Equities As Collateral Study

March 2011
EquitiesasCollateral
InU.S.SecuritiesLendingTransactions

AStudyImplementedby
TheRMAExecutiveCommitteeon
SecuritiesLending
COMMITTEE ON

COMMITTEE
MEMBERS

Chairman
Michael P. McAuley
Premier Global Securities Lending

Patrick Avitabile
Citi

Gene P. Gemelli
Credit Suisse

Sandra L. Linn
Northern Trust Company

Rebecca Nordhaus
Brown Brothers Harriman

Judith Polzer
J.P. Morgan

Jason P. Strofs
Blackrock

Ex-Officio
W. Tredick McIntire
Goldman Sachs Agency Lending

RMA Staff

Christopher Kunkle
Director,
Securities Lending & Market Risk

Fran Garritt
Associate Director

Loretta Spingler
Administrative Assistant

Kimberly Gordon
Administrative Assistant
SECURITIES LENDING

Attached please find a study with respect to the use of equity securities as collateral
in agency securities lending transactions. This study was undertaken by the Risk
Management Associations Committee on Securities Lending (the Committee). The
purpose of the study is to provide statistical and empirical evidence of the importance of
equity collateral as an essential component of a complete and robust risk management
program, and to support positive regulatory change that would permit the use of equity
collateral in the US securities lending market. The study is a compilation of the following
three documents.

Securities Lending: Equity as Collateral: Credit Exposure Analysis Summary by
Alan Laubsch of the RiskMetrics Group.
This document compares the credit exposure volatility of securities lending transactions
collateralized with equities to those collateralized with cash; briefly reviews the robustness
of major VaR methodologies; backtests daily and weekly credit exposure forecasts; tests
the robustness of equity collateral under stressed conditions; provides a brief analysis of
cash reinvestment risk; and discusses the systemic risk implications of equity as collateral.

Accepting Equities as Collateral: the European Lenders Experience by Mark C.
Faulkner of Data Explorers
This document provides empirical data with respect to the practical experiences of
European lenders that had outstanding securities lending and repurchase transactions with
Lehman Brothers that were collateralized by equities at the time of their default. It
describes what actually happened, what the outcomes were and what lessons can be
learned.

Equities as Collateral in US Securities Lending Transactions: An Overview of Legal
and Regulatory Considerations by the Legal, Tax and Regulatory Subcommittee of
the Committee.
This document summarizes the legal and regulatory barriers that prevent US market
participants from either accepting or pledging equities as collateral.

Our members lend securities as agent for their clients who are generally large
institutional investors. Most of these lending agents also provide their clients with a
borrower default indemnification pursuant to which they agree to reimburse the client for
any shortfall that may occur if collateral is insufficient to purchase replacement securities
in the event that a borrower defaults and fails to return lent securities.

RMA, 1801 MARKET STREET, SUITE 300, PHILADELPHIA, PA 19103 Tel: (215) 446-4003 Fax: (215) 446-4232 E-mail: ckunkle@rmahq.org

Most of these agents lend securities on a global basis and participate in other markets
such as the European and Canadian markets where equities have long been recognized as an
acceptable form of collateral for both securities lending and repurchase transactions. As a result,
many of their clients had outstanding transactions with Lehman Brothers International, Europe
(LBIE) when they defaulted in 2008 and had to exercise rights on behalf of these clients to
liquidate collateral and purchase replacement securities. It became very apparent to those agents
working through this process that baskets of equity securities were one of the best and most
liquid forms of collateral. Equity securities performed even better than cash collateral due
mainly to the fact that most cash collateral was invested in fixed income securities. Equity
securities performed extremely well as collateral because they had a single, readily determined
price at all times; could be sold immediately; were highly correlated to the lent securities; and the
required collateral margins were typically higher than other collateral forms. In addition, in
periods of market stress, baskets of equity collateral that were highly correlated to the lent
securities significantly reduced the amount of collateral movements needed to meet daily mark-
to-market requirements. These observations by our large US-based members are confirmed by
the similar experiences of European based lenders as documented in the attached Data Explorers
study of the European experience.

The main regulatory impediment to utilizing equity collateral in the US Market is
Securities and Exchange Commission (SEC) Rule 15c3-3. The requirements of the current
rule effectively prevent US broker dealers from pledging equities as collateral when borrowing
securities from our members lending clients. The rule deems these lending clients to be
customers of the broker dealer due merely to the fact that they have agreed to lend the broker
dealer a security. This is the case even though the security that is being lent is not in the
possession or control of the broker dealer but rather is in the custody of a third-party custodian.
In addition, the lending agent has typically provided a guarantee that the security will be returned
to the lending clients custodial account.

While we view the ability of US broker dealers to pledge equity collateral when
borrowing securities from our members clients as a very important risk management tool, we
are not advocating a wholesale change to SEC Rule 15c3-3 that would allow broker dealers to
pledge equities for all lending transactions. Rather, we urge that changes be considered to the
definition of customer along the lines of that proposed in a letter to SEC Secretary, J onathan
G. Katz, from State Street Bank and Trust Company, dated J uly 31, 2002 (the State Street
Letter), in response to the SECs request for comments on the subject of whether institutional
lenders of securities should be allowed to negotiate collateral agreements other than those
required by Rule 15c3-3. A copy of the State Street letter is enclosed and a web link is contained
in the following parenthetical (http://www.sec.gov/rules/proposed/s72002/mpmcauley1.htm ). In
addition, we would suggest that the above-described changes to the rule be applicable only to
loans of equity based securities such as equities, ADRs, ETFs and convertible bonds.

In addition to SEC Rule 15c3-3, other regulatory changes would be needed to support the
use of equity collateral in the US market. These include changes to: the US Employee
Retirement Income Security Act of 1974 (ERISA), as amended, which regulates many pension
plans securities lending activities; the U.S. Investment Company Act of 1940 (40 Act), which
regulates registered investment companies securities lending activities; and several U.S. federal
statutes that govern securities lenders rights in the event of the insolvency of a counterparty
including a systemically significant counterparty.

In summary, we urge regulators to review the enclosed material and to consider a
coordinated approach that would allow institutional participants in the US securities lending
market to pledge and accept equities as collateral in transactions involving the lending of equity
based securities. We believe that such a change would benefit all market participants and help to
reduce systemic risk in both normal and stressed environments. We also believe that such a
change would improve market liquidity, reduce borrowing costs for broker dealers and provide
beneficial owners and agent lenders with another important tool to manage the overall risk in
their securities lending programs.

We thank you for your consideration and should you have any questions with respect to
this study or any of the enclosed materials or proposals suggested herein, please call Christopher
Kunkle, Director, at 215-446-4003.

Submitted by:

Christopher R. Kunkle
Director, RMA

Attachments:

Securities Lending: Equity as Collateral
Credit Exposure Analysis
Alan Laubsch, RiskMetrics
August 9, 2010

Accepting Equities as Collateral
The European Lenders Experience
Mark C Faulkner, Founder & Head of Innovation, Data Explorers

Equities as Collateral In U.S. Securities Lending Transactions
An Overview of Legal and Regulatory Considerations
Risk Management Association, Legal, Tax, and Regulatory Subcommittee

State Street Letter

SecuritiesLending:EquityAs
Collateral
CreditExposureAnalysisSummary
AlanLaubsch
8/9/2010

Thispaperanalyzestheimpactofacceptingdiversifiedequityascollateralforequitylending
transactions.

TableofContents
Summaryoffindings.....................................................................................................................................8
Background...................................................................................................................................................8
RiskEvaluationOverview..........................................................................................................................9
CreditExposureAnalysisResults................................................................................................................10
AverageCreditExposureVolatility.........................................................................................................10
MaximumCreditExposureVolatility......................................................................................................11
Chartsofdailycreditexposurevolatility................................................................................................11
IndustrialCreditExposureVolatility...................................................................................................12
ConsumerStaplesCreditExposureVolatility......................................................................................12
FinancialsCreditExposureVolatility...................................................................................................14
ConsumerDiscretionaryCreditExposureVolatility............................................................................15
EnergyCreditExposureVolatility........................................................................................................16
HealthCareCreditExposureVolatility................................................................................................17
InformationTechnologyCreditExposureVolatility............................................................................18
MaterialsCreditExposureVolatility...................................................................................................19
TelecommunicationServicesCreditExposureVolatility....................................................................20
UtilitiesCreditExposureVolatility......................................................................................................21
CorrelationsDriveHedgeEffectiveness..................................................................................................22
ASimpleCreditExposureCalculator...................................................................................................23
VaRBacktestingResults..............................................................................................................................24
AlongtermstudyofequitiesVaRbacktesting...................................................................................24
Top10dailyDJIAoutliersurprisessince1900....................................................................................26
RecentS&P500backtestingresults....................................................................................................26
VaRbacktestingresults...........................................................................................................................27
S&P500backtest................................................................................................................................27
SectorBacktesting:CashvsEquityCollateral.........................................................................................28
FinancialsBacktest:Relative...............................................................................................................30

EnergyBacktest:Absolute..................................................................................................................31
EnergyBacktest:Relative....................................................................................................................32
MaterialsBacktest:Absolute..............................................................................................................33
MaterialsBacktest:Relative...............................................................................................................34
StressTesting..............................................................................................................................................35
Maximumexposurewithcashascollateral............................................................................................35
MaximumCreditExposureWithEquityAsCollateral............................................................................35
Bearmarketstresstests..........................................................................................................................36
StressTest:largestweeklylossesforS&P500...................................................................................37
StressTest:largestweeklylossesforfinancials..................................................................................38
PredictiveHistoricalStressTests............................................................................................................38
Stresstestingsummary...........................................................................................................................39
Cashreinvestmentrisk................................................................................................................................40
Systemicriskimplicationsofequityascollateral.......................................................................................42
Whatifwedontknowourportfolios?...................................................................................................43
IntegratingVaRandStressTests.............................................................................................................44
Summary&Conclusions.............................................................................................................................45
ReferencesandAdditionalReading............................................................................................................46
Appendix:AdditionalCreditExposureBacktestingCharts.........................................................................47
ConsumerDiscretionary:Absolute.....................................................................................................47
ConsumerDiscretionary:Relative.......................................................................................................48
HealthCare:Absolute.........................................................................................................................49
HealthCare:Relative..........................................................................................................................50
Utilities:Absolute................................................................................................................................51
Utilities:Relative.................................................................................................................................52
Telcom:Absolute................................................................................................................................53
Telcom:Relative..................................................................................................................................54
ConsumerStaples:Absolute...............................................................................................................55

ConsumerStaples:Relative................................................................................................................56
IT:Absolute.........................................................................................................................................57
IT:Relative...........................................................................................................................................58
Industrials:Absolute...........................................................................................................................59
Industrials:Relative.............................................................................................................................60

Acknowledgements:
Many individuals contributed to this study. This includes RiskMetrics colleagues Marianela Hoz
de Vila, Chen Huang, Denny Yu, Seth Greenberg, Christopher Finger, Carlo Acerbi and J orge
Mina. Thanks to the RMA for helping organize this study, and to all members of the securities
lending committee who participated in numerous group and individual discussions and shared
information and insights. Thanks especially to the active contributions of Rajiv Yadlapalli, J udy
Polzer, Andrew Peron, Nick Rudenstine of J PMorgan, Sandra Linn and Kristina Richardson of
Northern Trust, Elizabeth Seidel and Neil Hiralall at Brown Brothers Harriman, Tred Mcintire at
Goldman Sachs, Glenn Horner and Michael McAuley of State Street, and Francis Garritt at
RMA.

Summaryoffindings
The following summarizes the RiskMetrics study on the impact of accepting equity as collateral
for equity lending transactions. Our general conclusion is that diversified equity has potential as
an acceptable form of collateral if managed appropriately, which includes actively monitoring
portfolio risk characteristics. From the lenders view, equity collateral generally reduces credit
exposure volatility compared to cash collateral, and responds robustly under stressed conditions
as correlations increase. In particular, systemic spikes in credit exposures are reduced across all
industry sectors, although there are differences among sectors. Finally, allowing diversified
equity as a form of collateral also can potentially reduce systemic risks and costs in equity
lending.
Background
U.S. Rule 15c3-3 prevents broker dealers from posting equity as collateral when borrowing
equities from agent lenders. Equity is a permissible form of collateral between broker dealers,
and in other jurisdictions, including U.K., Europe, Australia, and Canada.

In broker dealer default scenarios it is generally understood that equity markets will suffer,
leaving one to think that a trade with cash collateral will always be safer. But this isn't the full
story.

Equity lenders will need to invest cash collateral in assets that yield more than the rebate rate of
their loaned positions. This generally leaves them in a short-term fixed income portfolio with
some element of credit risk that is riskier than US government securities (e.g., enhanced yield or
money market fund-like holdings) in order to make the trade economic. In effect, the cash
reinvestment into such enhanced yield funds creates a credit, liquidity, and/or duration mismatch.
While this study focuses mainly on the impact of equity as collateral, we will include a basic
analysis of cash re-investment risk.

An apples-to-apples comparison between equity versus cash as collateral would be to estimate
the credit exposure profile for the following:
Fromtheperspectiveoftheagentbankinanindemnifiedtransaction:equityloanversusequity
collateralcomparedtoequityloanversuscashcollateral.
Fromtheperspectiveofthelender:equityloanversusequitycollateralcomparedtoequityloan
versuscash,pluscreditexposuretothechosenreinvestmentvehicle(i.e.,thelenderfacestwo
creditexposures:onetotheagentbank,andthesecondtothechosenreinvestmentvehicle).
We will test the hypothesis of whether accepting soundly structured pools of equity collateral
would generally result in lower credit exposure volatility relative to cash collateral, while
performing robustly in stressed market conditions. In the limit, if both collateral and lent stocks

were closely matched (or highly diversified), credit exposure would be minimal and the main
challenges would be operational and execution risk in a potential default event. In practice,
however, we would expect some level of sector or size bias mismatch between lent equities and
collateral. Such a mismatch could result in tail risk if these two portfolios diverged significantly.

