Assessing the options
04 November 2014
Beneficial owners must be flexible in their approach to collateral, says
Simon Lee of eSecLending
Image: Shutterstock
In today’s market, collateral flexibility is an important consideration for lenders looking to optimise programme returns. In what is a competitive environment, revenue optimisation is achieved by best addressing the requirements of both the supply (lender) and demand (borrower) side of the lending transaction, relative to overall programme objectives.
At first glance, opportunities for lenders to increase earnings without unduly increasing risk may appear limited in today’s market environment, buts by recognising the joint dynamics of programme structure and collateral requirements, lenders can benefit from the increased emphasis regulation has placed on collateral, and its associated cost to collateral providers, ie, borrowers.
As the cost of collateral diverges across different collateral types it becomes increasingly important for lenders to recognise the impact that their collateral choice has on overall programme performance, particularly as it relates to the type of programme they participate in.
It is widely believed that lenders that employ a flexible collateral schedule enjoy advantages over lenders with restrictive collateral schedules. By accepting additional types of collateral, lenders can attract a larger and more diverse set of borrowers, increasing on-loan balances, and revenues. As the regulatory cost of collateral is clarified, it is becoming more apparent that when lenders restrict their collateral profiles they constrain their distribution channels, which can reduce their balances and therefore their revenues.
This dynamic can be illustrated by the example of a lender that solely accepts highly rated government bonds as collateral:
Government bonds are expensive relative to other collateral types. The more expensive the collateral, the lower the overall spread available in any given trade. A borrower will pay a lower fee to borrow a security to offset its higher collateral costs, limiting programme earnings.
By only accepting government bonds, lenders constrain their distribution to borrowers that are long in government bond collateral, limiting the number of borrowers willing to borrow from the lender’s programme.
By only accepting government bonds as collateral, lenders competitively disadvantage themselves relative to other lenders in the same programme. This is most apparent when the lender participates in a pooled programme, and is becoming more relevant in what is a lending market of constrained demand.
The acceptance of equity collateral has been increasingly recognised as a tool to improve programme performance. From the borrower’s perspective, equity collateral has always been a preferred form of collateral due to its plentiful supply, low costs, and liquidity. However, historically there was little demand from lenders and their agents: equity collateral was harder to administer, indemnity costs were higher and programme performance was not unduly hindered without it.
As indemnity costs are becoming better known and managed, administration of equity collateral by triparty providers is more sophisticated, and a flexible collateral schedule is now recognised as an important aspect of improving programme performance. As a result, more non-cash lenders are accepting equity collateral than before.
Lenders are always interested to know how much they will be able to enhance programme earnings when they diversify their collateral schedule. It is important to understand how the type of programme the lender participates in also impacts performance. This is particularly true for lenders participating in a pooled programme, where their assets are commingled with those of other lenders and loans are allocated through a ‘queuing’ system.
For example, a borrower wants to borrow a position that is held by three lenders in the pooled programme. Lender A and Lender B accept equity and government bond collateral, whereas Lender C only accepts government bond collateral. Rather than allocate this loan across three lenders, with two different forms of collateral and two different costs, the borrower will source the supply from A and B that accept the cheapest form of collateral (equity). This means Lender C, which only accepts the expensive form of collateral (bonds), will miss out on the loan entirely.
This is why lenders that participate in pooled programmes must always consider how changes to programme parameters, especially as they relate to collateral or programme enhancement, are viewed relative to other lenders in the same programme, as this can significantly influence the impact that any changes may have.
For lenders that participate in segregated programmes, where assets are not comingled across lender accounts, the question of performance relative to other lenders is irrelevant and does not apply. In these programmes, changes in collateral schedules can directly enhance the performance of the individual lender, given that their performance is not influenced by the parameters of any other competing lender.
For lenders that wish to take a more active role in enhancing securities lending performance, and where the opportunity to do so exists, lending via a segregated programme structure may be advantageous, particularly when considering expanding collateral schedules.
At first glance, opportunities for lenders to increase earnings without unduly increasing risk may appear limited in today’s market environment, buts by recognising the joint dynamics of programme structure and collateral requirements, lenders can benefit from the increased emphasis regulation has placed on collateral, and its associated cost to collateral providers, ie, borrowers.
As the cost of collateral diverges across different collateral types it becomes increasingly important for lenders to recognise the impact that their collateral choice has on overall programme performance, particularly as it relates to the type of programme they participate in.
It is widely believed that lenders that employ a flexible collateral schedule enjoy advantages over lenders with restrictive collateral schedules. By accepting additional types of collateral, lenders can attract a larger and more diverse set of borrowers, increasing on-loan balances, and revenues. As the regulatory cost of collateral is clarified, it is becoming more apparent that when lenders restrict their collateral profiles they constrain their distribution channels, which can reduce their balances and therefore their revenues.
This dynamic can be illustrated by the example of a lender that solely accepts highly rated government bonds as collateral:
Government bonds are expensive relative to other collateral types. The more expensive the collateral, the lower the overall spread available in any given trade. A borrower will pay a lower fee to borrow a security to offset its higher collateral costs, limiting programme earnings.
By only accepting government bonds, lenders constrain their distribution to borrowers that are long in government bond collateral, limiting the number of borrowers willing to borrow from the lender’s programme.
By only accepting government bonds as collateral, lenders competitively disadvantage themselves relative to other lenders in the same programme. This is most apparent when the lender participates in a pooled programme, and is becoming more relevant in what is a lending market of constrained demand.
The acceptance of equity collateral has been increasingly recognised as a tool to improve programme performance. From the borrower’s perspective, equity collateral has always been a preferred form of collateral due to its plentiful supply, low costs, and liquidity. However, historically there was little demand from lenders and their agents: equity collateral was harder to administer, indemnity costs were higher and programme performance was not unduly hindered without it.
As indemnity costs are becoming better known and managed, administration of equity collateral by triparty providers is more sophisticated, and a flexible collateral schedule is now recognised as an important aspect of improving programme performance. As a result, more non-cash lenders are accepting equity collateral than before.
Lenders are always interested to know how much they will be able to enhance programme earnings when they diversify their collateral schedule. It is important to understand how the type of programme the lender participates in also impacts performance. This is particularly true for lenders participating in a pooled programme, where their assets are commingled with those of other lenders and loans are allocated through a ‘queuing’ system.
For example, a borrower wants to borrow a position that is held by three lenders in the pooled programme. Lender A and Lender B accept equity and government bond collateral, whereas Lender C only accepts government bond collateral. Rather than allocate this loan across three lenders, with two different forms of collateral and two different costs, the borrower will source the supply from A and B that accept the cheapest form of collateral (equity). This means Lender C, which only accepts the expensive form of collateral (bonds), will miss out on the loan entirely.
This is why lenders that participate in pooled programmes must always consider how changes to programme parameters, especially as they relate to collateral or programme enhancement, are viewed relative to other lenders in the same programme, as this can significantly influence the impact that any changes may have.
For lenders that participate in segregated programmes, where assets are not comingled across lender accounts, the question of performance relative to other lenders is irrelevant and does not apply. In these programmes, changes in collateral schedules can directly enhance the performance of the individual lender, given that their performance is not influenced by the parameters of any other competing lender.
For lenders that wish to take a more active role in enhancing securities lending performance, and where the opportunity to do so exists, lending via a segregated programme structure may be advantageous, particularly when considering expanding collateral schedules.
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