Illinois State Treasurer’s Office
Robert Crossen
13 January 2015
Robert Crossen, cash management officer at the Illinois State Treasurer’s Office, outlines what will preoccupy beneficial owners in 2015 and what the future holds for indemnification, ahead of IMN’s international securities lending and collateral management conference in San Francisco
Image: Shutterstock
What is on the agenda for US beneficial owners in 2015?
The short-term interest rate environment is high on the agenda right now. It will likely change as the Federal Reserve raises the federal funds target rate. This will flow through to securities lending because the loan and reinvestment rates correlate closely to the federal funds target rate, which is in the 0 to 0.25 percent range—and has been for some time.
The Federal Reserve has been communicating that this rate will be the focal point of its policy. With US economic growth improving, the Federal Reserve has indicated its desire to move to more ‘normal’ rates. Minutes from Federal Open Market Committee (FOMC) meetings over the past 12 months show a strong preference to raise the target rate as well. Short-term rates have been near zero for years and the transition will be challenging for the Federal Reserve and the market.
The challenge is being prepared for the time when the Federal Reserve takes action and moves the federal funds target rate higher, and for how long. Expectations are that the change will be in April to June this year , and that’s what federal funds futures are indicating.
Once there is more certainty and the Federal Reserve takes action, it will affect securities lending, depending on what you’re lending, of course. For instance, we lend US treasuries—our lendable inventory stands at approximately 4.3 billion treasury bills and 2.2 billion in US government agency securities—and we typically have between 70 and 80 percent out on loan, so rates will have big impact on earnings.
A close second on the agenda—and closely related to rates—is regulation. Our lending agent has indicated that our lendable portfolio is very attractive at the moment. If regulations are requiring borrowers to hold more high quality liquid assets, then portfolios such as ours are going to be in high demand. We have seen that over quarter- and year-ends, when we have enjoyed some excellent returns. It won’t be this way forever, but as long as the opportunity is there, it fits our needs.
That’s how I see most agendas right now. It’s really a guessing game, although our agent is diligently watching the Federal Reserve and following events that will have an impact on the Federal Reserve’s course of action. Whether it’s 0.25 percent or lower at 0.10 percent, nobody really knows.
My conviction is that the Federal Reserve will be slow and deliberate with changes much different than it has been in the past. All of this filters through and securities lending appears to be determined to move away from the zero interest rate policy as the Federal Reserve slowly changes course.
Another unknowable is the future of indemnification—what is your perspective on this?
We do receive an indemnification from our agent, which is a non-US bank. That in itself has contributed to the discussion around indemnification, as I have read and heard that US domiciled banks seem to perceive a disadvantage due to the difference in capital requirements between these two types of institutions. US regulations appear to constrain US domiciled banks in this area. It appears that regulatory requirements place US domiciled banks in a position to back securities lending with the capital necessary to meet requirements—to provide a backstop to indemnification. The indemnification is viewed as a liability and will be treated that way.
Our agent has allocated appropriate capital to securities lending. US domiciled banks seem to be constrained in offering indemnification. I have heard that US regulators are taking the position that if indemnification should be offered in providing securities lending services, they should have to back it up with capital. This may not be exactly the way to say it, but it appears to be pretty relevant, otherwise indemnification would not be as widely discussed in securities lending. There may be other factors at work here as well. I can only speak from my experience.
As far as I’m concerned, indemnification will continue to remain a mainstay of the business. When we first began securities lending, we put out a request for proposals (RFP), to which we had several respondents. Personally, the idea of indemnification was a surprise. I did not expect it.
However, it soon became clear that indemnification stood out as something that would carry some weight in our decision, and it has worked out very well. It was very hard to ignore the benefits of indemnification when compared to other options.
How high on your list of priorities will indemnification figure when you next consider which agent lender to work with?
Indemnification will more than likely remain a very important part of the process and product being offered. I don’t know whether any US domiciled banks are offering indemnification at this point in time, so it will be very interesting to see what the responses will be when we issue our next RFP, which should be within the next 18 months.
I’m looking forward to seeing how that will pan out, because both non-US and US banks will no doubt respond and it will be interesting to see whether there are any differences between what both sides offer in terms of indemnification or if there are some new developments in this area. In the future, beneficial owners may need to decide whether indemnification is an important part of the product, or they may not have a strong conviction about its role.
The Dodd-Frank Act and other new regulations have hit US banks pretty hard. That’s not to say that regulators aren’t looking at non-US banks, because they are, but the indications are that they are prepared to back their agent lender businesses with sufficient capital. It has become more widespread to offer indemnification and US banks may feel disadvantaged, but it comes down to product and what an agent can offer. If they cannot offer indemnification, then it will have to be something else, be it in fees or agreeing to meet certain income targets. There is a host of ways to differentiate, as long as it comes down to the fact that nothing has changed for the beneficial owner.
It sounds like the business is going to get more competitive—would you agree?
It is going to be very competitive. Those that don’t offer indemnification will be looking to see how they can differentiate their offering to demonstrate that they have a quality product at a better price. Beneficial owners want to know that they are getting a good product. We are very happy with how our programme has performed—it has exceeded our expectations by millions of dollars and has provided us with a great source of income.
Why is the income so important?
Illinois has suffered financial difficulties so access to cash is key for us. The state treasury needs to maintain sufficient liquidity to meet obligations, whatever they may be. Treasury bills have secured a very good securities lending return, so much so that we have an asset/liability programme going on that has been very helpful. Íø±¬³Ô¹Ï lending has provided us with a unique opportunity to be able to get a pretty big return for the state given the interest rate environment.
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