Our study therefore simulates a range of realistically mismatched portfolios and compares the
performance of equity and cash as collateral.
RiskEvaluationOverview
In our risk evaluation approach, we take multiple perspectives on credit exposure arising from
equity lending transactions. A brief outline follows below:
1. CreditExposureVolatility
Wecomparecreditexposurevolatilityoftransactionscollateralizedwithcashvsequity,andthen
offerabriefreviewoftherobustnessofmajorVaRmethodologies.Wethenapplytheoriginal
RiskMetrics94methodology(RM1994)tobacktestdailyandweeklycreditexposureforecasts.
2. Stresstesting
Wetesttherobustnessofequityascollateralunderstressedconditions.First,weidentifytheten
largestweeklycreditexposures(Jan32005toJan292010)forequityandcashascollateral.We
thenfocusonlargehistoricaldownmarketstresses,whenbrokerdefaultismostlikely
We use the following parameters throughout the study:

1) Lentequities:wewillsimulateaseriesofconcentratedportfolioswithsectororsizebias(e.g.,
financials,smallcap).Forsectorconcentrations,wewillcreateproxiesusingS&P500sectors,
andforsizebiaswewilluseRussell2000and3000growthandvalueETFs.
2) Equitycollateral:wewillassumethatequitycollateralwillbediversified,proxiedbytheS&P500
index.
3) Liquidationhorizon:Weassumethatafivedayhorizonwillbeadequateforperformingan
orderlyliquidationofliquidsecurities.
4) Creditexposurewillbemodeledwithoutcustomarycollateralhaircuts:100%longsector
portfolioand100%shortlentequities.Thisisdoneforsimplicityandconsistency;and,if
desired,effectsofhaircutscouldeasilybefactoredinafterwards.
Whileourstudyfocusesontheperformanceofequityascollateral,wealsoincludeabriefanalysisof
cashreinvestmentrisk.
Finally,wetakeaviewofsystemicriskimplicationsofequityascollateral.

CreditExposureAnalysisResults
In this section we show the effects of equity as collateral on credit exposure volatility calculated
using RM 1994: Exponentially Weighted Moving Average (EWMA) volatility with .94 decay,
using log returns of daily closing price data. The results are broadly supportive of equity as
collateral, showing not only a reduction in average volatility across all sectors, but more
importantly significantly lower maximum volatility and more stable credit exposure volatility.
Equity as collateral performs well under stressed market conditions, benefiting from increased
correlations. By way of terminology, we will use credit exposure volatility and VaR
interchangeably.
AverageCreditExposureVolatility
Compared to cash collateral, average credit exposure volatility across all sectors is reduced by
41% with equity as collateral. The reduction in volatility ranges from 65% (Industrials) to 13%
(Consumer Stables).

Figure 1: Average Credit Exposure Volatility (99% Confidence Level VaR)
.
Avg Weekly 99%
VaR*
Cash
collateral Equity collateral Reduction
Industrials 7.6% 2.7% 65%
Cons Disc 7.9% 3.0% 61%
Inf tech 7.7% 3.2% 58%
Materials 9.6% 4.9% 49%
Financials 12.7% 7.3% 42%
Energy 9.8% 6.3% 35%
Telcom 7.5% 4.9% 35%
Healthcare 5.5% 3.9% 29%
Utilities 6.4% 4.9% 24%

Cons Stpls 4.5% 4.0% 13%
Table 1: Credit Exposure Volatility, ranked by average volatility reduction
MaximumCreditExposureVolatility
Equity collateral is especially effective at reducing credit exposure volatility when it is at its
highest: 56% on average across all sectors. Furthermore, the standard deviation of VaR is 58%
lower, on average, meaning that credit exposure volatility estimates tend to be more stable over
time with equity as collateral.

Figure 2: Maximum weekly 99% confidence level VaR

Max Weekly VaR
(%) Cash collateral Equity collateral Reduction
Cons Discr 27% 7% 75%
Info Tech 25% 8% 69%
Industrials 24% 8% 68%
Materials 33% 12% 63%
Telecom 28% 12% 58%
Average 29% 13% 56%
Utilities 27% 12% 53%
Energy 40% 19% 52%
Health Care 22% 11% 49%
Cons Stap 20% 11% 43%
Financials 44% 28% 37%
Table 2: Maximum Weekly VaR (Jan 2006 to 2010) for equity and cash collateral.
Chartsofdailycreditexposurevolatility
Graphing historical credit exposure volatility provides useful insights, and confirms the broad
effectiveness of equity collateral.

Below are charts of each industry sector from 31 May 05 to 29 J an 10.
IndustrialCreditExposureVolatility
We will start with a plot of Industrials, which showed the most significant reduction in credit
exposure compared to cash collateral: 63% on average, 68% lower peak exposures, 72% lower
credit exposure volatility.

Figure 3: Industrial Credit Exposure Volatility
ConsumerStaplesCreditExposureVolatility
As a contrast, next we will show the sector with the lowest benefit on average, Consumer
Staples. Due to the relatively low average correlation during normal market conditions, average
reduction in credit exposure volatility is only 13% on average. As correlations increase in
stressed conditions, however, the hedge becomes more effective. We see a 43% reduction in
peak exposures as well as a 20% reduction in exposure volatility when equity is used as
collateral.

Figure 4: Consumer Staples Credit Exposure Volatility

FinancialsCreditExposureVolatility
Next we show financials, which had the lowest reduction in peak credit exposure.
Reduction in credit exposure compared to cash collateral: 43% on average, 37% lower
peak exposure (lowest per industry sector), 38% lower credit exposure volatility
Figure 5: Financials Credit Exposure Volatility

ConsumerDiscretionaryCreditExposureVolatility
Significant reduction in credit exposure compared to cash collateral: 62% on average,
75% reduction in peak exposures, 75% reduction in exposure volatility
Figure 6: Consumer Discretionary Credit Exposure Volatility

EnergyCreditExposureVolatility
peak exposures, 54% lower credit exposure volatility

Figure 7: Energy Credit Exposure Volatility

HealthCareCreditExposureVolatility
Figure 8: Energy Credit Exposure Volatility
InformationTechnologyCreditExposureVolatility
Figure 9: Information Technology Credit Exposure Volatility

MaterialsCreditExposureVolatility

Figure 10: Materials Credit Exposure Volatility

TelecommunicationServicesCreditExposureVolatility
Figure 11: Telecommunication Services Credit Exposure Volatility

UtilitiesCreditExposureVolatility
Figure 12: Utilities Credit Exposure Volatility

CorrelationsDriveHedgeEffectiveness
The correlation between lent equities and collateral determines how well the pair performs.
Figure 13 shows that correlations between sectors tend to range between 70%-90%, using a 60
day lookback period. Table 3 shows that some sectors (Utilities, Telcom, Energy) have the
lowest average correlation and the most unstable correlations. In stressed markets, however,
correlations tend to converge among all sectors: the difference between the least correlated sector
(92%) and the most correlated sector (98%) is minimal. Investors often complain about
correlations going to 1 when markets crash. Equity as collateral actually benefits from this effect
as collateral and lent securities are more likely to move in lockstep.
Figure 13: Sector Correlations Vs S&P 500

Correlation Min
Average
Correlation
Max
Correlation
Std Dev of
Correlation Summary Correlation
Utilities 21% 70% 92% 14%
Telecom Svc 35% 71% 94% 13%

Energy 13% 71% 94% 19%
Health Care 47% 79% 96% 11%
Cons Stpl 47% 82% 95% 8%
Materials 53% 83% 96% 10%
Financials 72% 88% 95% 4%
Info Tech 73% 88% 98% 5%
Cons Discr 78% 90% 98% 4%
Industrials 77% 91% 98% 5%
Table 3: Sector vs S&P 500 correlation range
ASimpleCreditExposureCalculator
We built a simple Excel spreadsheet that allows users to quickly compute credit exposure
volatilities given standard deviations of the long and short portfolios and correlations. Users can
also change time horizon (5 days) and standard deviation multipliers (e.g., 2.61 for 99%
Confidence Level assuming a Student t distribution).
Collateral VaR Calculator
Days 5 enter
SD multiplier 2.61 enter
Equity collateral SD 2% enter
Lent portfolio SD 3% enter
Correlation 80% enter
Cash collateral VaR 17.5%
Equity collateral VaR 10.76%
Volatility reduction 38.5%
Figure 14: Simple Credit Exposure Calculator

VaRBacktestingResults
How did forecasted volatility compare to realized market movements? The performance of VaR
models differed significantly depending on methodology used. Historical simulation and other
unresponsive VaR methodologies (e.g., 1 year+simple moving average volatility) showed poor
predictive results. They adapted too slowly to spikes in volatility; and after volatility had already
started to decline, their forecasts were overly conservative. On the other hand, adaptive models,
such as EWMA or the RiskMetrics 2006 generalized ARCH model performed reasonably well
for equities and other liquid asset classes.
AlongtermstudyofequitiesVaRbacktesting
This section highlights some of the relevant findings from A Historical Perspective On Market
Risks UsingTheDJIAIndexOverOneCentury(2009)byGillesZumbachandChristopher
Finger.Thestudyconfirmedtheoutperformanceofadaptivevolatilityestimatesover
unresponsivemethodologies.ThestudyalsoshowsthattheNormal(Gaussian)distribution
underestimatesdownsideoutliersbeyond95%confidencelevel,andthattheStudentt
distributionwith5degreesoffreedomfitstaillosseswell(aswithotherassetclasses:seeGilles
Zumbach,BacktestingRiskMethodologiesfromOneDaytoOneYear(2007).Figure15below
showsthattheNormaldistribution(dashedblackline)intersectstheStudenttdistribution
(blackline)atthe95%confidencelevel,andisabetterfitbeyondthatconfidencelevel
comparedtotheactualdata.

Figure 15: The probability distribution of DJIA returns rescaled to have unit variance (blue line)
and of the residuals (red line), compared with Gaussian (dashed) and Student t(solid black).
Source: Gilles Zumbach, Christopher Finger: A historical perspective on market risks using the
DJ IA index over one century Feb 2009

The figure below shows DJ IA returns and annualized volatility from 1900. The rapid phase
transition from low to high volatility environments implies the need for dynamic models to
estimate short term credit exposure volatility for equities lending.
Figure 16: DJ IA Index level (top) and annualized volatility using RiskMetrics 2006 methodology
(bottom)

Top10dailyDJIAoutliersurprisessince1900
Yet even with the use of dynamic volatility estimates and Student t distribution, we find a
number of unusual outliers, especially on the downside. In Doomed to Repeat it (Nov 2008),
Christopher Finger identifies the following top 10 downside surprises for the DJ IA since 1990
(see Table 4). Interestingly, none of the large absolute loss events during the 2008-2009 Global
Financial Crisis (GFC) makes it on the top 10 list (due to the fact that volatility was already at
such elevated levels during this period).
Return
(%) Date Residual Volatility (%) Comment
1 26-Sep-55 -13.30 -6.50

8.10 Eisenhower heart attack
2 19-Oct-87 -12.60 -22.60

32.40 Black Monday
3 29-Jul-27 -10.10 -5.20

8.30 Failure of Geneva conference to naval weapons
4 13-Oct-89 -10.00 -6.90

11.40 Collapse of junk bond market
5 26-Jun-50 -8.10 -4.70

9.30 Start of Korean War
6 27-Feb-07 -7.80 -3.30

6.80 Beginning of subprime, China worries
7 20-J an-13 -7.00 -4.90

11.40 Tension between Turkey & Europe, naval fight w/Greece
8 30-J ul-14 -6.70 -6.90

16.90 NYSE about to close, WW1
9 28-J ul-14 -6.70 -3.50

8.50 Austrias ultimatum to Serbia, war looming
10 15-Nov-91 -6.60 -3.90

9.60 Program trading losses due to options/futures expiry
Table 4: 10 largest DJIA surprises since 1900

Contrary to popular perception, the most recent top ten surprise did not occur during the
Global Financial Crisis (GFC), but rather marked its inception on Feb 27 2007. The 3.3% drop in
the Dow J ones was moderate in absolute terms, but highly unusual given the low level of
volatility at the time. Christopher Finger tagged this outlier as Beginning of subprime and this
point indeed seemed to mark a phase transition of continually escalating risk culminating in the
2008 Lehman default and aftershocks. Large outliers often mark significant events, which may
translate into broader regime shifts.
RecentS&P500backtestingresults
Figure 17 below shows daily 95% VaR backtesting results for the S&P 500 index from J an 07
to April 10. The Feb 27 outlier event is circled on the left. Backtesting results show the
downside skew in markets during the GFC (7.12% downside vs 4.51% upside outliers), but
results are robust overall with residuals generally not much greater than 3 standard deviations
(sd). However, the intra-day data, reveals that the May 6 Flash Crash would have represented

7.78 sd fall, close in magnitude to the Feb 27 8.5 sd outlier. Outliers are important early warning
signals, often marking regime shifts. Risk managers should therefore pay close attention to such
signals when managing their counterparty credit exposures.

Figure 17: S&P 500 level (purple) overlayed with daily log returns (blue) with 95% VaR bands
(red)
VaRbacktestingresults
The following charts will illustrate daily and weekly 99% VaR backtesting results around our
sample S&P 500 sector portfolios from 3 J an 06 to 29 J an 10. Weekly forecasts showed fewer
outlier surprises than daily returns, indicating that tail risk generally became more normal at
weekly horizons. Furthermore long/short combination of equities generally showed lower
downside outliers than outright long positions, which further supports the use of equity as robust
collateral.
Again, the results below are based on the basic RM 1994 methodology, using log returns and
square root of time scaling of volatility from 1 day to 1 week. We use RM 1994 as the reference
model as it is the most transparent and easy to understand, while still providing robust results.

S&P500backtest
The S&P 500 backtest below shows significant daily downside outliers of 2.92%, but weekly
downside outliers are close to expectation at 1.32%.

Figures x. S&P 500 daily (top) and weekly (bottom) 99% VaR backtest
SectorBacktesting:CashvsEquityCollateral
The sector backtesting section is organized as follows. First, we show daily and weekly credit
exposure backtests with cash collateral (i.e., equivalent to short sector & long cash), and then
show the results substituting equity as collateral (i.e., short sector & long S&P 500). For weekly
forecasts, we simply scale daily volatilities by the square root of 5. For simplicity we assume no
margin haircuts (i.e., initial equity and cash collateral is assumed to be 100%, not 102% or
higher).
By way of terminology, we use Absolute when cash is assumed as collateral, and Relative when
equity is assumed as collateral.

FinancialsBacktest:Absolute
We start with an analysis of financials, which transitioned from being one of the lowest volatility
sectors prior to the Feb 27 07 outlier to the most volatile sector with absolute weekly VaR
exceeding 40% for several months following the Lehman meltdown.
Figure 18: Financials (Absolute), daily and weekly backtests

FinancialsBacktest:Relative
When looking at relative financial returns, we can see the same pattern of escalating waves of
risk commencing with the Feb 27 07 outlier as in the absolute chart. This makes sense, since
financials were the primary cause of the systemic risk that slowly infected broader markets.
Equity collateral does reduce average volatility by 42%, but peak volatility is only 37% lower.
Weekly excessions are the highest of any industry sector at 2.36% when using the Normal
distribution. Substituting the Student t distribution (i.e., with a standard deviation multiplier of
2.61 instead of 2.33) reduces weekly excessions to an acceptable 1.32%.

