Securities Lending. A Guide for Policymakers

Transcription

1 Securities Lending A Guide for Policymakers

2 Contents Introducing Securities Lending... 3 The Size of the Global Securities Lending Market... 4 Market Participants and Their Roles... 5 Lenders and Agents... 5 Borrowers... 5 The Role of Intermediaries... 6 Process... 8 Legal Agreements... 8 Transacting... 8 Collateral Management Lending by Central Securities Depositories ( CSDs ) Corporate Governance and Shareholder Engagement Pricing of Securities on Loan Benefits Directly Indirectly Risks Risks to the Lender Risks to the Borrower Regulation Market Led Developments

3 Education and Risk Awareness Infrastructure Matters of Interest to Policymakers Transparency Re-hypothecation Intermediation and Complexity Reliance on Short Term Funding Cash Collateral Investment Margin Practices and Procyclicality Securities lending and Retail Investors Empty Voting Appendix 1: Summary of Global Securities Lending Regulations About ISLA

4 Introducing Securities Lending Securities lending involves a transfer 1 of securities (such as shares or bonds) from a lender to a third party (the borrower ), who provides the lender with collateral in the form of shares, bonds or cash. The borrower pays the lender a fee over the duration of the loan (typically payable on a monthly basis) and, unless otherwise agreed, is contractually obliged to return the securities to the lender on demand within the standard market settlement period relevant to the lent security.. The borrower will also compensate the lender for any dividends/interest payments and corporate actions that may arise on the security whilst on loan. In essence, the lender remains economically exposed to the securities that have been lent and retains the key benefits of ownership, except for voting rights. Like all investment techniques, securities lending does give rise to certain risks and these need to be considered fully by investors. There are two key benefits to securities lending. Firstly it provides a low risk incremental income for investors and secondly, it provides liquidity to the broader global markets. Conservative estimates suggest that European investors earned 1bln in securities lending revenues during This revenue provides EU citizens with valuable additional returns on their long term savings and makes a positive contribution to helping pension schemes lower any deficits. 1 * Legally a securities loan is the transfer of title against an irrevocable undertaking to return equivalent securities. This means that registered securities such as shares, will be transferred out of the lender s name into that of the borrower and registered back when they are returned 3

5 The Size of the Global Securities Lending Market Whilst securities lending is largely an over the counter market a number of independent data companies have been collecting data from a wide range of market participants for many years and therefore reasonable estimates of the size of the market are available. The size of the securities lending market is usually measured by the amount of securities that are on loan. The graph below from a company called DataExplorers (now part of Markit) shows that market value of lent securities (represented by the green line) has been fairly steady for the past two years, averaging a little under 1.5trn. The blue line shows the amount of securities that lenders are willing to lend, and is currently a little under 10trn. DataExplorers estimates that the universe of participants in their data set represents approximately 85% of the total market. European securities represent around 30% of the available to lend and of the average value of securities that are lent. 4

6 Market Participants and Their Roles Participants in securities lending, can be broadly divided into two categories: lenders and their agents, and borrowers. Lender Borrower Beneficial Owners Intermediaries End Users Pension funds Mutual funds Insurance Companies SWFs Asset Managers Custodians Third-Party Agents Broker-Dealers Investment Banks Hedge Funds Broker-Dealers Investment Banks Lenders and Agents These are typically large scale institutional investors, such as pension funds, insurance companies, collective investment schemes and sovereign wealth funds. These investors would normally employ an agent (such as a custodian or investment manager) to arrange, manage and report on the lending activity. Borrowers These are typically large regulated firms, such as investment banks, market makers and broker dealers. Hedge funds are among the largest end borrowers of securities, but they borrow through investment banks or broker dealers as clients under prime broker contracts rather than directly from the investors. 5

