Counterparty default indemnification, whereby agent lenders agree to replace securities on loan of a beneficial owner in case of a counterparty default, will be impacted by regulatory initiatives such as Dodd-Frank and Basel III, according to the latest report from Finadium, the custody and securities lending consultancy.
The report, The Future of Counterparty Default Indemnification in Securities Lending Programs, available here, says that indemnification now typically comes with little extra cost, with clients sometimes even gaining additional collateral from failed counterparties when agent lenders repurchase assets in the open market.
Although collateral held in a securities lending transaction is the first line of defense against a counterparty default, indemnification by agent lenders provides extra security for beneficial owners. Therefore, removing indemnification altogether could reduce the number of participants in securities lending programs today, according to the report.
However, regulatory initiatives such as Dodd-Frank and Basel III introduce new variables that may force agent lenders to charge extra fees for counterparty default indemnificationalthough beneficial owners are likely willing to pay for it, Finadium says.
While much of the legislation is still up in the air, certain tenets of Dodd-Frank have a direct impact on indemnification, according to Finadium. Lower mandatory debt-to-equity ratios (15:1) and maximum credit exposures (25%) in Section 165 of Dodd-Frank, as well as Section 610, which limits securities finance activities to any single counterparty to 15%, limit the eligibility requirements of indemnification for beneficial owners.
Various aspects of Section 619, the Volcker Rule, may also be construed to disallow indemnification, requiring agent lenders to request exemption from the rule. Also, the U.S. new Orderly Liquidation Authority and the FDIC may intervene in a failing firm before it fails, meaning indemnification may never even come into play, Finadium says.
As for Basel III, varying ways regulators could count indemnification with regard to a banks capital requirements could impact banks leverage ratios but this matter is yet to be decided. Basel III will also impact liquidity coverage ratios as far as what is considered an asset and what is considered a liability, according to Finadium.
Finadium concludes that once Dodd-Frank and Basel III rules become clearer, agent lenders and beneficial owners will have to establish a reasonable fee structure for indemnification services. Participants may understand that regulatory change is not free, the consultancy notes.
The full report on the impacts of counterparty default indemnification in the context of new regulations is available from Finadium.