# Non Cash Collateral Opportunity

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[00:00:00.000] Hello, this is Brooke Gilman, and I am your host for today's Global Peer Financing Association
[00:00:04.900] Peer Connections Podcast. If you aren't already familiar with GPFA, you can find more information
[00:00:10.360] out on the web at globalpeerfinancingassociation.org, or you can also search for the group online via
[00:00:16.680] LinkedIn. They do regularly publish updates on LinkedIn, so if you aren't already following
[00:00:21.360] GPFA there, that's a great way to keep current. The GPFA membership is growing across the global
[00:00:27.160] beneficial owner community in securities lending and repo, and I know that the group welcomes new
[00:00:31.960] members and would love to hear from you. I want to welcome all our listeners today. We appreciate
[00:00:36.280] you tuning into these educational podcasts from GPFA members covering a variety of securities
[00:00:41.580] financing topics, and we definitely encourage you to reach out to GPFA if there are other topics
[00:00:46.620] you'd like to hear more about. I'm pleased to host two returning speakers to the GPFA podcast series
[00:00:52.240] from the California Public Employees Retirement System, CalPERS, Dan Kiefer and Mike Johnson,
[00:00:57.160] thank you both for joining me again today. Thank you, Brooke. Happy to be here again, Brooke.
[00:01:02.900] For our new listeners, Dan Kiefer is an investment manager with CalPERS and has been with the plan
[00:01:07.920] for 28 years. And Mike Johnson is an investment officer, having been with CalPERS for the past
[00:01:13.200] 14 years. And together, Dan and Mike oversee securities lending for their plan. So again,
[00:01:18.540] thank you both for joining me. So today, what we thought we would discuss, it's a topic that came
[00:01:23.940] up. And Mike, you referenced it a few different times in our last podcast, which was a broader
[00:01:29.180] overview of CalPERS's securities lending program style and strategy. And you talked about how the
[00:01:35.680] market really has evolved and shifted definitely within the last 10 years pretty significantly.
[00:01:40.860] But when you look at it over a longer period of time, quite significantly in terms of collateral
[00:01:45.440] types and collateral flexibility, and a lot of that has come as an aftermath after the global
[00:01:50.800] financial crisis where a lot of banking regulation was put into place and borrowers had to change
[00:01:57.020] because of balance sheet constraints and regulatory requirements that they have had to alter their
[00:02:03.280] collateral preferences quite significantly than maybe what they had been able to more easily
[00:02:08.720] pledge as collateral in a securities lending transaction previously. And so the U.S. market
[00:02:13.920] had historically, and still is historically, dominated by U.S. dollar cash as collateral.
[00:02:20.580] And outside of the U.S. market, other markets such as in Europe had always been more heavily
[00:02:25.620] dominated by non-cash collateral, whether that be sovereign debt, equities, or other securities.
[00:02:31.540] And so I know that CalPERS had started out like many U.S. pension plans, driven, having it
[00:02:37.940] primarily a cash collateral strategy driven by U.S. dollar cash, but that's shifted quite
[00:02:42.480] significantly for you over time. And so really just want to understand how that came to be for
[00:02:47.280] your program. But more importantly, want to dive into how you specifically went through the process
[00:02:54.660] of getting comfortable with taking non-cash collateral, what that was like in terms of
[00:02:59.560] shifting your own guidelines and your ability to accept non-cash collateral, and then what you've
[00:03:04.280] seen since in terms of the effects of your program and what it looks like today in terms of collateral
[00:03:10.000] makeup. So that's a lot for you guys to go through, but I'm sure you're up for the challenge.
