Bank of England Examines Market Developments in Securities Lending

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

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.