Figure 19: Financials (Relative), daily and weekly backtests

EnergyBacktest:Absolute
Energy was the second most volatile sector, and showed a sudden spike in VaR which
quadrupled from 10% to 40% at the onset of the Lehman crisis. Downside outliers (which
represent upside movements in Energy) are moderate for daily and weekly returns.

Figure 20. Energy (Absolute), daily and weekly backtests

EnergyBacktest:Relative
By comparison, relative energy volatility increases more gradually when equity is used as
collateral; and, at its weekly peak volatility is 20%, about half of the absolute sector volatility.

Figure 21: Energy (Relative), daily and weekly backtests
Backtesting charts with summary statistics for all other sectors are presented below.

MaterialsBacktest:Absolute

Figure 22: Materials (Absolute), daily and weekly backtests

MaterialsBacktest:Relative
Figure 23: Materials (Relative), daily and weekly backtests

For backtesting results for all other sectors, please see Appendix 1.

StressTesting
We take two perspectives on stress testing. First, we consider the maximum historical credit
exposure for each sector with cash vs equity as collateral. Secondly, we focus on credit exposure
in historical market downturns.
Maximumexposurewithcashascollateral
Table 5 shows that maximum credit exposure with cash as collateral occurred during the 27 Nov
08 and 3 Nov 08 rally, and equity as collateral would have resulted in minimal exposure. While
broker default is unlikely in rising markets; if such an event did occur, it would result in
synchronized losses across all major sectors and therefore result in large aggregate credit losses
throughout the securities lending industry.
Date Absolute CE Relative CE Sector Return
S&P 500
Return
Financials
27-Nov-
08 -30.4% -12.2% 30.4% 18.3%
Energy
27-Nov-
08 -24.8% -6.6% 24.8% 18.3%
Materials
27-Nov-
08 -23.5% -5.3% 23.5% 18.3%
Cons Discr
27-Nov-
08 -23.1% -4.9% 23.1% 18.3%
Telecom Svc
27-Nov-
08 -20.1% -1.8% 20.1% 18.3%
Industrials
27-Nov-
08 -16.0% 2.3% 16.0% 18.3%
Info Tech
27-Nov-
08 -14.6% 3.6% 14.6% 18.3%
Utilities
27-Nov-
08 -11.3% 6.9% 11.3% 18.3%
Cons Staples 3-Nov-08 -10.7% 3.0% 10.7% 13.6%
Health Care 3-Nov-08 -9.7% 3.9% 9.7% 13.6%
Table 5. Worst Sector Credit Exposures (CE) For Cash As Collateral (Relative)
MaximumCreditExposureWithEquityAsCollateral
Table 6 shows the maximum weekly credit exposures between 7 Feb '05 to 29 J an '10, assuming
equity as collateral. These weeks represent the largest one week S&P 500 outperformance for
each sector. While some of the credit exposures are sizeable (assuming no haircut), the results
are broadly robust. The maximum exposure week for each sector is unique, indicating that
industry specific factors drove exposures . The single largest credit exposure (financials, -22.8%)
arose during a large bull market when broker default is unlikely. Furthermore, for any default in

a bull market, credit exposure assuming cash collateral would have been larger (-35%). Credit
exposures during significant down market are highlighted in red. As expected the two largest
down market credit exposures are to defensive sectors that fell less than the S&P 500 (Utilities &
Consumer Staples), and clearly cash collateral outperforms equity in down markets (assuming no
reinvestment risk).
Sector Worst week
Relative CE
(equity)
Absolute CE
(Cash)
S&P 500
return Sector Return
Financials 13-Mar-09 -22.3% -35.0% 12.8% 35.0%
Cons Staples 20-Nov-08 -9.8% 0.0% -20.2% -10.4%
Utilities 17-Nov-08 -9.4% -1.1% -8.3% 1.1%
Energy 22-Sep-08 -8.8% -9.8% 1.0% 9.8%
Health Care 13-May-09 -7.6% -3.6% -4.0% 3.6%
Materials 12-Dec-08 -7.2% -8.4% 1.2% 8.4%
Telecom Svc 28-Oct-08 -7.2% -5.7% -1.5% 5.7%
Info Tech 12-Dec-08 -7.1% -4.1% -3.0% 4.1%
Cons Discr 26-Nov-08 -6.9% -18.1% 11.2% 18.1%
Industrials 10-Oct-08 -6.9% 0.0% -19.7% -12.9%
Table 6. Worst Sector Credit Exposures (CE) For Equity As Collateral (Relative)
In summary, when cash is used as collateral, credit exposures are driven largely by broad market
rallies. In contrast, equity as collateral results in more diversified and idiosynchratic credit
exposures across sectors.
Bearmarketstresstests
In this section we examine how diversified equity performs as collateral during large equity
selloffs.
We consider the following scenarios:
Top 10 worst drops in the overall equity market over the last 5Y
Top 10 drop weeks in financials over the last 5Y.
Period includes Bear near collapse and Lehman collapse
Predictive historical stress tests (e.g., 87 crash, LTCM, Asian Crisis, 911,
DotCom)
Assumptions
We used daily observations and chose worst weeks based on non-overlapping
weekly log returns

StressTest:largestweeklylossesforS&P500
Equity as collateral performs robustly during the largest weekly losses observed in recent history,
aided by increased correlations during stress events. Table 7 highlights credit exposures in excess
of 2% in red.
The following patterns emerge:
Minimal credit exposure to high beta sectors: Financials, Energy, Materials, Industrials,
Cons Disc
Largest credit exposure to low beta sectors, which tend to fall less than the broad market:
Consumer Staples (9.8% max), Health Care, Telcom, Utilities

Relative returns (long S&P 500 short sector)
Worst weeks
Absolute
S&P loss
Cons
Disc Cons Stpls Energy
Financial
s
Health
Care IndustrialsInf Tech Materials
Telecom
Svc Utilities
1 20-Nov-08 -20.2% 1.1% -9.8% 0.7% 16.2% -3.0% -1.3% -3.0% 7.0% -2.0% -8.5%
2 9-Oct-08 -19.8% 1.8% -3.2% 0.9% 14.7% -2.2% -4.8% -4.6% -5.6% 0.1% -1.4%
3 27-Oct-08 -14.9% 1.6% -3.9% 4.2% 3.0% -3.9% -0.8% -0.3% 11.0% -4.5% -3.3%
4 12-Nov-08 -11.8% 3.8% -5.9% 0.1% 8.3% -5.4% 0.1% 0.6% 3.9% -4.1% -7.3%
5 23-Feb-09 -11.7% -3.2% -7.7% 2.2% 10.9% -5.7% 3.2% 0.3% 2.0% -6.0% -1.0%
6 5-Mar-09 -11.3% -3.4% -6.2% -1.7% 20.5% -1.3% 2.3% -7.1% -2.3% -6.0% -0.1%
7 20-J an-09 -9.4% -2.2% -7.1% -1.9% 24.8% -6.9% -2.1% -2.0% -2.9% -4.8% -8.8%
8 3-Oct-08 -9.4% 2.3% -6.9% 4.0% 0.7% -5.4% 3.2% 2.6% 7.1% -3.5% -2.9%
9 19-Feb-09 -8.2% -1.3% -6.9% -1.3% 14.7% -5.0% 0.0% -0.4% 0.3% -4.0% -2.3%
10 29-Sep-08 -7.9% -0.5% -5.5% 5.6% 3.2% -4.0% 1.0% 0.2% 8.0% -2.9% -3.6%
Bear 6-Mar-08 -4.4% 1.0% -2.8% -0.2% 4.8% -0.9% -1.2% -0.5% -1.4% 0.2% -1.6%
Table 7. Top 10 worst drops in the overall equity market (2005-2010) plus Bear Stress

StressTest:largestweeklylossesforfinancials
The largest weekly drawdowns for financials showed a similar pattern: overall moderate credit
exposure, with the same maximum credit exposure of 9.8% to consumer staples. Minimal credit
exposure to high beta sectors.
Table 8. Top 10 worst drops for financials (2005-2010)
Relative returns (long S&P 500 short sector)
Weeks S&P Loss Cons Discr
Cons
Stpl Energy
Health
Care Industrials
Info
Tech Materials Telecom Utilities Financials
20-Nov-08 -20.2% 1.1% -9.8% 0.7% -3.0% -1.3% -3.0% 7.0% -2.0% -8.5% 16.2%
9-Oct-08 -19.8% 1.8% -3.2% 0.9% -2.2% -4.8% -4.6% -5.6% 0.1% -1.4% 14.7%
20-Jan-09 -9.4% -2.2% -7.1% -1.9% -6.9% -2.1% -2.0% -2.9% -4.8% -8.8% 24.8%
5-Mar-09 -11.3% -3.4% -6.2% -1.7% -1.3% 2.3% -7.1% -2.3% -6.0% -0.1% 20.5%
19-Feb-09 -8.2% -1.3% -6.9% -1.3% -5.0% 0.0% -0.4% 0.3% -4.0% -2.3% 14.7%
11-Nov-08 -11.7% 3.4% -6.0% -2.8% -5.5% 0.2% 1.2% 3.5% -2.0% -6.1% 9.7%
20-Feb-09 -8.3% -2.2% -6.6% 1.2% -4.8% 1.8% -0.8% -1.4% -5.9% 0.0% 12.2%
27-Oct-08 -14.9% 1.6% -3.9% 4.2% -3.9% -0.8% -0.3% 11.0% -4.5% -3.3% 3.0%
19-Nov-08 -6.2% 2.9% -4.2% -8.7% -1.9% 0.8% -0.1% 2.6% -0.6% -6.9% 11.7%
4-Feb-09 -5.6% 0.9% -0.6% -1.6% -5.5% 1.8% -3.4% 0.6% -1.6% -4.7% 11.4%

PredictiveHistoricalStressTests
In addition to recent stresses, we wanted to consider more distant stress scenarios. RiskMetrics
research identified five worst case daily and weekly scenarios that resulted in the largest
portfolio loss for global equity/fixed income investors prior to 2000:
1. Black Monday (1987)
2. Gulf War (1990)
3. Mexican Crisis (1995)
4. Asian Crisis (1997)
5. Russian Devaluation (1998)
We applied a predictive stress testing methodology (Kupiek) to estimate potential credit
exposure if we saw a repeat of these scenarios on our current sector exposures, given specific
correlation assumptions:
AllanThe transition to this paragraph might be better if you changed the order:
If we saw a repeat of these scenarios on our current exposures (given specific correlation
assumptions), we applied a predictive stress testing methodology to estimate potential credit
exposure.

To simulate stressed conditions, we used correlations observed at the height of the Lehman
crisis, Nov 20 2008, with .94 decay and 1 year lookback as this represented an actual broker
default event
Historical stress tests show relatively moderate credit exposures across all sectors, including
small caps. Credit exposures in excess of -2% are highlighted in red, smaller exposures in
orange.
Long S&P short
sector %return Asian Crisis '97
Black
Monday '87
Russian
Devaluation '98
Mexican
Crisis '95 Gulf War '90
Cons Discr 5.22 3.46 0.53 -1.92 -0.21
Cons Stap 0.2 -3.5 -3.88 -1.64 -1.82
Energy 1.67 -3.22 0.87 2.75 1.73
Financials -5.3 11.77 4.06 5.33 12.37
Health Care 0.25 1.97 -1.26 2.18 -0.71
Industrials -1.15 -3.9 -0.86 1.52 -3.97
Info Tech -0.66 -6.26 -1.05 -3.94 -5.56
Materials 4.74 0.02 2.82 -0.94 -5.18
Telcom -3.4 11.77 3.76 -4.52 1.67
Utilities 5.3 -6.93 -1.15 -5.58 -0.93
Russell 2000 Growth 6.94 -3.61 2.3 1.27 -6.98
Russell 2000 4.42 0.71 2.67 0.85 -4.11
Russell 2000 Value 4.39 -2.14 3.23 0.1 -3.63
Russell 3000 Growth 1.41 1.17 -1.96 1.26 -4.33
Russell 3000 1.72 -4.22 0.3 1.48 -1.83
Russell 3000 Value -1.57 -1.32 0.39 1.89 5.35
Table 8: Predictive Stress Tests: .94 decay set on 20 Nov '08 (Lehman crisis)
Stresstestingsummary
Stress results are broadly supportive of the potential for equity as collateral.
1. Equity as collateral performs well for high beta vulnerable sectors (e.g., financials, energy,
materials, industrial) that represent highest systemic risk to market.
2. Correlations between risky assets tend to increase during stressed conditions, making the
equity collateral more effective when it is most needed.

Cashreinvestmentrisk
The analysis of cash as collateral thus far has assumed that cash would hold 100% of its value. In
reality, most enhanced yield funds lost value, in some cases significantly. In the wake of the
Lehman default, the Reserve Fund froze redemptions and posted a-3% weekly loss, which then
amplified the run on credit markets. AAA rated subprime backed securities that were assumed to
be cash equivalents proved impossible to liquidate and plunged in value. For example, the
Schwab YieldPlus, which lost over 30% over a 1 year period due to concentrated investments in
AAA rated subprime bonds. On the other hand, if cash was invested in securities backed by the
U.S. government and other highly rated sovereigns, a flight to safety would have resulted in a
gain. Unfortunately, Treasurys were not a common option as lenders sought to maximize yield.
Furthermore, assumptions about the safety of government bonds are again being revisited in the
light of the escalating sovereign bond crisis.
From a systemic risk perspective, there are two major issues with cash collateral reinvestment:
1. Cash collateral is procyclical reinvestment adds liquidity in normal markets, forced
unwind in stressed markets drains liquidity. Simply put, it is a form of bad liquidity.
2. Cash as only collateral option results in a major systemic crowded trade.
From the perspective of the lender, cash reinvestment incurs the following risks:
1. CreditRisk
Reinvestmentofcashdoublescreditexposure
Exposuretocreditdowngradeanddefaultrisk,bothcorporateandsovereign
2. Pricetransparencyandcomplexity
Fixedincomeinstrumentsnormallyfoundinthereinvestmentportfolioaremoredifficultto
price
3. Liquidityrisk
Creditinstrumentscanbecomehighlyilliquidunderstress,andliquidityisdifficultto
measureandmonitorfortheassetclass(duelargelytolackoftransparency)
4. Durationmismatch
Giventhatequitylendingtransactionscanbeunwoundearly,itisnotpossibletomatchthe
maturityanddurationprofileoffixedincomereinvestments.
To quantify the risk of fixed income portfolio, relying on credit spread VaR is not sufficient
because such an approach only considers historical changes in spreads and not default or ratings
migrations. A better practice would be to integrate spread VaR with default simulations to
produce credit portfolio VaR and Expected Shortfall (ES) statistics. However, at short horizons
of 1 week, even relatively high confidence credit VaR/ES of 99.5% is likely to be miniscule.
Portfolio credit VaR should be viewed at longer horizons, such as one year, to reflect the
ongoing risk that default lenders face as part of engaging in the business of lending.

