May 2014
Borrower Default Indemnification in the Securities Lending Marketplace
Securities lending refers to a practice through which financial institutions, typically banks, broker
dealers or market makers (known as “Borrowers”), borrow equities or bonds to be used in financial
transactions for themselves or on behalf of their clients. The owner of the securities (known as a “Lender”)
requires the Borrower to post collateral in the form of cash or securities in an amount in excess of the value
of the securities lent. Lenders participate in these arrangements in order to earn fees from the Borrower. In
addition, in cases where the Lender receives cash as collateral, additional returns may be generated from
investing the cash.
Securities lending benefits the broader capital markets by increasing liquidity and facilitating activity
among market participants. As of December 31, 2013, more than $14.8 trillion of assets were available for
i
lending globally, with more than $1.8 trillion on loan on a daily basis. This incremental liquidity increases
transactions in the marketplace, facilitating price discovery, enhancing efficiency and helping to mitigate
ii
price volatility and settlement failures.
As with most financial market activities, securities lending involves risks as well as benefits. These
risks include credit risk exposure to the Borrower and reinvestment risk when cash is posted as collateral.
Over the past few years, virtually every aspect of securities lending has been scrutinized and many
changes have and continue to be made. These changes include stricter rules on collateral management,
iii
modifications to fee structures and increased transparency. This paper provides an overview of the
securities lending business and addresses specific questions that have been raised regarding the use of
indemnification.
Securities Lending Overview
Lenders may transact directly with Borrowers, but more commonly they engage a securities lending
agent to act on their behalf. A Lending Agent is not a principal to a securities loan, but is retained by the
Lender to arrange, manage and report on securities lending activity. The Lending Agent may also invest
the cash collateral received in connection with a loan. Of the top five global securities lending agents, four
(Bank of New York Mellon Corp., State Street Corp., JPMorgan Chase & Co. and Northern Trust Corp.)
offer securities lending agency as part of their custodial services, and the Lenders’ income generated from
securities lending may be used to offset a portion of custody or other fees. Most Lenders contract with
Lending Agents that are custodial banks or third party Lending Agents (such as eSeclending) although
asset managers such as BlackRock, Fidelity and Vanguard act as Lending Agents as well.
BlackRock engages in securities lending solely as a Lending Agent on behalf of our asset
management clients. The vast majority of the portfolios managed by BlackRock that engage in securities
lending are index portfolios where securities lending is a component of the investment process. BlackRock
offers this service to both funds and separate account clients. BlackRock has built a proprietary securities
lending infrastructure integrated into our portfolio management process that ensures securities lending
activity is executed in BlackRock’s clients’ best interests and with prudent risk management.
1
One of the risks of engaging in a securities lending transaction is that a Borrower could fail to return
a security to a Lender. This might happen because a Borrower is experiencing financial difficulty, or
because market conditions are such that the Borrower is unable to obtain the security in question to return
to the Lender. BlackRock’s Risk & Quantitative Analysis group (RQA), an independent function within
BlackRock, works closely with our Global Trading team to manage the risks associated with securities
lending. Risk management for securities lending starts with the selection of counterparties who must be
approved by RQA. BlackRock’s securities lending program only approves Borrowers that are wellcapitalized, highly regulated financial institutions and which are subject to ongoing monitoring by RQA.
The next major step in risk management for securities lending involves collateral. Every loan is
over-collateralized and the collateral is marked-to-market daily and adjusted to reflect any changes. At a
transaction’s initiation, Borrowers must provide collateral in excess of the value of the securities borrowed.
Cash is the most common type of collateral pledged by Borrowers in the U.S., whereas European and
Asian Borrowers typically collateralize their loans with high quality, liquid securities. Regulations governing
U.S. based Lenders require that security loans be collateralized at no less than 100% of the value on loan,
though U.S. market practice requires 102% for U.S. securities and 105% for non-U.S. securities. In
instances where a Borrower posts non-cash collateral, the common market practice is for the Lending
Agent to require a higher percentage of collateral relative to the value of the loaned securities. As such,
BlackRock typically requires counterparties to post collateral between 102-112% of the value lent. This
provides an additional “safety cushion” in the collateral value in the event that a Borrower fails to return the
security that is out on loan. As a further measure, loans and collateral are marked-to-market daily and the
Borrower may be required to deliver additional collateral to maintain the required excess level. Failure by
the Borrower to meet its mark-to-market obligations could constitute a default under the relevant securities
lending agreement.
