Securities Lending: Adapting to Change |
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| October 2009 |
Welcome
Richard Ernesti
Managing Director, Global Head of Client and Sales Management for Investor Services
Global Transaction Services, Citi
In this issue of Spotlight, we focus on the future of securities lending. One year on from the collapse of Lehman Brothers, a top-five borrower, lender confidence is returning and the volume of lendable assets expanding again. Nevertheless, lenders have understandably become more cautious and attitudes have changed in a number of areas. Citi is seeing clients re-engage their lending programmes, albeit with more stringent guidelines.
One of these is the issue of cash as collateral. Mindful of counterparty issues in the money markets, significant numbers of lenders remain wary of accepting cash. We question the wisdom of this approach. At Citi, we have a highly conservative and proven approach to the reinvestment of cash which has stood our lenders in good stead throughout the events of the past two years. By using the reverse repo markets to convert cash into collateral we achieve full collateralisation of every loan - giving lenders the same protection that they enjoy when they accept securities as collateral.
In this issue we also look at another aspect of the post-Lehman landscape - a new securities lending agreement. Devised by the International Securities Lending Association (ISLA) following consultation with market participants, the new agreement incorporates lessons learned from the Lehman default and provides a legal framework that recognises the realities of a multi-trillion dollar securities lending industry.
New Securities Lending Agreement
Brian Staunton
Managing Director, EMEA Head of Securities Lending
Global Transaction Services, Citi
When Lehman Brothers collapsed in September 2008, lenders and agents alike held their breath: would a legal framework and related processes devised when securities lending was still in its infancy prove robust enough to insure market participants against losses in a default of such magnitude? The answer was a qualified 'yes' - though it helped that, in the days following the collapse, government securities, which made up most of the collateral lenders had accepted, went up while the price of most other securities went down.
Nevertheless, the Lehman affair exposed a number of issues that had not been foreseen when either of the two borrower agreements then in use - the Global Master Securities Lending Agreement (GMSLA) or the Overseas Securities Lending Agreement (OSLA) - had been drafted or last updated. As a result, the International Securities Lending Association set about consulting its members on a revised GMSLA. This was finally issued in July this year.
The new agreement takes all the lessons learned in the wake of the Lehman default into account. Citi currently uses the OSLA, together with industry-standard agreements for UK equities and gilts. It will be migrating all its borrowers to the new GMSLA, which dispenses with the subsidiary agreements. The new GMSLA will apply to lenders too, since they are the principal to the agreements with borrowers.
There are three important changes to take into account. First, in a case of default, the new GMSLA contains a provision allowing a lender to set off any excess collateral on their stock loans against other exposures to the defaulting party. There was not a provision in the OSLA to allow lenders to do this in the case of Lehman, even though in some cases Citi’s clients found themselves with significant excess collateral on their securities loans. The new clause in the GMSLA 2009 should allow lenders to apply any excess collateral on their stock loans against, for example, any under-collateralised positions in derivatives or reverse repo transactions with the same counterparty.
Second, new procedures have been introduced that give more flexibility to the non-defaulting party in a close-out. Under OSLA, the lender’s agent had just two days in which to buy in replacement securities for the lender - or potentially be liable for any loss if the proceeds from the collateral failed to cover the repurchase cost. This can be very difficult to achieve. In any close-out, there are inevitably securities where these is no liquidity. And even where there is liquidity, the tight deadline for repurchasing stock in the volumes that agents deal with making it difficult to avoid moving the market.
Now that limit has been extended to five days. In addition, where it proves impossible to get a bid-offer quote in a security within that period - or the price shown on quote service is plainly stale - the agent has more flexibility to use a subsequent price provided that price can be justified.
The third important change involves the introduction of a 'mini close-out' clause. Under OSLA, the failure of a borrower to deliver equivalent securities back to the lender when requested triggered a default that terminated all trades between the two parties - even where the borrower was plainly still solvent and the failure to return the securities was down to other reasons (such as the failure on the part of a hedge fund client to come up with the securities as demanded). Now that failure will qualify as a mini close-out event in which the particular security trade is ring-fenced, the collateral sold and the original securities repurchased, while all other loans continue unaffected.
The new agreement is widely viewed as a major improvement on what went before. It removes an element of risk and uncertainty that was implicit in previous agreements, while the cross-netting facility should give a lot more comfort to clients. In essence, it brings stock lending into the 21st century with the benefit of a real life case study as a background in preparing the new agreement.
Time to Revisit Cash Reinvestment
Gareth Mitchell
Director, EMEA Head of Securities Lending Trading Desk
Global Transaction Services, Citi
There are not many areas of finance where cash has a bad name right now, but securities lending is one of them. Following the breakdown in trust in the inter-bank market, the Lehman collapse last year and reports in the Press of Securities Lenders experiencing losses, large numbers of lenders stopped lending against cash. Cash reinvestment was deemed risky. Before Lehman, cash collateral accounted for an estimated 90% of the securities lending market. Today, the equivalent figure is 50% at best.
But there is a strong case for revisiting the cash reinvestment issue. Just because a lender takes cash does not mean that cash must be invested in unsecured time deposits with a money market counterparty. Cash could simply be viewed as the means of acquiring further collateral. The reverse repo markets deliver precisely that, plus a margin. Reverse repos are in essence collateralised cash lines. The return they generate will depend on the lender’s appetite for credit risk, but there will always be a firewall of collateral in place to deal with most eventualities.
In essence, there is a big distinction to be drawn between collateralised cash reinvestment and uncollateralised cash reinvestment. With the former the chances of principal loss are as low as they would be with lending that is collateralised against securities from the outset: only if the borrower defaults and the value of the collateral falls by more than the additional margin taken can the lender be at risk. With uncollateralised cash reinvestment, the lender is exposed to counterparty and credit risk throughout the term of the loan.
Clearly, there are rules to observe in a cash-based lending programme. Some lending agents created cash pools which took a broad spread of credit risk. Unfortunately some of these cash pools now contain assets which are valued below par or worse still some of the assets have defaulted. Now lenders cannot withdraw their cash without accepting losses forcing them to continue lending just to finance their investment in the fund. Citi never took that route, and indeed has consistently adopted a very conservative approach to cash reinvestment.
How does that work? Very simple. We consult our clients and agree a strategy at the outset. Much depends on the assets to be loaned. For instance, corporate bonds trade against cash or hardly at all - largely because they tend to be smaller loans where the cost of collateral management can be prohibitive.
When it comes to choosing reinvestment collateral, clients determine their own risk profile. Government securities will generate low returns, corporate bonds much more (maybe 25 to 30 basis points for BBB credit). In the corporate market, we monitor and charge for liquidity risk. We demand extra margin for any bond that has not traded for five days. If it has not been priced for 30 days we will remove it from our list of acceptable collateral. There will be an additional 3% cross-currency margin if the bond is not priced in the same currency as the cash loan.
Clients can diversify their risk by imposing limits on individual issuers and requesting additional margining for different types of security. With our knowledge of the market, we can advise on whether a particular approach will prove attractive to borrowers or not.
Citi’s cash reinvestment model is a proven one. By converting cash into collateral via the reverse repo market, lending against cash takes on much the same risk profile as lending directly against collateral. Investors that shun cash collateral lending are denying themselves the opportunity to increase the utilisation of their assets and maximise return.
