This Finadium research finding tackles the interesting idea of buy-side firms developing their own mechanisms for contingent liquidity. A longer version of this article originally appeared in Calypso Intelligence, June 2014, and is reprinted with permission.
Josh Galper, Managing Principal, Finadium explains why buy-side firms should look at a contingent liquidity and securities finance in a different light
Contingent liquidity is an old concept in financial markets but a new twist brings the focus squarely on securities finance. The renewed interest from the buy-side is due not only to increasing financing costs for pension plans, asset manager and hedge fund borrowers but also the scarcity of accessing cash from a bank’s balance sheet. Buy-side firms are asking questions such as: In case of a private equity capital call, where will cash come from? Is it cheaper to self-finance margin trading than just borrow from a prime broker? What’s the best way to fund redemptions in complex strategies? The answer used to be setting up a bank line of credit, but that may no longer be feasible or cost effective.
In the past, banks would arrange credit lines that could be secured or unsecured and priced accordingly. The trouble now is that they must account for these uncommitted credit lines and add their capital exposure to applicable cost of capital ratios. Just like any financial obligation, these committed credit lines will consume a bank’s scarce balance sheet capital whether or not they are utilized. Simply having the line of credit open creates an obligation that must be recognized in accounting books. Borrowers looking for contingent lines of credit are now competing with multiple other bank divisions not just for cash but for the allocation of a portion of a risk capital ratio.
A small number of institutional investors are now recognizing that rather than compete with banks, they themselves may be the best source for their own liquidity. In addition, some have been asked by banks to be providers of contingent liquidity lines of credit.
From a functional perspective, institutions can look towards their securities lending programs as a means of generating contingent liquidity. The strategy starts by ensuring that a certain portion of the portfolio can be kept on loan for a consistent period of time in exchange for cash collateral. The easiest securities to lend in bulk tend to be government debt, but this may entail negative intrinsic return especially when market conditions are weak. However, so long as this reality is accepted, historical trends show that government debt portfolios can be highly utilized over long periods of time for cash generation. A lesser strategy would be to lend equities but even general collateral securities may periodically see weakened demand. Typically, cash collateral generated from a securities lending program has been reinvested to earn a spread. In a liquidity generation program however, the cash is kept aside for other purposes.
A logical question is, why would institutions engage in this risky activity rather than simply sell some assets and maintain cash on their books today? For some, the answer lies in their expected return on investments. Cash today earns close to a zero return. If the expected return for an institutional investment is 7% to 8%, then that cash produces a negative drain on the overall fund. The alternative of investing that cash – creating a contingent liquidity program using securities lending – leaves investors in an overall better position from an actuarial standpoint.
Finding contingent liquidity in today’s market is a tough challenge. Everyone wants it, from banks asking pension plans to institutions and asset managers setting up their own self-financing activities. Even CCPs need to figure out where their backup liquidity will come from. The reality is that there may not be enough readily available liquidity in financial markets to meet every demand in a time of extreme crisis. For ordinary purposes though, the current mandate is to generate funding strategies that are cost-effective in the face of expensive bank balance sheets. Buy-side firms with securities lending programs are in a good position to capture contingent liquidity, so long as their mandates, regulations and cultures allow them to take advantage of the opportunity.