Securities
Lending
A Guide for
Policymakers
Contents
Introducing Securities Lending ....................................................................... 3
The Size of the Global Securities Lending Market .......................................... 4
Market Participants and Their Roles .............................................................. 5
Lenders and Agents .................................................................................... 5
Borrowers ................................................................................................... 5
The Role of Intermediaries ......................................................................... 6
Process ............................................................................................................ 8
Legal Agreements ....................................................................................... 8
Transacting.................................................................................................. 8
Collateral Management ............................................................................ 10
Lending by Central Securities Depositories (“CSDs”)................................ 11
Corporate Governance and Shareholder Engagement............................. 11
Pricing of Securities on Loan ..................................................................... 12
Benefits ............................................................................................................. 14
Directly ...................................................................................................... 14
Indirectly ................................................................................................... 15
Risks .............................................................................................................. 17
Risks to the Lender. .................................................................................. 17
Risks to the Borrower ............................................................................... 18
Regulation ..................................................................................................... 18
Market Led Developments ........................................................................... 18
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SECURITIES LENDING
Education and Risk Awareness ................................................................ 19
Infrastructure ............................................................................................ 19
Matters of Interest to Policymakers ................................................................. 21
Transparency ............................................................................................ 21
Re-hypothecation ..................................................................................... 21
Intermediation and Complexity ................................................................ 23
Reliance on Short Term Funding............................................................... 24
Cash Collateral Investment ....................................................................... 24
Margin Practices and Procyclicality ......................................................... 25
Securities lending and Retail Investors ..................................................... 26
Empty Voting ............................................................................................ 27
Appendix 1: Summary of Global Securities Lending Regulations ................ 28
About ISLA..................................................................................................... 29
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Introducing Securities Lending
Securities lending involves a transfer1 of securities (such as shares or bonds)
from a “lender” to a third party (the “borrower”), who provides the lender
with collateral in the form of shares, bonds or cash.
The borrower pays the lender a fee over the duration of the loan (typically
payable on a monthly basis) and, unless otherwise agreed, is contractually
obliged to return the securities to the lender on demand within the standard
market settlement period relevant to the lent security.. The borrower will also
compensate the lender for any dividends/interest payments and corporate
actions that may arise on the security whilst on loan.
In essence, the lender remains economically exposed to the securities that
have been lent and retains the key benefits of ownership, except for voting
rights. Like all investment techniques, securities lending does give rise to
certain risks and these need to be considered fully by investors.
There are two key benefits to securities lending. Firstly it provides a low risk
incremental income for investors and secondly, it provides liquidity to the
broader global markets. Conservative estimates suggest that European
investors earned €1bln in securities lending revenues during 2011. This
revenue provides EU citizens with valuable additional returns on their long
term savings and makes a positive contribution to helping pension schemes
lower any deficits.
1
* Legally a securities loan is the transfer of title against an irrevocable undertaking to return equivalent
securities. This means that registered securities such as shares, will be transferred out of the lender’s
name into that of the borrower and registered back when they are returned
SECURITIES LENDING
3
The Size of the Global Securities Lending Market
Whilst securities lending is largely an over the counter market a number of
independent data companies have been collecting data from a wide range of
market participants for many years and therefore reasonable estimates of the
size of the market are available. The size of the securities lending market is
usually measured by the amount of securities that are on loan. The graph
below from a company called DataExplorers (now part of Markit) shows that
market value of lent securities (represented by the green line) has been fairly
steady for the past two years, averaging a little under € 1.5trn. The blue line
shows the amount of securities that lenders are willing to lend, and is
currently a little under €10trn. DataExplorers estimates that the universe of
participants in their data set represents approximately 85% of the total
market.
European securities represent around 30% of the available to lend and of the
average value of securities that are lent.
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Market Participants and Their Roles
Participants in securities lending, can be broadly divided into two categories:
lenders and their agents, and borrowers.
