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Opportunities and Challenges for Hedge Funds in the Coming Era of Optimization
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17
Part of improving this oversight has been to customize
or lay down clear program guidelines for lending
teams. These guidelines address several aspects of
the lending program.
§§
What asset classes are going to be placed into the
lending program and based on the asset owner’s
liquidity needs in that portfolio, how much of the
total portfolio can be put out on loan down to the
security level.
§§
What loan structure and term is most appropriate
based on the investment horizon of the asset owner
and their likely need to recall that asset.
§§
Which borrowers from the lenders approved list are
viewed as acceptable counterparties for the asset
owner, and has the lender performed adequate
due diligence to certify the creditworthiness and
reliability of their borrower pool.
§§
What is the organization’s income goal and does
this match their preference in terms of acceptable
cash versus non-cash collateral and their selection
of suitable reinvestment vehicles.
Once these guidelines are set, asset owners have
begun to demand sufficient transparency into their
lending program to ensure that their instructions
are being observed. This includes daily reports
showing loan activity, including the mark-to-market
on all outstanding contracts, collateral holdings and
valuations and the notification and tracking of any
corporate action events. Robust portfolio metrics and
benchmarks are also being requested to understand
the overall value of the lending program and how the
asset owner performed relative to the market and
their peer group.
Margins Decline Due to Reduced Cash
Reinvestment Risk Tolerance
While these efforts from asset owners have helped
to address concerns about risk in their lending
programs, their more conservative posture around
cash reinvestment has also impacted the margins on
their lending programs. This is illustrated in Chart 9.
To illustrate how there has been a decrease in the
cash reinvestment risk, we will look at the Risk
Management Association (RMA) composite U.S.
dollar-denominated cash reinvestment portfolio. This
portfolio generated an annualized return of 4.89% in
2007. This was down to only 0.23% in 2013. While
declining interest rates certainly played some role
in this shift, the re-allocation of cash reinvestment
assets also had a significant impact. In 2007, 27.6%
of the RMA’s composite portfolio was held in fixed
or floating rate commercial paper and asset-backed
securities and by 2013 that figure was down to only
13.6%. Conversely, in 2007, 2.0% of the portfolio was
held in highly conservative 2a-7 money market funds
and by 2013, that figure was up to 8.5%.
“ The trend is that securities lending is more of a
front office operation and not a back office function.
Our risk management committee used to not
be involved, and now at my firm, risk is running
the securities lending program,” — Asset Owner
—Money Manager
“ We are quite involved in our agent activities. We
put in all the parameters on what they can lend.
We can increase the buffer on specific names.
We can reach out and talk to the PM and risk
management internally to decide the right course
of action and then coordinate with the agent,”
— Asset Owner—Money Manager
“ We receive a daily report from our agent on what
is on loan. We are then creating regular reports
on our own to show the lending performance we
have added for our different portfolio managers,”
— Asset Owner—Money Manager
Return Earned
on Collateral
Investment
(Y bps)”
Source: Citi Business Advisory Services
Chart 9: Securities Lending Sources of Return:
Post-Crisis
Return Earned
on Collateral
Investment
Fully Paid
Long Asset
Low
Low
Risk
High
High
Return
X bps + Y bps Pre-Crisis
Lending program margin =
X bps + Y bps
Reduced Risk
Appetite on
Reinvest Resulting
in Lower
Program Margins
Return Based
on Demand
for Security
(X bps)