The king is dead, or is he?
19 May 2015
Is the ruling monarch of indemnification about to lose its crown? David Lewis of SunGard’s Astec Analytics takes a look
Image: Shutterstock
The financing industry is not alone in its view that ‘cash is king’—cash is the lifeblood of almost all business and, like blood, is something you cannot do without. But is the king under threat? Is its popularity on the wane? It could certainly be argued that cash is no longer as popular as it once was in the real economy—and by cash we mean physical notes and coin. With the advent of the mobile wallet and contactless cards, more and more transactions are being undertaken electronically, passing digital zeroes and ones across the internet for your latte rather than a pile of metal coins, or in most cases, more like a roll of notes.
In our industry, it has been suggested that cash is also in decline, at least as a form of collateral. There are potentially a whole host of reasons for this, and reasons why it is not true, or expected to happen. For the move away from cash camp, we have the perception of risk for one. Looking back at the financial crisis from 2007, the financing industry, and in particular securities lending, was hit particularly hard. Losses were accrued, but in the vast majority of cases these were limited to the cash reinvestment programmes associated with the cash collateral taken by the lenders.
This analysis doesn’t seek to analyse what actually went wrong in that scenario, just to observe that it occurred and certain behaviours have changed as a consequence. Few can argue that the end result of this has been much tighter reinvestment controls and credit criteria, and even fewer could argue that this is a bad thing from a risk management point of view, or that it has curtailed the additional revenues or reinvestment premium that clients could earn from these investments.
The drop in reinvestment premium is potentially, in itself, part of the reason why some market participants are moving away from cash as collateral, because without the premium available, the incentive to take cash is reduced. As with many economic issues, however, there is always the other hand to count on. Fighting in the cash corner is the need for liquidity—the motivation to lend securities is not always just to earn incremental revenues of course, it is often to raise cash for liquidity or other financing purposes. New regulatory pressures have also played their part here. The need for liquidity has driven market demand for high quality liquid assets (HQLAs) and this is expected to continue as the regulations take hold. What is that data telling us, though? Is the mix of cash and non-cash collateral usage changing and does that change differ across the regions?
Figure 1 shows the indexed value of fixed income assets lent against non-cash collateral from July 2012 to May 2015. Note that the values for Asia are logged against the right hand axis to allow for their scale compared with Europe and North America. Asia has seen a dramatic upswing in the value of fixed income assets in our sample, which are lent against non-cash collateral. Europe has also exhibited a significant increase in the value on loan against non-cash collateral, although more than doubling over this period it is a small increase compared with the meteoric rise in Asia.
It should be noted that there are two additional factors to be considered when looking at these numbers: SunGard’s Astec Analytics sample data continues to grow as we expand our offerings and coverage globally, particularly in Asia and Europe, as well as the general rise in asset values, especially quality government debt, which is a significant part of the data under analysis here. Even taking these outside variable influences into account, both regions have shown significant change over the last three years. The rise in value for US fixed income assets has been less dramatic, more like a 10 percent shift, but in what is likely to be the largest market by value in the world, 10 percent is not insignificant.
The rise in value on loan against non-cash collateral is one aspect of interest, but the proportion of those assets lent against cash and those against non-cash collateral is also of interest for a number of reasons. Figure 2 shows the proportion of fixed income assets by value lent against non-cash collateral for the European, North American and the sum of the global markets. Note that the plot lines shown represent the proportion of value lent against non-cash. As this figure rises, so the opposing value lent against cash falls. The cash collateral plots have been omitted from Figure 2 to aid clarity.
The European market, which is traditionally a non-cash collateral dominated environment, is shown on the graph to be increasingly non-cash orientated. In the middle of 2012, the data indicates that the European fixed income market was lent against non-cash between 60 to 65 percent by value. By Q1 2015, this proportion is in the 80 percent range. North America has also risen, although by less in absolute terms. Commencing in the mid-40s, the proportion of fixed income lent against non-cash collateral actually fell through 2013 and 2014, hitting a low point of around 40 percent a year ago. Since that time, the rise has been slow but steady, posting a score just above 50 percent in April and May 2015.
As noted above, not a stellar change on the face of it, but a 5 to 10 percent change in a market with outstanding balances measured in hundreds of billions is a change that has many ramifications that need to be addressed.
Historically, a market dominated by cash collateral, changing to have more than half of assets being lent against non-cash collateral, will affect pricing and the rates charged for assets, as well as risk management profiles as collateral management has to adapt, meaning trading systems may need to be upgraded or changed to manage an increasing proportion of collateral types rather than just the US dollar.
