The new rules in the US setting out how securities lending transactions will be dealt with in the event of a default of a major financial institution, notably a systemically important financial institution (SIFI), may provide some improvements but a number of uncertainties remain, according to a report by BNY Mellon and Finadium.
The report notes the current efforts towards creating more stable liquidation or resolution regimes are ongoing and represent changes for the securities lending industry. “While much regulation stills need to be written, the potential for improvement and increased clarity has been highlighted by the ongoing administration of Lehman Brothers,” says the report. “Recent settlements on securities lending transactions for Lehman Brothers, four years after the firm’s failure, illustrate the potential benefits of a well-defined resolution regime. For beneficial owners, new regulations will serve to reduce fears of counterparty defaults arising from bankruptcy and give more comfort to the overall stability of the financial system.”
The report notes how the Dodd-Frank Orderly Liquidation Authority’s (OLA) rules will impact on securities lending:
- Federal Deposit Insurance Corporation’s (FDIC) authority to take over banks will be expanded to include derivatives clearing firms and central credit counterparties. Broker-dealer subsidiaries of banking organisations may also be covered. However, for any broker-dealer that is a member of the Securities Investor Protection Corporation (SIPC) and is registered with the Securities and Exchange Commission, the FDIC must appoint SIPC as trustee. That broker-dealer will be liquidated under the provisions of the Securities Investor Protection Act (SIPA) with one important exception. All qualified financial contracts to which the broker-dealer is a party are removed from the SIPA proceeding and are dealt with by the FDIC under the provisions of OLA. Securities lending and repurchase contracts along with most other counterparty based instruments are considered qualified financial contracts and, as a result, would be subject to the provisions of OLA.
- Given the FDIC’s mandate to minimise taxpayer losses, whether a securities lending contract is transferred to a bridge company could be in large part dependent on the level of collateralisation. All qualified financial contracts for a single counterparty will either be transferred to the bridge company or remain in the insolvent entity. Overcollateralised securities loans would most likely be transferred to the bridge entity unless the counterparty had certain other contracts that were problematic. However, in the event that a counterparty’s loan transactions were undercollateralised by an unknown but sufficient amount, this transaction could cause the FDIC to decide not to transfer the qualified financial contracts for that counterparty to the bridge entity. The industry continues to have discussions with the FDIC in order to get more clarity around exactly how decisions to transfer qualified financial contracts will be made. Although there have historically been few losses in securities lending owing to counterparty defaults, the potential to have some assurance that valid and properly collateralised securities loans would be transferred to a bridge company would lend stability to both the markets and lending operations.
- The new OLA stay marks a change from how securities loans are dealt with in the bankruptcy of a broker-dealer that is a member of SIPC. In a SIPA proceeding, loans collateralised by cash are not subject to a stay. For loans collateralised by securities collateral, the OLA stay is likely an improvement over SIPA rules that could impose stays on terminations of five days or, in the case of Lehman Brothers, significantly longer. At the same time, new questions are raised whether all securities lending counterparties would be grouped by holding company or whether each subsidiary would be considered a separate legal entity. When evaluating solvent transactions on a counterparty basis, regulators may assess securities loans by each underlying lender as opposed to the agent who made the loan.
Compared to today’s bankruptcy rules, the report says the new regulatory initiatives offer several direct benefits:
- A clear definition of securities loans as qualified financial contracts, which places them alongside repurchase agreements, securities contracts, forward contracts, commodity contracts and swap agreements.
- An understanding that authorities have the right to take over a failing institution before bankruptcy occurs, to separate good assets from bad, and to manage those assets for the greatest benefit of shareholders and creditors.
- A reasonable expectation that fully collateralised securities loans would be transferred to the bridge entity.
The report concludes that while difficult situations may continue to arise, particularly for undercollateralised securities loans that may prevent transfer to a bridge entity, the likelihood is that crisis resolution regimes worldwide will benefit the securities lending market. “Regulators are working to present transparent resolution processes for failed institutions,” says the report. “The more that this can occur, the more likely that market participants will extend credit to counterparties and generate both market liquidity and returns.”
Reporting by: Janet Du Chenne, Global Custodian, an Asset International publication