Today we look at lending equities and taking equities as collateral, vs. lending equities and taking equity-backed repo as collateral. What are the trends, what’s the difference and why should we care?
Our surveys of the last year have revealed an increase in attention to lending equities and taking equities (typically blue-chip) back as collateral. Haircuts are between 5% and 10%, and beneficial owners in the US and Europe report that they are satisfied with the correlation risk in the loan. For asset owners lending small cap stocks and taking back large cap, this is a collateral upgrade trade – they are getting back better collateral than they are lending. No one has adopted our best idea for risk mitigation with equities as collateral – buying a put option on a basket that roughly correlates to the securities put up as collateral. This would theoretically allow haircuts to go to 0% as counterparty risk would be replaced by a closely hedged market risk. But even without additional insurance, beneficial owners that can legally accept equities appear more willing to move in this direction.
Equity repo meanwhile hasn’t moved much in 2013. US tri-party volumes have held constant at about US$110 billion, or 6% of total collateral outstanding. There was a slight increase in volumes from 2012 but this was pretty minimal. Money market funds are largely locked out of equity repo, so they are not worth considering as cash providers to this market. Meanwhile, repo asset classes other than sovereigns give institutions some pause. The main attitude is to accept assets as collateral that a fund would ordinarily hold itself. But, even funds that we consider very sophisticated tell us that they aren’t keen on equity repo – although they are considering equity for equities in securities lending.
We see the following types of risk involved when accepting equities as collateral in securities lending or putting cash into equity-backed repo:
Equities as collateral
Counterparty default risk – mitigated by indemnification in many but not all cases
Market/correlation risk – mitigated by 5% to 10% overcollateralization
Equity-repo in cash collateral accounts
Counterparty default risk – possibly mitigated by dual indemnification, also called collateral indemnification
Market/correlation risk – mitigated by an average 8% overcollateralization in US tri-party and 5.5% in European tri-party
The risk we don’t see in large cap equities is liquidity risk, which is our big concern about corporate bonds as non-cash collateral or in corporate bond-backed repo. So long as there is enough collateralization, equities should remain liquid and beneficial owners should be able to cash out in the case of a counterparty default.
This leaves us wondering, why is there a perception difference in taking equities as non-cash collateral vs. providing cash for repo backed by equities? There are of course operational differences, some in US markets may also be concerned about market risk with the tri-party repo collateral agents. Indemnification also plays a role, and there is every reason to opt for an indemnified transaction over a non-indemnified one. Rates and returns will also factor in but we see fees and repo rates as being pretty close for equities. As far as counterparty and market risk are concerned, we look at these two options as being pretty close. There may also be netting benefits on the borrower side when borrowing and providing collateral for a closely related asset.
The reason why this matters is that in a world where cash and government bonds are king, then equities and corporate bonds are the next most plentiful asset classes that borrowers want to post as collateral. As beneficial owners in securities lending are pressed to look at alternatives for non-cash, and as repo cash providers are told that there aren’t enough treasuries or gilts to satisfy demand, then equities will be at the top of the list for alternatives. This is a topic worth keeping an eye on.