In a turbulent market with liquidity at the center of attention, Asset Managers are exploring new sources of additional margins. The creation of support-type activities such as securities lending is one of the preferred solutions today.
Loan-Loan is a guaranteed OTC activity, favoring the liquidity of the market. Its use also allows access to short hedging mechanisms while optimizing its revenues.
Mainly managed by custodians on behalf of their clients, the business has been industrialized since 1990 and has seen the emergence of loan-lending trading desks hosted by Asset Managers, according to more or less complex operational models.
The implementation of Loan-Loan activity at an Asset Manager is not as easy as it seems. This project is technical, because of its many IT needs, but especially functional. It must be framed and organized in very specific steps. Many processes need to be defined in order to avoid any drift or failure.
Why implement a securities lending activity?
Loan Borrowing Securities is an over-the-counter activity governed by a master agreement , which must comply with the regulations governing the source funds used in the loanable inventory.
The development strategy of the Securities Lending and Loan activity for an asset manager allows you to:
- Generate a complementary and recurring income,
- Diversify and expand the customer offer.
Asset Managers hold securities within their funds that may be attractive to market counterparties.
Subject to prospectus compliance, portfolio managers may lend securities. They carry out these operations for variable durations and against payment of remuneration.
The objective pursued by the portfolio managers is to generate additional income.
The managers define a pool of loanable securities, taking into account many criteria, such as the category of securities, the market capitalization, the type of funds and their risk profile.
- Hedge Funds
- Investment banks
- Financial institutions
- Commercial banks
- To cover a short position
- To temporarily transfer ownership of securities to meet a financing need
- Central banks
- The insurance
- Seeking additional profitability
- Need funding
What risks for what returns?
Many risks are inherent in setting up such an activity. Regular monitoring of these risks is not only essential but requires independent piloting.
It is then necessary, before any development, to identify the potential returns of its loanable perimeter according to its information system, its own operational expertise and the dynamism of the market.
Only this preliminary process of arbitrage between risks and returns will make it possible to envisage its implementation.
These securities lending processes (the latter being held by a UCITS), present own constraints affecting the Asset Manager’s business.
It is essential to measure and monitor the counterparty risk (replacement risk) incurred under a loan-loan contract.
In fact, in the event of default by the counterparty, the collateral received as collateral will either be sold on the market ( collateral received in securities ) or used directly ( collateral cash ) to repurchase the securities lent.
To ensure proper protection, it is necessary to:
- Respect the limits of commitments and limits by counterparties,
- Follow the collateralisation levels in accordance with the contract implemented,
- Respect the diversification of securities received as collateral,
- Set up daily reports to control positions and exposures,
- Quickly mobilize the collateral in case of default of the counterparty.
The bankruptcy of Lehmann Brothers validated the need to guarantee operations by collateral.
As a result, for all Loan Actors, the “haircut” has to be reassessed upwards.
Actors with proactive risk management have limited losses.
- Increase haircut,
- Collateral in cash preferably,
- Enhanced counterparty risk monitoring.
Legal and regulatory risks
In non-regulated markets, securities lending activity is necessarily subject to a master agreement between the parties. These contracts govern:
- The terms and conditions of application of securities lending and borrowing transactions,
- Authorized counterparties,
- The eligible collateral and the associated Haircut level.
This agreement is put in place before any start of operations between two parties.
UCITS, whose positions are the source of the loanable inventories, are subject to
- Fund prospectus restrictions: Only funds that are subject to the prospectus may be subject to securities lending transactions,
- To regulatory ratios and “prospectus” (or contractual) ratios,
- With PEA tax ratio: PEA funds can only participate in the upper limit of the PEA ratio of 75%,
- Respect for the type of funds: distributing UCITS may not participate in securities lending and borrowing transactions during their coupon release periods, until January 1, 2013, the date for the modification of the regulations currently in force.
The implication of the legal services is necessary when the definition of the loanable inventories in collaboration with the actors of the Management.
Accounting and financial risks
The tools implemented as part of the loan-and-loan activity must allow:
- The reconstitution, in a chronological order, of all the events related to the operations,
- The justification of any information by an original document, from which it must be possible to go back through an uninterrupted path to the summary document and vice versa,
- The reconstitution of balances from one decree to another by the conservation of the movements affecting the accounting items.