New York (HedgeCo.Net) – A new survey from Citi reports that rapid asset growth is occurring across a set of investment strategies that exist within a “convergence zone” where traditional money managers, hedge funds and even private equity firms are creating competing funds that demand advanced investment techniques such as shorting, derivatives and leverage.
The survey is an extension of a previous Citi report published earlier this year that examined how demand to cover short exposures, collateralize synthetic, derivative or margin loan obligations is rising. This new piece looks at the other side of this equation — how emerging trends since the Global Financial Crisis are limiting the amount of supply moving into the market from traditional lending programs and how asset owners are looking for more routes to market to more fully utilize their lendable supply and cover such demand.
“Changes in market structure and new capital requirements have driven securities lending activity away from a maximum utilization approach to a more intrinsic one,” said Sandy Kaul, Global Head of Business Advisory Services at Citi. “In order to process these changes, the sell-side must adapt to being a more holistic solutions provider, working to understand, service and optimize the entire breadth of a client’s potential supply pool.”
Change in Model post GFC
Prior to the GFC, asset owners instructed lenders to adopt a maximum utilization approach to their portfolio. In this model, the lender would auction the highest percentage possible of the asset owner’s general collateral (GC) and less liquid assets. High volume of GC loans at low spreads would help build the collateral pool and supplement the lower volume of special loans being done at wider spreads. The collateral coming in against this combined set of loans would then be used to generate additional return. During the Global Financial Crisis, it became clear that cash coming into the loan programs was sometimes being deployed into overly aggressive re-investment vehicles. A backlash to aggressive cash reinvestment and to this lending approach occurred as a result.
Most asset owners have de-emphasized any contribution from returns on their collateral investments and have instead focused their programs primarily on the intrinsic value of the securities in their loan portfolio. This intrinsic lending approach has made low value GC loans less attractive and shifted the focus of lenders more exclusively toward the specials portion of the asset owner’s portfolio. Many equity asset owners’ have gone even further and insisted on a minimum spread that they would need to obtain to allow any GC loans.
Regulatory Changes
Regulatory changes being implemented post-GFC may have the potential to further narrow the pool of asset owner’s willing to put their supply out on loan. Rule 165(e) of the Dodd-Frank Wall Street Reform Act and Basel III related regulatory changes may force lenders to re-evaluate their provision of indemnification against borrower default and potentially look to charge for this coverage or remove it as an option. The decision as to whether or not to provide indemnification may be complicated by new counterparty concentration rules that seek to limit the overall amount of exposure any single counterparty can have to any other counterparty.
Banks themselves may also look to reduce their lending activity, take on more of an arranging role and support clearing of lending transactions through central counterparties because of the impacts of new Basel III rules.
New Supply Solutions
Asset owners are thus looking for more options to optimize their use of supply. Using the highest value supply in agency lending programs remains a key part of this emerging “solutions” approach, but asset owners are now looking to identify additional uses for the un-utilized portion of their lendable supply pool. This could include directing a portion of these supplies into principal or synthetic lending programs or using their assets in collateral programs where demand for high quality liquid assets is rising due to new OTC clearing rules. Supporting multiple routes to market for supply is key to the emerging model.
The full report is called: Enhanced Uses of Supply through Asset & Collateral Optimization & the Impact on the Securities Lending Markets
Alex Akesson
Editor for HedgeCo.net
alex@hedgeco.net
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