From a short term perspective, it makes most sense to run credit stress tests to quantify potential
losses in the event of a major default as part of a broader systemic crisis. We have illustrated
such an approach on a representative yield enhanced portfolio.
We have assumed the default of one obligor within the portfolio with minimal recovery rate
assumption, combined with a broad increase in credit spreads. The results are largely in line with
the 3% instant drawdown experienced by the Reserve fund, with around 2.2% loss attributed to
default and 65.3bp to spread movements. Two defaults result in total loss levels of 4.5%. The
stress scenario could be elaborated by differentiating between different types of assets, but given
the relatively short duration of the portfolio, the bulk of losses would still be driven by default
and recovery rate assumptions.
Figure 38: sample reinvestment portfolio credit stress test
In the future, this study could be expanded to analyze a broader range of standard reinvestment
portfolios.
While we have noted that spread VaR is not sufficient to quantify the tail risk for credit
instruments, it is worth noting that spread movements can provide early warning signals of
escalating risk. For a topical application of this analysis to sovereign risk, please see Early
Warning Case Study: European Divergence.

Systemicriskimplicationsofequityascollateral
Allowing diversified equity as collateral for equity lending transactions should have a net effect
of reducing systemic risk for the following three main reasons:
1. Equityascollateralisnotprocyclical,andunlikecashcollateral,thereisnoincentivetounwind
tradesforcashliquidityduringcrises.
2. Intheeventofabrokerdefaultandforcedunwindofequitylendingtransactions,diversified
equityrespondsrobustlyundersystemicstress:
Selling S&P 500 takes liquidity in the most liquid market but adds it back in less
liquid sectors
The net effect would be security and sector divergence and thus lowering
correlation within the equity market as a whole, which reduces a driver of
systemic risk
Price impact on the overall equity market would be negligible as sales are
matched with buys, which would lessen the wild swings seen in the imbalanced
cash collateral unwind process
3. An additional collateral option for investors would reduce the single major crowded trade
effect:
The new smaller crowded trade based on sector mismatch could be more readily
monitored in the transparent equity markets, as opposed to the opaque fixed income
markets associated with cash reinvestment
Nonetheless, any crowded trade would result in realized credit exposure growing larger
than expected in the event of a forced unwind. Crowded trades should therefore be
proactively monitored and penalized with extra margin and costs to discourage these
from getting larger

Whatifwedontknowourportfolios?
Some securities lending programs executed by third parties do not provide full transparency on
portfolio and collateral composition, and will require the use of generic rules for margining (e.g.,
by number of securities, maximum single issuer and industry concentrations, minimum trading
liquidity, etc.). While there are ways to estimate the likely range of credit exposures by
simulating large numbers of randomly generated portfolios, the results will be suboptimal.
Lenders will require a more conservative aggregate estimation of margin for the additional
uncertainty, but are still likely to be less protected than if the specific portfolio characteristics
were known. Even with higher average collateral levels, margin is likely going to be too low for
the riskiest combinations where it matters most. Furthermore, given that other equity lending
platforms will have the ability to determine more appropriate pricing and margin levels relative
to risk, platforms without transparency will attract a disproportionate amount of underpriced high
risk transactions and a low proportion of overpriced risk transactions.
In summary, while it is possible to run no-transparency platforms on a risk controlled basis, very
conservative levels of margin and pricing are required, and a greater amount of capital must be
tied up by securities lenders to protect against this uncertainty. Costs for both lender and
borrower will be high given the additional uncertainty due to lack of transparency.
If systems were upgraded to provide security identifiers, appropriate margin and pricing levels
could be calculated on a real-time basis. Collateral could even be customized to better match
lent securities. In short, risk transparency for such platforms would be a big win, lowering risks
and costs for lenders and borrowers.

IntegratingVaRandStressTests
We used VaR and Stress Tests to analyze the risk of equity lending transactions. One frequent
discussion point is how to prioritize and use these statistics, given that both are useful but partial
measures of risk.
Dynamic VaR backtests robustly for equity as collateral, with less fat-tailed surprises than
outright long equities positions, especially if the Student t distribution is used. VaR provides
useful early warning signals, and responds to escalating short term risk. On the other hand,
VaR only represents realized volatility, not the hidden pressures that often build up and cause
a sudden jump (events). For example, VaR was at very low levels just prior to the escalation
of the subprime crisis, and more recently the sovereign debt crisis.
Stress tests allow flexible analysis of tail risks, but choosing appropriate scenarios and
aggregating the results is a challenge. Historical stress scenarios as we have shown offer
useful perspectives, but hypothetical scenarios should also be considered. For example, many
firms were surprised by the extent of synchronized losses incurred by AAA rated subprime
securities which had no precedent. Reverse Stress Testing is also a useful technique, which
searches for portfolio specific large loss scenarios. This can be particularly useful to perform
across the entire portfolio of counterparty exposures, to identify scenarios that could cause
large aggregate credit losses. One advantage of Reverse Stress Testing is that it requires
continual searching for new scenarios as the portfolio changes, as opposed to re-running of
standard scenarios which can often build false confidence. But even with the best stress
testing approaches, we are still faced with the challenge of integrating and interpreting an
extensive collection of single point estimates which do not respond to changing market
conditions.
In considering the strengths and weaknesses of both VaR and Stress Testing, its clear that each
approach adds important dimensions to risk. Stress testing allows risk managers to probe for
structural vulnerabilities, while VaR provides a dynamic pulse on markets and is useful for early
warning signals. Dynamic VaR is suitable to use as a primary day-to-day risk measure, and is
appropriate given the short term nature of credit exposures. But stress tests should be performed
on a regular basis and may at times override VaR based perspectives, for example when VaR is
unusually low.
Furthermore, VaR analysis could be adjusted to account for a dependency between counterparty
default and equity moves through the calculation of Conditional VaR statistics. One might, for
example, calculate Conditional VaR based on the assumption of 2 standard deviation down
shock or a 10% weekly drop in equities. Christopher Finger describes such an approach in his
Toward A Better Estimation of Wrong-Way Credit Exposure.

Summary&Conclusions
In analyzing credit exposure arising from equity lending, we have observed significant
differences by sector and market cap and dramatically time varying volatility. Nonetheless,
diversified equity generally performed robustly as a form of collateral for equity lending. Below
we discuss the most important themes to focus on in implementing collateral management
programs.
Risk is not static and varies greatly depending on market conditions. This calls for the use of
responsive risk methodologies, such as EWMA or more sophisticated ARCH models.
Throughout the crisis, much attention has been paid on the prevalence of fat-tails in financial
markets. Indeed, the use of fat-tailed distributions such as the Student t can help improve
backtesting results. It is worth emphasizing, however, that the use of dynamic volatility forecasts
is much more important than the application of fat tailed distributions.
Managing risk requires being proactive at identifying and responding to emerging concentrations
of risks across the financial network. Monitoring concentrations by sector, issuer, market cap,
liquidity, and other standard factors is a fundamental discipline. It is also important to vigilantly
search for hidden concentrations; for example, securities that are exposed to the same underlying
driving factors or vulnerable to similar scenarios. A leap forward in systemic risk management
would involve sharing of risk transparency between market participants to better monitor and
address crowded trades. Even though agent lenders compete, they have much more to gain than
lose by sharing risk transparency. As the financial crisis has illustrated, any risk management
failure can have dire implications in our interconnected financial network.
This study is not exhaustive, and additional analysis should be conducted as agent lenders
implement equity as a form of collateral. It would make sense to conduct more extensive analysis
of concentrated portfolios. Furthermore, advances in liquidity risk management could advance
risk management practices by considering exogenous market liquidity and endogenous portfolio
characteristics (see Valuing Liquidity: An equity portfolio case study(2010) by Carlo Acerbi &
Christopher Finger).
Nonetheless, this study demonstrates that equity as collateral has great potential as a sound form
of collateral. With security level risk transparency, collateral could even be tailored to more
closely match lent equities and further lower risk. And most importantly, both costs and systemic
risk could be reduced by the inclusion of an alternative form of collateral that is not procyclical
and responds well under stress.

ReferencesandAdditionalReading
Finger,Christopher(2000).TowardABetterEstimationofWrongWayCreditExposure.
RiskMetricsGroup.Availableat
http://www.riskmetrics.com/publications/working_papers/wrongway_creditexposure.html
Zumbach,Gilles(2007).BacktestingRiskMethodologiesfromOneDaytoOneYear.RiskMetrics
Group.Availableat
http://www.riskmetrics.com/publications/working_papers/backtesting.html
Finger,Christopher(2008).DoomedtoRepeatit.RiskMetricsGroup.Availableat
http://www.riskmetrics.com/publications/research_monthly/20081100
Zumbach,GillesandFinger,Christopher(2009).AHistoricalPerspectiveOnMarketRisksUsing
TheDJIAIndexOverOneCentury.RiskMetricsGroup.
Acerbi,CarloandFinger,Christopher(2010).ValuingLiquidity:Anequityportfoliocasestudy
(presentation). RiskMetricsGroup.
Acerbi,Carlo(2010).MarktoLiquidity:quantifyingportfolioliquidityrisk.Availableat
http://www.riskmetrics.com/on_the_whiteboard/20100515

Appendix:AdditionalCreditExposureBacktestingCharts

The following pages show credit exposure backtesting results for all industry segments not
included in the main document.

ConsumerDiscretionary:Absolute
Figure 24: Utilities (Absolute), daily and weekly backtests

ConsumerDiscretionary:Relative
Figure 25: Consumer Discretionary, relative, daily and weekly backtests

HealthCare:Absolute
Figure 26: Health Care (Absolute), daily and weekly backtests

HealthCare:Relative

Figure 27: Health Care (Relative), daily and weekly backtests

Utilities:Absolute
Figure 28: Utilities (Absolute), daily and weekly backtests

Utilities:Relative
Figure 29: Utilities (Relative), daily and weekly backtests

Telcom:Absolute
Figure 30: Telecom (Absolute), daily and weekly backtests

Telcom:Relative
Figure 31: Telecom (Relative), daily and weekly backtests

ConsumerStaples:Absolute
Figure 32: Consumer Staples (Absolute), daily and weekly backtests

ConsumerStaples:Relative
Figure 33: Consumer Staples (Relative), daily and weekly backtests

IT:Absolute
Figure 34: Information Technology (Absolute), daily and weekly backtests
IT:Relative
Figure 35: Information Technology (Relative), daily and weekly backtests

Industrials:Absolute
Figure 36: Industrials (Absolute), daily and weekly backtests

Industrials:Relative
Figure 37: Industrials (Relative), daily and weekly backtests

Accepting Equities as Collateral
The European Lenders Experience

Mark C Faulkner
Founder & Head of Innovation, Data Explorers

NewYork
75RockefellerPlaza
19
th
Floor
NewYorkNY10019
+12127102210
London
2SeethingLane
LondonEC3N4AT
+44(0)2072647600

Executive Summary
The question that this short paper seeks to address is whether the experience of European
lenders accepting equities as collateral from Lehman Brothers at the time of their default
should re-enforce the status quo with regards to the current US regulatory environment or
challenge it.
Currently there are restrictions on the acceptability of equities as collateral for many US
lending programmes.
The European lending experience, where equities have been acceptable for many years,
combined with the default of Lehman Brothers provides us with a useful test case
environment in which to explore this important issue. This experience lies at the core of this
paper.
Conclusion & Recommendation
Based upon the positive experience of European lenders accepting equities as collateral from
Lehman Brothers at the time of their default,
our conclusion is based on there being potentially significant positive risk-mitigation
benefits for the lenders of securities in accepting equities as collateral.
As with all potential changes in regulation, the details will need to be considered carefully.
We would not want to see any further unintended consequences impacting the securities
finance industry or the broader capital markets.
Reduced cost and capital can be seen as re-enforcement for the argument in favour of
considering regulatory change rather than as the primary rationale.
Executed properly which means with adequate controls and within a robust operational
infrastructure - the argument for accepting equities as collateral, as part of a portfolio
approach to collateral management, is compelling.
Background
The purpose of this paper is to provide the reader with an insight into the practical
experiences of several European lenders who were accepting equities as collateral from
Lehman Brothers at the time of their default.
Our focus will be upon what actually happened, what the outcomes were and what lessons
can be learned. We will leave it to others to conduct a vital and more scientific analysis.
The default of Lehman Brothers put the global capital markets under sustained and
considerable pressure. That this pressure was felt in the international securities lending
markets comes as no surprise. Global markets are inextricably linked and Lehman Brothers
was a major player in the securities lending market.

The term perfect storm has joined black swan and tipping point in the popular
vernacular and we beg your indulgence for using it once again here. We feel that it is an
appropriate term to describe the circumstance in which the following occurred: -
Lehman Brothers was a major global player in the securities finance market:
Afirmthatengagedgloballyineverymajormarket,acrossallassetclasses
Afirmwithapropensitytodealinnoncashcollateralwhereverpossible
AninnovatorinthefinancingfieldwithextensiveTripartyrelationships

Afirmwithatrulyinternationalclientbasewithover350lendingrelationships
In this paper we will explore what happened when this perfect storm hit European
Lenders taking equities as collateral.
Outline
To set the scene properly for the readers of this paper we will cover the following main
topics:
Anintroductiontothesecuritieslendingprocessandthedifferentcollateralmodels
Themanagementofsecuritieslendingriskandhowtheriskscanbemitigated
AprofileofLehmanBrotherspositioningwithinthesecuritieslendingmarketplace
BackgroundontheEuropeanlendersinterviewed
Ananalysisofwhathappenedoncethedefaultoccurred
Observationsandrecommendationsbasedontheirexperiences
We recognise that many practitioners and regulators (our target audience for this paper) are
experienced in this field and have therefore assumed a fundamental knowledge of the
securities lending activity. For readers requiring more background information we suggest
An Introduction to Securities Lending
1
.

Disclaimer
Although Data Explorers has made every effort to ensure the information and data herein are correct, nevertheless no guarantee is given
as to accuracy or completeness. All opinions, views and estimates expressed herein are those of Data Explorers on the date it was
prepared and are subject to change without notice; however no such opinions, views or estimates constitute legal, investment or other
advice. You must therefore seek independent legal, investment or other appropriate advice froma suitably qualified and/or authorized
and regulated adviser prior to making any legal, investment or other decision. This material is intended for information purposes only
and is not intended as an offer or recommendation to buy, sell or otherwise deal in securities.

Copyright 2009 Data Explorers. All rights reserved.

