SECURITIES LENDING & REPO MARKETS

A CACEIS PRODUCT DEVELOPMENT PUBLICATION - OCTOBER 2010

CHALLENGES & OPPORTUNITIES

An overview of assets used as collateral in securities lending and major trends

3.4.4

As already mentionned, in securities lending transactions collateral can theorically be cash or securities. Non-cash collateral is typically drawn from: > Government bonds;

> Corporate bonds; > Convertible bonds; > Equities of specified indexes, mainly large caps; > Letters of credit from banks of a specified credit quality; > Certificates of deposit drawn on institutions of a specified credit quality; > Other money market instruments.

The bulk of the non-cash collateral market is made of highly rated government bonds, such as German Bunds, French OAT, UK Gilts or US Treasury bonds.

Yet, equities, in particular blue-chip stocks in indices, account for a growing weight of non-cash collateral, due to their inherent advantages of liquidity, transparency and ready available pric- ing information. In addition, equities collateral offers good correlation when the securities lent are also equities and potential diversification of risks. The predominance of non-cash collat- eral, such as equities, has served lenders outside the US well during the recent credit crunch. However, it should be noted that in the United States, many types of beneficial owners would be unable to take equity collateral without regulatory change. The overall securities lending market, which has for a long time been a cash collateral market, is now progressively moving towards a non-cash collateral market (from 67% of cash collateral in early 2007 to 57% in early 2010 according to Data Explorers information), as displayed in figure 34. Overall in Europe, non-cash collateral has historically been the collateral of choice, with high quality government and supranational bonds being the most popular forms of collateral. Today cash collateral accounts for only about 20% of the European market. By contrast, the United States continue to be predominantly a cash market, with cash col- lateral accounting for 95% of the US market. The variety of habits around the world in terms of nature of collateral used reflects historical legislation and tax incentives. Thus, US pension funds regulated by the Department of Labour for example are not allowed to take securities as collateral, whereas in the United Kingdom, until the mid 1990s, the manner in which reinvest- ment earnings were taxed made cash collateral unattractive and pushed market participants to adopt non-cash collateral.

Figure 34: % of collateral taken as cash in securities lending transactions

Jan. 2007

Jan. 2008

Jan. 2009

Jan. 2010

67% 75% 37%

59% 66% 24%

59% 85% 20%

57% 79% 20% 35% 75% 21% 95%

Overall

Australia

Canada

44%

50%

Netherlands

48%

55%

71%

Sweden

76%

12%

15%

United Kingdom

18%

92%

95%

United States

96%

Source: Data Explorers, 2010

page 54 | Securities Lending & Repo markets