Last week we published a new research report on the evolution of the agency lending business. One section of that report covered our thoughts about pricing in agency lending. We’d like to revisit this idea and see where it might go.
A new cost for counterparty default indemnification owing to new approaches for calculating Risk Weighted Assets (RWA), along with the introduction of central counterparties for securities lending, is likely to create more pricing options for beneficial owners. We see four main pricing tiers that agency securities lending could adopt:
Logically, the greatest fees are associated with the bilateral indemnified transaction. That’s where the credit limit exposures, counterparty risk and RWAs will fall highest. The second option would be bilateral loans without indemnification. While a portion of assets are already lent this way today, an expansion of this model would free agent lenders from the capital costs associated with their own risk exposures to borrowers. This would reduce costs for clients and/or allow more profitable loans to counterparties.
The third and fourth options introduce CCPs to the conversation. Option three would encompass lending securities on a CCP, which dramatically decreases the counterparty risk exposure weighting from 100% to a qualifying broker-dealer (under US rules) to 2%.
Lastly, agent lenders could offer, or clients could elect, to lend using CCPs without offering counterparty default indemnification. Already, 44% of large asset managers and insurance companies we surveyed in Q2 2014 thought that securities lending on CCPs would not require indemnification; a further 34% were undecided.
We tend to think that fee splits can only go up from here. Already we’ve been hearing about renegotiations that play to agent lenders, not clients (although there are always outliers). The problem for agents is the hyper-competitive nature of fee splits to begin with. If a competitor offers 92/8 and the best cost model is really 80/20, what’s the option? Go with 92/8 to keep the business. But sooner or later, someone has to blink. Doing business the old way with new costs is just too pricey.
We welcome your input to the conversation. Let us know what you think at info@finadium.com.