Turbulence and Fear Shift Stock Lending Fundamentals
October 20, 2008
The collapse of financial giants' share prices and U.S. regulators' recent ban on short selling have taken their toll on the securities lending market by dramatically reducing borrowed shares, lifting collateral requirements in Europe and raising the prospect of an increase in the U.S.
Lehman Brothers' Sept. 15 bankruptcy filing marked the start of massive volatility in an already unstable equity market. Less well publicized is the fact that the bulge-bracket firm had a large stock-lending desk that had engaged in transactions with most major borrowers and lenders. So far, there's been little indication that any institutions in the U.S. have found themselves adversely exposed to the firm--a testament, perhaps, to current collateral requirement conventions.
In London, however, hundreds of millions of dollars in cash and securities belonging to Lehman's hedge fund clients have been frozen in their prime brokerage accounts. Numerous European banks have also floundered in the credit maelstrom, prompting their respective governments to inject equity capital. The combination of events has sent stock markets reeling and prompted securities lenders to determine collateral requirements on a bilateral basis with borrowers.
"If lenders are taking equity, corporate bonds or bank paper, collateral may have lifted to 110 percent. It really varies by lender," said David Rule, CEO of the International Securities Lending Association (ISLA), a London-based trade group that represents beneficial owners of securities, agent banks and brokerages.
Collateral requirements are not mandated by regulators but rather are decades-old best practices. The requirements have been 102 percent for transactions within a country and 105 percent for cross-border deals, which has been the prevalent rate in Europe. The excess collateral comes into play when a borrower such as Lehman declares bankruptcy, ensuring the lender has sufficient collateral to cover itself by buying the security on the open market.
Tim D'Arcy, managing director at SunGard Data Systems, said attendees at Information Management Network's securities lending summit late last month almost unanimously said they had had counterparty exposure to Lehman. However, no one at the Edinburgh, Scotland conference acknowledged any losses. "Everybody patted themselves on the back and said the [collateral] system worked effectively--everybody was made whole, with no write-offs," said D'Arcy.
In fact, exposure to Lehman could have been much worse had lending to the investment bank not already been reduced by 80 percent, according to Wayne, Pa.-based SunGard. Aaron Gerdeman, product manager at SunGard Astec Analytics, a research and analytics provider specializing in securities finance that SunGard bought in October 2007, said the decline occurred gradually, starting about a year before Lehman's collapse. "We don't now whether that was Lehman or lending agency banks deciding not to continue those loans," Gerdeman said.
Counterparty Concerns
Either way, the collapse of such a large player is bound to raise concerns about counterparty risk. "If you want an extra cushion, it makes sense to want more collateral," said Josh Galper, managing principal of New York-based consultancy Finadium, formerly Vodia Group. "And in these markets, where there's a scarcity overall of securities to borrow, it's likely you'll get it."
ISLA's Rule explained that unlike the U.S., where 95 percent of collateral is cash, in Europe securities comprise 60 percent or more. Thus, negotiations between stock lending counterparties on the Continent are focusing on the type of instruments involved. Those lacking transparency, including even AAA-rated collateralized debt obligations, demand the most collateral and government bonds the least.
