Friday, November 7, 2008

Compliance Consultant's View of Securities Lending Risks

In a recent compliance alert, ACA Compliance Group took a look at the risk environment surrounding fund securities lending programs, finding that, "[t]he risks associated with a firm's securities lending program appear to be on the rise due to issues such as:"
(1) cash collateral programs taking large losses on subprime investments,

(2) the increased potential for counterparty default, and

(3) recent regulations imposed on short selling which has reduced the supply of securities available for lending.
Given these enhanced risk areas, ACA suggests that funds' compliance professionals consider the following steps in reviewing their firms' securities lending programs:
Re-evaluating counterparty risk on a more frequent basis. Many firms review the creditworthiness of their counterparties on an annual or semi-annual basis. In today's market, that may not be frequent enough. Counterparty exposure should be measured at various levels: out on loan, collateral reinvestment, the portfolio's direct investments particularly in derivative or complex instruments and non-DVP transactions. An adviser should review its firm's exposure to a particular counterparty on an aggregate basis in addition to any such reviews that may be conducted by a firm on a portfolio by portfolio (or client by client) basis.

Periodic reviews of portfolio holdings in cash collateral vehicles. A firm's senior executives and investment personnel should be asking themselves tougher questions regarding its securities lending program's invested collateral. How are current market conditions [affecting] the risk/return profile of invested collateral? Are there any credit issues related to recent downgrades? What valuation issues, if any, are arising with respect to the invested collateral? Recent industry news indicates increased concern with "breaking the buck," and restrictions being implemented on investor redemptions. Staying current with potential issues in the portfolio and self-evaluation of the holdings in the cash collateral vehicle may provide lead time in remedying a potential situation.
Increased monitoring of sell fails. As the rate of default by borrowers increases, advisers need to be wary of potential sell fails. They must stay diligent in ensuring that the lending agent or prime broker/custodian monitors the borrower to return the securities. Advisers, particularly those providing investment advice to registered mutual funds, should be monitoring the amount of time that its securities are out on loan. In general, the probability of a sell fail is correlated to the length of time that a security has been out on loan (securities out on loan for longer periods of time are more likely to be susceptible to sell fails). A compliance officer should review and evaluate a firm's sell fails for potential trends, such as whether a single borrower has continuously failed to deliver. This may lead to discussions with the lending agent in excluding said broker from borrowing in the future.

Evaluation of loan limits. Advisers, and particularly mutual funds, should evaluate their current lending limitation on a security. Decreasing the percentage of how much can be loaned to any one borrower, or on a security by security basis, could alleviate the counterparty and sell fail risks while allowing the firm to continue to effect an active lending program.

Improving disclosure to investors. Fund Boards and advisers may consider disclosing risks associated with participating in securities lending programs such as the potential for delays in the recovery of loaned securities and the [effect] on the portfolio should the borrower default. Another disclosure may address restrictions on the redemptions of assets, and the possibility of providing redemptions in-kind, both of which may have an [effect] on the adviser's ability to manage the account in accordance with the fund's investment objectives.

The full text of ACA's Compliance Alert is available at: