Finadium Research Report

Non-cash Collateral Trends in Securities Lending,
Listed Derivatives and OTC Markets

Finadium
December 2009

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Investors and service providers should be prepared for a marked increase in non-cash collateral use over the next three to five years. Across the global markets of listed derivatives, OTC derivatives and securities loans, the use of non-cash collateral currently ranges from being an established practice to being discouraged by legislation or local preferences. As a result of the credit crisis, however, most market participants will need to carefully consider their use of non-cash collateral and how to best manage the risks that posting or receiving non-cash collateral entails.

This report develops the thesis that changes in non-cash regulations and acceptance will have a broad impact on financial markets worldwide. Along the way, we seek to answer two key questions: what are the implications for US and other markets if the US government approves the broader use of treasuries, bonds and equities as margin collateral? And will this create substantially more liquidity for US and other exchanges or will it simply shift risk around with no further impact?

In the securities lending market, we use recent Finadium survey data to identify why non-cash collateral for securities lenders is not as popular in the US as it is in Europe. In theory non-cash should be popular: it provides risk diversification, is covered under some types of indemnification policies and commands a price premium. Why then do US lenders in a securities loan transaction continue to be resistant?

A regulatory-driven growth in the use of non-cash collateral will create new winners and losers. Trading firms able to optimize their collateral use will have greater access to market opportunities than their competitors. Central credit counterparties will need to manage the risk that such growth entails, particularly when the underlying securities are illiquid or hard to value. Cash collateral and money managers may see different opportunities in credit markets as more collateral shifts away from cash investments. As global regulations and attitudes finally settle, it is likely that a projected increased in the use of non-cash collateral will create lasting changes in financial markets.

This report is 26 pages with 18 exhibits.

TABLE OF CONTENTS
■ Executive Summary

■ The Use of Non-cash Collateral in the US and Europe

■ Sizing the Non-cash Collateral Market
– OTC Derivatives
– Listed Derivatives
– Securities Loans
– The Challenge of Repo

■ Valuing Cash and Non-cash Instruments
– A Pricing Premium for Non-cash in Securities Lending

■ Survey Data on US Pension Plans and Non-cash Collateral
in Securities Lending

■ Projecting the Growth of Non-cash Collateral Use
– Regulatory Trends

■ About the Author

■ About Finadium

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