June 2012

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Counterparty default or borrower indemnification is considered an important part of securities lending programs by many pension plans and mutual funds lending their assets to prime brokers, market makers and hedge funds. Indemnification clauses state that beneficial owners of securities will receive their assets or cash back in the case of a borrower default. This insurance is valued in particular by boards and senior managers at some of the largest lenders.

The future of counterparty default indemnification has been called into question by a series of regulatory initiatives designed to reduce risk in the banking sector. Basel III recommendations on leverage and capital usage could potentially have negative impacts on the practice if accounting for indemnification pushes banks above required ratio levels. In the US, several provisions of Dodd-Frank could constrain indemnification if accounting standards are set unfavorably, or if some parts of securities lending are considered as proprietary trading under the Volcker Rule. While few of these rules have yet to be fully clarified, the potential remains that indemnification could one day soon change from being a free offering included with most securities lending programs to one that is optional or comes with an explicit fee.

This briefing evaluates the main regulatory changes that could affect indemnification for US, European and global agency securities lending providers. The briefing concludes with ideas on quantifying the value of indemnification for both service providers and beneficial owners.

This briefing should be read by asset holders participating in the securities lending market and their legal advisors, and by securities lending agents, prime brokers, regulators and hedge funds that rely heavily on short selling.

This briefing is 17 pages.

■ Executive Summary

■ The Role of Counterparty Default Indemnification

■ Basel III Capital Requirements
– The Leverage Ratio
– The Liquidity Coverage Ratio and Other Measurements

■ Dodd-Frank and US Capital Impacts
– Sections 165 and 610
– The Volcker Rule
– The Orderly Liquidation Authority

■ Quantifying the Value of Counterparty Default Indemnification

■ About the Author

■ About Finadium


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