Idemnification: The not so hidden cost

 

Agent lenders have traditionally provided an indemnification to their securities lending clients to protect them against counterparty default. The cost of this guarantee has been borne by the agent. However, every indication shows that as regulatory changes start to bite, the cost of indemnification is likely to increase dramatically.

Currently there is no real precision in calculating the additional cost, as regulators are still considering the impact of Basel III recommendations and the US Dodd-Frank Act. Even though the regulations are not yet finalised, it’s likely that any guarantee (including indemnification) will need to be backed by the balance sheet capital of the agent lender providing the indemnity. The cost of the indemnification may even need to be disclosed to the beneficial lender.

Where the total cost of securities lending becomes more transparent, it will inevitably bring into question the revenue generated from the agent lending programme, compared with the total fees and the risk that is involved.
There is considerable speculation about the effect these changes may have on the market. A number of the smaller lenders using agency lending services will be identified by the agent lenders as non-profitable and the indemnity cover removed. This may mean a withdrawal of such players from the market. This in turn raises the possibility of a reduction in liquidity, and consequently an expected increase in trading spreads. Any increase in the cost to the agent lender is likely to be recouped via the fee charged. This in turn is likely to result in a change to the split of fees charged, in favour of the agent lender.

Traditionally, there has been a lack of transparency on the precise makeup of the agency lender fee. However, there are increasing discussions around making the indemnity costs transparent to the lender, with increased focus on the precise composition of the fee. With the risk element removed, the cost of market connection and operational processing can be precisely calculated.

Institutions that are balance-sheet sensitive are likely to have to account for every cent of balance sheet usage. Firms with limited funding will likely compare business line returns in order to decide who will have access to the precious balance sheet. In such instances, agent lending is likely to lose out to business lines that are more profitable. This could again impact on lending activity, and therefore, market liquidity.

Those institutions with painful memories of unwinding their securities lending positions after the Lehman’s collapse will fully understand the need for the regulatory changes, despite the cost to agent lenders of providing the indemnity to security lending clients. These changes are still shrouded with speculation, but there will certainly be additional costs to cover. Inevitably, this will reduce the net lending fee received by the beneficial lender and will result in a re-evaluation of the participant’s appetite to participate in the agent lending market. If there is a reduction (as most predict) then this will inevitably reduce the volume and affect market liquidity.