Agency Lending Disclosure Takes Center Stage: An Interview with Les Nelson
Les Nelson, Goldman Sachs & co.
For more than two years, securities industry leaders and regulators have been working to provide greater transparency in agency lending security transactions, emphasizing the need for borrowers, that is, broker/ dealers, to know who their principal lenders are and how they can monitor credit exposures and calculate required regulatory capital charges based upon the loans with each principal. Les Nelson, a managing director in Global Securities Lending for Goldman, Sachs & Co., has been leading this effort and served on the Agency Lending Disclosure Taskforce since it was formed in early 2004. The task force has mapped out the steps and timeline that the industry needs to follow in order to meet a February 2006 deadline, a date that was set based on the project plan and in consultation with regulators. @dtcc asked Nelson to discuss the work of the task force, agency lending requirements and how they will impact the industry.
@dtcc: First of all, will you tell us what an agent lender is and what role they play in the securities industry?
Nelson: As the name suggests, an agent lender lends securities to borrowers on behalf of other parties who are the actual principals in the transaction. For example, if a borrower comes to an agent lender – say, someone like State Street – and requests 5,000 shares of XYZ stock, State Street will lend these shares and will allocate the loan to various funds and institutions that participate in its lending program – say 1,000 from a pension fund, 2,000 from a mutual fund and 2,000 from another fund. Then in one transaction, they will lend the shares to the borrower. The agent lender, however, remains a go-between and is not a principal in the transaction.
@dtcc: When did regulators first look at agency lending disclosure issues and what was it that prompted them to do so in the first place?
Nelson: In early 2003, the Securities and Exchange Commission (SEC) approached the industry with concerns about the level of information provided borrowers by the agent lender. There had been an industry default that many connected with the regulators’ inquiries, but really their concern was that the industry follow existing guidelines and that borrowers be given more information on who their lenders were.
The SEC was joined by the New York Stock Exchange in a series of discussions that began with the Securities Industry Association’s (SIA) Capital Committee, and later the Securities Lending Division of the SIA. I was president of the division at the time, and that’s how I first became involved. It was after these initial discussions that an industry task force was formed in January 2004 with representatives from the SIA, the Risk Management Association’s Committee on Securities Lending, The Bond Market Association and other organizations, including DTCC. To date, we have more than 240 active members on the task force in various working groups, including credit, capital, infrastructure, legal, and testing, and have a consulting firm, Capco, as the project manager to help direct the effort.
@dtcc: Essentially, what were the greatest concerns when the task force began its work?
Nelson: There was a definite lack of transparency in this business, and the borrower didn’t know, on a loan-by-loan basis, who the underlying counterparties, or principal lenders, were. This has implications for credit and capital aspects of the business. From a credit perspective, if you don’t know who the ultimate counterparty is, then you can’t determine your credit exposure on any given day.
In addition, there are very specific capital rules intended to capture the exposure that a broker/dealer borrower has to a lender and vice versa. Let’s just talk borrower to lender in this case. If a borrower has collateralized a lender at greater than 105% of the value of securities borrowed – 105% is specified by existing regulations – the borrower may be required to take a regulatory capital charge as a result of that exposure. But if the borrower doesn’t have the information from the agent lenders on who the underlying loan-by-loan counterparties are, it’s impossible to do this capital monitoring and determine if a capital charge is needed with respect to the individual principals to whom the broker/dealer has exposure.
@dtcc: Can you provide an example where these rules come into play and explain why a borrower may have to take a capital charge?
“Both regulators and the SIA Securities Lending Division turned to DTCC at the start of the project because of DTCC's connectivity throughout the entire financial services industry.”
Nelson: Let’s say that I borrowed one share of stock from you that is currently selling at $100. You deliver the share and I give you cash collateral of 102%, or $102 - more specifically, you’ve debited my account at DTC for $102. Let’s say the stock drops in price that day from $100 a share to $95 a share. I see an exposure the next morning of $7, a stock loan worth $95 versus the $102 collateral that I gave you.
U. S. regulators, as I mentioned, allow borrowers to provide collateral worth up to five percent more than the value of what is borrowed. Beyond this level of over-collateralization, regulatory capital charges are required due to the exposure that the borrower has to the lender. Continuing our example, if our counterparty goes bankrupt, there will be a shortfall of $7 in the value of the stock versus the collateral we’ve provided…take that number and multiply it by the hundreds, thousands, or millions of shares you’ve actually borrowed.