7 The Role of Intermediaries As noted a lender may well be an insurance company or a pension scheme while the ultimate borrower could be a hedge fund; however the securities lending activity is usually undertaken by two intermediaries on each of their behalves. Agent Lender Manages Risk: counterparty, legal operational Manages collateral process Provides Technology and expertise Aggregates market supply Principal Intermediary Manages borrower risk Provides Credit Intermediation Manages daily collateral process Aggregates Market demand Managing the lending process is a specialised business and requires investment in systems and human resources. Investors who wish to lend securities usually employ a specialist agent such as an investment manager, custodian or independent third party to lend on their behalf. The lender undertakes a due diligence process to identify and appoint the most appropriate agent in much the same way that they would to appoint a fund manager or custodian bank. ISLA, along with a number of other market associations, has published guidance on what should be considered during this process. Where funds are sufficiently large, the investor may conduct the lending activity directly, although given the scale of investment required in people and technology to appropriately manage a securities lending program, this is somewhat rare. It is usual for the agent to obtain compensation for its services, through a fee sharing arrangement, often referred to as a fee split. This ensures that the lender only incurs costs when revenues are generated and aligns the interests of the third party agent to the lender in respect to 6

8 ensuring that the activity is profitable. The amounts charged by lending agents vary but 30% of the income would be a representative average. The main borrowers in the market are specialised firms such as prime brokers who borrow securities for their own firm s requirements (for example where they have internal trading desks or market making operations) or for clients such as hedge funds. Lenders will generally be reluctant to assume credit exposures to borrowers that are not well recognised, regulated or who do not have any credit rating. In these circumstances, the borrower when acting as prime broker, provides a credit intermediation service in taking a principal position between the lender and the hedge fund. Prime brokers are compensated by the hedge fund client through a spread on the amount that they pay to borrow from the market. 7

9 Process Legal Agreements Securities lending arrangements are underpinned by market standard legal agreements such as the Global Master Securities Lending Agreement (GMSLA) published by ISLA. This lending agreement is executed between the agent lender (on behalf of the lender) and the borrower. The lender also enters into an operating agreement with their agent which sets out all the parameters within which lending activity must take place (such as limits on the amounts that can be lent or restrictions on collateral that can be received). Once this agreement is in place the agent will be responsible for all day to day activities and will provide the lender with information tailored to their requirements. Transacting Beneficial Owner 4 2a Agent Lender/ intermediary 1 Principal Intermediary 3 2b 1 Agent lender and principal intermediary identify, negotiate and agree terms of loan 2a/b securities transferred from beneficial owner to Principal intermediary and then to end borrower 3 collateral transferred from Principal intermediary to agent lender 4 reporting of exposures to beneficial owner End Borrower Market settlement 8

10 Once a master lending agreement is in place, loans are generally negotiated between the agent and borrower, on a bilateral basis. Agents provide borrowers with electronic files showing the securities that their clients have available to lend each day. The borrower will normally instigate the request to borrow via telephone, secure electronic messaging or an automated platform such as Equilend 2. Once the loan has been agreed, both parties provide market instructions to enable the securities to be delivered to the borrower on the agreed date. In recent years there has been an increase in automated lending whereby lenders broadcast inventory with required fees and where the terms are agreeable, approved borrowers automatically match and instruct loan settlement. Loans can be agreed for a specific length of time (term) or on an open basis (callable). Open loans can be terminated by the lender at any time and the master agreement requires the borrower to return the securities in the standard market settlement period. This means they are able to sell securities whilst they are on loan and recall in time for sale settlement. Participating in securities lending should not impact the lender s investment strategy, including its ability to buy or sell securities, but procedures must be established to ensure that the agent is notified of investment management decisions. 2 See later section on Infrastructure 9

11 Collateral Management With the exception of lending by CSDs (see below) securities lending is always fully collateralised by the transfer of either eligible securities (referred to as non-cash collateral), or cash. Haircuts are set by the lender and applied to the collateral value meaning that lenders generally receive collateral of a greater value than the securities they have lent. The size of the haircut will depend on a number of factors including, but not limited to, the quality and liquidity of the collateral and the correlation it has to the lent securities. Loans and collateral are marked to market daily with any margin calls being made on a same day basis. If a security held as collateral defaults, the borrower is required to replace it with another. In the event of a counterparty default the lender has the right to liquidate the collateral held and use the proceeds to repurchase the lent positions in the market. The haircuts applied to collateral are designed to protect the lender against the risk that the proceeds from liquidating collateral are insufficient to replace the lent securities. It is therefore important that the lender considers the liquidity and volatility of the collateral as well as its price correlation with the lent securities. Commercially, the lender also needs to take into account that collateral to lenders represents an economic cost to borrowers and collateral margin represents an additional balance sheet cost to borrowers. Although there are no mandated margin or haircut levels for securities lending, a typical haircut would be 5 15% depending on the factors noted above. 10

