Why central banks need securities lending
03 September 2019
BNP Paribas’ Benoit Uhlen explores how central banks are becoming increasingly attracted to the proposition of low-risk, incremental income
Image: Shutterstock
Central banks have long recognised the value of securities lending as a mechanism for managing market liquidity. It has a vital and growing role to play in central bank operations and provides an important mechanism for enhancing liquidity, which helps central banks facilitate the smooth and efficient functioning of markets.
Securities lending offers valuable commercial benefits too. By monetising their holdings, central banks can add significant incremental income to their portfolios without substantially raising their risk profile–a proposition that many central banks are finding increasingly attractive.
Helping markets function
Central banks have long used securities finance transactions– including securities lending and repos–to support monetary policy and financial market stability.
When a central bank lends securities or uses repos to sell bonds to commercial banks, it removes cash from the market and tightens the money supply. This reduces competition for assets and keeps prices down. Buying debt instruments from commercial banks boosts the money supply by increasing banks’ cash reserves.
Securities lending also promotes healthy functioning markets by enabling borrowers to access securities for short selling, balance sheet management, or to facilitate orderly transaction settlement. The increased market liquidity results in tighter bid/offer spreads and elevated activity levels.
The regulatory imperative and demand for HQLA
Post-crisis, central banks’ securities finance activities have an even bigger role to play.
Regulatory initiatives such as the Basel III liquidity coverage and net stable funding ratios, along with the European Market Infrastructure Regulation’s (EMIR’s) clearing obligations, have created an enduring demand among market participants for high-quality liquid assets (HQLAs). At the same time, central banks’ HQLA portfolios (i.e. debt issued by G7 countries) have increased significantly in certain cases, owing to the trillions of dollars’ worth of securities bought under their quantitative easing programmes.
By initiating or expanding their securities lending activities, central banks can become important suppliers of much-needed HQLAs to meet borrower demand. Financing facilities offered by central banks, such as the Federal Reserve’s Reverse Repurchase Facility and System Open Market Account (SOMA) programme, highlight the importance of securities financing in the capital markets. Such central bank intermediation plays a vital role in the healthy functioning of capital markets.
Moreover, securities lending provides central banks with opportunities to optimise the performance of their HQLA holdings by generating a return on what is an often untapped-income source.
The benefits of securities lending
Securities lending is a prudent and proven strategy for asset holders to diversify their revenue and extract additional value from their portfolios of idle assets–a goal of heightened importance in the current low interest rate environment.
Historically, elevated volatility levels have benefitted securities lending programme participants. With an end to quantitative easing and changes to monetary policy in sight, higher volatility seems set to continue, bringing further demand for certain asset classes and sectors.
Revenue opportunities from securities lending participation can be substantial, depending on the portfolio of available assets. Non-cash collateral transactions can easily generate stable and predictable returns on a portfolio of G7 government debt, with a highly risk-averse approach that takes investment grade fixed income as collateral and allows for transactions to be closed on a daily basis.
Beneficial owners willing to expand the tenor and permissible collateral-set to include cross-currency assets or lower-rated securities (for example, European Central Bank eligible debt, or even equities from the main indices) can boost returns to 25 bps or more, while likely increasing utilisation rates. Employing trade structures that minimise the capital impact for borrowers, such as a pledge structure, can provide an additional return.
Augmenting revenue streams through securities lending can then provide a significant contribution to meeting central banks’ administration expenses and custody fees.
Well-managed risks
Many central banks have traditionally been wary of participating in securities lending. This hesitancy stems in large part from the risks brought about by the use of cash collateral and the losses that could result when that cash was reinvested in other, higher-yielding instruments.
However, the way programmes are structured has changed, bringing extra layers of protection for market participants.
Non-cash collateral transactions — which remove the interest rate mismatch, credit and liquidity risk associated with cash collateral, while providing equivalent returns — are increasingly the norm. In the US, more than half of all transactions now comprise non-cash collateral, compared to less than 20 percent three years ago. DataLend figures show that across the rest of the world, approximately 85 percent of all outstanding loans employ non-cash collateral.
Central banks can further reduce their risks by using an agency lender.
Many agency programmes have introduced robust indemnification policies that protect investors against borrower credit risk in case of a counterparty default. Agency indemnification guarantees are often buttressed by the use of over-collateralised transactions and a careful selection of borrowers to ensure exposure to only high-quality counterparties. Together, these safeguards provide central banks with important risk mitigation assurances.
What to look for in an agency lender
Central banks’ revenue opportunities and risk exposures will be determined to a large extent by the type of lending programme in which they participate. Capabilities to look for in an agent include:
Risk management: An indemnification policy is only as valuable as the agent’s ability to backstop it. Agents need to be well-capitalised and possess excess liquidity to meet potential demands. They should also use a diversified counterparties list to minimise concentration exposures.
