When every bps counts, securities lending and collateral management take on a new meaning

Russell Investments will soon put on a webinar called In a low-return environment, every basis point counts. While the presenters are focused on their ability to add returns from principal investments, the title also begs the question of how asset holders and money managers will generate those additional basis points in other ways. We look to securities lending and collateral management as part of the equation here.

Following our research with OMGEO on the future of collateral management (November 2011), we see collateral management moving firmly in the direction of foreign exchange, where the potential earnings or cost from collateral investments form an integral part of an investment strategy. This can a direct implication on generating those valuable basis points. As noted in our report:

“Collateral management is emerging as a new and important feature in pre-trade decision making, where the costs of collateral may affect where, whether and how to engage in a trade. The last slice of trading activity to go through this evolution was foreign exchange; where asset managers were once unconcerned with the FX rates on an international trade, now those figures are closely examined. As end-users can see more variation in the associated costs of an OTC derivatives trade by venue, separate from the commission or rates offered on the trade itself, so will collateral management technology become more important to trading desks.”

Securities lending is also known as a revenue source; mutual funds with small cap or international portfolios can generate an additional five or six basis points on their portfolios, well enough to pay for custody or other costs. Large cap funds don’t do as well in the securities lending market due to the lack of demand, but some still try and by virtue of their size can offset some costs.

We wonder whether Russell’s thesis, that every basis point counts, will be taken seriously enough to include securities lending and collateral management. The trends appear to be moving in this direction and asset managers seem to be on board. Russell is clearly a believer; their Form NQ shows pretty consistent cash collateral holdings for their securities lending activity. However, it may take some time for plan sponsors in particular to fully digest the notion that every basis point does count. The next challenge will be ensuring that returns line up with the resources that these funds have available to manage the associated risk.

Our report on collateral management can be found here or is available from OMGEO.

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