An Introduction to Securities Lending Collateral Models
In this section we will introduce the different securities lending models and demonstrate the
different roles of collateral as security and as a potential source of revenue. In the case of non
cashcollateralitissolelysecurity,inthecaseofcashcollateralitisboth.Giventhesubjectmatter
inhandwemakenoapologiesforfocussingonthenoncashcollateralmodel.
As a byproduct of being appropriately documented for regulatory purposes and as a result of

prudentriskmanagement,securitiesloansintodaysmarketsaremadeagainstcollateralinorder
to protect the lender against the possible default of the borrower. There are effectively two
distinctcollateralmodelsthatneedtobeconsidered.Collateralcaneitherbecash,ornoncash.
NonCashSecuritiesLendingTransaction:

1
www.dataexplorers.com/consultancy

Loan
Loan Terminates
Borrower Lender
Collateral
Loan Commences
Lender Borrower
Loan
Collateral
Loan
Loan Terminates
Borrower Lender
Collateral
Loan
Loan Terminates
Borrower Lender
Collateral
Borrower Lender
Collateral
Loan Commences
Lender Borrower
Loan
Collateral
Loan Commences
Lender Borrower
Loan
Collateral
Lender Borrower
Loan
Collateral
In many cases the owner of the assets being lent will appoint an agent to manage their lending
activity.Thisagentcanbeacustodian,a3
rd
partylenderoranassetmanagementlendingagent.
Daily marking to market will result in collateral flows in either direction during the term of
the loan.
The eligible collateral will be agreed between the parties, as will other key factors
including:
Notionallimits:Theabsolutevalueofanyassettobeacceptedascollateral
Initialmargin:Themarginrequiredattheoutsetofatransaction
Maintenancemargin:Theminimummarginleveltobemaintainedthroughoutthetransaction
o Concentrationlimits:
The maximum percentage of any issue to be acceptable, e.g. less than 5% of daily
tradedvolume
The maximum percentage of collateral pool that can be taken against the same
issuer,i.e.thecumulativeeffectwherecollateralintheformoflettersofcredit,CD,
equity,bondandconvertiblemaybeissuedbythesamefirm
Inalargenumberofsecuritieslendingtransactions,collateralisheldbyaTriPartyAgent.
ASecuritiesLendingTransactionInvolvingaTriPartyAgent
Lender Borrower
Tri Party
Agent
Loan
Collateral
Reporting
Reporting
Loan Commences
Tri Party
Agent
Borrower Lender
Loan
Collateral
Loan Terminates
Lender Borrower
Tri Party
Agent
Loan
Collateral
Reporting
Reporting
Loan Commences
Lender Borrower
Tri Party
Agent
Loan
Collateral
Reporting
Reporting
Loan Commences
Tri Party
Agent
Borrower Lender
Loan
Collateral
Loan Terminates
Tri Party
Agent
Borrower Lender
Loan
Collateral
Loan Terminates
Thi
s specialist agent (typically a large custodian bank or International Central Securities Depository)
will receive only eligible collateral from the borrower and hold it in a segregated account to the
order of the lender. The Tri Party Agent will mark this collateral to market, with information
distributedtobothlenderandborrower.TypicallytheborrowerpaysafeetotheTriPartyagent.
There is debate within the industry as to whether lenders that are flexible in the range of
non-cash collateral they are willing to receive are rewarded with correspondingly higher
fees. Some argue that they are, others claim that the fees remain largely static but that
borrowers are more prepared to deal with a flexible lender and therefore balances and
overall revenue rise.
Transactions collateralised with cash
Cash collateral is, and has been for many years, an integral part of the securities lending
business, particularly in the United States. The lines between two distinct activities -
securities lending and cash reinvestment - have become blurred; and to many US
investment institutions securities lending is virtually synonymous with cash reinvestment.
This is much less the case outside the United States but consolidation of the custody
business and the important role of US custodian banks in the market means that this
practice is becoming more prevalent.
Lender Borrower
Money
Markets
Loan
Collateral
Cash
Cash
Loan Commences
Lender Borrower
Money
Markets
Loan
Collateral
Cash
Cash
Loan Terminates
Lender Borrower
Money
Markets
Loan
Collateral
Cash
Cash
Loan Commences
Lender Borrower
Money
Markets
Loan
Collateral
Cash
Cash
Loan Commences
Lender Borrower
Money
Markets
Loan
Collateral
Cash
Cash
Loan Terminates
Lender Borrower
Money
Markets
Loan
Collateral
Cash
Cash
Loan Terminates

The importance of this point lies in the very different risk profiles of these increasingly
interrelated activities. Crucially, cash reinvestment is not typically covered by an indemnity
(of which more later) which can be argued to create a conflict of interest for the cash
manager they earn fees but do not share the direct financial risk of this activity. They do,

however, run considerable reputational and commercial risk if they do not manage this
potential conflict.
Cash reinvestment was traditionally dominated by unitized funds which pooled the
collateral for ease of management and to achieve the various economies of scale available
in money

market investment. However, segregated accounts with client specific risk profiles are now
becoming much more common.
Note that the securities lending loan term (i.e. time to maturity) will determine the
benchmark rate that is to be paid on the cash. Most loans can be recalled at any time, so the
cash will generally have an overnight rate benchmark. It is common for the interest to be
physically settled monthly.
Below we provide an example of the relative importance of cash and non-cash to different
fiscal locations and as you can see the US domiciled lenders are overwhelmingly taking
cash as collateral whilst other jurisdictions have a predilection for non-cash collateral.
The relative scale and importance of the US lending community brings the overall
percentage of collateral taken as cash up to 57%. However, the contrast between the US
trends and the UK, Canada and the Netherlands in particular is dramatic.
These statistics owe a great deal to historic tax legislation and inertia but have served many
of the non US lenders well in recent turbulent times.

The revenue generated from cash-collateralised securities lending transactions is derived in
a different manner from that in a non-cash transaction. It is made from the difference or
spread between interest rates that are paid and received by the lender.
Some securities lending agents offer bespoke reinvestment guidelines whilst others offer
reinvestment pools.
Summary
There are different securities lending models globally. These models have developed for a
wide variety of reasons, including: regulation; client preference; and tax
The US model is dominated by cash collateral. The European lenders have a higher
propensity to accept non-cash collateral. Tri - party providers have established an important
capability to facilitate collateralisation. The acceptance of cash collateral offers potential
revenue opportunities. Different securities lending models have different risk profiles.

In the next section we will explore the risks inherent in securities lending and how they
may be measured, managed and mitigated.

The Management of Securities Lending Risk
Inthissectionwewillfocusupontheriskmanagementissuesthatareandshouldbeontheminds
of all parties with fiduciary or risk management oversight responsibility for securities lending
programmes. A more detailed description of risk issues emanating from securities lending is
containedinourBestPracticepaper
2
.
Properly configured, securities lending should be a low risk, low return, high riskadjusted return
activity. This is very often the case. However there are risks which must be understood and
managed. Both market risks and operational/legal risks can result in financial losses for the
lenders, but the financial risks are more readily quantifiable than those in the nonfinancial risk
category.Alloftherisksidentifiedcanbemeasuredtosomedegreeandmanagedandmitigated
asubjectthatweexploreindetailinthissection.
The aftermath of the Lehman Brothers default showed that financial risks can be more
difficult to measure than previously thought; and that non-financial risks can play a
significant part in the total risk taken.
Non Financial Risks
These include:
Legal Risk covers both contractual risk and enforceability risk. Contractual risk refers to
ensuring the terms and conditions for securities lending between two institutions are
comprehensive and appropriate. One recent important example: problems following the
Lehman default in the legal set off calculation failing to match the reality of the sales and
purchases required to close positions. Enforceability risk refers to the enforceability of the
contract under prescribed national laws. In the event of a default situation, the right of the
nondefaulting party to net the collateral value and the underlying loan value is arguably the
mostimportantexampleofthis.
Operational Risk the risk that the securities lending agent does not have adequate controls
and infrastructure in place to manage a securities lending program. It should be noted that if
the lender does not or cannot engage in the process of collateral liquidation and loan
repurchase, they end up with a de facto change in asset allocation; this may be dramatic and
unexpectedtosomebeneficialowners(theownersofthesecuritiesbeinglent).
Recall Risk the risk that the borrower does not return recalled securities in time to enable a
saleorcorporateactiontobemet.
Reputational Risk the risk that by virtue of being engaged in a securities lending
program the reputation and standing of the lender is somehow damaged. This may result
from an operation failure or more likely in recent times, the headline risk of being in
the paper on the wrong side of a story.

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www.dataexplorers.com/bestpractices

Tax risks for example, crystallized profits on disposals of assets following a default
may attract Capital Gains Tax.

Non financial risks can be mitigated by appropriate legal agreements industry standard
documentation gives more security that they are enforceable, particularly when reinforced by
external legal opinion. Netting is an important element of risk management; market participants
willoftenhavemanyoutstandingtradeswithacounterpart.Ifthereisadefault,standardindustry
master agreements ensure that, postdefault, various payments are accelerated, i.e. payments
becomedueatcurrentmarketvalues.
Financial Risks and Mitigants

Thiscoversanumberofareasandisbestsummarisedinatableshowingpossiblemitigants.Given
thetopicofthispaperwehavegoneintomoredetailonthoserisksmorelikelytooccurinanon
cashenvironment:
FinancialRisk Mitigant
Default or Credit risk the risk that a counterpart or issuer
cannot meet its obligations. In a collateralised loan, a default
triggers the process of collateral liquidation and loan
repurchase, exposing the program to market risk; in outright
reinvestment the loss is immediate and prospects of asset
recoveryareusuallypoor.
CounterpartyorIssuerSelection/ApprovalbyLenderan
area of increasing focus and one which needs to be kept
under constant review. Agents who can demonstrate a
dynamic approach and remove most of the burden of
counterparty vetting are finding that their client
relationshipsarestrengthenedthisisparticularlyrelevant
wheretheagentmaybeunabletoofferastrongindemnity.
Market Risk (Mismatch risk, occurring only in the event of a
default)
the risk that the market price of the underlying security or
collateral moves adversely in a short period of time. This can
arise because of changes in yield curves (i.e. interest rates),
currencies,creditspreads,orequitymarkets.
the risk that the collateral cannot be realized at the price
valuedduetoilliquidityorvolatilityinthesecurity.
LiquidityRiskNonCash
theriskthatcollateralcouldnotberealizedatall(duetolack
of volume in the asset markets) or because the lender is
holdingahighproportionofthetotalissue
the risk that the inventory of lendable assets is not, in
general, in demand by the lending market; so it becomes
difficult to raise additional cash collateral to offset existing
illiquidityincashreinvestmentassets
Overcollateralisation (the scale of the margin or haircut
applied to the position when valued) the provision of
collateralwithamarketvalueinexcessofthemarketvalue
ofthesecuritieslent.
The amount the loan is overcollateralised can be varied to
takeintoaccountmarket,credit,FX,liquidityandmismatch
risk as well as the costs of liquidating the collateral
securitiesintheeventofdefault.
CollateralSchedulesDefiningaschedulethatiswithinthe
lenders risk parameters. This includes choice of asset
classes acceptable, the credit quality and markets of those
securities, as well as concentration limits. This should be
respectful of the underlying securities lending regulations
that apply to the lender. Some regulators will specify the
allowable collateral for their regulated entities. Some are
more conservative than others, for example the Irish,
LuxembourgandUKregulatorshaveclearguidanceonwhat
collateralisallowed.
Detailed Risk Modelling and ongoing Communications
betweenriskspecialists.
LiquidityRiskCashtheriskthatreinvestmentassetscannot
be liquidated to meet client demands for the return of
collateral; or that they can be liquidated but at significant
discountstoparvalue.
Detailed Risk Modelling and ongoing Communications
betweenriskspecialists.

Cash Reinvestment Risk in cash collateral securities lending
programs, there is a risk that the instrument bought with the
borrowerscashfallssignificantlyinvalueordefaults.Sothisis
acombinationofanumberofrisksyieldcurve, mismatchrisk,
spreadrisk,anddefaultorcreditrisk.

Indemnification
Indemnification is a major source of risk mitigation and can be seen as a type of insurance
policy. As with insurance policies there are many levels of coverage and protection
offered. Ultimately they all offer some varying degree of protection for the beneficial
owners faced by the unlikely default of their borrowing counterpart. It is important that the
indemnity terms are clear and provide for appropriate interaction with any service level
agreement.
Summary
Securities lending is a low-risk activity if managed correctly. As we have demonstrated in
this section, there are many different risks, but similarly, there are also many aspects of risk
mitigation.
When equities are being taken as collateral there are a number of critical issues for the
lender to consider, including: -
Liquidity
Concentration
Margin
ForeignExchange
Correlationwithlentassets
The scale and breadth of Lehman Brothers participation in the securities lending business
meant that as the Lehman Brothers default approached and unfolded, risk managers and
their risk mitigation practices were to find themselves tested to the limit irrespective of
their lending model or collateral type.
In the next section we will assess the Lehman Brothers profile in the securities lending
market.

A profile of Lehman Brothers in the Securities Lending Market
This is not a paper about Lehman Brothers. It is a paper about the experience of European
lenders taking equities as collateral. However, we could not think of a better example to
consider, one that is capable of providing the reader with a meaningful insight into the issue
in hand, than the default of Lehman Brothers.
Before sharing the results of a confidential survey of European lenders with the reader we
will provide a high level overview of the Lehman Brothers footprint. Reading the
financial press and recent books one is struck by how often the term unique is coined
when referring to Lehman Brothers. We make no apologies for using it once more here.
Lehman Brothers had a unique securities financing footprint that comprised many
different components. They were different and this is how: -
Loan Balances
Lehman Brothers were a major borrowing counterpart - fuelled by their client flow and
their substantial proprietary demand. Their demand profile for all securities borrowed is
shown below from early 2007 up to the time of their default. It is not appropriate to share
specific balances or any other detailed statistics on the y axis but the trend offers the
observer a valuable insight. Data Explorers estimates
3
that their balances represented up to
5% of global borrowing demand.

Lehman Brothers were active in all asset classes represented in the Data Explorers global
securities lending database.
Counterparts
Their loans were sourced from over 350 individual lending counterparts around the globe
(many of whom were agents acting on behalf of numerous underlying clients).

3
DataExplorersgathersdailydatafromtheglobalsecuritieslendingmarkets,visit
www.dataexplorers.comtofindoutmore

This counterpart profile was much more international (i.e. non-US) in profile than many of
their US broker dealer peers.
Their counterpart list included relatively more non-bank lenders (e.g. asset managers and
pension funds), many more exclusives (portfolios for which they had paid for exclusive
access), and also more broker dealers than their peers.
Pricing
The graph below indicates, Lehman Brothers paid the lending community relatively higher
fees than their peers.
This may be the result of a variety of factors:
thecompositionofloansafocusuponspecialsecuritiesinhighdemand
apossiblerecognitionofaLehmanBrothersriskpremiumbeingchargedbythemarket
a product of a higher proportion of relatively expensive equity borrowing balance
comparedtocheaperbondborrowing.

