Issues and specific amendments

Key issue

A key issue addressed in the Amendments concerns certain agency security borrowing and lending arrangements.  In general, security borrowing/lending transactions expose Dealer Members to potential loss despite the fact that they are collateralized transactions.  The exposure results from the fact that (i) borrowings of securities by Dealer Members are typically modestly over-collateralized, (ii) both the borrowed security and collateral values may fluctuate over time giving rise to further mismatches in coverage, and (iii) in the event of the insolvency of the Dealer Member’s counterparty, it may be difficult and time consuming to recover the collateral and close out the transaction – while market values continue to fluctuate.

Tri-party agency arrangements have risk protection features that mitigate a Dealer Member’s risk of loss through the use of a third party custodian which stands between the borrower and lender and holds, as agent, the collateral supporting the loan on the lender’s behalf.  These risk protection features are:

1. the collateral is held by the third party custodian agent, who qualifies as a “financial intermediary” under the Eligible Financial Contract Rules (Bankruptcy and Insolvency Act), and will not be released to the underlying principal customer.  In the event of a default by the Dealer Member, the custodian would liquidate the collateral, purchase the loaned securities in the market with the proceeds and return remaining proceeds, if any, to the Dealer Member; and
2. the agency arrangement qualifies as an “eligible financial contract” under the Eligible Financial Contract Rules (Bankruptcy and Insolvency Act) and therefore, in the event of an insolvency of either the custodian agent or the underlying principal customer, the collateral does not form part of the insolvent party’s estate and can be quickly returned to the Dealer Member.

As a result, these agency arrangements are considered by IIROC Staff to be at most no more risky than a bi-lateral security borrowing and lending agreement between the Dealer Member and the third party custodian, as if it was acting as principal.

Consequently, under the amendments, these agency arrangements would be treated, for margin purposes, in the same way as the equivalent principal arrangement would have been between the Dealer Member and the custodian, and therefore margined according to the counterparty credit risk classification of the custodian.

Typically, custodians that are active in the security borrowing and lending business are financial institutions (e.g. CIBC Mellon, BNY Mellon, State Street) that meet the definition of “acceptable institutions” and are considered the lowest credit risk clients under IIROC’s counterparty credit risk classification.

Current rules

Background on cash/securities loan arrangements

A cash/securities loan is an agreement that is executed between a Dealer Member and another entity (the “counterparty”).  The terms of the loan are governed by a loan agreement, which requires that the borrower provide the lender with collateral, in the form of cash or securities, of a value equal to or greater than the loaned cash/securities.  Major lenders of securities include investment funds, insurance companies, pension plans and other large investment portfolios.  Securities borrowing is an important tool used by hedge funds and other investment vehicles that follow a “short sale” strategy, to meet their transaction settlement obligations.

Current margin requirements

The current margin requirements for cash/securities loans allow Dealer Members to enter into such loans on:

• an unsecured basis with “acceptable institution”1 counterparties;
• a modestly over-collateralized  basis2 with “acceptable counterparty” 3 counterparties;
• a “value for value” basis with “regulated entity” 4 counterparties; and
• a “loan value equivalency”5 basis with “other”6 counterparties

The effects of these margin requirements are to limit, in the case of a securities borrowing arrangement, the dollar amount of collateral that may be delivered by the borrower to the lending counterparty.

Concerns with current margin requirements

There are two concerns with the current margin requirements:

1. the current rules do not set out specific margin requirements for agency cash and security borrowing and lending arrangements; and
2. the current rules do not impose the same margin requirements on cash and security borrowing and lending arrangements with “acceptable counterparty” versus “regulated entity” counterparties.

Agency agreements

Within the last year there has been a significant shift away from Dealer Members entering into cash and security borrowing and lending arrangements directly with the arrangement counterparty.  Rather, the recent trend is for Dealer Members to execute an agency arrangement, whereby the Dealer Member enters into cash and security borrowing and lending arrangement with a third party custodian, who is acting as agent for the ultimate counterparty (also referred to as the underlying principal counterparty) to the arrangement.  These agency arrangements have the following features:

• the third party custodian agent typically qualifies as an “acceptable institution” and administers an agency lending program on behalf of its clients;
• pursuant to the agency lending arrangements that are executed:
  • the loan collateral is held by the third party custodian agent and if the loan collateral includes securities the agent cannot re-hypothecate those securities;
  • in the event the Dealer Member defaults, the loan collateral that has been posted with the third party custodian agent will be liquidated by the third party custodian agent and the proceeds used to purchase the borrowed security, which will be returned to the underlying principal lender.  If the borrowed security cannot be purchased in the market, its equivalent value is returned to the underlying principal lender.  Any excess value on the realization on the loan collateral will be returned by the third party custodian agent to the Dealer Member;
  • the agency agreement qualifies as an “Eligible Financial Contract” under Canadian legislation relating to bankruptcy, insolvency and creditor’s rights, where the third party custodian agent meets the definition of “financial intermediary” in relation to the Eligible Financial Contract General Rules (Bankruptcy and Insolvency Act), which means that the contract continues in the event that any party to the contract becomes insolvent, and the collateral does not form part of either the custodian’s or the ultimate counterparty’s estate in the event of an insolvency of either of them.