Collateral transformation experience: Borrowers are increasingly keen to place more varied types of non-cash collateral. This can be seen in industry lobbying for changes to the US Securities and Exchange Commission’s Rule 15c3-3, to expand the permissible collateral a counterparty can pledge to include equities, and so make more efficient use of their balance sheets and capital.
Central banks willing to participate in collateral transformation transactions—in which HQLAs are exchanged for non-HQLA assets—can profit from substantially higher revenue opportunities. But, it requires a lending agent experienced in managing those transactions. An agent’s willingness and ability to expand the set of permissible collateral, and provide indemnification against borrower default is critical.
Utilisation rates: How many similar lenders with the same types of assets does the agency programme contain? Each will have to take turns lending their securities to the marketplace, so the greater the number of clients, the longer the lending queue.
Shorter lending queues, along with bigger borrowing pools, ensure beneficial owners have more of their available assets out on loan at any one time. Maximising this utilisation rate will in turn maximise the revenue the owner can earn.
Borrower monitoring: Borrowers’ creditworthiness must be monitored closely and continually to reduce credit risk. Agents should mark-to-market the borrowers’ collateral on a daily basis and manage margin payments to minimise potential losses in the event of default. Independent risk management is also critical in monitoring a programme’s activity, in addition to an experienced operational network to facilitate the settlement and maintenance of a lending programme.
Transparency: A clear view into how a securities lending programme is performing can provide central banks with important controls and comfort. Online access to real-time data will allow lenders to see which securities are on loan, the collateral received and rate at which they have been transacted.
Efficiency: Securities lending is a relatively low-margin, high-volume activity. Efficiency is critical, both for the viability of the agent’s business and profitability for the beneficial owners.
Product development: An agent’s ability to remain abreast of market infrastructure and regulatory developments is vital. Trade structures such as central counterparties and the pledge structure offer two new routes to market that balance the needs of lenders and borrowers, and minimise the capital impact for all participants involved.
Meanwhile, sophisticated technology tools—including the use of robotics and artificial intelligence where possible—enable agent lenders to automate the majority of transactions and respond to locates faster. This frees them to focus on developing counterparty relationships and trading strategies that extract maximum value from a clients’ lending portfolio with the minimum risk, thereby generating more revenue for the beneficial owner.
All gain and no pain
Central banks have long recognised the value of securities lending as a mechanism for managing market liquidity. Fewer have taken advantage of the significant and stable revenue streams an active lending programme can deliver for participating asset owners. But that is changing. And with the robust risk mitigation measures that the best agency lenders now provide, the risk-reward calculations have never looked so compelling.
Securities lending offers valuable commercial benefits too. By monetising their holdings, central banks can add significant incremental income to their portfolios without substantially raising their risk profile–a proposition that many central banks are finding increasingly attractive.
Helping markets function
Central banks have long used securities finance transactions– including securities lending and repos–to support monetary policy and financial market stability.
When a central bank lends securities or uses repos to sell bonds to commercial banks, it removes cash from the market and tightens the money supply. This reduces competition for assets and keeps prices down. Buying debt instruments from commercial banks boosts the money supply by increasing banks’ cash reserves.
Securities lending also promotes healthy functioning markets by enabling borrowers to access securities for short selling, balance sheet management, or to facilitate orderly transaction settlement. The increased market liquidity results in tighter bid/offer spreads and elevated activity levels.
The regulatory imperative and demand for HQLA
Post-crisis, central banks’ securities finance activities have an even bigger role to play.
Regulatory initiatives such as the Basel III liquidity coverage and net stable funding ratios, along with the European Market Infrastructure Regulation’s (EMIR’s) clearing obligations, have created an enduring demand among market participants for high-quality liquid assets (HQLAs). At the same time, central banks’ HQLA portfolios (i.e. debt issued by G7 countries) have increased significantly in certain cases, owing to the trillions of dollars’ worth of securities bought under their quantitative easing programmes.
By initiating or expanding their securities lending activities, central banks can become important suppliers of much-needed HQLAs to meet borrower demand. Financing facilities offered by central banks, such as the Federal Reserve’s Reverse Repurchase Facility and System Open Market Account (SOMA) programme, highlight the importance of securities financing in the capital markets. Such central bank intermediation plays a vital role in the healthy functioning of capital markets.
Moreover, securities lending provides central banks with opportunities to optimise the performance of their HQLA holdings by generating a return on what is an often untapped-income source.
The benefits of securities lending
Securities lending is a prudent and proven strategy for asset holders to diversify their revenue and extract additional value from their portfolios of idle assets–a goal of heightened importance in the current low interest rate environment.
Historically, elevated volatility levels have benefitted securities lending programme participants. With an end to quantitative easing and changes to monetary policy in sight, higher volatility seems set to continue, bringing further demand for certain asset classes and sectors.
