Securities Lending - IMN Conference: Cash versus Non-cash Collateral
Posted 18 February 2011 - 6:36am by Roy Zimmerhansl
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.
Body
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.
