Concept of Security lending

Security is an asset or third party commitment accepted by the security taker to secure an obligation of the security provider. In theory, cash is the perfect security. The assets traditionally used as security, such as government bills and bonds, exhibit characteristics that make them close substitutes for cash. In practice, cash security is provided in the form of bank deposits and is thereby subject to operational risks related to the transfer of these deposits or the risk that the depository institution defaults.

Although government securities are the main underlying asset used in repo transactions in all major countries, mortgage-backed securities or Pfandbriefe are frequently used. Pfandbriefe are securities issued by certain mortgage banks or state banks in Europe. They differ from other asset backed securities in that they are issued directly by banks, and the assets remain on their balance sheets. Pfandbriefe are issued with recourse.

In addition, more global financial institutions are beginning to accept equity as security for financing arrangements. Transactions such as equity repos can reduce financing costs for dealers while offering cash lenders a higher interest rate if they are willing to take the added risk of equity compared to security with a lower risk profile.

Against the background of these uses of security, some trends in the supply of security are particularly important. On the one hand, securities markets for fixed income instruments as well as for equities continue to grow strongly worldwide, thereby increasing the pool of assets available as collateral.

In contrast, the composition of this expanding pool of securities is changing significantly. The supply of government bonds, often seen as the preferred type of security, is increasing slowly, stagnating or even shrinking in major countries, with the notable exception of Japan. Corporate issues show the highest growth rates, although in many cases, including most continental European bond markets, starting from a very low level.

Additionally, debt securities issued by financial institutions such as asset and mortgage backed securities continue to be on the advance. There seems to be a general tendency towards longer maturities, although it remains an open question whether this reflects a secular trend or the current level of long term interest rates, which in most countries is low by historical standards.

These trends change the overall risk profile of the available pool of securities. With a growing weight of private sector paper, credit risk becomes increasingly important compared to a world where government securities are predominant. Private issues tend to be smaller and more heterogeneous. Additionally, there exist virtually no liquid derivatives markets for private sector fixed income securities. As a result, private issues are basically less liquid and more difficult to value and to hedge than government securities, as indicated by larger bid ask spreads and higher price volatility.

That said, an important distinction may be made between the highly rated issues of financial institutions, including asset backed and mortgage backed securities, on the one side, and corporate bonds on the other. The risk profile of asset-backed and similar instruments may be seen as standing between those of government and corporate issues, as indicated by yield spreads and perceived levels of liquidity and credit risk. An increasing duration of bonds outstanding is associated with higher market price risk of security if these become part of security portfolios.

What kind of securities acceptable

Multiple buyers and multiple sellers, Price discovery platform, Price dissemination, transparent clearing and reliable settlement, Spot and futures markets

What comes in between securities lending

Price risk, no mechanism for hedging, Credit risk, inadequate infrastructure to transfer risk from borrower to the securities, Operational risk, poor state of securities management process and control on securities, Inadequate and irregular MIS on stock holdings

Functions and responsibilities of a securities manager

Identification of potential risks and its mitigants, Due diligence to set up a secure structure, Accreditation, grading of securities, Technical specification, Financial evaluation, Empanelment of graders, certifiers, Facilitating structures for commodity lending, Electronic systems for control and monitoring, Arranging for 24/7 security, Insurance tie-ups and adequate liability coverage.

It looks so easy. Is it not.