Michael Saunders, Head of Agency Lending Americas, Securities Services at BNP Paribas explores some of the opportunities that the rising interest rate environment has created within securities finance.
Cash collateral reinvestment
If we look at the overall securities financing market, approximately two thirds of all loan balances globally are against non-cash collateral – although that ratio is inverted in the US where cash collateral dominates. Despite the excess liquidity in the markets, compelling opportunities exist to capture excess return through the acceptance of cash collateral in securities lending transactions.
The Federal Reserve’s reverse repurchase programme is reaching new highs on a daily basis, hovering in excess of $2.2 trillion, highlighting the excess liquidity prevalent in the market. Despite the surplus of liquidity and spread compression, central banks are tightening monetary policy globally, which represents significant opportunities for sophisticated beneficial owners.
A rising rate environment, where some central banks have been very transparent about their plans for further increases, has led the forward market to anticipate upwards of 200 basis points of Fed rate increases over the next nine months.
If you are a beneficial owner participating in a securities lending programme, given the choice to transact against cash or non-cash collateral, I would be in favour of receiving cash collateral because the opportunities in the market are far greatersays Michael Saunders.
Beneficial owners opting to invest their cash collateral in typical money market instruments can capture some of that anticipated rate hike premium. It is an opportune time to implement a duration-mismatched programme, lending assets on a short-term basis while investing the cash collateral for longer tenors. However, engaging in a duration mismatch strategy should be part of a cash reinvestment strategy, with beneficial owners remaining cognizant that funding conditions and basis mismatch can quickly erode the potential uplift.
As for whether it is a concern, or not, that many of those working in the securities lending industry may have limited experience of working in a rising interest rate environment, we should acknowledge that the industry has made great strides in implementing various forms of automation and discovery, both in price and liquidity discovery. There are numerous providers offering automated transaction and borrowing, and this has eased a lot of workload for experienced staff. Execution is only one of the variables needed to monetise opportunities in a tightening interest rate environment. There remains an imperative need to ensure the agent lender has the sophistication and knowledge needed to identify these mismatch opportunities and manage the risk accordingly.
Experts in securities lending that have experienced rate hike cycles before will benefit from automation by being able to focus on anticipating market movements. Experienced lenders can optimise lending and reinvestment programmes to quickly monetise price dislocations, by looking at various metrics in the market such as interest rate futures or euro-dollar contracts, and pricing-in the probability of higher interest rates.
If you are looking to implement non-traditional cash reinvestment strategies, experience is important in terms of knowing how to manage a reinvestment portfolio in line with the guidelines of clients. Parameters such as the weighted average maturity and ample amounts of liquidity held can play a role in seizing opportunities when they arise. Putting the cash collateral to work both quickly and efficiently in order to monetise the market dislocation is critical and requires a proper management of the reinvestment portfolio.
When beneficial owners are selecting an agent, they should take note of the experience of the team investing that cash collateral. They need to ensure opportunities will not be missed, and more importantly, that risks will be managed correctly.
While the experience of the agent lender is obviously key, the knowledge of the client is also important as they generally keep a high level of control on cash collateral reinvestment activities. Clients need to know when to restrict activities, or not, to maximise the benefits of their lending programmes.
At the end of the day, it all comes down to what the client is expecting. Sophisticated beneficial owners will push boundaries to maximise revenues while other participants are seeking the market return to generate incremental income on their idle assets. An agent lender that has experience facing market volatility should be more effective with P&L generation and risk mitigation in the anticipated upcoming market conditions.
Increase of directional strategies
The impact of higher interest rates and the divergence in pace of central banks tightening will translate into increased volatility. Typically, this volatility presents opportunities for securities lending participants.
The data from industry aggregators highlights the increased demand for companies linked to sectors that are sensitive to higher rates, such as consumer finance, mortgage lenders and credit card companies. These sectors have started to show signs of demand and will eventually be under pressure as rates continue to rise and the consumer becomes challenged with the ensuing higher financing charges.
I would venture to say that companies linked to consumer finance – whether they are credit card companies, mortgage lenders or payday loan-type providers – will be impacted by a change in the ability of consumers to pay back their loans due to higher interest rates. These companies may see an increase in short interest or elevated borrows.says Michael Saunders.
Currency arbitrage opportunities
Another topic of interest for the securities lending industry is whether there will be increased opportunities for currency arbitrage given central banks are raising rates at different levels and paces.
While there is a globally coordinated central bank tightening cycle underway, the Fed is moving at a faster pace than the central banks of other developed countries. This leads to increased strength in the US dollar and typically creates cross-currency basis widening. For beneficial owners engaged in collateral transformation and specifically cross-currency transformation, we can expect increased opportunities in the months ahead.
“One example of this is lending US Treasuries and accepting Japanese government bonds, or lending US Treasuries and accepting UK gilts. We anticipate these spreads will widen from the historical average that we have seen over the past year or so. This will happen as a direct result of the FOMC tightening having a pace that is faster than many other central banks.”, says Michael Saunders.
Whether these arbitrage opportunities persist or not and whether disparity in central bank monetary policy continue through the remainder of this year and beyond remains to be seen.
Depending on your global monetary policy outlook, it is anticipated that the Fed will be raising rates through to the middle of 2023 with the target being somewhere between 3.50% and 4.0%. If you fast-forward a year from now, to June 2023, and you have a US interest rate of at least 3.75% and the Bank of England is at 2%, that arbitrage opportunity should remain.
However, it is not as simple as saying ‘the interest rate in the US is at 3.75% and the interest rate in the UK is at 2% so there is an immediate arbitrage opportunity’ – there is not that direct correlation. But we can still assume that this cross-currency basis arbitrage should be around for the next twelve months.
BNP Paribas’ solutions
In the US, the Securities Services business of BNP Paribas allows clients to take advantage of the trends highlighted above through its agency securities lending programme and its directed agent repo liquidity solution (cash reinvestment). Implementing the appropriate strategy is of course at the discretion of each individual beneficial owner. However, it remains imperative clients are cognizant of the opportunities presented in a rising interest rate environment.