Lender
Beneficial Owners
 Pension funds
 Mutual funds
 Insurance Companies
 SWFs
Borrower
Intermediaries
 Asset Managers
 Custodians
 Third-Party Agents
 Broker-Dealers
 Investment Banks
End Users
 Hedge Funds
 Broker-Dealers
 Investment Banks
Lenders and Agents
These are typically large scale institutional investors, such as pension funds,
insurance companies, collective investment schemes and sovereign wealth
funds. These investors would normally employ an agent (such as a custodian
or investment manager) to arrange, manage and report on the lending
activity.
Borrowers
These are typically large regulated firms, such as investment banks, market
makers and broker dealers. Hedge funds are among the largest end borrowers
of securities, but they borrow through investment banks or broker dealers as
clients under prime broker contracts rather than directly from the investors.
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The Role of Intermediaries
As noted a lender may well be an insurance company or a pension scheme
while the ultimate borrower could be a hedge fund; however the securities
lending activity is usually undertaken by two intermediaries on each of their
behalves.
•
•
•
•
Agent Lender
Manages Risk:
counterparty, legal
operational
Manages collateral process
Provides Technology and
expertise
Aggregates market supply
•
•
•
•
Principal Intermediary
Manages borrower risk
Provides Credit
Intermediation
Manages daily collateral
process
Aggregates Market
demand
Managing the lending process is a specialised business and requires
investment in systems and human resources. Investors who wish to lend
securities usually employ a specialist agent such as an investment manager,
custodian or independent third party to lend on their behalf. The lender
undertakes a due diligence process to identify and appoint the most
appropriate agent in much the same way that they would to appoint a fund
manager or custodian bank. ISLA, along with a number of other market
associations, has published guidance on what should be considered during this
process. Where funds are sufficiently large, the investor may conduct the
lending activity directly, although given the scale of investment required in
people and technology to appropriately manage a securities lending program,
this is somewhat rare. It is usual for the agent to obtain compensation for its
services, through a fee sharing arrangement, often referred to as a fee split.
This ensures that the lender only incurs costs when revenues are generated
and aligns the interests of the third party agent to the lender in respect to
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ensuring that the activity is profitable. The amounts charged by lending agents
vary but 30% of the income would be a representative average.
The main borrowers in the market are specialised firms such as prime brokers
who borrow securities for their own firm’s requirements (for example where
they have internal trading desks or market making operations) or for clients
such as hedge funds. Lenders will generally be reluctant to assume credit
exposures to borrowers that are not well recognised, regulated or who do not
have any credit rating. In these circumstances, the borrower when acting as
prime broker, provides a credit intermediation service in taking a principal
position between the lender and the hedge fund. Prime brokers are
compensated by the hedge fund client through a “spread” on the amount that
they pay to borrow from the market.
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Process
Legal Agreements
Securities lending arrangements are underpinned by market standard legal
agreements such as the Global Master Securities Lending Agreement (GMSLA)
published by ISLA. This lending agreement is executed between the agent
lender (on behalf of the lender) and the borrower. The lender also enters into
an operating agreement with their agent which sets out all the parameters
within which lending activity must take place (such as limits on the amounts
that can be lent or restrictions on collateral that can be received). Once this
agreement is in place the agent will be responsible for all day to day activities
and will provide the lender with information tailored to their requirements.
Transacting
Beneficial Owner
2a
4
Agent Lender/
intermediary
1
Principal
Intermediary
3
2b
1 Agent lender and principal intermediary identify,
negotiate and agree terms of loan
2a/b securities transferred from beneficial owner to
Principal intermediary and then to end borrower
3 collateral transferred from Principal intermediary to agent
lender
4 reporting of exposures to beneficial owner
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End Borrower
Market
settlement
Once a master lending agreement is in place, loans are generally negotiated
between the agent and borrower, on a bilateral basis. Agents provide
borrowers with electronic files showing the securities that their clients have
available to lend each day. The borrower will normally instigate the request
to borrow via telephone, secure electronic messaging or an automated
platform such as Equilend2. Once the loan has been agreed, both parties
provide market instructions to enable the securities to be delivered to the
borrower on the agreed date.
