Risk in Securities Lending

"Risk in the harsh light of day"
By John J. Piccitto
ISF Magazine
1st Quarter, 2002

Securities financing can be a risky business. When setting up a programme, any fledgling lender needs to be sure that the risks taken on by the underlying holders of the assets are evident, easily quantifiable and understood. Doing the right thing is vital. Knowing how to do it is difficult. John Piccitto reports.

For the first time lender of securities, risk is a top priority. Identifying, quantifying, minimizing and if at all possible, avoiding risk are all vital if the lender is to be convinced that lending is safe. There may be no such thing as a risk-free lending programme, but a number of basic considerations can reduce risks for all concerned. The importance of credit control cannot be overstated when dealing with potential clients and the possibilities of new business they bring to a firm. After initial contacts have been made, and contracts are being drawn up, a sign-off should be requested from the credit department before trading begins to ensure that due diligence has been carried out. This is an essential phase of getting to know your customer and, at present, receives a great deal of attention among law enforcement bodies.

Besides confirming the identity of the client and the clients’ backers, the credit department will evaluate the potential clients’ financial character and set trading limits on the amount of business that can be done with this new account.

Subsequently, the credit department should, and in most cases will, monitor the account on a continuing basis via its internal systems, ensuring that traders do not exceed these limits. In the case of an overrun, or trading violation, the trader may be directed either to cancel some deals or to reduce the overall position until the value of the position falls below the established limit. This is particularly important for clients located in East Asia , where exposure can occur due to time zone differences.

Same-day transactions

In the normal scheme of things, loaning securities and receiving collateral to cover the loan happens on the same business day. The transactions are carried out through established custodian banks that act on behalf of the borrower and the lender. The lender asks its custodian bank to deliver securities to the borrower’s custodian bank and to accept money or securities being used as collateral, from the borrower. Likewise, the borrower asks its custodian bank to pay money or deliver securities (collateral or returned items) to the lender’s custodian bank and to accept the borrowed securities, or collateral back from the lender. But daylight exposure takes place when a lender sends his securities to a borrower who is located in one time zone and the borrower sends his collateral to the lender in another time zone.

The exposure occurs when the collateral does not reach the lender until the lender’s next business day. Thus the lender is exposed: he has delivered his securities and has not received his collateral on the same day. However, the reverse can also happen. The borrower can experience exposure, since he has paid for the securities that haven’t arrived yet, due to the time zone difference.

Daylight exposure can also take place under normal trading conditions. For example, when a client executes a buy transaction and only deposits funds on his own settlement date, which may be some six to twelve hours or even more after the seller’s settlement date, due to the time zone factor.

But exposure risks can be minimized. Some large custodian banks attempt to eliminate their own exposure by asking for collateral one day prior to delivery of their securities. This ensures that the collateral for the borrowed securities arrives in-house prior to the securities going to the borrower’s custodian bank. But in this scenario, the borrower is exposed, since his collateral is in the hands of the lender who is also holding the requested securities. So the risk of exposure will always be there, on one side of the transaction or the other. Finally (and the importance of relationship in the securities finance business cannot be overstated), both parties must rely on trust and past experience with their trading counterparts to set up and settle trades. Even though contracts that ensure that buy-ins can be effected may be in place between borrower and lender, without some knowledge of the counterparty and a measure of trust in the counterpart’s business practices, transactions will never happen.

One solution to the problem of daylight exposure involves the use of a third party bank’s escrow services. The borrower’s collateral (usually non-cash) is deposited with a contracted agent bank who will act for both the borrower and the lender, for a fee of course (paid by the borrower), on each transaction, as far as collateral pledge is concerned. This safeguards the lender, since collateral is on hand on the exact settlement date. The borrower treats the service like any other depot for its securities.

Know your customer

Another attempt to ensure that collateral and securities arrive on the same day can be made through the use of the fee income. For example, if the lender does not receive its cash collateral on the settlement date of the transaction, the lender may charge a full fee for the securities without deduction of a rebate. The borrower, on the other hand, may decide not to pay the full fee for the borrow if the securities are not delivered, even though the borrower’s collateral has been accepted by the lender.

Typically, established clients are more predictable than new ones. But in both cases, old or new clients, the know your customer rule is important.

You have to have enough information about the people you’re doing business with, and keep that information coming in for dissemination among appropriate in-house areas. All potential borrower clients should submit up-to-date, audited financial reports to the credit area of the lender’s firm to avoid any credit/due diligence risk. Lenders should do likewise. This ensures that the in-house credit analyst has the basis for appropriate judgments to set up the client on the credit system and to assign a line of trading. Receiving a regular copy of the client’s annual report will help credit analysts build up an accurate, up-to-date credit profile of the client.

Once a line of trading is set up, the analyst should be contacted by the trader, or the desk manager, when the client’s profile changes in any way; take-over (real or rumoured), bankruptcy, trading suspension from any recognized exchange, or negative earnings reports, for example. Positive news also should be reported to the credit analyst, since that will increase the trading line in all probability.

