How long has Arizona’s pension fund been open to securities lending and what initially drove the decision?
The Arizona State Retirement System (ASRS) has been involved in securities lending for more than 20 years. The key reasons behind the ASRS’s involvement are opportunities for periodic arbitrage-like sources of return, in areas such as tax differentials, as well as a recognition of high-value fundamental (intrinsic) demand for securities, which can generate incremental risk-adjusted income.
Can you outline the terms of the Arizona pension fund’s securities lending programme?
The primary objective in our securities lending program is to generate a relatively high risk-adjusted return from fundamental or intrinsic market demand factors rather than from reinvestment strategies, while being able to preserve principle, ensure adequate liquidity to meet loan redemptions without realised losses, and not significantly encumber the management of the underlying portfolios.
The ASRS runs a modified ‘specials only’ lending programme with both a non-cash as well as an extremely conservative cash collateral investment strategy intended to provide high risk-adjusted incremental income.
The pension fund accepts both cash (US dollars only) and non-cash collateral, such as US and other developed market securities. Our collateral parameters also allow us to accept both fixed income and equity, with certain restrictions to ensure adequate daily mark to market of the collateral held.
Any cash collateral received is invested in triparty repo agreements that are in turn collateralised at 102 percent. Our repo collateral rules allow for US government securities, including bills, bonds or notes, and US agency securities, such as agency debt and agency mortgage-backed securities.
The margins for the collateral depends on the securities on loan and the type of collateral. Initial and maintenance margins range from 102 percent to 115 percent of the market value of securities on loan with collateral marked daily and maintenance margin adjusted the subsequent business day.
Is the ASRS able to engage in both open and term lending?
The overwhelming majority of securities loans are standard agency loans that are cancellable or recallable by either the ASRS or the borrower on any given business day with a normal settlement period for the type of security on loan. The ASRS also engages in ‘term’ loans and would engage in dedicated programmes as opportunities arise. Term loans are analysed on a case-by-case basis as tactical lending transactions and market condition warrant.
If Rule 15c3-3 were to be amended to allow equities to be accepted as collateral, would you incorporate that into your programme?
Yes. In essence, we are supportive of collateral that is price correlated with the borrowed securities, which can often be accomplished with equity collateral.
Who is your agent lender and how active is Arizona in the day-to-day lending process?
State Street acts as our agent lender, with the ASRS setting higher level lending guidelines and overseeing the entire process. For example, on term loans, meaning those that are not immediately recallable, the ASRS actively decides to engage with a borrower and participates in the negotiation of the terms of the loans.
As our custody bank and also our securities lender, State Street is viewed as the agent lender that should bring term and fixed portfolio opportunities to the ASRS. The ASRS does not have an internal lending desk, but does internally manage fixed income and equity portfolios, which assists in market insight.
What would you say to another state that is considering securities lending?
It appears that the majority of US state pension funds participate in securities lending in one form or another, although during the global financial crisis a number of funds exited securities lending. Most funds have subsequently resumed lending, generally in a more conservative manner.
Should the ASRS be asked, we would respond that we view securities lending in terms of overall portfolio construction, and therefore include securities lending in our asset allocation studies similar to how an asset class would be included.
Did the ASRS withdraw from securities lending during the economic crisis?
Yes, effectively the ASRS did withdraw in large part from securities lending post-2008 while we reviewed our guidelines and ensured that the market had the requisite liquidity.
Have your lending terms changed significantly, following the ASRS’s decision to return?
Our lending terms have changed somewhat, mainly in two areas. First, we are focused even more on the intrinsic value of the demand side, and second, we are more conservative with our cash reinvestment guidelines.
We are, however, flexible when demand-side opportunities arise.
Are there any circumstances that could cause you to close down your programme again?
Yes, the ASRS would consider closing its securities lending programme under a number of scenarios, including if the arbitrage-like and intrinsic demand sides for securities were to be eliminated, if the risk of the universe of allowable reinvestment assets were to rise significantly, if over-collateralisation rates were to be notably reduced, or if the overall market liquidity became structurally less liquid.
Quite simply, the ASRS would consider closing its securities lending programme under a scenario where many issues were to occur that resulted in a higher risk/return ratio. For example, if the arbitrage-like demand caused by such things as tax differentials were significantly reduced, possibly via greater global tax harmonisation.
Moreover, if the intrinsic demand side for securities, such as the demand to facilitate shorting, were to be significantly reduced, or the risk/return ratio of the universe of allowable reinvestment assets were to rise significantly, the ASRS would be forced to reconsider the viability of its lending programme.
Finally, if the over-collateralisation rates, which are typically from 102 percent to 105 percent, were to be significantly reduced, or the overall market structure became too cumbersome or became structurally less liquid, then again ASRS would consider leaving the market.
If the ASRS were to leave, are there other similar revenue streams that you might consider engaging in?
There are no revenue streams that we consider to be direct substitutes to securities lending, but we are always looking for additional return streams, whether it is private market debt opportunites, in-house portfolio management, cash drag minimisation, or any other areas that come to our attention.