Given the features of these agency arrangements, IIROC Staff have concluded that the risk assumed by a Dealer Member when entering into one of these arrangements is no greater than the risk assumed by a Dealer Member when entering directly into an equivalent “principal” arrangement with the third party custodian agent.  Furthermore, there is an argument to be made that the risk is lower as the Dealer Member:

• will not have its collateral frozen, should the ultimate counterparty become insolvent; and
• will be able to quickly access its collateral, should the custodian become insolvent, because the agency lending arrangement qualifies as an “Eligible Financial Contract”.

The current notes and instructions to Schedules 1 and 7 of Dealer Member Form 1 do not discuss these specific types of agency arrangements, nor do they recognize that the risk of such arrangements is equivalent to comparable “principal” arrangements.  The result is that Dealer Members are required to “look through” the third party custodian agent to determine the entity that is the ultimate counterparty under the current IIROC margin rules, and provide additional margin for such arrangements in amounts that represent as much as 3% of the market value of the loan.

Different margin requirements for arrangements involving “acceptable counterparty” versus “regulated entity” counterparties

As a general rule, IIROC’s rules allow Dealer Members to transact with other regulated dealers on a “value for value” basis, with mark to market imposed on outstanding transactions, without capital penalty.  This general rule currently applies to all cash and security borrowing and lending arrangements between a Dealer Member and:

• another Dealer Member; and
• another dealer that qualifies as a “regulated entity”, such as a FINRA dealer.

Notwithstanding this fact, it is now common street practice for Dealer Members to be asked to provide collateral with a value in excess of the amount of the loan when entering into cash and security borrowing and lending arrangements with regulated entities (i.e. other Dealer Members and foreign dealers).

The current IIROC rules that apply to cash and security borrowing and lending arrangements, where the counterparty is an “acceptable counterparty” allow for delivery of excess collateral representing between 102% and 105% of the amount of the loan without any margin implication.  As credit risk exposures to “acceptable counterparties” and “regulated entities” are treated the same way for all other transactions, there is no risk-related reason why a modest amount of excess collateral should not be permitted for cash and security borrowing and lending arrangements where the counterparty is a “regulated entity”, without similar margin relief.  Without this relief, Dealer Members are required under the current IIROC margin rules to provide margin, that represents as much as 5% of the market value of the loan, in instances where a modest amount of over-collateralization is requested.

Amendments

To address the concerns with the current margin requirements, specifically that the current rules:

• do not set out specific margin requirements for agency cash and security borrowing and lending arrangements, and

• do not impose the same margin requirements on cash and security borrowing and lending arrangements with “acceptable counterparty” versus “regulated entity” counterparties,

the following amendments to that the Notes and Instructions to Schedules 1 and 7 and Schedule 7A of Dealer Member Form 1 are being made:

