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Regulatory burden is the main concern for RMA

07 September 2011

As a series of regulatory developments start to affect the securities lending, the Risk Management Association’s director of securities lending and market risk, Christopher Kunkle, explains how the sector will cope. Annabelle Palmer reports

Read more: RMA SEC securities lending Chris Kunkle SIFMA

Global Investor/isf: There are a vast number of regulatory developments for the financial sector now - which is the most important for the securities lending industry?

Chris Kunkle: They are all important. The reason we decided to have a regulatory front-end to the conference is because there’s so much occurring in the US, Europe, and Asia at the moment. We’re looking at how regulations could negatively affect the securities lending industry, what could be misunderstood or misinterpreted, and how securities lending relates to various other industries such as the short selling and the prime brokerage industries.

With respect to the Dodd-Frank regulation, we have worked hard with the Securities and Exchange Commission (SEC), as has the Securities Industry and Financial Markets Association (SIFMA) and others, to help them understand securities lending so we don’t get an uninformed policy affecting the business. That has been very important.

Another concern is the Federal Deposit Insurance Corporation’s (FDIC) Orderly Liquidation Authority (OLA). If there is a default of systemically important financial institutions there are certain requirements for the liquidation of collateral. Securities lending may fall into this and OLA’s stay provision means a court, or creditor, could hold up the ability to liquidate collateral. The collateral could drop in value so you don’t want it held for a day or five days. That’s a fairly significant issue.

Is there a possibility that these developments will coalesce into a global regulatory standard?

Basel III is a generally accepted financial standard in the banking arena. And theInternational Organisation of Securities Commissions in Spain has representatives from various exchanges and regulators that participate on its board as part of a global regulatory process.

Global regulatory standards are not there yet, but various regulators do look at what is going on with other regulators. The Fed watches what goes on in London, London watches what goes on in the Fed, and Asian regulators look to see what the SEC is considering in terms of securities finance regulation. But I don’t know if they are perfectly correlating.  The Financial Stability Board is also an organisation that is also going to affect global coordination from a regulatory standpoint.

Are central clearing counterparties (CCPs) a positive development? Can they mitigate counterparty risk in securities lending?

We are all still learning about CCPS. You see a lot of a discussion about them, but are they driving away the bilateral securities lending arrangement? And will they fully replace that? I don’t think so.

It’s not that I don’t want them to succeed but I don’t think they have proven they mitigate risk yet. Some lenders have a relationship where they have to go to a participant that can clear on the central clearing counterparty and hence you are actually still doing a bilateral arrangement with the people that then trade into the underlying CCP. I think a lot of learning still needs to be done.

Also, the idea that both the borrower and lender provide margin to the CCP, in the form of additional collateral, does not make sense to the beneficial owner and will be a hard sell.

So beneficial owners are not too happy about it then?

They won’t do it if they have to provide an additional margin and their by-laws may not even permit that. They don’t have to do it in a bilateral arrangement right now. Go tell a large mutual fund or pension fund: ‘you are going to have to provide additional 102% collateral into the CCP’. It’s not going to go down well.

Also, prove to me in a massive default, or even a slight default, that a CCP is better at liquidating. A CCP doesn’t have capital so who are you going to go to? All of your participants?I am neither for CCPs nor against them. They had just better prove where they are going to mitigate risk and protect clients.

Is securities lending risky?

If you lend securities and take cash collateral, the cash collateral has to be invested. In the 2008 liquidity crisis problems occurred. You have several lawsuits going on right now because clients lost money. Many invested according to proper guidelines but if they had a portion of broker paper, such as Lehman or structured investment vehicles (SIVs) they took a hit. 

Remember that SIVs were in the portfolios of a majority of US money market funds under 2(a)-7 guidelines and they were acceptable investments in those vehicles. This was not a securities lending investment pushing some outer realm of quality.

Did people understand the risks at that time?

I came from a client relationship management background and I feel my clients and other agents’ clients were firmly aware of what they were doing. I know at several firms I have been at, we went out of our way to make people understand where their money was being reinvested.

How do you compare what happened in 2008 with the collateral reinvestment problems that happened in 1994 with the collar and cap mortgages?

I think it was drastically different. In the early 1990s there were sometimes not comprehensive investment guidelines in place and investments may have exceeded product guidelines. In 2007, these investments were clearly mandated in investment agreements and clients were aware that these investments were being made. 

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