Daylight exposure is defined as the period in the day when one party to a trade has a temporary credit exposure to the other, due to one side of the trade having settled before the other. The period extends from the point of settlement of the first trade to the time of settlement of the other. (IBP-174)
If the counterparty is acting as an agent lender, a loan of securities is generally only released once eligible collateral to the same value (including margin) has been provided. A counterparty may release a loan which is under-collateralised if the exposure is within their agreed exposure threshold or if this is within their risk parameters. This is known as the hold and release approach. Daylight exposure generally only impacts the collateral provider as a result. (IBP-175)
The specific market the collateral and loaned securities are settling in is a key factor in this. If the loan and collateral are in different markets and in different time zones, the period of time a counterparty may be exposed will increase. e.g. On a portfolio made up of Japanese collateral and US Loans, the Japanese Collateral would need to be pledged first thing in the morning to settle in the Japanese market, but the US Treasury loan could only be released when the US market opens later that day. (IBP-176)
To prepay is to collateralise a loan prior to the subsequent release of that loan instruction to market.
The prepay concept ensures that an asset lender has sufficient collateral prior loan settlement.
Prepays can either be done overnight, i.e., the day before loan settlement, but only if both parties agree to the resulting overnight exposure. Alternatively, a prepay may be agreed and processed on the same day as the loan settlement.
A prior day prepay is more likely to be agreed where there is a mismatch between the respective markets of collateral and loan, or where one party does not have a physical presence in the local time-zone.
Where collateral is managed via a triparty arrangement, which provides increase automation options, many market participants utilise vendor solutions which are able to trigger an automated loan instruction release on successful receipt of collateral.
If the counterparty is acting as lender, they will generally adopt a hold and release system. This means that the loan is only released when the relevant collateral is received. If hold and release is not used or if the counterparty is acting as borrower, the below approaches are generally used to reduce or remove daylight exposure. (IBP-178)
It is best practice that individual loans should be released as soon as they are covered, and that a lender should not wait for an entire portfolio to be covered before starting to release trades. Additionally it should be recognised that the covering of a new loan could be through the release of collateral associated with the return of another loan, or through an overnight move in the value of the portfolio or collateral which produces an excess in collateral. The lender should consider various factors when deciding the order in which to release loans – this could include the settlement cut-off of that market, the value of the trade, upcoming record dates and could also be based upon borrower request. Vendor solutions are available to fully automate this process which also reduces the need for lenders and borrowers to have a physical presence in other regions to be able to facilitate an efficient hold and release model.
In order to facilitate same day settlement, a timely margin call process needs to present to ensure the collateral and loan settle before market close. This can be achieved by the use of a triparty agent who can accommodate the collateralisation of loans in a very short period of time around the clock. (IBP-180)
If a bank has a global presence in every time zone, there is a possibility the collateral can be received same day for all loans. This is dependent on the turnaround time of margin calls and also the securities which are being traded. (IBP-181)
Where a trade is booked as a delivery-versus-payment (DVP) transaction, the trade instruction should be released immediately to the market. No holding of the instruction is required as the cash collateral will settle simultaneously with the loaned security.
For securities loans settled via a DVP instruction, where that cash represents the final collateral, the loan should be booked as a cash rebate transaction.
The ISLA Best Practice group discussed the management of cash pool transactions, where a securities loan is booked versus a fee and the cash element being a separate cash flow. It was agreed that DVP should not be used for cash pool trades due to the additional maintenance requirements and inherent risk of multiple cash movements. (IBP-182)
If a loan is not collateralised, internal escalation procedures should be followed and the counterparty should be advised. The loan may be cancelled or re-agreed for a future date assuming this exposure falls outside the counterparty's risk and threshold parameters. (IBP-183)
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