New Opportunities in Securities Lending

Opportunities in Securities Lending
Beneficial owners can benefit from stringent risk management and by accepting more types of collateral

By Don D’Eramo, senior managing director, securities finance division, State Street Canada

The recent turmoil in the global financial markets has accelerated the transformation of the securities finance industry in Canada. Once a quiet, back-office function that generated modest returns and little attention, securities lending has since become a highly complex undertaking—albeit one still capable of yielding significant returns when properly managed for risk. As such, success in today’s market will be borne in part out of beneficial owners’ ability to recognize and understand the risks inherent in securities lending.

Going forward, well-informed institutional investors with securities to lend must continue to reassess their risk/reward parameters. This will be a crucial first step in deciding how to participate in the evolving marketplace and, importantly, what types of collateral are acceptable to secure their lending transactions.

Collateral: non-cash assets versus cash
As recently as five years ago, virtually all securities lending transactions by agent lenders in Canada was backed by non-cash collateral—typically government bonds. Today, rather than restricting themselves to one security type, some beneficial owners meet borrowers’ demands by accepting, in addition to government securities, bank paper, corporate debt, equities and other securities as collateral. Beneficial owners who take in a variety of non-cash collateral can participate in more transactions, potentially garnering higher revenues. They can also benefit—from a risk management perspective—as price volatilities of their collateral pool may match those of the loan.

Cash is another viable collateral type that is an important component of Canadian securities lending transactions. In the months leading up to the current market predicament, cash-collateralized loans provided beneficial owners with revenues substantially higher than loans with non-cash collateral, due in part to the favourable interest rate environment, widening credit spreads, and many borrowers’ penchant for putting up cash instead of other securities. Those beneficial owners who were willing to meet these preferences experienced greater utilization of their lending programs and higher revenue per transaction because of the resulting wider investment spreads.

Following the market events of this past summer, cash continues to be important, although risk management is a primary focus as beneficial owners have become more diligent when accepting cash as collateral. While there are risks associated with cash-collateralized loans, it remains a good option for beneficial owners as long as they are aware of the risks and their own unique tolerances and are vigilant in their risk management practices.

Success through risk management and flexibility
In today’s market, collateral management continues to have a major impact on the revenue a securities lending program can generate. After examining its own risk/reward tolerances for non-cash and cash collateral types, a beneficial owner needs to select a strategy and establish guidelines that its lending agent can pursue on its behalf. To make informed decisions, a beneficial owner must receive accurate and timely information from its agent regarding the conditions in the marketplace. Further, it needs to fully understand what its agent is doing with both the lending and asset management components, regularly monitor performance and risk management reporting and be continuously engaged in the program.
Looking ahead, beneficial owners will need to ensure providers have the resources, scale, oversight, and proper risk management, to execute their preferred approach to securities lending. Better informed, these beneficial owners are likely to decide that having a flexible collateral management plan can pay attractive dividends in all market conditions.

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