1. Cash collateral reinvestment
Steven V. Mann
Professor of Finance
Moore School of Business
Cash collateral reinvestment

2. Securities lending is an investment strategy
Securities lending is an investment strategy in which beneficial owners of securities loan their securities to generate additional return
Loans are collateralized usually with cash (102% or 105%)
Transfers ownership of the securities including the voting rights but retains the economic benefits
Cash dividends and market value continue to accrue to the lender

3. Who borrows and why? Who borrows? Motivations for borrowing?
Broker/dealer firms
Hedge funds
Institutional investors
Cover a short position (e.g., settlement coverage, convertible bond arbitrage)
Financing
Temporary transfers of ownership (e.g., tax arbitrage, dividend reinvestment plan arbitrage)

4. Who lends securities and why?
Motivations for lending?
Mostly buy-and-hold investors of actively traded securities – insurers, pension funds, mutual funds, endowments…
Generate incremental return
Defray expenses of holding a portfolio of securities
Monetize the premium from holding hard-to- borrow securities

5. Mechanics of a securities lending transaction
Two elements of the transaction
Loan of a security
Cash Collateral Reinvestment

6. A Basic Securities Lending Transaction – Act I
Cash Collateral
Securities Lender
Securities Borrower
Lending Agent
Securities
Securities
Cash Collateral
Cash Collateral Pool

7. A Basic Securities Lending Transaction – Act II
Cash Collateral
Securities Lender
Securities Borrower
Lending Agent
Securities
Securities
40% of Gross Spread
Cash Collateral
60% of Gross Spread
Rebate
Cash Collateral Pool

8. What are the inherent risks?
Counterparty risk
Reinvestment risk
borrower defaults and fails to return securities
risks associated with investing the cash collateral – interest rate risk, credit risk, liquidity risk, etc.

9. What are the inherent risks?
Legal risk
Operational risk
compliance with the terms of the agreement, program guidelines, etc.
processing error in the securities lending infrastructure

10. Investing the cash collateral
When cash is the collateral (called cash collateral), the proceeds are reinvested by the security lender or the lending agent.
The security lender faces the risks associated with reinvesting the cash.
The fee earned by the security lender is then the difference between the income earned from reinvesting the cash and the amount the security lender agrees to pay the security borrower.
Fee split with lending agent

11. Embedded fee vs. rebate
The security lender's fee is called an embedded fee when there is cash collateral.
The agreed upon amount that the security lender pays to the security borrower is called a rebate (negotiated interest rate).
Security lender only earns a fee if the amount earned on reinvesting the cash collateral exceeds the rebate.
In fact, if the amount earned is less than the rebate, the security lender incurs this cost.
Indemnification

12. Borrow fee
When collateral is letter of credit or security, security borrower compensates security lender by a predetermined fee.
This fee is called a borrow fee and it is based on the value of the security borrowed.

13. Return is uncertain with cash collateral
Notice that while the security lender knows what the fee will be in the case of non-cash collateral (assuming no default), this is not the case when there is cash collateral.
The fee is a function of the performance of the portfolio or security in which the cash collateral is reinvested.

14. Cash collateral reinvestment then and now
Prior to the financial crisis, cash collateral pools began lengthening maturity and moving down in credit quality
Investing in structured products that were highly rated but were exposed to other risks
Highlights the importance of choosing an investment strategy consistent with one’s risk tolerance.

15. Strategies for reinvesting cash collateral
Maturity
Credit risk
Liquidity
Separately managed vs. commingled cash collateral pools

16. Cash collateral reinvestment and which securities to lend
Cash collateral investment and securities lending are distinct decisions but they are not independent
How much of my portfolio should I lend? How much cash should I borrow?
Which securities should I lend? How much risk am I willing to take?

17. Three paths forward… Low margin/high turnover Hard-to-borrow
asset/liability management

18. A Guide for Moving Forward
Think about risk holistically
De-leveraging
Revisit contracts/agreements/guidelines and adjust accordingly
Consider separately managed collateral pools if the alternatives are unappealing

19. A Guide for Moving Forward
Perform return attribution analysis – know how the returns were achieved
Alternative forms of collateral