors to have as wide a range of collateral as fits their risk acceptability. That’s because there are also ebbs and flows of availability of collateral at borrowers that can skew their borrowing preferences – a wider approved collateral profile will more consistently attract borrower demand, thereby gaining an advantage over lenders that are one-dimensional.
This week I listened to the latest episode of the Peer Connections Podcast, and you can find it here. I encourage everyone to take 20 minutes and listen to this important show. This is the podcast from the Global Peer Financing Association, the group that was officially formed in July this year to “promote a more efficient and actionable way to encourage and support peer-to-peer securities financing trading activity”. The podcast was hosted by the always-excellent Brooke Gillman of eSecLending and featured Dan Kiefer and Mike Johnson of the California Public Employees Retirement System, who oversee the CalPERS securities lending programme.
This podcast focused on the CalPERS experience of adding non-cash collateral to their lending activity, and it brought out several key points which are sometimes viewed with scepticism by lending investors. I think that hearing the research, analysis, risk assessment and experiences of one of the world’s largest pension funds[1] should go a long way to adding credibility to the efforts of agent lenders and borrowers to widen the collateral pools acceptable to clients. When you also hear that they had to change state law to enable non-cash, it shows their willingness to follow through on their findings.
To the meat of the post …
Marks to market (MTM) can be easier to deal with in non-cash. Whereas a significant drop in MTM values or large returns by borrowers can force an investor to sell a cash investment, possibly at an inopportune moment, non-cash simply involves a target value of collateral against which securities are held. If there are sales or a drop in loan value, securities are simply returned to borrowers.
Don’t take collateral that you wouldn’t be able to invest in directly. CalPERS had been investing in equity repo, so holding equities directly as collateral didn’t require a change in collateral policy.
Arguably equities might be more volatile than other assets but can have better liquidity than other assets. I write ‘arguably’ because Dan makes the excellent point that in the run-up to the Global Financial Crisis, many assets bought with cash were superficially less volatile, but that was because they didn’t really trade, so didn’t reflect actual volatility and certainly didn’t have any meaningful liquidity. I have made the point for many years that equity markets can’t have a dramatic fall unless there is substantially increased liquidity as princes fall.
The other key subtlety which I and others have talked about over time is the mix of securities on loan and the securities received as collateral. The CalPERS sensitivity analysis found that the securities collateral had a lower ‘beta’ than the loaned securities. Beta is a measure of the movement of the value of a security relative to the market. That is of course intuitively correct – short-sold securities (the equities on loan) are expected by the short seller to move away from the overall market move. A hedged transaction can be profitable, whether markets fall or rise. The collateral a borrower provides, of course, excludes any securities they anticipate needing to borrow, so in other words, the lender ends up lending more volatile stocks and receiving less volatile securities as collateral. That’s how you want to be positioned and it's great that CalPERS was able to satisfy themselves on the issue.
Finally, the BIG KAHUNA – CalPERS found that by adding non-cash collateral, there was demand for assets which had no bids for the same assets when cash collateral was required. It can be a daunting leap of faith for some investors when obtaining approvals to expand their collateral profile, given that there are no guarantees in securities lending life. They wonder ‘If I make this change, will my investors really benefit?’ There is nothing I can add to Mike’s own words: “More Bidders – Better Bids”.
So, there you have it – real value from expanding the collateral pool without necessarily adding risk to your programme. Of course, if you listen to the podcast, you will realise that CalPERS invested significant time and effort in coming to their conclusions. While this validates that there is money to be made from adapting your schedules, we advise investors to seek expert advice from securities lending experts before making any changes.