Collateral return

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What Is Collateral Return?

Collateral return refers to the income generated from the reinvestment of cash collateral received in a securities lending transaction. In the realm of financial markets and portfolio management, particularly within the broader category of securities finance, securities owners lend out their holdings to borrowers, often for purposes like short selling or covering failed deliveries. In exchange for the loaned securities, the borrower provides collateral, which can be either non-cash (like other securities) or cash. When cash is received as collateral, the lending agent, or sometimes the beneficial owner, reinvests this cash into various money market instruments or other suitable investments. The earnings generated from this reinvestment constitute the collateral return.

History and Origin

The practice of securities lending, and by extension, the concept of collateral return, has a history extending back to at least the 19th century. Its prevalence significantly increased in the Uniteds States during the 1970s, as custodian banks began actively lending out the portfolio securities of their clients, and registered investment companies also started participating.¹⁶,¹⁵

Initially, securities lending was often perceived as a relatively low-risk activity. However, the 2007–2009 financial crisis exposed significant vulnerabilities, particularly concerning cash collateral reinvestment programs. Many lenders and their agents experienced unanticipated illiquidity and substantial losses, highlighting the risks inherent in the reinvestment of cash collateral. T¹⁴his period spurred increased scrutiny and led to new reporting requirements and a greater focus on the nature and diversity of collateral in financial markets.

¹³## Key Takeaways

• Collateral return is the income earned from reinvesting cash collateral in a securities lending transaction.
• It is a significant component of the overall revenue for securities lenders.
• The reinvestment strategy for cash collateral aims to balance return generation with liquidity and safety.
• Risks associated with collateral reinvestment, such as credit risk and liquidity risk, became apparent during the 2007–2009 financial crisis.
• Regulatory bodies, such as FINRA, have increased their focus on the disclosures and supervisory requirements surrounding securities lending programs, particularly concerning how customers are compensated from collateral reinvestment.,,

¹²#¹¹#¹⁰ Formula and Calculation

The calculation of collateral return is generally straightforward, representing the net interest or income earned from the reinvested cash collateral. It is typically expressed as a percentage or a dollar amount.

The basic formula for collateral return can be represented as:

Where:

• Reinvestment Income is the total interest or other earnings generated from the assets in which the cash collateral is reinvested.
• Reinvestment Expenses include any costs associated with managing the reinvestment portfolio, such as management fees or trading costs.

This net income is then often shared between the securities lender (beneficial owner) and the lending agent, based on a pre-agreed revenue split.

Interpreting the Collateral Return

Interpreting the collateral return involves understanding its contribution to the overall profitability of a securities lending program and the associated risks. A higher collateral return generally indicates a more efficient and profitable reinvestment strategy. However, it's crucial to consider the risk taken to achieve that return. Aggressive reinvestment strategies might yield higher returns but expose the lender to greater credit or liquidity risks.

Market participants, including institutional investors and pension funds, closely monitor collateral return as it directly impacts the incremental income generated from their otherwise idle assets. The stability and predictability of collateral return are also important factors, especially for institutions that rely on this income for their overall investment performance. The Federal Reserve, for example, accepts various types of collateral for its discount window operations, ranging from U.S. Treasuries to corporate bonds, with specific criteria to ensure minimal credit risk and high liquidity.

##⁹ Hypothetical Example

Consider a large university endowment that decides to lend out $100 million worth of its readily available equity securities through a securities lending agent. The borrower provides $102 million in cash collateral (reflecting a 102% collateralization rate common in equity lending).

The lending agent takes this $102 million in cash collateral and reinvests it in short-term government securities and highly rated commercial paper. Over a month, these investments generate $50,000 in interest income. The agent incurs $5,000 in operational costs and fees for managing this reinvestment portfolio.

The collateral return for that month is calculated as:

($50,000 \text{ (Reinvestment Income)} - $5,000 \text{ (Reinvestment Expenses)} = $45,000)

This net collateral return of $45,000 is then split between the university endowment and the lending agent according to their agreed-upon revenue-sharing arrangement, for instance, a 70/30 split. The endowment receives $31,500, and the agent receives $13,500. This demonstrates how collateral return contributes directly to the endowment's return on investment while the underlying securities are on loan.

