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

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

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)

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

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

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

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

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.

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

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

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

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.

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.

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.

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

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?

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

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

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