In recent years there has been an increase in automated lending whereby
lenders broadcast inventory with required fees and where the terms are
agreeable, approved borrowers automatically match and instruct loan
settlement.
Loans can be agreed for a specific length of time (term) or on an open basis
(callable). Open loans can be terminated by the lender at any time and the
master agreement requires the borrower to return the securities in the
standard market settlement period. This means they are able to sell securities
whilst they are on loan and recall in time for sale settlement.
Participating in securities lending should not impact the lender’s investment
strategy, including its ability to buy or sell securities, but procedures must be
established to ensure that the agent is notified of investment management
decisions.
2
See later section on Infrastructure
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Collateral Management
With the exception of lending by CSDs (see below) securities lending is always
fully collateralised by the transfer of either eligible securities (referred to as
non-cash collateral), or cash. Haircuts are set by the lender and applied to the
collateral value meaning that lenders generally receive collateral of a greater
value than the securities they have lent. The size of the haircut will depend on
a number of factors including, but not limited to, the quality and liquidity of
the collateral and the correlation it has to the lent securities.
Loans and collateral are marked to market daily with any margin calls being
made on a same day basis. If a security held as collateral defaults, the
borrower is required to replace it with another.
In the event of a counterparty default the lender has the right to liquidate the
collateral held and use the proceeds to repurchase the lent positions in the
market. The haircuts applied to collateral are designed to protect the lender
against the risk that the proceeds from liquidating collateral are insufficient to
replace the lent securities. It is therefore important that the lender considers
the liquidity and volatility of the collateral as well as its price correlation with
the lent securities. Commercially, the lender also needs to take into account
that collateral to lenders represents an economic cost to borrowers and
collateral margin represents an additional balance sheet cost to borrowers.
Although there are no mandated margin or “haircut” levels for securities
lending, a typical haircut would be 5 – 15% depending on the factors noted
above.
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Lending by Central Securities Depositories (“CSDs”)
CSDs sometimes offer securities lending services. These arrangements vary
but some are focused on covering settlement failures, where an account at
the CSD is short of securities on a settled basis but not on a traded basis. If an
investor signs up to the service, their securities can be automatically borrowed
by the CSD on behalf of other CSD clients to ensure timely settlements and
guaranteeing the lent position using a lien over the borrowers securities
accounts. The securities are only borrowed for the time required until the
borrowing account has securities delivered, so can be for a short intraday
period, or a number of days. The fees charged are significantly higher than in
the rest of the market, reflecting the expectant short loan period, and the
lender relies on the CSD credit guarantees instead of physically receiving
collateral.
Corporate Governance and Shareholder Engagement
When securities have been lent the lender retains all shareholder benefits,
such as dividends, interest payments and corporate actions, but not the right
to vote. However, lending does not need to impact the lender’s corporate
governance responsibility, as loans can be recalled in order to exercise the
right to vote. The lender must decide whether the vote or the economic
benefit of the loan is more important to their investment strategy and either
restrict the securities from being lent over the voting period, or recall lent
securities in time to vote.
The borrower provides warranties in the master agreement that securities are
not being borrowed for the primary purpose of exercising voting rights as this
activity is considered inappropriate.
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Pricing of Securities on Loan
The fee that a lender charges for borrowing securities is a function of supply
and demand. Where demand is high, relative to supply, the rates charged will
be correspondingly higher and vice versa. Loans of “easy to borrow”
securities are normally priced around 10 basis points, whereas “hard to
borrow” securities may be priced at 500 basis points or more. Any securities
can attract higher fees if they have a higher intrinsic value to the borrower
other than shortage of supply. Ultimately pricing is set based upon the agent
and borrower’s knowledge of the market and by reference to market data
provided by certain specialist data companies.
The two graphs below provide an illustration of lending fees between April
2011 and April 2012 for European Equities and European bonds respectively.
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Where non-cash collateral is accepted, the lender charges a basis point
percentage based on the value of the securities which is accrued daily and
usually paid on a monthly basis in arrears for all activity during the month.
