Non-Cash Collateral Opportunity

Hello, this is Brooke Gilman, and I am your host for today's Global Peer Financing Association Peer Connections Podcast. If you aren't already familiar with GPFA, you can find more information out on the web at globalpeerfinancingassociation.org, or you can also search for the group online via LinkedIn. They do regularly publish updates on LinkedIn, so if you aren't already following GPFA there, that's a great way to keep current. The GPFA membership is growing across the global beneficial owner community in securities lending and repo, and I know that the group welcomes new members and would love to hear from you. I want to welcome all our listeners today. We appreciate you tuning into these educational podcasts from GPFA members covering a variety of securities financing topics, and we definitely encourage you to reach out to GPFA if there are other topics you'd like to hear more about. I'm pleased to host two returning speakers to the GPFA podcast series from the California Public Employees Retirement System, CalPERS, Dan Kiefer and Mike Johnson, thank you both for joining me again today. Thank you, Brooke. Happy to be here again, Brooke. For our new listeners, Dan Kiefer is an investment manager with CalPERS and has been with the plan for 28 years. And Mike Johnson is an investment officer, having been with CalPERS for the past 14 years. And together, Dan and Mike oversee securities lending for their plan. So again, thank you both for joining me. So today, what we thought we would discuss, it's a topic that came up. And Mike, you referenced it a few different times in our last podcast, which was a broader overview of CalPERS's securities lending program style and strategy. And you talked about how the market really has evolved and shifted definitely within the last 10 years pretty significantly. But when you look at it over a longer period of time, quite significantly in terms of collateral types and collateral flexibility, and a lot of that has come as an aftermath after the global financial crisis where a lot of banking regulation was put into place and borrowers had to change because of balance sheet constraints and regulatory requirements that they have had to alter their collateral preferences quite significantly than maybe what they had been able to more easily pledge as collateral in a securities lending transaction previously. And so the U.S. market had historically, and still is historically, dominated by U.S. dollar cash as collateral. And outside of the U.S. market, other markets such as in Europe had always been more heavily dominated by non-cash collateral, whether that be sovereign debt, equities, or other securities. And so I know that CalPERS had started out like many U.S. pension plans, driven, having it primarily a cash collateral strategy driven by U.S. dollar cash, but that's shifted quite significantly for you over time. And so really just want to understand how that came to be for your program. But more importantly, want to dive into how you specifically went through the process of getting comfortable with taking non-cash collateral, what that was like in terms of shifting your own guidelines and your ability to accept non-cash collateral, and then what you've seen since in terms of the effects of your program and what it looks like today in terms of collateral makeup. So that's a lot for you guys to go through, but I'm sure you're up for the challenge. Well, on the historical perspective, I'm going to dive into how we got to the non-cash and I'll let Mike give some examples and go into more detail on the current non-cash program. We've always looked at securities lending that the lending revenue should be the dominant amount of revenue, not the reinvestment side. And we went from a moderate risk program to basically a low risk reinvestment program. So we didn't want to make our money on the reinvestment side. And back, you know, 2006, seven, a lot of lenders were making a good chunk, maybe over 50% of their money on the reinvest side, not on the lending side. And we felt after the financial crisis, that the focus needed to be on a low-risk reinvestment program. And we, throughout the crisis or pre-crisis, we noticed we were investing in equity repo. So basically taking equities as collateral from a reinvestment perspective. So taking our cash and going out and buying equity repo is pretty much the same in our minds as taking lending and receiving equities on the other side on a non-cash side. And the benefit of the non-cash side is you can pair your loan with your reinvestment piece. You could bring off both pieces at the same time. Unlike having equity repo, where you could have your loan out with somebody and then have equity repo out with somebody else. And if you had a significant recall or if a big market action happened, then you're affecting two sides of that piece. And during the crisis, there was only a couple things that really traded that had any liquidity, and that was equities and treasuries. So a lot of the cash reinvest product that we had invested our cash in was not liquid. And we found that out like many other lenders. So the process of going to a non-cash program, we felt was a de-risking of the program and almost a simplification of the program. And we had our risk guys take a look and do sensitivity analysis on what we were lending out versus what we were taking as collateral and trying to match those collateral types. And we found out that we were taking right-way risk. So the betas were usually higher on the stuff that we were lending out, lower on the stuff that we're receiving as collateral. And there was plenty of liquidity given our constraints on our collateral profile on what type of collateral we receive. So there was plenty of liquidity if you had a borrower default to be able to sell that collateral in the market. And the one big benefit is not having to sell the collateral because it's just a return of collateral in the event of a mark-to-market. Let's say the market's down 10% overnight. well, then you're just giving securities back if there's a mismatch. Instead of having to sell or make a transaction, it's just a movement of securities, which is a heck of a lot easier. You're not in the market transacting. It's a movement and it's easy to track. So I think that's where we started looking at it internally. And then we had to get buy-off internal and we had to change state law in order for us to take equities as collateral. And I'll let Mike dive into the background of how we had to change law and then how we kind of rolled out the program. Thanks, Dan. Yeah, we