The following are excerpts from the US Office of Financial Research recent report, “Asset Management and Financial Stability,” September 2013.
Inadequate risk management relating to reinvestment of cash collateral for asset management securities lending programs illustrates how redemption-like risk can create contagion and amplify financial stability shocks. Lending available securities on an over-collateralized basis was considered a low-risk method to earn incremental income for a fund or separate account before the financial crisis. In a securities lending transaction, a security is temporarily transferred to a securities borrower, who may use it for short-selling, hedging, dividend arbitrage, or market-making.28 Securities lenders often share revenues with agent lend- ers, who broker transactions, provide accounting services, manage transactions, and often reinvest the cash collateral. Most agent lenders also provide indemnity for any borrower default by paying the lender for any collateral deficiency.
If securities lenders fear a loss of value in reinvested cash collateral due to market stress, they have an incentive to recall lent securities and exit reinvestment funds. Alternatively, borrowers may seek to return securities if they believe that their posted collateral may be at risk. The most prominent example during the crisis of inadequate risk management in cash collateral reinvestment occurred in the insurance context with AIG. Through a subsidiary, AIG Securities Lending Corporation, AIG ran a large securities lending business on behalf of its life insurance subsidiaries. AIG Securities Lending Corporation’s cash collateral reinvestment practices, coupled with AIG’s financial distress, caused it to sell assets that had become illiquid at a loss in order to return the cash collateral. This substantially contributed to AIG’s losses.
This risk was not limited to AIG. Some asset managers also invested cash collateral in assets adversely affected by the financial crisis, such as structured investment vehicles and Lehman Brothers notes, and they provided financial support to those cash collateral reinvestment funds.29 The losses on cash collateral rein- vestment amplified fire sales and runs during the crisis. They also contributed to the seizing of the money markets, in which cash collateral was typically invested. Daily marks and return of collateral due to the declining stock market further stressed the liquidity of collateral reinvestment funds.
Cash collateral reinvestment practices are not generally subject to comprehensive, targeted regulation and are not necessarily transparent to regulators or clients whose securities are lent. Due to data limita- tions, it is difficult to know, at any given time, the counterparty or risk exposures created by cash collateral reinvestment.
The connection between securities lending markets and cash collateral reinvestment, redemption risk, and short-term funding markets is not well understood and is difficult to measure due to a lack of compre- hensive data.30 When cash collateral is managed in separate accounts, visibility into these connections is reduced.
Data gaps in securities lending and repo markets
As noted earlier, monitoring the reinvestment of cash collateral from securities lending is important for financial stability purposes, but such monitoring is limited by a lack of data. Collecting transaction level and position data on securities lending between large international financial institutions, including the compo- sition of the underlying cash collateral reinvestment assets, would improve regulators’ visibility into market activities.57 Section 984 of the Dodd-Frank Act requires the SEC to adopt rules increasing the transparency of information about securities lending available to broker-dealers and investors. Such a rulemaking could fill some of the data gaps described earlier.
Similar concerns exist regarding the involvement of asset managers in repo activity. During a period of market stress in which funding liquidity is drying up, firms with large repo books and an array of inter- connections may have difficulty unwinding clients’ investments quickly. Because such a situation could dislocate markets and heighten fire-sale risk, data on repo activity are critical to monitoring developments that could indicate stress. Currently, many repo transactions can be monitored only indirectly. Although the SEC is considering approaches to enhance transparency in the closely related securities lending market, collecting data at the transaction level and position level on the overall volume of repo transactions in all three market segments—the tri-party, bilateral (that is, transactions settled between dealers on a delivery versus payment basis), and general collateral markets—would provide regulators a holistic view of asset managers, as well as interconnections and concentrations within repo markets.