Strong personal relationships have always been a cornerstone of the securities lending marketplace. Market participants focus on developing a broad, reliable network of relationships, so they can be the first lender borrowers contact in the morning, or the first borrower to be offered hard-to-borrow securities by a lender. While strong relationships will always be important, there is a growing emphasis on data collection. Decisions are being influenced by data analytics. In my view, the future of securities lending will be data-driven and the leaders will be those that make the most effective use of data.
The Expanding Role of Data and Technology in Securities Lending
One of the catalysts driving an increased emphasis upon data is Securities Financing Transaction Regulation (SFTR) that is forcing market participants to make technology investments to collect data for regulatory reporting. The ability to collect more data and integrate systems across entities can make inventory more accessible. It's all about utilization.
An increased quality and breadth of data enables advanced data analytics, such as machine learning. There's little doubt that such a lucrative business (driving nearly $10b in revenues according to a recent DataLend announcement) is going to attract advanced data science.
Over the next few years, I expect we will see two technology changes in the securities lending space that will benefit beneficial owners: machine learning and distributed ledger technology. Firms and vendors have been investing in new technologies that could enable participants to apply machine learning in order to discover surprising and valuable insights.
For example, programs that can anticipate changes in the demand for securities enable firms to make more informed decisions about when to lend and rerate securities. Similarly, distributed ledger technology has the potential to not only improve the transparency for beneficial owners, but also to potentially enable them to take a more active role in their lending programs.
OCC believes that investing in technology to improve client outcomes will prove to be a wise decision in the securities lending marketplace. We are focused on technology that can give our clearing firms an advantage by improving their capital and operational efficiency, lowering their costs, and raising their utilization. We believe that distributed ledger technology has great promise for increasing efficiency, reducing reconciliation costs, and making stock loan programs more profitable.
Prudent Risk Management May Lower the Need or Cost for Indemnification
Any lending program needs stability and trust. Prudent risk management is the bedrock of this stability. Risk stemming from a counterparty's default within the securities lending space can be mitigated primarily through three mechanisms: credit evaluation, excess collateral and indemnification.
- Credit evaluation is an important step to ensure that any new counterparties are credit worthy, and this assessment should be reaffirmed on a frequent basis.
- Excess collateral (e.g. 102 percent for cash collateral) is the primary tool in securities lending that helps avoid losses should the lender need to buy-in the loaned securities in the event of a borrower's default.
- Indemnification is a back-stop if the collateral is insufficient.
OCC uses a three-tier approach to risk management:
Our first tier is careful assessment of new members and ongoing monitoring.
Our second tier is margin collateral, which is based upon models of future stock prices and the amount of collateral is recalculated daily to cover losses at a 99 percent confidence interval. This margin collateral is in addition to the 100 or 102 percent collateral given by the borrower to the lender.
Our third tier of risk mitigation is a guarantee fund, which is only drawn upon if a defaulted clearing firm's margin collateral was insufficient to cover their obligations. Essentially, indemnification is an insurance policy, and like insurance, the premium is related to the likelihood of drawing upon the insurance policy. The securities lending industry could advance techniques, like OCC's three-tier approach to risk management, as a way to lower the probability of drawing upon indemnification.
If the counterparty risk evaluation is effective and the collateralization rate is more certain to cover the replacement cost of lent securities, then the conversation about indemnification may change. The guarantee provided by central clearing by organizations like OCC is another alternative that would help reduce the likelihood of drawing upon indemnification.
In my view, increased data analytics and enhanced risk management are exciting initiatives that have the potential to increase utilization, improve revenues, and lower costs for users of this market. The future of securities lending is bright.