Finally, suspicious trading activity, though not the easiest thing to spot, should be reported fast - to senior management, as well as credit and legal representatives - so as to receive appropriate action and response. A good trader knows his clients’ trading patterns and should be able to spot anything unusual. It should be remembered that everyone involved in the trading process is responsible for money laundering detection and reporting, not just the money laundering officer.

Legal risk

Legal risk can be reduced or avoided if there is up-to-date legal documentation in place between the borrower and the lender. Ninety-five percent of today’s market participants use standard agreements, OSLA ( non-UK, securities) or MEFISLA (UK securities), for example. The remaining 5% who wish to use their own documentation – the AFTI agreement in France and both the local Japan and German market standard agreements come to mind – should realise that the odd alteration or two or three creates what amounts to a custom contract under which to conduct business.

In-house counsel must always approve this customised trading document before trading can begin and this process will add to the time between initial contact and the commencement of business. There should be no trading before there is documentation in place.

Unfortunately, that is not especially welcome news to the marketing and sales staff who are eager to sign up more clients and to get more business on to the books of the firm. The story is much the same for traders, whose business sometimes depends on the quick availability of hard-to-locate stocks. Pressure from these quarters, as well as from their managers, needs to be controlled by those responsible for risk avoidance.

For instance, marketing staff are often so eager to get clients signed up and trading, they may require the client to fax back a copy of the signed document and use this as proof of signed documentation. Then, should the client forget to send in the actual document (and because the desk manager has approved the commencement of trading on the basis of a fax) the documentation on file is seriously flawed. Simply giving the client a few business days to get the actual document in reduces this risk greatly. This is especially effective if the client knows that all business will cease if the actual document is not sent in to the office within a specified time limit.

Unfortunately, legal risk does not end when a satisfactory document is set in place. The legal department should be consulted about out-of-the ordinary types of transactions, such as yield enhancement deals, or “tax trades,” which may or may not step over the legality line in certain countries or market jurisdictions where these trading practices are either frowned upon (Germany) or specifically prohibited (Australia). Lawyers can be most helpful when doing business with clients located in countries where the recovery of the lender’s securities or the borrower’s collateral may pose a problem should there be a default, or in the case of clients located in countries where the government is less than stable. The legal department should have a little list, and some useful suggestions, for dealing with both these problems.

Foreseen or unforeseen, risk situations arise which require adroit thinking and a knowledge of legalities to negotiate them.

Risk in action: Malaysia

An example of this sort of legal risk occurred in 1998/9, when the government of Malaysia suspended the movement of its currency beyond its borders. Buy and sell, and borrow and loan transactions still took place. The Kuala Lumpur Stock Exchange was still open for business, but money had to remain in Malaysian banks and could not be moved outside the borders of the country. These laws were in place for more than a year; only recently have things returned to normal.

Since the Malaysian situation was unforeseen by anyone, business managers were left to deal with the situation fait accompli. However, one broker/dealer did manage to work its way through the quagmire by passing its local currency on to its local office in Malaysia.

Then when the local Malaysian office applied to the broker/dealer’s London treasury for additional funding, this was charged to the local office but paid to the broker/dealer’s London trading desk in exchange for the local currency passed to it on the day. Other broker/dealers with no office in Malaysia simply had to wait until the currency crisis ended, or make other, more cumbersome arrangements.

Risk in action: Australia

The legal context of a business or trading strategy can change very suddenly, even within a stable political environment, catching even the most perspicacious on the hop. Yield enhancement transactions, otherwise known as “tax trades”, were very popular in Australia in 1997. Eventually, however, the Australian government learned of their existence, calculated how much income it was losing to trades done “on/off-shore” and realised that dividend franking credits were being used and accounted for in innovative ways.

Without prior warning, it enacted legislation on May 13, 1997 which was then applicable to all trades recorded from the beginning of the year. Since these trades had not been specifically forbidden by law before that date, legal advisors to trading desks could only recommend against the trades (indeed, if they chose to do so). Suddenly, after May 13th, the flood of returns left more than one trading desk wishing they had listened to such suggestions.

The kind of legal risk represented by an abrupt regulatory volte-face can hardly be avoided; it can only be coped with. In anticipation, a careful balance of probabilities has to be found in negotiation between legal advisors and managers. That happens best in an environment where counsel and trading desk managers understand each other’s views and dealing is carried out so that everyone- client, trader and local governments-all receive their fair share of what is due to them.

Trading risks

Trading risks can span a huge variety of potential problems: from the mechanical mistakes on the desk to the inadvertent misunderstanding of a clients’ instructions on a corporate action.

Desk errors are the most common of these. Errors such as borrowing 10,000 shares of a security instead of 100,000 shares (or buying a security instead of selling it) are usually corrected by the back office, upon notification by the counterparty (receipt of confirmation), with the approval of the desk manager. The reason for the manager’s approval is that there might be some market action necessary which usually leads to a money loss, substantial or not. This is called a trade correction.

