Fan of the mismatch
05 September 2017
Experts debate whether equities as collateral will ever be acceptable
Image: Shutterstock
As beneficial owners face pressure to accept lower quality assets as collateral for their HQLA, should they be accepting equities, or are their concerns about quality warranted?
Peter Hutchinson
Managing partner
Consolo
Traditional thinking is that the safest form of collateral is the asset that is most correlated to the asset being lent. This gives assurances that in a market crisis, the lent asset and the collateral against it will move in the same direction.
In the case of high-quality liquid assets (HQLA), the assumption is that in a crisis the market price will increase due to a 鈥榝light to quality鈥�. Therefore, it is logical that when lending HQLA, the best form of collateral is other HQLA. This is a safe assumption, although in the case of government bonds, not all are equal. However, there is little or no value to the borrower in like-for-like transactions for capital management purposes, and so in order to be commercially attractive, lenders need to move away from this tight correlation.
Taking equities as collateral against HQLA may be a way beneficial owners can increase returns without necessarily significantly increasing risk, provided detailed analysis is undertaken and the equities carefully chosen.
Collateral is intended to be utilised when a counterparty defaults, and the surviving counterparty needs to replace assets that have been lent. This process in almost always undertaken in volatile markets where other firms are in the same situation of trying to close out positions. It is inevitable that it becomes a 鈥榝ire sale鈥�, and the most important aspect of the market is going to be the ability to trade.
On the surface, equity seems to be an unlikely form of collateral to accept against HQLA. Where HQLA is likely to increase in value in a crisis, equities are likely to fall, and the negative correlations can be seen in historical data over and over again. However, there is a predictability in these behaviours and any potential shortfall risk can be measured using historical data and mitigated by increased haircuts.
During the 2008 financial crisis, one of the biggest issues lenders faced was the ability to sell. Firms were caught out with highly rated corporate bonds that couldn鈥檛 be sold because of the liquidity squeeze. The price to replace the lent HQLA was increasing while the collateral couldn鈥檛 be sold and firms faced having to sell well below market just to realise the collateral. Firms that held equities had no such problems. In many cases, hedge funds were seeking to close out short positions and were active buyers of equities in the market adding to liquidity. Although markets fell, liquidity was maintained and provided the level of over collateralisation (haircut) was sufficient, lenders were able to replace lent HQLA without loss.
Of course, quality still matters and a lender needs the equity to be trading after a counterparty default. Due diligence is key but with sufficient analysis, and appropriate haircuts, I would strongly argue that equities can be good collateral against HQLA lending.
Tracey Adams
Regional head of product for the Asia Pacific
Lombard Risk
As high-quality collateral becomes scarcer, many institutions are concerned by the cost of high-quality liquid assets (HQLA). While some beneficial owners are willing to accept lower quality collateral, others prepare to compete on the quality of collateral they agree to accept. In an environment where collateral scarcity and mobility has become a fundamental concern, clarity and ease of use rank higher鈥攅ven over cost. Cost will always be an important factor but the values of collateral must remain. This means collateral must be tangible, high-quality, liquid and easy to value. This is critical in maintaining the core principles of Basel III and the US Dodd-Frank Act.
Recent years have witnessed the growth in the use of equities as collateral and this is expected to continue. The market is moving further towards a non-cash collateral environment, with equities playing a major role. An independent study conducted in Q1 2017 found that cash collateral as a percentage of on-loan balance was around 40 percent while non-cash collateral was 60 percent, up slightly from 2016.
From a lending perspective, as well as providing greater returns, equities are widely available and on balance sheet. That said, this is only one segment of the market. There are many who believe there are limits on the use of equities as collateral. Even in terms of stock loans, many beneficial owners still regard price volatilities on equities as unacceptably high risk.
If we turn to other collateral market areas, central counterparties (CCPs) for example, equities are widely considered too risky. In many cases, equities are excluded (such as by LCH), while some CCPs such as Eurex Clearing, LCH SA and CC&G accept equities subject to strict limitations. This include haircuts, concentration limits and other requirements, for example, being part of a leading market index.