What we can do here is “cure” that exposure, for example, by doing a “mark to market” and getting back some of my collateral in order to reduce the collateral level to less than 105 per cent. And if I do this within 24 hours of when the exposure occurred, I don’t need to take a capital charge.
@dtcc: So what will the requirements call for lenders and borrower to do?
Nelson: Basically, the task force recommendations call on the agent lender to provide data to the borrower so their credit departments and groups that monitor regulatory capital are able to determine credit exposure on a principal-by-principal basis every day, and allow them to calculate capital charges that exist if the exposures are greater than 105%, again at a principal level. This data will allow borrowers to monitor the amount of credit exposure they have with each principal lender, so they can say “Okay, for XYZ Pension Plan, here’s the market value of what I’m borrowing, here’s the market value of the collateral I’m giving and this is the amount of exposure that I have.”
@dtcc: Will borrowers need a whole new recordkeeping system to meet these requirements?
Nelson: We were concerned about the bookkeeping issue and we spent a long time talking to the regulators about this because the impact on our business could have been very serious.
For example, if Goldman Sachs borrows 60,000 shares of General Electric stock from JPMorgan Chase, we currently book one loan in Chase’s name on our securities lending system. Regulators at first indicated that our books and records should reflect who the actual principal lender is on a loan-by-loan basis…so you would have to record that of the 60,000 shares, 12,000 was borrowed from pension plan ABC, 8,000 came from this mutual fund, 14,0000 from this entity and so on. Factor into this that there are thousands of underlying counterparties, and you see how this would seriously burden the borrowers in terms of the dramatic increase in the number of loans they would have to book and the corresponding increase in transactional activity. Also, agent lenders were concerned about the broker/dealers’ securities lending trading desks becoming aware of the loans being made from individual principal lenders’ portfolios and the possibility that the broker/dealers would attempt to establish direct relationships with the principal lenders.
Taking both of these factors into account, the regulators agreed that the borrowers wouldn’t have to book the individual loans by principal lenders, but the records transmitted by the agent lenders would have to be retained in accordance with existing regulations relating to books and records.
@dtcc: Agent lenders will still have to transmit information on a loan-by-loan basis. Isn’t that still a tremendous undertaking?
Nelson: Of course it is, and it’s why this is a multi-year project. We calculated that somewhere between three and four million individual loan records will need to be transmitted each day to borrowers from the agents they’re working with. And that number is expected to grow at an annual rate of 20%. The amount of information processing will be enormous.
@dtcc: What role has DTCC played in these discussions thus far, and what will be its role going forward?
Nelson: DTCC has been involved from the start and plays a critical role in the project. Margaret Koontz and Tom McCarthy have been working with the task force since day one, as well as coordinating DTCC’s efforts with regulators like the SEC. Industry officials suggested that DTCC act as the communications hub when an agent and its borrowing counterparty are using different vendor systems (e.g., Loanet and EquiLend). If agent lenders and borrowers are on the same technology platform, they can transmit information directly from one to another. Otherwise, regulators want them to use DTCC as their communications hub. Also, DTCC’s role as the communication hub creates the opportunity for agent lenders and borrowers to not use a vendor as an intermediary, instead interacting directly with DTCC in sending and receiving the files associated with this project.
Both regulators and the SIA Securities Lending Division turned to DTCC at the start of the project because of DTCC’s connectivity throughout the entire financial services industry. The connectivity that DTCC provides is critically important given the variety of systems that agents and broker/dealers choose to use and the amount of data that will be moving each day among industry participants.
@dtcc: Can you discuss the timetable for implementation? Is everything and everyone on schedule for February 2006?
Nelson: Actually, we’ve planned two separate implementations. The first is for the credit pre-qualification process. Firms should have testing completed by June 30. During July, the industry will send and receive incremental add/delete requests for credit prequalification of new principals. On August 1, we will begin a three-month period during which borrowers will receive lender information in order to requalify existing principals. This process is scheduled to be completed by the end of October. The second implementation is for the daily detailed loan file. We hope to have this completed by the end of February 2006.
What is very important is for each firm to be doing its internal technology development in order to meet the schedule. Any firm that is not doing so already will have lots of catching up to do. If they have not done so already, firms really need to get someone in their organizations involved in the work of the industry task force so that they have someone who knows exactly what’s going on. @
[Editor’s Note: For more information on the Agency Lending Disclosure Taskforce, visit www.stp.capco.com.]