New data on why and when for collateral transformations in securities lending (Finadium subscribers only)

The latest Finadium survey of asset managers shows some new data points on the collateral transformation trade. We are paying close attention to this important topic. This article is part of the Finadium research subscription.

Finadium has conducted a survey of large global asset managers every year since 2008 and we have regularly asked about the collateral transformation trade. Our findings until this year have been that there was little interest from borrowers. Last year we saw increasing demand for accepting equities as collateral in European securities lending transactions, but there was no reason to call these particularly collateral transformation trades. The transaction could have been equities for equities just as easily as government bonds for equities. This year we are starting to see a different story.

In Europe, asset managers report a meaningful, if not huge, increase in demand for collateral transformation trades. Particularly, borrowers are looking to access government bonds and give in return corporate bonds or equities. Equities seem to be easier for lenders to stomach as collateral given the liquidity of equities relative to corporate bonds. In some cases, lenders say that borrowers will not borrow unless lender will accept equities. The really interesting thing here is that spreads for the transactions are tight compared to government bonds for other government bonds or similar kinds of loans. Asset managers report a 5 basis point premium on a 6 to 9 month transaction for accepting equities over the same loan with government bonds as collateral. Borrowers have enough liquidity; they want the collateral transformation trade but not so much that they are willing to pay up for it. Lenders expect that there will be a time when a reasonable spread is earned for collateral transformations, but that will not happen in 2014.

In the US, collateral transformations remain more of a distant thought than a current reality. The most forward thinking asset manager we spoke with was trying to conduct a transformation trade simply in order to get it done. Testing the pipes is a legitimate reason to conduct the transaction, but there was no real economic need. Going forward, the expectation is that muni bond funds will be most in dire straits to execute transformations, but that is not a challenge for this year.

At this point, the WHY of  collateral transformations appears to be elected choice. European lenders that want to get loans out the door and are finding that a surfeit of liquidity on the borrower side means that lenders have to be more flexible on their collateral criteria. Otherwise, the loan won’t get done. This is not a “reach for yield” conversation; it is a “make a loan or don’t make a loan” conversation. We think that something similar may well happen regarding securities lending CCPs over the next year. US lenders are just testing the waters to see what can possibly be done if ever the time comes when collateral transformations are a necessity.

The WHEN of collateral transformations is just a little bit now but probably a lot more in two years. Banks still have more liquidity than they need and have shed Tier 2 and Tier 3 portfolios leading to less demand for high-quality liquid assets. Further, there still hasn’t been a tremendous need for new collateral to post on CCPs or OTC derivatives trades, and BCBS/IOSCO rules on non-cleared OTC derivatives won’t kick in until the end of next year. At this point, collateral transformations at rates that bring in a broader number of lenders to the market looks like a story for 2016.

Finadium’s full results for our 2014 asset manager survey will be released in the early July.

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