Where cash collateral is accepted the lender must pay a rate of interest on the
cash collateral held, minus the lending fee for borrowing the securities (this is
amount is referred to as the rebate). The lender must therefore invest the
cash in order to generate sufficient returns to pay the interest owed and
generate a return for the portfolio. Accepting cash as collateral involves
certain different risks for the lender which are covered later.
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Benefits
Securities lending is used by a wide range of investors and intermediaries
inside and outside of the EU. Its use supports greater market settlement
efficiency, market making activities and a wide array of trading strategies that
provide liquidity to the securities markets and its participants.
Directly
Long term investors, such as pension funds, collective investment schemes
and insurance companies, generate incremental revenues from engaging in
securities lending. These returns help to reduce the costs of providing
pensions and long term savings to investors. As mentioned above we
conservatively estimate that European lenders earned in excess of €1bln last
year. This revenue makes a useful contribution to the investment objectives
of the lender (be those the provision of long term pension payments or an
enhancement to the overall investment performance of the funds). Some
lenders view the returns available from lending as a way of reducing the costs
of managing their investments.
Some important strategies which are used by long term investors to protect
their portfolios are supported by short selling, which in turn requires
securities lending activity. For example, a corporate bond holder may wish to
protect his portfolio against interest rate moves, and can achieve this by
taking a short interest in government bonds as part of the overall portfolio. In
this way the portfolio exposure to interest rates is reduced.
Investors will also borrow securities for a variety of reasons including to
ensure efficient and cost effective collateralisation of other transactions such
as repo or derivatives.
Improved liquidity, lower dealing costs, better price formation and better risk
management are important to all users of the capital markets, including
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Government and corporate issuers of securities, long term investors such as
pension funds, and retail investors.
Corporate issuers of securities, who use the markets as an effective way of
raising capital to finance their businesses, are able to raise capital on cheaper
terms than they would do in a less efficient marketplace. This can be seen in
markets where short selling is restricted, such as many in the Middle East. A
good example recently involved the Dubai listed Emaar Properties. Their
US$500m of convertible bonds had incurred costs of an estimated US$50m
over a five year period because of the high coupon (7.5%) the company had to
pay to investors who were unable to hedge the convertible bond position by
selling the equity short. Put simply, because short selling was not available to
investors, this company had to pay substantially more to raise finance than a
comparable company issuing a similar bond in a market that did recognise
short-selling. This money could have been used for developing new
businesses, supporting economic growth and increasing employment.
Indirectly
The market also benefits more broadly from securities lending. Securities are
borrowed for a number of reasons, supporting a number of trading strategies
as well as the timely settlement of transactions in the market.
Securities lending helps prevent settlement failure and so improves market
efficiency. Settlement failure may happen because of a mismatch in
settlement instructions between the parties or because the seller has had a
purchase fail to settle. In order to facilitate the sale and avoid any costs or
penalties, the security can be borrowed to facilitate the settlement.
Market makers have obligations to make constant two-way pricing and the
ability to borrow securities to ensure settlement helps them meet customer
demand. It is not usual for market makers to lend securities held for the
purposes of market making.
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Short sellers borrow securities in order to cover their sales. The new EU short
selling regulation requires all short sellers to cover their sales and this will
generally require them to borrow securities. Securities lending supports many
investment strategies through short-selling that would otherwise be
extremely difficult to execute. These include strategies such as hedging which
are important to long term investors.
Securities lending also offers an alternative source for secured funding. For
example, banks can borrow eligible central bank or CCP collateral to use in
other aspects of their business. In this way a lender, who owns but has no day
to day need for, government bonds can earn a return by lending them out,
and the borrower acquires securities that can be used to raise funding in the
repo markets. This provides banks with an additional, diversified funding
source, and the more sources a bank can access the less a shock in one source
will impact them.
The benefits of securities lending have been widely recognised by regulators
around the world, by national and supranational organisations and by
academics. Index providers, such as FTSE International, include the existence
of a well-functioning securities lending market in their criteria for a country's
inclusion in their developed market indices. Recognising its broader benefits,
governments around the world have provided exemptions and reliefs for
securities lending transactions as well as the transfer of associated collateral,
from locally imposed stamp or other similar transfer taxes, VAT, and capital
gains tax charges.
