Equities as Collateral
03 April 2018
As the acceleration towards a higher percentage of non-cash collateralised transactions continues, it is for the benefit of all US market participants to support the expansion of this change
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As the acceleration towards a higher percentage of non-cash collateralised transactions continues, it is for the benefit of all US market participants to support the expansion of this change.
According to Mike Saunders, head of trading and investments, securities lending at BNP Paribas Securities Services, the trend is certainly towards non-cash collateral as the US seeks to align with the rest of the world in their implementation and expansion of permitted collateral.
Saunders explains: 鈥淗istorically, the US securities lending market has been biased towards cash collateral. However, this is changing and at a frenetic pace. The preference to accept non-cash collateral will continue in the years ahead.鈥�
He also suggests that the preference for non-cash collateral has grown rapidly over the last three years and the growth is expected to accelerate as beneficial owners and the regulatory environment shift towards greater collateral flexibility.
Although the market share of non-cash collateral transactions has grown, challenges still remain which prohibit beneficial owners from engaging in non-cash collateral-based transactions to fully reap the benefits offered in a non-cash transaction. He notes that the shift towards non-cash collateral as the result of several factors with regulatory and balance sheet constraints at the forefront. The demand side under Basel III is forcing dealers to pursue balance sheet reduction exercises prior to critical reporting periods causing a significant reduction in reverse repurchase transactions in the cash market. The focus on balance sheet allocation naturally shifts the demand to borrow to non-cash transactions which offer broker dealers an opportunity to net and move transactions off balance sheet. As such, non-cash collateral-based transactions are less balance sheet-intensive than cash collateral-based transactions hence the growth in non-cash collateral.
It can be argued that the benefits of engaging in a non-cash collateral-based transaction outweighs transactions collateralised by cash. A non-cash transaction enables the netting of transactions as it is one lending contract, removes the cash collateral reinvestment risk, promotes dealer balance sheet efficiency and negates the negative or low interest rate environment globally. In addition, non-cash transactions are less strenuous on the document front, removing the need for a master repurchase agreement/global master repurchase agreement (MRA/GMRA).
Sam Pierson, an analyst at specialist data provider IHS Markit, also weighs in. He says the issue is that brokers are motivated to do non-cash because it will be more efficient from a balance sheet perspective. Lenders in the US are often unable to take anything except cash or potentially treasuries as collateral, partly as the result of regulation, partly the result of their wishing to generate extra revenue by investing the cash collateral and partly wanting to have the security of cash collateral versus a riskier form of collateral.
Saunders states that despite the growing demand from borrowers to engage in non-cash transactions, beneficial owners continue to face regulatory hurdles, which limit their participation in non-cash transactions.
The largest hurdle to unlocking a tremendous amount of liquidity and supply in the US remains SEC Rule 15c3-3, which currently limits the collateral type posted by borrowers to cash, US treasuries and US agency debt. This rule is also applicable to SEC 1940 Act Funds causing additional challenges such as a collateral look-through calculation.
The acceleration of the acceptance of non-cash collateral has led the prominent industry working group in the US, the Risk Management Association (RMA), along with several leading market participants to engage in a major campaign to amend the SEC 15c3-3 regulation. These efforts would permit the pledging of equity collateral versus an equity borrow but not cross-asset transactions (for example, fixed income versus equities).
Regulators and the SEC Market鈥檚 Division appear open to discussing the expansion of 15c3-3 and have been prudently examining the benefits and impact of such a change, explains Saunders. Recent communication as of February 2017, support the progress and open dialogue. While these discussions have been years in progress, a final ruling is to be expected in the very near future, he observed.
Fran Garritt, director of securities lending at the RMA, identifies two issues with equities as collateral, the first being getting equities approved as a permissible collateral. The second is the broker/dealer debit calculation where the collateral used has a certain capital requirement that must be held by the broker.
