GFOA Advisories identify specific policies and procedures necessary to minimize a government's exposure to potential loss in connection with its financial management activities. It is not to be interpreted as GFOA sanctioning the underlying activity that gives rise to the exposure.
Only governmental entities that have the necessary expertise and resources should engage in securities lending programs.
Where permitted by state statutes, governmental entities participate in securities lending programs as a way of earning incremental investment income on non-pension fund assets. In securities lending programs, a governmental entity (directly as principal or through an intermediary) lends securities such as U.S. Treasury, agency, or government sponsored enterprise (GSE) securities, from its investment portfolio in return for cash or non-cash collateral. If the collateral is cash it is then reinvested. The participants include the governmental entity, the borrower and the contracted lending agent, if lending is performed through an intermediary.
There are several counterparties to this type of transaction (govt entity, lending party, tri party, etc.). A securities lending transaction has many of the same characteristics as a reverse repurchase transaction. In both, securities are lent to a counter party with the governmental entity receiving collateral to be reinvested. A major difference is that securities lending programs through an intermediary are contractual and ongoing whereas reverse repurchase transactions are typically one-time or non-recurring.
Broker-dealers typically are the borrowers in securities lending programs. They use the borrowed securities primarily to cover fails (the non-delivery of securities expected to be delivered on a date certain) and short sales (the sale of securities not presently owned by the seller in order to take advantage of an expected lower market price) and to execute arbitrage transactions. Accordingly, securities lending programs play an important role in maintaining orderly markets.
The securities loaned are collateralized for the term of the loan and marked-to-market daily. Minimum collateral is usually set at 102% or more. This margin reduces the lender's exposure to the borrower. The governmental entity retains ownership of the securities including the coupons paid during the period the securities are loaned.
Cash collateral usually has a borrowing rate less than the overnight money market funds rate. The difference between the borrowing rate and the reinvestment rate produces a net gain in interest income and determines the value of the trade. The resulting income is subsequently split between the participants in the securities lending program. There are many options on reinvestment of cash collateral which should be carefully reviewed and adopted by the government.
Because securities lending programs are not primary activities for most governmental entities and market access may be limited, they may contract with a lending agent.1 Typically, a master trust, custodial or safekeeping bank or asset manager will act as lending agent facilitating the securities lending programs.
The typical steps in establishing and operating a securities lending program are:
- Governmental entity solicits proposals for lending agent to establish contractual limits and requirements (collateral requirements, authorized collateral, fees).
- Governmental entity designates portion of the portfolio to be lent through lending agent.
- Lending agent presents portfolio to broker-dealers as available for lending.
- Designated securities are lent through agent to approved borrower.
- Collateral (for securities loan) is delivered at predetermined level to approved custodian.
- Simultaneous to receipt of the collateral, securities are delivered to the borrower.
- Cash collateral is reinvested in a segregated liquid transaction until the security is returned. In the case of cash collateral, the lending agent negotiates the interest rate on the collateral paid to the borrower of the securities, which is called the rebate rate. In the case of non cash or securities collateral, the lending agent negotiates a fee paid by the borrower. The governmental entity should specify reinvestment options.
- At the end of the loan term, borrower returns securities to governmental entity via lending agent and simultaneously the lending agent returns collateral to borrower.
- The difference between what is earned on the cash collateral investment and the rebate rate is the gross spread. The lending agent retains a portion of the gross spread as its fee and credits the remainder to the owner of the securities as negotiated between the governmental entity as the lender and the lending agent. Payment is normally made monthly.
- The governmental entity keeps the remaining reinvestment income.
- The value of the collateral is marked to market daily to ensure full collateralization.
- At the end, borrower returns securities to governmental entity via lending agent and simultaneously the lending agent returns collateral to borrower.
While securities lending programs historically have been considered relatively low risk, there are risks and some governmental entities have suffered significant securities lending losses. Most of these losses were related to either default risk or maturity risk, which are discussed in more detail below.
Securities Lending Risks
- Borrower Risk. The risk that the borrower will not be able to return the borrowed funds at the end of the loan term. Borrowers must have high credit ratings from the rating agencies, and, more importantly, must meet certain other financial criteria as specified by the lending agent and the governmental entity in the securities lending agreement. A second aspect of counterparty risk is that the borrower fails to provide additional collateral as required
- Concentration Risk. The lack of diversification by borrower amplifies borrower risk.
- Collateral Risk. The lender (governmental entity) does not receive sufficient or authorized collateral to cover the market value of borrowed securities.
