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Securities Lending Risks & their Mitigants

The collateralised nature of securities lending, combined with robust daily mark to market procedures and tried and tested legal frameworks, make securities lending a relatively low risk activity. However, there are risks that market participants should be aware of when undertaking securities lending. These should be understood, quantified and mitigated wherever possible.

Here are some of the risks involved in security lending activity, together with ways they can be managed or mitigated with effective oversight.

Counterparty Risk

The risk that either the borrower defaults on the loan and is unable to return the securities, or that the lender defaults and may not be able to return the collateral.

Mitigation: Both the lender and borrower must complete appropriate due diligence and a counterparty credit risk assessment before considering who they are willing to lend to and how much they are willing to lend. Both parties are also protected by the Global Master Securities Lending Agreement’s (GMSLA) close-out provisions, which allow them to set off their rights and seize the securities or collateral cover amounts due, in the case of an insolvency by one or the other. Furthermore, lenders may be protected against the risk of a margin shortfall by the lending agent in case of the insolvency of a counterpart. Moreover, counterpart limits are often specified in the agreement with the agent. An important service offered by agent lenders is counterparty default indemnification, a type of insurance policy. In the event
of a counterparty default, the agent, acting on behalf of the lending client, will immediately take control of any collateral
delivered by the defaulting counterparty. For more information on indemnification click here

Collateral Risk

The risk that the value of the collateral falls below the replacement cost of the securities that are lent. If this happens and the borrower defaults on the loan, then the lender will suffer a loss equal to the difference between the two.

Mitigation: Establishing rules governing collateral can be complex and lenders should discuss this with their agent or legal adviser. A lender’s collateral policy will affect the returns that are achievable (i.e. the riskier the policy, the higher the potential return). In setting the collateral policy, the lender and agent should take into account factors such as liquidity and price correlations between the loans and collateral (i.e. whether the price of the collateral is generally expected to move in line with the price of the lent securities). This is why so-called ‘haircuts’ are usually also agreed between the parties. In effect, this requires the borrower to deliver collateral of a greater value than the securities being lent, so the excess collateral value is sufficient to cover any negative price correlation between the loan and collateral.

Cash Collateral Risk

The risk that the lender suffers a loss on the re-investment of cash collateral.

Mitigation: The lender must ensure that the investment guidelines governing the investment are fully understood and provide an acceptable level of risk and return. Lenders should be aware of the liquidity risk inherent in the investment of cash collateral should investments need to be sold at short notice to return the collateral.

Settlement Risk

The risk that the securities being borrowed are delivered to the borrower before the collateral is received.

Mitigation: Lenders should consider whether they wish to receive the collateral the day before the loan settles to avoid risk. At the end of the loan period, lenders should ensure that their shares are returned before or at the same time as collateral is released back to the borrower. In the case of cash, the collateral is delivered on a delivery versus payment basis thereby eliminating the risk of non-delivery.

Operational Risk

The risk of errors or disruptions in the operational processes of securities lending, including settlement, reconciliation and record-keeping.

Mitigation: Lenders and agents must establish strong operational controls and procedures, and conduct regular audits and reviews of operational processes.

Concentration Risk

Overreliance on a small number of borrowers or a limited set of securities may expose the lender to concentration risk.

Mitigation: Diversify lending activities across multiple borrowers and securities, and avoid excessive exposure to a single counterparty or security.

Market Risk

The value of the borrowed securities or collateral may be affected by market fluctuations, leading to potential losses.

Mitigation: Monitor market conditions closely and adjust collateral levels as needed. Use risk management tools, such as stress testing, to assess the impact of adverse market movements. Implement conservative investment policies for collateral.

 

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