CalPERS boosts cash return through repurchase facility

A repurchase facility announced this month with access to cash from CalPERS to cover the cost of a counterparty default — the first such agreement involving an asset owner — is shining a light on potential roles for asset owners as sources of liquidity.

The one-year facility, created by the $301.7 billion California Public Employees' Retirement System, Sacramento — in collaboration with the Options Clearing Corp. and agency securities lending provider eSecLending LLC — would provide Options Clearing with the option of a cash draw from CalPERS, facilitated by eSecLending, if a counterparty defaults on a derivatives trade.

“It's not a pure securities lend,” said Greg Korte, principal and practice leader, trust, custody and securities lending for North America, at Mercer Sentinel, Chicago, a consultant on asset servicing and investment operations. “It's almost like a market-making deal. eSec Lending has an agreement with OCC, which sees the need to diversify the liquidity traditionally given by banks. Now you have a funding source with CalPERS.” Mr. Korte is not connected with the CalPERS deal.

Daniel E. Kiefer, portfolio manager and head of securities lending at CalPERS, said the facility arranged with Options Clearing and eSecLending was purely a repo facility. He said Options Clearing sought to increase its credit lines outside of clearing member firms to non-banks “in order to diversify and mitigate risks. ... OCC introduced the concept of the collateralized liquidity facility between a public pension fund and (central counterparty clearinghouse) to their regulators (the Commodity Futures Trading Commission). We're taking the cash collateral from our securities lending program. It's tough to find quality liquid investments. This also diversifies our counterparty arrangements with someone beyond the Street.

“This product enhances our cash return,” Mr. Kiefer said. “We have our cash in a floating-rate vehicle so the facility is built to account for a modest rise in rates.”

Neither Options Clearing nor Mr. Kiefer would comment on how much CalPERS will make through the facility, although Mr. Kiefer said, “CalPERS is paid a competitive risk-adjusted return for this transaction.” In the March 12 announcement of the facility, Curtis Ishii, senior investment officer for fixed income at CalPERS, said it “achieves incremental risk-adjusted returns for our pensioners” but didn't provide details.

CalPERS is providing “tail-risk capital for counterparty relationships,” said David Wilson, managing director and institutional group leader at Nuveen Asset Management, Chicago. “It's very low risk because of all the regulations that now tightly control this market.” If another Bear Stearns collapse or “one of those 1-in-100-year event happens,” he said, “the consequences could be severe. But to them, given the safeguards, it's not as big a risk.”

CalPERS is filling a gap in default protection left by brokers with less capital to lend because of regulations limiting their risk. Scot Warren, Chicago-based executive vice president, business development for Options Clearing, said the firm saw asset owners as a unique source of liquidity that “wouldn't be part of the problem, who was an arm's length removed from brokerages. That's how CalPERS came in.”

Mr. Warren said similar arrangements could be created for other markets. Asset owners “could be involved in any settlement process,” Mr. Warren said.

Nuveen's Mr. Wilson and other sources said more asset owners could provide contingent cash to central counterparties. In fact, asset owners could, because of their holdings in cash and other securities like fixed income, could use that inventory to potentially provide liquidity in some markets.

Asset owners “could become market makers themselves,” said Mr. Wilson. “They certainly have the capital to do this. ... I do think this is likely. Pension funds are looking to get income. Some investors are nervous about the bull market in equities. Everyone is nervous about rates. This is a good way” to get income.

Added Jamie Selway, managing director and head of electronic brokerage at Investment Technology Group Inc., a New York-based financial markets technology provider: “CalPERS, which is fundamentally a consumer of market infrastructure, is extending credit to a part of market infrastructure. Historically, it'd be the opposite. Maybe it's a sign of the times, where asset owners will be increasingly in the role of liquidity provider.”

David Long of the C$60.8 billion ($48.4 billion) Healthcare of Ontario Pension Plan, Toronto, said large asset owners would have the capacity to provide liquidity to fixed-income markets, but the issue is what doing so would require of them.

“Large asset owners do have the risk tolerance and balance-sheet capacity to provide trading liquidity to fixed-income markets,” said Mr. Long, senior vice president and chief investment officer, asset-liability modeling and derivatives and fixed income, at HOOPP. “In general, however they lack the trading expertise, culture, systems and compensation models necessary to compete in that business. The logical thing for them to do, if they seek the returns from this business, is to buy or create stand-alone trading entities; however, once that is done, these entities would fall into the same regulatory and other barriers faced by the other firms in the business.”

Mr. Long said one way large asset owners could provide liquidity is to participate “in exchanges or swap execution facilities. In these, participants can easily take on the role of liquidity provider, liquidity taker, speculator, etc. I'm sure that this is done to some extent already,” like on the CME Group Inc.'s Standard & Poor's 500 index futures or the 10-year note futures. “However these contracts are few in number and high in volume. Trading the thousands of individual fixed-income securities in the market through any platform would require more sophistication on a variety of competencies.

“Nonetheless, nature doesn't like vacuums and if there is a good return to be made from liquidity, it will migrate to the best-suited providers, which may include large asset owners.”

Mercer Sentinel's Mr. Korte said “he wouldn't say no” when asked if asset owners could become market makers, but said it's more likely there would be more securities lending involving fixed income. He also said the CalPERS repo facility could cause other large asset owners to set up similar facilities with central counterparties. “There's a big need for backstop funding,” Mr. Korte said. “You're going to look at large pockets of liquidity from sovereign wealth funds and large insurance companies. It's unique that a large pension fund is doing this, but CalPERS has played a role in other innovations.”

When asked if there would be other possible market opportunities for CalPERS, Mr. Kiefer said: “I can't say. We were innovative with this in the first place, so you can expect us to be innovative. But that's all I can say.”

Mr. Kiefer said the real benefit of the Options Clearing-eSecLending agreement is that it will reduce systemic risk by adding stability to derivatives trading.

“In some ways, it's a win-win-win,” Mr. Kiefer said. “First, we're putting cash to work with a high-quality counterparty. And for OCC, they're pairing up with a quality partner with low systemic risk, allowing them to add diversification. And us, as a player, we trade options. In effect, we're adding stability. Our participation is derisking the same sandbox that we play in. It's more than us just making money. We're a long-term investor, and that means we're interested in making the system work.” n