Another area of risk involves the investment of cash collateral. During the financial crisis, some
cash collateral reinvestment pools managed by Lending Agents experienced price declines and in some
cases, losses. Since then, the Securities and Exchange Commission (SEC) in 2010, the Office of the
Comptroller of the Currency (OCC) in 2012, and the European Securities Markets Authority (ESMA) in
iv
2010 modified the rules for money market funds (MMFs) and short-term investment funds (STIFs). As of
v
the writing of this letter, the cash investment fund rules for state-chartered banks have not been modified.
As noted in Exhibit 1, the current SEC, OCC, and ESMA guidelines for MMFs and STIFs require high
quality, short maturity securities as well as specifying portfolio liquidity requirements, portfolio stress
testing, and greater transparency and disclosure.
2
Exhibit 1: Key Rules for Cash Management Vehicles
SEC Rule 2a-7
•
Quality /
Concentration /
Diversification
Maturity
Liquidity
•
•
•
Max. WAM: 60 days
Max. WAL: 120 days
•
≥10% in daily liquid
assets
≥30% in weekly liquid
assets
•
•
Stress Testing
•
Transparency /
Disclosure
Max. issuer
concentration: 5%
vii
Max. 2nd tier issuer
viii
concentration: 3%
OCC STIF Rules
•
Portfolio and issuer
quality standards and
concentration restrictions
must be identified,
monitored and managed
•
•
Max. WAM: 60 days
Max. WAL: 120 days
•
Liquidity standards,
contingency plans for
market stress must be
developed and regularly
tested
Required to periodically
stress test MMF to
examine MMF’s ability
to maintain a CNAV
•
Monthly public
disclosure of portfolio
holdings and additional
data (i.e. “shadow
NAV”)
•
Required to periodically
stress test STIF to
examine STIF’s ability to
maintain a CNAV
Monthly disclosure to
client and OCC of
portfolio holdings and
additional data (i.e.
“shadow NAV”)
vi
ESMA Guidelines
•
•
High quality instruments or
ix
deposits
Concentration and
diversification limits
Short-term MMFs:
• WAM ≤ 60 days;
WAL ≤ 120 days
• 397 days residual maturity
Standard MMFs:
• WAM ≤ 6 mos.;
WAL ≤ 12 mos.
• ≤2 year’s residual mat.
w/reset 397 days
•
Liquidity risk must be
monitored and managed
•
Required to periodically
stress test
•
•
Daily NAV, price calculation
Daily
subscription/redemption of
units
At BlackRock, RQA monitors compliance with cash collateral reinvestment guidelines with credit
analysis and decision making independent of portfolio management. The team currently managing the
cash management funds and accounts has acted in advance of credit rating agency downgrades in 91 out
of 93 instances over the past decade – eight months in advance of those downgrades, on average. All
cash management funds and account assets are held at third party custodians and are segregated from
BlackRock’s own assets.
Within the U.S., the market standard is the use of cash collateral, however, outside the U.S., it is
common to use non-cash collateral. In these markets, BlackRock accepts high quality, liquid non-cash
collateral, primarily in the form of government bonds and equities. RQA approves the types of collateral
that counterparties are allowed to pledge for non-cash collateralized loans, and RQA specifies collateral
“haircuts” to ensure an appropriate “safety cushion” is in place. Risk assessments of each security and
Borrower are conducted daily to ensure that non-cash collateral conforms to the internal schedule and
requirements, and, if necessary, BlackRock can require a Borrower to provide additional collateral or recall
the lent security. BlackRock maintains all non-cash collateral in an approved escrow account, segregated
x
from other client assets and from BlackRock’s own balance sheet.
