Outreach Blog

Friday, September 23, 2011

Bank of England Examines Market Developments in Securities Lending


Author: David Schwartz J.D. CPA David Schwartz J.D. CPA

In their Quarterly Bulletin (Q3 2011), the Bank of England (BOE) examines the lessons the financial crisis revealed in the securities lending industry, as well as some of the more recent market driven and regulatory developments emerging to mitigate these risks.  In particular, BOE voices a high level of concern over the risk of contagion arising from the interconnectedness between participants created by securities lending transactions, and the dangerous opacity of risks incurred across all participants prior to the financial crisis.

Interconnectedness

Securities lending creates additional interconnections between various types of financial institutions . . . During episodes of stress, interconnectedness can cause contagion when problems at one or few institutions are transmitted across networks, impacting counterparties and their customers.

A prime example of how interconnectedness can exacerbate counterparty risks was Lehman Brothers:

Lehman Brothers, for example, was a large borrower in the securities lending market and often borrowed securities on behalf of clients, such as hedge funds. When Lehman failed, most beneficial owners were able to liquidate their collateral and replace their lost securities.  But a small number of beneficial owners struggled to liquidate their collateral and made losses.  And hedge funds that had borrowed securities via Lehman found it difficult to reclaim the collateral that they had pledged to Lehman in order to borrow securities.  This was partly due to rehypothecation of collateral by Lehman, a practice that involves using collateral posted by their clients as collateral for other purposes.

These unexpected counterparty concerns in turn caused some market participants to restrict their market activity precipitously revealing yet another risk underestimated at the time: the sudden contraction in the securities available for loan. 

The Lehman situation and its repercussions demonstrate just how quickly and pervasively market stresses can be amplified and transmitted in previously unexpected ways. 

Opaque or Misunderstood Risks

Long counterparty chains also have the dangerous capacity to obscure risks and make it very difficult to appreciate appropriately the risks participants are exposed to and price and act accordingly.   When participants throughout successive links in the securities lending chain do not fully understand the risks inherent in their lending activities, those risks may be amplified greatly. 

Obscured or opaque securities lending risks not only affected lenders and borrowers of securities, but also investors in investment funds and banks’ counterparties.  These investors may not have had access to the kind of information they needed regarding the risk exposures of institutions in which they invested, making it difficult for them to assess the level of risk tied up in the institutions’ lending activities. 

In the case of banks, for example, that are large borrowers of securities, securities lending can lead to a significant amount of assets being pledged as collateral.  This means that a portion of their assets are ‘encumbered’ — another party has legal claim over them.  The proportion of a bank’s balance sheet that is encumbered in this way may be unknown to other market participants.  But encumbrance can be an issue for unsecured creditors of a bank as it means they have fewer assets to lay claim on if the bank fails.  So in a stressed situation, depositors and creditors may be more uncertain about being repaid, potentially leading them to withdraw their funding pre-emptively.

At another end of the lending transaction chain, it seems that many beneficial owners were not aware of or did not understand the magnitude of the counterparty and liquidity risks involved in their lending programs, and many were not aware of the kind of collateral they held.  Beneficial owners experienced unanticipated difficulty unwinding lending transactions because many had invested their cash collateral in programs of financial institutions or corporate entities heavily dependent on floating rate notes, asset backed securities, or other relatively long-term or suddenly illiquid securities.  This created a “maturity mismatch between their assets and their liabilities as most securities borrowers could return the borrowed securities and request their cash collateral back at any time.” 

Market Driven Developments

In reaction to the lessons learned in the financial crisis, market participants have instituted a number of broad ranging initiatives intended to reduce opacity, improve understanding, and mitigate risk associated with securities.   To this end, market participants have are reexamining and reviseing lending programs and mechanics, and joined with other market participants to create structures to facilitate lending transactions and provide additional clarity regarding and mitigation of counterparty and other risks. 

  1. Reexamination of Lending Programs. Beneficial owners are reviewing their lending programs, reexamining lending guidelines and reassessing acceptable risk levels to better anticipate and control counterparty, credit, and liquidity risks.  Typical changes include revising types of acceptable collateral as well as collateral reinvestment guidelines. 
  2. Education of Beneficial Owners.  Securities lending participants from all parts of the industry have launched initiatives to help educate beneficial owners so that they have a better understanding of risks, rewards, and mechanics of their securities lending programs.  These initiatives include seminars, webinars, as well as best practice guidance.   
  3. Revisions to lending contracts.  Standard legal contracts used in securities lending transactions have been reexamined and revised to address some of the shortcomings found in standard contracts during the financial crisis.  These changes are not taking place uniformly throughout the global securities lending markets, and no leading standard set of contracts has yet emerged.  
  4. Central counterparties.  Market participants are examining the use of central counterparties as a method for mitigating some aspects of counterparty risk.