Revenue opportunities from securities lending participation can be substantial, depending on the portfolio of available assets. Non-cash collateral transactions can easily generate stable and predictable returns on a portfolio of G7 government debt, with a highly risk-averse approach that takes investment grade fixed income as collateral and allows for transactions to be closed on a daily basis.
Beneficial owners willing to expand the tenor and permissible collateral-set to include cross-currency assets or lower-rated securities (for example, European Central Bank eligible debt, or even equities from the main indices) can boost returns to 25 bps or more, while likely increasing utilisation rates. Employing trade structures that minimise the capital impact for borrowers, such as a pledge structure, can provide an additional return.
Augmenting revenue streams through securities lending can then provide a significant contribution to meeting central banks’ administration expenses and custody fees.
Well-managed risks
Many central banks have traditionally been wary of participating in securities lending. This hesitancy stems in large part from the risks brought about by the use of cash collateral and the losses that could result when that cash was reinvested in other, higher-yielding instruments.
However, the way programmes are structured has changed, bringing extra layers of protection for market participants.
Non-cash collateral transactions — which remove the interest rate mismatch, credit and liquidity risk associated with cash collateral, while providing equivalent returns — are increasingly the norm. In the US, more than half of all transactions now comprise non-cash collateral, compared to less than 20 percent three years ago. DataLend figures show that across the rest of the world, approximately 85 percent of all outstanding loans employ non-cash collateral.
Central banks can further reduce their risks by using an agency lender.
Many agency programmes have introduced robust indemnification policies that protect investors against borrower credit risk in case of a counterparty default. Agency indemnification guarantees are often buttressed by the use of over-collateralised transactions and a careful selection of borrowers to ensure exposure to only high-quality counterparties. Together, these safeguards provide central banks with important risk mitigation assurances.
What to look for in an agency lender
Central banks’ revenue opportunities and risk exposures will be determined to a large extent by the type of lending programme in which they participate. Capabilities to look for in an agent include:
Risk management: An indemnification policy is only as valuable as the agent’s ability to backstop it. Agents need to be well-capitalised and possess excess liquidity to meet potential demands. They should also use a diversified counterparties list to minimise concentration exposures.
Collateral transformation experience: Borrowers are increasingly keen to place more varied types of non-cash collateral. This can be seen in industry lobbying for changes to the US Securities and Exchange Commission’s Rule 15c3-3, to expand the permissible collateral a counterparty can pledge to include equities, and so make more efficient use of their balance sheets and capital.
Central banks willing to participate in collateral transformation transactions—in which HQLAs are exchanged for non-HQLA assets—can profit from substantially higher revenue opportunities. But, it requires a lending agent experienced in managing those transactions. An agent’s willingness and ability to expand the set of permissible collateral, and provide indemnification against borrower default is critical.
Utilisation rates: How many similar lenders with the same types of assets does the agency programme contain? Each will have to take turns lending their securities to the marketplace, so the greater the number of clients, the longer the lending queue.
Shorter lending queues, along with bigger borrowing pools, ensure beneficial owners have more of their available assets out on loan at any one time. Maximising this utilisation rate will in turn maximise the revenue the owner can earn.
Borrower monitoring: Borrowers’ creditworthiness must be monitored closely and continually to reduce credit risk. Agents should mark-to-market the borrowers’ collateral on a daily basis and manage margin payments to minimise potential losses in the event of default. Independent risk management is also critical in monitoring a programme’s activity, in addition to an experienced operational network to facilitate the settlement and maintenance of a lending programme.
Transparency: A clear view into how a securities lending programme is performing can provide central banks with important controls and comfort. Online access to real-time data will allow lenders to see which securities are on loan, the collateral received and rate at which they have been transacted.
Efficiency: Securities lending is a relatively low-margin, high-volume activity. Efficiency is critical, both for the viability of the agent’s business and profitability for the beneficial owners.
Product development: An agent’s ability to remain abreast of market infrastructure and regulatory developments is vital. Trade structures such as central counterparties and the pledge structure offer two new routes to market that balance the needs of lenders and borrowers, and minimise the capital impact for all participants involved.
Meanwhile, sophisticated technology tools—including the use of robotics and artificial intelligence where possible—enable agent lenders to automate the majority of transactions and respond to locates faster. This frees them to focus on developing counterparty relationships and trading strategies that extract maximum value from a clients’ lending portfolio with the minimum risk, thereby generating more revenue for the beneficial owner.
All gain and no pain
Central banks have long recognised the value of securities lending as a mechanism for managing market liquidity. Fewer have taken advantage of the significant and stable revenue streams an active lending programme can deliver for participating asset owners. But that is changing. And with the robust risk mitigation measures that the best agency lenders now provide, the risk-reward calculations have never looked so compelling.
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100% ON RETURNS If you invest in only one securities finance news source this year, make sure it is your free subscription to Securities Finance Times
