Addressing default and collateral risks with blockchain
Securities lending generates billions of dollars in revenue for investment firms, including mutual funds, pension funds, insurance companies, exchange traded funds, and sovereign wealth funds.
May 3, 2017
A blog post by Rohit Kataria, Investment Management senior analyst
In 2016, global securities lending revenue amounted to $9.16 billion, and North America accounted for the largest share, at 51 percent.1 Securities lending may seem like a straightforward practice, but it’s actually fairly complex. A typical securities lending transaction involves multiple entities: borrower, lender, lending agent, prime broker, and clearinghouse. Lenders typically include various investment firms, as noted above, whereas, broker/dealers and hedge funds make up the bulk of the borrower group. Lending agents, on the other hand, are broker-dealers, custodial banks, and some large asset management firms as well.
In almost every securities lending transaction, lenders are exposed to multiple risks, such as counterparty default risk, collateral reinvestment risk, market risk, liquidity risk, operational risk, and legal risk. In particular, counterparty default risk and collateral reinvestment risk seem to have captured the most attention from regulators.
Counterparty default risk can be mitigated if the lending agent indemnifies against borrower default. Indemnification is a standard industry practice, so it may be argued that material loss due to borrower default is quite unlikely. Nevertheless, the Financial Stability Board (FSB) expressed the opinion that the indemnification exposure of non-bank affiliated investment management firms engaged in agency activities is large enough to create systemic implications.2 To address this concern, the FSB recommends that regulators closely monitor securities lending programs to identify emerging risks or regulatory arbitrage and test the ability of indemnification providers to cover potential losses.3
The second material risk is collateral reinvestment risk. When lenders or their agents receive collateral, they reinvest it to generate additional yield. Cash is the most favored form of collateral and is often invested in liquid assets, such as money market funds, repurchase agreements, and deposits. Lenders could be exposed to hidden risks if the reinvestment strategy is aggressive and the collateral is invested in volatile and/or illiquid assets. These risks should be monitored closely.
In its role to protect investors’ interest, the Securities and Exchange Commission (SEC) aims to enhance oversight, transparency, and information disclosure of securities lending programs of mutual funds. With the Investment Company Reporting Modernization rule, the SEC mandated mutual funds to furnish the following information:4
- Aggregate value of all securities on loan and counterparty information
- Aggregate principal amount and value of collateral, and asset class (in case of non-cash collateralization)
- Net income from lending activities and associated fees
Improved transparency, regulatory oversight, periodic due diligence of the program, and working closely with the lending agents could minimize destabilizing outcomes and help investors better understand the intrinsic risks associated with securities lending programs.
But emerging technologies, such as blockchain, could also be very helpful in this effort. The potential of blockchain to enable increased transparency, create audit trails, make records immutable, and the near real-time nature of transactions may transform the securities lending process, and possibly the roles of all parties involved.
This promise has stimulated the interest of banks, investment management firms, and others into testing and launching prototypes of blockchain solutions to transform the securities lending process. For instance, the transparency into the activities and status of the borrower, the lending agent, and the reinvestment vehicle would enable lenders to more effectively manage default and reinvestment risk. In addition, the activities of the lending agent could also become more efficient.
One blockchain prototype in the market today eliminates the manual intervention by the agent to transfer a collateral back to the borrower’s account by converting it into a digital token that can be used for other transactions, and a digital, immutable record of how the collateral has been invested is created on the distributed ledger. This approach enables the collateral to be transferred to the borrower’s account as the lending position is settled, and may help meet reporting requirements throughout the process.
The potential of blockchain to enable increased transparency, create audit trails, make records immutable, and the near real-time nature of transactions may transform the securities lending process.
What do you think?
What are your thoughts on the risks associated with securities lending? Could blockchain help manage the risks effectively?
1 “The Purple,” research publication, Datalend, February 2017
2 Agent lender banks and bank-affiliated investment managers are governed by the Basel rules and other regulations in different jurisdictions
3 “Policy Recommendations to Address Structural Vulnerabilities from Asset Management Activities,” Financial Stability Board, January 12, 2017
4 Final rule, “Investment Company Reporting Modernization,” Securities and Exchange Commission, October 13, 2016
QuickLook is a weekly blog from the Deloitte Center for Financial Services about technology, innovation, growth, regulation, and other challenges facing the industry. The opinions expressed in QuickLook are those of the authors and do not necessarily reflect the views of Deloitte.