[00:03:15.220] Well, on the historical perspective, I'm going to dive into how we got to the non-cash and I'll let
[00:03:21.900] Mike give some examples and go into more detail on the current non-cash program. We've always
[00:03:28.220] looked at securities lending that the lending revenue should be the dominant amount of revenue,
[00:03:33.800] not the reinvestment side. And we went from a moderate risk program to basically a low risk
[00:03:41.020] reinvestment program. So we didn't want to make our money on the reinvestment side. And back,
[00:03:47.640] you know, 2006, seven, a lot of lenders were making a good chunk, maybe over 50% of their
[00:03:55.740] money on the reinvest side, not on the lending side. And we felt after the financial crisis,
[00:04:01.720] that the focus needed to be on a low-risk reinvestment program. And we, throughout the
[00:04:09.560] crisis or pre-crisis, we noticed we were investing in equity repo. So basically taking equities as
[00:04:15.520] collateral from a reinvestment perspective. So taking our cash and going out and buying equity
[00:04:21.260] repo is pretty much the same in our minds as taking lending and receiving equities on the
[00:04:27.820] other side on a non-cash side. And the benefit of the non-cash side is you can pair your loan
[00:04:33.620] with your reinvestment piece. You could bring off both pieces at the same time. Unlike having
[00:04:39.860] equity repo, where you could have your loan out with somebody and then have equity repo out with
[00:04:45.460] somebody else. And if you had a significant recall or if a big market action happened,
[00:04:51.180] then you're affecting two sides of that piece. And during the crisis, there was only a couple
[00:04:57.900] things that really traded that had any liquidity, and that was equities and treasuries. So a lot of
[00:05:04.260] the cash reinvest product that we had invested our cash in was not liquid. And we found that out
[00:05:09.960] like many other lenders. So the process of going to a non-cash program, we felt was a de-risking
[00:05:17.600] of the program and almost a simplification of the program. And we had our risk guys take a look and
[00:05:24.900] do sensitivity analysis on what we were lending out versus what we were taking as collateral
[00:05:31.940] and trying to match those collateral types. And we found out that we were taking right-way risk.
[00:05:37.800] So the betas were usually higher on the stuff that we were lending out, lower on the stuff
[00:05:43.200] that we're receiving as collateral.
[00:05:45.240] And there was plenty of liquidity
[00:05:46.700] given our constraints on our collateral profile
[00:05:50.700] on what type of collateral we receive.
[00:05:54.160] So there was plenty of liquidity
[00:05:55.680] if you had a borrower default
[00:05:57.780] to be able to sell that collateral in the market.
[00:06:00.340] And the one big benefit is not having to sell the collateral
[00:06:04.660] because it's just a return of collateral
[00:06:07.180] in the event of a mark-to-market.
[00:06:09.280] Let's say the market's down 10% overnight.
[00:06:11.740] well, then you're just giving securities back if there's a mismatch. Instead of having to sell or
[00:06:18.320] make a transaction, it's just a movement of securities, which is a heck of a lot easier.
[00:06:23.540] You're not in the market transacting. It's a movement and it's easy to track. So I think
[00:06:27.380] that's where we started looking at it internally. And then we had to get buy-off internal and we
[00:06:32.920] had to change state law in order for us to take equities as collateral. And I'll let Mike dive
[00:06:39.220] into the background of how we had to change law and then how we kind of rolled out the program.
[00:06:44.380] Thanks, Dan. Yeah, we stumbled across a state statute. We were looking at a transaction back
[00:06:48.600] in 2015, 2016. We were looking at a peer-to-peer transaction, actually, doing it versus non-cash,
[00:06:54.180] and we stumbled across an old state statute. We turned to find out what was written back in the
[00:06:58.500] 70s that allowed us to take cash and or collateral in the form of cash or bonds or other interest
[00:07:03.320] bearing notes that were backed by the U.S. government. So, and then U.S. government issued
[00:07:07.280] or cash we're able to take. And we're able to also find out that cash also meant currency,
[00:07:12.220] so any kind of local currency. We think at the time it was written in the 70s, that was what
[00:07:16.460] the SEC lending program was like. They were doing loans versus U.S. dollar and U.S. government-backed
[00:07:21.960] bonds. So we think that's why it was written in the law. So we sponsored an assembly bill to get
[00:07:27.120] a change made that would allow CalPERS to expand our collateral set. And it was kind of twofold.