    Provided CCPs are highly robust, they can potentially provide benefits to the securities lending market.  By acting as a secure node within a network of financial institutions, they can reduce system-wide counterparty credit risk.  And CCP margin methodologies, which are generally more standardised and transparent, should lead to more continuous and predictable changes in margin requirements.  This can reduce the likelihood of sudden collateral calls on borrowers, which can cause them liquidity problems.

    Debate over the merits versus the costs of CCPs continues throughout the industry, and securities lending participants continue to weigh how effective CCPs may be in providing counterparty risk mitigation and improved operational efficiency.  For an independent and comprehensive analysis of the arguments for and against industry-wide adoption of CCPs see: http://www.secfinex.com/assets/Documents/CCPGoodBadInevitable.pdf?1315820205

  5. Trade repositories.   These central data centers collect data on transactions, notional value, currency, maturity, and counterparties on a trade-by-trade basis, and are perceived as having great utility in increasing transparency about aggregate and individual transaction data and trends. 

    Trade repositories can improve the transparency of a market, helping authorities and market participants to see the pattern of risk and flows across markets.  There are global trade repositories for credit, interest rate and equity derivatives. Transparency in the securities lending market could also be enhanced through the introduction of a trade repository.

Regulatory Developments

Though there are few active initiative regulatory initiatives directly aimed at securities lending, more sweeping regulatory activities aimed at stabilizing and improving the financial system may have lasting effects on securities lending. 

Basel III

A major facet of Basel III is aimed at increasing capital requirements to mitigate counterparty credit risk more adequately.  As Basel III guidelines are adopted in different countries, banks borrowing or lending securities may be required to reserve more capital to offset more accurately the risk of a counterparty defaulting making borrowing securities more expensive for banks.  This, in turn, may cause increases in the cost of providing market-making services and the cost of collateral upgrade trades for bank funding purposes.

Solvency II

Solvency II is a European Union initiative aimed at enhancing the solvency of insurers in order to protect policyholders and beneficiaries.  The details of Solvency II are still being finalized and implementation is expected to begin in 2013 (though many expect implementation will be delayed http://www.ft.com/cms/s/0/e94fff8c-9a95-11e0-bab2- 00144feab49a.html#axzz1Z0lm7DKy).  

With regard to securities lending, Solvency II may lead to insurers having to hold additional capital against counterparty exposures to banks, thereby increasing the amount of capital held by insurers against loaned securities.  The additional cost of imposed on lenders may reduce insurers’ incentive to lend securities and could be passed on to borrowers of securities through higher fees.

Dodd-Frank Act

Certain aspects of the Dodd-Frank Act will affect securities lenders, borrowers and agents.  The principal effects of the Dodd-Frank Act on securities lending industry participants are:

  • Changes to the statutory regime governing insolvencies of significant broker-dealers and other financial institutions.
  • Limitations on the ability of Federal Deposit Insurance Corporation ("FDIC")-insured banks and their affiliates to sponsor, maintain and engage in transactions with cash collateral pools.
  • Credit exposure limitations and additional capital requirements that may result in lower volumes of securities lending and repurchase agreement activity by affected banks and bank affiliates, both as principals and in indemnified agency securities lending programs.
  • Enhanced limitations on transactions between affected banks and their affiliates, which may impact riskless principal or "conduit" lending and similar alternative lending programs.
  • Changes to the federal securities laws that will result in additional disclosure in connection with securities lending.

Dodd-Frank requires the United States Securities and Exchange Commission (SEC) to promulgate regulations in the area as well.  The SEC has held roundtable discussions on the topic, and has is expected to propose new regulations in the area in the short term. 

Short-Selling restrictions

Many countries have imposed restrictions on short-selling, some temporary, and some more permanent to head of potentially disruptive short- selling and resulting destabilizing of assets prices.  Insofar as these restrictions reduce short-selling activities, demand for securities to borrow may also be reduced. 

Conclusion

Securities lending continues to provide value and contribute to market efficiency, and remains a robust global industry.  The financial crisis highlighted some key areas where securities lending practices at the time obscured some risks, and the interconnected of the actors and transactions amplified or exacerbated market stresses.  In anticipation of and in concert with regulatory changes, securities lending market participants have taken concrete steps in addressing some of these areas. 

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The CSFME’s Regulatory Outreach Programs

Regulatory reform has become a collaborative process. Where once market supervisors promulgated rules without regard for input from practitioners, today’s reform process has evolved into a dialogue of mutual respect for the opinions of all stakeholders in the capital markets. The process of regulatory outreach has become embodied in virtually every developed markets in the world.