12 Lending by Central Securities Depositories ( CSDs ) CSDs sometimes offer securities lending services. These arrangements vary but some are focused on covering settlement failures, where an account at the CSD is short of securities on a settled basis but not on a traded basis. If an investor signs up to the service, their securities can be automatically borrowed by the CSD on behalf of other CSD clients to ensure timely settlements and guaranteeing the lent position using a lien over the borrowers securities accounts. The securities are only borrowed for the time required until the borrowing account has securities delivered, so can be for a short intraday period, or a number of days. The fees charged are significantly higher than in the rest of the market, reflecting the expectant short loan period, and the lender relies on the CSD credit guarantees instead of physically receiving collateral. Corporate Governance and Shareholder Engagement When securities have been lent the lender retains all shareholder benefits, such as dividends, interest payments and corporate actions, but not the right to vote. However, lending does not need to impact the lender s corporate governance responsibility, as loans can be recalled in order to exercise the right to vote. The lender must decide whether the vote or the economic benefit of the loan is more important to their investment strategy and either restrict the securities from being lent over the voting period, or recall lent securities in time to vote. The borrower provides warranties in the master agreement that securities are not being borrowed for the primary purpose of exercising voting rights as this activity is considered inappropriate. 11

13 Pricing of Securities on Loan The fee that a lender charges for borrowing securities is a function of supply and demand. Where demand is high, relative to supply, the rates charged will be correspondingly higher and vice versa. Loans of easy to borrow securities are normally priced around 10 basis points, whereas hard to borrow securities may be priced at 500 basis points or more. Any securities can attract higher fees if they have a higher intrinsic value to the borrower other than shortage of supply. Ultimately pricing is set based upon the agent and borrower s knowledge of the market and by reference to market data provided by certain specialist data companies. The two graphs below provide an illustration of lending fees between April 2011 and April 2012 for European Equities and European bonds respectively. 12

14 Where non-cash collateral is accepted, the lender charges a basis point percentage based on the value of the securities which is accrued daily and usually paid on a monthly basis in arrears for all activity during the month. Where cash collateral is accepted the lender must pay a rate of interest on the cash collateral held, minus the lending fee for borrowing the securities (this is amount is referred to as the rebate). The lender must therefore invest the cash in order to generate sufficient returns to pay the interest owed and generate a return for the portfolio. Accepting cash as collateral involves certain different risks for the lender which are covered later. 13

15 Benefits Securities lending is used by a wide range of investors and intermediaries inside and outside of the EU. Its use supports greater market settlement efficiency, market making activities and a wide array of trading strategies that provide liquidity to the securities markets and its participants. Directly Long term investors, such as pension funds, collective investment schemes and insurance companies, generate incremental revenues from engaging in securities lending. These returns help to reduce the costs of providing pensions and long term savings to investors. As mentioned above we conservatively estimate that European lenders earned in excess of 1bln last year. This revenue makes a useful contribution to the investment objectives of the lender (be those the provision of long term pension payments or an enhancement to the overall investment performance of the funds). Some lenders view the returns available from lending as a way of reducing the costs of managing their investments. Some important strategies which are used by long term investors to protect their portfolios are supported by short selling, which in turn requires securities lending activity. For example, a corporate bond holder may wish to protect his portfolio against interest rate moves, and can achieve this by taking a short interest in government bonds as part of the overall portfolio. In this way the portfolio exposure to interest rates is reduced. Investors will also borrow securities for a variety of reasons including to ensure efficient and cost effective collateralisation of other transactions such as repo or derivatives. Improved liquidity, lower dealing costs, better price formation and better risk management are important to all users of the capital markets, including 14

