Michael Saunders of BNP Paribas explains the opportunities and challenges of non-cash collateral as well as discussing how technology can be leveraged in the collateral space
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What are the main opportunities to be had for non-cash collateral?
Industry metrics certainly validate the increase of non-cash collateral in securities lending, predominantly in the US market. As a programme, BNP Paribas clients are assisting in the growth of non-cash collateral. The significant growth can be attributed to several factors benefiting both the beneficial owner and the borrower in a transaction, which includes a lower risk profile for the beneficial owner along with a significant savings of capital consumption from a borrower’s perspective.
Non-cash collateral transactions provide a significant opportunity for beneficial owners to lower their programme’s risk profile as the cash collateral reinvestment component of the transaction is eliminated. The result is an overall lower risk profile as the risks typically associated with a cash collateral programme become mitigated. Specifically, duration mismatch, as well as interest rate mismatch, becomes eliminated in non-cash transactions. Further, the element of liquidity risk typically associated with funding a portfolio of long-dated instruments is removed entirely.
Borrowers are also keen to engage in non-cash transactions. The benefits are clear as non-cash transactions consume less balance sheet and thus capital for a borrower. This savings enables a beneficial owner to engage in transactions which otherwise would be prohibitive from a capital viewpoint, specifically low margin activity such as general collateral.
The ability to increase utilisation rates across a programme through a non-cash programme benefit both a beneficial owner and borrower creating an ideal scenario of capital efficiency and increased loan activity.
What are the main challenges around managing non-cash collateral loans? What regulatory restrictions exist?
There are several challenges in managing a non-cash programme. The first relates to providing beneficial owners with an understanding along with the benefits of engaging in a non-cash transaction. Our experience at BNP Paribas has been that many beneficial owners have a rather novice understanding of non-cash collateral transactions due to the sudden increase in market share of non-cash transactions in the marketplace.
Operational flows and an understanding of a trade lifecycle can also pose a challenge in a non-cash transaction. Historically, a majority of non-cash transactions have been on a bilateral basis. While this still exists, there is a prominent shift to utilise tri-party banks to facilitate the collateral management element of non-cash transactions. This shift has and will continue to ease the perceived operational burden in a non-cash transaction as the functions of collateral valuation, collateral concentration and collateralisation are assisted through a tri-party bank.
Aside from the operational components, a rather large challenge associated with a non-cash lending strategy is dismissing the misnomer that non-cash lending is only feasible and applicable when accepting non-traditional assets or even equity collateral. Certainly collateral flexibility assists in wider fees of a transaction. However, opportunities certainly exist in accepting high-quality assets such as US Treasuries. As an example, BNP Paribas highlights the ability of an SEC 1940 Act fund engaged in a non-cash collateral programme with a restrictive non-cash collateral profile limited to US Treasuries.
Demand remains robust from counterparties to borrow low margin securities versus the limited collateral set simply due to the capital benefits realised by the counterparty. The beneficial owner benefits under a non-cash transaction as lending activity is realised for these general collateral trade which otherwise would not have been feasible in a cash collateral profile.
The message is clear from the BNP Paribas perspective. Non-cash lending permits transactions, which otherwise would not be attainable despite collateral restrictions associated with regulatory requirements.
What trends are you seeing from beneficial owners and borrowers? Is there an increase in beneficial owners considering alternative collateral profiles?
Across our global teams, BNP Paribas is experiencing an increased level of engagement from our client base to understand our collateral flexibility in a non-cash transaction. The opportunity to engage in transactions involving cross-currency transactions from a multitude of global markets provides substantial opportunities to increase programme activity and revenue for our clients in a risk-controlled manner. The ability to accept securities across the capital structure as well as non-traditional assets has assisted in the growth of the business globally.
The continued growth of non-cash transactions in the market has presented an opportunity to diversify a programme’s borrower base away from the traditional borrowers. Agents continue to expand their programme’s trading counterparties to gain exposure to the borrowers willing to engage in non-cash collateral transactions. This includes the addition of several offshore entities and exploring alternate types of trade structures.
How can technology be leveraged in the collateral space?
As an industry, several vendors have formed somewhat of a cottage industry to facilitate the non-cash collateral activity. The shift throughout the industry of both borrowers and agents to utilise tri-party banks in the collateral management function is a testament to this. Further, industry metrics are including transaction detail bifurcated between cash and non-cash collateral. This is very positive and highlights the growth and acceptance of non-cash collateral activity.
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