What is LDV ?

Who benefits from LDV?

LDV benefits all participants in the securities finance industry.  Lenders are better able to exercise their corporate governance responsibilities and, since lenders recall fewer loans, overall securities lending volume and revenue increase.  Loan, borrow, and collateral portfolios are more stable, allowing agents and brokers to more effectively manage investment, counterparty, and operational risks.  Corporate issuers receive more proxy votes from long-term investors, allowing them to reach quorum more quickly and at lower cost, and counterbalance votes of short-term activists.  Higher loan volumes also improve financial market liquidity and price discovery.

 

What is Lender-Directed Voting, or LDV?

LDV is a new process that matches securities lenders' loaned shares to broker securities that would otherwise go unvoted, enabling lenders to direct proxies without recalling loans.  It substantially improves existing market practices, which require lenders to recall loan in order to vote proxies.  Recalls are inefficient in that they reduce overall lending and borrowing revenue, and create instability in loan, borrow, and collateral portfolios. 

Why haven't lenders voted on loaned shares in the past?

Historically, institutional securities lenders had to forgo voting rights on loaned shares because there was no mechanism to vote without recalls.  Recent technology and transparency improvements in securities finance markets, however, enable loaned shares to be matched with broker shares that would otherwise go unvoted.  In particular, the Agent Lender Disclosure Initiative made apparent the direct counterparty relationship between lenders and broker-borrowers and provided brokers with detailed loan data necessary to include lenders in their proxy allocation routines.

Are there enough unvoted shares to cover lender voting interest?

Approximately 60 billion U.S. equities go unvoted each year[1], while roughly 15 billion shares are on loan[2], suggesting that sufficient votes could be available to meet lender vote demand.  However, it is unlikely that lender voting interest will be fully covered for all issues, such as those with particularly contentious proxy events or that are hard-to-borrow in securities lending markets. 

[1] www.broadridge.com/investor–communications /us/Broadridge_Proxy_Stats_2010.pdf
[2] Data from RMA securities lending composite, assuming $20 average stock price

Does the broker have the lender’s shares on the proxy record date?

1.  U.S. Federal Reserve Regulation T (“Reg T”) defines the permitted purposes for the extension of credit in the borrowing and lending of securities. In general, all of these purposes involve settling trades through re-delivery of the borrowed securities. Most often, the broker’s need to borrow has arisen after failing to receive securities required for an impending trade settlement, either as the result of an operational breakdown or after a short sale.

2.  Given the broker-borrower’s mandatory compliance with Reg T, it can be argued that borrowed shares, which are re-delivered in the settlement of a trade, are not available on the broker’s books (as a technical matter, the position would be held at DTCC) in order to earn voting rights on the proxy record date. However, this argument would only be true per se if the settlement took place on the proxy record date, because an analysis of the ongoing process reveals that the proxy votes, not just the entitled shares, are properly treated as fully fungible on the broker-borrower’s books.

3.  Reg T does not require that the borrowed shares be returned to the original lender when a subsequent receipt of securities is used to offset the original failure-to-receive. At that point, the borrower can certainly return the securities to the original lender. Yet, an active borrower can also compliantly decide to close a loan of the same securities with a different institutional lender whose terms may have become less attractive or from another broker-dealer lender who may be viewed as more likely to recall shares at an inconvenient time in the future, especially if the shares were borrowed for an ongoing short position. Still another reason may exist to hold the securities if the broker considers the return on its cash collateral, received through a rebate from the lender, to be very attractive compared with other investment options. In all those cases, as well as for actively traded issues where there may be a high risk of ongoing settlement failures, the broker can simply keep the newly-received shares in its inventory, balanced against its obligation to the lender.

4. As a result of efficient management of its settlement obligations, a broker – perhaps all brokers – may well have borrowed positions on their books on proxy record dates. The brokers would have gained the right to assign proxies or even to vote at the next corporate meeting as a direct result of the original loans from institutional lenders. In effect, the proxies are fungible on the brokers’ books, along with the borrowed shares themselves subject, of course, to an equitable assignment of proxy rights in compliance with stock exchange rules. Yet, brokers are not expressly permitted to assign proxies to their institutional lenders. At this point, the Lender Directed Voting (“LDV”) argument gains relevance and substance.