16 Government and corporate issuers of securities, long term investors such as pension funds, and retail investors. Corporate issuers of securities, who use the markets as an effective way of raising capital to finance their businesses, are able to raise capital on cheaper terms than they would do in a less efficient marketplace. This can be seen in markets where short selling is restricted, such as many in the Middle East. A good example recently involved the Dubai listed Emaar Properties. Their US$500m of convertible bonds had incurred costs of an estimated US$50m over a five year period because of the high coupon (7.5%) the company had to pay to investors who were unable to hedge the convertible bond position by selling the equity short. Put simply, because short selling was not available to investors, this company had to pay substantially more to raise finance than a comparable company issuing a similar bond in a market that did recognise short-selling. This money could have been used for developing new businesses, supporting economic growth and increasing employment. Indirectly The market also benefits more broadly from securities lending. Securities are borrowed for a number of reasons, supporting a number of trading strategies as well as the timely settlement of transactions in the market. Securities lending helps prevent settlement failure and so improves market efficiency. Settlement failure may happen because of a mismatch in settlement instructions between the parties or because the seller has had a purchase fail to settle. In order to facilitate the sale and avoid any costs or penalties, the security can be borrowed to facilitate the settlement. Market makers have obligations to make constant two-way pricing and the ability to borrow securities to ensure settlement helps them meet customer demand. It is not usual for market makers to lend securities held for the purposes of market making. 15

17 Short sellers borrow securities in order to cover their sales. The new EU short selling regulation requires all short sellers to cover their sales and this will generally require them to borrow securities. Securities lending supports many investment strategies through short-selling that would otherwise be extremely difficult to execute. These include strategies such as hedging which are important to long term investors. Securities lending also offers an alternative source for secured funding. For example, banks can borrow eligible central bank or CCP collateral to use in other aspects of their business. In this way a lender, who owns but has no day to day need for, government bonds can earn a return by lending them out, and the borrower acquires securities that can be used to raise funding in the repo markets. This provides banks with an additional, diversified funding source, and the more sources a bank can access the less a shock in one source will impact them. The benefits of securities lending have been widely recognised by regulators around the world, by national and supranational organisations and by academics. Index providers, such as FTSE International, include the existence of a well-functioning securities lending market in their criteria for a country's inclusion in their developed market indices. Recognising its broader benefits, governments around the world have provided exemptions and reliefs for securities lending transactions as well as the transfer of associated collateral, from locally imposed stamp or other similar transfer taxes, VAT, and capital gains tax charges. 16

18 Risks As with all investment activity, participating in securities lending involves some risk. Historically the market has focused on the risks to the market participants themselves. More recently, as a result of reviews of the shadow banking system, the European Commission and Financial Stability Board have been considering whether the use of securities lending poses wider risks to the financial markets as a whole. These are considered later. Risks to the Lender. As mentioned above, most of the risks for securities lenders are managed by the use of specialist agents who have invested in infrastructure and expertise to manage the activity. The main risk for a lender is the default of a borrowing counterparty. In this event the securities or cash held as collateral must be used to restore loaned securities to the portfolio. This is why the quality and liquidity of collateral is so important and why appropriate haircuts (which in effect require the borrower to deliver collateral of a greater value than the securities being lent) must be applied. Haircuts need to be at such a level that the excess collateral value is sufficient to cover any negative price correlation between the loan and collateral portfolio for the period between default and portfolio restitution. Where cash collateral has been received and invested, the investment must be sufficiently liquid to be able to access the cash quickly and purchase the lent securities. When Lehman Brothers collapsed, it represented the biggest counterparty default to impact the securities lending industry. In the majority of cases, investors were able to liquidate collateral and restore lent positions without loss. However some cash collateral takers did incur losses from their investment strategies. Also, some hedge funds struggled to reclaim the collateral that they had provided to Lehman Brothers against borrowed 17

19 securities, partly due to the securities being re-hypothecated and used for other collateral requirements. In addition to the risk of default, lenders must manage certain other operational risks, such as ensuring that any dividends or corporate actions that the lender is entitled to are properly claimed and received. Agent lenders manage all of the day to day process of securities lending on behalf of the lenders, applying the policies and guidelines provided, and regularly reporting information such as loan values, counterparty exposures and collateral held. Risks to the Borrower Borrowers of securities are exposed to similar risks as the lender. If a lender defaults, they may not be able to return the borrower s collateral. In such event the borrower can exercise their set off rights under the master agreement and can seize the borrowed securities to cover amounts that the lender is due to pay. Regulation Securities lending is a global activity but current regulations have been developed on a regional basis and are generally applicable to certain types of institutions or fund types. A sample of these has been listed in appendix 1. Most of the regulation has been focused on investor protection, for example limiting the types of counterparty a lender can do business with, or limiting the type of collateral they can accept. Market Led Developments The securities lending market has seen many developments over the last 10 years aimed at reducing risks and increasing transparency. 18

