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Securities Lending Tutorial

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Securities Lending Tutorial Powered By Docstoc
					Steven V. Mann
Professor of Finance
Moore School of Business

CASH COLLATERAL REINVESTMENT


                           1
Securities lending is an
investment strategy
 Securities lending is an investment strategy in
  which beneficial owners of securities loan their
  securities to generate additional return
 Loans are collateralized usually with cash (102%
  or 105%)
 Transfers ownership of the securities including
  the voting rights but retains the economic
  benefits
 Cash dividends and market value continue to
  accrue to the lender

                                                     2
Who borrows and why?

Who borrows?                Motivations for borrowing?
 Broker/dealer firms        Cover a short position (e.g.,
 Hedge funds                 settlement coverage,
                              convertible bond arbitrage)
 Institutional investors
                             Financing
                             Temporary transfers of
                              ownership (e.g., tax
                              arbitrage, dividend
                              reinvestment plan
                              arbitrage)

                                                              3
Who lends securities and
why?
Who lends?                Motivations for lending?
 Mostly buy-and-hold      Generate incremental
  investors of actively     return
  traded securities –      Defray expenses of holding
  insurers, pension         a portfolio of securities
  funds, mutual funds,     Monetize the premium
  endowments…               from holding hard-to-
                            borrow securities




                                                         4
Mechanics of a securities
lending transaction

    Two elements of the transaction



Loan of a             Cash Collateral
 security             Reinvestment

                                        5
 A Basic Securities Lending
 Transaction – Act I

                                                    Cash Collateral


Securities Lender                Lending                              Securities Borrower
                    Securities    Agent
                                                     Securities


                                       Cash
                                       Collateral




                                   Cash
                                 Collateral
                                   Pool

                                                                                            6
 A Basic Securities Lending
 Transaction – Act II

                                                       Cash Collateral
                    Securities

Securities Lender                   Lending                                Securities Borrower
                                     Agent
                                                         Securities


                           40% of         Cash
                           Gross          Collateral
                           Spread
           60% of
           Gross                                                  Rebate
           Spread


                                      Cash
                                    Collateral
                                      Pool

                                                                                                 7
What are the inherent risks?

Counterparty risk               Reinvestment risk
 borrower defaults and fails    risks associated with
  to return securities            investing the cash
                                  collateral – interest rate
                                  risk, credit risk, liquidity
                                  risk, etc.




                                                                 8
What are the inherent risks?

Legal risk                    Operational risk
 compliance with the terms    processing error in the
  of the agreement, program     securities lending
  guidelines, etc.              infrastructure




                                                          9
Investing the cash
collateral
 When cash is the collateral (called cash
  collateral), the proceeds are reinvested by the
  security lender or the lending agent.
 The security lender faces the risks associated
  with reinvesting the cash.
 The fee earned by the security lender is then the
  difference between the income earned from
  reinvesting the cash and the amount the security
  lender agrees to pay the security borrower.
 Fee split with lending agent

                                                      10
Embedded fee vs. rebate

 The security lender's fee is called an embedded
  fee when there is cash collateral.
 The agreed upon amount that the security
  lender pays to the security borrower is called a
  rebate (negotiated interest rate).
 Security lender only earns a fee if the amount
  earned on reinvesting the cash collateral exceeds
  the rebate.
 In fact, if the amount earned is less than the
  rebate, the security lender incurs this cost.
 Indemnification

                                                      11
Borrow fee

 When collateral is letter of credit or security,
  security borrower compensates security
  lender by a predetermined fee.
 This fee is called a borrow fee and it is based
  on the value of the security borrowed.




                                                     12
Return is uncertain with
cash collateral
 Notice that while the security lender knows
  what the fee will be in the case of non-cash
  collateral (assuming no default), this is not
  the case when there is cash collateral.
 The fee is a function of the performance of
  the portfolio or security in which the cash
  collateral is reinvested.



                                                  13
Cash collateral reinvestment
then and now
 Prior to the financial crisis, cash collateral
  pools began lengthening maturity and
  moving down in credit quality
 Investing in structured products that were
  highly rated but were exposed to other risks
 Highlights the importance of choosing an
  investment strategy consistent with one’s risk
  tolerance.


                                                   14
Strategies for reinvesting
cash collateral


         Maturity      Credit risk




                       Separately
                      managed vs.
         Liquidity    commingled
                     cash collateral
                         pools




                                       15
Cash collateral reinvestment
and which securities to lend
 Cash collateral investment and securities
  lending are distinct decisions but they are not
  independent
 How much of my portfolio should I lend?
  How much cash should I borrow?
 Which securities should I lend? How much risk
  am I willing to take?



                                                    16
Three paths forward…

 Low margin/high turnover
 Hard-to-borrow
 asset/liability management




                               17
A Guide for Moving Forward

 Think about risk holistically
 De-leveraging
 Revisit contracts/agreements/guidelines and
  adjust accordingly
 Consider separately managed collateral pools
  if the alternatives are unappealing




                                                 18
A Guide for Moving Forward

 Perform return attribution analysis – know
  how the returns were achieved
 Alternative forms of collateral




                                               19

				
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posted:8/22/2011
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