Can cash collateral and negative rates mix?
08 December 2020
With markets still in the throes of COVID-19, the threat of negative interest rates still looms large for the securities finance industry, with major consequences in store for those reliant on cash collateral and reinvestment. SFT delves into what happens if rates go south
Image: stock.adobe.com/oatawa
Since COVID-19 upended global financial markets at the start of the year, negative interest rates have loomed as central banks around the world wrestle to restore each country’s struggling economy. Since the global financial crisis of 2008, several central banks, including the European Central Bank, have employed the controversial policy tool to stimulate growth.
When rates are negative, it costs banks to hold money, which encourages them to lend it out. This is not a typical scenario, but it is most likely during a deep economic recession when monetary policy and market forces have already pushed interest rates to their nominal zero bound. With the future far from certain, some central banks hinting at where they sit on the matter, should markets deteriorate again next year.
Currently, interest rates across the world are at rock-bottom, hovering at zero percent or a fraction above. In the UK, the ongoing challenges of the pandemic coupled with the end of the Brexit transition period on 31 December, could see the Bank of England (BoE) resort to negative interest rates to keep the economy’s wheels turning.
The BoE is open to cutting interest rates below zero next year and preparations were under way to allow it to support the economy with lower borrowing costs, in a move that would bring the BoE into line with the European Central Bank and the Bank of Japan. The UK’s monetary policy committee said it was seeking to overcome obstacles to negative interest rates that would allow further cuts from the current 0.1 percent base rate.
In the US, the Federal Reserve reduced the federal funds rate and enacted lending programmes in a bid to protect the markets during the market turmoil in H1. However, since then, the central bank’s chair Jerome Powell said negative rates are “not an appropriate or useful policy”, believing the costs outweigh the benefits. The economic shock from COVID-19 may call for drastic measures, but negative interest rates are not one of them — not yet at least.
The collateral question
Securities lending participants are particularly concerned about the possibility of negative yields on cash collateral reinvestment funds and repos and how that could impact the economics of lending securities. This is especially true in markets with a significant cash-collateral market, such as the US, but would also impact those that prefer non-cash collateral, such as the EU and UK.
David Lewis, senior director of securities finance at FIS, says: “Logic suggests that negative interest rates would drive an increase in the use of non-cash collateral as cash is no longer king. In reality, not everyone will be able to switch to non-cash collateral overnight, so there will be a lag and some may never migrate fully, possibly even dropping out of the market altogether.”
According to the Risk Management Association’s (RMA) securities lending council in a recent whitepaper, negative interest rates could affect every aspect of securities lending, including borrower demand, investment valuation, taxation, accounting and operating models. According to the International Capital Market Association (ICMA), since 2014, negative rates have become persistent and widespread. The trade body suggests in a report that, initially, many cash investors have been reluctant to accept negative rates, including parties to repo transactions being remunerated on deposits of cash margin and on income due on securities they have given as collateral.
A frequently-cited concern associated with securities lending is cash reinvestment risk. From a beneficial owner’s perspective, this is the risk that reinvested cash collateral becomes illiquid or decreases in value. A recent State Street whitepaper argued that “although the weight of evidence suggests that securities-for-cash results in minimal market disruption, 2008 laid bare the consequences of when cash reinvestment strategies become the primary purpose of a securities loan transaction”.
For instance, State Street says that “skeptics of securities lending” will point to how one of the largest global insurance companies in 2008 almost collapsed due to lending activities. However, it is critical to note that even by 2008 standards, this firm took risks that stood far apart from their peers and industry norms. It is clear that some firms used cash collateral for the sole purpose of leveraging its portfolio, for example, having considerably more securities on-loan compared to its peers.
Before the crisis, repo was the only financial instrument which paid a rate of return that could become negative under normal market conditions. Negative repo rates can happen when a particular collateral security is subject to exceptional borrowing demand or reduced supply in the repo market.
While the probability of a negative interest rate policy in the US is low, the more prominent risk it presents to the cash-collateral-reliant securities finance market means lenders and borrowers should consider the implications across securities finance front-to-back, including loan demand, cash collateral yields, taxation, and operating models.