stumbled across a state statute. We were looking at a transaction back in 2015, 2016. We were looking at a peer-to-peer transaction, actually, doing it versus non-cash, and we stumbled across an old state statute. We turned to find out what was written back in the 70s that allowed us to take cash and or collateral in the form of cash or bonds or other interest bearing notes that were backed by the U.S. government. So, and then U.S. government issued or cash we're able to take. And we're able to also find out that cash also meant currency, so any kind of local currency. We think at the time it was written in the 70s, that was what the SEC lending program was like. They were doing loans versus U.S. dollar and U.S. government-backed bonds. So we think that's why it was written in the law. So we sponsored an assembly bill to get a change made that would allow CalPERS to expand our collateral set. And it was kind of twofold. we asked for certain changes on the legislation to expand our collateral set. And then that got approved. And then once that got approved, we said, we got this approved, but we actually had put some kind of limits and restrictions on it ourselves. So that's when we got our risk team together and went to one of our internal committees with what we recommended to take so we can have CalPERS official approved non-cash collateral set. And that's kind of high level how it happened and how it came to be. As Dan mentioned, and I want to reemphasize this, we looked operationally and just as a whole, we looked at cash loans and non-cash loans almost the same. Because now to reiterate this, I was at a conference once, I said that we look at them the same because we do a loan, we take cash, we'll put that in equity repo, right? Then day, that's almost the same thing. But as Dan highlighted, there's the same counterparty defaults on the loan, the same counterparty we buy in on the collateral side. So it's actually end result for us looking at non-cash collateral, we're able to lower our risk profile and make more revenue at the same time. So it was kind of a win-win for the program. So what were some of the immediate results then? Because I know when you spoke about it, the last podcast we had in terms of the fact that you guys manage your lending program through an auction process. And so once those collateral schedules were changed and you went through the process to get it changed to the state statute level, and then also all of your internal risk guidelines and such, You obviously rolled that out as sort of a new offering, because last time you talked about how you're really presenting your offering in terms of what solutions you can bring to the borrowers through that auction process. What was the reaction then like from the borrowing community to your assets? Did it differ much year over year when, you know, say a year prior, you were just still dollar cash or government debt, and then a year later, you had a broader collateral set to include equities? Did you notice a change right away or did that take a while to ramp up? Well, Brooke, it was a total game changer because the market was moving in a direction and there was really no North American pension funds that were offering non-cash. So we were kind of the first ones to that kind of market. And we had this large auction plan. And I think we were just waiting. we had just received approval or during the auction period was, you know, going to get the approval legislatively in order to do this. And we wouldn't have had bids from a cash perspective. So literally we created value. And the nice thing about our intrinsic program is we have full transparency and we have over 20 years of data on these auctions and a lot of similar assets let's get auctioned every year. So we had some large, chunky U.S. equity portfolios that we didn't see any demand from a cash side because cash was getting more and more expensive due to changes as a result of Dodd-Frank and some of the other regulatory changes affecting some of our bidders. We had bidders come in on the non-cash side and unlocked significant value from a lending standpoint. Correct. As Dan mentioned, we have had a couple auctions that 100% of the bids were non-cash. Non-cash bids on our auctions are definitely the majority right now. We moved right time, right place. Yeah, and those bids continue to dominate from a non-cash perspective. We've moved to a model, a low-risk reinvestment strategy. So we're not looking at driving revenue from our cash reinvest. So that's not really a focus. And then some of our modeling that we're doing for leverage and liquidity, we're not assuming that the cash from the program stays out permanently. That's internal look that we get from our risk folks. So we weren't really getting a lot of credit internally for our cash. We were running a low risk and then we were chasing product that didn't have all, you know, once you have billions of dollars chasing product, it's hard to even find reinvestment product. So this allows us to increase our loan balances, unlock value that wouldn't have been there and drive program revenue right to the bottom line. And how have those non-cash guidelines evolved or have they evolved at all since you first looked at it? Because I appreciate, especially for if we have any of your beneficial owner peers listening to this that might today not be taking non-cash, but might be thinking about it and wondering how they move forward. There's going to be, because you have noted here, there's various things to think about. It's the risk profile of what type of non-cash you're taking versus what type of assets you're lending. There's also the operational factors to sort of understand and understand how a non-cash program operates and how that differs. But did you guys start out with whatever your guidelines look like today? Did it look like that at day one that you approved it or have you evolved your thinking around that or expanded it or do you intend to expand that in the future? How has it been in your actual experience in terms of living through the types of non-cash that you accept and what maybe your long-term visions are? We had our approved non-cash collateral schedule set up in 2018, and we haven't made any changes to it. I heard a couple counterparties complain that our over-collateralization percentages were a little bit too high, but that just tells me we hit the nail on the head there. So we'll still continue to come and bid with us. So that tells me we got the right touch point. Dan mentioned earlier, we had right way risk on this thing. Well, we set it