5. As noted, in addition to holding the shares cum voting rights, the broker also retains an obligation to its original lender. Indeed, one could argue that an institutional lender's ownership rights are stronger than those of other “beneficial owners” to whom the broker owes shares in the same securities. That is partly due to the distinction that can be drawn between the institutional lenders, who do not receive proxy assignments, and the broker’s own margin customers and hedge fund clients, who do receive proxy assignments. The distinction resides in the timeline of their property rights: the former owned the shares fully prior to lending them to the broker, while the latter required broker-financing in order to acquire their positions. Although we have seen that the institution’s shares may now be on the broker’s books, it is very likely that the financing customers’ shares are out on loan, i.e., hypothecated as collateral to source the broker’s own funding needs. And, in such cases, those positions are truly not in the brokers’ DTC account, although the brokers may well be assigning proxy rights to their accountholders. One can ably argue that those proxies would more equitably be assigned to the institutional lenders.

How can lenders instruct broker shares?

Brokers administer proxy allocation routines to distribute proxies to their customers.  Since broker shares are held in fungible bulk and lenders have beneficial ownership to loaned shares, brokers can include lenders in their allocation routines.  After brokers allocate proxies to lenders, standard proxy processes are followed to garner and submit voting instructions and submit them to corporate issuers.  For example, proxies are assigned to Broadridge accounts designated for the lenders, then are instructed by lenders or ISS on the lenders' behalf.

Could lenders also instruct custodians' unvoted shares?

Regulatory and operational considerations may pose challenges to matching custodians' unvoted shares with lenders’ loan positions.  In particular, custodian shares are not held in fungible bulk, as are broker shares, which presents difficulties when considering custodial allocation of proxies across lender accounts. Furthermore, custodians are not counterparties on loans, so the lenders are not beneficial owners to any of the custodians’ unvoted shares.

Does LDV contribute to “over-reporting,” since lenders’ shares were delivered to new buyers who now have the associated voting rights?

Existing proxy reconciliation processes are sufficient to address any potential "over-reporting" issues.  For example, brokers already use post-reconciliation processes to mitigate the risk of over-reporting that may arise from assigning proxies to margin customers whose shares may have been loaned or rehypothecated.

How do brokers decide which lender(s) are assigned proxies?

Beneficial owners and regulators have expressed concerns about voting opportunities being directed to preferred lenders or leveraged for beneficial loan terms.  In the same way that agent lending queues are designed so that lenders get equitable access to borrower demand, brokers need pre-defined and algorithmic “proxy queues” to ensure equitable assignment of voting opportunities.  Furthermore, on-going auditing and validation of proxy assignments may be needed to ensure against development of a “market for votes.” 

What if proxies are not available from a lender's borrower, but are from another broker?

Reallocation of the loans to brokers with available proxies would increase overall lender voting opportunities.  However, numerous other loan factors would need to be taken into account, such as counterparty risk assessments and credit limits, loan prices, and collateral types and quantity.  Considering these factors, loan reallocations may not be in the overall best interest of lenders and borrowers, and will have to be considered on a case-by-case basis.

How can lenders know, before record date, how many proxies they will be assigned?

To the extent that lenders receive proxies through LDV, they will not have to recall loans to regain voting rights.  However, broker holdings change daily and varying numbers of investors vote, so the number of proxies that can be assigned to lenders cannot be known with certainty until just before the meeting date, which is typically two months after lenders must make record date recall decisions.   The number of available proxies must therefore be forecasted, taking into account factors such as each broker's customer base, the scarcity of shares in the securities lending market, and the expected materiality of proxy ballot items.

