US reforms forcing change to sec-lending models

Securities financing traders say that myriad rule changes are causing them to be more selective in choosing lenders and borrowers, with rising compliance costs forcing them to focus on high-margin securities.

Regulations – ranging from single-counterparty concentration limits under the US Dodd-Frank rules to US proposals targeting money-market funds – have hit securities lending to such an extent that it's no longer profitable to run a low-margin, high-volume business.

Attendants at a conference in Hong Kong last week organised by the Pan Asia Securities Lending Association (Pasla) argued that agency banks can no longer survive simply by having the largest pool of lendable assets on offer.

Jason Strofs, managing director in BlackRock’s global securities-lending division, says that, in particular, US proposals to replace the fixed $1 net asset value for money-market funds (MMFs) with a floating NAV are worrying.

“If we move to floating NAV in the US [for MMFs], that would have a significant impact on the returns of our clients,” he says. “I don’t think clients would accept the risk that you would have a negative [return] on their lending programme one month and a positive return the subsequent month, as the valuations of these money-market funds keep changing.”

Traditionally, many beneficial owners of securities who get cash collateral from their borrowers have reinvested that cash in MMFs to get reinvestment returns.

The US Securities and Exchange Commission is proposing to scrap the traditional $1 NAV for these funds, arguing that such stability encourages investors to rush for redemption on sensing the first sign of systemic issues. It cites the collapse of the $62.5 billion Reserve Primary Fund during the 2008 crisis, which in turn caused a wider run on these funds.

“Agent lenders increasingly need to look at return as measured against risks,” says Strofs. “Such money-market fund reform would constrain how agent lenders manage cash on behalf of their clients. Returns from lending certain types of securities would decrease.”

As a result, agent lenders can no longer rely on building up supply inventory comprising simply blue-chip stocks or other assets that are liquid and abundant, say custodian bankers and asset managers.

Paul York, Asia head of securities finance trading at State Street Bank and Trust, agrees that agent lenders are more closely scrutinising who and what they are lending on behalf of.

“Long gone are the days when agent banks would bid for any portfolio, or consider themselves the best simply by having the largest pool of assets,” notes York. “This is more about quality of asset class.” They now look for high-margin markets before committing themselves to a lending programme, he adds.

Meanwhile, counterparty-concentration limits proposed under the Dodd-Frank rule are also hitting agent lenders hard. Under the 'section 165' rule, any agent lender that provides clients indemnification against borrower default will be caught, whereas traditionally such indemnification had been exempted from lending limits.

As a result, agent lenders offering such indemnification will have to limit net credit exposure to a borrower of securities – as well as to the collateral issuer – to 25% of their capital. BNY Mellon estimates that section 165 could result in up to $4-6 billion in lost industry revenue.

“If agent lenders or custodians are made to write down the entire value of their indemnifying loans on their balance sheet,” says York, “that is a cost to the industry.”

In addition, this counterparty concentration limit would mean an agent lender’s hands are tied even when it has the supply of securities demanded by borrowers.

“Are we getting to a point where we have to introduce a conduit to dilute those counterparty risks?” asks York.

The value of securities on loan globally stands at $2.5 trillion, up from $1.5 trillion in mid-2012. In Asia, the figure for the top eight sec-lending markets – led by Japan, Hong Kong and Australia – is $88.7 billion, according to points collected at the conference citing Data Explorers.