As markets change their perspectives on the type and make up of collateral they take, they will need to adapt systems and processes as well as develop new knowledge and gather experience in managing the new regime. With many pieces of new legislation yet to actually bite, it is quite likely that the proportion of non-cash collateral traded will continue to rise. It may be too premature to say that the king is indeed dead, but it seems the sun may be beginning to set on this particular monarch’s reign.
In our industry, it has been suggested that cash is also in decline, at least as a form of collateral. There are potentially a whole host of reasons for this, and reasons why it is not true, or expected to happen. For the move away from cash camp, we have the perception of risk for one. Looking back at the financial crisis from 2007, the financing industry, and in particular securities lending, was hit particularly hard. Losses were accrued, but in the vast majority of cases these were limited to the cash reinvestment programmes associated with the cash collateral taken by the lenders.
This analysis doesn’t seek to analyse what actually went wrong in that scenario, just to observe that it occurred and certain behaviours have changed as a consequence. Few can argue that the end result of this has been much tighter reinvestment controls and credit criteria, and even fewer could argue that this is a bad thing from a risk management point of view, or that it has curtailed the additional revenues or reinvestment premium that clients could earn from these investments.
The drop in reinvestment premium is potentially, in itself, part of the reason why some market participants are moving away from cash as collateral, because without the premium available, the incentive to take cash is reduced. As with many economic issues, however, there is always the other hand to count on. Fighting in the cash corner is the need for liquidity—the motivation to lend securities is not always just to earn incremental revenues of course, it is often to raise cash for liquidity or other financing purposes. New regulatory pressures have also played their part here. The need for liquidity has driven market demand for high quality liquid assets (HQLAs) and this is expected to continue as the regulations take hold. What is that data telling us, though? Is the mix of cash and non-cash collateral usage changing and does that change differ across the regions?
Figure 1 shows the indexed value of fixed income assets lent against non-cash collateral from July 2012 to May 2015. Note that the values for Asia are logged against the right hand axis to allow for their scale compared with Europe and North America. Asia has seen a dramatic upswing in the value of fixed income assets in our sample, which are lent against non-cash collateral. Europe has also exhibited a significant increase in the value on loan against non-cash collateral, although more than doubling over this period it is a small increase compared with the meteoric rise in Asia.
It should be noted that there are two additional factors to be considered when looking at these numbers: SunGard’s Astec Analytics sample data continues to grow as we expand our offerings and coverage globally, particularly in Asia and Europe, as well as the general rise in asset values, especially quality government debt, which is a significant part of the data under analysis here. Even taking these outside variable influences into account, both regions have shown significant change over the last three years. The rise in value for US fixed income assets has been less dramatic, more like a 10 percent shift, but in what is likely to be the largest market by value in the world, 10 percent is not insignificant.
The rise in value on loan against non-cash collateral is one aspect of interest, but the proportion of those assets lent against cash and those against non-cash collateral is also of interest for a number of reasons. Figure 2 shows the proportion of fixed income assets by value lent against non-cash collateral for the European, North American and the sum of the global markets. Note that the plot lines shown represent the proportion of value lent against non-cash. As this figure rises, so the opposing value lent against cash falls. The cash collateral plots have been omitted from Figure 2 to aid clarity.
The European market, which is traditionally a non-cash collateral dominated environment, is shown on the graph to be increasingly non-cash orientated. In the middle of 2012, the data indicates that the European fixed income market was lent against non-cash between 60 to 65 percent by value. By Q1 2015, this proportion is in the 80 percent range. North America has also risen, although by less in absolute terms. Commencing in the mid-40s, the proportion of fixed income lent against non-cash collateral actually fell through 2013 and 2014, hitting a low point of around 40 percent a year ago. Since that time, the rise has been slow but steady, posting a score just above 50 percent in April and May 2015.
As noted above, not a stellar change on the face of it, but a 5 to 10 percent change in a market with outstanding balances measured in hundreds of billions is a change that has many ramifications that need to be addressed.
Historically, a market dominated by cash collateral, changing to have more than half of assets being lent against non-cash collateral, will affect pricing and the rates charged for assets, as well as risk management profiles as collateral management has to adapt, meaning trading systems may need to be upgraded or changed to manage an increasing proportion of collateral types rather than just the US dollar.
As markets change their perspectives on the type and make up of collateral they take, they will need to adapt systems and processes as well as develop new knowledge and gather experience in managing the new regime. With many pieces of new legislation yet to actually bite, it is quite likely that the proportion of non-cash collateral traded will continue to rise. It may be too premature to say that the king is indeed dead, but it seems the sun may be beginning to set on this particular monarch’s reign.
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