March 2008

Cash collateral gaining momentum in securities lending

Under current market conditions, institutional investors are seeking to use all sources of alpha generation at their disposal. Due to this desire for alpha, more securities lenders are accepting cash as collateral now than ever before. Plan sponsors and fund managers alike are enjoying higher overall returns than their peers in non-cash collateral programs. To meet this demand, all major global securities lending agents now offer clients securities lending programs using cash as collateral.

What is cash collateral?

Securities lending transactions are always collateralized against securities or cash to protect against the unlikely event of borrower default. Securities borrowers typically demand that their lenders offer flexibility in the range of permitted collateral so that they can maximize the value of their balance sheet resources. Institutional investors, who permit their assets to be lent against cash collateral, enjoy several benefits including a more attractive inventory to borrowers and the ability to generate incremental returns through the prudent management of cash.

Broad market acceptance globally

Outside Canada, cash is the predominant form of collateral in securities lending transactions, making up more than 95 per cent of all collateral provided in the United States and over 50 per cent globally. Canada lags behind significantly, with non-cash collateral comprising 75 per cent of all loans. In Canada, cash collateral balances continue to grow as plan sponsors and fund managers realize the significant benefits that a well-managed reinvestment program can provide to their funds. Figure 1 demonstrates growth in Canadian loans collateralized by cash over the past year and a half, which have risen from $20 billion to nearly $30 billion in early 2008 (source: Performance Explorer).

Significant financial benefits can be enjoyed by lenders who accept cash collateral (as seen in Figure 2). With the enhanced spreads attributable to the reinvestment of cash, flexible collateral solutions provide lending clients with a powerful way to maximize overall revenues. Figure 2 illustrates a comparison of portfolio revenues of two clients – one that accepts cash (dark red) and another that is confined to non-cash collateral (orange). The rapid increase beginning in August relates to widening credit spreads and subsequent cash reinvestment returns (source: Performance Explorer).

Managing risks

In all securities lending transactions, there is a potential for borrower default – although this has never occurred in the Canadian agent lending market. The risk of default is mitigated by daily marking to market of collateral and rigorous screening of borrowers. In cash collateral transactions, clients assume the principal risk on all underlying investments made in the reinvestment pool. This risk is mitigated by a prudent approach to managing cash collateral, the first and foremost objective being capital preservation.

CIBC Mellon's conservative reinvestment strategy has consistently generated high returns even under the troublesome circumstances facing short-term markets in recent years. Since July 2007, our results have weathered the liquidity/credit crisis, Bank of Canada overnight rate increase and now three successive rate reductions. Furthermore, CIBC Mellon's reinvestment portfolio has never had any exposure to third-party conduit (non-bank sponsored) asset backed commercial paper (ABCP) conduits.

Positive outlook

Securities lending against cash collateral has gained significant momentum over the past year, with strong growth anticipated well into 2009. Excellent returns resulting from the general widening of credit spreads, and the strong potential for continued Bank of Canada rate reductions will help to sustain these high revenues and contribute material income to most funds throughout 2008.

If you would like more information, please contact your relationship manager.

By Jeffery Alexander, director, business development

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Trade Talk® is provided for general information purposes only and CIBC Mellon Global Securities Services Company, CIBC Mellon Trust Company, CIBC, The Bank of New York Mellon Corporation and their affiliates make no representations or warranties as to its accuracy or completeness. Readers should be aware the content of this publication should not be regarded as legal, tax, accounting, investment, financial or other professional advice nor is it intended for such use.

In This Issue

Table of contents Caution, for now Unprecedented FX market growth Corporate action news scrubbed clean Message from the CEO Cash collateral gaining momentum in securities lending New website for secure e-mail delivery

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