- Credit/Default Risk. The risk that the collateral investment made by the securities lending agent either defaults or suffers a ratings downgrade putting it out of compliance with a governmental entity's policies or results in a reduced market value or a loss to the entity.
- Interest Rate Risk. The risk that the yield on the invested collateral is less than the rebate paid to the borrower. (The lending agent must verify the daily spread before any lending is committed.)
- Maturity Risk. The risk that the maturity of the collateral re-investment exceeds the maturity of the loan. Inaccessibility to the cash would require the governmental entity to provide other funds not necessarily available.
These risks generally involve problems with contractual or administrative issues of the program. Clear guidelines and requirements must be set. These may include problems with margin maintenance, settlement, corporate actions, dividends or interest, marking to market, monitoring, billings and reporting.
Typically, a lending agreement provides that borrower's credit risk, broker-dealer default risk, and collateral maintenance are risks undertaken by the lending agent. However, indemnification provisions vary. The governmental entity, as lender, can demand final approval of acceptable counter-parties and the assets available for lending. These decisions generally affect the split of the investment proceeds. Risks typically borne by the governmental entity involve reinvestment risk.
Liquidity requirements are often accepted and guaranteed by the lending agent upon one day's notice, as substitution by the borrower in large lending programs is easily accomplished and essentially risk-less. Normally, the governmental entity provides one day's notice if it wishes to sell a security that is on loan. Programs that require the governmental entity to undertake responsibility for managing the liquidity present greater risks and require that the governmental entity place limits on the amount of the portfolio which may be put on loan. The conditions for the term of the securities on loan and the reinvestment of the proceeds must be carefully established by contract and strictly managed.
While investment strategies that include securities lending programs are not inherently risky when employed judiciously with appropriate precautions and controls, GFOA urges state and local government officials to exercise caution in their use of securities lending programs.
Only governmental entities that have the necessary expertise and resources should engage in securities lending programs. Prior to participating in a securities lending program, government finance officers should:
- Determine whether the entity's portfolio and ongoing strategy are appropriate to securities lending;
- Determine whether securities lending is permissible under state statute and the governmental entity's written investment policy;
- Prepare a written securities lending cash reinvestment policy, which may be attached to or incorporated into the entity's investment policy or exist as a stand-alone policy. The investment restrictions in this cash reinvestment policy should be consistent with the entity's own investment guidelines and strategy. Furthermore, the policy should include an explicit statement that the entity may set restrictions on the reinvestment of cash collateral as market conditions change. Such restrictions may include authorized commercial paper programs by program name, rating and/or term and asset-liability matching requirements. This policy should be incorporated into the contract with the securities lending agent.
- Exercise special caution in selecting and evaluating the creditworthiness of lending agents and counterparties to the securities lending program
- Consider the lending agent's experience, technological resources, assets, borrowers base, and fee basis
- Execute a written lending agreement subject to appropriate legal and technical review with special attention to:
- indemnification provisions
- investment guidelines
- notification requirements for changes to the lending agent's list of acceptable investments
- terms of the lending, including the maturity of loans and the types of securities purchased
- liquidity provisions and risks
- requirement for daily collateral mark to market and collateralization levels
- basis for the split of investment proceeds and timing of payments
- Establish a monitoring process for reviewing the lending agent's reports for compliance and performance, which should be done no less frequently than on a monthly basis
- Ensure independence of the audit process.
- Avoid possible counter-party risk by having all parties involved (government, lending agent, and custodian) sign a tri-party contract.
- Require proper reporting procedures at all levels including:
- Margin compliance
- Counterparty participation
- Payment information
- Reinvestment detail
- Consider the resources and required training of staff to adequately monitor compliance with the agreement by all parties.
1 This advisory discusses risks and practices associated with a third-party agent securities lending program, the most common type of securities lending program, versus a principal program. In a principal program, a single broker-dealer or bank enters into a contract with the governmental entity and usually quotes a guaranteed income stream to the entity or the governmental entity manages its own internal program which requires considerable staff time and expertise. Principal programs thus provide the borrower with the exclusive right to borrow from a portfolio.
- Investing Public Funds, Second Edition, Girard Miller with M. Corinne Larson and W. Paul Zorn, GFOA, 1998.
- GFOA Best Practice, "Presenting Securities Lending Transactions in Financial Statements," 1998.
- GFOA Best Practice, "Repurchase Agreements & Reverse Repurchase Agreements," 2010