Corporate Governance Blog

Monday, February 27, 2017

Basel Clarifies NSFR Repo Treatment


Author: David Schwartz J.D. CPA

On February 24, 2017, the Bank for International Settlements (BIS) published a new set of responses to interpretation questions related to the Net Stable Funding Ratio (NSFR).[1] This release is a follow-up to the initial FAQ published in July of 2016 and includes important guidance concerning the treatment of repo for purposes of calculating the ratio. The purpose of the NSFR to move banks to more stable sources of funding that are less vulnerable to shocks. Banks and financial institutions that rely on short-term financing have raised a number of concerns about the ratio’s treatment and weighting of repo and reverse repo transactions, with some even calling for repo to be exempt from the ratio altogether. The Basel Committee’s FAQ does not address all of these concerns. But the interpretations do provide valuable clarifications to some technical aspects the treatment of repo and securities finance transactions (SFT) for the purpose of calculating the ratio, including netting of repo and reverse repo and RSF factors applicable to secured funding transactions.[2]

 

This latest FAQ provides interpretive guidance in areas such as: 

 

  • the required stable funding factor for non-operational deposits held at other financial institutions, and for loans that have optionalities; 
  • treatment of retail and small-business deposits and term deposits; allocation of assets according to maturity buckets; 
  • circumstances for net basis reporting for certain securities financing transactions (such as repo or reverse repo);
  • determination of adequate period for a non-maturity reverse repo (also known as open reverse repo); and 
  • treatment of margining for derivative contracts.

 

Repo Netting

 

Netting of repo and reverse repo for purposes of the NSFR has been an area of ambiguity since the NSFR was first proposed. The February FAQ provides some measure of clarity in that regard with the following guidance approving netting of securities financing transactions in fairly narrow circumstances: 

 

5. Under what circumstances can positions arising from securities financing transactions (such as repo or reverse repo) be reported on a net basis in the NSFR? 

 

Answer: Amounts receivables and payable under these securities financing transactions should generally be reported on a gross basis, meaning that the gross amount of such receivables and payables should be reported on the RSF side and ASF side, respectively. The only exception, as per paragraph 33 in the NSFR standard, is that “securities financing transactions with a single counterparty may be measured net when calculating the NSFR, provided that the netting conditions set out in Paragraph 33(i) of the Basel III leverage ratio framework and disclosure requirements document are met.”

 

Pargraph 33(i) of the Basel III Leverage Ratio Framework and Disclosure Requirements provides for netting of SFTs under prescribed conditions including cash payables and cash receivables in SFTs (1) having the same counterparty, (2) the same explicit final settlement date, (3) legally enforceable rights to offset amounts owed to and owed by a single counterparty, and (4) an intention to settle net or settle simultaneously (or its equivalent).

 

Repo Weighting and Collateral Treatment

 

In addition to clarifying repo netting, the FAQ provides interpretive guidance on some technical aspects of applying required stable funding factors (RSF) to amounts receivable and collateral under repo transactions. 

 

4. What is the treatment in terms of encumbrance for collateral pledged in a repo operation with remaining maturity of one year or greater but where the collateral pledged matures in less than one year? 

Answer: In this case, for the purpose of computing the NSFR, the collateral should be considered encumbered for the term of the repo or secured transaction, even if the actual maturity of the collateral is shorter than one year. This follows because the collateral would have to be replaced once it matures. Thus, the collateral pledged under a transaction maturing beyond one year should be subject to a RSF factor of 100%, regardless of its maturity. 

 

5.1 How should reverse repo and secured funding transactions be treated in the NSFR? 

 

a. What is the applicable RSF factor for the amount receivable by a bank under a reverse repo transaction? 

Answer: With the exception of loans (reverse repos) to financial institutions with residual maturity of less than six months secured by level 1 assets (which receive a 10% RSF factor as per paragraph 38 of the NSFR standard) or by other assets (which receive a 15% RSF factor as per paragraph 39 of the NSFR standard), the treatment for the amount receivable is the same as with any other loan, which will depend on the counterparty and term of the operation. 

 

b. What is the treatment for the collateral received? 

Answer: According to paragraph 32 of the NSFR standard governing secured funding arrangements, the NSFR treatment of collateral received in a reverse repo is determined by the collateral’s balance sheet and accounting treatments, which should generally result in banks excluding from their assets, securities that they have borrowed in securities financing transactions (such as reverse repos and collateral swaps) which are kept off-balance sheet. In this case, there is no NSFR treatment for the collateral. If, however, the collateral received is kept on-balance sheet, such collateral should receive an RSF factor according to its characteristics (whether it is HQLA, its term, issuer, etc). 

 

c. How should the encumbrance treatment as specified in paragraph 31 of the NSFR framework be applied to secured lending (eg reverse repo) transactions where the collateral received does not appear on the bank’s balance sheet, and it has been rehypothecated or sold thereby creating a short position? 

Answer: The encumbrance treatment should be applied to the on-balance sheet receivable to the extent that the transaction cannot mature without the bank returning the collateral received to the counterparty. As per paragraph 31 of the LCR framework (referenced in footnote 14 of paragraph 31 in the NSFR framework), for a transaction to be “unencumbered”, it must be “free of legal, regulatory, contractual or other restrictions on the ability of the bank to liquidate, sell, transfer or assign the asset”. Since the liquidation of the cash receivable is contingent on the return of collateral that is no longer held by the bank, the receivable should be considered as encumbered. When the collateral received from a secured funding transaction has been rehypothecated, the receivable should be considered encumbered for the term of the rehypothecation of the collateral. When the collateral received from a secured funding transaction has been sold outright, thereby creating a short position, the receivable related to the original secured funding transaction should be considered encumbered for the term of the residual maturity of this receivable. Thus, the on- balance sheet receivable should:− be treated according to the answer to question 5.1.a if the remaining period of encumbrance is less than six months (ie it is considered as being unencumbered in the NSFR);− be assigned a 50% or higher RSF factor if the remaining period of encumbrance is between six months and less than one year according to paragraph 31; and− be assigned a 100% RSF factor if the remaining period of encumbrance is greater than one year according to paragraph 31. 

 

d. How should the encumbrance treatment specified in paragraph 31 of the NSFR framework be applied to secured lending (eg reverse repo) transactions where the collateral appears on the bank’s balance sheet, and it has been rehypothecated or sold, thereby creating a short position? 

Answer: Collateral received that appears on a bank’s balance sheet and has been rehypothecated (eg encumbered to a repo) should be treated as encumbered according to paragraph 31. Consequently, the collateral received should:− be treated as being unencumbered if the remaining period of encumbrance is less than six months according to paragraph 31 of the NSFR standard, and receive the same RSF factor as an equivalent asset that is unencumbered;− be assigned a 50% or higher RSF factor if the remaining period of encumbrance is between six months and less than one year according to paragraph 31; and− be assigned a 100% RSF factor if the remaining period of encumbrance is greater than one year according to paragraph 31.If the collateral has been sold outright, thereby creating a short position, the corresponding on- balance sheet receivable should be considered encumbered for the term of the residual maturity of this receivable, and receive an RSF factor according to the answer to question 5.1.c above. 

 

6. Some loans are only partially secured and are therefore separated into secured and unsecured portions with different risk weights under Basel II. How should these portions be treated for the calculation of the NSFR?

Answer: The specific characteristics of these portions of loans should be taken into account for the calculation of the NSFR: the secured and unsecured portions of a loan should each be treated according to its characteristics and assigned the corresponding RSF factor. If it is not possible to draw the distinction between the secured and unsecured part of the loan, the higher RSF factor should apply to the whole loan. 

 

7. What is the adequate period for a non-maturity reverse repo (also known as open reverse repo)? Would that be categorised under “loans with residual maturities of less than six months”?

Answer: Paragraph 29 states that assets should be allocated to the appropriate RSF factor based on their residual maturity or liquidity value. When determining the maturity of an instrument, investors should be assumed to exercise any option to extend maturity. For assets with options exercisable at the bank’s discretion, supervisors should take into account reputational factors that may limit a bank’s ability not to exercise the option. In particular, where the market expects certain assets to be extended in their maturity, banks and supervisors should assume such behaviour for the purpose of the NSFR and include these assets in the corresponding RSF category. In the case of a non-maturity reverse repo, they should be assigned as RSF=100% (to continue over the one-year term), unless banks can demonstrate to supervisors that the non-maturity reverse repo would effectively mature in a different period.

