Lending out securities is one of the best ways
for institutions to add income to the bottom line
but some are put off by a perceived, rather than
an actual, level of risk. John Piccitto explains
why it is time for the industry to address this misconception.
A friend who manages the pension
fund for a county council in the UK put his finger
on a problem: “The
perceived risk as title changes when
securities are loaned is mainly what puts off most
county councils from securities lending.”
Along with his many other colleagues who manage pension
funds, mutual funds or other pools of securities, my
friend has a point. Lending out securities remains
an excellent way for institutions to add income to
the bottom line. But the process often seems more perilous
than it is which is why the industry needs to address
this problem urgently.
Both formal and informal indemnification against risk
is part of any stock-lending operation. The issue of
risk has been a recent talking point, both in the preventative
sense such as Basel II, capital adequacy formulas,
and the growing recognition of executive and non-executive
board members’ legal responsibilities, and in
the more electrifying context of transgressions and
transgressors, for example Ahold, Equitable Life, Putnam,
Parmalat and Standard Life. While we can’t resolve
all the uncertainties and perils in a securities lending
arrangement, and some lenders seem quite willing to
trade more formal guarantees for profitability, we
should emphasize the relative safety of the business,
and be clear about the guarantees that are traditionally
and typically available from borrowers of securities
to the lenders who own portfolios.
It’s no surprise that the safety issue turns
to the relationship between profitability and risk.
Taking great risk for great profits may be fine for
hedge funds, but it is less appropriate for pension
fund holders. In this arena, the lender who wants more
profit must be particularly careful about the deal
he makes with potential borrowers, starting by deciding
whether to use a custodian bank or a third-party lender.
Among various third-party lenders, great care must
be taken about who does which tasks, and what specific
and implied guarantees are offered.
A custodian bank, acting as agent for many portfolio
owners, pools all assets under its control and lends
them out according to an algorithm, so spreading business
around fairly among a large number of client portfolios.
Custodian banks are safe and their reputation in the
marketplace is substantial. Often they offer specific
indemnification policies but, in either case, they
have considerable resources to rectify problems. However,
their use of an individual portfolio can be non-intensive
and frustrating to the portfolio owner who is after
the greatest use of his assets and therefore the most
profit.
The more ambitious lender may enlist the services
of a third-party lending operation. Custodian banks
conduct some of the best of these within their custodian
programmes, others are offered by experienced insurance
companies with a reputable name in the marketplace.
Some third-party lenders are recommended by experience
and reputation, or are guaranteed by indemnification
policies or by parent company guarantees. A third-party
lender is in effect the “outsourced agent” of
the securities lending function for selected clients
who own securities and who select this route to market.
Giving instructions as needed to the custodian banks
where the portfolio owner’s shares are held,
third-party lenders fill orders from potential borrowers.
The third-party lender does not usually custody shares,
holding them overnight, nor does it take “ownership” of
securities by transfer of title.
But some third-party agents are gradually easing into
custody functions and greater transparency is needed
at this point. Here, the concept of formal and informal
indemnification is the lender’s key to safety.
In indemnification, one party to a transaction insures
the other party to the transaction, so that whatever
happens, the insured will be made whole in case of
loss. An insurance policy that indemnifies promises
that in the event of loss, the insured will be restored
to the financial position that existed prior to the
loss. A variety of contingencies can be dealt with
in the securities lending version of such an agreement.
For example the initial percentage of a loss may be
omitted from coverage if the indemnifying party has
a cash position to support. The contingency, and therefore
the cost of, problems in particular currencies may
be omitted from consideration if business is to be
transacted in one currency only. Reducing coverage
helps keep costs to a minimum.
Indemnifications are available from a lender’s
agent (a custodian bank) to potential lenders to protect
the lenders from borrower default, or borrower insolvency.
If borrower insolvency is an important consideration
in risk calculation, such promises should be scrutinized
carefully. It is not good enough that the lender is
indemnified against loss only if the lending agent
cannot be proved to be in any way at fault, because
this arrangement only suits a lending agent with either
flawless procedures or a very deep pocket.
Generally, the larger the potential custodian or third-party
lender, the longer it has been in business and the
more solid its balance sheet, the more reliable it
will be. The more creditable and credit-worthy its
promise of indemnification, the less likely the lender
is to require a specific policy of indemnification.
Among large custodian banks, some have offered indemnification
as standard policy for many years. Some custodian banks
offer indemnification if and when it is requested.
Given that the business experience and track record
of the custodian, and the obvious concern of the parent
firm for its reputation, many borrowers don’t
feel that an actual policy is worth the additional
charge.
A large custodian bank can provide standard, blanket
indemnification to all clients in their custody and
securities lending programmes. Or these matters can
be handled informally, the lender relying on the borrower’s
reputation in the market place. A custodian’s
indemnification policy might cover, say, operational
difficulties, such as the failure to return stock in
time for the client’s own settlements. In the
case of a large institution, a lender could be made
whole out of the custodian’s internal supply,
should that become necessary, a convenience less likely
in a smaller organization.
More informally, large custodians can also cover their
lending clients as far as daily transactions are concerned.
For example, should a counterparty fail to pay dividends
on payment date, or to deposit proceeds into the client’s
account, the custodian will make certain that the relevant
payment reaches the client’s account when it
should, and then claim against the defaulting party,
possibly charging an administrative fee to the defaulting
party for the service. Custody clients can expect contractual
settlement from their custodians on their sales, purchases
and dividend income. They will also expect this level
of service on their securities lending programme.
