What is Securities Lending?
Securities lending is an activity whereby securities are lent from one party (the lender) to another (the borrower). In order to secure the securities loan, the borrower is required to provide collateral for the loan; this can be done in the form of cash or securities, and additionally the borrower is required to pay a borrowing fee. Naturally, this can be a revenue earner for the institutions that are lending their securities and in turn, provide the additional benefit of increasing market liquidity.
Why do we care?
From May 2024 in North America, Securities transactions will be required to settle on a T+1 basis rather than the current T+2 timeline. The removal of the current 1-day buffer to identify a recall, has raised concerns around the increased risk of an institution failing to deliver on a sell on the contractual/intended settlement date.
Operational challenges and the impact of a trade fail are not limited to just two institutions e.g., the borrower and lender, but there may be a custodian and/or a securities lending agent (intermediary between the lender and borrower) involved in the process. Collateral substitution is an example of this, whereby the underlying collateral asset is sold, and multiple parties may be involved where there is re-hypothecation. This highlights the timeliness and rapid responsiveness required for a loan request, recall, reallocation or collateral substitution.
Concerns raised are with the timeliness of identifying a recall to satisfy the delivery of a sale. Recalls are not necessarily on a contractual settlement basis and the lender may not have any assurance as to when their stock will be back and available to them. The market deadline being discussed for a recall in the U.S. is 11:59pm, this means that the recall needs to be issued by this time and the borrower is required to return the stock the next day. There are significant Operational challenges with this and the need for a potential follow the sun model for non-U.S. domiciled institutions. Realistically, recall notices may not be picked up until the next working day and this will therefore have an impact on the success of that recall happening that day.
In a compressed timeframe there is an increased risk of overdrafts, caused by failed deliveries that result from the failure to return loaned positions in time. This risk has, in itself, raised two additional concerns:
- Firstly, the concern around market liquidity. By nature, securities lending increases market liquidity, however in a reduced settlement cycle, there is a risk of reducing the liquidity due to lenders retaining their stock to cover sales and reduce their risk of failing to deliver.
- Secondly, concerns have been raised in the industry that the cost of securities lending trading could be increased. As a safeguard against recall failures, there is a possibility that collateral requirements may be increased as a means of protection to the lender. The impact here is that by the lender trying to safeguard themselves, the increased cost could deter borrowers and ultimately reduce securities lending activity. This in turn could prohibit securities lending being a revenue earner for the lender. From the borrower’s perspective, they are required to act on recall instructions by 11:59pm on any given day and if they fail to return the stock the next day the lender may claim against them.
What should you do?
As with non-securities lending trades, successful management and settlement of these transactions in a T+1 environment requires both speed and accuracy, and automation is a key solution to these requirements.
Irrespective of your market position, when partaking in securities lending activity, there are key questions that you will need to answer. These are not new questions, but in T+1 these are questions that you will need answered on trade date:
- What are your positions in each security and in which depot are they held? e.g., Euroclear, DTC, CDS
- What securities are out on loan?
- What securities have been recalled?
- What securities are required in order to meet delivery obligations and where these securities can be sourced if unavailable?
- Has the security that has been sold been pledged as collateral that now requires substitution?
In order to answer these questions, it’s vital that certain factors are considered and applied to your organization in order to understand your readiness to support securities lending in a T+1 environment:
- Accurate and up-to-date record keeping:
- this includes any external reporting from custodians or lending agents e.g., position and settlement reports. How are these consumed? How frequently are they received?
- the creation and completion of accurate and timely reconciliations
- From a settlement level, it is essential that you know what your positions are and what has failed. It is fair to call out the dependency on Operations to settle non-securities lending transactions on a timely basis to ensure that the expected inventory is received
- Automation of processes and Technological requirements:
- There will be a compressed timeline to identify recalls and reallocation processes. As with multiple operational areas, automation is key and in a securities lending world, the recall process should be automated. If it is currently not automated, then an assessment of technological requirements should be performed
- Risk assessment:
- From a lenders perspective there may be a need for an increase in collateral requirements to support the increased risk of a client
- From a borrower’s perspective there may be a need for a wider operational review to ensure that market trades are settled on value date
Here at Capgemini we have the experience to help you assess your readiness to support securities lending for T+1. If you are yet to evaluate your broader post-trade processes across operations, we have the expertise and knowledge from our experienced subject matter experts to help support your T+1 program, including data analysis and counterparty outreach. For further information, visit Contact Us – Quorsus to get in touch with our team of experts.