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Securities Lending Market Soars to $16 Trillion
RiskCenter.com (October 10, 2006)

Location: New York
Author: Ellen J. Silverman
Date: Tuesday, October 10, 2006
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With total lendable assets close to $16 trillion globally, the securities lending arena quietly has grown into a powerhouse. Major players such as The Bank of New York (BNY) and JPMorgan Chase are becoming acutely attuned to the myriad of complexities involved with what was once perceived to be a relatively riskless business.

Securities lending involves a lender that provides capital to a borrower in exchange for collateral. The borrower is required to return the identical securities to the lender at a specified date in the future, in addition to interest or other premium. For lenders, the process is a means to generate additional revenue on assets that otherwise would be sitting idle. Borrowers do this to cover transaction failures or for shorting purposes. Custodian banks such as the BNY and JPMorgan Chase often serve as intermediaries within the process, enabling their pension fund clients to offer their assets as loans.

According to a recent article in Wall Street & Technology, "Pension funds and dealers, the growth in the market has been a boon, as the funds are able to generate additional revenues off their assets and the dealers are able to secure lower-cost loans. But as the market has grown at a faster pace than the technology that serves it, lenders are becoming more and more concerned with controlling the risks associated with lack of liquidity, poor credit, default by the counterparty and migration of credit ratings, among other risks."

While automation and technology solutions can help mitigate securities lending risks, they also can provide a false sense of security, according to Brad Bailey, senior analyst, Aite Group. "Technology can be a double-edged sword," he says. "While it allows greater efficiency and more-accurate representation of risks through sophisticated models, players might be inclined to run their operations with insufficient excess capital should there be any type of problem." Even the most-advanced technology cannot completely remove all of the risks in the securities lending market. Bailey stresses, "If we were in a situation where a major counterparty failed, it would be very scary and part of a very large systemic failure within the securities industry," he says.

The securities lending market continues to grow as more and more dealers tap the market's cost-cutting attributes to benefit their global funding desks. "One of the core functions that makes a dealer profitable is their global funding desk," notes Art Certosimo, EVP and head of broker-dealer services at BNY. "One of their core expenses is funding, and anything they can do to lessen that funding expense drops directly to the bottom line." Therefore, dealers want to use their worldwide assets as collateral to take all of their unsecured funding and transition it to lower-cost secure funding, Certosimo explains. On the other side of the deal, investors like securities lending simply because they get an increased return on their assets, which normally would be earning a lower interest rate, according to Certosimo. "Dealers won't pay high interest rates if they are required to deliver U.S. Treasuries, for example, [as collateral]," he asserts. "But if they can use equities for collateral, they are more apt to pay a bit more." In other words, a dealer understands that lenders are taking on greater risk if they accept equities as collateral, so the dealer is willing to pay higher interest on those loans. With high-quality collateral, such as relatively stable U.S. Treasuries, dealers would not want to pay higher interest rates on a loan since the risk to the lender is lower.

Throughout the lending process, tremendous amounts of capital are being exchanged, often without full disclosure to lenders as to who is borrowing their assets. In response, regulations such as the Agency Lending Disclosure (ALD) initiative, which is set to take effect in October and is supported by the SEC and the SIA, seek to provide more transparency throughout the lending process.

While solutions from vendors such as SunGard, EquiLend, Quadra Serve and Locatestock.com add additional transparency into the lending process to reduce risk, custodian banks such as BNY that act as intermediaries between dealers and pension funds, forming a tri-party relationship, are seeing tremendous growth in their collateral cash management businesses. Much of the increase is due to proprietary systems and functionality that are robust enough to handle massive amounts of transactional data and the complex parameters placed on loans by fund clients.

Traditionally, collateral pools typically were less risky because they were smaller and predominantly high quality. Investors could rely on the fact that if their counterparty through the loan defaulted, value could still be extracted from taking possession of the collateral. But now, with a diverse group of collateral pieces coming into play, including more-volatile stocks, investor confidence levels need to be managed, according to Certosimo, who adds that sophisticated systems are necessary to manage the process. "Investors are prone to collect collateral but are now putting more restrictions on it to reduce risk," he says. "And while investors can build whatever parameters they want, it's nearly impossible to handle manually."

This is an industry that is growing more complex, according to Brian Traquair, president, securities finance, SunGard. The securities lending industry naturally is more complex than normal securities trading, according to Traquair, because of the ongoing relationship created with each new loan. In a buy-sell trade, for instance, once money and stock have changed hands, the two parties are done. In a stock or tri-party repo loan, however, the relationship has just begun. Traquair explains, "As long as the loan is outstanding, parties to the trade need to look at credit, market exposure, partial returns, callbacks and other transactions every day." The loan parameters that need to be considered can make securities lending transactions more complex to price and manage.

Clearly, as the securities lending market becomes more complex and the risk increases, the demand for solutions to provide transparency into the process also will increase. To further reduce complexity in the growing marketplace, many believe end-to-end solutions will continue to gain traction. "As the stock loan and tri-party repo markets converge, the trend to find comprehensive single-source solutions becomes more apparent each year," says Traquair.

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Article Printed From RiskCenter.com

 

 

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