Securities Lending Today

Securities Lending Cash versus Non-cash Debate - part two

As a follow on from my last post I have received a number of comments from people directly and in various fora that I am part of.  So while I was planning on doing a post on the issue in the future, I feel compelled to respond now in brief.

Is there really a debate on "Cash versus Non-cash" in the US?  Many give a resounding "No" and if my information of a shift from 96% to "only" 91% cash collateralised securities lending activity in the US are accurate, then it is easy to say there no argument.  However, I would make the observation that the 5% has shifted in just 12 months and considering the US is the biggest market for the business, this is a large absolute sum of money.

There are a few other points I'd like to throw out as to why the shift hasn't been more substantial:

• In my view, part of the lack of desire to shift is a reluctance to accept a reduction in return - even at the current handful of basis points that is inherent in non-cash;
• The restructuring of some reinvestment portfolios to shorter durations and higher quality has lessened the risk (a few people have made this very relevant point to me);
• Less pressure on broker dealer balance sheets (at the moment) to push non-cash

Interestingly, as I allude to in my last post, cash will continue to grow in importance in vanilla securities lending transactions. Non-cash previously being touted for collateral in these transactions will continue to migrate toward term funding transactions which are treated better by regulators for liquidity management purposes.  So both become more important. 

The issue today is that many people look at securities finance on a silo basis:

• is it cash or non-cash?
• is it securities lending or repo or swap or something else entirely?
• is that MY collateral or Your collateral or the FIRM's collateral?
• So whose collateral is it anyway?

That is SO "last decade" thinking.  It's  a brave new integrated world.  Ignore it at your peril.

Securities Lending - IMN Conference: Cash versus Non-cash Collateral

The question of cash versus non-cash collateral has been the subject of much debate since the summer of 2007 when the first wave of what became the credit and liquidity crunch first hit the markets.  It is therefore an important issue for the IMN conference.

As with my CCP post, the starting point is the report from Craig McGlashan in Fundamentals.  I suggest you start by taking a few moments and reading his article.

Barry Winter, moderating the panel, started with some stats and unfortunately since I wasn't there I can’t really give any views on those.  However, I can share a bit of info that I saw recently, courtesy of my friends at Data Explorers.  It looks like cash collateral usage has actually increased as a percentage of the overall lending market since 2007.   While US penetration has dropped marginally, it has picked up dramatically in the UK.  There are some specific reasons behind the UK trend which I will go into in a future post, but for now, accept that this is the case. 

Mick Chadwick brings up a number of good points in the article.  It’s what one does with the cash that matters.  To paraphrase, “Cash collateral doesn’t kill programs, people do”.  He points out correctly that cash reinvestment was driving lending activity in the run-up to the market peak.  My view is that the losses were largely a result of the near "perfect storm" of falling market
values, reduced leverage and borrowing demand from hedge funds, the Lehman default and subsequent suspension of lending by a number of lenders.  Not so much bad investments, but poor timing and bad luck.  I am not saying that errors weren’t made, but most of the issues were external to securities lending.

Mick points out indemnifications don’t generally cover losses resulting from cash reinvestments.   Indemnifications are also a subject for another post.

James Slater brings out what I consider is the nub of the issue.  Collateral flexibility and finding what beneficial owners are comfortable with is the important point.  Everything we do in our business involves risk – the goal is to investigate and understand which risks participants are comfortable with.   Chris Fay correctly identifies this as risk tolerance and as it is an individual firm decision, there can be no right answer.

Anthony Toscano offered that the non-cash drive was dealer driven in Europe.  While that is certainly true, it doesn’t really tell the full story.  Cash wasn’t possible from a tax perspective for UK lenders for many years, so even if they were interested in taking cash, they couldn’t have.  Further, until the creation of the euro, there wasn’t a liquid and diverse money market in European, and even after that it took years for market depth and breadth to appear.  Mark my words … cash will continue to grow in importance in Europe.  James Slater reinforced the growth of cash usage in Canada, apparently now in the region of 25% of the market.

Non-cash showed its value in the aftermath of Lehman and cash investors in equity repo were similarly pleased with the results of liquid instruments with measurable turnover and published prices.

There is indeed no right answer on the cash versus non-cash collateral debate - different decisions for different market participants.  That’s true for beneficial owners, agent lenders and the borrowing community.  At the end of the day the decisions drive the returns.  It’s your choice – make certain you understand the implications.

P.S.  Just a quick note on the JPM gold as collateral announcement.  I had my first conversations about this possibility with SBC (Swiss Bank Corp) in the mid 1990’s.  When I moved to Rabobank, the boss said “everything we have is cash or collateral that can be turned to cash”.  That included the gold we had in the Treasury group.  He was right then, he remains right now.  Good thing that the market has caught up.  

Stock Lending - The Final Word for 2010

Ok, so I couldn't resist one last message. 

For many securities lending people 2010 has been a disappointing year.  Expectations early in 2010 for a revival in fortunes for securities lending quickly fizzled out.  Although hedge fund assets under management improved to within a whisker of peak levels, the strategies attracting money didn't result in short sales and the attendant borrowing.  Hedge funds ended the year far more "long" than "short".  Bank proprietary trading, particularly in equities, was virtually non-existent and as a result of Dodd-Frank, the landscape may have changed forever.  Historically low interest rates meant that there was no meaningful pick up from taking additional interest rate risk on the cash reinvestment aspect of the business.  The year ended with a number of firms announcing further redundancies or the potential for job cuts in the near future.

