RMA Committee on Securities Lending

Transcription

1 RMA Committee on Securities Lending Statement of Best Practice Valuation of Accrued Interest and Collateral held against loans of Fixed Income securities borrowed under an MSLA Goal of this paper The U.S. Securities Lending and Borrowing (SLB) industry has a variety systems at its disposal for automating the various processes involved in maintaining open loan positions, and ensuring the loan collateral valuations meet contractual requirements agreed between the parties to the loan. However, the language of the industry s commonly used contractual agreements does not provide enough detailed guidance on the methodology of determining collateral value. This paper seeks to provide sufficient clarity on the appropriate method for determining collateral value. This is viewed as necessary guidance for the various software vendors who provide software tools and services to the industry. Background on bonds and US accounting treatment In essence, a bond is a contractual agreement between 2 parties an issuer and an investor to exchange a stream of payments. While there are variations from bond to bond, in the most basic example, an issuer receives an up-front principal payment from an investor, and in exchange agrees to pay the principal amount back to the investor at a future maturity date, and a series of interest payments at agreed upon payment dates. Interest payments are sometimes called coupon payments, giving rise to the commonly used term coupon date. US accounting rules state that investors who hold interest-bearing bonds should track the number of days between the most recent and the next interest payment dates. Each business day, they will record on their accounting records an Interest Receivable equal to: (Interest amount / # of days in payment period ) * # days since last update. This record keeping is called accruing interest. On the interest payment date, two actions happen: a) the receipt of the payment reduces the prior day s Interest Receivable balance, and b) the investor continues the accrual process so that the Interest Receivable balance is increased by the appropriate number of calendar days since the last accrual. Valuation of bonds The bond market functions to assign a price to each bond, which is used to determine its market value. For bonds which pay periodic interest, this price has two components, both commonly expressed as a percentage: 1. The Clean Price. This is market value of the instrument itself, and is the price bond investors have assigned to all the future payments of interest and principal except the next interest payment. Page 1 of 6 Published: March 1, 2013

2 2. The Accrued Interest. This represents the Interest Receivable for the next interest payment due to the bond holder. If an investor sells a bond, he will only do so if he is compensated for the Interest Receivable balance he has recorded on his books, but for which he has not yet been paid. If he were not compensated, he would have to write down the receivable, and record a loss. The Accrued Interest is determined by dividing the Receivable by the quantity of shares. Both components give us the bond s Dirty Price : ( Clean Price% + Accrued Interest% ) Both of these valuation components are well understood, and practices for determining their values are well defined. Application to Securities Lending and Borrowing (SLB) Several components are used to calculate the collateral value for fixed income securities: 1. The most recent market clean price of the asset on loan there are a number of data services that provide this information. 2. The agreed-upon additional collateral required by the lender, commonly called the margin or haircut. This is generally expressed as a percentage of the market price, and functions as a cushion to secure against price swings in the market. 3. The accrued interest. 4. Rounding of the Price per share. This serves as a computational convenience to allow the parties to deal in round numbers. There are a variety of legal agreements under which SLB participants operate. In the US, the most commonly used agreement is the Master Securities Lending Agreement (MSLA). The MSLA language is excerpted in Appendix A, and provides that market participants can determine whether it is market practice to apply the margin to the clean price or dirty price. It is established that US market practice is to value collateral as follows: Collateral Price = ((Clean Price% * Margin %) + Accrued Interest%), rounded up Collateral Value = (Collateral Price * Share Quantity) The process of maintaining the collateral value at appropriate levels is accomplished via the mark-tothe-market (mark) process which revalues individual loans, generally on a daily basis. Marking to market serves to protect both the lender and the borrower in the event of a contra party default by ensuring the loan collateral is close to the value of the underlying security. It ensures that the lender has received sufficient collateral from the borrower to repurchase the assets on loan in the event of a contra party default; on the other side, the mark ensures that the borrower is holding sufficient value in the securities borrowed to recover his collateral in the event of a lender default. In the US in particular, there are very specific regulatory expectations that shape the process. These practices are well defined and well understood in the marketplace, which has led to a very high degree of automation in the mark process. Best practice recommendation How many days to accrue interest? Page 2 of 6 Published: March 1, 2013