Garritt explains: 鈥淚n the case of equities, it鈥檚 100 percent making the trade uneconomical. Is it likely to change any time soon? I don鈥檛 know. Hopefully. If it does, brokers will need time to get their systems up and running, he said. Some will do so quicker than others.鈥�
鈥淭hey will also want to do this as soon as possible as they get capital relief under the stock loan return (SLR) for equities instead of cash as collateral. On the beneficial owner side, there will be a few issues. First, sovereign wealth funds, central banks, endowments will not need any clarification from any regulator to accept equities as collateral.鈥�
Garritt adds that the 1940 Act funds (mutual funds) and the Employee Retirement Income Security Act (ERISA) funds (pension funds regulated by the Department of Labor) will need to get approved, or at least clarification that they can accept equities.
He adds: 鈥淚 also believe that some, if not most, will choose not
to accept.鈥�
Brokers will want to use equities and will guide trades towards beneficial owners who will accept them. Garritt suggests: 鈥淟ike central counterparties, it will be another arrow in the quiver of tools that market participants can use. Both central counterparties (CCPs) and equities as collateral help the broker with balance
sheet/capital management.鈥�
Saunders also addresses the point that it is not only regulated mutual funds currently constrained by the rather limited collateral type. Insurance companies are regulated by the individual states in which they are incorporated thus leaving each state insurance regulator with the mandate to impose state statutes. But little or nothing is set in stone.
He says: 鈥淥ur research and experience demonstrates that cash collateral remains the predominant collateral type for no reason other than historical reasons and the prioritisation of an insurance company engaged in securities lending to lobby their state regulator.鈥�
In contrast to insurance companies and the US Securities and Exchange Commission (SEC) registered 1940 Act funds, state-sponsored pension funds appear rather unconstrained on the permitted collateral type in a securities finance transaction. While this may appear on the surface a positive for non-cash collateral, legacy lending guidelines often require legislative or at a minimum, board changes to implement non-cash collateral into a securities lending agreement.
Again, on the agenda for sponsoring a change either at the legislative or board level, the voice for the implementation of non-cash collateral is rather muted, according to Saunders.
However, the underfunded status of a majority of state-sponsored plans and the search for increased revenues has driven pension funds to action to expand their collateral parameters. Those who have taken the initiative to implement these changes have reaped the first mover advantage of engaging in non-cash collateral.
Another important consideration when discussing pension funds is the shift from defined benefit plans toward defined contribution plans. The change in pension structure is impacting the securities lending market indirectly. As contributors elect their investments, flows have been directed towards mutual funds. The effect has been mutual fund assets have grown substantially. Relating this to shift to securities lending, these new flows are now susceptible to collateral restrictions of cash, US treasuries and government-guaranteed debt and thus lower lending returns typically associated with a wider array of permissible collateral.
According to Saunders, the benefits and popularity of non-cash collateral are apparent as demonstrated in the securities lending market outside the US. Non-cash collateral typically is associated with higher levels of collateralisation while removing the cash collateral credit reinvestment and duration mismatch risk. The demand to lend under non-cash transactions permits greater liquidity in the market while reducing the correlation in the event of collateral liquidation. The benefits are so apparent that equities have become the dominant permitted collateral for UCITS, which are highly regulated fund structures throughout Asia, Europe and Latin America.
Turning to the collateral preference of official institutions such as central banks, sovereign wealth funds and supra-sovereign entities, Saunders observes that each of these entities possesses varying levels of engagement in their lending programmes and views as to their rationale for participation in securities lending.
While it is common for central banks to approach securities lending with their mandate to provide liquidity, in contrast, sovereign wealth funds typically are more focused on revenue generation, Saunders explains. Regardless of their intent in securities lending participation, a majority of official institutions accept a wide array of collateral including both cash and non-cash collateral including equities.
Saunders suggests that the correct implementation of both a cash- and non-cash collateral lending programme is imperative. Diversification and collateral monitoring are crucial. Agents and collateral managers possess the ability to impose granular diversification parameters on all collateral sets. Further, it has become market standard for beneficial owners to receive on a timely basis detailed reports of the pledged collateral to ensure all guidelines and collateral preferences remain compliant.
Looking at other live issues, Garritt suggests that another topic within the US that will need to be discussed when it comes to equities as collateral is how triparty will factor into the equation.