The RMA highlights that while lower interest rates generally can whittle down government debt, they also subtract from the returns earned by banks and individual savers. And when rates turn negative, it is not clear exactly what the bottom-line effects might be long term across the economy.
Bullet dodged?
Sam Pierson, director and product specialist at IHS Markit, is among those that believe negative rates are unlikely. “I would say that it’s more that the market is back on the trend toward increased usage of non-cash after a counter-trend increase in cash usage this year,” he explains.
Pierson highlights the big trend in collateral this year was increasing usage of cash as a percentage of total loan balances in March after the Fed rate cut when cash reinvestment was generating an excess return relative to the rebates paid to borrowers which were tied to overnight rates. He explains: “There is certainly a mix in products used for cash reinvestment, but the overall result has been that reinvestment returns have largely retraced to pre-COVID levels so the boost to returns has largely worn off.”
Reinforcing this idea, Tim Smith, managing director at Hazeltree, believes it could be “politically unacceptable” to go negative. He is also more sanguine than most regarding the impact on cash collateral if it does happen, arguing that participants are already used to receiving negative rebates.
Elsewhere, Matthew Chessum, investment director at Aberdeen Investment, is of the opinion that with the recent good news of successful vaccines sending markets higher, the potential for negative interest rates seems to have eased somewhat. “We will hopefully see an upward movement in short end rates and avoid the base rate going negative,” he explains. “It could be argued that just the talk of negative rates played a big enough part in implementing policy as treasury bill yields fell to negative levels and the short end of the curve remains at low single digits out to a year and in some cases beyond.”
Given the challenges this past year, it’s difficult to see at this point how long it will take for the economy to bounce back, adds Chessum. Industry experts in securities finance are fairly upbeat that we are going to come out the other side, if drawn out longer than expected. Chessum adds: “given the amount of quantitative easing and debt issuance that has already taken place, the Bank of England may still look at alternative policies to help stimulate the recovery.”
Chessum concludes that the market is currently “experiencing the low and will see incremental increases in the curve from late January onwards”.
He adds: “If this does happen then slowly but surely cash collateral will come back into play although yields have a way to recover just yet to ensure that all lending trades can be profitable.”
When rates are negative, it costs banks to hold money, which encourages them to lend it out. This is not a typical scenario, but it is most likely during a deep economic recession when monetary policy and market forces have already pushed interest rates to their nominal zero bound. With the future far from certain, some central banks hinting at where they sit on the matter, should markets deteriorate again next year.
Currently, interest rates across the world are at rock-bottom, hovering at zero percent or a fraction above. In the UK, the ongoing challenges of the pandemic coupled with the end of the Brexit transition period on 31 December, could see the Bank of England (BoE) resort to negative interest rates to keep the economy’s wheels turning.
The BoE is open to cutting interest rates below zero next year and preparations were under way to allow it to support the economy with lower borrowing costs, in a move that would bring the BoE into line with the European Central Bank and the Bank of Japan. The UK’s monetary policy committee said it was seeking to overcome obstacles to negative interest rates that would allow further cuts from the current 0.1 percent base rate.
In the US, the Federal Reserve reduced the federal funds rate and enacted lending programmes in a bid to protect the markets during the market turmoil in H1. However, since then, the central bank’s chair Jerome Powell said negative rates are “not an appropriate or useful policy”, believing the costs outweigh the benefits. The economic shock from COVID-19 may call for drastic measures, but negative interest rates are not one of them — not yet at least.
The collateral question
Securities lending participants are particularly concerned about the possibility of negative yields on cash collateral reinvestment funds and repos and how that could impact the economics of lending securities. This is especially true in markets with a significant cash-collateral market, such as the US, but would also impact those that prefer non-cash collateral, such as the EU and UK.
David Lewis, senior director of securities finance at FIS, says: “Logic suggests that negative interest rates would drive an increase in the use of non-cash collateral as cash is no longer king. In reality, not everyone will be able to switch to non-cash collateral overnight, so there will be a lag and some may never migrate fully, possibly even dropping out of the market altogether.”
