Experts at the Financial Stability Board (FSB) have cited regulatory inconsistencies and borrower default indemnification as areas in need of attention in the securities lending market.

In a recent paper, the international body acknowledged that, in general, regulatory tools and risk management practices seem to be in place for funds that engage in securities lending as beneficial owners and for asset managers acting as agent lenders.

However, the risk associated with agent lender indemnifications is a potential vulnerability that may have systemic implications.

Agents (often custody banks) provide their lending clients with indemnification against "borrower default" that is, if the borrower fails to return the securities that have been lent. 

This has given beneficial owners additional assurance as to the safety of their lending programs.

A limited number of large asset managers, such as BlackRock, act as agent lenders in securities lending markets and provide indemnifications to their clients’ securities lending programmes.

However, although very few asset managers seem to be currently involved in providing such indemnifications, the FSB reckons the scale of exposures can be as large as that of some global systemically important banks.

"If a shock occurred that was large enough to overwhelm an asset manager’s ability to meet its indemnification commitments, such an impairment could precipitate a contraction of securities lending activity if clients of other asset managers question the value of the indemnification they have received," said the consultation paper.

"Such a withdrawal could disrupt other market participants’ funding strategies, short positions, and collateral management activities, exacerbating market stress.

“This may force securities borrowers to exit their positions or find another lender of securities, possibly affecting asset prices and market liquidity," the document added.

BlackRock has previously pointed out that there have been only a handful of borrower defaults in the industry in the past thirty years.

In cases where BlackRock was involved, the firm held sufficient collateral to fund the repurchase of securities on loan.

It has also never had its indemnification agreements triggered or had to use its own monies to repurchase a security on a client’s behalf.

The FSB's paper adds that while some of the risks associated with indemnification (e.g. counterparty, collateral value) are similar to those faced by beneficial owners and are subject to similar regulatory measures, some risks remain that are not fully addressed by regulatory measures.

For example, asset managers and other entities that are not affiliated with banks do not face capital requirements related to their indemnification exposures in any jurisdictions.

FSB added that the difference in rules relating to indemnification risk for bank and non-bank agent lenders may create an incentive for agent lending activity to migrate away from 'prudentially regulated entities' and could result in a concentration of systemic risks outside the banking sector.

Comments on the consultation are due by September 21, 2016.