SECURITIES LENDING & REPO MARKETS

A CACEIS PRODUCT DEVELOPMENT PUBLICATION - OCTOBER 2010

FISCAL AND OPERATIONAL ISSUES

It should be noted that contrary to the securities lending market, the OTC derivatives mar- ket is still predominantly cash collateral orientated, with rates ranging from 80 to 90% of cash collateral. ISDA’s latest estimations state that the collateral value in the OTC market is USD3.2tr. If this market moves away from cash, then there will be a demand on the GC col- lateral, which will undoubtely benefit to the securities lending and repo market.

3.4.5

Cash collateral reinvestment in securities lending programs

In the case of cash collateral, securities lending transactions and cash collateral reinvest- ment are often closely linked together. Indeed, a lender taking cash as collateral pays rebate interest to the securities borrower, so the cash must be reinvested at a higher rate to make any net return on the collateral. Typically lenders delegate reinvestment to their agents.

This process is illustrated in figure 35.

Figure 35: Illustration of the cash collateral reinvestment process

LENDER AGENT Securities lending

Cash collateral delivery

BORROWER

LENDER

SPREAD BETWEEN INTEREST RATE PAID AND INTEREST RATE RECEIVED

Interest rate

Cash collateral re-investment

received

MONEY MARKET INSTRUMENTS

Copyright CACEIS, 2010

Cash collateral reinvestment obviously offers more attractive investment opportunities in the context of low money market yields, as it is the case today. Furthermore, reinvesting cash collateral in assets that carry a higher credit risk expects higher returns. Hence it is crucial that the beneficial owners understand the risk/rewards attached to any cash program and customise their reinvestment program to match their level of risk toler- ance. In other words, beneficial owners must ask themselves what they expect from cash collateral: Only an insurance or an insurance plus an opportunity to make more money?

3.5

Risk versus return

3.5.1

Risk management considerations

The risks involved in repo and securities lending should neither be under- nor over-estimat- ed. However, they are quantifiable and, if properly understood and monitored, manageable.

An outcome of the financial crisis from a lender perspective is the realisation that risk needs to be identified, understood and controlled. Risk management is more im- portant than ever. The following table sums up the main risks which can occur in repo and securities lending, splitting them in three distinct categories - market-related risks including counterparty and col- lateral-related risks, operational risks and legal risks -, and the best practices to mitigate them:

BORROWERS

market

3.5

Securities Lending & Repo markets | page 55