Tuesday, November 15, 2016

Sovereign Wealth Funds Could Boost Global Liquidity

Author: David Schwartz J.D. CPA

Prior to Basel III and Dodd-Frank, broker-dealers were the world’s main supply of high quality liquid assets (HQLA).  New regulations have forced broker-dealers to reduce drastically their inventories of these high quality collateral assets at a time when a flight to quality and safety has placed these assets in extremely high demand. This unintended consequence of regulatory reform has restricted supply, driven up the price of HQLA, and reduced global liquidity overall. Sovereign wealth funds, on the other hand, have been investing heavily in HQLA since the 1980s and 1990s, becoming one of the largest owners of these desirable assets, particularly G7 government bonds. The prolonged low interest rate environment has prompted many sovereign wealth funds to explore new ways to enhance yield. Among these yield enhancement methods is securities lending. Given their ample inventories of HQLA, securities lending by sovereign wealth funds has the potential to ease, if not cure, the world’s liquidity woes.  


A report published in October of 2016 by the Official Monetary and Financial Institutions Forum in conjunction with BNY Mellon seeks to understand to what extent sovereign wealth funds can ease global liquidity woes through securities lending.  The report entitled, “Mastering Flows. Strengthening Markets. How Sovereign Institutions Can Enhance Global Liquidity,” surveyed two dozen sovereign institutions with asset under management of $4.74 trillion. Among other things, the survey revealed a great willingness of sovereign investors to make even more of their supplies of HQLA available for loan than ever before.


Three quarters of respondents indicated a willingness to use between 10-15% of their balance sheet for securities lending activities. Some were even open to considering as much as 60%. In addition, most of the respondents were bullish on securities lending, expecting to earn returns as much as five to eight basis points.


Freeing these supplies of HQLA from sovereign portfolios will no doubt enhance market liquidity. But the report states that it is too early to quantify the liquidity effects of sovereign securities lending. The report urges sovereign funds looking to increase their activities in the capital markets to be more connected with key market participants such as custody banks, central clearing counterparties, and tri-party repo providers. The report also cautions sovereign funds plunging into securities lending to ensure they have a good understanding regarding the associated counterparty risk, credit risk, collateral risk and cash collateral reinvestment risks.


The full report may be accessed via:  https://www.bnymellon.com/_global-assets/pdf/our-thinking/mastering-flows-strengthening-markets.pdf