The pursuit of yield
09 December 2012
Securities lending offers an opportunity to enhance yield using a capital efficient strategy. Jemma Finglas of BNP Paribas Securities Services reports
Image: Shutterstock
Lending opportunities have arisen owing to the increased demand for high quality liquid assets (HQLA) that satisfy the needs for collateral by financial institutions. This requirement is generated by the European Markets Infrastructure Regulation and the need to satisfy the liquidity coverage and net stable funding ratios of Basel III.
Demand for HQLA is currently strong and rising, generating some of the biggest opportunities for insurance companies to put their own assets to work in generating alpha and ensuring market liquidity for all stakeholders. The most efficient conduit for transactions is the stock lending market.
Opportunities in securities lending for UK insurance companies
Financial institutions need to borrow HQLA on a continuous and uninterrupted basis. Lending a nominal value of highly liquid, fixed income government assets, on a term basis across a number of approved borrowers under a strong indemnification, and against the backdrop of a broad collateral schedule, is where the best opportunities currently lie. The lender reserves the right of substitution on the assets and benefits in terms of fee income from terming a nominal amount with a given borrower of their choice.
Accounting treatment
Accounting standards that are applicable to all companies including UK insurance companies are issued by the Financial Reporting Council (FRC). In 2012 and 2013, the FRC fundamentally reformed accounting standards, creating the new ‘UK GAAP’ requirements and specifically FRS 102: Financial Reporting Standard for the UK and Ireland.
FRS 102 provides guidelines under which securities finance is treated and enables the lender to apply these and/or IAS 39 Financial Instruments: Recognition and Measurement (or its pending replacement, IFRS 9).
Under both standards, securities lending transactions are treated the same.
When undertaking a loan transaction, the lender retains the economic risk of the underlying asset and therefore retains the asset on the balance sheet at the same value as if the lending transaction had not taken place.
Provided the receiver of non-cash collateral is able to sell or re-pledge collateral (ie, has full title transfer), but does not do so, the collateral is ‘derecognised’ and recorded as a note to the accounts and not included in the balance sheet calculations, according to Paragraph 11.33 of FRS 102.
Where a lender receives cash collateral, this is recorded in the balance sheet as a future liability and any subsequent re-investment of the cash is recorded as an asset. This means that while cash collateral transfers and re-investments must be included, it has no impact on the overall balance sheet.
Taxation implications
HM Revenue & Customs have given specific exemptions to capital gains requirements for securities lending transactions. TCGA92/S263B provides that acquisitions and disposals of securities under a stock lending arrangement are normally to be disregarded for the purposes of Capital Gains Tax or Corporation Tax on chargeable gains (‘for capital gains purposes’).
Fees generated from securities lending are treated as income for tax purposes, as is the net profit from repo and reverse repo transactions.
Similarly, in countries where financial transaction taxes are applicable, there are currently exemptions in place for securities lending.
Reporting requirements
The importance of being able to produce transparent reporting has never been as widely recognised as it is today. UK insurance companies are required to produce a number of key reports and information templates for shareholders, policyholders and regulators, not least of all for Solvency II reporting, which requires highly detailed and specific data.
Specifically, this reporting is in respect of the Financial Stability Analysis Purpose for large undertakings, which is defined as insurance companies or insurance groups with more than €6 billion in balance sheet total. Specifically for securities lending, they will be required to produce quantitative reporting templates (QRT) D5 and D6 for securities lending and collateral held under Solvency II.
Solvency II
The EU Solvency II Directive will establish a single set of rules governing insurer creditworthiness and risk management and provides the framework for insurance companies to calculate their capital requirements and drive more efficient risk based capital allocation.
Under Solvency II, which is due for implementation in 2016, investment strategies will need to be fully risk assessed and capital allocated. For securities lending, this has a twofold impact.
Firstly insurance companies will be able to compare securities lending to other investment strategies on a risk-adjusted return basis and make informed decisions about the appropriateness of the activity and their level of participation.
Secondly, under Solvency I, insurance companies hold capital in cash or high quality fixed income assets such as government bonds (‘near cash assets’).
In calculating and meeting the solvency capital requirement as defined by Solvency II, insurance companies are likely to need to hold a larger proportion of these assets in order to meet their liabilities, but this may reduce yield.
Giving insurance companies a yield
Securities lending offers an opportunity to enhance the yield of high-quality assets using a capital efficient strategy, particularly where the agent lender provides a strong indemnification.
BNP Paribas has considered the implications of lending activity for UK insurance companies and it is clear that it represents an important opportunity to generate attractive risk-adjusted returns.