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Risks
As with all investment activity, participating in securities lending involves
some risk. Historically the market has focused on the risks to the market
participants themselves. More recently, as a result of reviews of the “shadow
banking” system, the European Commission and Financial Stability Board have
been considering whether the use of securities lending poses wider risks to
the financial markets as a whole. These are considered later.
Risks to the Lender.
As mentioned above, most of the risks for securities lenders are managed by
the use of specialist agents who have invested in infrastructure and expertise
to manage the activity.
The main risk for a lender is the default of a borrowing counterparty. In this
event the securities or cash held as collateral must be used to restore loaned
securities to the portfolio. This is why the quality and liquidity of collateral is
so important and why appropriate haircuts (which in effect require the
borrower to deliver collateral of a greater value than the securities being lent)
must be applied. Haircuts need to be at such a level that the excess collateral
value is sufficient to cover any negative price correlation between the loan
and collateral portfolio for the period between default and portfolio
restitution.
Where cash collateral has been received and invested, the investment must
be sufficiently liquid to be able to access the cash quickly and purchase the
lent securities.
When Lehman Brothers collapsed, it represented the biggest counterparty
default to impact the securities lending industry. In the majority of cases,
investors were able to liquidate collateral and restore lent positions without
loss. However some cash collateral takers did incur losses from their
investment strategies. Also, some hedge funds struggled to reclaim the
collateral that they had provided to Lehman Brothers against borrowed
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securities, partly due to the securities being re-hypothecated and used for
other collateral requirements.
In addition to the risk of default, lenders must manage certain other
operational risks, such as ensuring that any dividends or corporate actions
that the lender is entitled to are properly claimed and received. Agent lenders
manage all of the day to day process of securities lending on behalf of the
lenders, applying the policies and guidelines provided, and regularly reporting
information such as loan values, counterparty exposures and collateral held.
Risks to the Borrower
Borrowers of securities are exposed to similar risks as the lender. If a lender
defaults, they may not be able to return the borrower’s collateral. In such
event the borrower can exercise their set off rights under the master
agreement and can seize the borrowed securities to cover amounts that the
lender is due to pay.
Regulation
Securities lending is a global activity but current regulations have been
developed on a regional basis and are generally applicable to certain types of
institutions or fund types. A sample of these has been listed in appendix 1.
Most of the regulation has been focused on investor protection, for example
limiting the types of counterparty a lender can do business with, or limiting
the type of collateral they can accept.
Market Led Developments
The securities lending market has seen many developments over the last 10
years aimed at reducing risks and increasing transparency.
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Education and Risk Awareness
It is important that the lender fully understands the risk profile of their specific
activity and it was apparent after the Lehman Brothers default that some
lenders may not have been fully aware of, or understood the counterparty
and liquidity risks involved. As a result the industry has published independent
educational material for lenders, which was coordinated via the Bank of
England’s Stock Lending and Repo Committee (SLRC) and endorsed by a
number of market trade associations. In addition a checklist highlighting risks,
features and parameters, was developed to formalise the on-going
engagement between agent lenders and their clients.
Infrastructure
Automated Global Platforms
Over the last decade the market has developed global platforms for trading
and post trade reconciliation of securities loans. The use of these platforms
has allowed participants greater connectivity, enabling them to electronically
transact and process security loans. This has increased processing efficiency
and reduced operational risk.
Triparty Collateral Managers
Managing collateral transactions can be complex and expensive. Over the last
ten years the use of triparty collateral managers, who focus only on collateral
related processes, has increased significantly. Tri-party collateral managers
receive loan valuations from both lender and borrower on a daily basis, and
automatically transfer eligible collateral, which is defined by the lender prior
to transacting, from the borrowers account to the lenders segregated
collateral account. The book transfer method and the automation collateral
eligibility checking offered by such managers represents a meaningful
reduction in the operational risks associated with non-cash collateral
management.