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Indemnification Liability
xi
For over two decades it has been the practice of Lending Agents (both custodial banks and asset
managers) to offer to some Lenders indemnification against “Borrower default”—that is, if the Borrower fails
to return the securities that have been lent. Some Lenders are required by their investment policies to
have this type of indemnification in order to participate in securities lending programs. Borrower default
indemnification is limited to the “shortfall” that could occur in the event the collateral delivered is insufficient
at the time of default to acquire replacement securities for those out on loan. As an example, in the event
of a Borrower default, if a Borrower had provided $102 of collateral to borrow securities currently valued at
$100, and the cost of repurchasing the loaned securities was $103, the indemnification provider would
make the Lender whole for the difference between the collateral received and the cost to repurchase the
loaned security. In other words, in order for the indemnification to be triggered, there would have to be
both a Borrower default and the value of the collateral received would need to be insufficient for
repurchase—a confluence of events that has been rarely experienced by any Lending Agent. Importantly,
the Lending Agent does not guarantee the investment performance of the securities lending arrangement
including the returns on any cash investment vehicle. As of December 31, 2013, BlackRock had
indemnified $118.3 billion of client securities on loan and Borrowers have posted collateral of $124.6 billion,
or 105% of the value on loan. In the unlikely event of a Borrower default, BlackRock would use the
Borrower’s collateral to repurchase the lent security on behalf of the client. If there was a shortfall between
the value of the collateral and the cost of repurchasing the security, BlackRock would cover the shortfall.
As a Lending Agent on behalf of clients, BlackRock has a strong incentive to have robust risk management
practices. In the more than 30 years since BlackRock and its predecessor entities started our securities
lending program, there have been three instances of Borrower default in our program (and four instances in
the industry in total). In each instance, BlackRock (including its predecessor entities) has held collateral
sufficient to fund the repurchase of securities on loan and has never had its indemnification agreements
triggered or had to use its own monies to repurchase a security on a client’s behalf.
BlackRock is required to account for the fair value of any potential liability associated with the
indemnification on its balance sheet in accordance with Generally Accepted Accounting Principles (GAAP).
As a corporate risk for BlackRock, RQA monitors total notional indemnified loan balances (across all
counterparties) and total risk daily, and these exposures are reviewed by the BlackRock Corporate Risk
Management Committee on a regular basis. RQA also periodically conducts stress testing to determine
whether BlackRock maintains sufficient liquidity should a Borrower fail to return a security and there is a
shortfall in the collateral needed to replace the security. While the stress testing methodology is reviewed
and updated as required, currently our practice is that for each Borrower, we make an estimate of the
potential collateral exposure in the event that the counterparty defaults. Our methodology does this by
multiplying: 1) Value-at-Risk of indemnified balances (net of collateral received) over a 5 day liquidation
horizon at a 99% confidence level, using current volatilities; 2) 40%, which is an industry standard
applicable recovery rate used by market participants as an assumption of how much of a defaulted
exposure one would expect to recover and 3) the probability of counterparty default using current credit
default swap (CDS) spreads. The fair value of the indemnification liability at December 31, 2013, was
immaterial to BlackRock’s financial statements.
Notwithstanding the immateriality of the liability on a current “expected value” basis (and in
accordance with GAAP), BlackRock also evaluates an estimate of “stress risk” to ensure we have adequate
liquidity to support potential indemnification needs in the event of a “stress event” where the market
environment may look very different from today. Our methodology is based on a potential default of the
largest borrower under the indemnity, to which a “stress risk” factor of 6% is then applied. Consequently,
BlackRock holds over $1.0 billion in unencumbered liquidity against potential indemnification exposure as
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part of its ongoing corporate liquidity management program, and has access to an additional $6 billion of
liquidity, both in the form of unencumbered cash and a $4 billion, 5-year bank credit facility.
BlackRock has reviewed both current and prospective regulatory capital treatment of
indemnification. To date, we believe that the regulatory capital treatment of indemnification for U.S. agent
banks has not been a significant contributor to risk weighted exposures and capital, as the overcollateralization of securities loans, often with Treasury securities or cash, translates to a low (or in some
cases zero) risk-weighted charge. We understand that, with U.S. regulatory approval, some agent banks
have had the option of using internal Value-at-Risk modeling methods as an alternative to standardized
models-based approaches to comply with regulatory requirements. Going forward, the proposed rules
contemplate a new set of "standardized" haircuts based on loan and collateral type, which will need to be
applied to both loans and collateral, with no correlation offset. This is likely to increase the risk-weighted
exposure and capital associated with indemnification. A comparison of current versus prospective
requirements, based on a simplified, representative indemnified portfolio, has been published recently by
Glenn Horner of State Street Global Markets in The Value and Cost of Borrower Default Indemnification
xii
(State Street Digest of Topics in Securities Finance, Issue 1, November 2013 ).