How do things look for 2011? Trading opportunities come and go.  Last year's dearth of shorts doesn't doom us to another dreadful year.  If markets continue to rise, the need for hedging will increase, arbitrage opportunities will pop up and mispricing leading to directional shorts will rise.  Asian activity will undoubtedly continue the growth trend of the past few years.  ETFs, a staple for the US market is increasing in importance for traders eslewhere in the globe.   Some bank prop traders will end up as hedgies and their Prime Brokers will make more money on them as clients than they would have done as internal clients.

M&A has recently made a bit of a recovery, but only time will tell whether this is another false start or sustainable in the long run.  Shorts in the US finished 2010 at low points for the year.  Some think that's because of general optimisim, others as a sign traders don't want to carry shorts over the holiday period. 

So ... what is your expectation for the coming year?  Will business be better - share your vote below.

 

 

Don't forget you can always post comments on the blog as well, or send me your views at roy@stocklendingtoday.com I hope that you have found the blog interesting, informative and occasionally a bit of fun.

Thanks for your support over the past year, and I wish you all a Happy, Healthy and Prosperous 2011!

P.S.  It's never too early to think about your training needs for 2011.  Check out the newly expanded range of FinTuition courses at www.fintuition.com

Securities Lending - Last Word for 2010?

It's about noon GMT on Christmas Eve.  Based on the calls I've made this morning, and the emails I've sent out I may be the last person still at his desk in London.  I'm  calling it a day in a few minutes and will spend the afternoon eating some of the baked goodies my wife and kids have been making over the past couple of days.

The year started with high expectations for a demand recovery for the business.  Remember that with all of the Specials activity of 2009, it was actually a very good year for lender revenues, even though demand was severely curtailed.  So this time last year people were hoping for good things for core securities borrowing demand.  Unfortunately those hopes were dashed fairly early on as hedge funds continued to get net longer rather than shorter and proprietary trading for investment banks in the equity space was virtually non-existent.  Revenues were hammered across the board, and although inevitably some firms did well, I sense the feeling across the industry was one of disappointment.

Much progress was made in terms of education, information and communication and I think this sets the stage for a better future.  After all, revenues ebb and flow over the years, whereas informed market participants ensure a stable operating core for the business.  I have said that I believe that we are in the midst of a 5-7 year reshaping of the industry and I am hoping that the surprise, shock and revelations of the past three years of Liquidity Crisis, Reinvestment Losses and Lehman Default are Ghosts of the Past rather than Ghosts of the Future.

I recently ran a survey and haven't had time to share the results with you yet.  The most important statement asked for views on  Securities Lending itself.  "Securities Lending is a risky business that has generated substantial losses."  The results are shown in the chart below. 

Let me first acknolwedge that the survey is self-selecting to an extent.  People that follow the blog or have seen the survey displayed on LinkedIn or Twitter are by definition interested in securities lending and most, if not all have a vested interest in it continuing as is.  Yes, I get that, and accept the bias.  However, I also have a lot of people who follow me specifically because they HATE securities lending (or at least the short selling associated with securities lending).  They are usually pretty good at stirring up contrary feelings.

The results:

So you can see that people overwhelmingly believe the business to be low risk.  Is that correct, given the well publicised losses that a number of Beneficial Owners experienced?  In any investment prouct - which securities lending is - participants should recognise that there are "Up" years and "Down" years and it is the relative volatility and depths of losses that decide the degree of risk.  

The liquidity crisis and Lehman's default created a perfect storm which resulted in actions by hedge funds, prop traders and Beneficial Owners that triggered some losses and exacerbated what would otherwise have been small losses.  The actual degree of default in cash reinvestments remains low, and much of the negative performance was due to forced sales. 

Given the history of profitable annual returns in securities lending year after year, followed by turmoil for a significant, but small proportion of the overall lending community, it seems that the survey results are an accurate reflection of the return risk that securities lending presents.  Securities lending has generated consistently positive returns for investors year afer year.

Compare that with underlying portfolio losses during the same period which was pervasive across both the institutional and retail investment community and one can't help but reach the conclusion that overall this business is one that generates a useful return that cumulatively benefits portfolios over time.  Not without risk, but one that if properly understood by investors and professionally practiced by providers, securities lending is low risk and additive to fund performance.

I wish you all the best over the Holiday Season and hope you have a Happy, Healthy and Successful 2011.

 

Securities Lending – Truth or Fiction?

Yesterday I had the pleasure of speaking at the Global Custody Forum in London.  I was a panellist on the securities lending panel alongside a very strong group of fellow speakers:  Sarah Nicholson, who is responsible for securities finance at Aviva Investors, Tony Baldwin who heads up funding at Daiwa Capital Markets, which includes repo trading and treasury, and David Carruthers, Segment Director at DataExplorers.  Our fearless panel leader was Sunil Daswani, head of sales  and relationship management for securities lending at Northern Trust. 

When Sunil was taking us through the panel session preparation someone came up with the idea of putting forward some of the myths of the industry and exploding them for the audience.  Having done about a thousand conferences this year, I know that things don’t go according to plan, and we had more than enough to talk about without getting to the myths.  Seems a bit of a shame to waste the idea, so I thought I would float it out there and get your views.

I have included a few questions in the survey pop-up below and I’d like your views.  Once we get enough responses I will come back and respond to the issues.  So, now it’s over to you – what do you think?

Take the Survey - Four Questions, 30 Seconds!

In the meantime, I will use the interim results at the two conferences I am chairing before the end of the year.  Tomorrow (Thursday 2 December) I will be in Luxembourg for the GSL Luxembourg Securities Lending Summit and next Thursday, 9 December I will be in Dubai for our Middle East Summit.  I’ll be discussing the myths and the survey at both events and when I post my blog response next week some time, I will include comments from the events.