Americas securities lending regulation: Creative compliance

Americas securities lending regulation: Creative compliance

As securities finance moves beyond the credit crisis era, internal compliance officers must administer policy manuals that have been overwhelmed by new rules from legislation, regulation and, implicitly, from the lessons learned in litigation.

This is just as true for customers as for their service providers.

Agent banks, responding to regulatory capital pressures, now offer creative service options which allow customers to make loans on a peer-to-peer basis, manage their own cash collateral and clear trades in central counterparties (CCPs).

To avoid problems, institutions which opt into peer-to-peer lending without an agent’s indemnification against borrower default and lenders which accept indemnified clearing through CCPs will both likely require enhanced vetting of counterparties and real-time monitoring of on-loan positions with dynamic credit limits.

Agents may assist in those functions but will likely be held back by concerns about becoming defined as a control person, with legal exposure to the actions of their customers.

Lender cash management means that data linkages among the custodian banks and lending agents, which were refined during the advent of third-party agents, must now also link to the customers’ own reinvestment desks.

Similarly, the use of CCPs will require improved recall management protocols and perhaps even substitutions outside the settlement utility itself.

Capital charges are encouraging lenders and agents to clear trades through central counterparties.

Such an approach will raise issues that have rarely if ever been considered in securities finance.

For instance, customers and agent banks will have to find creative solutions to agree on crisis ready access to collateral held in multiple custodial entities and jurisdictions.

And, after the next crisis, surviving CCP members will be expected to participate in the unravelling of netted transaction files.

As difficult as it was after the 2008 crisis to unwind legacy records at just one firm, Lehman Brothers, experts quake at the thought of how monumental the task would be if or when a large CCP collapses with dozens or perhaps hundreds of active member firms.

While the creative new protocols are being tested, the movement to the two-day settlement of equity trades in the United States will also put pressure on routine securities lending operations.

Availability buffers at trading desks will have to be held to levels capable of substituting for returned loans in large scale during volatile corrections and market breaks.

Corporate actions, as always, will present great challenges to operations and compliance managers in ways that defy prediction.


A desire for greater transparency, largely in response to the growth of so-called shadow banking, has driven many of the regulatory reforms. For that reason, reporting requirements have increased exponentially. However, the confidentiality requirements of certain customers make it difficult, or even impossible, for agents to comply fully.

For instance, US state and local government funds may not accept the federal authority of regulators for intrusive disclosure, citing the separation of powers implied by the Tenth Amendment to the US Constitution.

Indeed, at a recent IMN/Euromoney securities finance conference, an official from the US Treasury’s Office of Financial Research stated that the lending agents’ inability to provide customer-level detail for reported loans had compromised the quality of the resulting securities finance transaction database.

Presumably, federal regulators could request enabling legislation to force disclosure, although such an attempt will probably not prevail without a favourable ruling from the US Supreme Court. The records of sovereign wealth funds are even more problematic.

There is no authority that can enforce their compliance except (perhaps) the Basel central bank committees. In any event, regulators in all jurisdictions will have to become creative to entice disclosure of loan record details by their own regional and foreign governments. Compliance officers in US regulated banks and dealers, notwithstanding these difficulties, will still be required to ensure adherence to federal

Compliance officers in US regulated banks and dealers, notwithstanding these difficulties, will still be required to ensure adherence to federal regulations, or request exemptions and submit verifiable disclaimers in their disclosure reports.


Cross-market flows of liquidity are so complex that they require special documentation to satisfy regulatory concerns.

In June 2014, the New York Fed released a study describing how global banks reacted to liquidity shocks during the credit crisis in quite different ways from their domestic competitors.

Those banks with foreign affiliates moved to quickly shift funds internally, shoring up their home markets with available funds from markets that they considered to be less important.

As a result, the Fed study pointed out that the damage could be magnified abroad, especially in those markets with a significant foreign banking presence.

Funds that are transferred among subsidiaries, especially away from a market in crisis must have sufficient documented justification to defend against later charges of malfeasance or misappropriation.

If local authorities subsequently were to reject the grounds for such transfers, the ripple effect could endanger the justification for related transactions and profits, even leading to challenges from tax authorities on economic substance, and civil claims for damages and unjust enrichment.

Regulatory fines would be the least of any CEO’s concerns in that nightmare scenario. Even without a crisis, compliance managers for institutional lenders will have to prove that fair dealing and arms-length negotiation per industry standards were followed if an affiliated agent or borrower is engaged in loan transactions.