The CSFME has adopted a role of facilitating this collaborative dialogue at all stages of the professional contribution process. Starting with students’ contributions to published commentary letters, through panel presentation and webinars, right up to trade association initiatives, the CSFME provides assistance through education, data compilation, analysis and commentary for some of the most pressing issues in contemporary markets.

DLT and Preferred Securities Financing

We believe the widespread use of encrypted third-party ledgers, blockchains, and smart contracts (i.e., DLT) is inevitable in securities finance, and that those technologies will permit lending agents to offer new revenue opportunities to their clients. Among these, we believe that certain agents will use DLT to help their lenders expand their loan books by opening their lendable portfolios on a preferential basis to the hedge funds in which they've already invested, as well as to other trusted counterparties, a concept we have dubbed, “Preferred Securities Financing.”  

CSFME is openly soliciting participation in a research initiative to assess the potential benefits to securities lenders from the use of DLT and data sourced from new regulatory disclosures. Specifically, our research will focus on how DLT, blockchain, and smart contracts can facilitate Preferred Securities Financing.  Learn More about our DLT Securities Finance Initiative

Research and Analysis of the Effects of Financial Regulatory Reforms

Given the sweeping changes in financial market regulation following the financial crisis, CSFME has turned its focus to questions relating to to how these changes are affecting the risks and economics of bank activities. The purpose of the Center’s research in this area is to foster sound policymaking and effective regulation with minimal adverse and unintended consequences. CSFME studies supervision and regulation of global financial institutions, the effects of reregulation on the global financial industry, optimal roles and methods of regulation in securities markets, corporate governance at financial institutions, and the most effective metrics and methods of data collection for understanding and measuring the effects of regulations on the global financial landscape. 

Lately, in response to a call from the FDIC for research on financial sector policy and regulation, the Center submitted a paper modeling the indirect costs to markets of bank regulatory reform.  The paper critiques regulators’ models for assessing these costs, and provides empirically-based suggestions for a more complete dynamic model of the long-term effect of bank capital reform.  Mindful of the Basel Committee's ongoing reviews of modeling tools, i.e., May 2012 and March 2016, the Center's critique is intended as a constructive addition to the holistic conceptual base of the regulatory reforms.

The Center also continues to provide input on regulatory proposals.

In March of 2016, CSFME submitted a comment letter to the Bank for International Settlement's (BIS) December 2015 consultative document regarding step in risk.  While supporting generally the goals of the Basel Committee to minimize the potential systemic implications resulting from situations where banks may choose to provide financial support during periods of financial stress to entities beyond or in the absence of any contractual obligations, the Center expressed some concerns and offered some suggestions regarding the approach taken by the Consultation. Drawing on practical experience, the Center offered an example from the trade finance sector supporting its belief that the nature of step-in risk may be one example of an acceptable, non-diversifiable exposure, given the potential positives for the economy at large.

In February 2015, CSFME submitted a comment letter in response to the Financial Stability Board’s November 2014 consultative document, Standards and Processes for Global Securities Financing Data Collection and Aggregation. In its letter, the Center identified additional metrics that may be necessary to assess properly the risk of collateral fire sales associated with securities lending transactions.  In particular, CSFME asserted that FSB and sovereign regulators must expand the data initiative beyond position aggregates, to include risk mitigation resources as well as termination activity.

Students Learn to Evaluate and Contribute to the Reform Process

As the level of intensity surrounding the reform process continued to build in 2013, the CSFME began to bring a fresh perspective to the reform process. By working with finance students and the US regulatory agencies, CSFME hoped to challenge the settled views of stakeholder by introducing the views of those whose careers would be shaped by the outcome of the reforms.

In the spring of 2013, a select group of Fordham University economics students met in Washington with officials at the U.S. Treasury, Office of Management and Budget, Federal Reserve Board, and the Securities and Exchange Commission. The CSFME helped arrange the meetings and funded the logistics. By all accounts, the experience was very positive for students and regulators alike.

Buidling upon the success of the 2013 pilot program, in 2014, both Fordham and the CSFME decided to expand the outreach program and formalized the Regulatory Outreach for Student Education program as the ROSE program. Honor students in finance and economics were selected by the deans of four schools within the university: the Graduate School of Business Administration, Fordham College at Lincoln Center, the Gabelli School of Business, and Fordham College at Rose Hill. The students were organized into four teams representing their schools. The CSFME selected a contemporary issue of career significance, the Financial Stability Board’s Consultative Document on G-SIFI designation of non-bank, non-insurer financial institutions. Each team was charged with studying the issues in debate, then presenting their opinions in the manner of a formal comment letter to the FSB. Over four months, the students reviewed earlier opinion pieces, met with practitioners and regulators, and then submitted their opinions. Without influencing their opinions, the CSFME arranged access to research materials and opinion leaders, then reviewed their letters and, as appropriate, recommended submission on university letterhead. In April, 2014, the four teams’ letters were published by the FSB on its website. In recent memory, no university had ever had one letter, much less four, published on a regulatory website. To finalize the 2014 ROSE program, the CSFME arranged for all four teams to present their opinions to the key regulators at the Federal Reserve Board and the SEC in Washington, D.C. The day of meetings ended with regulators’ praise at the degree to which the students had understood the issues and presented their opinions clearly.