Equally, rulings under the Basel Committee on Banking Supervision (BCBS) and the International Organization of 色花堂Commissions (IOSCO) framework have signified a clear move away from non-cash collateral in favour of cash collateral. Rather than a question of whether accepting lower quality assets as collateral for high-quality liquid assets (HQLA) is a good idea, firms should ask themselves if they have the best processes and levers for enhancing collateral values.
Many institutions have been proactive in upgrading technology and changing organisational structures to improve asset mobility, while others still need to consider the value chain and assess the steps that make it possible to select an all-encompassing securities inventory which includes availability, agility and robustness. At the basic level, this means getting the operations right. Is the system still defining eligibility the same way that it did five years ago?
Does the collateral and settlement solution have an unnecessary number of systems and portals in between one another, hindering the settlement process? Such measures include cross product (or enterprise-wide) collateral management solutions, where inventories and available assets are pooled, projected on, ranked in terms of high quality and linked to a robust and scalable optimisation tool.
In turn, the optimisation tool must be linked to the collateral management inventory to ensure that a true cost of collateral can be assessed, including the weighting on the balance sheet.
Collateral must be tangible, of a high-quality, liquid and easy to value鈥攎ainstream equities generally fulfil this industry criteria provided the equities are listed on a main stream share index. If termed, and with an appropriate haircut, one could argue that equities can easily be accepted as collateral against HQLA. Indeed, Rule 15c3-3 in the US has brought forward this very notion. However, aside from the lending argument, what remains fundamental is the proper collateral management infrastructure that enables the entire process, regardless of asset class.
Walter Kraushaar
Head of sales and advisory business.
Comyno
To answer this question, it is worth looking into the history of the securities lending business of the big US-based beneficial owners, where cash collateral is still 鈥榢ing鈥� and all the relevant risk management, trading and settlement systems were designed to mainly handle rebate trades on a delivery-versus-payment (DVP) basis.
All existing operational and IT infrastructure of the industry, ie, the core securities lending and repo systems, practices and technologies have been built around the DVP model. As such, all non-cash collateral was and still is, even in Europe, where fee-based cash pool trades have always been conducted.
Subsequently, the existing IT infrastructure is also still not managing non-cash collateral in a state-of-the-art and efficient way. Most purpose-built US securities lending systems try to understand non-cash/fee-based loans and borrows by treating them as pseudo-cash transactions in one way or another, which causes a lot of manual and expensive workarounds for the beneficial owners.
However, the need of a general upgrade of the IT infrastructure is unavoidable, given today鈥檚 global markets and regulatory environment.
In today鈥檚 short-term interest rate environment, technically speaking, rebates on cash investment really don鈥檛 exist anymore. Cash investment returns are so low that lenders no longer pay much if anything in rebates. The business has essentially become a fee-based business utilising an oxymoron鈥搕he negative rebate. A rebate that is 鈥榥egative鈥� is just a fee under another name. In addition, borrowers are hit for larger capital utilisation costs than ever before. Under the liquidity coverage ratio (LCR) and net stable funding ratio (NSFR) calculations, resulting in more stringent capital reserve rules, the cost of using cash collateral against less liquid collateral (equities) has increased dramatically.
It is fair to say that from a pure risk perspective and without the infrastructural boundaries, equities offer some substantial advantages against cash and other non-cash collateral even for the collateral taker:
In the case of the default of a counterparty, main index equities are always liquid and easy to sell at the various exchanges
There is 鈥榓lways鈥� a market and a standard settlement process for this asset class鈥攁fter all, it is traded on a stock exchange
Lending out fixed income securities against equities is a 鈥榥on-correlated鈥� transaction from a risk point of view for the beneficial owner
Lending out high-quality liquid assets (HQLA) will result in a higher return for the beneficial owner
However, despite the obvious advantages of equity collateral, many beneficial owners are still struggling to open up their collateral policies into the asset class of equities as they have infrastructural issues revolving around risk and operational process. Equities collateral change the risk equation (and who carries the risk) in fundamental ways, and are far less of a straight-through process than cash collateral.