20 Education and Risk Awareness It is important that the lender fully understands the risk profile of their specific activity and it was apparent after the Lehman Brothers default that some lenders may not have been fully aware of, or understood the counterparty and liquidity risks involved. As a result the industry has published independent educational material for lenders, which was coordinated via the Bank of England s Stock Lending and Repo Committee (SLRC) and endorsed by a number of market trade associations. In addition a checklist highlighting risks, features and parameters, was developed to formalise the on-going engagement between agent lenders and their clients. Infrastructure Automated Global Platforms Over the last decade the market has developed global platforms for trading and post trade reconciliation of securities loans. The use of these platforms has allowed participants greater connectivity, enabling them to electronically transact and process security loans. This has increased processing efficiency and reduced operational risk. Triparty Collateral Managers Managing collateral transactions can be complex and expensive. Over the last ten years the use of triparty collateral managers, who focus only on collateral related processes, has increased significantly. Tri-party collateral managers receive loan valuations from both lender and borrower on a daily basis, and automatically transfer eligible collateral, which is defined by the lender prior to transacting, from the borrowers account to the lenders segregated collateral account. The book transfer method and the automation collateral eligibility checking offered by such managers represents a meaningful reduction in the operational risks associated with non-cash collateral management. Central Counterparty Developments 19

21 The costs and benefits of a Central Counterparties (CCP) for securities lending is currently being considered by the market with a small number of services on offer. CCPs are widely used in repo transactions and some other derivative transactions, with collateral being posted to the CCP. It is not clear however whether a CCP is suitable for securities lending activity and some believe if their use was to be mandated it could limit participation in the market. When using a CCP, both loan and collateral securities are delivered directly to the CCP with the loaned security being delivered on, and the collateral being held by the CCP. Both lender and borrower will provide margin to the CCP as protection against default. Provided the CCP is sufficiently secure, they could be potentially beneficial by reducing market wide counterparty exposure. Standardised margin methodology may also provide a more consistent margin requirement and avoid sudden margin calls on banks which can cause them liquidity issues. However, difficulties exist in the range of eligible collateral and the additional costs to lenders, who currently receive margin directly and don t provide any. Development of Market Data The provision of market data for securities lending has increased exponentially over the last ten years. Lenders and borrowers provide data files daily with details of available to lend and lent securities which is then aggregated and provided back to the market on an anonymous and daily basis. This transparency enables analysis of market wide dynamics such as lending liquidity and lending rates and provides the basis for performance measurement. 20

22 Matters of Interest to Policymakers Over the past 12 months, securities lending has been subject to significant regulatory attention with reviews of shadow banking, short selling practices, ETF and UCITS, and Corporate Governance concerns. There are certain themes that have run through these which are discussed below. Transparency The securities lending industry is sometimes considered as being opaque and not sufficiently transparency. There is in fact a lot of data available, sometimes for a fee, however it is largely only used by market participants and the provision of data is not compulsory. Agent lenders have invested heavily in reporting tools and techniques to ensure that lenders have full transparency of activity undertaken on their behalf. Furthermore the industry is currently working toward meeting the requirements of Basel III, Solvency II and regulators liquidity reporting which will further improve transparency. Securities lending is mostly conducted on a bilateral basis rather than through any exchange and this means there is little publically available information about the fees paid for borrowing securities. Re-hypothecation Re-hypothecation describes the process by which a collateral giver (fund customer) transfers collateral to a collateral taker (Prime Broker) and that collateral taker uses the collateral for onward financing transactions. It is most commonly associated with Prime Brokerage arrangements and has risen to prominence after the financial crisis. 21