According to the Risk Management Association’s (RMA) securities lending council in a recent whitepaper, negative interest rates could affect every aspect of securities lending, including borrower demand, investment valuation, taxation, accounting and operating models. According to the International Capital Market Association (ICMA), since 2014, negative rates have become persistent and widespread. The trade body suggests in a report that, initially, many cash investors have been reluctant to accept negative rates, including parties to repo transactions being remunerated on deposits of cash margin and on income due on securities they have given as collateral.
A frequently-cited concern associated with securities lending is cash reinvestment risk. From a beneficial owner’s perspective, this is the risk that reinvested cash collateral becomes illiquid or decreases in value. A recent State Street whitepaper argued that “although the weight of evidence suggests that securities-for-cash results in minimal market disruption, 2008 laid bare the consequences of when cash reinvestment strategies become the primary purpose of a securities loan transaction”.
For instance, State Street says that “skeptics of securities lending” will point to how one of the largest global insurance companies in 2008 almost collapsed due to lending activities. However, it is critical to note that even by 2008 standards, this firm took risks that stood far apart from their peers and industry norms. It is clear that some firms used cash collateral for the sole purpose of leveraging its portfolio, for example, having considerably more securities on-loan compared to its peers.
Before the crisis, repo was the only financial instrument which paid a rate of return that could become negative under normal market conditions. Negative repo rates can happen when a particular collateral security is subject to exceptional borrowing demand or reduced supply in the repo market.
While the probability of a negative interest rate policy in the US is low, the more prominent risk it presents to the cash-collateral-reliant securities finance market means lenders and borrowers should consider the implications across securities finance front-to-back, including loan demand, cash collateral yields, taxation, and operating models.
The RMA highlights that while lower interest rates generally can whittle down government debt, they also subtract from the returns earned by banks and individual savers. And when rates turn negative, it is not clear exactly what the bottom-line effects might be long term across the economy.
Bullet dodged?
Sam Pierson, director and product specialist at IHS Markit, is among those that believe negative rates are unlikely. “I would say that it’s more that the market is back on the trend toward increased usage of non-cash after a counter-trend increase in cash usage this year,” he explains.
Pierson highlights the big trend in collateral this year was increasing usage of cash as a percentage of total loan balances in March after the Fed rate cut when cash reinvestment was generating an excess return relative to the rebates paid to borrowers which were tied to overnight rates. He explains: “There is certainly a mix in products used for cash reinvestment, but the overall result has been that reinvestment returns have largely retraced to pre-COVID levels so the boost to returns has largely worn off.”
Reinforcing this idea, Tim Smith, managing director at Hazeltree, believes it could be “politically unacceptable” to go negative. He is also more sanguine than most regarding the impact on cash collateral if it does happen, arguing that participants are already used to receiving negative rebates.
Elsewhere, Matthew Chessum, investment director at Aberdeen Investment, is of the opinion that with the recent good news of successful vaccines sending markets higher, the potential for negative interest rates seems to have eased somewhat. “We will hopefully see an upward movement in short end rates and avoid the base rate going negative,” he explains. “It could be argued that just the talk of negative rates played a big enough part in implementing policy as treasury bill yields fell to negative levels and the short end of the curve remains at low single digits out to a year and in some cases beyond.”
Given the challenges this past year, it’s difficult to see at this point how long it will take for the economy to bounce back, adds Chessum. Industry experts in securities finance are fairly upbeat that we are going to come out the other side, if drawn out longer than expected. Chessum adds: “given the amount of quantitative easing and debt issuance that has already taken place, the Bank of England may still look at alternative policies to help stimulate the recovery.”
Chessum concludes that the market is currently “experiencing the low and will see incremental increases in the curve from late January onwards”.
He adds: “If this does happen then slowly but surely cash collateral will come back into play although yields have a way to recover just yet to ensure that all lending trades can be profitable.”
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