[00:07:31.820] we asked for certain changes on the legislation to expand our collateral set. And then that got
[00:07:38.000] approved. And then once that got approved, we said, we got this approved, but we actually had
[00:07:42.420] put some kind of limits and restrictions on it ourselves. So that's when we got our risk team
[00:07:46.980] together and went to one of our internal committees with what we recommended to take
[00:07:51.300] so we can have CalPERS official approved non-cash collateral set. And that's kind of high level how
[00:07:56.160] it happened and how it came to be. As Dan mentioned, and I want to reemphasize this,
[00:08:00.380] we looked operationally and just as a whole, we looked at cash loans and non-cash loans almost
[00:08:05.540] the same. Because now to reiterate this, I was at a conference once, I said that we look at them
[00:08:10.060] the same because we do a loan, we take cash, we'll put that in equity repo, right? Then day,
[00:08:15.600] that's almost the same thing. But as Dan highlighted, there's the same counterparty
[00:08:19.240] defaults on the loan, the same counterparty we buy in on the collateral side. So it's actually
[00:08:23.400] end result for us looking at non-cash collateral, we're able to lower our risk profile and make
[00:08:29.580] more revenue at the same time. So it was kind of a win-win for the program. So what were some of the
[00:08:34.920] immediate results then? Because I know when you spoke about it, the last podcast we had in terms
[00:08:41.060] of the fact that you guys manage your lending program through an auction process. And so
[00:08:46.180] once those collateral schedules were changed and you went through the process to get it changed
[00:08:51.120] to the state statute level, and then also all of your internal risk guidelines and such,
[00:08:55.880] 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.
[00:09:06.200] What was the reaction then like from the borrowing community to your assets?
[00:09:11.180] 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?
[00:09:22.440] Did you notice a change right away or did that take a while to ramp up?
[00:09:26.940] Well, Brooke, it was a total game changer because the market was moving in a direction
[00:09:33.260] and there was really no North American pension funds that were offering non-cash.
[00:09:37.600] So we were kind of the first ones to that kind of market.
[00:09:40.720] And we had this large auction plan.
[00:09:44.520] And I think we were just waiting.
[00:09:45.920] we had just received approval or during the auction period was, you know, going to get the
[00:09:52.220] approval legislatively in order to do this. And we wouldn't have had bids from a cash perspective.
[00:10:00.740] So literally we created value. And the nice thing about our intrinsic program is we have
[00:10:07.520] full transparency and we have over 20 years of data on these auctions and a lot of similar assets
[00:10:14.500] let's get auctioned every year. So we had some large, chunky U.S. equity portfolios that we
[00:10:22.340] didn't see any demand from a cash side because cash was getting more and more expensive due to
[00:10:27.020] changes as a result of Dodd-Frank and some of the other regulatory changes affecting some of our
[00:10:32.920] bidders. We had bidders come in on the non-cash side and unlocked significant value from a lending
[00:10:40.340] standpoint. Correct. As Dan mentioned, we have had a couple auctions that 100% of the bids were
[00:10:45.180] non-cash. Non-cash bids on our auctions are definitely the majority right now. We moved
[00:10:50.380] right time, right place. Yeah, and those bids continue to dominate from a non-cash perspective.
[00:10:56.060] We've moved to a model, a low-risk reinvestment strategy. So we're not looking at driving revenue
[00:11:03.420] from our cash reinvest. So that's not really a focus. And then some of our modeling that we're
[00:11:09.180] doing for leverage and liquidity, we're not assuming that the cash from the program stays
[00:11:15.780] out permanently. That's internal look that we get from our risk folks. So we weren't really getting
[00:11:20.760] a lot of credit internally for our cash. We were running a low risk and then we were chasing
[00:11:25.220] product that didn't have all, you know, once you have billions of dollars chasing product,
[00:11:29.360] it's hard to even find reinvestment product. So this allows us to increase our loan balances,
[00:11:36.740] unlock value that wouldn't have been there and drive program revenue right to the bottom line.