The best way to combat this type of error initially is to confirm verbally with the client and reiterate his exact telephoned instructions. What does he want to do? Buy or sell? Ten thousand or 100,000 shares? Specific price or a limit price? All-in, or paying a specific dividend rate? Fixed income securities collateral or cash or equities? Such a technique may seem trivial, but it’s most effective and will keep you and the firm out of trouble.

Any slip in the routine can be expensive. An overworked trader, about to go away on holiday for a few weeks, decided to borrow over $250 million worth of Italian government securities and switch collateral that his desk had deposited at a local lender. But he neglected to confirm with the local lender whether or not the new collateral was acceptable. He left on holiday. His colleagues who remained on the desk while he golfed his way around Scotland had to retrieve the Italian government securities and replace them the following day with French equities, which were acceptable to the lender.

This risk, and the large cost of dealing with it, could have been avoided if the trade details were confirmed as part of an automatic routine when the deal was set up. Corporate actions are another opportunity for mistakes that constitute trading risks. A large loss to the firm can result if the client’s instructions are not followed to the letter in this matter. Does he want cash in lieu for his account or does he want the securities that are being offered? And if no orders are given, nothing should be done for the client on the assumption that this is what he would want. No guesswork and no filling in the blanks is allowed.

Communication is the key to prevention. The more you talk to the client to determine his exact instructions, the better. It is wise, if a little annoying, to repeat each of the client’s instructions back to him during a conversation and then confirm them in writing, or by electronic means.

The back office can be a cause of risk if transactions are not posted correctly at close of business on the trade blotter. The only way errors in this area can be avoided is by checking and double-checking, preferably by two different people. Computerised systems, which are control friendly, verify all postings to a master control sheet.

Finally, not knowing the rules and procedures on local exchanges can lead to trading losses, among other things. A broker/dealer was running a prime brokerage operation in London and had a large client under agreement. This client had a wide portfolio of international securities on deposit. The equity finance desk manager decided to borrow one of the securities from the client’s holdings in order to satisfy a fail-to-deliver for his proprietary trading desk on a Scandinavian exchange.

However, unknown to the desk manager, the exchange in question reported all stock loan and borrow transactions as a disposition of the assets, thus creating a fall on the exchange price of the borrowed security at close of business.

When the prime broker learned of this, it was forced to issue a retraction to the exchange and an apology was sent to the client who said that the prime broker was not to lend its securities to anyone any longer, even though all the documentation gave the prime broker the right to do so. The monetary loss was in the millions of dollars.

Recalls of securities can be deadly at the best of times. When a theme park outside of Paris was heavily trading its securities, a UK broker/dealer was issued a recall of the securities it had borrowed from a local French bank. However, the securities turned out to be extremely difficult to return. The result was that the French bank could not return the total number of securities borrowed to its lender who charged the French bank for its fail-to-deliver on an amount in excess of five-times the original broker/dealer’s recall. The fail charge was in turn passed on to the UK broker/dealer who had to eat a loss in excess of some FFr 6,500,000!

Most trading risks can be avoided if procedures are followed carefully. And the longer an error remains undetected, the greater the risk of large payments to correct the mistake at a later date. Once you spot an error, move to correct it immediately. Don’t let it fester. Reputation risk is something every firm strives to avoid, but sometimes not hard enough.

More than any other factor, reputation is what makes success in business; take away a firm’s reputation and its customers stampede to the competition, perhaps because they suspect that if one area of the operation is tainted, so might the rest be. It is sobering to remember how quickly the value of a venerable firm can shrink to the point where it can be sold for £1.

The impact of such things is surprisingly long lived. Fifteen years after Maxwell’s machinations with his employees’ pension funds, at least one county council in Britain still forbids securities lending. Its investment manager says that the county ruling was a direct result (presumably of the publicity) of the Maxwell episode.

Avoiding risk

Avoiding reputation risks is a management call. Shortly after the Australian government legislated so speedily against tax trades, the German government began an investigation into some local occurrences of the same types of transactions. But rather than legislate, Germany chose to issue a word of caution to two of their largest banking institutions as well as to other parties involved. The sanction of a reputation risk was discretely mentioned. Convinced, everyone involved ceased the relevant trading strategies in Germany.

Such a decision is more difficult, of course, when the government one day is not the government the next. The reputation risk courted by businesses that stayed in South Africa until the end of the apartheid regime was fortunately minimized by the relatively peaceful nature of the transition of power. Both those international companies that had remained in the country and the successor government appear to have benefited.

Put at its worst, reputation risk is a question of dubious practices and right-on-the-line trading strategies balanced against the probability of a trading ban.

Read the news: sanctions, indictments and convictions happen more often these days as national exchanges increase supervision and send data (and sometimes extradite suspects) across borders. Recent events have greatly increased vigilance in financial markets.

Excepting reputation risks, all the risks discussed in this article can be avoided by following procedures that are put in place, reviewed regularly, communicated to all relevant employees and followed scrupulously. In the case of avoiding risks concerning reputation, trading, legal and credit, the objective is to clear the field for transacting business and getting the job done.