Asset Managers and Collateral: Control of the Center
*Control of the center is a chess strategy. Control of the center is considered significant as tactical battles often happen around the central squares, from where pieces can access most of the board.
In post-crisis lending markets, asset managers have played an increasingly important role in providing collateral. Their importance to the system makes the Financial Stability Board's (FSB) long-awaited policy recommendations especially significant.
Recommendations for asset management address four structural vulnerabilities that could upset financial stability: liquidity risks, leverage, operational risks and securities lending by managers and funds. While the board focuses primarily on liquidity and leverage risks, the section on securities lending merits attention.1 The recommendations are limited to a need to monitor asset managers' lending activities, but there is a risk that they will lead regulators to a mindset of "when in doubt, prohibit." If this happens, markets will suffer.
Securities lending enhances liquidity, risk management and price discovery for the traded securities. Mutual funds and pension plans, for example, accounted for 66 percent of the reported euro 14 trillion of securities that institutional investors made available for lending in the global pool last year, according to International Securities Lending Association (ISLA).2
Asset managers usually participate in this market as beneficial owners and the actual lending is done through an “agent” such as a bank. This means that asset managers merely give the agent guidelines on behalf of their clients, which include mutual funds and exchange traded funds (ETF).
The FSB warns of a very limited, yet growing number of managers who act as agents themselves. They inject collateral into the system by lending securities directly and providing borrower or counterparty indemnifications — an insurance-like promise to clients to ensure them against potential defaults. These commitments, FSB warns, could potentially contribute to instability. The board urges more scrutiny and makes broad recommendations on appropriate policy responses to attack this potential systemic risk.
However, the role of asset managers as agents — and providers of capital — is crucial because it enables participants to get funding from the wholesale money market.3 To draw an analogy from chess, they represent the critical center squares that provide access to the rest of the board. In repurchase agreements (repos), for instance, collateral is necessary for market liquidity. Furthermore, regulations such as the Liquidity Coverage Ratio (LCR) have created a need in the market for high-quality liquid assets (HQLA) that did not exist before. Banks hunt for high-quality collateral to comply with LCR requirements and to reduce capital charges for equity securities.
It is important to emphasize the vital, constructive contribution of securities lending as regulators begin to consider policy responses to their potential to create systemic risk. There is a tendency among prudential regulators to prohibit certain activities in order to enhance the resilience of financial entities. The best-known example in the U.S. is the Volcker Rule, which bars banking entities from proprietary trading as well as from retaining any ownership or sponsorship of hedge funds and private equity funds. The UK's "ring-fencing" regulation serves a similar purpose.
The FSB’s policy recommendations will provide an intellectual foundation for designing prudential regulations, but they should not lead to new rules that prevent asset managers from supplying collateral. If they are unable to fill this role, the scarcity of collateral and its impact on liquidity may itself create systemic risks.
1 For further assessment of the issue, see http://www.milkeninstitute.org/publications/view/821
3 Market liquidity can be obtained from wholesale money market through different instruments such as repurchase agreement (repos). The importance of repos is that they are secured as they use securities as collateral.