23 Under Prime Brokerage arrangements, the Prime Broker typically extends credit to the fund customer. The credit may take the form of financing long positions or financing short positions. The total amount of credit extended to the fund customer is determined and the pre-agreed re-hypothecation rate is applied. The re-hypothecation rate is typically greater than the amount of credit extended, that is to say, if the Prime Broker lends 100 it will need an amount greater than 100 to fund the extension of credit. In today s market, re-hypothecation rates vary between 140%-200% of the total extension of credit depending on a number of factors including the liquidity of the securities taken as collateral. The Prime Broker may never take more than the re-hypothecation amount. Following the determination of the value of securities that may be rehypothecated, the fund customer will then permit the Prime Broker to take the requisite amount of securities and title to the securities will be transferred to the Prime Broker. The Prime Broker may use (or re-hypothecate) the collateral with the proviso that the Prime Broker must return equivalent securities to the fund customer once the fund customer repays the original loan/extension of credit. In this way, re-hypothecation is similar to a repo transaction with securities posted one way and cash posted the other with an obligation to return cash and securities once the transaction is terminated. Some institutional lenders use a type of re-hypothecation in order to collateralise derivative transactions as efficiently as possible, or to meet the requirements of derivative central counterparties ( CCPs ). For example they may enter into a loan of securities under which they receive collateral that is eligible to cover margin calls from the CCP. This mechanism allows the investor to obtain eligible securities without the need to sell core investments from the portfolio or borrow cash unsecured at significantly higher interest rates. 22

24 The ability to re-hypothecate is important for markets to operate efficiently. It is important that any regulatory measures designed to restrict rehypothecation are focused on the legitimate concerns and do not harm the benefits that investors receive. Intermediation and Complexity Questions are sometimes asked about the number of intermediaries in securities lending, with the end lender and end borrower rarely having a direct relationship, and often with two intermediaries between them. The concerns are that the level of intermediation complicates the process, adding unnecessary counterparty risks to the activity and taking value from the principals to the transactions. Securities lending is not a core capability of lenders and it is only economical for the very largest funds to invest directly in the specialised systems and resource required. It is also an expensive process that smaller lenders can only benefit from because an agent lender acts as a conduit to the market. The agent lender performs a vital role in providing the expertise and focus that the activity required to manage the process efficiently and in a risk controlled manner. It is important to note that the agent lender only acts within parameters set by the lender who retains absolute control over the activity. Principal intermediaries also perform an important role in the process by providing the lender with a regulated and credit rated entity with which to transact, without which lenders would not make their portfolios available for lending. The value of the credit intermediation role they undertake should not be under estimated. Principal intermediaries also enable the beneficial owner to access a large number of small end borrowers by amalgamating them through a single rated entity. 23

25 Reliance on Short Term Funding Securities lending can provide an additional source of short term funding for banks and an opportunity to exchange otherwise unused long securities for central bank eligible collateral. The ability to use securities in this way helps banks to keep funding costs down. To the extent that lenders are able to transact on a term basis borrowers are better able to meet bank liquidity ratios. Long term investors such as insurance companies and pension funds have historically provided significant unsecured funding to the financial markets and moving toward providing this funding on a secured basis reduces the counterparty risks taken by these institutions. Overnight secured funding can be quickly withdrawn in volatile markets or in times of crisis, and applied margins can be adjusted, which has led some policymakers to consider the stability of this type of funding. However, arguably, long term investors may be better able to absorb illiquidity in stressed markets. Cash Collateral Investment The investment of cash collateral can give rise to maturity and liquidity risk transformation and this is therefore an area being considered by the FSB as part of its review of the shadow banking system. Whilst more prominent in the US than in Europe, the investment of cash collateral drew particular attention during the liquidity crisis of 2008/09. Where cash is provided as collateral the cash has to be invested in order to pay the rebate back to the borrower (see page 13). Any rebate is based on a notional opportunity cost of the cash and therefore a market rate of return has to be achieved on the cash to cover this cost. The lender receives the 24

26 returns on the cash investment (less the rebate paid to the borrower) and also bears the risks of these investments. It is possible to enhance overall lending returns by increasing the rate of investment return in excess of the borrower s opportunity cost, however like all investments that higher return implies higher risk either through greater credit risk or creating a duration mismatch - i.e. paying the rebate based on overnight investment rates but investing the cash on a more termed basis. One notable feature of the liquidity crisis was the fact that the amount of credit risk or duration mismatch in a great number of collateral investment vehicles was far greater than the extraordinary market conditions could sustain. As a result lenders either realised losses on their cash investments or found that they could not exit securities lending without realising such losses. Following the liquidity crisis both lenders and their agents have fundamentally re-evaluated the role of cash collateral in securities lending. Some lenders stopped accepting cash permanently, others only temporarily. Agent lenders have almost uniformly converged investment guidelines to align with the eligibility and duration requirements of registered money markets funds along the lines of the US 2-a-7 rule. Margin Practices and Procyclicality Some commentators have suggested that the practice of amending margins, or applied haircuts, in response to changing market conditions has the effect of speeding up the rate at which crises develop. The concern is that when markets are stable and default risk is assumed low, haircuts are naturally reduced, but as markets become less stable lenders increase haircut requirements to protect themselves against the higher risk of default. The question is whether this process acts to drain liquidity from market participants which in turn makes markets more procyclical. 25

