Risk Management in Securities Lending

Risk Management in Securities Lending
How to mitigate those risks

By William F. O’Meara, vice-president, securities lending relationship manager for Canadian, corporate pension, and correspondent trust market segments, Northern Trust Global Securities Lending

Securities lending is usually known as a low-risk investment opportunity to earn incremental revenue. The level of risk in securities lending can usually be tailored to a beneficial owner depending on the level of risk they are willing to accept. Below are the primary risks in securities lending, how these risks can be mitigated and how beneficial owners can monitor their own program.

There are four primary risk areas in securities lending. Borrower default risk is an event in which the borrower does not return the loaned securities and there is insufficient collateral to buy in the security. Collateral risk occurs when the investment in the cash collateral option or the non-cash collateral becomes impaired or decreases in value. Interest rate risk relates to the possibility of negative spreads on securities lending transactions due to the rebate rate owed to borrowers exceeding the income earned from the reinvestment of cash. Trade settlement risk occurs when a beneficial owner or their investment manager sells an on-loan security and the borrower is unable to return the security to the agent lender to settle the trade.

Borrower default risk can be mitigated in several ways. The agent lender should have a borrower approval process to review and select borrowers for program participation by a group independent of securities lending. The lender should set exposure limits on each borrower and should have a process in place for continuously monitoring the borrower’s financials, credit ratings, performance, overall credit risk, and exposure limits. Mark-to-markets should be completed on loan and the collateral positions for each borrower daily to ensure the proper amount of collateral is held. Borrower default indemnification also mitigates this risk.

Collateral risk can be managed through investment research, portfolio management expertise and guidelines that reflect the beneficial owner’s risk and reward objectives. Agent lenders should have a team of people dedicated to investment research and monitoring, as well as a portfolio structure to review the total dollar exposure, percentage of the portfolio, maturity and country exposure. Agent lenders should have a process for monitoring compliance with investment guidelines. They should also maintain credit quality, maturity, liquidity and diversification within the guidelines. To manage non-cash collateral risk, the agent lender to complete a daily mark-to-market to ensure that the appropriate amount of collateral is held.

Interest rate exposure can be managed through close coordination between the traders negotiating terms with the borrowers and portfolio managers investing the cash collateral. The agent lender should take an asset/liability management approach towards lending activity and use statistical and objective duration risk measures to determine interest rate sensitivity. Portfolio structure should be based on relative sensitivity of the underlying loans and interest rate forecasts. Portfolios should be stress tested to assure that the structure is appropriate and revenue should be measured for risk and market value sensitivity. Agent lenders should have models that show the effects of rising and declining interest rates on the portfolio.

Trade settlement risk can often be managed by security substitution for agent lenders with a large diverse pool of lendable assets. Recalling a loan requires timely notification by the client. The borrower agreement should clearly state the time period allowable for the return of securities. Some agent lenders provide trade settlement protection in the event a trade does not settle.

Beneficial owners should review their program parameters with their agent lender to learn more about the processes and procedures in place for managing each of the above risks. Beneficial owners should also ask about the strength of their securities lending provider such as credit ratings and capital available to support lending. Each beneficial owner should be aware of their investment guidelines and what approach the portfolio manager takes within the guidelines.
Beneficial owners should know what their indemnification covers. Agent lenders typically offer operational and borrower default indemnification. Beneficial owners should proactively monitor their program through reporting, periodic due diligence reviews, and access to knowledgeable staff. They should ensure that they understand their legal agreement and should ask questions of their agent lender if they have concerns or want more information.

> click here to download the presentation