Fire sale risk in securities lending

Fire sale risk in securities lending

  • Export:

Participants:

Alastair O’Dell, Global Investor/ISF, chair
Craig Starble, chief executive, eSecLending
John Griffin, senior risk manager and head of derivatives & trading counterparties, Himco
Tred McIntire, managing director, Goldman Sachs Agency Lending
Doug Brown, managing director, Americas sales and relationship management, State Street
Mike McAuley , managing director and global head of product and strategy, BNY Mellon



Chair: Regulators are concerned about what would happen to securities lending trades if there was a firesale in a crisis. Do you share the concern?

McIntire: The risk of firesales of collateral was a discussion item at a meeting with regulators in November, and it is clear that they are concerned about firesales in a default situation. The securities lending market, distinct from the repo market, is less likely to cause fire sales in a stress situation. In the Lehman default, securities lending agents were in the market buying replacement securities.

One step that could lead to partially mitigating the issue would be to allow broker- dealers to offer equities as collateral to lending customers. Equities would offer a number of benefits, including broadening the range of collateral options, the benefit of correlation with loaned equities, and ease of pricing, among others. It would also introduce more balance as lenders might potentially both buy and sell equities in a crisis.

Starble: There would be better correlation and liquidity characteristics – that is what we learned from the Lehman crisis. Regardless of the price, at least we knew we had a market we could rely on. In many other asset classes there was either no bid or it was extremely low. We are talking a lot to the exchanges and the CCPs about firesales. We are applying our auction technology as a platform for them to liquidate portfolios in times of distress.

In the past, it has been clear that the trade itself has been fine but a lot of the post-trade reporting and compliance issues – how many bids you really got for an asset, was it done in a coordinated way – were lacking. The firesale issue will be around for years as the regulators are pushing entities hard to come up with living wills so they know exactly how they are going to liquidate transactions. They are even doing mock auctions and transactions to make sure they work properly.

Brown: The issue is that we could all be liquidated at the exact same time and need to sell the exact same securities.

McAuley: Right now the work is focused on the tri-party repo market. It looks like the next step in tri-party repo reform. One important point as it relates to securities lending is that in a default situation agent lenders are typically net purchasers of assets so we provide some price support to the overall market. The firesale concerns really vary by asset class.


Chair: Will the tapering of quantitative easing (QE) create opportunities or challenges for beneficial owners?

Brown: We will probably see some increased demand and maybe better spreads. Looking back to the last time we saw rates rise, between 2004 and 2006, spreads did not significantly increase, but we were not in a zero interest rate environment then. The fact that rates are so low right now means we will probably see spreads increase a little, maybe from the tapering and rates going up.

So you are going to get a yield curve once again. The yield curve has been flat for so many years that you will see increased returns from cash investments, where you are investing cash. Again, they will not be dramatic increases because cash structures have changed fairly significantly since 2008.

McIntire: Another consideration in regard to the taper is the potential impact on the equity markets broadly. We all saw what happened the last time that there were hints of a taper. The speed of the wind-down of QE will be an important driver of market sentiment. Emerging markets are likely to experience a somewhat magnified impact as we saw when the Fed hinted at beginning the taper.

Starble: Volatility should be a good thing for us overall from a demand perspective, but a long-term reduction in world markets would not be good, obviously. To me, it is pretty clear that whenever QE tapering begins, we will see a little bit more volatility than we have today.

Brown: Right now everyone just assumes the regulators and central banks will continue driving markets. But once they begin to take themselves out of the market, you are going to see more fundamentalsdriven activity. People have already started trading a little more of fundamentals once again.

Griffin: Yes, there is a desperate need to trend back to some type of normalcy. Right now, every trade you put on is led by when QE is going to end. That is not the way we should be investing. There have been plenty of articles in the last couple of months and there has been great difficulty in being a successful long-short hedge fund recently.

Starble: There is a one-way viewpoint on the equity markets: hedge funds cannot be short because they are worried they will get run over in a matter of weeks. That created a pretty poor demand profile for our business. For demand to improve, we need to get back to a two-way market where at least 20% or 30% of hedge funds are short.

The prospect of slightly higher short-term rates is going to be relatively meaningful for the business. It will allow us to do trades we may not have done under the old zero interest rate regime. It will provide a little bit of opportunity to maintain liquidity and do transactions that are at the margin, or negative, today. We may be able to be more positive if we see a little bit of relief.

Griffin: We have had a very squirrelly market cycle since May. People thought tapering would begin in the summer – everyone expected the Fed to taper and the market had priced it in – but it did not. I felt a great deal of sympathy for portfolio managers and traders – they have this whole other factor which is even more out of their hands than the usual inputs to add to their traditional process of deciding whether a trade is a good or bad one.

Brown: And we still have the budget issues out there, sitting unresolved for February, as well as the mid-term elections. But we have seen a significant increase in clients that have not lent before entering lending programmes in the last 18 months, whether executing one-off opportunities or repo-only structures. Spreads are down from earlier this year, but if you look at historical trends and you take out the volatility of 2008 to 2010, they are actually slightly above the average of the last 10 years. So it is still a good marketplace. IPO and M&A activity has dropped off, as well as big trades in the second half of this year, but the hope is that we see that pick up again in 2014.

McIntire: Since mid-May 2013, US specials demand decreased significantly. This partly reflects the fact that some of the short sellers were on the wrong side of names like Tesla. In 2013, we saw certain client segments such as mutual funds continue to move in the direction of minimum spread criteria. They are being a little more selective about the types of loans they want as they just do not see the opportunities on the reinvestment side. In general, mutual funds tend to look at the basis point return rather than look at just the absolute dollars. So, we have seen reduced interest in participating in GC loans on the mutual fund side.

  • Export:

Related Articles