There may not be a regulatory mandate, but there is a compelling business case to be made for tackling this issue once and for all. Every stakeholder will derive real financial benefit鈥攕traight to the bottom line.
John Arnesen
Global head of agency lending
BNP Paribas
Concerns about accepting equities as collateral are well documented and while the trend is moving to greater acceptance, it is still not fully acceptable under certain regulation in the US. Ironically, it is regulation that has led to a boom in the posting of equities via high-quality liquid assets (HQLA) term trades.
Beneficial owners need to consider several factors when reviewing lending opportunities with diverging levels of loan collateral credit quality. Before deciding on which collateral to accept, lenders need to assess the credit and liquidity risk of accepting collateral upgrade or downgrade structures within their programmes.
If working with an agent offering indemnification, lenders should assess the capital strength of their agent lender鈥檚 balance sheet as well as examining their overall securities lending programme and track record. Lenders need to ask themselves: to what extent does the indemnification policy cover miss-matched collateral? Does the policy cover equities as collateral against fixed income loan transactions?
Beneficial owners typically earn proportionately higher revenues as the credit gap widens between the securities lent and the corresponding collateral. Indemnification can add to the mitigation of risks associated with a loan and collateral credit divergence as, in the event of a borrower default, the agent providing the indemnity will cover any shortfall in the value of the liquidated collateral. As principal to the borrower albeit through an agent, the lender is exposed to agent credit risk. To neutralise this risk, indemnified agency lending programmes provide access to a diversified list of counterparties.
Credit quality is one factor that requires consideration but the argument that liquidity is potentially a more important factor is valid. Taking government or high-grade corporate fixed income securities as collateral against loans of the same quality are clearly well correlated but unless deeply special, will not produce meaningful fees鈥攊f any fee or demand at all. Less well-correlated trades do present greater revenue opportunity as described in the typical HQLA transactions, which are generally collateralised by primary index equities. There is little argument about the liquidity of exchange-traded equities so despite the mismatch of asset classes, is this actually a readily liquid transaction?
The lion鈥檚 share of our programme accepts equities as collateral and that isn鈥檛 restricted to assets managers but includes central banks and sovereign wealth funds. The analysis these institutions undertake is rigorous so there is clearly a general recognition of the value of equities as an acceptable asset class as collateral.
Sunil Daswani
Senior vice president and international head of securities lending, capital markets
Northern Trust
Northern Trust has accepted equities as collateral for a number of years, versus both equity and fixed income loans. It is our role as a lending agent to have educational discussions with clients regarding these options, allowing them to make an informed decision on election strategies that fit their risk-reward appetite.
In order to optimise the value of a client鈥檚 portfolio, one of the many strategies we employ is to accept equities for clients where this collateral helps achieve their lending objectives and is within their risk tolerances.
In the current regulatory regime, we are all accustomed to, our comprehensive and efficient risk, capital, and collateral management model is compliant with advanced risk requirements as detailed by Basel III. Northern Trust鈥檚 systems and procedures have sufficient functionality to facilitate a flexible, rule-based collateral management approach. Acceptable collateral is thereby maximised according to lender, regulatory and bank rules, including concentration checks and sophisticated inclusion/exclusion rules. The model鈥檚 underlying assumptions are reviewed frequently and these policies incorporate robust back-testing and stress testing procedures.
Ongoing asset purchase programmes from global central banks continue to drain the supply of sovereign and corporate bonds, making these expensive forms of collateral. Clients that want to maintain utilisation, while adding new revenue opportunities, should consider accepting equities as collateral. This trade type works well for clients with a deep and stable inventory of highly-rated sovereign bonds, particularly if they expect to hold the bonds over a three-month time horizon. Accepting equities as collateral can lead to increased borrower diversification, often allowing clients to face higher-rated counterparts they may not have transacted with previously, while in a stressed market environment, main index equities maintain liquidity.
