A FISL proposal: new securities lending structures needed for US ’40 Act funds, ERISA plans and UCITS funds

In advance of the Finadium Investors in Securities Lending conference on May 17-18 in New York, we’re making a proposal for a structure that any US ’40 Act funds, ERISA plan and UCITS fund could use to engage in the securities lending market. Three new market inputs increase the urgency to get this going. Without change, we are concerned about these client types being increasingly sidelined from securities lending participation.

The problem statement is well known: bank balance sheet requirements disadvantage high RWA lenders, while regulatory restrictions specific to US ’40 Act funds, ERISA plans and UCITS funds can make them unattractive borrowers and limit their counterparty options. It’s also known that Total Return Swaps can be less costly than physical securities borrows to help hedge fund clients meet their investment objectives and that large bank borrowers have gotten increasingly good at internalization of long and short positions.

Securities lending has a “near-record year” 2022, as reported by both S&P Global Markets and DataLend, with revenues reported at $9.89 billion by EquiLend and $12.52 billion by S&P Global Markets. All lender types participated in the increase, but agent lenders note that their large pension and Sovereign Wealth Fund clients, including those that can be flexible on collateral types and need for indemnification, can earn much more than regulated fund structure entities.

The need for change is driven by three new market inputs. The first is bank collateral optimization including across triparty agents. At our Rates & Repo Europe event on March 29, we heard from a well-placed panelist that his firm’s larger clients were asking for direct data feeds from triparty agents in order to drive their own collateral optimization engines. This is a natural next step forward for big banks, and technology firms like Transcend can already deliver cross-triparty optimization tools out of the box. the more accurate collateral management and sourcing of inventory, the less need for external borrows. This alone does not end securities lending participation for less attractive counterparties but it doesn’t help.

The second is that banks are increasingly looking at low RWA strategies like CCPs in repo and Total Return Swaps. A logical progression in the low RWA strategy space could be a bank saying they no longer will borrow US Treasuries in securities lending but instead want that business cleared on FICC as a repo. This is before we get to the SEC’s proposal for mandatory clearing of US Treasuries that could potentially include US Treasury securities loans.

The third is planned changes to Basel III rules starting in Europe that would change the risk weight for unrated counterparties. Without a rating, which no fund would run out to get, some beneficial owners could become unattractive borrowers to a punitive degree.

The defensive move for these client types and their service providers is for selected beneficial owners to lend to a rated, central pool controlled by either an agent lender or non-bank financial intermediary, who would then be able to lend to a bank borrower on attractive RWA and collateral terms. For beneficial owners, this is nothing more than adding another counterparty. Some agents and prime brokers have started to move in this direction, for example Goldman Sachs’s agency prime model that facilitates loans between beneficial owners and hedge funds with what we hear is no or minimal balance sheet exposure to the bank. We’re proposing to take this to another level and incorporate all impacted beneficial owner types that are currently unattractive lenders due to either Basel III rules or their own regulation.

While the application of this idea may be newer in securities lending, it has a long history in the Asset-Backed Commercial Paper (ABCP) space. The functional models are there. Getting them into securities lending will take time, but the opportunity is now in front of the industry to build up the legal and operational infrastructure needed to enhance the lending attractiveness of US ’40 Act funds, ERISA plans and UCITS funds for the long-term.

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