Based on its review, and recognizing that actual estimates of risk weighted exposure will be both
institution- and portfolio-specific, BlackRock is reasonably confident that its unencumbered liquidity
holdings are comparable to our understanding of the proposed regulatory capital treatment of securities
lending.
FSOC’s 2013 and 2014 Annual Reports
On April 25, 2013, the Financial Stability Oversight Council (FSOC) published its 2013 Annual
xiii
Report which included a section on “Securities Lending” . Importantly, the FSOC’s report suggests that
while securities lending should be monitored, it does not present an imminent threat, and acknowledges the
use of indemnification in securities lending arrangements.
On May 7, 2014, when the FSOC published its 2014 Annual Report, securities lending
indemnification by asset managers was identified as a new practice and the following statement appeared
xiv
under “Potential Emerging Threats” :
“Some asset managers are now providing indemnification to securities lenders as part of
their securities lending business. There are likely benefits for asset managers from
combining indemnification provision with securities lending, but there also is the potential
for enhanced risks. Unlike banks, asset managers are not required to set aside capital
when they provide indemnification. Also, although asset managers have access to
management fees, they do not have access to banks’ stable deposit funding base.
Consequently, the indemnification that asset managers provide may be a source of stress
on their own balance sheets, while at the same time resulting in lower protection for the
lenders relative to indemnities provided by banks.”
Securities lending indemnification is not a new practice, and this statement implies that banks have
stronger credit profiles than asset managers and that they can use their deposit base to support securities
lending.
We can only speak for BlackRock. We are rated A1 and AA- by Moody’s and S&P, respectively,
which is among the highest in the asset management industry and equal to or higher than other Securities
Lending Agents (See Exhibit 2). As noted above, the contingent liability is disclosed in our financial
statements, and BlackRock maintains a high level of liquidity. Importantly, BlackRock does not rely on
wholesale short-term funding or FDIC-insured deposits for its liquidity.
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Exhibit 2: Credit Ratings of Securities Lending Agents
BlackRock
Bank of New York Mellon Corp.
State Street Corp.
JPMorgan Chase & Co.
Northern Trust Corp.
A1
A1
A1
A3
A2
Moody’s
(Stable)
(Stable)
(Stable)
(Stable)
(Stable)
AAA+
A+
A
A+
S&P
(Stable)
(Negative)
(Negative)
(Negative)
(Stable)
Conclusion
Securities lending remains a highly scrutinized capital market activity, and while some reforms
have occurred (particularly in cash management vehicles) and others proposed, we support additional
xv
reforms which will improve practices further.
Borrower default indemnification is an established practice in securities lending, provided by the
majority of Lending Agents to a variety of their clients. Some clients may only participate in securities
lending programs if there is explicit indemnification. Capital, liquidity or other similar requirements imposed
on indemnification, if too high, will make indemnification uneconomical, and likely reduce participation by
Lenders in the practice of securities lending. This reduction will negatively impact both asset owners who
have benefitted from the income derived from securities lending activities, and market liquidity.
Asset owners elect whether or not to participate in securities lending. For those who choose to
participate, they can lend directly to Borrowers, or contract with their asset manager or their custodian to
act as Lending Agent. Those entities that enter securities lending programs are sophisticated investors
who have the capacity either directly or through their consultants to make an informed choice on whether or
not to participate, whether to use a Lending Agent and if so, whom to select.
BlackRock’s priority is managing assets in the best interests of its clients and approaches
securities lending as one component of its investment process. This integrated model aligns lending
strategy with overall investment objectives to provide our clients with a holistic risk mitigation strategy,
including borrower default indemnification protection, and the potential to realize higher returns than might
otherwise be achievable.