As always, Northern Trust would only recommend accepting equities in a risk-controlled manner, forming part of well-diversified and well-laddered pool of collateral options.
Peter Hutchinson
Managing partner
Consolo
Traditional thinking is that the safest form of collateral is the asset that is most correlated to the asset being lent. This gives assurances that in a market crisis, the lent asset and the collateral against it will move in the same direction.
In the case of high-quality liquid assets (HQLA), the assumption is that in a crisis the market price will increase due to a 鈥榝light to quality鈥�. Therefore, it is logical that when lending HQLA, the best form of collateral is other HQLA. This is a safe assumption, although in the case of government bonds, not all are equal. However, there is little or no value to the borrower in like-for-like transactions for capital management purposes, and so in order to be commercially attractive, lenders need to move away from this tight correlation.
Taking equities as collateral against HQLA may be a way beneficial owners can increase returns without necessarily significantly increasing risk, provided detailed analysis is undertaken and the equities carefully chosen.
Collateral is intended to be utilised when a counterparty defaults, and the surviving counterparty needs to replace assets that have been lent. This process in almost always undertaken in volatile markets where other firms are in the same situation of trying to close out positions. It is inevitable that it becomes a 鈥榝ire sale鈥�, and the most important aspect of the market is going to be the ability to trade.
On the surface, equity seems to be an unlikely form of collateral to accept against HQLA. Where HQLA is likely to increase in value in a crisis, equities are likely to fall, and the negative correlations can be seen in historical data over and over again. However, there is a predictability in these behaviours and any potential shortfall risk can be measured using historical data and mitigated by increased haircuts.
During the 2008 financial crisis, one of the biggest issues lenders faced was the ability to sell. Firms were caught out with highly rated corporate bonds that couldn鈥檛 be sold because of the liquidity squeeze. The price to replace the lent HQLA was increasing while the collateral couldn鈥檛 be sold and firms faced having to sell well below market just to realise the collateral. Firms that held equities had no such problems. In many cases, hedge funds were seeking to close out short positions and were active buyers of equities in the market adding to liquidity. Although markets fell, liquidity was maintained and provided the level of over collateralisation (haircut) was sufficient, lenders were able to replace lent HQLA without loss.
Of course, quality still matters and a lender needs the equity to be trading after a counterparty default. Due diligence is key but with sufficient analysis, and appropriate haircuts, I would strongly argue that equities can be good collateral against HQLA lending.
Tracey Adams
Regional head of product for the Asia Pacific
Lombard Risk
As high-quality collateral becomes scarcer, many institutions are concerned by the cost of high-quality liquid assets (HQLA). While some beneficial owners are willing to accept lower quality collateral, others prepare to compete on the quality of collateral they agree to accept. In an environment where collateral scarcity and mobility has become a fundamental concern, clarity and ease of use rank higher鈥攅ven over cost. Cost will always be an important factor but the values of collateral must remain. This means collateral must be tangible, high-quality, liquid and easy to value. This is critical in maintaining the core principles of Basel III and the US Dodd-Frank Act.
Recent years have witnessed the growth in the use of equities as collateral and this is expected to continue. The market is moving further towards a non-cash collateral environment, with equities playing a major role. An independent study conducted in Q1 2017 found that cash collateral as a percentage of on-loan balance was around 40 percent while non-cash collateral was 60 percent, up slightly from 2016.
From a lending perspective, as well as providing greater returns, equities are widely available and on balance sheet. That said, this is only one segment of the market. There are many who believe there are limits on the use of equities as collateral. Even in terms of stock loans, many beneficial owners still regard price volatilities on equities as unacceptably high risk.
If we turn to other collateral market areas, central counterparties (CCPs) for example, equities are widely considered too risky. In many cases, equities are excluded (such as by LCH), while some CCPs such as Eurex Clearing, LCH SA and CC&G accept equities subject to strict limitations. This include haircuts, concentration limits and other requirements, for example, being part of a leading market index.