The standards for rebutting claims of abusive fees, conflicts of interest and self-dealing in Erisa or other class-action cases are beyond the scope of this article, but worthy of regular review by attorneys and compliance managers in affiliated subsidiaries.


Traditional methods of preparing requests for proposals and reviewing responses will have to be supplemented by functional reviews of the systems used by cash managers on the reinvestment desk to control co-existing legacy accounts, along with the possibility of liquidity fees and gates to be imposed on pooled accounts in a crisis, both at the agent and at its fund customers.

This was an extremely contentious issue during post-crisis litigation.

The SEC’s recent empowerment of these safeguards for regulated money funds will not make it easier to implement in practice, much less to anticipate.

While pooled arrangements for collateral reinvestment have become less popular in recent years, agent banks may still have to accept lenders with impaired, long-term legacy assets in their segregated reinvestment accounts.

Those lenders, once burned and twice shy, may be sceptical of an agent’s promised enhancements to front-end compliance systems, especially when non-traditional counterparties are added to the mix.

Systems will be held to a higher standard, as compliance officers at lenders insist on proof of accurate data dictionaries with fulsome descriptions of assets, and compliance officers at agents insist on clear, comprehensive investment guidelines.

Major system revisions will undoubtedly require approval by attorneys and operations managers on both sides of the trade.

To prepare for the worst, transaction records will have to be stored off-site such that a trustee can selectively provide access to bankruptcy attorneys and their consultants.

Systems documentation must be kept current, not only to prove capability during the period in dispute but also to allow the resurrection of activity and positions long after the systems management team has taken its last paycheque and only the general counsel’s office still has air conditioning.


Compliance officers everywhere are being asked to help negotiate contracts with creative and complex warranties. However, banks’ ability to accede to these demands is greatly constrained by the potential for heavy costs from special regulatory capital requirements.

Even without the specific asset risk weights under Pillar One of the Basel Capital Accord, regulators can use their Pillar Two authority to require an increase in capital reserves for the perceived operational risks implied by guarantees, and they can follow up with forced Pillar Three disclosures to investors.

Consider that lenders’ attorneys often press during contract negotiations for guarantees to their clients of minimum lending volumes or income, minimum spreads on loans, backed-dated credits for operations errors (such as misdirected wire transfers) and similar issues.

However, concessions that risk exposing bank lending agents to Pillar 2 additions to capital requirements, per the Basel capital rules, will likely not be granted without customers’ concessions in fee splits, relaxation of counterparty credit minimums or the acceptance of stay provisions in bankruptcy.

In effect, banks will require more income to offset their higher capital charges.

To the extent that there is a resumption of exclusive borrowing deals, lenders’ attorneys will likely ask their counterparties for minimum balance requirements to enhance liquidity, along with the customary guarantees of minimum revenues.

Compliance with balance guarantees, if accepted, will probably be maintained on a quarterly or even annual basis, exposing an interim risk of vulnerability to forced sales of longer-dated collateral instruments in a market break.

Since short sellers often close their positions to capture profits in a break, their prime brokers may be quite busy returning borrowed securities en masse.

Those returns can force lenders to sell the instruments purchased with cash collateral at a loss. That’s the nightmare scenario for systemic market regulators.


The scope and nature of fiduciary services are changing, regardless of whether the US Labor Department’s novel rule is introduced. Even the application of the existing standard is contentious.

For example, service providers try to avoid being named as fiduciaries unless so defined explicitly in the contract.

But it’s not easy to avoid. In litigation, plaintiff’s attorneys have asked the courts to apply the same fiduciary standard to financial agents who perform similar functions as fiduciaries.

In defence, service providers attempt to prove that their actions in dispute were consistent with non-fiduciary industry practice, or, as a fallback, that they were de facto compliant with the prudent person rule.

Most recent cases were settled out of court, so there remains no clear guideline for reliance by legal or compliance officers.

Therefore, the safest course for compliance officers at service providers is to assume the higher standard and act accordingly.

For customers, it is best to define the specifics of critical services in the contract and attempt to hold the provider to overt, consistent compliance.

Of course, the unfortunate final test of compliance lies within the purview of the courts.

Ed Blount is the executive director and founder of the Center for the Study of Financial Market Evolution (CSFME).

Since the credit crisis, Ed Blount has testified as an expert in securities finance before all three branches of the US federal government, including more than a dozen matters in litigation at all jurisdiction levels.

He is lead co-author of Securities Finance Disputes, in the 2017 Litigation Services Handbook, published by John Wiley and Sons, New York, and can be contacted at

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