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Steven V. Mann Professor of Finance Moore School of Business. Cash collateral reinvestment. Securities lending is an investment strategy. Securities lending is an investment strategy in which beneficial owners of securities loan their securities to generate additional return

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Steven v mann professor of finance moore school of business

Steven V. Mann

Professor of Finance

Moore School of Business

Cash collateral reinvestment


Securities lending is an investment strategy
Securities lending is an investment strategy

  • Securities lending is an investment strategy in which beneficial owners of securities loan their securities to generate additional return

  • Loans are collateralized usually with cash (102% or 105%)

  • Transfers ownership of the securities including the voting rights but retains the economic benefits

  • Cash dividends and market value continue to accrue to the lender


Who borrows and why
Who borrows and why?

Who borrows?

Motivations for borrowing?

  • Broker/dealer firms

  • Hedge funds

  • Institutional investors

  • Cover a short position (e.g., settlement coverage, convertible bond arbitrage)

  • Financing

  • Temporary transfers of ownership (e.g., tax arbitrage, dividend reinvestment plan arbitrage)


Who lends securities and why
Who lends securities and why?

Who lends?

Motivations for lending?

  • Mostly buy-and-hold investors of actively traded securities – insurers, pension funds, mutual funds, endowments…

  • Generate incremental return

  • Defray expenses of holding a portfolio of securities

  • Monetize the premium from holding hard-to-borrow securities


Mechanics of a securities lending transaction
Mechanics of a securities lending transaction

Two elements of the transaction

Loan of a security

Cash Collateral Reinvestment


A basic securities lending transaction act i
A Basic Securities Lending Transaction – Act I

Cash Collateral

Securities Lender

Securities Borrower

Lending Agent

Securities

Securities

Cash Collateral

Cash Collateral Pool


A basic securities lending transaction act ii
A Basic Securities Lending Transaction – Act II

Cash Collateral

Securities Lender

Securities Borrower

Lending Agent

Securities

Securities

40% of Gross Spread

Cash Collateral

60% of Gross Spread

Rebate

Cash Collateral Pool


What are the inherent risks
What are the inherent risks?

Counterparty risk

Reinvestment risk

  • borrower defaults and fails to return securities

  • risks associated with investing the cash collateral – interest rate risk, credit risk, liquidity risk, etc.


What are the inherent risks1
What are the inherent risks?

Legal risk

Operational risk

  • compliance with the terms of the agreement, program guidelines, etc.

  • processing error in the securities lending infrastructure


Investing the cash collateral
Investing the cash collateral

  • When cash is the collateral (called cash collateral), the proceeds are reinvested by the security lender or the lending agent.

  • The security lender faces the risks associated with reinvesting the cash.

  • The fee earned by the security lender is then the difference between the income earned from reinvesting the cash and the amount the security lender agrees to pay the security borrower.

  • Fee split with lending agent


Embedded fee vs rebate
Embedded fee vs. rebate

  • The security lender's fee is called an embedded fee when there is cash collateral.

  • The agreed upon amount that the security lender pays to the security borrower is called a rebate (negotiated interest rate).

  • Security lender only earns a fee if the amount earned on reinvesting the cash collateral exceeds the rebate.

  • In fact, if the amount earned is less than the rebate, the security lender incurs this cost.

  • Indemnification


Borrow fee
Borrow fee

  • When collateral is letter of credit or security, security borrower compensates security lender by a predetermined fee.

  • This fee is called a borrow fee and it is based on the value of the security borrowed.


Return is uncertain with cash collateral
Return is uncertain with cash collateral

  • Notice that while the security lender knows what the fee will be in the case of non-cash collateral (assuming no default), this is not the case when there is cash collateral.

  • The fee is a function of the performance of the portfolio or security in which the cash collateral is reinvested.


Cash collateral reinvestment then and now
Cash collateral reinvestment then and now

  • Prior to the financial crisis, cash collateral pools began lengthening maturity and moving down in credit quality

  • Investing in structured products that were highly rated but were exposed to other risks

  • Highlights the importance of choosing an investment strategy consistent with one’s risk tolerance.



Cash collateral reinvestment and which securities to lend
Cash collateral reinvestment and which securities to lend

  • Cash collateral investment and securities lending are distinct decisions but they are not independent

  • How much of my portfolio should I lend? How much cash should I borrow?

  • Which securities should I lend? How much risk am I willing to take?


Three paths forward
Three paths forward…

  • Low margin/high turnover

  • Hard-to-borrow

  • asset/liability management


A guide for moving forward
A Guide for Moving Forward

  • Think about risk holistically

  • De-leveraging

  • Revisit contracts/agreements/guidelines and adjust accordingly

  • Consider separately managed collateral pools if the alternatives are unappealing


A guide for moving forward1
A Guide for Moving Forward

  • Perform return attribution analysis – know how the returns were achieved

  • Alternative forms of collateral


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