Practical Applications

Collateral return plays a vital role across various segments of the financial industry:

• Securities Lending Programs: For beneficial owners of securities, such as pension funds, mutual funds, and insurance companies, generating collateral return is a primary motivation for participating in securities lending. It allows them to earn incremental income on assets that would otherwise sit idle.
• ⁸ Liquidity Management: Cash collateral, once reinvested, contributes to the overall liquidity of the financial system. The ability to efficiently reinvest and manage this cash helps facilitate various market activities, including repurchase agreements (repos).
• Risk Management: The type of investments chosen for collateral reinvestment is a critical aspect of risk management. Lenders and agents must balance the desire for higher returns with the need to maintain the safety and liquidity of the collateral, as outlined by regulatory guidelines and industry best practices.
• Regulatory Scrutiny: Regulatory bodies, like the Financial Industry Regulatory Authority (FINRA) in the United States, have intensified their scrutiny of securities lending practices, particularly regarding how firms manage and disclose risks associated with cash collateral reinvestment. Recent enforcement actions by FINRA against firms for issues related to fully paid securities lending programs, including misrepresentation of compensation to investors, highlight this increased focus.,, T⁷h⁶e⁵ Securities and Exchange Commission (SEC) has also adopted new rules aimed at enhancing transparency in the securities lending market, requiring reporting of transactions to FINRA.

##⁴ Limitations and Criticisms

While collateral return offers a valuable income stream, it is not without limitations and criticisms:

• Reinvestment Risk: The primary limitation is reinvestment risk. The cash collateral must be reinvested, and the investments chosen can lose value, potentially eroding the collateral and leading to losses for the lender. As seen during the 2008 financial crisis, certain structured assets purchased with cash collateral experienced significant losses.
• ³ Liquidity Mismatch: There can be a liquidity mismatch if the reinvested collateral is in illiquid assets, while the borrower demands the return of their collateral quickly. This could force the lending agent to sell illiquid assets at a loss.
• Credit Risk of Reinvestment Assets: Even seemingly low-risk investments carry some degree of credit risk. If the issuer of the reinvested collateral assets defaults, the principal could be at risk.
• Complexity and Transparency: The mechanics of collateral reinvestment can be complex, and the transparency of some programs has been a point of concern for regulators. The specific types of investments, the fees charged, and the revenue split may not always be clear to the beneficial owners. FINRA has specifically addressed issues of firms failing to provide adequate disclosures about compensation to customers in fully paid securities lending programs.
• ² Opportunity Cost: Funds tied up as cash collateral, even if reinvested, might have an opportunity cost if more attractive investment opportunities arise elsewhere that cannot be easily accessed due to the collateral's illiquidity or specific investment mandates.

Collateral Return vs. Securities Lending Fee

Collateral return and the securities lending fee are distinct but related components of the income generated from a securities lending transaction.

While the securities lending fee is a direct payment for borrowing the security, collateral return is an additional revenue stream derived from the management of the cash collateral provided by the borrower. Both contribute to the overall profitability for the securities lender.

FAQs

What is the primary purpose of generating collateral return?

The primary purpose of generating collateral return is to earn incremental income for the beneficial owner of the securities that are on loan. This income is derived from the prudent reinvestment of the cash collateral received from the borrower. It allows assets that would otherwise be held idly to contribute to portfolio earnings.

How does collateral return differ when non-cash collateral is used?

When non-cash collateral, such as other securities, is used in a securities lending transaction, there is typically no direct collateral return generated through reinvestment. Instead, the income for the lender primarily comes from the securities lending fee paid by the borrower. The non-cash collateral is held by the lender as security, but it is not typically reinvested to generate additional income in the same way cash collateral is.

Who typically manages the reinvestment of cash collateral?

The reinvestment of cash collateral is most often managed by the securities lending agent, which can be a custodian bank or a specialized third-party agent. These agents have the expertise and infrastructure to manage large pools of cash collateral efficiently and in accordance with the lender's guidelines and risk parameters. Some larger institutional lenders may manage a portion of their cash collateral internally.

What are the main risks associated with collateral return strategies?

The main risks associated with collateral return strategies include reinvestment risk, which is the risk that the reinvested collateral assets could decline in value; liquidity risk, where the collateral cannot be converted to cash quickly enough without significant loss to meet obligations; and credit risk, the risk that the issuer of the reinvested assets may default. These risks are heavily scrutinized by regulators.

##¹# Is collateral return guaranteed?

No, collateral return is not guaranteed. It depends on the performance of the assets in which the cash collateral is reinvested. While reinvestment strategies are typically conservative, focusing on high-quality, liquid instruments, market fluctuations and credit events can impact the actual returns generated, and in some cases, lead to losses.