Securities Loans Collateralized by Cash: Reinvestment Risk, Run Risk, and Incentive Issues

Abstract

Securities loans collateralized by cash are by far the most popular form of securities-lending transaction. But when the cash collateral associated with these transactions is actively reinvested by a lender's agent, potential risks emerge. This study argues that the standard compensation scheme for securities-lending agents, which typically provides for agents to share in gains but not losses, creates incentives for them to take excessive risk. It also highlights the need for greater scrutiny and understanding of cash reinvestment practicesespecially in light of the AIG experience, which showed that risks related to cash reinvestment, by even a single participant, could have destabilizing effects.

Securities Lending as Wholesale Funding: Evidence from the U.S. Life Insurance Industry

“…short position (Duffie 1996, Keane 2013; to avoid a settlement/delivery failure (Musto, Nini & Schwarz 2011), possibly as part of market making activity; to combine one security with other securities as part of an arbitrage trading strategy; to obtain collateral for use in other transactions (Dive, Hodge, Jones & Purchase 2011); and to take advantage of tax or regulatory arbitrage (Faulkner 2006). The details of these trading strategies are often complex and we refer the reader to the reference list for further explanation.…”

“…(Keane 2013, Baklanova, Copeland & McCaughrin 2015. Because most of the securities lending, particularly by life insurers, is against cash collateral, the reinvestment of cash collateral is an essential component of the strategies adopted by securities lenders.…”

Reference Guide to U.S. Repo and Securities Lending Markets

“…Another important dimension of securities lending transactions is the relationship between lending fees and reinvestment income (Keane, 2013). The relative size of the lending fee and reinvestment income in a securities lending transaction depends on the nature of the securities loaned.…”

“…Gorton and Metrick (2012) and Copeland, Martin, and Walker (2014) describe different mechanisms through which runs occur in repo markets, and Krishnamurthy, Nigel, and Orlov (2014) emphasize the role of collateral in propagating a run. In addition, Keane (2013) discusses the risks associated with securities lending and advocates for greater regulatory and market scrutiny of this activity.…”

“…See FSOC annual reports for 2011, 2013, 2014 See http://www.federalreserve.gov/newsevents/speech/tarullo20141120a%20.htm. Other Federal Reserve officials have expressed similar concerns about the risks of wholesale funding.…”