In the last six months, the impact of the credit crunch on the securities lending market has been rewarding for those with the right investment strategy, according to a paper released by the Spitalfields Advisors.
The scale of the securities lending market and its impact upon the short-term money markets of the world has never been more important or appreciated. For an industry that is so often the whipping boy for market instability it is most welcomed and unusual to be recognised as part of the solution rather than part of the problem.
As in any part of the financial world, where volatility exists, so does the potential to make above average returns. This gave securities lenders the opportunity to gain greater returns. Data from the Performance Explorer Service shows that Re-investment Returns to Lendable Assets in recent months, across all asset classes, have been multiples of average 2007 levels. And these conditions might set the tone for 2008.
The recent turmoil has not only created profit opportunities for some, but also some interesting discussion points for the securities lending industry, such as the importance on knowing the measurement of risk.
Risk, and the measurement of risk-adjusted-returns, is at the forefront of most beneficial owners’ minds as they try and come to terms with lending programmes that have changed character significantly over recent months. It is to be expected that beneficial owners will dedicate more resources to the management of their securities lending programmes and in particular collateral and re- investment guidelines going forward.
The credit crunch also brings to focus the historic borrower-lender relationship, and the question raised is if this relationship has changed. The pressures that have affected supply and conflicting collateral, liquidity and capital demands have placed relationships under extreme strain at times. It remains unclear whether the relationship has strengthened in the heat of battle or if the traditional dynamic is altered.
The recent credit crunch has impacted the market as a whole. The shortage of cash liquidity in the capital markets has prompted two key things: Firstly, the cost and demand for government bonds has increased, prompting Securities Lending Return To Lendable Assets for US Governments to rise.
Secondly, the extreme balance sheet pressure the borrowers are experiencing has led to concerns that borrowers would either return loans secured versus cash collateral or have to substitute cash for non-cash collateral. If this were to happen it would force a liquidation of re-investment assets – some of which may be loss-making due to the re-pricing of risk in the market place.
In reaction, lenders raised rebates to maintain cash balances (sometimes effectively lending some securities for nothing or even at a loss) – and it’s a tactic that has worked to a large degree so far. Balances versus cash collateral have remained broadly unchanged, whilst the percentage of revenue share from reinvestment activity has soared. On occasions it has even exceeded 100%.
There are now a number of securities lending programmes that are effectively mis-named. Such is their orientation and revenue generation profile, they are more appropriately “re-investment” or “leveraged finance” programmes. Some might say the “tail is now wagging the dog.”
Securities lenders who re-invested cash collateral were presented with the opportunity to buy the same assets they were buying before, but this time with a reward that was two-to-three times higher for taking the same risk. However, as yields rose, prices fell – meaning those already holding these securities were suffering mark-to-market losses. The adoption of either mark-to-market accounting polices or an accrued methodology played an important role in the transparency and communication of this situation to the underlying beneficial owners who bear most – if not all – re-investment risk.
This was the challenge for lenders and their agents – to maintain cash collateral balances, avoid crystallising their losses on existing positions and, meantwhile take advantage of the exceptional re-investment return environment.
The credit crunch has had a very significant impact on the securities lending market. It has created a unique-in-recent-times environment for lenders to earn exceptional returns. It also shows no sign of ending soon as further central bank money is injected into the global banking system and concerns persist as to the amount of losses global financial institutions really are carrying.
Time will tell whether this is, in fact, a great buying opportunity for those with a risk appetite and patience to weather the storm.