Equally, rulings under the Basel Committee on Banking Supervision (BCBS) and the International Organization of 色花堂Commissions (IOSCO) framework have signified a clear move away from non-cash collateral in favour of cash collateral. Rather than a question of whether accepting lower quality assets as collateral for high-quality liquid assets (HQLA) is a good idea, firms should ask themselves if they have the best processes and levers for enhancing collateral values.
Many institutions have been proactive in upgrading technology and changing organisational structures to improve asset mobility, while others still need to consider the value chain and assess the steps that make it possible to select an all-encompassing securities inventory which includes availability, agility and robustness. At the basic level, this means getting the operations right. Is the system still defining eligibility the same way that it did five years ago?
Does the collateral and settlement solution have an unnecessary number of systems and portals in between one another, hindering the settlement process? Such measures include cross product (or enterprise-wide) collateral management solutions, where inventories and available assets are pooled, projected on, ranked in terms of high quality and linked to a robust and scalable optimisation tool.
In turn, the optimisation tool must be linked to the collateral management inventory to ensure that a true cost of collateral can be assessed, including the weighting on the balance sheet.
Collateral must be tangible, of a high-quality, liquid and easy to value鈥攎ainstream equities generally fulfil this industry criteria provided the equities are listed on a main stream share index. If termed, and with an appropriate haircut, one could argue that equities can easily be accepted as collateral against HQLA. Indeed, Rule 15c3-3 in the US has brought forward this very notion. However, aside from the lending argument, what remains fundamental is the proper collateral management infrastructure that enables the entire process, regardless of asset class.
Walter Kraushaar
Head of sales and advisory business.
Comyno
To answer this question, it is worth looking into the history of the securities lending business of the big US-based beneficial owners, where cash collateral is still 鈥榢ing鈥� and all the relevant risk management, trading and settlement systems were designed to mainly handle rebate trades on a delivery-versus-payment (DVP) basis.
All existing operational and IT infrastructure of the industry, ie, the core securities lending and repo systems, practices and technologies have been built around the DVP model. As such, all non-cash collateral was and still is, even in Europe, where fee-based cash pool trades have always been conducted.
Subsequently, the existing IT infrastructure is also still not managing non-cash collateral in a state-of-the-art and efficient way. Most purpose-built US securities lending systems try to understand non-cash/fee-based loans and borrows by treating them as pseudo-cash transactions in one way or another, which causes a lot of manual and expensive workarounds for the beneficial owners.
However, the need of a general upgrade of the IT infrastructure is unavoidable, given today鈥檚 global markets and regulatory environment.
In today鈥檚 short-term interest rate environment, technically speaking, rebates on cash investment really don鈥檛 exist anymore. Cash investment returns are so low that lenders no longer pay much if anything in rebates. The business has essentially become a fee-based business utilising an oxymoron鈥搕he negative rebate. A rebate that is 鈥榥egative鈥� is just a fee under another name. In addition, borrowers are hit for larger capital utilisation costs than ever before. Under the liquidity coverage ratio (LCR) and net stable funding ratio (NSFR) calculations, resulting in more stringent capital reserve rules, the cost of using cash collateral against less liquid collateral (equities) has increased dramatically.
It is fair to say that from a pure risk perspective and without the infrastructural boundaries, equities offer some substantial advantages against cash and other non-cash collateral even for the collateral taker:
In the case of the default of a counterparty, main index equities are always liquid and easy to sell at the various exchanges
There is 鈥榓lways鈥� a market and a standard settlement process for this asset class鈥攁fter all, it is traded on a stock exchange
Lending out fixed income securities against equities is a 鈥榥on-correlated鈥� transaction from a risk point of view for the beneficial owner
Lending out high-quality liquid assets (HQLA) will result in a higher return for the beneficial owner
However, despite the obvious advantages of equity collateral, many beneficial owners are still struggling to open up their collateral policies into the asset class of equities as they have infrastructural issues revolving around risk and operational process. Equities collateral change the risk equation (and who carries the risk) in fundamental ways, and are far less of a straight-through process than cash collateral.