3 A gap does exist, related to the application of accrued interest in the price and value calculation. While the calculation of a single day s accrued interest is well understood, the number of days of accrued to apply to the mark price on any given day is open to interpretation. The MSLA and other documents that govern lending practices are vague on this subject. So, returning to our formula for Collateral Price ((Clean Price% * Margin %) + Accrued Interest%) how many days should we count when determining the Accrued Interest? We believe that the strongest case can be made for using the same methodology that is used in the cash markets, where bonds are bought and sold. Established practice is to begin accrual on the date of the most recent cash event interest payment date, purchase date, or issue date and to end accrual on the date of the most recent calendar date. So a loan booked or marked on a Friday would include interest accrued through Thursday. If booked or marked on a Monday, it would include interest accrued through Sunday. Conclusion In conclusion, we are recommending the RMA endorse the concept that interest should accrue from the most recent payment date through the most recent calendar date. This is applicable to both initial collateral valuations of new loans and variation collateral requirements of existing loans. This seems particularly beneficial as the industry seeks to further automation in the re-pricing/markto-market process for a larger universe of assets and loans. In the traditional fixed income markets (Fed-eligible government or agency bonds) re-pricing is a relatively manual procedure involving active reconciliation and pre-agreement on prices and terms. Because there is substantial human intervention in the process, differing views on the application of accrued interest are worked out by the individuals performing the task. As we contemplate a more automated environment, agreement on this valuation methodology will be necessary to support re-pricing automation. Page 3 of 6 Published: March 1, 2013

4 Appendix A: MSLA language on determination of Market Value Market Value Unless otherwise agreed by Borrower and Lender: 1. If the principal market for the Securities to be valued is a national securities exchange in the United States, their Market Value shall be determined by their last sale price on such exchange at the most recent Close of Trading or, if there was no sale on the Business Day of the most recent Close of Trading, by the last sale price at the Close of Trading on the next preceding Business Day on which there was a sale on such exchange, all as quoted on the Consolidated Tape or, if not quoted on the Consolidated Tape, then as quoted by such exchange. 2. If the principal market for the Securities to be valued is the over-the-counter market, and the Securities are quoted on The Nasdaq Stock Market ( Nasdaq ), their Market Value shall be the last sale price on Nasdaq at the most recent Close of Trading or, if the Securities are issues for which last sale prices are not quoted on Nasdaq, the last bid price at such Close of Trading. If the relevant quotation did not exist at such Close of Trading, then the Market Value shall be the relevant quotation on the next preceding Close of Trading at which there was such a quotation. 3. Except as provided in Section 4 of this Annex, if the principal market for the Securities to be valued is the over-the-counter market, and the Securities are not quoted on Nasdaq, their Market Value shall be determined in accordance with market practice for such Securities, based on the price for such Securities as of the most recent Close of Trading obtained from a generally recognized source agreed to by the parties or the closing bid quotation at the most recent Close of Trading obtained from such a source. If the relevant quotation did not exist at such Close of Trading, then the Market Value shall be the relevant quotation on the next preceding Close of Trading at which there was such a quotation. 4. If the Securities to be valued are Foreign Securities, their Market Value shall be determined as of the most recent Close of Trading in accordance with market practice in the principal market for such Securities. 5. The Market Value of a letter of credit shall be the undrawn amount thereof. 6. All determinations of Market Value under Sections 1 through 4 of this Annex shall include, where applicable, accrued interest to the extent not already included therein (other than any interest credited or transferred to, or applied to the obligations of, the other party pursuant to Section 8 of the Agreement), unless market practice with respect to the valuation of such Securities in connection with securities loans is to the contrary. 7. The determinations of Market Value provided for in this Annex shall apply for all purposes under the Agreement, except for purposes of Section 13 of the Agreement. Page 4 of 6 Published: March 1, 2013

5 Appendix B: To demonstrate this discussion, consider a hypothetical bond with these characteristics. Periodic interest rate 10% Period length 10 days Payment frequency Once every 10 calendar days Accrual Basis Actual / Actual Share quantity 100,000 Loan Margin 102% Rounding (0.01) 2 places to right of decimal Event Issue Date Pay date Day Accrued Interest (%) 1% 2% 3% 4% 5% 6% 7% 8% 9% 10% 1% 2% Int. Receivable ($) 1,000 2,000 3,000 4,000 5,000 6,000 7,000 8,000 9,000 10,000 1,000 2,000 Clean Price (%) 100% 100% 100% 100% 100% 100% 100% 100% 100% 100% 100% 100% Margin (%) 102% 102% 102% 102% 102% 102% 102% 102% 102% 102% 102% 102% Loan Price (%) 103.0% 104.0% 105.0% 106.0% 107.0% 108.0% 109.0% 110.0% 111.0% 112.0% 103.0% 104.0% Dirty Price (%) 101.0% 102.0% 103.0% 104.0% 105.0% 106.0% 107.0% 108.0% 109.0% 110.0% 101.0% 102.0% Graph of Loan Price (%) ( Clean Price * Margin% ) + Accrued Interest % % % % % % % Page 5 of 6 Published: March 1, 2013

6 Modification History Date Edited by Description Version # Feb. 1, 2013 Jim Clancy, eseclending Inc. Initial Document 1.00 Mar. 1, 2013 Jim Clancy, eseclending Inc. Edits, based on RMA member firm feedback Page 6 of 6 Published: March 1, 2013