Fallen by the sell side

The business case for indemnification, a tried and tested truth of securities lending’s robustness if ever there was one, is increasingly being found wanting

The wave of regulation that came in the wake of the 2008 financial crash was significant enough to reshape the entire landscape of the securities lending sector, and nothing, even established features like indemnification, were spared.

Since the deluge of new regulatory demands—think Basel III et al—first began to transform the market ecosystem, the issue of indemnification has been bubbling away. Beneficial owners, or even securities lending as a whole, were never the primary targets of regulators, although shadow banking reforms threaten to change that. Nevertheless, the trickle down effect of their decisions has undoubtedly made its mark on both sides of the trade, through new capital and liquidity requirements and balance sheet restrictions, just to name a few.

Beyond the regulatory concerns, beneficial owners have also become a victim of their own success, as far as indemnification is concerned. What started as an enticing method used by agent lenders to bring beneficial owners back into the securities lending market after the crash has, thanks to massive growth in lending volume and average value, become difficult to sustain.

Today, some agent lenders say indemnification is too expensive, under-valued and unnecessary in an ultra-regulated trading environment. Many beneficial owners counter that indemnification is still an essential aspect of a securities lending programme and not to be tampered with.

It now serves to highlight the question of who needs who more in the agent lender-beneficial owner relationship. Do beneficial owners enjoy enough returns to justify them paying the extra costs for indemnification, which, in the end, is employed to satisfy their own investment guidelines? Or, given the negligible risk of loss compared to the cost of the cover, are they able to go without?

Alternatively, in a marketplace where supply dwarfs demand, do agent lenders need to accommodate beneficial owners’ strict lending parameters, just to keep their assets available for lending?

J.P. Morgan’s Paul Wilson argues: “As an agent lender, we expect to be paid a fair price for a fair service, and indemnification is part of that.”
“It would be fair to say that, historically, indemnification has perhaps been under-valued, under-appreciated. Indemnification is certainly a key topic across the industry and for some agents. To be honest, it’s probably one of the main issues for many.”

At IMN’s recent Beneficial Owners’ International Securities Lending & Collateral Management Conference in Arizona, the future of indemnification featured prominently. During one panel discussion, it was described by Citi’s David Martocci as the elephant in the room.

Another panel of agent lenders and prime brokers agreed unanimously that the problem with indemnification, as it currently exists, is that it’s stagnant. They said it must evolve, given the pressure on spreads and increasingly onerous capital requirements.

The growing demand for upgrade and term trades within securities lending has also altered the state of play when it comes to borrower default indemnification.

As a result, blanket cover indemnities, currently enjoyed by some beneficial owners, are becoming a deeply unpractical and uneconomical offering for some agent lenders.

Wilson offers a more detailed explanation, saying: “This can create two issues for agents. Firstly, it’s a question of capacity and having a sufficient capital base to support it. Second is whether there is a sufficient or reasonable return on equity being generated on that capital.”

“In an environment where borrowers are looking to undertake more financing and/or balance sheet efficient trades, most notably upgrade and term trades, the consiquence of which is a shifting or increased expense for the agent.”

The issue divides opinion among beneficial owners as much as agent lenders and brokers. Nevertheless, some typical investors, such as pension funds, are revisiting the question.

During one of the many indemnification-related debates at the IMN conference, panellist Gino Timperio of State Street suggested that a small but increasing proportion of State Street’s clients are willing to forgo indemnification.

Wilson, on the other hand, states: “In conversations with our clients we know they really value the J.P. Morgan indemnification. I have seen some research and surveys that suggest that a good portion of beneficial owners are willing to consider foregoing indemnification but that doesn’t really seem to be a message we have been hearing.”

On the other side of the debate, speaking up for the conservative beneficial owner, Roelof Van Der Struik of PGGM Asset Management, said: “The main purpose of indemnification is that it aligns us with our agent lender because if we lose money, they lose money.”

Fortune favours the brave, however, and beneficial owners willing to shed the restrictive safety net of an indemnity—widening their acceptable collateral parameters at the same time—will be well placed to capture revenue from the regulatory-driven demand by borrower for term and evergreen lending transactions.

At the same time, as the possibility of a post-indemnification world becomes more likely, it also reinvigorates the debate around the use of central counterparties (CCPs). For beneficial owners in need of a new form of investor protection to enable their securities lending programme to continue, CCPs may be the answer.

Commenting during a virtual roundtable in January 2015, James Slater of BNY Mellon said of CCPs: “Capital requirements and the leverage ratio are driving interest around the utilisation of CCPs. This isn’t a new topic of conversation in the securities finance space, but it continues to attract more serious attention from market participants.”
“We see most CCPs with committees or groups working on potential solutions for the securities finance market—in particular, to address participants’ concerns around added costs, how to maintain confidence when participants don’t get to choose counterparties, and the measures put in place to mitigate various processing risks.”

Despite the regulatory impacts on indemnification being well known and well discussed for several years, it’s still too early to tell which way the industry will go as the requirements come into effect.

During the IMN conference, a snap poll of the audience, which included representatives from all aspects of the securities lending sector, found that 100 percent of the buy side in attendance would be willing to negotiate different cost levels to borrow securities based on the risk weighting of beneficial owners.

For beneficial owners in the room, 31.3 percent said they would be willing to lend without indemnification. Citi’s Martocci gave context to this figure, stating that if that question was posed even up until a year ago, he would have expected the percentage willing to do so to be around 5 percent.

Only 38.9 percent of beneficial owners said they would be willing to adjust their fee splits to include an indemnification feature, suggesting there is a small group of beneficial owners unwilling to lend without an indemnity but also unwilling to negotiate less favourable fee splits to pay for the service.

Only time will tell what happens to this demographic of lenders, but James Vance of the Western & Southern Financial Group, offers one pessimistic possibility, concluding: “Some pension funds will look at all the changes that are happening in the industry and say it isn’t worth it anymore.”

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