[00:11:43.100] And how have those non-cash guidelines evolved or have they evolved at all since you first looked at
[00:11:48.800] it? Because I appreciate, especially for if we have any of your beneficial owner peers listening
[00:11:53.760] to this that might today not be taking non-cash, but might be thinking about it and wondering how
[00:11:59.700] they move forward. There's going to be, because you have noted here, there's various things to
[00:12:03.900] think about. It's the risk profile of what type of non-cash you're taking versus what type of
[00:12:08.860] assets you're lending. There's also the operational factors to sort of understand and understand how a
[00:12:13.920] non-cash program operates and how that differs. But did you guys start out with whatever your
[00:12:19.420] guidelines look like today? Did it look like that at day one that you approved it or have you
[00:12:23.300] evolved your thinking around that or expanded it or do you intend to expand that in the future?
[00:12:28.040] How has it been in your actual experience in terms of living through the types of non-cash
[00:12:33.400] that you accept and what maybe your long-term visions are? We had our approved non-cash
[00:12:38.420] collateral schedule set up in 2018, and we haven't made any changes to it. I heard a couple
[00:12:42.660] counterparties complain that our over-collateralization percentages were a little bit
[00:12:47.260] too high, but that just tells me we hit the nail on the head there. So we'll still continue to come
[00:12:52.060] and bid with us. So that tells me we got the right touch point. Dan mentioned earlier, we had right
[00:12:57.100] way risk on this thing. Well, we set it up that way. The one thing that we're not doing, we're
[00:13:01.180] not doing a collateral downgrade trade. We're not taking equities versus U.S. treasuries for
[00:13:05.560] instance. But everything else behind that where everything matches up to our collateral, we kind
[00:13:10.060] of have right-way risk. And we test that when you do collateral adequacy tests on at least a
[00:13:14.220] quarterly basis and an annual basis. We also do a counterparty default scenario and we run different
[00:13:20.520] value at risk to see where the collateral stands up. We do different various distress scenarios.
[00:13:25.960] We run those assets that, hey, if this happened in that distress scenario, what would our collateral
[00:13:30.160] look like? And we've confirmed, we have touch points that we do have right-ray risk here.
[00:13:35.620] And a lot of times, three or five days into these stress tests, collateral is a larger percentage
[00:13:40.420] than it was initially. And that's a data point that I think beneficial owners are just going to
[00:13:45.140] have to get comfortable with themselves. They're going to have to look at what are they comfortable
[00:13:48.520] taking? I think there's some good guidelines out there in the marketplace as a whole,
[00:13:52.460] domestic and international, what the haircut should be like there. And look at your current
[00:13:57.280] repo collateral schedules that you have. What are the collateral percentages there? That's how we
[00:14:01.520] started. That was the basis that we used to create our schedule. And no one's running away from us.
[00:14:06.220] So that tells us we hit a sweet spot, I believe. So I think getting comfortable with your collateral
[00:14:10.200] set and then try a couple loans and do the collateral adequacy testing on those, get
[00:14:14.740] comfortable with those. And I said, if you set it up to be right way risk, your numbers are going
[00:14:20.500] to have right way risk. And Brooke, we're trading with people that are all on our approved
[00:14:25.940] counterparty list. So all of these entities have been pre-approved from a credit risk perspective
[00:14:30.960] and all those counterparties are monitored. So if there's a problem, then there'll be limits that
[00:14:38.280] are taken down of those counterparties. But first and foremost, you look at the underlying liquidity
[00:14:43.900] of your collateral. What proved to have the least amount of liquidity is what everyone was in. In
[00:14:49.260] 08-09, the cash reinvestment side had the least amount of liquidity in all the asset-backed
[00:14:55.000] securities and notes, equities proved to have plenty of liquidity. And people mistake volatility
[00:15:01.640] of a market with risk. Volatility is one aspect of risk as you're looking at your collateral.
[00:15:09.060] But a lot of those asset backs didn't have any volatility because there was no price for them.
[00:15:14.780] You couldn't move them. So the nice thing about having volatility is it gives you an underlying
[00:15:20.400] market and you can tap that market. And that's what we look at. We're lending equities that we're
[00:15:25.540] taking and we can move our equities. And most of the time, you're not looking at a default scenario.