Irrespective of the reason, the relatively high fees paid by Lehman Brothers, when
combined with their large balances made them a highly valuable borrowing counterpart to
their long list of counterparts.

Collateral
During the timeframe covered in the graph below Lehman Brothers collateralised 44% of
its lending business with non cash collateral, compared to 36% non cash for the other
borrowers represented in the Data Explorers universe.

This non cash collateral comprised many different forms of collateral including equities.
The proportion of equities utilised as collateral varied considerably from counterpart to
counterpart reaching well over 50% with some lenders. Lehman Brothers were regarded
as innovators in the field of securities finance and experts at turning assets into cash. They
were pioneers of equity repo; energetic supporters of tri-party - a product which fitted their
requirements and facilitated the adoption of non-cash collateral; and collateral trading as
well as lending was a primary motivation for their large securities financing desks.
Summary
Lehman Brothers was a large global borrower of securities with extensive counterpart
relationships. The firm had more of a propensity to collateralise loans with non-cash than
its peers. It had an extensive network of European lenders with an appetite for accepting
equities as collateral.
This makes them and their default an excellent case to examine when considering the
subject matter of relevance.
We will now explore the profile of the European lenders that we interviewed whilst
researching this paper.

The European Lender Profiles
When considering how best to address the question being asked of us by the industry, its
regulators and its clients we felt that it was imperative to get to the facts of the matter to
really try and understand what actually happened at this critical juncture. For, if equities
can really perform as appropriate collateral for European lenders at times of such duress,
perhaps their acceptability elsewhere might be worthy of serious investigation.
We therefore decided to interview experienced European lenders that dealt with Lehman
Brothers and took equities as collateral.
Given the sensitivity of the subject matter and the fact that litigation between the Lehman
Brothers Estate and many of their ex-counterparts is ongoing the conversations referenced
in this paper have been made confidentially. We are very grateful for the interviewees time
and their candid input and respectfully ask the reader to remember that the opinions
expressed in this paper are ours not theirs.
What can be said about them collectively is the following: -
ThelendersarenotRiskManagementAssociationmemberswefeltthatthepaperwouldcarry
moreweightifitwerenotfuelledbycontributionsfromitssponsorsandwasindependentof
them. Far too many reports are lobbying in disguise. We therefore have neutrality that our
institutionalintervieweesshare.
The lenders are institutional asset management lenders, acting as agents on behalf of their
underlying funds not agent banks. We were interested in understanding the experience of
Europeaninstitutionallendersthatcouldprovideaninsightintothepotentialperspectiveand
experienceofunderlyingclients.Theexperiencecanbeofbenefittoaglobalconstituencyof
lenders.
We also avoided broker dealers (who have extensive experience taking equities as collateral)
theprincipalcounterpartsactiveinthesecuritiesfinancemarketsthataresubjecttodifferent
regulatory controls and have less fiduciary responsibility than agents where caveat emptor
applies
ScaleTheintervieweeshaveacombined:
o GlobalAssetsUnderManagement$1,830Billion
o GlobalAssetsAvailableforloan$415Billion
o Valueofassetsonloan$62Billion
They are experienced lenders of long standing all with greater than 25 years of active
securitieslendingexperience.Onewithover40yearsoflendingexperience.
They are globally active lenders with international experience. They have experience in bond
and equity lending across developed and developing markets in Asia, Europe and the
Americas.
LehmanBrotherswasoneoftheircounterparts.Theydealtwith:
o LehmanBrothersInternational(Europe)(LBIE)
o LehmanBrothersHoldingsIncorporated(LBHI)
o LehmanBrothers(Luxembourg)EquityFinanceS.A.
Their exposure to Lehman Brothers was considerable in aggregate although some of them
viewedLehmanasaTier1borrowerandothersasTier2andTier3.

They conducted securities lending and repo business with Lehman Brothers under a range of
legalcontractswhichincluded:
o MasterEquityandFixedInterestStockLendingAgreement(MEFISLA)
o MasterGiltEdgedStockLendingAgreement(GESLA)
o OverseasSecuritiesLendersAgreement(OSLA)
o GlobalMasterSecuritiesLendingAgreement(GMSLA)
o GlobalMasterrepurchaseAgreement(GMRA)
o MasterSecuritiesLendingAgreement(MSLA)
TheyallusedtheservicesofTriPartyAgents,including:
o JPMorgan
o BankofNewYorkMellon
o Euroclear
o Clearstream
Equitiesformedpartoftheircollateralportfoliowhichincluded:
o GovernmentBonds
o CorporateBonds
o Equitiesfrommainstreamindicesincluding:
S&P500
FTSE100
CAC40
DAX30
Nikkei225
o Otherequitymarketsandsmallerindiceswerealsoacceptedbyourrespondentsmargins
weretypicallyhigherforthelessliquidequitycollateral.
None of the European lenders took cash as collateral for securities lending transactions from
LehmanBrothers
The purpose of engaging these institutions directly was to go beyond any theoretical
analysis to understand what actually happened at this time of maximum duress.
Having outlined their characteristics in this section we will now move on to consider what
actually happened post the Lehman Brothers default and what their experiences were and
what recommendations they have.

What actually happened post the Lehman Brothers default?
To provide the reader with some context on the significance of these events and their global
impact we offer a short chronology of some of the key events. Of critical significance to
lenders was when the entity that they were contractually exposed to went into default or
administration. This was the trigger for action and the Lehman Brothers Luxembourg
entity, for example did not technically default until a few critical days later than the US
parent and larger UK entities.
Matters were also made more complicated by the sale of certain parts of Lehman Brothers
to Barclays and Nomura.
Corporate Events
On September 15
th
, 2008, Lehman Brothers Holdings Incorporated (LBHI) filed for
Chapter 11 bankruptcy protection citing bank debt of $613 billion, $155 billion in bond
debt, and assets worth $639 billion; the filing marked the largest bankruptcy in US history.
It further announced that its international subsidiaries would continue to operate as normal.
Later on that day in the United Kingdom, Lehman Brothers International (Europe)
(LBIE) went into administration with PricewaterhouseCoopers appointed as
administrators.
On September16
th
, Barclays plc announced its agreement to purchase, subject to regulatory
approval, Lehman Brothers North American investment-banking and trading divisions
along with its New York headquarters building. On September 20
th
, 2008, a revised version
of that agreement was approved by J udge J ames Peck.
In J apan, the J apanese branch, Lehman Brothers J apan Inc., and its holding company filed
for civil reorganization on September 16
th
, 2008, in Tokyo District Court.
On September 17
th
, 2008, KPMG China became the provisional liquidators appointed over
Lehman Brothers two Hong Kong based units - Lehman Brothers Securities Asia Limited
and Lehman Brothers Futures Asia Limited. They were also appointed as the provisional
liquidators for three further Hong Kong based Lehman Brothers companies, Lehman
Brothers Asia Holdings Limited, Lehman Brothers Asia Limited and Lehman Brothers
Commercial Corporation Asia Limited on September 18
th
, 2008.
On September 22
nd
, 2008, Nomura Holdings, Inc. announced it agreed to acquire Lehman
Brothers' franchise in the Asia Pacific region including J apan and Australia.
On September 23
rd
, 2008, Nomura announced its intentions to acquire Lehman Brothers'
investment banking and equities businesses in Europe and the Middle East. A few weeks
later it was announced that conditions to the deal had been met, and the deal became legally
effective on October13
th
, 2008.

Market Performance
As Lehman Brothers defaulted the markets globally were affected. The lenders of securities
were fortunate to be collateralised and now the issue before them all was whether the sale
of the collateral held would be sufficient for them to replace the assets that they had on
loan.
Large portfolios of securities were going to have to be liquidated and different portfolios of
securities purchased. At this point the terms of agreements were being reviewed, execution
channels opened and notices given.
Conventional wisdom suggested that at times of a large broker dealer default there would
be a sell off in the equity markets and a rally in Government Bonds a so-called flight to
quality. We now move on to examine how the market actually performed.
Lehman Brothers shares tumbled over 90% on September 15
th
, 2008. The Dow J ones
closed down just over 500 points on September 15
th
, 2008, which was at the time the largest
drop in a single day since the days following the attacks on September 11
th
, 2001.
On September 17
th
, 2008, the New York Stock Exchange delisted Lehman Brothers.
As the chart below demonstrates counterpart risk is very real and not at all hypothetical.

In the immediate aftermath of the Lehman Brothers Default (see circle inset in graphs
below) asset prices behaved in an extreme manner and volatility rose. There was a flight to
US Treasuries as the cart below shows.

In the immediate aftermath of the Lehman Brothers default Pan European Government
Bond markets declined. Over the longer term were well supported too (see below) which
was not welcomed by European lenders that had engaged in the collateral upgrade trade
with Lehman Brothers and did not react to the default quickly. Here the lender lends
Government Bonds versus equity collateral. As a consequence of engaging in these
transactions which were popular with Lehman Brothers, we are aware that some European
lenders (not those that we interviewed) may have delayed execution of trades and
consequently realised losses. Their relatively low margins and their delay in execution were
their Achilles heel.
The quicker the reaction time and prompt execution of buy-ins seems (within a 5-10 day
time frame) to reflect best market practice. The interviewees were not indemnified by
lending agents and therefore in a position to make execution decisions unencumbered by
any considerations related to indemnification such as underlying credit risk to an agent.

Immediately after the default the global equity markets traded upwards.

American equities formed part of the interviewed lender collateral pools. Initially rising
after the default and then declining dramatically.

The FTSE 100 and other UK equities were taken utilising the UKspecific Delivery by
Value. (DBV) process. There was a sharp rise in the FTSE 100 immediately after the
default.

As did main stream European equities delivered using Tri-Party providers.

J apanese equities were also acceptable to our interviewed lenders. And although they rose
relatively less than the European equity markets - they remained flat in the immediate
aftermath of the default.

As the charts above indicate, in the period immediately following the Lehman Brothers
default the global markets saw some unusual patterns of trading behaviour. For example,
some of the mainstream equities in certain markets actually rose in the period immediately
after the default. Perhaps this was due to borrowers covering short positions or as a result of
lenders buying back equity loans. Below we see how a diversified basket of UK equities
and UK Gilts performed over ten days.

The
table
above demonstrates the challenge facing a lender accepting UK equities or UK Gilts as
collateral over this 10 day period post the default. Overall equities actually performed more
strongly than Governments during this period but soon thereafter Government Bonds
appreciated whilst equities declined in price.
Date Diversified basket of UK stocks UK Government Bonds
01-Oct-2008
1.17% 0.00%
30-Sep-2008 1.74% 2.12%
29-Sep-2008 -5.30% 1.18%
26-Sep-2008 -2.09% -3.89%
25-Sep-2008 1.99% -0.92%
24-Sep-2008 -0.79% -0.68%
23-Sep-2008 -1.91% 1.14%
22-Sep-2008 -1.41% 2.83%
19-Sep-2008 8.84% -5.95%
18-Sep-2008 -0.66% 1.72%
Net position 0.96% -0.45%
As a result of these unusual trading patterns some trades which had perhaps been
considered relatively high risk and unattractive e.g. lending Government Bonds versus
equity collateral - remained viable provided that lenders had imposed higher margin levels
of over collateralisation and executed quickly.

The volatility of markets (as represented by the VIX below) increased to historic highs post
the Lehman Brothers default and reinforces the need for efficient and timely execution.

Looking further ahead to the remainder of 2008 bond markets globally did perform more
strongly than equity markets - i.e. more in line with the prevailing wisdom after a large
broker dealer default. However, most lenders (and certainly our interviewees) had already
taken action wherever possible.
All four of our interviewed lenders had adopted a dynamic approach to both the
appreciation of risk and haircuts levels that protected them and their underlying clients from
losses in the post Lehman environment. They executed the portfolio trades like the
professional asset managers that they are. Furthermore they had been raising margins on
Lehman Brothers in advance of their default (some to as much as 20%).
A key factor that has emerged as a prerequisite in terms of handling the liquidation process
is access to effective and powerful execution capabilities.
We are aware of some lenders (not our interviewees) who, without access to efficient
execution capabilities had to wait several days to both execute and settle sales and buyback

transactions. The incremental time involved increased both exposure to market risks and
operational problems. Going forward beneficial owners will increasingly look at this area
when selecting a securities lending provider.
To illustrate the importance of timing further it is worth noting that on the issue of
indemnities - many owners of assets were surprised to find that they (the beneficial owners)
were exposed to un-indemnified residual market risk - even under indemnified programs if
their agent was unable to buy back securities in the market acting on their behalf. This was
not a widespread issue but remains a subtle but important point nonetheless.
One of the key capabilities that the four European lenders we interviewed shared was their
ability and willingness to explore risk and change collateral margins in line with their
perceived risks. This active involvement in risk management stood them all in good stead
during the events leading up to, and post, the Lehman Brothers default.
Their approaches shared a number of common features, including the following: -

They all acted as agents for their underlying fund management clients and took the
responsibilityofprotectingthemveryseriously.
They communicated with regards to risk management internally to senior management and to
theirunderlyingclientsonaregularbasis
They committed resources specifically to the accurate measurement and management of risk
usingestablishedmodelsandprocedures.
They adopted an approach to eligible collateral across their lending program that was not
counterpartspecific.
Theymanagedmarginsupwardstoreflecttheirperceptionofanyincreasedcounterpartrisks
Theywereexperiencedintheexecutionoflargeportfoliotransactionstheyknewhowtotrade
shouldsomethinggowrong
Theircollateraleligibilitycriteriarevolvedaroundassetsthattheywerefamiliarwith,knewhow
tosellandwereliquid(ittranspiredthatsomeoftheirproblemscamefromcollateralsuchas
convertibleandcorporatebondsthatweresubsequentlyfoundtobenotliquidatall).
So what size of margin was deemed to be appropriate for these European lenders? Specific
margins across the interviewees varied - but had one thing in common they rose over time
for Lehman Brothers and provided for excess cash post execution in other words more
than enough.

Below we share some outputs from some research that Data Explorers has conducted
regarding the lending of non-US equities against receipt of standard collateral buckets and
haircuts. It is typical of the types of issues that the interviewees asked and continue to ask

themselves namely what is the appropriate margin and what is the scale of my potential
financial exposure after I have sold my collateral and purchased back the assets on loan?

