Of all the obstacles that securities lending CCPs must surmount in order to achieve success, processing voluntary corporate actions may seem like the least of them. However, we are now at the point where the details truly matter and the devil is having a field day with them. The problem with voluntary corporate actions in a CCP environment is that no one is there to guarantee the other side. This problem must be resolved for lenders to feel comfortable that a CCP will manage this type of risk exposure.
In a voluntary corporate action, a company may put out a Rights issue or may have some sort of voluntary reorganization. If this were a transaction between two large counterparties, both sides would have the weight or clout with each other to enforce that the lender receives all the proper rights, shares or cash that it was due. In a securities lending transaction with a smaller counterparty, typically a MSLA create a legal framework that ensures that the lender is made whole.
Since CCPs have neither an MSLA nor a moral or commercial obligation to follow through on a voluntary corporate action, this can create uncertainty in the potential for risk from the lender’s point of view. The best solution here is that the CCP offer a contractual guarantee that it will deliver all voluntary corporate actions. However, this creates excess risk on the CCP side and means it would have chase down a borrower to ensure that all obligations were fulfilled. CCPs are unwilling to do this, and we agree that to put them in this position would be a mistake.
Another possible solution is that every lender on a CCP have an MSLA in place with every borrower. While time-consuming to create, this would allow each lender to track down each borrower in case a voluntary corporate action were not properly delivered. In this case, we think that the value of the CCP would be diminished; why have the CCP in the middle if lenders were prepared to do business with any counterparty that could even just qualify to be a CCP member? Perhaps the CCP would still be useful from a risk capital perspective but it would not satisfy member needs for counterparty credit protection.
Since on the surface is desirable to have CCPs be in the middle of certain securities transactions from a risk capital perspective, we will make the argument today that the idea of each lender creating an MSLA with each borrower is impractical. Instead, what else can CCPs do to improve the situation?
While we have not yet heard anything from the OCC, Eurex has provided us with documentation about their proposal for how to handle voluntary corporate actions. It is Eurex’s business and not ours to talk about their details, but we find it compelling to note that an advanced solution is something along the lines of a bilateral negotiation. This may ultimately be where CCPs must wind up in order to manage the variety of possibilities that could arise while maintaining their own risk-neutral position. This does not solve the guarantee problem but could be a safe middle ground that lenders would trust.
Whatever the outcomes, managing the risk associated with voluntary corporate actions has been a sticking point to adoption of securities lending CCPs. This will be the next challenge that CCPs must address in the securities lending space to achieve success.