There may not be a regulatory mandate, but there is a compelling business case to be made for tackling this issue once and for all. Every stakeholder will derive real financial benefit鈥攕traight to the bottom line.
John Arnesen
Global head of agency lending
BNP Paribas
Concerns about accepting equities as collateral are well documented and while the trend is moving to greater acceptance, it is still not fully acceptable under certain regulation in the US. Ironically, it is regulation that has led to a boom in the posting of equities via high-quality liquid assets (HQLA) term trades.
Beneficial owners need to consider several factors when reviewing lending opportunities with diverging levels of loan collateral credit quality. Before deciding on which collateral to accept, lenders need to assess the credit and liquidity risk of accepting collateral upgrade or downgrade structures within their programmes.
If working with an agent offering indemnification, lenders should assess the capital strength of their agent lender鈥檚 balance sheet as well as examining their overall securities lending programme and track record. Lenders need to ask themselves: to what extent does the indemnification policy cover miss-matched collateral? Does the policy cover equities as collateral against fixed income loan transactions?
Beneficial owners typically earn proportionately higher revenues as the credit gap widens between the securities lent and the corresponding collateral. Indemnification can add to the mitigation of risks associated with a loan and collateral credit divergence as, in the event of a borrower default, the agent providing the indemnity will cover any shortfall in the value of the liquidated collateral. As principal to the borrower albeit through an agent, the lender is exposed to agent credit risk. To neutralise this risk, indemnified agency lending programmes provide access to a diversified list of counterparties.
Credit quality is one factor that requires consideration but the argument that liquidity is potentially a more important factor is valid. Taking government or high-grade corporate fixed income securities as collateral against loans of the same quality are clearly well correlated but unless deeply special, will not produce meaningful fees鈥攊f any fee or demand at all. Less well-correlated trades do present greater revenue opportunity as described in the typical HQLA transactions, which are generally collateralised by primary index equities. There is little argument about the liquidity of exchange-traded equities so despite the mismatch of asset classes, is this actually a readily liquid transaction?
The lion鈥檚 share of our programme accepts equities as collateral and that isn鈥檛 restricted to assets managers but includes central banks and sovereign wealth funds. The analysis these institutions undertake is rigorous so there is clearly a general recognition of the value of equities as an acceptable asset class as collateral.
Sunil Daswani
Senior vice president and international head of securities lending, capital markets
Northern Trust
Northern Trust has accepted equities as collateral for a number of years, versus both equity and fixed income loans. It is our role as a lending agent to have educational discussions with clients regarding these options, allowing them to make an informed decision on election strategies that fit their risk-reward appetite.
In order to optimise the value of a client鈥檚 portfolio, one of the many strategies we employ is to accept equities for clients where this collateral helps achieve their lending objectives and is within their risk tolerances.
In the current regulatory regime, we are all accustomed to, our comprehensive and efficient risk, capital, and collateral management model is compliant with advanced risk requirements as detailed by Basel III. Northern Trust鈥檚 systems and procedures have sufficient functionality to facilitate a flexible, rule-based collateral management approach. Acceptable collateral is thereby maximised according to lender, regulatory and bank rules, including concentration checks and sophisticated inclusion/exclusion rules. The model鈥檚 underlying assumptions are reviewed frequently and these policies incorporate robust back-testing and stress testing procedures.
Ongoing asset purchase programmes from global central banks continue to drain the supply of sovereign and corporate bonds, making these expensive forms of collateral. Clients that want to maintain utilisation, while adding new revenue opportunities, should consider accepting equities as collateral. This trade type works well for clients with a deep and stable inventory of highly-rated sovereign bonds, particularly if they expect to hold the bonds over a three-month time horizon. Accepting equities as collateral can lead to increased borrower diversification, often allowing clients to face higher-rated counterparts they may not have transacted with previously, while in a stressed market environment, main index equities maintain liquidity.
As always, Northern Trust would only recommend accepting equities in a risk-controlled manner, forming part of well-diversified and well-laddered pool of collateral options.
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