Equities appear to demand a higher level of overcollateralization across all asset classes.
Outputs relating to the acceptance of Government Bonds would appear to be counter
intuitive but it should be noted that the model is asymmetric rather than purely event
driven. This means the model used does take into account possible corrections within debts
and equity markets subsequent to initial fall in equities and flight to Government bond
collateral.
Overall findings here, particularly with regard to equity vs equity loans is that the optimal
haircut point for this type of business is around 10% . This is very much in line with current
market practise.
It should be noted that although we have assumed that positions are hedged including
covering any cross current Fx risk, the model used for this analysis operates at a relatively
high macro level and does not necessarily incorporate cross sectional equity volatilities
such as French equities vs French equities and French equities vs US equities. Further
CollateralType MarginLevels
2% 5% 10% 20%
Riskoutputsexpressedas ValueatRisk
(VAR)asapercentageofPrincipalonloan
MainIndexEquities 4.29% 1.41% 0.00% 0.00%
MidCapEquities 5.99% 3.34% 0.00% 0.00%
SmallCapEquities 8.65% 6.17% 2.06% 0.00%
ETF's 4.29% 1.41% 0.00% 0.00%
Emerging MarketEquities 7.47% 4.69% 0.10% 0.00%
ADR's/GDR's 7.52% 4.98% 0.77% 0.00%

LetterofCredit 11.88% 8.88% 3.88% 0.00%
CertificatesofDeposit 11.88% 8.88% 3.88% 0.00%
work in this area could be undertaken on this point but it may well take us outside the scope
of this initial piece of work.
To conclude-

The analysis envisages a diverse basket of international equity (non US) assets being loaned
against the different collateral types listed in the first column. As the margins are increased
from 2% -10% it is intuitive that the risk will decline. The risk outputs are expressed as the
value at risk as a percentage of the principal on loan. Value at risk is calculated at 99%
confidence levels with a 10 day time horizon (which is just one possible option used by
lenders and is more conservative than 95% and 5 days). Principal is the value of the loan
portfolio.
The conclusions reached are intuitive the higher the margin the lower the risk.
International market standard margins of 5% carry with them levels of risk that vary
dependent upon the asset class accepted (for purposes of this simple analysis we have
assumed single asset classes

being taken as collateral). At 10% margin the risk significantly reduces and at 20% it
becomes statistically insignificant.

Higher levels of margin (over collateralisation) does reduce residual risk levels to
manageable levels. However, in some cases the suggested levels fall outside market
convention and therefore what borrowers are likely to post as collateral. A margin of 20%
is unlikely to be acceptable to a borrower unless they are operating under exceptional
circumstances or duress (in which case the lender might consider whether or not they wish
to deal with them at all).

In recognition of that the fact that borrowers provide excess collateral to the lenders and are
effectively assuming greater risk (their starting point for any unwind due to lender default is
negative from the outset) borrowers are keen to keep margins as low as possible. Certain
trade structures, particularly involving high quality collateral and high quality counterparts,
may be executed with minimal margin levels and this might, possibly, lead to borrowers
demanding parity (i.e. nil margins as they do in some repo transactions).

As a general market observation we are seeing an increasingly flexible approach to the
deployment of collateral and the setting of margins. We believe this process of change will
accelerate as market participants begin to actively manage these issues rather than leave this
important area to a passive collateral management function. From the perspective of our
interviewees:
They adjusted margins progressively higher as the Lehman Brothers default approached
reachinglevelsupto20%
Without exception they emerged with excess collateral after closing their Lehman Brothers
exposure

Theyall expressedtheopinionthattheyfeltappropriately compensatedfortheriskthat they
weretaking.
20%marginsarehighandnotlikelytobepracticalorenforceableinanoncrisisenvironment.
Thereisadangerthatmarginsrequestedbylenderswillbetoohighfortheborrowerstobein
apositiontomeet,.
Equity collateral margins in the 5%10% range were the norm prior to the crisis for our
interviewees.
Calls for margins above 10% in noncrisis times are not necessarily justifiable from a risk
mitigation perspective (see the table above) or economically acceptable to the borrowers
fromacostorcapitalperspectiveforstandardforthemainstreamliquidindices.
Highermarginsmaybesensibleforlessliquidorconcentratedpositions.
European lenders have historically enjoyed a greater freedom, with regards to their ability to
acceptawiderrangeofcollateral,thantheirpeersintheUS.
This is in no small part due to regulatory and fiscal drivers. European tax regimes are a
major reason behind the development of the prevalent non-cash collateral culture. Until
fairly recently the requirement to withhold tax on interest rebated on cash collateral has
acted as an understandable encouragement to use non-cash collateral. This historical
accident stood them in good stead as the Lehman Brothers default occurred.
Having reviewed what happened post the Lehman Brothers default we will now explore the
lessons learned and recommendations that were made by our interviewees.

Observations and recommendations
The institutions that we interviewed in the compilation of this paper all emerged in a strong
position (from a securities lending perspective) post the Lehman Brothers default and a
large part of that success they put down to the collateral that they were taking. They all
felt very comfortable accepting equity collateral and in particular welcomed the liquidity
that equities offered - even at a time of great market duress.
Despite such a positive outcome all four interviewees recognised that there were
opportunities to improve procedures and recommendations to be implemented. We also
provide the reader with additional perspective from a survey of the audience at a recent
Forum (appendix 1) and from a recent report (appendix 2). Below we identify the major
points that they made in this regard.
Itisessentialtoreviewallagreementsandprocedurestoensurethatyouenjoythefreedomto
actasyoumayneedto,wheneveryouneedto.Theseinclude:
o SecuritiesLendingAgreementswiththeappropriatelegalentityatalltimes
o TriPartyAgreements(ifappropriate)
Someofthequestionsthatrequirefocusare:
o Doestheagreementofferthelendersufficientcontractualprotectionatalltimes?
o Doestheagreementandtheactualservicesupportthefollowing?
efficientelectronicinstructions(notfacsimile);
shortnoticeadaptationstocollateralschedules;
andtheabilitytoviewcollateralinthelendersaccountonline?
Executioncapabilitiesinallappropriatejurisdictions (understandinadvance whetherthere are
anyissuespertainingtoanagentsabilitytotradeonbehalfofunderlyingaccountsthatmight
requiretradingaccountstobeestablishedPRIORtoexecutione.g.Spain,Korea?)
Risk management must have an appropriately priority within your securities lending
programme.
Measure the risk in your securities lending programme and communicate it internally and
externally
Makesurethatseniormanagementandtheunderlyingclientsunderstandandbuyintothestyle
ofsecuritieslendingprogramme(includingcollateralacceptability)thatisbeingadopted.
Only accept collateral that you would buy in the ordinary course of your asset management
business.Ifyouwouldnotinvestinitinyourcoreactivitywhyonearthwouldyouacceptitas
collateral?
Make sure that you actually know how to sell the collateral that you hold practice program
trades in all eligible collateral asset classes AND lent asset classes it is NOT just about the
sellingofcollateralbuyingbackthelentsecuritiesthatyouareeffectivelyshortofisjustas
importantwhenunwindinglendingexposures.
They all recognised the critical importance of the TriParty providers taking equities as
collateral is not practical without the involvement of efficient collateral management
processes.
TheyhavemovedTriPartymanagementfromthebackofficetothefrontofficeandsomehave
initiatedregular(quarterly)meetingswiththeirprovider.
TheyfeelandactmorelikecustomersoftheTriPartyprovidersnow,thantheydidpreLehman
Brothers(priortothedefault,inrecognitionofthefactthattheborrowerspickedupthetab
theyfeltsomewhatdifferently)
They have also sought to clarify the legal position regarding 3
rd
party pricing and sub custody
whichwerepreviouslyfelttobenotassecureasunderclassiccustodyarrangements.
TheyhaveexploredthelegalramificationsofanyintradaylinesthatTriPartyprovidersofferto
brokerdealerstoensurethattheprocessisrobustenough
Theintervieweesallviewcollateralassecuritynotasanadditionalrevenueopportunityandare
focussed more than ever upon the liquidity of that collateral. The liquidity of main stream
equities is more tangible and transparent than it is in many other asset classes that has
reinforcedtheirwillingnesstoacceptequitiesaspartofabalancedportfolioofcollateral.
They all adopt concentration limits for individual assets and asset classes based on empirical
observationswhichareregularlyreviewed.
One has excluded all financial assets as collateral across all eligible collateral classes to avoid
correlated exposures should a major default occur again they wish to avoid additional
financialservicessectorexposureandthisincludesNOTacceptingbondsorequitiesissuedby
thefinancialsector.
The four interviewees continue to accept equities as collateral and would encourage others
to do so too - so long as they follow the recommendations outlined above.

Appendix1
Taking equities as collateral and the experience post Lehman Brothers default was also
discussed at the recent Data Explorers London Forum - held on March 17
th
, 2010. We had
the opportunity to ask the audience a wide range of questions during the day and there were
a few questions that are directly relevant to our subject matter here.
The audience of 175 was comprised predominantly of beneficial owners and market
practitioners. We asked them the following questions. The respondents had a broad
collateral profile and the results need to be taken for what they are a small, but interesting,
sample of market experience and NOT as scientifically representative.
1 When Lehman defaulted, what percentage of collateral did you end up with after
collateral had been liquidated and lent securities repurchased?
A. Down >10% 4.7%
B. Down 6-10% 3.1%
C. Down 0-5% 14.1%
D. Up 0-5% 53.1%
E. Up 6-10% 10.9%
F. Up >10% 14.1%
So over 78% of the respondents emerged with excess margin after they had sold their
collateral and bought back the securities that they had on loan to Lehman Brothers. The
question did not probe into more detailed issues such as the collateral taken (this was not
equity specific); the scale of the exposures; what was actually held as collateral and on
loan; or the speed with which the lenders acted to protect themselves. However, it was
reassuring to find that so many were in excess. That is cold comfort for those 21% in a
deficit position let us hope that they were properly indemnified by their providers.
Anecdotal feedback on the day suggest that the collateral shortfalls were associated with
convertible bond, corporate bond or cash re-investment issues not equities.

2 In Europe will collateral in future be:-
A: More cash 21.7%
B: Less cash 52.2%
C: Neutral 23.9%
D: Non-cash only 2.2%
So, in the opinion of the assembled audience the European collateral trend is clearly
expected to be towards non-cash collateral. Whether or not this actually happens as
predicted, time will tell.

3 For non cash collateral do you expect to see:-
A: More equities 76.7%
B: Less equities 23.3%

Perhaps the most relevant vote of the day with regards to the subject matter of this paper
is the last one. Not only do European lenders expect to take proportionately more non-
cash collateral in the future, they expect equities to make up proportionately more of that
non-cash collateral. They would not do so if their experience of accepting equities as
collateral (and that of their peers) had not been positive. One cannot think of a better way to
summarise this paper than that.

Appendix 2
ForadditionalcolourweobservethatintherecommendationsforthcominginTheCommitteeon
the Global Financial System (CGFS) paper 36 published March 2010 and entitled The role of
marginrequirementsandhaircutsinprocyclicalitytheyincludethefollowing:
To improve the stability of the supply of secured financing through the securities lending
programme, develop best practice guidelines for negotiating terms for securities lending, and
requirecustodianbanksadministering suchprogrammestoprovideimproveddisclosure ofthe
risksunderlyingtheirreinvestmentactivities.
ToallowmacroprudentialauthoritiestoassessfinancingconditionsinsecuredlendingandOTC
derivatives markets, consider the value of regularly conducting and disseminating a
predominantlyqualitativesurveyofcredittermsusedinthesemarkets,includinghaircuts,initial
margins,eligiblepoolsofcollateralassets,maturitiesandothertermsoffinancing.
Wewelcometheirrecommendationregardingbestpracticeguidelinesandcallingforimproved
disclosure. However, we question whether a predominantly qualitative survey will assist the
marketsmuchwhenwhatisreallyneededisanempiricallyrobustapproachtosuchmatters.

RMA Legal Review

Equities as Collateral
In
U.S. Securities Lending Transactions

An Overview of Legal and Regulatory Considerations

Risk Management Association (RMA)
Legal, Tax & Regulatory Subcommittee

March, 2011

Introduction

The major participants in the U.S. securities lending market are subject to several laws and
regulations that prohibit them, or which effectively prohibit them due to unfavorable treatment,
from accepting equity securities as collateral for securities loans. These laws and regulations
include the Securities and Exchange Commissions Rule 15c3-3 (SEC Rule 15c3-3), known as
the Customer Protection rule, which regulates broker-dealers securities borrowing activities, the
US Employee Retirement Income Security Act of 1974 (ERISA), as amended, which
regulates many pension plans securities lending activities, the U.S. Investment Company Act of
1940 (40 Act), which regulates registered investment companies securities lending activities,
and several U.S. federal statutes that govern securities lenders rights in the event of the
insolvency of a borrowing broker-dealer. The purpose of this section is to provide an overview
of these laws and regulations as well as some proposed changes to them that would facilitate the
future use of equities as collateral for securities loans to the extent the market adopts the use of
this type of collateral.

SEC Rule 15c3-3 (impact to Broker Dealers)

United States broker-dealers (broker-dealers) typically act as the borrowers in securities
lending transactions in the U.S. Broker-dealers generally borrow for the purpose of satisfying
their delivery obligations or the delivery obligations of their customers.

The Securities and Exchange Commissions Rule 15c3-3, promulgated under the Securities
Exchange Act of 1934, as amended (Rule 15c3-3), contains a number of requirements that
broker-dealers must comply with when borrowing their customers fully-paid or excess margin
securities. The definition of customer under Rule 15c3-3 is generally broadly construed to
encompass agency lending. It may be questioned whether this definition was intended to cover
the sophisticated lenders currently supplying the securities lending industry. However, to the
extent this construction of customer is maintained by the SEC, there are two requirements that
generally prevent or adversely impact a broker-dealers ability to use equity securities as
collateral in securities lending transactions.

First, Rule 15c3-3 specifies permissible categories of collateral that may be used by broker-
dealers in connection with their securities borrowing activities and also provides that the U.S.
Securities and Exchange Commission (the SEC) may designate as permissible collateral such
other collateral as necessary or appropriate in the public interest and consistent with the
protection of investors after giving consideration to the collaterals liquidity, volatility, market
depth and location, and the issuers creditworthiness. Currently, the Rule does not list equity
securities as a permissible category of collateral and the SEC has not designated equity securities
as permissible collateral despite having the authority under the Rule to do so.