He says: 鈥淚 don鈥檛 think any bank will do an equities collateral trade bilaterally. It will certainly be done through tri-party. Brokers鈥� systems will be a big deal. J.P. Morgan, Citi, Credit Suisse, Morgan Stanley, Goldman Sachs will be fine and will get up and running quickly.鈥�
Loan Balances by Collateral Type
Source IHS Markit
According to Mike Saunders, head of trading and investments, securities lending at BNP Paribas Securities Services, the trend is certainly towards non-cash collateral as the US seeks to align with the rest of the world in their implementation and expansion of permitted collateral.
Saunders explains: 鈥淗istorically, the US securities lending market has been biased towards cash collateral. However, this is changing and at a frenetic pace. The preference to accept non-cash collateral will continue in the years ahead.鈥�
He also suggests that the preference for non-cash collateral has grown rapidly over the last three years and the growth is expected to accelerate as beneficial owners and the regulatory environment shift towards greater collateral flexibility.
Although the market share of non-cash collateral transactions has grown, challenges still remain which prohibit beneficial owners from engaging in non-cash collateral-based transactions to fully reap the benefits offered in a non-cash transaction. He notes that the shift towards non-cash collateral as the result of several factors with regulatory and balance sheet constraints at the forefront. The demand side under Basel III is forcing dealers to pursue balance sheet reduction exercises prior to critical reporting periods causing a significant reduction in reverse repurchase transactions in the cash market. The focus on balance sheet allocation naturally shifts the demand to borrow to non-cash transactions which offer broker dealers an opportunity to net and move transactions off balance sheet. As such, non-cash collateral-based transactions are less balance sheet-intensive than cash collateral-based transactions hence the growth in non-cash collateral.
It can be argued that the benefits of engaging in a non-cash collateral-based transaction outweighs transactions collateralised by cash. A non-cash transaction enables the netting of transactions as it is one lending contract, removes the cash collateral reinvestment risk, promotes dealer balance sheet efficiency and negates the negative or low interest rate environment globally. In addition, non-cash transactions are less strenuous on the document front, removing the need for a master repurchase agreement/global master repurchase agreement (MRA/GMRA).
Sam Pierson, an analyst at specialist data provider IHS Markit, also weighs in. He says the issue is that brokers are motivated to do non-cash because it will be more efficient from a balance sheet perspective. Lenders in the US are often unable to take anything except cash or potentially treasuries as collateral, partly as the result of regulation, partly the result of their wishing to generate extra revenue by investing the cash collateral and partly wanting to have the security of cash collateral versus a riskier form of collateral.
Saunders states that despite the growing demand from borrowers to engage in non-cash transactions, beneficial owners continue to face regulatory hurdles, which limit their participation in non-cash transactions.
The largest hurdle to unlocking a tremendous amount of liquidity and supply in the US remains SEC Rule 15c3-3, which currently limits the collateral type posted by borrowers to cash, US treasuries and US agency debt. This rule is also applicable to SEC 1940 Act Funds causing additional challenges such as a collateral look-through calculation.
The acceleration of the acceptance of non-cash collateral has led the prominent industry working group in the US, the Risk Management Association (RMA), along with several leading market participants to engage in a major campaign to amend the SEC 15c3-3 regulation. These efforts would permit the pledging of equity collateral versus an equity borrow but not cross-asset transactions (for example, fixed income versus equities).
Regulators and the SEC Market鈥檚 Division appear open to discussing the expansion of 15c3-3 and have been prudently examining the benefits and impact of such a change, explains Saunders. Recent communication as of February 2017, support the progress and open dialogue. While these discussions have been years in progress, a final ruling is to be expected in the very near future, he observed.
Fran Garritt, director of securities lending at the RMA, identifies two issues with equities as collateral, the first being getting equities approved as a permissible collateral. The second is the broker/dealer debit calculation where the collateral used has a certain capital requirement that must be held by the broker.
Garritt explains: 鈥淚n the case of equities, it鈥檚 100 percent making the trade uneconomical. Is it likely to change any time soon? I don鈥檛 know. Hopefully. If it does, brokers will need time to get their systems up and running, he said. Some will do so quicker than others.鈥�
鈥淭hey will also want to do this as soon as possible as they get capital relief under the stock loan return (SLR) for equities instead of cash as collateral. On the beneficial owner side, there will be a few issues. First, sovereign wealth funds, central banks, endowments will not need any clarification from any regulator to accept equities as collateral.鈥�
Garritt adds that the 1940 Act funds (mutual funds) and the Employee Retirement Income Security Act (ERISA) funds (pension funds regulated by the Department of Labor) will need to get approved, or at least clarification that they can accept equities.
