Asset owners taking holistic approach to collateral management
Asset owners are increasingly taking a holistic approach to their collateral management processes as a result of their growing retreat from securities lending coupled with the migration of over-the-counter (OTC) derivatives instruments into centralised clearing as mandated under Dodd-Frank and the European Market Infrastructure Regulation (EMIR), according to a Citi study.
Many asset owners, having experienced losses on overly aggressive re-investment of the collateral they receive in against securities loans, are de-emphasising the contribution from returns on their collateral investments and instead focusing more on the intrinsic value of the securities they lend from their portfolio. The Citi paper highlighted this had made low value loans of general collateral supply less attractive “and prompted lenders to focus more exclusively towards the specials portion of the asset owner’s portfolio.” The paper added that some equity asset owners demand a minimum spread before they consider making a loan.
“Asset owners simply do not want to be as aggressive with the re-investment of collateral as they were prior to the crisis and this is resulting in a shift in the emphasis of what is loaned out of their portfolios. Many asset owners are now putting up guidelines stipulating they will not lend out general collateral unless it generates a certain number of basis points. It is effectively putting a hurdle towards securities lending,” said Sandy Kaul, head of business advisory services at Citi, and author of the report.
Regulation is also playing a significant role in curbing securities lending. Basel III, for example, will increase capital costs for securities lending agents offering borrower default indemnifications. Rule 165(e) of Dodd-Frank prohibits institutions with more than $50 billion in assets from having an aggregate net exposure to a counterparty exceeding 25 per-cent of the former’s capital. This is reduced to 10 per-cent when each counterparty has more than $500 billion. These rules are further likely to make asset owners less likely to loan out collateral. “Agent lenders will have to price indemnifications against borrower defaults into the price of their securities lending programme or convince them to go without indemnification, and this could be quite costly for borrowers such as fund managers. Lending could potentially become more expensive,” said Kaul.
This, however, is unlikely to result in diminished shorting activity at hedge funds, for example, said Kaul. “Admittedly, if hedge funds are paying a lot more to short general collateral, they will borrow less. But managers could use indices or exchange traded funds (ETFs) as a means by which to short instead of doing single stock shorts through a general collateral position,” said Kaul.
The transition into mandatory clearing is also going to impact lending at asset owners, particularly if collateral transformation upgrades and downgrades prove to be a more lucrative undertaking. Central counterparty clearing houses (CCPs) are only permitted to accept high-grade collateral – usually cash or government bonds – for initial margin while firms can typically only post cash collateral for variation margin. There is likely to be a strong market for obtaining eligible collateral to post to CCPs.
“We are already seeing a build-up of collateral demand in the US where mandatory clearing has been on-going for some time now. We will see the same in Europe once EMIR takes effect. A lot of asset owners are going to be asking themselves whether they will get a better spread providing collateral for clearing members to post to CCPs versus the revenues accrued through their securities lending programmes. As a result, asset owners are going to have a much more holistic approach towards how they manage their collateral,” said Kaul.
Collateral transformations will be particularly profitable for asset owners should there be a collateral shortage once EMIR and the bilateral margining of non-cleared derivatives begins in earnest in 2015. Papers published in the summer by Citi and the Depository Trust & Clearing Corporation (DTCC) in conjunction with the London School of Economics (LSE) argued that there will be limited availability of high-grade collateral as opposed to an actual shortfall.
“Our paper highlights that there is a pool of collateral available at asset owners that can be used to alleviate the collateral squeeze, but that same pool of supply will also be used to cover shorts. Asset owners cannot think of collateral and securities lending in isolation. They must think of collateral as a single business utility,” said Kaul.