Custodians may also provide protection against daylight
exposure and any resulting default, which occurs when
the delivery of securities in one time zone doesn’t
coincide with the deposit of collateral that takes
place in another. Against this eventuality, custodians
may request either a pre-payment of the collateral,
or a delivery-versus-payment transaction (securities
plus collateral in one coordinated movement) to eliminate
any daylight exposure.
Custodian banks can also provide formal cover
against borrower default and borrower insolvency, but
this involves an important distinction for potential
lenders to consider. Default and insolvency are different.
Default happens when a borrower doesn’t carry
out part of the bargain. The usual remedy, after efforts
to rectify the situation have been exhausted, is to
sell the collateral that has been put up against the
loan.
Historically, collateral held against default was
felt to be sufficient coverage against securities lending
risks. In the early 1990s, a government lender of international
securities asked a major broker/dealer borrower to
pay its earned dividends on payment date as per their
standard documentation. The broker/dealer at first
refused to make payment on the ground that it had not
received the cash dividend from its counterparty, which
happened to be the broker/dealer’s own internal
bond trading desk.
The lender immediately began to attach the collateral,
at which point the broker/dealer had a hasty change
of heart and paid what was owed in full, an amount
in excess of $1.5 million. But that was in the days
before computers were standard issue, and when collateral
and concern for reputation were sufficient guarantee.
The idea of formal indemnification was just beginning
to be applied to this kind of business context.
But when default occurs because of the insolvency
of the borrower, for example in the case of Barings
Bank, Yamaichi Securities, BCCI or hedge funds such
as Long Term Capital Management, then the collateral
becomes the property of the bankruptcy court, or the
corresponding institution in the country where the
bankrupt party files, and cannot be sold to cover the
lender’s loss, at least not immediately. So a
prospective lender needs to look very carefully at
the institution that seeks to borrow to reloan his
portfolio and also at potential end-users to evaluate
his risk in the event of borrower default and of actual
bankruptcy.
Third-party lenders
Third-party lenders focus their lending efforts
on relatively few portfolios and work for the benefit
of a few clients. Typically, they present themselves
as leaner, more flexible and more individual lender-friendly
than custodian banks. Usually, third-party lenders
operate through the portfolio owner’s custodian
bank, borrowing issues from portfolios to relend on
an as-needed basis. Third-party lenders monitor positions
extremely closely, often marking-to-market several
times a day, closing positions every evening and returning
issues to the custodian nominated by the owner of the
shares, so avoiding the risk involved in longer periods
of exposure. It is the portfolio owners’ perception
of this extra, focused service that makes third-party
lenders attractive. The explicit reason is usually
increased profits, and the implicit assumption is that
the risk involved isn’t too great.
Usually third-party lenders do not take portfolios
in-house, so avoid the need for any form of indemnification
that arises from holding assets in custody for clients.
However, if a third-party lender proposes to move into
the area of custody, taking securities on board, and
holding them overnight to lend out at a later date,
lenders should carefully consider the risks involved.
Third-party lenders are diverse. Some are part
of global corporations with international reputations,
and some are not. Some have considerable track records
and others don’t. Among smaller, less well-known
companies, if indemnification is not available or proves
to be insufficient, the potential lender may ask for
a parent company guarantee. This can take many different
forms and should be carefully reviewed by counsel.
However, the potential lender must remember that if
the arrangement with the third-party lender stipulates
that the securities in the portfolio are to remain
at the client’s own custodian, then a form of
indemnification might be in effect through the custodian’s
overall custody program.
A third-party lender may offer its ability to control
and effectively manage the collateral versus the loan
transactions to offset the lack of formal indemnification
that might be provided by a custodian. Basically, an
exchange of financial data, such as current balance
sheet, business history and parent company guarantee,
from both the third-party lender and the potential
client, is important to a lender’s assessment
of whether or not to take this risk.
A formal indemnification policy is always a valuable
asset to the lender who can get it from the custodian
they are working with. Even if it does not add value
to the actual economic aspect of the programme, indemnification
makes the lender feel secure and comfortable with the
lending programme, thus enabling potential lenders
to come to the market with their securities.
Shrewd practice
Prospective lenders must be shrewd about the
matter of indemnification, balancing the risks involved
against the cost to the lending deal of the necessary
degree of risk protection. Flexibility and personalisation
of the product may well be trade-offs. Indeed, a trade-off
operates generally through the broad issue of both
formal and informal indemnification. As usual, you
not only get what you pay for, but also you pay for
what you get. Established, larger institutions, such
as custodian banks or the third-party lending operations
that are part of such institutions, are relatively
safe and reliable. Often they offer specific indemnification
policies and cover potential risks in a variety of
contexts. Similarly, third-party lenders with proven
track records are also safe and reliable when they
work through custodians and do not attempt custodial
functions that they can’t reasonably support.
However, if a prospective borrower offers huge returns
on loans, but seems vague about financials, parent
company guarantees and details such as whether coverage
of borrower insolvency also covers borrower default,
then look carefully at what you’re getting. And
look even more carefully at what you’re risking.
And on the subject of risk, Basel II has had a ripple
effect among legislators and regulators, in the UK,
the Netherlands and Germany. The attention to the culpability
of officers and board members of malfeasant companies
and their officers suggests that proactive consideration
of risk is not just a good policy, it is the only policy.
Indeed, it is the logical response to what an article
in the Economist (24 January 2004) called a “feeling
of being under siege” on the part of people who
work in the financial industry, and especially among
those who manage pension funds, mutual funds and other
pools of securities.
