The Bank of England released the minutes from March’s Securities Lending Committee meeting, with agenda items including recent market trends, diversity and inclusion, Environmental, Social and Governance (ESG) investing and indemnification.
Volatility was already easing at the time of the meeting after several bank failures in the US caused ripple effects. There were comments that the market feels “full,” with many at capacity amid increased demand from hedge fund clients. This environment was noted as predating the volatility caused by the collapse of SVB (Silicon Valley Bank). RWA consumption remains the biggest driving factor behind the constraints, with the rolling impact of Basel IV beginning to be felt more widely.
Other topics of discussion included T+1 settlement. Views on the overall effect on the securities lending industry are polarized. There are likely to be issues around settling recalls, with accelerated recall timeframes. Some members suggested that this might drive a bifurcated market where some lenders cannot get recall notices to borrowers until the settlement date. If the change is pushed too quickly it will only drive up the level of fails.
There could also be issues where there are settlement mismatches between markets. Specials will pose a particular problem. One alternative option would be to use tokenization which might be quicker, and apply less strain to the market.
Indemnification
The Committee held a discussion on the use of indemnities in securities lending. It was pointed out that agent lenders have to hold capital to account for the risks inherent in securities lending around the provision of indemnities – the cost of this is typically around 10-13bp, but this cost has historically not been recognized and fully compensated for in pricing.
Given the returns on securities lending are relatively low, the bulk of lending will struggle to be profitable to the agent if indemnified. For this to be at more realistically profitable levels, it was suggested that agent lenders will need to alter their pricing, or lenders may have to forfeit indemnification. However, indemnities are very important to many clients, to ensure that low income lending is risk free.
It was emphasized that agent lenders can still offer a service in the event of defaults. But, if the current paradigm continues, members felt that market liquidity will reduce.
The Committee noted that in recent events it was the spike in CDS levels that caused more issues than the wider volatility from SVB (Silicon Valley Bank). Whilst the effects were fairly modest, it has brought a lot more focus onto indemnities.
On the topic of ESG, there were observations that clients were talking about ESG regularly, but at the moment there is less discussion. Clients do use recalls and proxy voting, but collateral schedules are rarely affected. Repos and other transactions with underlying green collateral have had limited interest. Green assets can be used in repo transactions, but it is much harder to raise repo cash to specifically identified green usage. ESG was felt by several members to have been deprioritized as other global events (e.g. Ukraine) have taken up more attention.