[00:15:31.040] You're looking at markets locking up and you can just return your non-cash. Just return it. They
[00:15:37.060] want to unwind it. You have a situation. You're not forced to sell anything. All you're doing is
[00:15:42.320] sending somebody's collateral back. You don't own the collateral. It's pledged to you. When you do
[00:15:47.320] a cash transaction and take cash, you own the collateral set. So you're buying into a different
[00:15:53.680] risk altogether. To me, it's a lot more transparent and it's a lot easier from an operational
[00:15:59.880] standpoint, especially if you get markets locking up. Right, absolutely. And you mentioned that
[00:16:06.200] you're obviously dealing with your existing approved counterparty list, but you also, I think
[00:16:11.340] in a little bit ago noted that if you hadn't adjusted your collateral profile that for some
[00:16:17.780] of your auction offerings you would have perhaps struggled to see bids versus cash just given at
[00:16:24.040] you know different points in times given that maybe borrowers wouldn't have had demand on an
[00:16:27.780] exclusive basis for certain asset types versus cash so would you say then that even though I
[00:16:33.520] appreciate that the nominal list of your approved borrowers hasn't changed but that your approved
[00:16:39.320] borrower diversity or diversification or depth and breadth has changed? Because it sounds like
[00:16:44.900] it's changed for the better, ultimately, because you offer them this greater flexibility. You
[00:16:49.160] probably have more market participants borrowing from you today than you would otherwise. Is that
[00:16:53.220] a fair statement? Yeah, we've given economic value to people that had internal constraints. So what
[00:17:02.060] you'll find is different counterparties take a look at their own risk or their own counterparty
[00:17:09.100] or the cost of cash, pledging cash differently.
[00:17:13.400] So now we have somebody that historically
[00:17:16.500] their cash costs quite a bit
[00:17:18.300] and they can pledge non-cash and it frees something up.
[00:17:21.700] We're seeing those people win more auctions.
[00:17:24.300] So we've seen players that never have really participated
[00:17:26.840] actively or have been awarded
[00:17:28.620] and they're the winners of that auction.
[00:17:32.660] So it's reshuffling the deck, which is always good.
[00:17:37.500] And then whenever you're reshuffling the deck,
[00:17:38.780] I think you're unlocking value. And there were no bids for certain of our assets. So those assets
[00:17:45.540] didn't have value to the market on a cash basis. And we unlocked value for certain people because
[00:17:53.300] of their own unique circumstances and the way they cost cash and way they're able to offset
[00:17:59.620] posting of equities or other alternative collateral sets. Yeah, to just add and reemphasize
[00:18:05.920] what Dan said is that we've seen the last six options, more borrowers come into bid. So more
[00:18:11.380] bidders, better bids. Right. Absolutely. Well, that feels like a good place to end this then.
[00:18:18.350] More bidders, better bids. Well, good. Well, thank you both for sharing this information. I mean,
[00:18:23.610] I do hope, and again, part of the aim of GPFA is to encourage information sharing and discussion
[00:18:31.070] of best practices and that peer dialogue amongst beneficial owners and the securities financing
[00:18:35.990] industries and so hopefully this conversation around your experience with how you guys first
[00:18:42.710] started to consider and then the process you went through to adapt your own well first of all state
[00:18:48.250] laws but then internal policies and risk policies to allow for non-cash and what your experiences
[00:18:53.390] have been hopefully that's going to be helpful for others that might be thinking about non-cash
[00:18:57.330] and recognizing that it's part of the market if they're not adapting to it then they might not be
[00:19:02.350] keeping pace with their peers so I think that folks will find value and we'll look forward to
[00:19:07.190] hopefully chatting with you guys on other topics so and we'd encourage any of our listeners to
[00:19:11.810] reach out to GPFA directly via LinkedIn or our website and let us know what other topics would
[00:19:17.170] be of interest to hear directly from some of our members so thank you again Dan and Mike and this
[00:19:22.890] was great thank you guys