Inappropriate, unclear, lacking evidence, unfounded and based on an overemphasis of the risks—these just some of the descriptions offered by market participants on the draft of the G20-backed Financial Stability Board’s (FSB) policy recommendation on securities lending.
Despite this, the FSB’s final recommendation on securities lending, published on 12 January, remained identical to the initial draft that inspired more than 50 separate comment letters from market participants offering amendments.
As part of its extensive review into “structural vulnerabilities from asset management activities that could potentially present financial stability risks”, the FSB categorised securities lending as one of four key risk areas that required closer monitoring.
Specifically, the FSB concluded that the practice of agent lenders offering indemnification wholesale to their clients could be a risk to the financial stability of those asset managers and, by extension, the wider financial market.
“Although very few asset managers seem to be currently involved in providing such indemnifications, the scale of exposures can be as large as that of some global systemically important banks,” it said.
The multi-year fact-finding mission, which began in March 2015, resulted in 14 policy recommendations on a range of asset manager activities, from liquidity mismatch issues to handling operational risk.
Recommendation 14 proposed that regional market authorities “should monitor indemnifications provided by agent lenders/asset managers to clients in relation to their securities lending activities” in an effort to “detect the development of material risks or regulatory arbitrage that may adversely affect financial stability”.
Authorities must then “verify and confirm asset managers adequately cover potential credit losses from the indemnification provided to their clients”.
According to the FSB, the review was born out of a need to “assess the recent changes in the structure of asset management activities; identifying and prioritising potential structural sources of vulnerability that could affect the global financial system; evaluating the role that existing policy measures could play in mitigating potential risks; and making policy recommendations as necessary.”
The majority of the comment letters endorsed and encouraged the FSB’s mission to collect and distribute data on asset managers activities and perceived risks, but went on to comprehensively deconstruct the board’s argument for focusing on the service of indemnification.
Stuck between a BlackRock and a hard place
Of all the market entities that waded into the debate on legitimacy of focusing on indemnification as a source of systemic risk, none were more vocal than BlackRock.
In its response to the first draft proposals, BlackRock simply stated: “Potential losses to a securities lending agent or its clients due to borrower default indemnification is not a systemic risk.”
The firm said that the FSB should have considered whether data collection about borrower default indemnification provided by securities lending agents would be “additive to data reporting efforts”.
It added: “Both the value of outstanding loans receiving borrower default indemnification and the value of collateral posted against those loans should be collected and considered in tandem. However, in many cases, the consultation fails to differentiate between market risks that could result in losses by investors from vulnerabilities that could produce or transmit systemic risk.”
“For example … borrower default indemnification is a limited obligation, and any potential client losses are limited to the difference between the value of the lent security and the value of the collateral posted, and potential losses are further mitigated by various limits imposed by clients.”
BlackRock’s campaign on this particular set of recommendations began back in May 2015 when it released a whitepaper accusing policymakers of “misunderstanding the lending practice”.
It claimed that there are many misunderstandings specific to its own involvement with securities lending, and these have “unfortunately” formed the foundation of recent policy discussions. Ultimately, BlackRock regarded the proposal as inappropriate and unnecessary.
Feel the concern
The view that further reporting requirements on securities lending transactions and asset managers would only place further burdens on those affected was echoed repeatedly by other market participants and industry bodies.
The International Securities Lending Association summarised the views of its members to the initial proposal in four concise points: (i) Asset manager are subject to regulatory oversight by local and European regulators and as such will be required to disclose liabilities and capital adequacy; (ii) the absence of a formal capital regime does not prevent them from ensuring liabilities are monitored and accounted for; (iii) given the diversity of indemnifications, standardised reporting will be exceptionally difficult to impose with any accuracy and risks misinterpretation; and (iv) regulators have oversight of all the relevant information to apply the FSB recommendations without further need of additional reporting or regulatory initiatives.
Since the unchanged final draft was published, ISLA has reiterated its concern.
“We continue to support the work of the FSB in terms of moving to a more transparent market that will enable regulators and policymakers to better understand the securities lending markets.”
“Whist we note the focus on indemnification in the FSB’s latest recommendations in respect of asset management sector, we would stress that any form of indemnification should only been seen as a backstop to a well run and managed lending programme where the risks associated with lending are clear and well understood by the parties involved,” ISLA explained.
“It is also important to recognise that simply tracking indemnification may not reflect all of the risks involved as the nature and scope of indemnification may vary from programme to programme.”
In a similar vein, the Risk Management Association said: “The fact that the FSB did not expand the scope of its recommendation beyond monitoring confirms what many in the industry already know: there is no evidence to suggest that asset managers’ provision of borrower default indemnification contributes to systemic risk.”
“Many asset managers have expressed concern regarding any expansion of data collection that would be required to implement the monitoring recommended by the FSB.”
“They fear it could cause significant operational burdens for them and increase costs to investors—all to monitor an activity that has not been shown to contribute to systemic risk.”
The International Capital Market Association (ICMA), along with others, including BlackRock, raised concern over an apparent misconception regarding differences between banks and asset managers acting as agent lenders. ICMA stated: “We have more concern about the claim that different regulation of banks and asset managers could lead to regulatory arbitrage in securities lending.”
“There are important differences between banks and asset managers that are reflected in their regulatory frameworks.”
“Most importantly, asset managers do not rely on government-insured deposits to support their liquidity and asset managers do not have access to central bank liquidity.”
Simply, because asset managers are not a utilising taxpayers money for their balance sheet, unlike most banks, they should not be held to the same high level of capital requirements.
Finally, the Association of the Luxembourg Fund Industry, which is not a regular contributor to debates on niche markets such as securities lending, commented: “We agree with the focus on the risks identified, although we believe some risks are overemphasised, such as securities lending and transfer of accounts.”
The FSB’s decision to ignore these concerns bucks an emerging trend of stronger ties between market participants and regulators.
This trend recently saw the European Securities Markets Authority (ESMA) highly praised for its pragmatic handling of potential pitfalls in the Securities Financing Transaction Regulation (SFTR).
After receiving a deluge of industry comment, a well-informed ESMA smartly sidestepped one of the industry’s worst fears of creating a major liquidity issue by revising its collateral reporting rules in its second-level consultation, published in October 2016.
It’s worth bearing in mind that the FSB’s recommendations are just that, and it will be up to individual market authorities to interpret them.
The vast majority of industry opinion seems sceptical, at best, as to their usefulness.