1. Amend the definition of “excess collateral deficiency” that appears in Note 2 of the Notes and Instructions to Schedules 1 and 7, such that margin only applies when the collateral provided is in excess of:
   • 102% of the loan when the collateral provided is cash; and
   • 105% of the loan when the collateral provided is in the form of securities.
   • In addition, the following non-material amendments have been added to the definition of “excess collateral deficiency” that appears in Note 2 of the Notes and Instructions to Schedules 1 and 7 to make the definition clearer:
   • ““cash loans receivable” are loan transactions where the purpose of the loan is for the Dealer Member to lend cash and receive securities as collateral from the counterparty”;
   • ““securities borrow arrangements” are loan transactions where the purpose of the loan is for the Dealer Member to borrow securities and deliver cash or securities as collateral to the counterparty”;
   • ““cash loans payable” are loan transactions where the purpose of the loan is for the Dealer Member to borrow cash and deliver securities as collateral to the counterparty”; and
   • ““securities loan arrangements” are loan transactions where the purpose of the loan is for the Dealer Member to lend securities and receive cash or securities as collateral from the counterparty”.
2. Introduce new Note 5(b) to the Notes and Instructions to Schedules 1 and 7 to specify the margin requirements for cash loans receivable and cash loans payable.  In addition, the following non-material amendments to Note 5 to the Notes and Instructions to Schedules 1 and 7 have been made:
   • for Schedule 1, the two arrangements “Cash loans receivable and securities borrowed arrangements” have been separated into “Cash loans receivable” and “Securities borrow arrangements” and “Securities borrow arrangements” will be in new Note 6 and the other subsequent Notes renumbered accordingly, each arrangement will have its own “Written agreement requirements”, “Additional written agreement requirements for certain agency agreements” (does not apply to cash loan receivable), “Margin requirements” in order to make the requirements for each arrangement clearer; and
   • for Schedule 7, the two arrangements “Cash loans payable and securities loan arrangements” have been separated into “Cash loans payable” and “Securities loan arrangements” and “Securities loan arrangements” will be new Note 6 and the other subsequent Notes renumbered accordingly, each arrangement will have its own “Written agreement requirements”, “Additional written agreement requirements for certain agency agreements” (does not apply to cash loans payable), “Margin requirements” in order to make the requirements for each arrangement clearer.
3. The following material amendments have been made under new Note 6(b) to the Notes and Instructions to Schedules 1 and 7 with respect to the additional written agreement requirements for certain agency agreements where the agent may be treated as equivalent to principal:
   • the loan collateral must be held by the third party custodian agent and if the loan collateral is made up of securities there must be no right to re-hypothecate those securities.  This no re-hypothecation of collateral requirement is limited to collateral provided in the form of securities, because it is normal market practice for third party custodian agents to use the cash it receives as collateral in its business;
   • the default process that describes one of the additional risk protection features of the security borrowing and lending agency arrangement that must be met;
   • the third party custodian agent must meet the definition of “financial intermediary” in relation to the Eligible Financial Contract General Rules (Bankruptcy and Insolvency Act)—the definition of “financial intermediary” is available on the Justice Laws Website ; and
   • the criteria to clarify when the agency arrangement must not be treated in the same manner as an equivalent principal arrangement between the Dealer Member and the custodian and, in those cases, how the agency arrangement is to be treated.
4. The following material amendments have been made under new Note 6(c) to the Notes and Instructions to Schedules 1 and 7 with respect to margin requirements that:
   • add various situations in which an agency agreement could differ and include their corresponding treatment in order to clarify the margin requirements for agency security borrowing and lending arrangements under various situations.
5. Amend under new Note 7(b) to the Notes and Instructions to Schedules 1 and 7 to set “market value deficiency” as the standard margin requirement for resale and repurchase agreements involving “acceptable counterparties” and “regulated entities”—while the current rules do allow over-collateralization for certain resale and repurchase agreements involving “acceptable counterparties”, this margin requirement is being amended from “excess collateral deficiency” to “market value deficiency” because:
   • overcollateralization is not a common practice for repurchase and resale agreements; and
   • allowing the continued overcollateralization for repurchase and resale agreements would run counter to Bank of Canada’s remarks on introducing  “haircuts”7
      Shedding Light on Shadow Banking: for these agreements in the near future.
6. Amend Schedule 7A to extend the existing overcollateralization concentration test, that currently only applies to overcollateralization exposures to “acceptable counterparties”, to overcollateralization exposures to both “acceptable counterparties” and “regulated entities”.

Attachments

Attachment A – Amendments to Schedules 1, 7 and 7A [and related Notes and Instructions] of Dealer Member Form 1;

Attachment B –  Black-line comparison of amendments to Schedules 1, 7 and 7A [and related Notes and Instructions] of Dealer Member Form 1 to current Dealer Member Form 1;

Attachment C –  Discussion of four types of counterparties defined within IIROC’s capital and margin rules; and

Attachment D –  Summary of margin impact of the amendments to certain cash and securities borrowing and lending arrangements.

• 1See Attachment C for a description of “acceptable institutions”.
• 2Transactions that involve a modest amount of over-collateralization are transactions where the market value of the cash or securities provided as loan collateral by investment dealer is slightly in excess of the market value of the cash or securities received in by the investment dealer pursuant to the loan arrangement.  Street practice is to require 102% over-collateralization when cash is provided as loan collateral and 105% over-collateralization when securities are provided as loan collateral.
• 3See Attachment C for a description of “acceptable counterparties”.
• 4See Attachment C for a description of “regulated entities”.
• 5Transactions performed on a “loan value equivalency” basis are those where the loan value  of the cash or securities (which is market value less margin) received in by the investment dealer is equal to the loan value of the cash or securities delivered out by the investment dealer.
• 6See Attachment C for a description of “other” counterparties.
• 7Shedding Light on Shadow Banking: Bank of Canada