The longstanding issues surrounding Securities Lending Indemnification are symptomatic of the need for change in an industry that has always struggled with inertia and structural and economic change.
In this paper, Mark Faulkner, Credit Benchmark Co-Founder and author of “An Introduction to Securities Lending” reflects on the securities finance industry from a personal perspective and explores some of the challenges associated with Securities Lending Indemnification. The paper aims to explain the confluence of events behind these problems, assess their impact upon the market structure and make some suggestions to help mitigate the issues moving forward.
Executive Summary:
Securities Lending is a long-established secure activity, offering small but incremental returns.
It plays a critical role in facilitating the efficacy and “lubrication” of the capital markets.
Any historic losses have typically come from the overly aggressive reinvestment of cash collateral.
Securities Lending Indemnification does not protect the beneficial owners from reinvestment risk losses[1].
Beneficial Owners have become overly dependent upon Securities Lending Indemnification, with many requiring it as a matter of course rather than after assessing its value as a true risk mitigant.
Traditionally, the custodial agent banks have provided indemnification; however, Asset Management Lending Agents have not – which is to be expected given that they operate under differing regulatory regimes – but unusual given their similar roles and responsibilities.
Indemnification protects the beneficial owner from two unlikely, concurrent events – a borrower default and a contemporaneous collateral shortfall post liquidation.
The economic benefit associated with Securities Lending Indemnification is very low – about 0.2bps.
The true economic / real-world cost of indemnification is about 0.9bps – exceeding the benefit BUT the cost is not passed on to the beneficial owners by the custodial lending agents.
The regulatory capital cost of indemnification under Basel III is approximately 13bps, significantly exceeding the economic cost. Yet it is similarly not passed on to either the beneficial owners or borrowers. Agent advocacy with regulators has gone some way to reducing this cost – but the spreads between the benefit, economic cost / regulatory capital cost of indemnification remain material.
Macro events and structural changes in the securities lending market have conspired to make the business less profitable over recent years – a phenomenon that is true across the industry and especially so for lending agents.
The term “market” can only be loosely applied to an industry resistant to adaptation to economic forces.
The growing adoption of Capital Relief Transactions is one important way of mitigating the capital challenges of the industry. However, U.S. regulators are currently seeking a pause in new transactions after a record level of activity in 2021.
The decoupling of the cost, the benefit, and the regulatory capital cost of indemnification is unsustainable in the current market conditions and will hopefully prove a catalyst for change.
There remains a window for regulatory engagement and advocacy and we encourage all parties to get involved – both as individual organizations and as trade associations.
The growing capital implications associated with indemnification are just an example of the myriad of regulatory capital challenges faced by the securities finance industry. Regulatory capital issues are not “bank-related” issues; they impact all participants in the securities finance industry including the agent banks providing indemnifications, the prime brokers and their clients, and the traditional “buy-side” beneficial owners.
We implore all interested parties to work together with the regulators to ensure that the securities lending industry can perform its critical role in the provision of short-side liquidity for the global capital markets. There remains a window of opportunity for trade associations to join the banks on the front line to lobby and engage with the regulators before Basel IV for example.
Addressing the issues associated within the securities lending industry in general and those of Securities Lending Indemnification in particular has major capital markets ramifications and it is time for all parties to realise that something better change.
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[1] Unless cash collateral is reinvested in explicitly indemnified reverse-repo programs offered by some lending agents.
