One panelist speaking about changes to the collateral markets: “(we) hoped they were cyclical, but they are structural.” As the derivatives world goes from OTC to a listed environment, the impact of collateral being sucked into CCPs will be a trillion dollar plus dilemma.
The dealer appetite is for “long sticky” funding but the beneficial owners need to stay “short and nimble”. This was a theme heard many times. This predicament was also described as a “rubber band stretching in two directions”. The issue goes beyond prudent risk management – regulators are pushing dealers to fund longer while telling beneficial owners to go short. One panelist interestingly noted that “borrowers aren’t prepared to pay up for term trades”, framing the issue of long versus short funding as the demand simply not stepping up to pay the right price for longer dated deals. We wonder if this may trivialize the market segmentation effect: beneficial owners simply may not be allowed to lock up trades that reduce their portfolio flexibility.
Securities lending has fully evolved from an operationally driven back office function to being part of the beneficial owners investment program. Emphasis is placed on both liability management and cash reinvestment. This is a response to the cash reinvestment issues faced post-Lehman and good for the industry.
“Indemnification will be a significant draw on capital.” We may see a bifurcated world with differentiated pricing depending on whether a program has indemnification or not. A question was asked whether this would benefit 3rd party lenders who were outside of the capital regimes? The panelists, all being from banks, artfully dodged the question. We are reminded of a comment made by a beneficial owner at the European Beneficial Owners conference last year — they said (something to the effect) that without indemnification, their board simply won’t allow their securities to be lent and the modest amount of money earned won’t be worth the risk. Ahem.
Several times the question of intrinsic value lending versus general collateral lending came up. GC was all but pronounced dead, a victim of low interest rates and conservative cash reinvest policies. Yet it was noted that GC accounts for 80% of the volume, albeit 20% of the revenue. One panelist said that “it works for some” and that “a lot of fixed income trading is driven by non-market needs” (read: pricing is based on factors other than the spread earned).
Collateral transformation or upgrade trades got a fair share of attention. They were referred to as “the next generation of trades”. But for all the focus these trades are getting, the comment that stuck with us was “lots of people are talking about it, not a lot are doing it.”
Note: We have wondered aloud if securities lenders are really the right place to do these trades. A link to an earlier post about it is here. Beneficial owners, as noted above, want to be “short and nimble”. But collateral transformation is driven by CCP collateralization and the banks wanting high quality paper for regulatory liquidity reasons. Both of these require long-term trades. No beneficial owner should want to end up like Dexia. The discussion is hitting the blogosphere too. Here is a post from “Streetwise Professor” worth taking a look at.
And no discussion is complete without a mention of the inevitability of CCPs in the securities lending space. CCPs were seen as mitigating capital costs, but at an expensive price. We heard the “this market is different” argument in that there are post-trade interactions in securities lending which differentiate it from other markets (read: corporate actions). Someone suggested that any CCP effort must come “for the industry, by the industry”. Given the indifference to CCPs in the industry, we are not holding our breath.