BNP Paribas has knowledge and experience in maximising returns for insurance companies. With its business structure and reporting capability, UK insurance companies can benefit from this additional revenue stream with minimal impact on other activity.
Demand for HQLA is currently strong and rising, generating some of the biggest opportunities for insurance companies to put their own assets to work in generating alpha and ensuring market liquidity for all stakeholders. The most efficient conduit for transactions is the stock lending market.
Opportunities in securities lending for UK insurance companies
Financial institutions need to borrow HQLA on a continuous and uninterrupted basis. Lending a nominal value of highly liquid, fixed income government assets, on a term basis across a number of approved borrowers under a strong indemnification, and against the backdrop of a broad collateral schedule, is where the best opportunities currently lie. The lender reserves the right of substitution on the assets and benefits in terms of fee income from terming a nominal amount with a given borrower of their choice.
Accounting treatment
Accounting standards that are applicable to all companies including UK insurance companies are issued by the Financial Reporting Council (FRC). In 2012 and 2013, the FRC fundamentally reformed accounting standards, creating the new ‘UK GAAP’ requirements and specifically FRS 102: Financial Reporting Standard for the UK and Ireland.
FRS 102 provides guidelines under which securities finance is treated and enables the lender to apply these and/or IAS 39 Financial Instruments: Recognition and Measurement (or its pending replacement, IFRS 9).
Under both standards, securities lending transactions are treated the same.
When undertaking a loan transaction, the lender retains the economic risk of the underlying asset and therefore retains the asset on the balance sheet at the same value as if the lending transaction had not taken place.
Provided the receiver of non-cash collateral is able to sell or re-pledge collateral (ie, has full title transfer), but does not do so, the collateral is ‘derecognised’ and recorded as a note to the accounts and not included in the balance sheet calculations, according to Paragraph 11.33 of FRS 102.
Where a lender receives cash collateral, this is recorded in the balance sheet as a future liability and any subsequent re-investment of the cash is recorded as an asset. This means that while cash collateral transfers and re-investments must be included, it has no impact on the overall balance sheet.
Taxation implications
HM Revenue & Customs have given specific exemptions to capital gains requirements for securities lending transactions. TCGA92/S263B provides that acquisitions and disposals of securities under a stock lending arrangement are normally to be disregarded for the purposes of Capital Gains Tax or Corporation Tax on chargeable gains (‘for capital gains purposes’).
Fees generated from securities lending are treated as income for tax purposes, as is the net profit from repo and reverse repo transactions.
Similarly, in countries where financial transaction taxes are applicable, there are currently exemptions in place for securities lending.
Reporting requirements
The importance of being able to produce transparent reporting has never been as widely recognised as it is today. UK insurance companies are required to produce a number of key reports and information templates for shareholders, policyholders and regulators, not least of all for Solvency II reporting, which requires highly detailed and specific data.
Specifically, this reporting is in respect of the Financial Stability Analysis Purpose for large undertakings, which is defined as insurance companies or insurance groups with more than €6 billion in balance sheet total. Specifically for securities lending, they will be required to produce quantitative reporting templates (QRT) D5 and D6 for securities lending and collateral held under Solvency II.
Solvency II
The EU Solvency II Directive will establish a single set of rules governing insurer creditworthiness and risk management and provides the framework for insurance companies to calculate their capital requirements and drive more efficient risk based capital allocation.
Under Solvency II, which is due for implementation in 2016, investment strategies will need to be fully risk assessed and capital allocated. For securities lending, this has a twofold impact.
Firstly insurance companies will be able to compare securities lending to other investment strategies on a risk-adjusted return basis and make informed decisions about the appropriateness of the activity and their level of participation.
Secondly, under Solvency I, insurance companies hold capital in cash or high quality fixed income assets such as government bonds (‘near cash assets’).
In calculating and meeting the solvency capital requirement as defined by Solvency II, insurance companies are likely to need to hold a larger proportion of these assets in order to meet their liabilities, but this may reduce yield.
Giving insurance companies a yield
Securities lending offers an opportunity to enhance the yield of high-quality assets using a capital efficient strategy, particularly where the agent lender provides a strong indemnification.
BNP Paribas has considered the implications of lending activity for UK insurance companies and it is clear that it represents an important opportunity to generate attractive risk-adjusted returns.
BNP Paribas has knowledge and experience in maximising returns for insurance companies. With its business structure and reporting capability, UK insurance companies can benefit from this additional revenue stream with minimal impact on other activity.
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