Charting a new course

Asset managers with high quality fixed income portfolios are seeing a significant increase in demand for securities lending. One of the key drivers for this demand is the regulatory change that is forcing bank borrowers to meet new liquidity requirements and others to find high quality collateral for the new Central Counterparty (CCP) clearing house for the Over The Counter (OTC) derivatives market.

Fixed income lending has traditionally played a secondary role in comparison with equity lending, coming to prominence only during moments of market stress to satisfy the needs of a “flight to quality” before being relegated once more as markets are calmed. However, that is beginning to change.

Regulation drives change
Legislation such as the Dodd-Frank Wall Street Reform and Consumer Protection Act in the United States and the Basel III regulations on bank liquidity are having an impact across all areas of financial services, including the OTC derivatives market. The Dodd-Frank Wall Street Reform and Consumer Protection Act is far reaching. It looks to address concerns over the stability of the OTC derivatives market in particular by ensuring that transactions are cleared through a CCP wherever possible. As for bank liquidity, Basel III regulation aims to address a concern highlighted during the credit crisis, namely that too many banks relied on short term liquidity which proved unsustainable through an extreme market event.

Liquidity
As borrowers, typically investment banks, look to position themselves to meet the new liquidity requirements, they are increasingly looking for longer term loans, particularly for highly rated paper such as government bonds. These transactions vary in length from 30 days to 2 years with an average of around 90 days.

As the benefit for borrowers of these loans becomes clear and demand increases, borrowers may be prepared to pay greater fees to lenders who hold these types of assets, and those who are able to be flexible on the duration of the loan and the collateral required. This may lead to an increase in fees for the more typical ‘open’ term loans of fixed income securities as more bonds are lent on term trades and supply for the more traditional short term loans comes under pressure.

In addition to this liquidity driven opportunity, upcoming regulatory changes impacting the OTC derivative market are having a significant impact. The OTC derivative market is estimated to be worth around $580trn.

In order to address the concerns surrounding the stability and lack of transparency of this market, legislation such as the Dodd-Frank Act in the US and European Commission’s proposed regulation requires that OTC derivative transactions be cleared through a CCP.

Collateral
In an International Monetary Fund paper analysing the impact of such a move, one interesting statistic is their estimate that CCPs will require an additional $2trn of collateral.* Understandably, the collateral requirements of CCPs are very conservative as they look to protect themselves and their members. Generally they accept only high quality, liquid instruments such as government bonds and other highly rated paper. Clearly, $2trn is a lot of collateral and this additional requirement should see interesting revenue opportunities for fixed income portfolios that lend their assets.

Revenue
With this increased demand for bonds, fixed income portfolios that already lend are able to capture additional revenue right now, with the expectation of additional opportunities in the near future.

For portfolio managers with bond portfolios that do not currently lend their assets, perhaps because the returns were previously seen as marginal, the outlook is positive. It may be a time to reconsider the benefits that lending may offer to portfolios.

Bill Foley,
Director of Securities Lending

*IMF Working Paper: Making OTC Derivatives Safe – A Fresh Look, Manmohan Singh

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