The role of securities lending in the overall strategic thinking of plan sponsors and fund managers is undergoing a fundamental shift, reflecting a greater recognition of the ever-increasing complexity of financial market innovation. In its infancy, securities lending was viewed as a value-added service provided by custodians that modestly augmented plan performance or served to cover custodial and/or other administrative expenses. As such, many industry participants placed minimal emphasis on programme differentiators and securities lending mandates were generally won on the coat tails of the core custody sales process.
In today’s challenging market environment, this mindset has rapidly given way to a recognition of the revenue enhancements provided by securities lending. Furthermore, in this prolonged period of economic uncertainty, the relationship between return and risk has gained much more attention. For most plan sponsors and fund managers, the risk-adjusted contribution of securities lending can be shown to add efficiency to the core asset allocation.
The goal of the return management process for securities lending is to maximise earnings in the context of an acceptable level of risk. The risks inherent in any securities lending programme – including market, credit, liquidity, operational, legal, and regulatory – are all relevant to the principal common objectives shared by participants, namely stability of income and preservation of principal. Of these, market and credit risk most readily lend themselves to quantification and modeling due to the greater frequency and depth of the data available.
Market risk: Market risk potentially impacts both the future market value of a portfolio of assets and/or liabilities and spread income associated with the portfolio. The market risk associated with securities lending contains two components: interest rate risk and spread rate risk.
Interest rate risk: Interest rate risk is the risk of interest rate fluctuations impacting spread income and/or the value of the integrated portfolio (ie, both the collateral reinvestment and the funding / loan portfolios). This type of risk arises from maturity/reset timing mismatches between the asset and liability positions. The liability is the cash collateral received from a borrower that has a certain cost while the asset is the investment purchased using that cash collateral that generates a certain yield. As part of the interest rate risk management process, a number of alternative interest rate ‘paths’ are modeled, in which the timing and magnitude of potential rate changes are examined.
In addition to having an effect on spread income, changes in interest rates also have an impact on the market value of the portfolio. The relationship of market value to purchase price is captured by its net asset value (NAV). A security with a yield exceeding the current market rate of interest for an investment with a similar maturity structure and credit quality will be valued in excess of par, while a security with a yield lower than the current market rate of interest for a similar investment will be valued below par. In the latter scenario, an investment might have seemed attractive at the inception of the transaction, but with an increase in interest rates, the original investment is now trading at a value below the purchase price. In effect, if the security is not sold prior to maturity, it will only incur an ‘opportunity cost’ or a foregone opportunity to earn the current yield. As such, NAV is an indicator of how the portfolio will perform relative to the market going forward, and increased volatility of this measure is suggestive of a build-up of risk.
Spread rate risk: Spread rate risk can be viewed as either market- or credit-related, but is best summarised as the market risk associated with the macro-economic credit outlook. This risk affects floating rate securities, whose return is impacted by the following elements: the index rate and the spread over this rate, and an element of risk associated with each. The index rate, or reference rate, is a designated interest rate to which the coupon of a floating rate security changes (eg, Prime, LIBOR).
Changes in market spreads have significant market value implications for floating rate securities, which generally have longer expected maturities than the fixed rate securities typically purchased in a securities lending program. However, the widening and tightening of such spreads, which generally occurs in response to changes in perceived credit quality for the class of securities of which this issue is a part (eg, AA Finance), will typically vary within a narrow band. Over the longer term, it is the potential for changes in interest rate levels – and not spreads – that poses the greater risk to earnings. Clearly, this is what makes floating rate securities an attractive investment.
Credit risk: The second primary risk factor is credit risk. This risk takes two forms – reinvestment credit risk and borrower credit risk.
Reinvestment credit risk: Reinvestment credit risk is the risk that a change in the creditworthiness of an issuer will result in a change in the market value of the issue. In the extreme case, it is the risk that default, or the inability of the issuer to meet payment obligations, will result in a substantial erosion in value. Changes in credit quality that do not result in default will not have a realised monetary consequence unless the issue is sold prior to maturity. However, there is an opportunity cost to the extent that the yield available to current purchasers of the security is higher. A defaulted issue can impair the value of the reinvestment portfolio to the extent most or all of its value is not recoverable.
Borrower credit risk: Borrower credit risk arises from the potential inability of a borrower to return the loaned securities. Losses can arise when the collateral on hand is insufficient to purchase replacement securities at the time at which a borrower defaults. Borrower credit risk is a low-probability – but potentially high-impact – event. This risk can be mitigated by entering into lending agreements with highly rated counterparties and by ensuring that the loans are properly collateralised on a daily basis.
To measure the combination of both market and credit risks, statistical modeling can combine the potential residual (or unsecured) risk in a portfolio of loans and collateral to an individual borrower with an assessment of the likelihood that the borrower will default over a defined time horizon. Residual risk is defined as the level of price risk that may be unsupported by the collateral margin held.
Today, plan sponsors and fund managers are increasingly looking to the securities lending agent’s ability to optimise performance within their unique risk tolerances and return expectations. Securities lending agents are increasingly being viewed in a manner that is comparable to investment managers, with all of the expectations of providing optimal performance and innovative financial solutions. Those lending agents who see their goal as meeting these expectations, and who invest in the necessary systems and personnel to achieve it, will develop a sustainable competitive advantage in the marketplace. This will lead to greater efficiency in the industry.
Peter A Economou CFA is senior vice president, head of global trading and risk management, securities finance at State Street