Central Counterparty Developments
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The costs and benefits of a Central Counterparties (CCP) for securities lending
is currently being considered by the market with a small number of services
on offer. CCPs are widely used in repo transactions and some other derivative
transactions, with collateral being posted to the CCP. It is not clear however
whether a CCP is suitable for securities lending activity and some believe if
their use was to be mandated it could limit participation in the market.
When using a CCP, both loan and collateral securities are delivered directly to
the CCP with the loaned security being delivered on, and the collateral being
held by the CCP. Both lender and borrower will provide margin to the CCP as
protection against default. Provided the CCP is sufficiently secure, they could
be potentially beneficial by reducing market wide counterparty exposure.
Standardised margin methodology may also provide a more consistent margin
requirement and avoid sudden margin calls on banks which can cause them
liquidity issues. However, difficulties exist in the range of eligible collateral
and the additional costs to lenders, who currently receive margin directly and
don’t provide any.
Development of Market Data
The provision of market data for securities lending has increased exponentially
over the last ten years. Lenders and borrowers provide data files daily with
details of available to lend and lent securities which is then aggregated and
provided back to the market on an anonymous and daily basis. This
transparency enables analysis of market wide dynamics such as lending
liquidity and lending rates and provides the basis for performance
measurement.
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Matters of Interest to Policymakers
Over the past 12 months, securities lending has been subject to significant
regulatory attention with reviews of shadow banking, short selling practices,
ETF and UCITS, and Corporate Governance concerns. There are certain
themes that have run through these which are discussed below.
Transparency
The securities lending industry is sometimes considered as being opaque and
not sufficiently transparency. There is in fact a lot of data available,
sometimes for a fee, however it is largely only used by market participants
and the provision of data is not compulsory.
Agent lenders have invested heavily in reporting tools and techniques to
ensure that lenders have full transparency of activity undertaken on their
behalf.
Furthermore the industry is currently working toward meeting the
requirements of Basel III, Solvency II and regulators liquidity reporting which
will further improve transparency.
Securities lending is mostly conducted on a bilateral basis rather than through
any exchange and this means there is little publically available information
about the fees paid for borrowing securities.
Re-hypothecation
Re-hypothecation describes the process by which a collateral giver (fund
customer) transfers collateral to a collateral taker (Prime Broker) and that
collateral taker uses the collateral for onward financing transactions. It is
most commonly associated with Prime Brokerage arrangements and has risen
to prominence after the financial crisis.
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Under Prime Brokerage arrangements, the Prime Broker typically extends
credit to the fund customer. The credit may take the form of financing long
positions or financing short positions. The total amount of credit extended to
the fund customer is determined and the pre-agreed re-hypothecation rate is
applied. The re-hypothecation rate is typically greater than the amount of
credit extended, that is to say, if the Prime Broker lends €100 it will need an
amount greater than €100 to fund the extension of credit. In today’s market,
re-hypothecation rates vary between 140%-200% of the total extension of
credit depending on a number of factors including the liquidity of the
securities taken as collateral. The Prime Broker may never take more than the
re-hypothecation amount.
Following the determination of the value of securities that may be rehypothecated, the fund customer will then permit the Prime Broker to take
the requisite amount of securities and title to the securities will be transferred
to the Prime Broker. The Prime Broker may use (or re-hypothecate) the
collateral with the proviso that the Prime Broker must return equivalent
securities to the fund customer once the fund customer repays the original
loan/extension of credit. In this way, re-hypothecation is similar to a repo
transaction with securities posted one way and cash posted the other with an
obligation to return cash and securities once the transaction is terminated.
Some institutional lenders use a type of re-hypothecation in order to
collateralise derivative transactions as efficiently as possible, or to meet the
requirements of derivative central counterparties (“CCPs”). For example they
may enter into a loan of securities under which they receive collateral that is
eligible to cover margin calls from the CCP. This mechanism allows the
investor to obtain eligible securities without the need to sell core investments
from the portfolio or borrow cash unsecured at significantly higher interest
rates.