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Notes
i
Source: Markit.
ii
On securities lending’s importance to providing liquidity see, e.g the Bank of England’s review
http://www.bankofengland.co.uk/markets/Documents/gilts/sl_intro_green_9_10.pdf. For discussion of the
importance of short selling see, e.g. the NY Fed’s review
http://www.newyorkfed.org/research/staff_reports/sr518.pdf.
iii
See, e.g., Strengthening Oversight and Regulation of Shadow Banking: Policy Framework for Addressing Shadow
Banking Risks in Securities Lending and Repos, Financial Stability Board, dated August 29, 2013, available at
http://www.financialstabilityboard.org/publications/r_130829b.pdf; Guidelines for Competent Authorities and UCITS
Management Companies: Guidelines on ETFs and Other UCITS Issues, European Securities and Markets
Authority, December 18, 2012, available at http://www.esma.europa.eu/system/files/2012832en_guidelines_on_etfs_and_other_ucits_issues.pdf ; and Dodd-Frank Wall Street Reform and Consumer
Protection Act, Public Law 111-203, §984(b), 124 Stat. 1932 (2010), available at
http://www.gpo.gov/fdsys/pkg/PLAW-111publ203/html/PLAW-111publ203.hstm.
iv
See, e.g., Money Market Fund Reform, Investment Company Act Release No. 29, 132, dated February 23, 2010,
available at http://www.sec.gov/rules/final/2010/ic-29132.pdf; Short-Term Investment Funds: Final Rule, OCC
Bulletin 2012-31, dated October 10, 2012, available at http://www.occ.gov/news-issuances/bulletins/2012/bulletin2012-31.html; and Guidelines on a Common Definition of European Money Market Funds, Ref. CESR/10-049,
dated May 19, 2010, available at http://www.esma.europa.eu/system/files/10_049.pdf.
v
STIFs managed by trust banks or through bank trust departments are overseen by the OCC if federally chartered,
and by state banking authorities if state-chartered. Beginning in 2012 and every annual report thereafter, the
FSOC has recommended that relevant member agencies take action to assure that cash management vehicles
investment rules are comparable in order to reduce run risk and movement of cash from one type of fund to
another. While the OCC and SEC have responded with changes and proposed changes, neither the Fed nor the
FDIC have taken steps within their supervisory authorities to update the cash management vehicle investment
rules for state-chartered banks.
vi
As of May 2014. Note that the SEC is expected to issue final rules for additional structural reforms to Rule 2a-7
money market funds in the coming months. This chart is meant for illustrative purposes only. It is not an exhaustive
list of all rules that apply to cash management vehicles under the SEC, OCC, and ESMA jurisdictions, respectively.
Acronyms: WAM = Weighted Average Maturity; WAL = Weighted Average Life; CNAV = Constant NAV.
vii
A 2 -tier security is a security rated in the second-highest short-term rating category.
viii
With additional restrictions of 0.5% per single issuer and a final maturity not exceeding 45 days, details of Rule 2a7 available at https://www.blackrock.com/cash/literature/whitepaper/us-money-market-funds-and-rule2a7.pdf.
ix
Awarded one of the two highest short-term credit ratings or Investment Grade for Sovereign debt in Standard
MMFs.
x
In the case of BLL, as a result of the Company’s ability to resell or repledge the collateral, the Company records on
the consolidated statements of financial condition the cash and noncash collateral received under these
arrangements as its own asset in addition to an equal and offsetting collateral liability for the obligation to return
the collateral.
xi
BlackRock and its predecessors have been providing indemnifications since the 1990’s.
xii
Available at
http://www.statestreetglobalmarkets.com/wps/wcm/connect/8e7cce0043ffb24c931dbbc0761529b7/InView_Indemn
ification+FINAL_Nov.pdf?MOD=AJPERES&CONVERT_TO=url&CACHEID=8e7cce0043ffb24c931dbbc0761529b
7.
xiii
See FSOC 2013 Annual Report, page 67. Available at
http://www.treasury.gov/initiatives/fsoc/Documents/FSOC%202013%20Annual%20Report.pdf.
xiv
See FSOC 2014 Annual Report, page 115. Available at
http://www.treasury.gov/initiatives/fsoc/Documents/FSOC%202014%20Annual%20Report.pdf.
xv
See BlackRock Viewpoint “Securities Lending: Balancing Risks and Rewards.” Available at
http://www.blackrock.com/corporate/en-us/literature/whitepaper/balancing-risks-and-rewards-may-2012.pdf.
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