up that way. The one thing that we're not doing, we're not doing a collateral downgrade trade. We're not taking equities versus U.S. treasuries for instance. But everything else behind that where everything matches up to our collateral, we kind of have right-way risk. And we test that when you do collateral adequacy tests on at least a quarterly basis and an annual basis. We also do a counterparty default scenario and we run different value at risk to see where the collateral stands up. We do different various distress scenarios. We run those assets that, hey, if this happened in that distress scenario, what would our collateral look like? And we've confirmed, we have touch points that we do have right-ray risk here. And a lot of times, three or five days into these stress tests, collateral is a larger percentage than it was initially. And that's a data point that I think beneficial owners are just going to have to get comfortable with themselves. They're going to have to look at what are they comfortable taking? I think there's some good guidelines out there in the marketplace as a whole, domestic and international, what the haircut should be like there. And look at your current repo collateral schedules that you have. What are the collateral percentages there? That's how we started. That was the basis that we used to create our schedule. And no one's running away from us. So that tells us we hit a sweet spot, I believe. So I think getting comfortable with your collateral set and then try a couple loans and do the collateral adequacy testing on those, get comfortable with those. And I said, if you set it up to be right way risk, your numbers are going to have right way risk. And Brooke, we're trading with people that are all on our approved counterparty list. So all of these entities have been pre-approved from a credit risk perspective and all those counterparties are monitored. So if there's a problem, then there'll be limits that are taken down of those counterparties. But first and foremost, you look at the underlying liquidity of your collateral. What proved to have the least amount of liquidity is what everyone was in. In 08-09, the cash reinvestment side had the least amount of liquidity in all the asset-backed securities and notes, equities proved to have plenty of liquidity. And people mistake volatility of a market with risk. Volatility is one aspect of risk as you're looking at your collateral. But a lot of those asset backs didn't have any volatility because there was no price for them. You couldn't move them. So the nice thing about having volatility is it gives you an underlying market and you can tap that market. And that's what we look at. We're lending equities that we're taking and we can move our equities. And most of the time, you're not looking at a default scenario. You're looking at markets locking up and you can just return your non-cash. Just return it. They want to unwind it. You have a situation. You're not forced to sell anything. All you're doing is sending somebody's collateral back. You don't own the collateral. It's pledged to you. When you do a cash transaction and take cash, you own the collateral set. So you're buying into a different risk altogether. To me, it's a lot more transparent and it's a lot easier from an operational standpoint, especially if you get markets locking up. Right, absolutely. And you mentioned that you're obviously dealing with your existing approved counterparty list, but you also, I think in a little bit ago noted that if you hadn't adjusted your collateral profile that for some of your auction offerings you would have perhaps struggled to see bids versus cash just given at you know different points in times given that maybe borrowers wouldn't have had demand on an exclusive basis for certain asset types versus cash so would you say then that even though I appreciate that the nominal list of your approved borrowers hasn't changed but that your approved borrower diversity or diversification or depth and breadth has changed? Because it sounds like it's changed for the better, ultimately, because you offer them this greater flexibility. You probably have more market participants borrowing from you today than you would otherwise. Is that a fair statement? Yeah, we've given economic value to people that had internal constraints. So what you'll find is different counterparties take a look at their own risk or their own counterparty or the cost of cash, pledging cash differently. So now we have somebody that historically their cash costs quite a bit and they can pledge non-cash and it frees something up. We're seeing those people win more auctions. So we've seen players that never have really participated actively or have been awarded and they're the winners of that auction. So it's reshuffling the deck, which is always good. And then whenever you're reshuffling the deck, I think you're unlocking value. And there were no bids for certain of our assets. So those assets didn't have value to the market on a cash basis. And we unlocked value for certain people because of their own unique circumstances and the way they cost cash and way they're able to offset posting of equities or other alternative collateral sets. Yeah, to just add and reemphasize what Dan said is that we've seen the last six options, more borrowers come into bid. So more bidders, better bids. Right. Absolutely. Well, that feels like a good place to end this then. More bidders, better bids. Well, good. Well, thank you both for sharing this information. I mean, I do hope, and again, part of the aim of GPFA is to encourage information sharing and discussion of best practices and that peer dialogue amongst beneficial owners and the securities financing industries and so hopefully this conversation around your experience with how you guys first started to consider and then the process you went through to adapt your own well first of all state laws but then internal policies and risk policies to allow for non-cash and what your experiences have been hopefully that's going to be helpful for others that might be thinking about non-cash and recognizing that it's part of the market if they're not adapting to it then they might not be keeping pace with their peers so I think that folks will find value and we'll look forward to hopefully chatting with you guys on other topics so and we'd encourage any of our listeners to reach out to GPFA directly via LinkedIn or our website and let us know what other topics would be of interest to hear directly from some of our members so thank you again Dan and Mike and this was great thank you guys