03 February 2011

ISLA response to EC SLD consultation paper

Securities lending is used by a wide range of investors and intermediaries. Its use supports greater settlement efficiency, market making activities and a wide array of trading strategies that provide liquidity to the securities markets. Long term investors, such as pension funds, generate important incremental revenues from engaging in securities lending. Over the course of several decades the market has developed a robust framework for the operation of securities lending that incorporates the use of market standard legal agreements and sound risk management practices, such as the receipt and daily marking to market of collateral. The benefits of securities lending have been widely recognised by regulators around the world, by national and supranational organisations and by academics. 

In Europe, much securities lending takes place under the Global Master Securities Lending Agreement (“GMSLA”) published by ISLA. The agreement provides a robust legal framework for documenting securities lending transactions. The framework is underpinned by the annual collection of legal opinions that support the GMSLA’s effectiveness across a wide range of jurisdictions.

ISLA's comments on the consultation document are restricted to matters that are of potential relevance to the securities lending market, namely issues relating to the principles outlined under Account Held Securities, Priority and Passing on Information.

Account held securities

ISLA considers it important for the Directive to allow account providers to distinguish between securities accounts (which would have the legal effects specified in the principles) and other records relating to securities (which do not). For example, a custodian acting prudently will keep a record of all securities formerly held in custody but lent out by its clients; such records would not constitute "securities accounts" as they merely represent contractual, rather than proprietary, entitlements of clients, to have such securities returned at the end of the loan. Such records therefore do not confer the rights set forth in Principle 3.

In addition, the proposals do not seem to permit the parties to amend the rights of the account holder by contract to exercise securities credited to a securities accounts. If this is the case this may have unintended consequences. For example, an agent lender may seek to place a contractual restriction on a client's ability to deal with collateral received under a stock loan (other than by way of reinvestment of that collateral) in order to ensure that it is available to be returned to a borrower, or sold by the agent on behalf of the account holder in the event of a borrower default. Lending contracts with account holders usually allow for some subrogation of rights to the lending agent in the event of a borrower’s default. It is important, and in the account holders best interests that these contractual arrangements are honoured.

Priority (Collateral arrangements)

Paragraph 22.1 (p) and (q) define “earmarking” and “control-agreements” which ISLA envisage may be used in the context of certain market arrangements for securities given as collateral, in which the collateral provider seeks to retain authority over actions in respect of the securities in question. 

While “earmarking” or “control agreements” do not in and of themselves preclude collateralisation by full legal transfer to the creditor, we would urge that in developing this legislative proposal, it is important to ensure that no confusion arises that would compromise alternate legal forms of collateralization, so that collateralised securities lending under the GMSLA continues to be capable of being managed in the robust way that is already established in the market.

There is also a general concern with the approach adopted under the paper as it provides for interests in an account established by way of earmarking to take priority over interests created by way of a "control agreement" notwithstanding the chronological order in which such interests have been created. The reason for the approach is not clear and it creates issues for agent lenders such as custodians, who take a lien or security interest over their clients accounts to secure performance of their clients obligations.

A final point concerning the proposal and the treatment of collateral arrangements concerns territorial scope. Whilst securities loans conducted under the GMSLA provide for full title transfer of lent securities and collateral, in some jurisdictions, collateral is received by way of a pledge. This type of arrangement is commonly used by US based lenders for European securities.

Passing on information

Under the proposals an account provider is required to pass on all information (e.g. in respect of corporate actions) to the ultimate account holder without delay. Whilst this principle is understood for general securities held in custody this requirement may place unnecessary burdens on securities lending agents in respect of securities collateral they hold for their clients. It is customary for collateral securities that are subject to corporate actions and dividends to be substituted over record dates however this does not always happen.

Lenders who hold securities as collateral are generally only interested in the security value of the collateral and requiring agent lenders to pass on information about corporate actions and voting events (in which lenders do not normally participate) would require system investments and costs that appear to have little or no value.

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