Sunday, February 12, 2017

Bizarre Collateral in Securities Lending Exposed by Bank of Mellon

This article was first published by me on Talkmarkets:

There is a bizarre use of collateral these days, and it is exposed by Bank of Mellon. First of, the banks are being advised by certain bankers to hoard bonds.  And counterparties are encouraged to bolster their stock and securities positions by using stocks as collateral! The securities lending market often is used for short positions in the stock market.

Here is a definition of securities lending from Investopedia:

Securities lending is the act of loaning a stock, derivative or other security to an investor or firm. Securities lending requires the borrower to put up collateral, whether cash, security or a letter of credit. When a security is loaned, the title and the ownership are also transferred to the borrower.

Peter Venkman once said in Ghostbusters something to the effect that we have dogs and cats, and mass hysteria. I think that in securities lending, defined below, we  are finding out we have exactly that.

Based on data from the four main tri-party service providers in Europe (BNY Mellon, Clearstream, Euroclear and JP Morgan) – which collectively hold the vast majority of non-cash collateral received by lenders – 57% of securities held in tri-party were equities at the end of June 2015, up from 53% six months earlier. Clearly, post-crisis regulatory and macro-economic trends have turned conventional wisdom in the securities lending market (i.e., where asset owners historically lent out equities in return for government bonds as collateral) on its head! [emphasis mine]
Tri-party acts as a clearing house, a third party that holds the collateral for the securities lending market. Mutual funds, ETF's, insurance companies, and pension funds are often the main lenders and hedge funds are the primary borrowers.

Hedge funds appear to be taking advantage of this arrangement, as the collateral in a downturn would be worth far less than the original loan amounts which would seem to breach fiduciary requirements of pension funds and insurance companies. Other dangers and disadvantages are shown at this second Investopedia article.  However, the tri-party market may increase the safety of this market.

Offsetting that safety is the use of non cash collateral. Even the author of the above quote, Steve Kiely, EMEA Head of Securities Finance New Business Development BNY Mellon Markets Group, appears to be astonished at the amount of non cash collateral, ie stocks being used as collateral. Because of this change, banks are being encouraged to hoard treasury bonds (as if there was not already enough demand for bonds):

Although low interest rates and the very real possibility of downgrades for OECD government bonds have played their part, Basel III’s Liquidity Coverage Ratio (LCR) and Net Stable Funding Ratio (NSFR) are the key reasons for this switch. These ratios encourage banks to hoard high-quality liquid assets (HQLAs) – largely government  bonds, while other aspects of the Basel capital and liquidity framework (which is being rolled out by national regulators up to 2019) punish balance sheet holdings of equity securities. Moreover, lenders that are naturally long on equities can experience operational and cost efficiencies in accepting equities as collateral, even when lending out equities.
Needless to say, this is risky business as Mr Keily goes on to say. And hoarding of bonds in this theater is sort of Japan-like, and hoarding in general is, well, a reason why yields are low, not only in this area, but also throughout structured finance.

The new ISLA report has stocks used as collateral standing at 48 percent of all collateral in tri-party as of June, 2016. That is a pretty large drop from 57 percent the year before. Does this mean that banks are getting nervous about equities as collateral? They certainly have deleveraged and have used more bonds as collateral in 2016. That will further increase demand for bonds.

Perhaps equity collateral makes less sense if a potential crash is considered, forcing margin calls and putting institutions who loaned out the money at great risk of violating their fiduciary responsibilities. If the Bank of Mellon is concerned about the risk in this market, perhaps individual investors, pensioners, and those insured by insurance companies should be as well. 

No comments:

Post a Comment