27 The conflict is that the lender wants the highest possible haircuts and the borrower wants the lowest possible. With a focus on capital and liquidity requirements, the levels of haircut are increasingly important to both parties, and this is driving a more considered position. Lenders increasingly look at risk models which incorporate a variety of market scenarios and which take into account factors such as the liquidity of collateral, the correlation between loaned securities and collateral, and their own capability to sell or absorb particular asset types in the event of a counterparty default. It has been suggested that greater use of central clearing or the imposition of minimum regulatory haircuts might help reduce the perceived procyclicality in the market. The question is whether these tools would make matters worse. Securities lending and Retail Investors Reservations are sometimes expressed in relation to the suitability of participation in securities lending for retail investors. However, the low risk, incremental revenues generated from participation can be an important addition to the performance of these funds. There is no reason that securities lending should be considered inappropriate, provided the retail investor is fully aware of their participation and the risks undertaken on their behalf are aligned to the risk profile of the investor s objectives. For this reason, full transparency should be provided as part of the fund documentation such as in the prospectus or fund rules. These disclosures should describe the process and provide detail of the risks involved. 26

28 Empty Voting Derivative instruments and some trading strategies have made it possible to decouple the economic interest in a security and the voting rights. Whilst these instruments are used for legitimate purposes, there have been concerns expressed that they could be used to influence the direction of a company vote. This process is called empty voting and borrowing securities in order to utilise the attached voting rights is one potential method of achieving this. It is important to differentiate between voting in respect of corporate events, where the lender has legal right to instruct, and receive, their chosen benefits from the event, and an AGM/EGM vote which the lender does not have right to during a loan. Equally, the provider of collateral loses the same voting rights for securities whilst securities are used as collateral. There is a general consensus in the industry that borrowing securities specifically to exercise the voting rights at an AGM or EGM is not appropriate and this is clearly stated in the Bank of England s Code of Best Practise, as well as warranties given by the borrower to this effect in the master agreement. Nevertheless, because of the opaqueness of the voting processes, concerns remain and it is difficult to prove or disprove the existence of this activity. 27

29 Appendix 1: Summary of Global Securities Lending Regulations country Institution regulatory authority specific reg Europe UCITS UCITS 4 Directive All MiFiD Banks Basel II UK Insurance FSA Prudential Insurance source Book (PRUINS) UCITS FSA UCITS COLL 5.4 Local Authorities Local Government Pension Scheme (Management and Dept of Communities and Investment of Funds) Regulations 2009 (Statutory Local Government Instrument SI2009/3093 France PEA (Plan d Epargne en Action) Germany KAGS BaFin InvG Wertpapierdarlehen, Sicherheiten Luxembourg UCITS CSSF Circular 08/356 Spain Securities Market Law (Art Law 24/1988) Measures to Reform the Financial System (Art. 15 and 16 Law 44/2002) Provision 18 Law 62/2003 USA US Employee Retirement Income Securities Act ("ERISA"). Prohibited Transaction Exemption (effective Jan2, 2007) US employee benefit plans US Mutual Funds SEC US Investment Company Act of 1940 Broker- Dealers SEC Securities Exchange Act 1934 SEC Rule 15c3-3 Regulation T 28

30 About ISLA The International Securities Lending Association (ISLA) was founded in 1989 to represent the common interests of lenders and borrowers of securities internationally. The association has more than 90 members comprising insurance companies, pension funds, asset managers, banks and securities dealers, who in turn represent more than 4,000 clients. ISLA publishes a master legal agreement which is widely used in the market internationally, as well as a series of guides, best practice papers and educational materials. Further details about ISLA can be found on our website 29