He adds: 鈥淚 also believe that some, if not most, will choose not
to accept.鈥�
Brokers will want to use equities and will guide trades towards beneficial owners who will accept them. Garritt suggests: 鈥淟ike central counterparties, it will be another arrow in the quiver of tools that market participants can use. Both central counterparties (CCPs) and equities as collateral help the broker with balance
sheet/capital management.鈥�
Saunders also addresses the point that it is not only regulated mutual funds currently constrained by the rather limited collateral type. Insurance companies are regulated by the individual states in which they are incorporated thus leaving each state insurance regulator with the mandate to impose state statutes. But little or nothing is set in stone.
He says: 鈥淥ur research and experience demonstrates that cash collateral remains the predominant collateral type for no reason other than historical reasons and the prioritisation of an insurance company engaged in securities lending to lobby their state regulator.鈥�
In contrast to insurance companies and the US Securities and Exchange Commission (SEC) registered 1940 Act funds, state-sponsored pension funds appear rather unconstrained on the permitted collateral type in a securities finance transaction. While this may appear on the surface a positive for non-cash collateral, legacy lending guidelines often require legislative or at a minimum, board changes to implement non-cash collateral into a securities lending agreement.
Again, on the agenda for sponsoring a change either at the legislative or board level, the voice for the implementation of non-cash collateral is rather muted, according to Saunders.
However, the underfunded status of a majority of state-sponsored plans and the search for increased revenues has driven pension funds to action to expand their collateral parameters. Those who have taken the initiative to implement these changes have reaped the first mover advantage of engaging in non-cash collateral.
Another important consideration when discussing pension funds is the shift from defined benefit plans toward defined contribution plans. The change in pension structure is impacting the securities lending market indirectly. As contributors elect their investments, flows have been directed towards mutual funds. The effect has been mutual fund assets have grown substantially. Relating this to shift to securities lending, these new flows are now susceptible to collateral restrictions of cash, US treasuries and government-guaranteed debt and thus lower lending returns typically associated with a wider array of permissible collateral.
According to Saunders, the benefits and popularity of non-cash collateral are apparent as demonstrated in the securities lending market outside the US. Non-cash collateral typically is associated with higher levels of collateralisation while removing the cash collateral credit reinvestment and duration mismatch risk. The demand to lend under non-cash transactions permits greater liquidity in the market while reducing the correlation in the event of collateral liquidation. The benefits are so apparent that equities have become the dominant permitted collateral for UCITS, which are highly regulated fund structures throughout Asia, Europe and Latin America.
Turning to the collateral preference of official institutions such as central banks, sovereign wealth funds and supra-sovereign entities, Saunders observes that each of these entities possesses varying levels of engagement in their lending programmes and views as to their rationale for participation in securities lending.
While it is common for central banks to approach securities lending with their mandate to provide liquidity, in contrast, sovereign wealth funds typically are more focused on revenue generation, Saunders explains. Regardless of their intent in securities lending participation, a majority of official institutions accept a wide array of collateral including both cash and non-cash collateral including equities.
Saunders suggests that the correct implementation of both a cash- and non-cash collateral lending programme is imperative. Diversification and collateral monitoring are crucial. Agents and collateral managers possess the ability to impose granular diversification parameters on all collateral sets. Further, it has become market standard for beneficial owners to receive on a timely basis detailed reports of the pledged collateral to ensure all guidelines and collateral preferences remain compliant.
Looking at other live issues, Garritt suggests that another topic within the US that will need to be discussed when it comes to equities as collateral is how triparty will factor into the equation.
He says: 鈥淚 don鈥檛 think any bank will do an equities collateral trade bilaterally. It will certainly be done through tri-party. Brokers鈥� systems will be a big deal. J.P. Morgan, Citi, Credit Suisse, Morgan Stanley, Goldman Sachs will be fine and will get up and running quickly.鈥�
Loan Balances by Collateral Type
Source IHS Markit
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