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The ability to re-hypothecate is important for markets to operate efficiently.
It is important that any regulatory measures designed to restrict rehypothecation are focused on the legitimate concerns and do not harm the
benefits that investors receive.
Intermediation and Complexity
Questions are sometimes asked about the number of intermediaries in
securities lending, with the end lender and end borrower rarely having a
direct relationship, and often with two intermediaries between them. The
concerns are that the level of intermediation complicates the process, adding
unnecessary counterparty risks to the activity and taking value from the
principals to the transactions.
Securities lending is not a core capability of lenders and it is only economical
for the very largest funds to invest directly in the specialised systems and
resource required. It is also an expensive process that smaller lenders can
only benefit from because an agent lender acts as a conduit to the market.
The agent lender performs a vital role in providing the expertise and focus
that the activity required to manage the process efficiently and in a risk
controlled manner. It is important to note that the agent lender only acts
within parameters set by the lender who retains absolute control over the
activity.
Principal intermediaries also perform an important role in the process by
providing the lender with a regulated and credit rated entity with which to
transact, without which lenders would not make their portfolios available for
lending. The value of the credit intermediation role they undertake should
not be under estimated. Principal intermediaries also enable the beneficial
owner to access a large number of small end borrowers by amalgamating
them through a single rated entity.
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Reliance on Short Term Funding
Securities lending can provide an additional source of short term funding for
banks and an opportunity to exchange otherwise unused long securities for
central bank eligible collateral. The ability to use securities in this way helps
banks to keep funding costs down. To the extent that lenders are able to
transact on a term basis borrowers are better able to meet bank liquidity
ratios.
Long term investors such as insurance companies and pension funds have
historically provided significant unsecured funding to the financial markets
and moving toward providing this funding on a secured basis reduces the
counterparty risks taken by these institutions.
Overnight secured funding can be quickly withdrawn in volatile markets or in
times of crisis, and applied margins can be adjusted, which has led some
policymakers to consider the stability of this type of funding. However,
arguably, long term investors may be better able to absorb illiquidity in
stressed markets.
Cash Collateral Investment
The investment of cash collateral can give rise to maturity and liquidity risk
transformation and this is therefore an area being considered by the FSB as
part of its review of the shadow banking system.
Whilst more prominent in the US than in Europe, the investment of cash
collateral drew particular attention during the liquidity crisis of 2008/09.
Where cash is provided as collateral the cash has to be invested in order to
pay the rebate back to the borrower (see page 13). Any rebate is based on a
notional opportunity cost of the cash and therefore a market rate of return
has to be achieved on the cash to cover this cost. The lender receives the
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returns on the cash investment (less the rebate paid to the borrower) and also
bears the risks of these investments.
It is possible to enhance overall lending returns by increasing the rate of
investment return in excess of the borrower’s opportunity cost, however like
all investments that higher return implies higher risk either through greater
credit risk or creating a duration mismatch - i.e. paying the rebate based on
overnight investment rates but investing the cash on a more termed basis.
One notable feature of the liquidity crisis was the fact that the amount of
credit risk or duration mismatch in a great number of collateral investment
vehicles was far greater than the extraordinary market conditions could
sustain. As a result lenders either realised losses on their cash investments or
found that they could not exit securities lending without realising such losses.
Following the liquidity crisis both lenders and their agents have fundamentally
re-evaluated the role of cash collateral in securities lending. Some lenders
stopped accepting cash permanently, others only temporarily. Agent lenders
have almost uniformly converged investment guidelines to align with the
eligibility and duration requirements of registered money markets funds along
the lines of the US 2-a-7 rule.
Margin Practices and Procyclicality
Some commentators have suggested that the practice of amending margins,
or applied haircuts, in response to changing market conditions has the effect
of speeding up the rate at which crises develop. The concern is that when
markets are stable and default risk is assumed low, haircuts are naturally
reduced, but as markets become less stable lenders increase haircut
requirements to protect themselves against the higher risk of default. The
question is whether this process acts to drain liquidity from market
participants which in turn makes markets more procyclical.
