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Opportunities and Challenges for Hedge Funds in the Coming Era of Optimization
arise to help deal with this issue. One such option,
using reinsurance vehicles to indemnify the risk, was
frequently mentioned although the costs at present
are seen as prohibitively high.
Central Clearing Counterparties May Help
Reduce Balance Sheet Impact
Another option to offering indemnification on bilateral
securities lending transactions and taking the higher
capital charge is to centralize the clearing risk of
securities lending transactions.
In the bi-laterally cleared securities lending
model, indemnification costs are accumulated at
the transaction level by the lender. This may be
a theoretical accumulation of cost today due to
indemnification being an implicit cost, but with the
Basel III rules, this will need to become an explicit cost
in the coming years. This is illustrated in Chart 27.
Chart 27 goes on to show that in a centralized model,
the clearing house (CCP) assumes the role of buyer to
every seller and seller to every buyer. They oversee
the exchange of assets as part of the transaction
and facilitate the unwinding of those positions at
the expiration of the contract as well as any recalls
or buy-ins. They provide daily reporting to the
counterparties that are members of the CCP on their
transactions and their net exposures to the CCP.
In the case of a borrower or lender default, they
would call upon the remaining pool of CCP members
to collectively participate in reassigning the contracts
or they would liquidate those exposures. Losses
involved with that process would be covered from a
“centralized guaranty fund” that the CCP requires
each member to maintain with the size of that fund
commensurate to their overall net exposure.
The benefit of the CCP model in this scenario would
be two-fold. First, the lender would not have to set
aside additional capital under the Basel III rules
because they would not be offering transaction-level
indemnification against a borrower default. Second,
while their dailymarginandguaranty fund contribution
would be an explicit cost to the business, the size of
that capital commitment would be computed based
“ I think there is going to be a split in the clients we offer
indemnification to. Some clients have already engaged
in an un-indemnified securities lending program,”
— Agent Lender
“ Loans are fully collateralized plus a margin by government
bonds or cash. Indemnification provides an additional safety
net. If clients are in the right program with the right risk
parameters, then there is no real need for indemnification,”
— Agent Lender
Chart 27: Bilateral vs. Centrally Cleared Securities Lending
Centrally Cleared Securities Lending
Bilateral Securities Lending
Counterparty
#1
Transaction
Level
Indemnification Costs
Counterparty
#2
Counterparty
#1
Counterparty
#2
Centralized Guaranty Fund
CCP
Securities
Collateral
Securities
Securities
Collateral Less
CCP Fee
Collateral
Daily Margin & Adjustments
to Guaranty Fund Contribution
Based on Net Position
Exposure Acros All Transactions
Daily Margin & Adjustments
to Guaranty Fund Contribution
Based on Net Position
Exposure Acros All Transactions
Source: Citi Business Advisory Services