 

The full text of the February 24,2017 FAQ is available via: https://www.bis.org/bcbs/publ/d396.pdf

 

 

 

[1] The NSFR was first proposed by the Basel Committee (BIS) in 2009 and included in the 2010 Basel III Agreement. BIS issued a consultation on the NSFR in January 2014, and final guidelines in October 2014.  At present, the NSFR is in an observation period until January 1, 2018 when it becomes a minimum standard under the Basel III liquidity risk framework.

 

[2] The NSFR is defined as the amount of available stable funding (ASF) relative to the amount of required stable funding (RSF). The ASF is defined as the portion of capital and liabilities expected to be reliable over the time horizon considered by the NSFR, which extends to one year.  NSFR = ASF (Available Stable Funding) ÷ RSF (Required Stable Funding) ≧ 100%

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Corporate Outreach Milestones

MILESTONES FOR LENDER DIRECTED VOTING

May 8, 2014: Council of Institutional Investors; - CII Elects New Board, Names Jay Chaudhuri Board Chair. http://www.bloomberg.com/news/2014-01-31/north-carolina-treasurer-may-cede-pension-control-5-questions.html )

February 2014:  Swiss Minder Initiative implies the value of LDV. http://www.ipe.com/switzerlands-minder-initiative-will-cripple-securities-lending-experts-warn/10000947.article.

January 2014 – FL SBA begins their SecLending Auction Program with eSecLending.

November 27, 2013 – CSFME staff call with Glass Lewis Chief Operating Officer. He gave his commitment for cooperation and support for LDV, and most importantly, he suggested that perhaps we should discuss with a Broadridge/State Street/Citi the scenario that permits Citi to forward an “Omnibus Ballot” of proxies to State Street, which State Street would then take and assign the proxies to their pension lenders/LDV participants, which would then be incorporated into a single ballot and sent to Broadridge. This eliminates the secondary ballot issue. While this description is oversimplified, Glass Lewis was fairly certain the parties involved could operationally create such a combined ballot. Responding to the question on cost, the Glass Lewis executive stated that the cost depends on the number of voting policies a fund has. Most funds have one policy; therefore, depending on the client, the cost would be $.75 – $2.00 per ballot.

October 21, 2013 – CSFME staff call with ISS Chief Operations Officer. He committed his cooperation and support to advance LDV’s implementation into the markets. He responded to the question about cost: “It depends on the client and the services they use. $6-7 per ballot on average.”

June 25-28, 2013 – CSFME staff attended ICGN Annual Conference in NY, NY. Spoke with executives of CalSTRS; ICGN Chair and Blackrock about LDV.  We received favorable comments and encouragement from each.

June 6, 2013: CSFME meets with Chief Investment Officer for NYC Pension Funds. While very much in favor of the LDV concept, the comments that the NYC Pension Fund Boards are for the most part followers in new initiatives and would prefer a roll-out by other funds first.

April 5, 2013: ‘SEC gives CSFME limited approval for LDV going forward’ providing brokers assign proxies only from their proprietary shares.

March 26, 2013 – CSFME and its legal team presented the case for LDV to SEC Commissioner Dan Gallagher. Present by phone and speaking on behalf of LDV were representatives of FL SBA who spoke about the difficulty of timely recall of shares on loan following release of record date and issues on agenda; and a representative from CalSTRS who spoke about their recall policy affecting income.

March 13, 2013 – CSFME meet staff of Senator Rob Portman and Congressman Steve Stivers of Ohio. These meetings were for the purpose of lining up political support, should the SEC resist the LDV concept. We also met and spoke with CII Deputy Director Amy Borrus for one hour and 15 minutes for a scheduled 30 minute meeting.  She expressed great interest in the value of LDV to long-term beneficial owners.

