Designing a securities lending program
By Josh Lavender, executive director, J.P. Morgan Worldwide Securities Services | October 25, 2011 1:09 pm
A best-practice approach for entering a securities lending program requires lenders to be able to clearly define the product, how it works and the associated risks in order to design a customized program that explicitly meets the lender's risk and return objectives. Having a thorough understanding of securities lending is the first step in any program design.
Securities lending is an investment overlay strategy that involves the temporary transfer of a security by its owner (the lender) to another investor or financial intermediary (the borrower) in a transaction that is collateralized with cash or securities. Securities lending is intended to complement investment strategies, and affords an institutional investor the opportunity to produce alpha by generating income that can be used to increase portfolio returns or offset portfolio expenses with a manageable level of risk.
Globally, securities lending:
- provides critically needed liquidity in the financial markets;
- supports a variety of trading strategies;
- facilitates trade settlements; and
- supports general financing techniques.
Traditionally, the income earned from securities lending is added to the investment return associated with the lending portfolio(s). The lender's portion of this income is used to lower the cost of various bank services (e.g., custody) provided to the lender. There are lenders who choose not to use this type of “bundled” approach and look for each bank service to be priced independent (i.e., “unbundled”) of the income earned from securities lending. Either approach, “bundled or unbundled” should become part of the process for designing a securities lending program, requiring lenders to define their goals for participating in this type of investment strategy. A lender will need to decide if they are looking only to earn enough income to fully or partially offset bank-related fees, or if the main focus is to enhance portfolio returns. Each approach or goal will lead a lender to a different type of lending strategy risk profile.
Working in tandem with the lending agent, lenders should design a program that achieves their goal and meets their risk/return objectives. A lender will need to consider four areas:
- program structure;
- loan type;
- parameters; and
Program structure refers to five types of lending distribution methods: agent discretionary, client directed, auctions, exclusives and principal.
In an agent discretionary program, a lender will use the lending agent to facilitate and negotiate loan transactions, evaluate borrower credit risk, provide collateral monitoring and/or cash collateral reinvestment, and on-going loan maintenance, and record keeping.
A client directed program allows lenders to operate their own lending platform using their custodian to facilitate loans and/or cash collateral reinvestment transactions.
Generally speaking, auctions, exclusives or principal are arrangements whereby a lender agrees to make their portfolio(s) or a portion thereof available for borrowing on an exclusive basis to a particular borrower for a pre-determined fee or price and period of time.
Each program structure may be appropriate depending on a lender's goals, portfolio composition and market conditions.
The second program design consideration is the types of loans (e.g., open, term, general collateral and specials) a lender is willing to engage in and the lending philosophy (e.g., value or volume) used.
Most loans are specified for an open period, which implies the loan can be terminated at any time and the rebate rate or fee can be renegotiated. A term loan is for a specific period of time, generally at a fixed rebate rate or fee.
General collateral loans are for securities that are not experiencing high borrowing demand and therefore produce lower earnings per loan due to higher rebate rates or lower borrowing fees. This approach, often described as volume lending, could necessitate a more aggressive cash collateral reinvestment strategy (e.g., money market) to allow for a greater level of reinvestment spread (i.e., yield earned above the federal funds rate) through the investment of cash collateral in higher yielding and longer duration securities. Volume lending will typically produce larger cash collateral balances which may lead to higher program earnings.
A value approach would involve lending mostly “specials”, which are defined as securities with high borrowing demand, as noted by very low and sometimes negative rebate rates or high fees paid by the borrower(s). This type of strategy produces a higher return per loan and would allow for more conservative cash collateral reinvestment guidelines (e.g., overnight repo).
During the design and implementation phase, a lender will need to determine if any specific parameters should be enacted. One parameter, minimum spread, is defined as a specific level that sets a spread between the collateral investment rate and rebate, which needs to be achieved before a loan can take place. Another parameter, maximum on-loan, is used to specify the highest amount of a portfolio and/or a security can be on-loan at any point in time. This parameter can be noted as an outright percentage of a portfolio or specific market value.
A borrower limits parameter, denotes the maximum amount (e.g., by market value or percentage) that a lender's program can be on-loan to a particular borrower.
Finally, a lender can establish specific account and security level restrictions. For example, a lender may choose to make a certain CUSIP ineligible for lending.
Each of these parameters allows a lender flexibility to design and implement a securities lending program that explicitly meets their objectives.
The final step a lender takes in designing a securities lending program deals with collateral options (e.g., cash and/or securities).
Lenders who choose to accept only securities as collateral should be aware that lending opportunities may be reduced and they will need to decide which types of securities are acceptable from a risk standpoint.
When cash collateral is accepted by the lender, they may have the option of selecting from a variety of cash investment vehicles. Such options include a dedicated separate account, a commingled fund, an external (i.e., to the lending agent) investment vehicle and a “self-invest” model, whereby the lender invests the cash. A separately managed account allows a lender to customize their cash collateral reinvestment program to meet their unique risk and return requirements, allowing for increased transparency and control. A commingled fund pools lenders together according to a common investment strategy. With an external investment vehicle, a lender may already have positive experience with a specific fund or investment manager and therefore select this option. A lender who believes managing short-term cash is a core competency of their firm, might choose to use the “self-invest” model.
This part of the securities lending design process requires that the lender fully understands and is comfortable with the cash collateral reinvestment vehicle's investment philosophy and guidelines. Choosing the appropriate cash collateral reinvestment vehicle can depend on a variety of factors such as lending program size, liquidity requirements, control/ownership level, desire to influence investment decisions, transparency level and ability to match risk/return tolerance.
In conclusion, securities lending has been an integral part of the financial markets for more than 75 years and continues to provide valuable opportunities for investors to earn additional income or alpha within a risk controlled environment, enabling lenders to enhance portfolio returns and offset portfolio expenses. The best practice approach to designing a securities lending program should encompass a thorough understanding of the product, lending and collateral options and the lenders' individual goals and risk/return objectives.
Josh Lavender is an executive director in J.P. Morgan's Worldwide Securities Services business. Prior to joining J.P. Morgan in 2008, Mr. Lavender spent 13 years with General Motors Asset Management, where he was responsible for the evolution and management of the firm's global securities lending program and overseeing a variety of fixed income mandates.