Cash vs Non-Cash Collateral in Securities Lending
Richard Comotto
30 years: Money markets
The use of either cash or non-cash collateral in securities lending transactions depends on the preferences and objectives of the parties involved. Non-cash collateral is often favoured for its lack of balance sheet impact and ease of return if the value of the loaned securities decreases. However, cash collateral may be preferred for its liquidity or when the lender wants to avoid the need for frequent revaluation.
The use of either cash or non-cash collateral in securities lending transactions depends on the preferences and objectives of the parties involved. Non-cash collateral is often favoured for its lack of balance sheet impact and ease of return if the value of the loaned securities decreases. However, cash collateral may be preferred for its liquidity or when the lender wants to avoid the need for frequent revaluation.
Cash vs Non-Cash Collateral in Securities Lending
7 mins 26 secs
Key learning objectives:
Understand why parties would accept/offer non-cash collateral
Understand why parties would accept/offer cash collateral
Overview:
The use of either cash or non-cash collateral in securities lending transactions depends on the preferences and objectives of the parties involved. Non-cash collateral is often favoured for its lack of balance sheet impact and ease of return if the value of the loaned securities decreases. However, cash collateral may be preferred for its liquidity or when the lender wants to avoid the need for frequent revaluation.
Why offer or accept non-cash collateral?
In a securities loan, non-cash collateral is often used because it does not impact the balance sheet, poses no reinvestment risk, and can be easily returned if the value of the loaned securities decreases. There may also be potentially significant correlations between the price of the loaned security and the price of the collateral securities, reducing the need for variation margining. Additionally, collateral securities may be reused.
However, non-cash collateral is not as liquid as cash and cannot be exchanged simultaneously with loaned securities, leading to potential daylight settlement risk. Collateral securities also need to be continuously revalued for variation margining and are subject to corporate events and actions.
Why offer or accept cash collateral?
In a securities loan, cash collateral can take the form of bank deposits and liquid investments such as money market mutual funds. The use of cash collateral is common in the US and Japanese securities lending markets but is limited in Europe by regulations such as the UCITS Directive.
The use of cash collateral in securities lending has some advantages, such as its liquidity and the fact that it does not need to be revalued. It also allows for delivery-versus-payment, eliminating settlement risk. Cash collateral reinvestment by the lender can enhance the return on the loan, and there are no corporate events associated with cash, reducing operational costs.
However, cash collateral reinvestment by the lender is required meaning they have to act as the cash reinvestment agent or employ one, and the returns will depend on interest rates, which may be very low.
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