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The conflict is that the lender wants the highest possible haircuts and the
borrower wants the lowest possible. With a focus on capital and liquidity
requirements, the levels of haircut are increasingly important to both parties,
and this is driving a more considered position. Lenders increasingly look at
risk models which incorporate a variety of market scenarios and which take
into account factors such as the liquidity of collateral, the correlation between
loaned securities and collateral, and their own capability to sell or absorb
particular asset types in the event of a counterparty default.
It has been suggested that greater use of central clearing or the imposition of
minimum regulatory haircuts might help reduce the perceived procyclicality in
the market. The question is whether these tools would make matters worse.
Securities lending and Retail Investors
Reservations are sometimes expressed in relation to the suitability of
participation in securities lending for retail investors. However, the low risk,
incremental revenues generated from participation can be an important
addition to the performance of these funds.
There is no reason that securities lending should be considered inappropriate,
provided the retail investor is fully aware of their participation and the risks
undertaken on their behalf are aligned to the risk profile of the investor’s
objectives.
For this reason, full transparency should be provided as part of the fund
documentation such as in the prospectus or fund rules. These disclosures
should describe the process and provide detail of the risks involved.
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Empty Voting
Derivative instruments and some trading strategies have made it possible to
decouple the economic interest in a security and the voting rights. Whilst
these instruments are used for legitimate purposes, there have been concerns
expressed that they could be used to influence the direction of a company
vote. This process is called ‘empty voting’ and borrowing securities in order to
utilise the attached voting rights is one potential method of achieving this.
It is important to differentiate between voting in respect of corporate events,
where the lender has legal right to instruct, and receive, their chosen benefits
from the event, and an AGM/EGM vote which the lender does not have right
to during a loan. Equally, the provider of collateral loses the same voting
rights for securities whilst securities are used as collateral.
There is a general consensus in the industry that borrowing securities
specifically to exercise the voting rights at an AGM or EGM is not appropriate
and this is clearly stated in the Bank of England’s Code of Best Practise, as well
as warranties given by the borrower to this effect in the master agreement.
Nevertheless, because of the opaqueness of the voting processes, concerns
remain and it is difficult to prove or disprove the existence of this activity.
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Appendix 1: Summary of Global Securities Lending
Regulations
country
Europe
Institution
UCITS
All
Banks
regulatory authority
UK
Insurance
UCITS
FSA
FSA
Local Authorities
specific reg
UCITS 4 Directive
MiFiD
Basel II
Prudential Insurance source Book (PRUINS)
UCITS COLL 5.4
Local Government Pension Scheme (Management and
Dept of Communities and
Investment of Funds) Regulations 2009 (Statutory
Local Government
Instrument SI2009/3093
France
PEA (Plan d’Epargne en Action)
Germany
KAGS
BaFin
54 - 57 InvG Wertpapierdarlehen, Sicherheiten
Luxembourg
UCITS
CSSF
Circular 08/356
Spain
Securities Market Law (Art. 36.7 Law 24/1988)
Measures to Reform the Financial System (Art. 15 and 16
Law 44/2002)
Provision 18 Law 62/2003
USA
US employee benefit plans
US Mutual Funds
Broker- Dealers
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US Employee Retirement
Income Securities Act
("ERISA").
SEC
SEC
Prohibited Transaction Exemption 2006-16 (effective Jan2,
2007)
US Investment Company Act of 1940
Securities Exchange Act 1934
SEC Rule 15c3-3
Regulation T
About ISLA
The International Securities Lending Association (ISLA) was founded in 1989 to
represent the common interests of lenders and borrowers of securities
internationally. The association has more than 90 members comprising
insurance companies, pension funds, asset managers, banks and securities
dealers, who in turn represent more than 4,000 clients. ISLA publishes a
master legal agreement which is widely used in the market internationally, as
well as a series of guides, best practice papers and educational materials.
Further details about ISLA can be found on our website www.isla.co.uk.
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