Mitigating Risks in Securities Lending Transactions

1. What Every Bank/Lender should know about their Broker/Borrower Mitigating Risks in Securities Lending Transactions

2. Outline Brief history of the Securities Lending Market Risk Identification Risk Mitigation Rules to Live (Survive) By Acknowledgement to Frank J Souder of Wachovia Global Securities Lending for basic outline of slide presentation.

3. Securities Lending Today • Multi-trillion dollar business • Truly international • Has moved from fee generation to portfolio leverage (in US) • Seen as relatively low risk

4. Needed for a Lending Market • Legal framework • Safe settlement system • Market standards • Market transparency and liquidity • Adequate accounting treatment • Regulation to prevent abuses • Reasons to borrow

5. Significant Market developments 19th Century • Probable birth of securities lending in London 1950s • Some limited lending in a few countries 1960s • Active inter-dealer market in US develops • Increased short selling • Increased number of fails • First formal equity lending transaction in London

6. Significant Market developments 1966 • Dematerialization of US treasuries begin • FRB begins eliminating physical certificates • FRB begins its book-entry system 1970s • US custodial banks start lending on behalf of their customers • New trading strategies spur demand (convertible bond arbitrage, tax arbitrage) • Matched book repo starts to develop

7. Significant Market developments 1973 • DTC Founded • Took over CCS which was beginning electronic settlement of trades • Provided custody for banks and brokers • Accelerated dematerialization 1974 • Bankhaus Herstatt failure • “Great Awakening” to settlement risk

8. Significant Market developments 1981 • Amendments to ERISA permitted many pension funds to begin lending 1980s • Large increases in government securities markets of many countries • Increases in trading • Demand building for efficient repo and lending markets

9. Significant Market developments 1982 • Collapse of Drysdale Securities prompts many changes in markets • Contracts standardized by BMA (now SIFMA) • Accrued interest collateralized • Standard margins established • Disclosure of lenders’ identity (reluctantly)

10. DRYSDALE SECURITIES • Scheme created to reap interest profits from uncollateralized portion of government securities borrows • Scheme fails when investments ‘go south’ and coupons cannot be paid • Lending Banks eat the losses • Lesson: Know your Collateral – always assume default of counterparty • Lesson: Follow the Money

11. Significant Market developments 1982 • Collapse of Lombard Wall • Court rules that repos are collateralized loans and court permission needed to sell 1984 • Failure of Lion Capital • Failure of RTD Securities • NY school districts badly hurt

12. Significant Market developments 1985 • ESM Government Securities fraud • Bevill, Bressler, Schulman fraud • New bankruptcy laws • Flight from “Trust Me” or HIC repo and growth of triparty custody 1986 • Passage of GSA

13. Significant Market developments Late 1980s/Early 1990s • Legal uncertainty, unfavorable tax treatment, regulatory road blocks in most countries outside of US and UK • US and UK firms begin developing offshore lending markets 1990 • Group of Thirty publishes report calling for reduction of barriers to securities lending

14. Significant Market developments 1991 • Legislative changes in the UK permit pension funds and unit trusts to lend 1994 • Sharp rise in US interest rates cause many lenders to lose money • “Great Awakening” to the possibility of loss in securities lending accounts

15. Significant Market developments 1994 • Revision of the UCC • Recognition of the “virtual security” 1995 • Collapse of Barings PLC because of rogue trader Nick Leeson • “Great Awakening” to the fact that even well-capitalized, industry giants, can default

16. Significant Market developments 1997 • Malaysia suspends securities lending 1998 • Rescue of LTCM • Black swans exist • Systemic risk can be huge • Esoteric instruments create big problems

17. Significant Market developments 1999 • Euro created giving impetus to cash collateral in Europe Mid 1990s thru today • Globalization of markets • Many countries creating favorable lending environment • Hugh growth in derivatives fueling demand for borrowing

18. Significant Market developments 2001 • SIPC liquidates MJK Clearing • SEC demands compliance with KYC rule • “Great Awakening” to the importance of knowing your customer • Industry-wide effort to develop ALD begins (implemented in 2006)

19. MJK CLEARING • Beginning in 1999, reputed Saudi arms dealer and co-conspirators raise cash by manipulating the price of GENI (from $1.67 to $25) and lending shares to Deutsche Bank through Native Nations Securities and ultimately other unsuspecting BDs • Numerous BDs then on-lend and/or on-finance the cash loan using GENI as collateral • On September 25, 2001 shares in GENI are deemed (relatively) worthless and all parties attempt to mark the loans to the market • Native Nations fails and MJK uses customer cash to meet the stock loan margin call • MJK fails triggering largest SIPC bailout in history • Deutsche agrees to pay fine of $270 Million and finder is convicted of fraud • Lessons: Know your customer, Follow the Money • Preventive Measure (for Native Nations): Did this meet the Reg T purpose test? • Preventive Measure (for MJK): Assuming default is the collateral too concentrated?

20. Significant Market developments 2007 • Sub-prime crisis • Crash of ABCP market • Losses in many securities lending accounts • Another “Great Awakening” to the risks in securities lending • SEC indicts Securities Lending traders in Finder skimming

21. FINDER INDICTMENTS • 38 people indicted by SEC for skimming more than $12 million in profits utilizing finders from 1998 to 2006 • 5 also indicted for securities fraud • Morgan Stanley’s practices prohibited paying finders for securities lending transactions but a rogue trader did so without management’s knowledge. • Lesson: Know your people, know your business

22. Securities Lending in 2008 • Still relatively safe • In need of more automation as volumes increase • Some risks have returned because of globalization, e.g. settlement risks • Need of constant vigilance as product evolves

23. How Did We Get Here? • “You can always trust Americans to do the right thing — once they’ve exhausted all the other possibilities.” • Winston Churchill

24. Developed Lending Markets Today Legal Framework • Good bankruptcy and lien laws in most areas (international at times a problem) Safe Settlement System • Virtually all book-entry settlement/ DVP • Much automated tracking and automated payment of distributions on lent securities • Extensive use of triparty facilities • Automated marking of a large number of equity loans (US)

25. Rules and Regulations • Reg SHO • Regulation enacted to reduce fails and eliminate naked short selling. • Created uniform list of securities with high fail ratios. (Threshold List) • Reg T • The Federal Reserve Board regulation that governs customer cash accounts and the amount of credit that brokerage firms and dealers may extend to customer for the purchase of securities. • Defines acceptable purposes for borrowing shares. • 15 c3-3 • Possession and Control of Securities or otherwise known as the “Customer Protection Rule”. • Recent changes are still in a proposal period. • 17A 13 • Quarterly mailing of open borrow and loan confirmation

26. Developed Markets Today Numerous market standards • Standard cut-off times • Standard recall periods • Standard contracts • Standards for exchanging information (ALD – US) Market transparency and liquidity • Transparency varies among markets but getting better • Large supplies give good liquidity

27. Developed Markets Today Reasons to borrow • Increase every day- much demand Adequate accounting treatment • Loans not treated as sales • Tax laws follow the accounting rules, in general Regulation to prevent abuses • Adequate – (differences of opinion) Active industry groups working to improve product

28. Rules to Live (Survive) By… • KYC (Know your counterparty) • KYC (Know your collateral) • If, “Information is Power”, and “Time is Money”, then Timely Information is how fortunes are made and lost • Follow the Money (and you’ll understand the value/risk) • If it seems too good to be true, someone is probably getting ripped off • The Money’s in the Money • What you don’t know can kill you

29. The Four Most Dangerous Words… • This time is different.