January 17, 2013 – CSFME conference call with CoPERA Director of Investments.  Among CoPERA’s concerns were: (1) How are agents/brokers notified re: LDV? (2) Who moves or approaches first lender to agent or agent to lender? CSFME responds  that a side letter is needed between lender, agent and broker.

November 8, 2012 – CSFME conference call with Council of Institutional Investors (CII) detailing LDV. Some in attendance were opposed to securities lending because of their desire to vote 100% of recall. This position would be irrelevant giving CalSTRS’ change to policy on proxy recall.

October 24, 2012, 2PM – CSFME presents LDV to Broadridge Institutional Investor Group. At this meeting, a representative of CalSTRS states: “We would view brokers willing to provide proxies more favorably than those who would not.” We were also informed by CalSTRS that they were looking to change their 100% recall policy. A representative of SWIB led a discussion on International Voting Issues, and apparently was chairing 3 meetings to determine the following: 1. who is voting internationally? 2. What are the issues in the international markets? 3. How do we increase and improve international processes?

October 24, 2012, 11AM – EWB/KT conference call with ICGN.  Executives stated that the argument for LDV may not be as strong in a non-record date market, and asked what would be the cost for LDV.  They further stated that they would like to see the U.S. go with LDV first and would need more information and operational detail.

October 13, 2012 email note from Elizabeth Danese Mozely to Broadridge’s Institutional Investor Working Group: “TerriJo Saarela, State of Wisconsin Investment Board, will provide commentary on their fund’s interest in international voting and an update on her participation in the Council of Institutional Investors’ working group on international voting.  Our discussion will include the differences in process for voting abroad, share blocking, attendance at the meeting via proxy or Power of Attorney (POA), best practices available through the various laws and regulations, etc.”

September 18, 2012: CSFME contacts Blackrock/ICGN Chair for a brief on LDV.

August 13, 2012 – CSFME conference call with OTPP.  Discussion of LDV was not timely in that their SecLending Program stopped lending securities through agents in mid-2006. State Street is their custodian and they were using a tri-party repo through Chase to Lehman, until the Lehman collapse. All the assets sat at Chase. It was not clear who had voting rights. At the time of this discussion in August 2012, OTPP was thinking formulating an SLA because they do not have the capacity to lend securities on their own. We have had no discussion with them since.

August 2, 2012 – CSFME contacts Ontario Teachers’ Pension Plan (OTPP) regarding LDV.

March 19, 2012 – CSFME conference call with executive in charge of securities lending for Franklin Templeton

February 22, 2012 – ICGN sends LDV letter of support to the SEC, signed by Chairman of the ICGN Board of Governors.

September 30, 2011 – CalSTRS sends LDV letter of support to the SEC, signed by Director of Corporate Governance Anne Sheehan.

July 18, 2011 – Florida SBA sends LDV letter of support to the SEC, signed by Executive Director and Chief Investment Officer.

November 2011 – CSFME introduces Council of Institutional Investors editor to LDV.

July 5, 2011 – CSFME sends a Comment Letter to the Securities and Exchange Commission regarding LDV.

October 2010 – CSFME releases report: Borrowed Proxy Abuse: Real or Not? This report and the SEC’s Securities Lending and Short Selling Roundtable prompted the question from beneficial owners and regulators regarding the need to recall shares on loan to vote proxies, why can’t lenders receive proxies for shares on loan when we get the dividends? From this question, the idea for Lender Directed Voting was born.

January 2010 – SEC issues rules that brokers no longer have the discretion to vote their customers’ shares held in companies without receiving voting instructions from those customers about how to vote them in an election of directors. http://www.sec.gov/investor/alerts/votingrules2010.htm. The rule, periodically, contributed to the difficulty of corporate meetings attaining a quorum.

Fall 2009/2010 – Four public pension funds join CSFME in Empty Voting studies/LDV initiative; FL SBA, CalSTRS, SWIB and CoPERA.

September 29-30, 2009 - SEC Announces Panelists for Securities Lending and Short Sale Roundtable; http://www.sec.gov/news/press/2009/2009-207.htm.