We had four conversations over the last couple of weeks with asset managers saying that their agent lenders were analyzing or suggesting a 25 bps minimum spread for their securities lending programs, or that they had these minimums in place and were conducting a sanity check. We look at whether this is a trend and what the implications are both for the managers and the securities lending market as a whole.
In an environment with low demand and return for general collateral, and where reinvestment returns in overnight repo barely justify GC business at all, we think that a 25 bps spread makes sense. For some programs this will mean reductions in lending utilization of 60% to 80%, while keeping an equivalent amount in revenues. This is pretty close to the 80/20 rule – 20% of loans bring in 80% of revenues. Dropping the remaining 20% of GC revenues has the added benefit of reducing counterparty exposure and collateral reinvestment risk.
For agent lenders, 25 bps spreads reduce balances on loan as GC gets priced out, which while reducing overall revenues has some positive aspects as well. For agents newly taking capital charges for securities loans (for indemnification or otherwise), lower balances mean less capital charge. Agent lenders managing cash collateral will also see reduced balances, some of which might be substantial. However, in an era where money market funds can suffer from uncertainty, lack of occasional supply and the continuing overhang of regulatory change, this might not be terrible either. The major issue for agent lenders is calibration – a planned reduction in client lending volumes is much better than the expectation that revenues must hit $X and not hitting that target due to lack of demand or unattractive reinvestment options.
For asset managers, this policy reduces risk while maintaining the bulk of revenues. On paper it looks pretty good in 2012’s revenue figures. However, we are slightly concerned that changes to dividend arbitrage in Europe might make 2014’s returns worse than some managers now expect; we showed in our September 2012 research report, “Regulation, Taxation and the Outlook for Lending in European Securities,” that div arb now accounts for an estimated 40% of beneficial owner profits in securities lending. Funds may be surprised when putting on a 25 bps minimum spread that a loss of div arb revenues makes the remaining take only 20% to 40% of their earlier revenues. On the other hand these funds will no longer will pay taxes on French dividends and will see more harmonized tax rates in other jurisdictions. (For French companies they will be hit with a 3% government tax on all dividends paid, but that is still an equal playing field tax rather than one levied on one domestic fund group over another).
The loss of dividend arbitrage will affect the market in other ways as well. In our same September 2012 report we said we expected that 20% of the mutual fund market will leave securities lending as dividend arbitrage diminishes. But that group would leave with or without a minimum spread; they are just too dependent on div arb to continue lending. For the rest, lending with the minimum will likely continue to make fine sense.
In terms of pricing, we think that a reduction in GC supply is a net benefit to both borrowers and lenders. We see plenty of supply still in the market and expect no upwards push on GC rates on account of asset managers moving to a minimum 25 bps spread. As noted in an eSecLending white paper from 2012, US mutual funds held 22% of the then US$12.3 trillion in available lending inventory; all mutual funds worldwide held about 43% of the total pool. Taking a chunk out of this availability in the current market will not make much difference given current GC demand. If the trend were to spread to big pension plans then we may have other things to say (as GC rates inch up to the 25 bp minimum, but we aren’t there yet.
We think it is increasingly becoming the norm for mutual funds to have some sort of minimum spread, and think that this is a trend worth tracking closely.