There is a sea change coming to the market in direct repo and securities lending, at least for many firms that want to continue to earn reliable revenues. The term “direct” is a bit of a misnomer, and the idea of lending to the credit exposure of a hedge fund is certainly not the first thing that asset holders get excited about. But as we further analyze the subject, we think that direct might lead to a major breakthrough for asset holders in both revenue generation and risk management. Here’s the argument:
The traditional model of securities lending has been based on a low-risk, low-volatility market structure where 2%, 5% or even 10% over-collateralization levels from banks was considered fair and adequate to protect asset holders against both credit risk and market movements. Arguably, that thesis no longer holds true.
A move to direct lending resets the expectations of what over-collateralization level asset holders might receive. Would 140% collateral be unreasonable, especially when the option for a hedge fund or REIT borrower might be no access to cash or securities at all? That might actually be a very good deal for the borrower.
On the revenue side, taking a bank out of the principal business means that a whole level of regulatory capital charges just got removed. The hedge fund borrower is no longer paying a bank for the privilege of its credit intermediation services. This frees up daily cash flow that can be effectively split with a cash or securities lender: instead of General Collateral going from an agent lender to a bank borrower for 15 bps, it could now be lent for 20 bps to a hedge fund borrower. The hedge fund would probably still owe a service fee to a bank for operations and valuation activity but this is a small price relative to capital charges arising from the transaction. (These capital charges are real and ugly, by the way – see our December 2015 report on regulatory costs for more info).
For asset holders in indemnified securities lending programs, there is a possibility that the agent lender might be willing to take on the credit risk exposure to the hedge fund or REIT borrower. This adds another cost to the asset holder lender, but defraying that credit exposure while getting the benefits of greater over-collateralization plus higher fees could well be worth it.
The rules of the securities lending market are changing. As we look more closely at going direct in repo and securities lending, we tend to think this might be a really good deal for asset holders who can determine their optimal collateralization and rate levels.
For those interested in the topic, we’ve got the following material in our pipeline:
- In March we will release a Finadium research report on what asset holders in securities lending need to know now about counterparties and indemnification.
- We’ll follow that up in April with a similar report on cash and non-cash collateral.
- We’ll also have a panel at our March 15 conference in NYC on what good news is out there for the buy-side.