E Bizarre Collateral In Securities Lending Exposed By Bank Of Mellon

There is a bizarre use of collateral these days, and it is exposed by Bank of Mellon. First off, the banks are being advised by certain bankers to hoard bonds.  And counterparties are encouraged to bolster their stock and securities positions by using stocks as collateral. The securities lending market often is used for short positions in the stock market.

Here is a definition of securities lending from Investopedia:

Securities lending is the act of loaning a stock, derivative or other security to an investor or firm. Securities lending requires the borrower to put up collateral, whether cash, security or a letter of credit. When a security is loaned, the title and the ownership are also transferred to the borrower.

Peter Venkman once said in Ghostbusters something to the effect that we have dogs and cats, and mass hysteria. I think that in securities lending, defined below, we  are finding out we have exactly that.

Based on data from the four main tri-party service providers in Europe (BNY Mellon, Clearstream, Euroclear and JP Morgan) – which collectively hold the vast majority of non-cash collateral received by lenders – 57% of securities held in tri-party were equities at the end of June 2015, up from 53% six months earlier. Clearly, post-crisis regulatory and macro-economic trends have turned conventional wisdom in the securities lending market (i.e., where asset owners historically lent out equities in return for government bonds as collateral) on its head.

Tri-party acts as a clearing house, a third party that holds the collateral for the securities lending market. Mutual funds, ETF's, insurance companies, and pension funds are often the main lenders and hedge funds are the primary borrowers. 

Hedge funds appear to be taking advantage of this arrangement, as the collateral in a downturn would be worth far less than the original loan amounts which would seem to breach fiduciary requirements of pension funds and insurance companies. Other dangers and disadvantages are shown at this second Investopedia article.  However, the tri-party market may increase the safety of this market.

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Disclosure: I am not an investment counselor nor am I an attorney so my views are not to be considered investment advice.

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