Steady state: securities lending post-Lehman

Nevertheless, custodians have stepped up client reporting, as well as due diligence on counterparties, after the startling collapse of Lehman Brothers in September 2008. The ensuing bankruptcy left a number of hedge funds—in the U.S. and Canada—unable to trade the securities they had borrowed until British administrators settled creditor claims as they wound up Lehman’s London prime brokerage unit. But those were the borrowers. On the other side, Canadian lenders were unaffected: custodians moved quickly to liquidate collateral to replace the shares on loan.

In the interim, lenders have learned a lot about how the theoretical risks of securities lending can play out in practice. “You don’t get paid more money without taking more risk,” says London-based Mark Faulkner, founder of and head of innovation at Data Explorers, which tracks the global securities lending industry. “If they are in a situation where they are getting, for want of a better word, somewhat ‘extraordinary’ profits from lending securities, you can bet your bottom dollar it’s because they’ve more risk in the program.”

Canadians lenders were spared that risk.

Cash and Non-cash Collateral
Securities loans can take two forms. The first is cash, which is reinvested in programs run by custodians. The second is non-cash reinvestment. Securities borrowed are exchanged for other high-quality securities. Positions are marked-to-market daily, and if there’s a shortfall, borrowers are required to post higher collateral. In non-cash reinvestment programs, lenders earn a fee for their securities loans.

In a cash reinvestment program, beneficial owners pay the borrower a rebate rate that is less than the market rate that they receive on their reinvestment of that cash collateral. Reinvestment assets could include repos—collateralized repurchase agreements—commercial paper, floating rate notes and even asset-backed securities, Faulkner explains.

It was cash reinvestment programs that were most affected during the financial crisis. In the event of something like a Lehman default, the critical question is, “Can I liquidate what I own at close enough to par to have enough money to buy back what I have lent?” Faulkner says. “The problem for many lenders—and I’m not suggesting Canadian lenders—around the world was, when that moment came, the answer was no. Some didn’t have sufficient funds, or the prices at which the assets they bought were trading were so unpalatable that they couldn’t bring themselves to sell. So they couldn’t buy back the stock that was on loan.”

Lehman wasn’t necessarily unpredictable. Nor were Canadian beneficial owners necessarily exposed. Faulkner notes that most Canadian lenders (80%) opt for non-cash reinvestment, unlike
U.S. lenders (4%).

“We were building liquidity ahead of that time,” says Don D’Eramo, senior managing director, securities finance, with State Street Corp. in Toronto. “So if there were any fluctuations in balances, you are positioned to meet those requirements.”

Northern Trust adopted a similar stance, says George Trapp, senior vice-president, securities lending, with Northern Trust in Chicago. “Our focus was on making sure we were prepared for any borrower filing for bankruptcy—whether it was Lehman or any other counterparty. And it was making sure that we understood what our collateral positions were and that they were marked-to-market on a daily basis. Then it was quickly executing on the liquidation of the collateral and the purchasing of the securities back to get them back into the client accounts.”

In all, it’s been a salutary process, to the benefit of plan sponsors. “Certainly, the whole credit crisis created a level of angst,” says James Slater, senior vice-president, capital markets, with CIBC Mellon in Toronto. “That said, it did provide an opportunity from a provider perspective to validate a lot of what we do.”