Cash Collateral LoanCollateral Loans
Investment company investors take part in stock borrowing directly through separated account and directly through mixed investment companies such as general investment companies, investment companies or the ETF. An intermediary makes the deal easier by identifying a debtor and negotiates credit conditions on account of the sponsoring party. The conditions for loans of Securities are usually kept open until either party has terminated the contract, or they are made "callable" if the creditor has the right to call back the instrument at any point before the credit period foreseen.
As a countermove to the collateral, the Mortgagor provides collateral that can be provided in cash or in kind. Collateral is intended to prevent the creditor from defaulting and is generally between 102% and 105% of the value of the collateral lent. Each day, credit intermediaries will calculate on a mark-to-market approach whether the debtor must book collateral ("premium") or whether the creditor must give collateral if the value of the securities lent varies ("discount").
Lenders or loan agents generally invest cash collateral in a conservative manner in very high-quality and high liquidity asset classes such as US Treasury and Treasury bonds, as well as CD s/Commercial papers and loans to corporations, often according to SEC 2a-7 regulations. Upon completion of a collateral arrangement, the creditor and his loan agents shall surrender the collateral in return for the collateral and receive a pre-negotiated loan charge for the collateral booked.
In a cash collateral arrangement, however, the creditor gives back the collateral (in return for the collateral) and grants the debtor a discount. Discount is an interest payment arranged for the safekeeping of collateral and is reduced by a margin depending on the supply/demand features of the collateral provided.
Often the buyer spreads are higher than the interest due on the collateral, resulting in a discount loss. Income earned by the credit intermediary is composed of the claim spread plus the re-investment spread less discount commission. It is added to the total yield of the whole portfolios and may include administration and managerial charges.
Credit intermediary agrees with creditor on income distribution from 50%/50% for smaller programmes to 90% for creditor with bigger programmes. Today the credit markets are about 20 trillion dollars in terms of volume and about 2 trillion dollars in terms of borrowed capital. Big investment trusts with relatively passively held portfolio, such as equityTFs and index trusts, are more likely than actively held trusts to hold stocks.
Because of the type of their portfolio, these investment vehicles are able to borrow more for longer durations, making them privileged partners for their credits. When assessing a security loan programme, the investors should concentrate on the credit intermediary's capacity to minimise the risk of adverse effects on cash security, cash and credit risk as well as the risk of adverse effects on contracting parties.
Creditors should foster operating disciplines through rigorous control, auditing and visibility to supervise the day-to-day operations of the programme. Prior to the global financial crises (GFC), cash collateral clean-up policies were less rigorous and credit intermediaries sometimes invested in less cash, longer-term asset classes to increase returns. Some of these more risky exposures were adversely affected during the downturn, and creditors recorded huge falls in cash collateral asset classes.
New rules since the GFC have imposed restrictions on higher-risk collateral re-investment, but the creditor must remain cautious and make sure that its borrower receives a full overview of the collateral re-investment pools. Loan intermediaries should give an overview of qualifying assets and guidance on asset origination, solvency and maturities.
In order to prevent adverse effects, it should adhere to stringent credit quality policies, such as regular reinvestment adherence controls and rigorous testing to make sure that the yield on re-invested collateral surpasses the credit discount. Agents should also make sure that the maturities of the re-investments match those of the loan maturities in order to reduce cash exposure and make sure that cash is available to process transactions.
The credit intermediary should monitor the borrower's exposure to counterparty credit risks by reviewing the borrower's position. Agents should conduct a day-to-day mark-to-market operation for the deal and secure overcollateralisation of the loan. A credit intermediary may make provision for compensation arrangements for the security loan programme which would be activated if the collateral were insufficient to meet a failure of the debtor; the credit intermediary would buy the security or make available an appropriate present value.
Like any investment programme, there is no free luncheon. When reviewing a credit policy, the investor needs to be familiar with the credit intermediary's credit manager's credit control programme to ensure that their passively managed policies successfully do what they should be doing: follow the index.