How stock lenders can manage rising indemnification costs

In a fast-changing regulatory and macro-economic environment, where interactions between different forces can lead to unpredictable outcomes, securities lenders will only achieve the best returns by remaining alert.

Stephen Kiely, head of securities finance new business development, BNY Mellon Markets Group

In a fast-changing regulatory and macro-economic environment, where interactions between different forces can lead to unpredictable outcomes, securities lenders will only achieve the best returns by remaining alert.

Active market participants have become very familiar with developments such as the growing use of equity as collateral, and the increased demand for term trades, but a third trend – rising costs for lending agents to provide borrower default protections (‘indemnification’) – has emerged relatively recently. We believe that this will assume much greater importance this year, and managing the implications should be high on the agenda for any stock lender.

Like much of the change in securities lending, the driver behind the increased indemnification costs is Basel III. Unfortunately, there is little upside from the cost increases for the securities lending community, but there is an opportunity to minimise the downside.

Under Basel III’s proposal on risk-based capital and leverage requirements, there is the potential for agent lenders to hold more capital against the borrower default protections they offer to lending clients (prime brokers acting for borrowers also face higher capital charges). The cost of providing these indemnifications could rise steeply as banks come into line with the new rules over the coming years.

This means that the hurdle rate for agent lenders executing transactions on behalf of securities lending clients will be significantly higher than previously, causing banks to be more cautious in the new business they take on, and more precise when calculating the likely outcome of proposed transactions involving existing clients.

Agent lenders will continue to offer indemnification to clients. They recognise that it has become a critical pre-requisite to lending for many risk-averse beneficial owners that require provision for the replacement of loaned securities, and/or protection against a shortfall in the value of collateral in the event of a borrower default. It is inevitable, however, that clients will see shifts in pricing from agent lenders and should adjust their approach accordingly in order to pursue profitable opportunities and avoid situations where the capital implications are likely to prove counterproductive.

Beneficial owners should expect different fee splits across their lending programmes reflecting the cost of capital to agent lenders for different transactions, rather than a standard approach across all trades. One way of reducing the impact of the regulatory change could be for lenders to move in favour of transactions in which the currency of the loan and the underlying collateral are correlated, as this can significantly reduce the cost of capital for the lending agent providing protections.

Eighteen months ago the use of equity collateral was an emerging trend. Now, it is so dominant that market participants are being disadvantaged if they do not follow suit, both in terms of operational and cost efficiencies. Indemnification costs will be a major theme for 2016, significantly changing the economics of transactions.

The securities lending market continues to be reshaped by regulation as much as pure demand and supply forces. Beneficial owners must be prepared to respond quickly to manage their assets efficiently.

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