J.P. Morgan Securities' latest "Short-Term Market Outlook and Strategy" provides a rare glimpse inside the world of securities lending reinvestment. It says, "Over the past year, securities lenders have followed somewhat in the footsteps of prime MMFs in terms of balances. While the decline in assets wasn't as dramatic as prime MMFs where we saw $1tn of assets move into government MMFs, we did see a 10% drop in assets under management among securities lenders year-over-year. According to the Risk Management Association (RMA), balances in securities lenders' cash reinvestment portfolios fell $67bn in 2016 to $582bn, the lowest level we have on record." The piece explains, "As we discussed in our 2017 Outlook, securities lenders were a liquidity provider when prime MMFs pulled away from the credit markets in the run up to MMF reform in the second half of last year. Together with other short-term fixed income investors, they helped to absorb money market supply that would have otherwise been bought by prime MMFs.... Clearly, the backup in credit spreads late last year as a result of MMF reform gave an opportunity for non-MMF investors to take advantage of the widening spread environment and capture higher yields. As the data suggests, securities lenders were one of them." JPM also writes, "Interestingly, securities lenders' total allocation to MMFs was largely unchanged throughout last year in spite of MMF reform. `While there appeared to be a shift towards non-2a-7 MMFs (e.g., offshore funds, other liquidity focused funds), the amount invested in SEC 2a-7 funds remained fairly steady. It's possible that within the 2a-7 fund category, a shift took place from prime funds to government funds. But without knowing more details, it’s unclear whether there was a similar aversion to prime MMFs among securities lenders as there was to other institutional investors. Looking ahead, we suspect securities lenders will continue to be an active participant in the short-term fixed income market. While balances will likely trend lower given the impact of regulations (i.e., securities borrowers are increasingly collateralizing their borrowings with securities instead of cash), we think the move will be very gradual in nature. In the meantime, securities lenders will continue to balance liquidity and yield, which could mean more non-traditional repo and floaters given a rising interest rate environment."
