The Lehman situation, he adds, is “not something that you would wish on yourself or that you’d ever want to go through again, but I think there were some positives that came out of it. The contracts we had stood up extremely well; the processes, the risk modelling that we did, the theory that we’d built around that—which drove a lot of the components in terms of how we managed the business—held up as we expected.”
In the aftermath, plan sponsors “took it upon themselves to learn more about the lending program in terms of understanding what the risks were and made decisions as to whether to stay in or whether they needed to make adjustments.”
Few left; however, many recalibrated their risk appetites. Not because they saw losses, but because they understood the potential for losses under exceptional market conditions.
Changes Post-Lehman
So what’s changed? Well, there have been several regulatory misfires. A temporary ban on short selling at the height of the crisis did little to help provide what investors needed most: liquidity. Citing an Oliver Wyman study, Faulkner notes that bid-ask spreads widened, liquidity left the market and price discovery was impaired.
The relationship between securities lending and short selling was also poorly understood. “A small portion of our business is probably uncovered directional short selling,” explains Yvonne Wylie, head of securities lending at RBC Dexia Investor Services in Toronto.
“There are a number of other trading strategies that exist in the market today that are driving the need to borrow securities. It’s not just specifically tied to short selling,” she adds. There are other trading strategies—among them, convertible bond arbitrage, index arbitrage, mergers and acquisitions activity—where borrowers use short selling to hedge their exposure to adverse stock market movements.
Still, the Lehman default “did cause the spotlight to shine on securities lending a bit, and although for some that may have been uncomfortable,” says Slater, “we saw it as an opportunity to engage our clients and provide the m with information in terms of how the program worked, how we worked to manage the risks and how we could increase the level of information reporting in order to build their comfort.”
Of course, there was heightened due diligence on counterparties. There was more attention focused on the quality of collateral. There have been, in some instances, higher margin requirements. Typically, in Canada, bonds are collateralized at 102% and equities at 105% of the amount borrowed. And there was a re-evaluation of cash reinvestment programs.
In the end, custodians have refined their reinvestment program guidelines, not so much in what they take as collateral but rather in making more explicit to beneficial owners how their programs work—and tweaking them where necessary.
“We pride ourselves on ensuring that we optimize within a client’s risk profile, whether that is in a non-cash world or a cash structure,” says D’Eramo, adding, “[It’s important] to ensure that you have ongoing conversations with your clients to understand what goals and risk parameters they want to insert in that program.”
Clients’ Response
“Post-Lehman, obviously, the risk profile that certain beneficial owners had in their cash collateral programs trended to a more conservative type of reinvestment guideline,” notes D’Eramo. “We’ve seen trends where clients would move from commingled structures to segregated account structures so that they can fine-tune their reinvestment guidelines. So we’ve seen a trend toward more segregated, more conservative guidelines.”
Fine-tuning client guidelines also means more granularity, so plan sponsors can get a better picture of their exposure. “Part of it, from an underlying lender’s standpoint, is understanding the parameters of their program,” explains Wylie. “It’s really getting into a higher level of detail in terms of understanding what securities are going out on loan, whom you are actually lending to and the type of collateral you are holding at any one time.”
Granularity, in turn, feeds transparency, giving plan sponsors an overview of not just their risks but their risk-adjusted returns—and an ability to compare those returns against a benchmark group of similar participants in a securities lending program.
