Wean US pension funds off cash collateral reinvestment, Data Explorers tells regulators

American pension funds that lend securities are addicted to the returns from reinvestment of the cash collateral they receive and need to be weaned off it, says Data Explorers, the London-headquartered provider of data and analytics on securities lending and financing and short selling.

Data Explorers, which has supplemented its data with face-to-face interviews with some major institutional lenders, says that the overwhelming appetite of US lenders for insisting on cash rather than securities as collateral explains much of their poor experience in the aftermath of the collapse of Lehman Brothers in September 2008.

Nothing new there, a cynic might say: everybody knows that the realised and unrealised losses in US securities lending programmes have always stemmed from cash collateral reinvestment programmes. But what is new about the Data Explorers research is the revelation that the equity collateral preferred by many European lenders performed much better than expected: in the cases studied by Data Explorers, lenders were more than made whole when they realised equity collateral supplied be defaulting borrowers.

“Collateral is an essential component of securities lending transactions,” says Mark Faulkner, Founder and Head of Innovation at Data Explorers. “What one accepts and how it performs is of critical importance, especially when things go wrong, as in the case of Lehman. The extent to which US regulations continues to encourage a reliance on cash collateral will be a key theme covered at the New York Securities Financing Forum in May.”

The Data Explorers research not only highlights the overwhelming reliance on cash collateral by US domiciled institutions, but also shows the wide variety of collateral-taking habits around the world. In the US, cash collateral has consistently accounted for over 90% of collateral taken by lenders. This contrasts heavily with other countries, such as the UK, where cash accounts for only 21% of collateral and Canada, which has seen reliance on cash almost half to only 20% over a three year period (see Chart 1). The Australian market, on the other hand, is still 80% cash.

Data Explorers concedes that the variety of experiences around the world reflect historical legislation and tax incentives as well as inertia. US pension funds regulated by the Department of Labour (DoL) , for example, are not allowed to take securities as collateral. Indeed, it is the better performance of non-cash collateral (such as equities) outside the United States that has persuaded Data Explorers to urge the DoL to reconsider its rules.

Survey results from the recent Securities Financing Forum, hosted by Data Explorers in London have reinforced the finding. Following the Lehman Brothers default, UK and European securities lending respondents to a survey conducted at the event revealed that less than 10% incurred a loss after collateral was liquidated and lent securities were repurchased, whereas 78% actually ended up with a surplus.

The positive experience of European lenders accepting equities as collateral will be one of the subject up for discussion at the Data Explorers Securities Financing Forum in New York on 26 May. Data Explorers says 150 representatives drawn from regulators, hedge funds, institutional lenders, prime brokers and lending agents have signed up for the event, which is being moderated by Matt Miller of Bloomberg News.

Tags: PensionsCollateral