The cost of indemnification — insurance against counterparty default — might have to be carried on bank balance sheets under possible domestic and international regulations, and that could spur asset owners to make changes in their securities lending programs.
Regulators are still considering whether such costs must be accounted for as part of Basel III recommendations and the Dodd-Frank Wall Street Reform and Consumer Protection Act. “The ultimate resolution of the Dodd-Frank regulations plus potential harmonization with Basel III is a huge issue,” said Paul Sachs, principal, Mercer Sentinel Group, Philadelphia. “Even though the final regulations aren't set yet, it could be that any guarantee, including indemnification, has to be backed by balance sheet capital.”
Generally, potential regulations apply to indemnification for all counterparty default risk, including derivative or swaps trades, but the impact will be on the securities lending agreements specifically, while derivatives are affected more by moves to central clearinghouse exchanges, sources said.
Indemnification costs in recent years have been paid for as part of bundled services agreed to by lenders and their agents. “Right now, no one ever sees it, so no one thinks about it,” Mr. Sachs said. “But regulations could require indemnification costs to be disclosed, which leads to the questions, "Will indemnification be offered? What will it look like?'”
Colin Rainbow, senior investment consultant at Towers Watson & Co., Reigate, England, said that if the cost of indemnification is spun out, clients will need to consider whether they want to indemnify or not and will need the information necessary to make that call. “In fact, they might have to look at if they even want to do securities lending,” he said. “They'll need to look at the revenue coming from their lending program, and how much in fees they're paying out; will it be worth it?”
Josh Galper, managing principal at consultant Finadium LLC, Boston, said the prospective rule changes could have several results. Securities lending agents might assume the cost of indemnification; those agents might pass on the costs to clients; asset owners could choose to forgo indemnification entirely; or some combination of all three depending on the final regulations and what agents and asset owners decide about the costs.
Clearly, asset owners favor keeping indemnification. In a survey by Finadium released last month, 81% of North American institutional investors said indemnification was important to their securities lending programs.
“For investors, counterparty default indemnification is a critical component to a securities lending program,” Mr. Galper said. “In many cases, it's required by pension funds” and included in their governance rules.
The potential regulatory changes are “not a front-burner issue today, though everyone knows it's coming,” Mr. Sachs said.
Will that mean an exodus by pension funds and other institutional investors from securities lending? “That's a good question. The jury's still out,” Mr. Sachs said. “But to me, it's a macro issue. Personally, I think the answer is still, yes, there's still a place for securities lending. How do you have efficient markets without securities lending? You can't short stocks without securities lending. When someone shorts a security, they need to borrow the security so that they can make the delivery to settle the trade. Without securities lending, there is no borrowing; hence, a short sale could not be settled.”
