In this article we present two models for risk mitigation in collateral transformation trades. Starting in 2013 we are using Securities Finance Monitor to try out a new distribution mechanism for Finadium research subscribers. If you or your company is a research subscriber, you should have full access to the article below by simply clicking on the title. If not, please contact us at email@example.com to find out how to sign up and get access to Finadium reports, briefings and ideas today.
Our research has identified that beneficial owners in securities lending transactions are often reluctant to engage in collateral transformation trades due to the credit mismatch that occurs and the risk that a counterparty default would leave them with unwanted collateral. Cash investors are wary of corporate bond or equity backed repo transactions for similar reasons.
On the demand side, we see slowly but steadily growing evidence of banks looking for collateral transformations for balance sheet management and to support an expected increase in OTC derivatives collateral requirements. According to the December 2012 Federal Reserve Senior Credit Officer Opinion Survey on Dealer Financing Terms (SCOOS):
“With regard to the level of interest in collateral transformation transactions that allow clients to provide pristine collateral, roughly one-fifth of survey respondents reported some current activity on the part of dealers and other financial intermediaries, pension plans and endowments, and insurance companies. Between about one-fourth and one-half of respondents pointed to frequent or at least some discussion of prospective transactions with all client types covered in the survey.”
We believe that there are two ways that securities lending borrowers and collateral providers can promote risk–balanced growth in collateral transformation transactions and increase the comfort of beneficial owners and cash providers. The first is the use of insurance. The second is the use of options and futures to hedge specific collateral risk.
In securities lending, many beneficial owners already enjoy counterparty default indemnification against the loss of securities. Since there is no cash collateral held in a collateral transformation trade, agents are obligated to return securities in whole to their clients in the event of a counterparty default.
But what happens if indemnification goes away, is perceived as unreliable or is otherwise not available? The beneficial owner would be left holding collateral in the event of a counterparty default. In collateral transformation trades, this would replace high-quality government bonds with corporate bonds, equities or other financial instruments. The beneficial owner is left to liquidate the collateral, most likely at a loss, and this is an unwelcome situation.
In order to mitigate the risk of losses in a collateral liquidation, we propose that beneficial owners, their agent or securities borrowers purchase insurance against a possible fall in value of the assets posted as collateral. This would require assets to conform to specific categories, for example A- or better corporate bonds. So long as all the assets were similar, an insurance company could offer a policy that would specifically guard against the fall in value of those assets. The policy may also come into effect if assets could not be sold for whatever reason within a defined time frame.
We understand that this type of insurance policy would carry a cost and expect that that cost would come out of the fees paid by the borrower to the lender. The lender’s return would be reduced correspondingly. However, in a choice between no loan or a loan with slightly reduced revenues and much greater risk protection, we believe that the trade off is worth it.
Options and Futures
Instead of insurance, bank borrowers may also provide listed derivatives hedging against the fall in value of a certain pool of assets. This again requires that collateral be within a certain category, for example S&P 500 equities. Once the collateral parameter has been established, a bank would buy for its counterparty an S&P 500 put option of an amount corresponding to the value of the loan. The exact value would need to be adjusted dynamically, but the basic idea would eliminate maturity mismatch risk while protecting against a fall in the value of the collateral assets in the event of a counterparty default.
Again, the cost of these options and futures would come out of the lender’s return, but the level of risk involved should drop substantially.
The same principals hold true in a repo transaction. While inventory for corporate bond repo is currently low, broker-dealers are still interested in repoing out other collateral types but meet resistance from cash providers on both collateral and the term of the transaction. A guarantee from insurance or a listed derivative would shift the liquidation risk away from the cash provider to either an insurance company or a centrally cleared derivative contract.
While banks looking to access high-quality treasuries or cash may choose to forego additional risk mitigation measures, we think that their borrowing options will be limited at current price points. Feedback from our most recent institutional investor survey suggests that there is too much caution in the market to willingly accept collateral transformation activities at current return levels. As detailed in our December 2012 report, Sizing Up the Collateral Transformation Trade, substantially increasing returns for investors is one option. However, purchasing insurance or an options and futures combination may prove less costly and generally more attractive from the lender viewpoint.