Securities lending has become an established practice today in the financial markets where it performs the dual purpose of providing liquidity to the markets for settlement of transactions as well as allowing investors to generate additional returns on the securities they own on their own balance sheets. There are however, some risks that are embedded in these transactions that the investor investing needs to be wary of. Some of these risks include counterparty risk, collateral reinvestment risk, operational risk and non-cash collateral risk.
With counterparty risk, lenders need to be aware of the possibility that borrowers may default on the loan that the lender provided with the security, leading them to be unable to return the borrowed security. This is a primary reason that lenders conduct extensive due diligence on the creditworthiness of borrowers as well as require collateral to be posted on the part of the borrowers that can be liquidated to claw back some of the losses. Once the collateral is posted, provided it equals or exceeds the security value, the lender can lay claim to the return from that collateral if they enforce their rights quickly enough under the lending agreement.
The second type of risk in securities lending is that of reinvestment. When collateral is posted by borrowers in the form of cash, that cash is reinvested in order to earn the interest income on that cash. However, in this scenario, there is a possibility of losing the principal cash amount. During the financial crisis of 2008, there were two problems that arose. One was the liquidity in the pools of cash collateral and the other was the losses that arose from these pools. The liquidity problems in cash collateral pools were a direct consequence of the lack of liquidity in the underlying investment which forced lenders to limit withdrawals from those pools.
The regulatory environment in the United States has made cash collateral the prevalent form of posting collateral by borrowers in these securities lending and borrowing transactions. However, outside of the United States, non-cash collateral has been increasingly common even as American regulators have been skeptical about it, in part owing to unfamiliarity as to how it’s governed. However, the greater concern is about the question of its robustness and the frequency by which the collateral should be marked-to-market. Besides the initial valuation parameter, fluctuations in the value of the collateral can cause the lender to be adversely exposed to a downturn in financial markets. This risk is largely mitigated by marking to market daily and adjusting collateral requirements between the two parties accordingly.
The last affiliated risk with securities lending and borrowing is that of operational risk which may not be unique to securities lending itself, but certainly plays a part in any and all investment activities. In securities lending specifically, there can be stock exchange problems, miscommunications between the two parties, missed record dates, reconciliation failure, mark to market inaccuracy etc. The problems hence mentioned are not affiliated with that of the underlying value of the collateral or its ability to be clawed back, but more so problems arising out of the technology or human infrastructure that financial markets today run on. It is a pertinent reminder that while technology has come a long way from even a decade ago, there is still potential for failure that can adversely impact the activities of both lenders and borrowers.
While there have been discussions on whether one form of collateral is better than the other, it is believed that there is no singular answer. Any form of collateral may be appropriate as long as the lenders understand the liquidity and volatility of the underlying collateral and price them accordingly. In addition, using a variety of collateral can also reduce risk by providing adequate diversification which has led to some market players lobbying regulators to permit a range of collateral usage of equities and bonds as well.