One student team even offered suggestions that regulators had not previously considered and praised for their creativity. “We always know what the trade groups will say, but you brought a fresh perspective.” That team, Fordham College at Lincoln Center, was awarded the 2014 ROSE Award for Analytic Excellence. In retrospect. each student completed the program with a credit that will not only endure on their resumes but also contribute to the evolution of the financial markets through the Twenty First Century.

In 2015 and 2016, Fordham formalized the ROSE Program as a for-credit course in their curriculum. The focus of the 2016 ROSE Program was the Bank for International Settlement's December 2015 consultative document proposing a preliminary framework for identifying, assessing and addressing step-in risk potentially embedded in banks' relationships with shadow banking entities.  Five teams of graduate and undergraduate students in economics, finance, accounting, management, and law researched and drafted comment letters on the consultation and submitted their letters to a panel of distinguished industry judges.  After reviewing each excellent submission, the judges then one winning letter to be presented at a visit to the Federal Reserve Bank on April 27, 2016. The winning team's letter was submitted in full to the BIS, along with a summary of the key ideas from the letters from each of the other four teams, and the submission was published on the organization's website with those of the consultation's other commenters.   All five teams of Fordham Scholars visited Washington, DC on April 27, 2016 and met with officials at the Fed, Treasury Department, and FINRA.  

Institutional Securities Lenders respond to Academic Criticisms

In 2006 the Center was created, initially for the purpose of testing academic criticisms of the securities lending markets. With funding and data support from the Risk Management Association, CSFME found “no strong evidence to conclude that securities lending programs have been used to any great extent to manipulate proxy votes or exercise undue influence on Corporate Governance issues.” Our study also found that “broker borrowbacks” had contributed to spikes in lending activity around record date – the same phenomenon that the academics had misinterpreted as evidence of hedge fund manipulation – due to the efforts of brokers to meet recall notices from securities lenders. In effect, the brokers were scrambling to acquire votes for their customers, not building positions to swing corporate elections. The academics had fatally misinterpreted their findings!

Ed Blount of CSFME testified at the SEC’s Roundtable on the results of the research in September, 2009. Then, the CSFME white paper, published in 2010, was submitted to the SEC as an attachment in response to a consultative document on the “Proxy Plumbing” process. As a result of the Center’s contribution to the collaborative process, the misguided call for reform of securities lending began to subside. Once again, securities borrowers were fairly recognized to be honest brokers in the corporate governance arena.

Securities Lenders consider new means to retain their Voting Rights

In a follow-up to the Empty Voting project (“Borrowed Proxy Abuse” as it came to be known), the CSFME responded in 2011 to requests by the participating securities lenders, by turning its attention to ways in which those lenders might be able to retain their corporate governance rights, while still benefiting from the income attributable to their securities loans. After all, as many studies have found, securities lending contributes significantly to the efficiency of market operations. Why should lenders be forced to choose between their loan fees and fiduciary duties to vote their shares, especially if they are contributing to market efficiency?? With independent funding, the CSFME retained attorneys from two prestigious Washington D.C. law firms, Stradley Ronon and Sidley Austin, to investigate the legal underpinnings to market practices which force pensions, mutual funds, insurers and other institutional securities lenders to give up their voting rights when they lend portfolio securities. In practice, margin customers of brokers also lend their securities, yet they usually retain voting rights -- and most of them aren’t even long-term beneficial owners. Both groups of beneficial owners retain dividend rights, so why, institutional investors asked, shouldn’t institutions also keep their voting rights? With the benefit of exhaustive legal research, CSFME filed a petition with the Securities & Exchange Commission to initiate a pilot program to test new market procedures by which recently-introduced efficiencies in market operations might permit lender to retain votes.  Learn more about Paradoxical Erosion of Corporate Governance

In 2013, the SEC approved that pilot program, largely in response to the encouraging recommendations of the International Corporate Governance Association, as well as the California State Teachers Retirement System and the Florida State Board of Administration.

That pilot was initiated in 2014. Simultaneously, the CSFME began to apply the results to new initiatives in Canada and Switzerland, where the pressure to meet fiduciary voting obligations was intensifying.  More about Full Entitlement Voting



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