In a liquidity-constrained market, what revenues opportunities are there for securities lenders? Silvia Pavoni finds that quality of collateral is key.

In current credit market conditions, the need for cash and high quality securities has created some interesting revenue perspectives for the securities lending sector, which is responsible for an international liquidity pool of $3000bn-worth of cash collateral.

Securities lenders, particularly in the US, have traditionally preferred collateral to come in the form of cash. Not only does cash pose a lower risk for the lender, it also provides the lender with an opportunity to reinvest the cash in a separate pool to gain further yield. In a liquidity-constrained market, such yield can be significantly higher.

If cash is in great demand and the liquidity pool generated by securities lending attracts investors’ attention, high quality securities play a similar role, too. Government bonds are highly sought after and have started generating healthy margins for their beneficial owners.

Government bonds have attracted a premium price since August 2007. Data provider Performance Explorer shows an average securities lending (SL) fee of 9.28 basis points (bps) and average total return to lendable (TRTL) of 7.43bp in the first seven months of 2007. Returns from the beginning of August to date have had an average SL fee of 18.9bp and an average TRTL of 22.17bp.

“In my view, fixed income portfolios will continue to attract strong revenues in 2008,” says Mr Oliver. “We initially thought that 2007 was the year of the credit crunch but now I believe it was merely the aperitif – 2008 will be the main course. Demand for quality assets will be high throughout this year.”

Market restrictions

The current financial market conditions have, naturally, also created important restrictions in the market. The lack of liquidity is not only giving a premium to cash and high quality securities; it also imposes tighter balance sheet constraints on borrowers, increasingly forcing them to offer non-cash collateral.

“There is a general trend in the market that started in the last quarter [of 2007] where the broker dealers side of the business is more interested in giving non-cash collateral rather than cash collateral,” says Craig Starble, State Street’s senior vice-president and head of securities finance business in the US.

Jacques-Philippe Marson, CEO of BP2S, BNP Paribas’ securities service business, agrees. “Borrowers are extremely sensitive to the type of collateral they will pledge; and the more flexibility a lender can provide, the better,” he says. “This has led to an increased use of tri-party collateral managers who independently value and manage these increasingly diversified portfolios. Borrowers have looked to substitute cash collateral for cheaper non-cash alternatives.”

Cash positions

The way the market reacts depends considerably on the relationship between lenders and borrowers. So far, lenders and their agents have raised rebates to maintain the cash balance, as detailed in a sector report by Spitalfields Advisors.

Maintaining the cash position, and reinvestment, was so crucial that lenders sometimes effectively lent securities for no revenue or at a loss. This tactic has been successful as cash positions have remained broadly unchanged while the percentage of revenue share from reinvestment has increased – exceeding 100% in some cases, according to the report.

“Revenue streams [from cash reinvestments] have become increasingly important as the margins for lending have decreased in recent years – about 50% of lending revenues are usually derived from cash reinvestment,” says Mr Marson.

“To keep cash balances in the reinvestment programmes, lenders are giving away stocks extremely cheaply just to secure the cash. One can only speculate what may happen if these cash balances are suddenly withdrawn and the reinvestment decisions are exposed,” he adds.

Short-term strategy

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This strategy, however, cannot be regarded as a long-term solution. Tim Douglas, head of global securities lending at Citigroup, says that his clients would not find this strategy acceptable. “In my mind, the business should operate in terms of classic arbitrage. It is possible that such practice happens, but it doesn’t happen here.

“Our clients would not be happy about it and they would not tolerate it for very long. I don’t see how it could be a viable strategy over the long term,” he says.

Should cash have to be returned, lenders might have to liquidate positions, which – depending on the type of reinvestment – could result in a loss for positions that have been devalued as a result of the credit crunch. Luckily, this is still a hypothetical situation and there has not been a trend in the industry forcing borrowers to replace their cash collateral with non-cash alternatives.

“The cash collateral balances still remain remarkably steady. But it will be interesting to see if the balance of loans versus cash collateral, compared to those versus non-cash collateral, narrows during the peak period in the next three months – with non-cash collateral balances growing to narrow the gap,” says Ed Oliver, senior business consultant at Spitalfields Advisors.

More selective reinvestments

The credit crunch and market uncertainty has not constrained borrowers only. It also forced beneficial owners to be much more selective about which assets they feel comfortable reinvesting their cash into. High quality, shorter term assets are now preferred, such as repo transactions and bank deposits. “When there is a credit or liquidity crisis, the market requires a more conservative approach,” says Mr Starble. “We have seen a shortening of reinvestment maturities.”

The credit crunch has also amplified the need for transparency and a risk-adjusted reporting system for securities lending returns, because in times of troubles it is crucial that all parties understand the risk associated with their returns in a numerical way.

“We do an online reporting of what [clients] own in the portfolio and regular pricing of those securities” says Mr Starble. “The industry overall hasn’t done a great job in terms of risk-adjusted return methodology. We are going to see a significant focus on this in the future. Whether it’s about cash or non-cash, can it be modelled properly from a risk adjusted return perspective? We’ve been doing it since 1994; most others haven’t.”

A risk-adjusted reporting system would also help beneficial owners to make decisions about possible collateral upgrade trades, in which bonds are lent out and substituted for lower grade collateral, attracting a higher level of income.

An alternative model

With ongoing turbulence in financial markets (the latest shock coming from Bear Stearns and its rescue financing and subsequent heavily discounted takeover offer by JPMorgan that would wipe out shareholders’ value), authorities are trying to restore confidence and calm.

Subsequent rate cuts by the US Federal Reserve and the creation of a primary dealer credit facility (PDCF) in the US might at least narrow the spreads as broker dealers get access to better funding. The PDCF is a specialised lending facility that will provide liquidity to primary dealers at terms similar to those that are available to banks at the discount window, and it has allowed dealers to access funding directly from the central bank.

As for the rest of the financial world, overall it seems that the revenue opportunities of the future will come from a more traditional model. “Just as in most of the rest of the capital markets, it feels to me that we are returning to a ‘back-to-basics’ environment,” says Mr Douglas.

“The next sizeable revenue opportunity could well be the expansion of securities lending in other reasonably mature capital markets around the world.”

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