The just released Bank of England Quarterly Report 2011:Q3 includes an interesting article on Securities Lending

“Developments in the global securities lending market” was authored by Matthew Dive of the Bank’s Payments and Infrastructure Division, Ronan Hodge and Catrin Jones of the Bank’s Financial Institutions Division and James Purchase of the Bank’s Sterling Markets Division. The article reviews the mechanics of securities lending, followed by a discussion of the risks and recent developments.

The BoE addresses interconnectedness in securities lending and how it can exacerbate contagion during times of stress.

In addition, the article looks at the opacity created in securities lending by

 Long counterparty chains,
 The lack of publically available data on transaction pricing
 The lack of understanding by some market participants of the risks of securities lending

The report examines how the markets have responded, noting more conservative guidelines imposed by beneficial owners, beefed up education efforts by the Securities Lending and Repo Committee (SLRC), and improvements to the Global Master Securities Lending Agreement (GMSLA) aimed at revising the methodology used to value collateral in the event of a default.

The article reviewed the benefits and disadvantages of CCPs in securities lending, noting,

“Provided CCPs are highly robust, they can potentially provide benefits to the securities lending market. By acting as a secure node within a network of financial institutions, they can reduce system-wide counterparty credit risk. And CCP margin methodologies, which are generally more standardised and transparent, should lead to more continuous and predictable changes in margin requirements. This can reduce the likelihood of sudden collateral calls on borrowers, which can cause them liquidity problems.”

The report also included that CCPs will bring additional expenses, especially the cost of providing margin.

The report had a section on collateral upgrade trades from the point of view of bank funding needs. They wrote,

“But these transactions may also be associated with risks to financial stability. In particular, the limited disclosure around these transactions may add to issues around opacity; as a form of secured funding they add to the encumbrance of banks’ assets; and because the transactions are subject to margining, the value of the funding they provide may vary lending they support. In addition, their recent appearance means the robustness of these transactions during stress is untested as is the capacity of the lender of securities to manage a default in a way that does not entail costly externalities for the financial system.”

Finally, the authors addressed the impact of regulatory changes on securities lending. With regard to Basel III, they wrote

“Banks borrowing or lending securities may need to allocate more capital to capture more accurately the risk of a counterparty defaulting. This could make borrowing securities more expensive for banks, which could in turn increase the cost of providing services such as market-making and the cost of collateral upgrade trades for bank funding purposes.”

About Solvency II, they included

“Market contacts note that Solvency II may lead to insurers having to hold additional capital against counterparty exposures to banks. This could increase the amount of capital held by insurers against securities loans. The additional cost of transactions may reduce insurers’ incentive to lend securities and could potentially be passed on to borrowers of securities through higher fees.”

The article also made reference to Dodd-Frank and the impact that closing down proprietary trading desks may have on securities lending. Concluding the section on regulatory changes, they wrote

Higher capital requirements for banks and insurers should make participants more able to withstand negative shocks and reduce the risks that arise from interconnections. But it could also reduce the supply of — and demand for — securities loans, diminishing some of the benefits to the functioning of the financial system associated with securities lending.”

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