SECURITIES LENDING & REPO MARKETS

A CACEIS PRODUCT DEVELOPMENT PUBLICATION - OCTOBER 2010

FISCAL AND OPERATIONAL ISSUES

3.5.2

Securities lending returns mechanisms

Securities lending returns comprise two components:

> Securities lending return to lendable (the intrinsic value of the securities lending rate); > Reinvestment return to lendable (coming from the collateral reinvestment side).

The sum of these returns is called Total return to lendable.

In the United States where cash collateral has historically been predominant, a greater proportion of the returns come from reinvestment rather than securities lending itself.

As should be expected, returns from securities lending programs increase in proportion to:

> Firstly, the interaction of demand and supply; - Demand for any given security will vary from time to time; whilst ‘general collateral’ securities, for which there is low demand and excess supply, will afford lenders lower returns, securities subject to greater demand will offer significantly higher returns. > Secondly the amount of risk a lender is willing to assume; - Lenders willing to take a wider range of collateral securities than the safest government bonds will have higher lending balances and therefore higher revenue. Those prepared to take cash collateral and reinvest in the money markets also have the opportunity to earn additional returns. Other factors influencing returns include the nature and size of the securities portfolios available for lending and the stability of the portfolio, as well as the tax status of the lender (in the context of tax-driven arbitrage strategies).

New model of returns towards intrinsic value

3.5.3

The recent crisis and the Lehman default have raised for lenders awareness of risk versus return within the global securities lending markets, all the more as in the United States some aggressive cash reinvestment programs have been finger pointed after losses notably related to substantial reinvestment in asset-back securities and in funds of long maturity.

However, it is important not to paint all cash reinvestment programs with the same brush, as certain providers fared very well.

Cash collateral is not intrinsically safer or riskier than securities collateral but if a lender accepts cash collateral, their cash reinvestment parameters must be clearly defined: Which approach? Conservative or not? For what duration? In what instru- ments? On a segregated or pooled basis? Etc. More than ever, it is crucial that the risk return profile is understood and profession- ally managed. Beneficial owners reacted to the crisis with a range of different responses. They started to put into question their existing lending programs and ask themselves questions such as: > If we accept cash collateral, howmuch liquidity should we have, and are the reinvestment guidelines consistent with our objectives? > What new parameters, if any, should we consider for the lending program?

3.5

Securities Lending & Repo markets | page 57