Secondly, Rule 15c3-3 requires broker-dealers to maintain a bank account for the exclusive
benefit of its customers (the Reserve Account). This requirement, together with the
requirement that a broker-dealer maintain possession and control of a customers fully paid or
excess margin securities, serves to ensure that sufficient assets will be available to meet specific
customer securities account claims in the event of a broker-dealer insolvency or liquidation. In
accordance with the formula specified under the Rule, a broker-dealer is obligated from time to
time to deposit in the Reserve Account cash and/or assets of a type allowed under the Rule.
Currently, if a broker-dealer were to use equity securities as collateral in order to borrow
securities to meet delivery obligations for customer transactions, the broker-dealer would be
obligated to make a net deposit into the Reserve Account, making the borrow transaction
significantly less desirable to the broker-dealer. If a broker-dealer delivers cash or Treasuries as
collateral for the same borrow transaction, however, the broker-dealer is not obligated to make a
net deposit into the Reserve Account. Therefore, to make equity securities collateral an
economically viable alternative for broker-dealers, the SEC would need to designate equity
securities as equivalent to cash or U.S. treasuries collateral for purposes of borrowing securities
to meet delivery obligations for customer transactions.

ERISA (impact to Pension Plans and their lending agents)

Under current rules, it is unclear whether a lending agent could accept equity securities as
collateral for securities lending transactions on behalf of its ERISA-regulated Plan clients, even
if the client agreed to do so. The following describes the origin of this lack of clarity and sets
forth some actions that could permit such a transaction.

A large portion of the assets controlled by lending agents in the United States consist of
retirement plan assets from corporations, or other entities ("Plans"). Securities lending by
Plans are generally governed by the US Employee Retirement Income Security Act of 1974, as
amended (ERISA). Securities lending by Plans must be conducted under a prohibited
transaction exemption ("PTE"). PTE's are issued by the US Department of Labor ("DOL")
which administers and interprets ERISA, and may consist of "Class" exemptions or "Individual"
exemptions. Most agent lenders rely on PTE 2006-16, a class exemption, to engage in securities
lending transactions for Plans and also to receive compensation with respect to securities lending
services. Agent Lenders and their Plan clients may choose not to rely on PTE 2006-16 for
securities lending and instead rely on other exemptions that are not described here. However,
the following discussion relates solely to PTE 2006-16 as we believe that the majority of
lending agents acting on behalf of Plans rely on PTE 2006-16.

PTE 2006-16 imposes certain conditions regarding securities lending on behalf of Plans.
Regarding collateralization of the transaction, it requires different levels of collateral depending
on the securities being lent and the collateral received. For any securities (US or non-US) it
requires that the Plan receive collateral equal to at least 100% of the then market value of the
securities lent if the collateral is US Collateral. The collateral amount of 100% must also be
maintained by daily adjustments based on the market value of the securities lent as of the close
of business on the preceding market day. US Collateral includes US dollar cash, securities
issued or guaranteed by the US Government or its agencies or instrumentalities, an irrevocable
letter of credit denominated in US dollars and issued by a bank other than the borrower or an
affiliate, certain mortgage-backed securities, and negotiable certificates of deposit and bankers
acceptances that meet certain criteria. Equity securities are not included in the definition of US
Collateral.

If the collateral received is Foreign Collateral, then the minimum level of collateralization is
either 100%, 101%, 102% or 105% depending on certain criteria including whether the collateral
is denominated in certain currencies, whether the collateral is denominated in the same currency
as the securities lent, and also whether the lending agent provides the Plan with indemnification
against losses due to borrower default. Foreign Collateral includes securities issued or
guaranteed as to principal by certain multilateral development banks, sovereign debt rated in one
of the two highest categories by at least one NRSRO, cash denominated in GBP, CAD, CH, J PN
or Euro, or irrevocable letters of credit issued by certain foreign banks. Foreign Collateral may
also include any collateral not otherwise listed above as either US Collateral or Foreign
Collateral that is described in Rule 15c3-3, so long as the lending agent indemnifies the Plans
against losses due to borrower default. Equity securities are not explicitly included in the
definition of Foreign Collateral, but could be under Rule 15c3-3 if the SEC were to expand
permissible collateral under such rule to include equity securities, as discussed above under SEC
Rule 15c3-3 (Impact to Broker Dealers).

It therefore appears that the DOL has relied upon the SEC to determine whether to expand
permissible collateral for ERISA Plans to include equity securities or other forms of collateral
not expressly permitted under PTE 2006-16. However, in the preamble of the adopting release
issued with PTE 2006-16, the DOL states

In response to a comment, the Department has determined not to revise the exemption
to include equity securities and fixed-income securities as these items appear to be
outside the scope of Rule 15c33, and the Department has insufficient information about
how these items would function as collateral. (71 Fed. Reg. 63791, Oct. 31, 2006)

This statement in the preamble that the DOL has chosen not to revise the ERISA exemption to
include equity securities appears to conflict with language within the exemption itself which
automatically includes as permissible Foreign Collateral anything the SEC designates as
permissible collateral under Rule 15c3-3. At a minimum, in the event the SEC chose to expand
permissible collateral under Rule 15c3-3 to include equity securities, the industry would look to
the DOL to clarify this point. In the alternative, the DOL could issue an amendment to PTE
2006-16 expressly permitting equity securities as collateral without waiting for SEC action.

The 40 Act (impact to mutual fund lenders)

The U.S. Investment Company Act of 1940, as amended (the Investment Company Act) does
not provide specific regulations for lending portfolio securities of a registered investment
company (such a company referred to herein as a, Fund). While the Investment Company Act
does not prohibit such transactions, securities lending presents certain potential issues under the
Investment Company Act, specifically relating to a Funds control over portfolio securities
during the loan (raising issues under Section 17(f) of the Investment Company Act) and whether
the obligation to return collateral to a borrower of securities creates a senior security under
section 18(f) of the Investment Company Act. Guidelines in response to these issues have been
developed through a series of no-action letters which outline the parameters for permissible
securities lending by a Fund.

The initial no-action guidance established certain basic guidelines for the lending of portfolio
securities, including the requirements for 100% collateralization, daily mark-to-market, the
ability to terminate loans at any time, receipt of reasonable interest on loans, as well as
dividends, distribution and increased market value. From these general guidelines, no-action
relief has developed a limited list of permitted collateral for loans of Fund portfolio securities,
which, in line with these general guidelines, ensures full collateralization, maximum liquidity
(for the return of collateral), reasonable earnings and protection of the Fund assets.

Currently, permissible collateral for Funds engaged in securities lending include: cash, securities
issued or guaranteed by the U.S. government or its agencies, irrevocable standby letter of credit
issued by a bank, or any combination thereof. (See State Street (cash as collateral), Lionel D.
Edie Capital Fund, Inc. (publicly available May 15, 1975) (Edie Capital) (US government and
agency securities as collateral), and Adams Express Company (publicly available October 20,
1979) (Adams Express) (irrevocable bank letters of credit as collateral).)

The permissibility of equity securities as collateral in securities lending transactions has not yet
been addressed by the SEC. As US brokers are restricted from providing equity securities as
collateral to its clients for loans as discussed above under SEC Rule 15c3-3 (Impact to Broker
Dealers), this issue has not formally been considered. However, it should be noted that Funds
are not limited to lending only to US brokers and as the global demand for equity securities
increases, Funds may wish to increase their lending to non-US borrowers. If Funds wish to
effectively compete with other market participants in the global market, Funds will be at a
disadvantage so long as they cannot accept equity securities as collateral.

As a baseline for inclusion of equities as collateral, several factors may be considered based on
prior guidance and present market practice. Specifically, inclusion of this collateral type should
provide Fund lenders: full collateralization, maximum liquidity, adequate security (protection)
and the increased potential to earn reasonable earnings on its lending activities.

FullCollateralization.Inclusion of equities as collateral must satisfy the basic
requirementforfullcollateralization,suchthat(1)theFundwillreceivecollateralthatis
worthatleast100%ofthemarketvalueofthesecuritiesloanedatthetimeoftheloan,
and(2)thelevelofcollateralprovidedisadjustedtotheextentthevalueoftheloaned
securities changes (i.e. collateralization of at least 100% based on daily markingto
market). The institutional trading of exchangelisted equity securities ensures
compliance with the requirement for full collateralization because there is a constant
means of market valuation, which can be monitored and accessed by any market
participant.Areliableandconstantmarketvaluationisthefoundationforensuringan
accuratemarktomarketprocessthroughoutthetenoroftheloan.
MaximumLiquidity. Thebroadeningofcollateraltypestoincludeequitiesascollateral
should support the position outlined in Salomon Brothers (publicly available May 4,
1975),thatIfthesolepurposeofcollateralisassecuritythenthesoletestforselecting
thecollateralshouldbewhetheritgivesmaximumliquidity.Asnotedabove,certain
equity securities have a market for trading which facilitates steady liquidity, consistent

publicinformationandanopenmarketforsettlingtransactions,allelementssupporting
maximumliquidity.
AdequateSecurity. If a primary purpose of collateral is to provide security or

protection for the lender, equity securities should meet this requirement. The
transparency and liquidity of equities support the adequacy of the security a Fund
lenderrequiresbecauseitequipsthelenderwithinformationregardingthesesecurities
thatisunparalleledinthedebtmarket.
ReasonableInterest. The SEC has also indicated that reasonable interest should be
earned by lending in connection with lending transactions. To the extent equities are
includedascollateral,thediversificationofcollateralshouldresultinincreasedearning
potential for lending Funds. With the expansion of acceptable collateral, Funds may
improve their position to negotiate lending rates, thereby potentially increasing the
return from existing lending relationships. In addition, to the extent Funds increase
theirlendingtononUSborrowers,Fundslendingopportunityshouldalsoincreaseasa
these nonUS borrowers expect more collateral flexibility in connection with lending
transactions.

SIPA Concerns

A. Background Regarding Insolvency Proceedings and SIPC Stay.
Under Title 11 of the United States Code (the US Bankruptcy Code), the exercise of a
contractual right by an eligible lender (or lending agent on behalf of its clients) to cause the
liquidation, termination or acceleration of, or to offset or net obligations arising under securities
lending agreements with a borrower subject to insolvency proceedings, falls within a safe harbor
exception for securities contracts and therefore would be exempt from the automatic stay
under the Bankruptcy Code.4 U.S.C. 101(22), 362(b)(6), 555, 561(a) & 741(7).

While an insolvent US broker-dealer is subject to liquidation under Chapter 7 of the US
Bankruptcy Code, as a member of the Securities Investor Protection Corporation (SIPC), it is

4
ItisalsonotablethatbrokerdealersthataredeemedtoposeasystemicrisktotheU.S.financialstabilityand
whicharecounterpartiestosecuritieslendingcontractsandotherqualifiedfinancialcontractscouldbesubject
toinsolvencyproceedingsundertheOrderlyLiquidationAuthority(OLA)provisionsoftheDoddFrankWall
StreetReformandConsumerProtectionAct(theDoddFrankAct)of2010ratherthanabankruptcyproceeding.
InanOLAproceeding,alendertoabrokerdealerwouldbesubjecttoastayunderOLA,ratherthanaSIPCstay.
TheOLAstaywouldpreventthelenderfromexercisingrightstoliquidation,termination,accelerationorrightsto
setoffornetunderthesecuritieslendingcontractbasedontheinsolvencyofthebrokerdealer(e.g.,anipsofacto
terminationclause)foramandatoryonebusinessdayperiodaftertheappointmentoftheFDICasreceivertothe
brokerdealer.Atonlyonebusinessday,theOLAstayissignificantlyshorterandmorecertainindurationthanthe
SIPCstay,andappliesequallyregardlessofwhetherthebrokerdealerhaddeliveredcashorsecuritiescollateral.
ManydetailsoftheapplicationoftheOLAstaywillbeclarifiedasregulationsareissued.

also subject, at the election of SIPC, to liquidation proceedings under the Securities Investor
Protection Act (SIPA), which take precedence over the bankruptcy proceeding.

The stay under SIPA, as well as the SIPA financial contracts exception, closely resemble the
automatic stay and the safe harbor provisions of the US Bankruptcy Code. 15 U.S.C.
78eee(b)(2)(c)(i). However, upon the request of SIPC, there is the potential for a stay of
liquidation of securities collateral posted by the debtor broker-dealer (including under a
securities lending agreement or a repurchase agreement) for a period of time. 15 U.S.C.
78eee(b)(2)(c)(ii). While not expressly provided for under SIPA, the duration of the stay has
historically been a 21-day period, which may be extended at the discretion of SIPC.

For securities lending and repurchase agreements, SIPC has historically allowed for a limited
exception to the SIPC stay. The market expectation (based on prior cases and a key Letter from
the President of SIPC to The Bond Market Association) has been that SIPC would provide
consent, based on such a submission, within four or five days; in the SIPA case of Lehman
Brothers Inc., counterparties have indicated that they were able to have the stay lifted within
three days of the commencement of the SIPA case. The ability to obtain relief from the stay for
liquidation of securities collateral posted in securities lending transactions is not established
under SIPA, but rather solely by policy letters, and therefore could be subject to modification by
SIPC in its discretion, and is also subject to some degree of uncertainty as to ability of a secured
party to enforce adherence to the policy.

B. Heightened Concerns under SIPA Raised by Use of Equities as Collateral

The potential for a stay under SIPA creates a period of market risk in relation to securities posted
as collateral that become subject to a SIPC stay. To the extent the uncertainty created by the stay
delays the repurchase of replacement securities, a stay also exposes the principal lender to
market risk on that side of the transaction as well. This risk applies equally to all securities
posted as collateral under securities lending agreements with a debtor broker-dealer. Given the
potential for a flight to quality in the circumstance of a significant broker-dealer failure,
lenders may perceive market risk in respect of equity securities held as collateral and subject to
the SIPC stay, as greater than that with respect to fixed income securities (e.g., US Treasury
securities) held as collateral and subject to the SIPC stay.

State Law and Taxation Considerations

As explained briefly below, some consideration of applicable state laws and state and federal tax
rules may be needed to determine the extent of the enforceability and reliability of security
interests in equity collateral as well as any potential tax implications for acceptance of such
collateral in certain cross-border lending transactions.

The standard form of agreement in the US industry, the Master Securities Lending Agreement
(MSLA), applies New York state law which has well-developed law regarding security
interests in pledged collateral. Any amendment to the standard MSLA negotiated by the industry
would also rely on New York state law and get the benefit of this well-developed jurisprudence.
However, the MSLA is not necessarily used in the industry and so lending agents may have
applied different governing state laws which may not have as much clarity regarding the rights of
the parties. For example, some states may not have adopted the UCC or may have deviated from
the standard UCC in a way that changes the expected rights of the parties.

In addition, there may be specific tax ramifications to consider, which may differ according to
the jurisdiction in which business is taking place. Tax concerns also arise in the context of cross-
border lending (loans to non-US borrowers), where there may be US withholding tax
implications for loans collateralized with equity securities.

Conclusion

In summary, in the United States, there are broad regulatory hurdles to equities being taken as
collateral. These regulatory issues impact various segments of the lending market, which are
subject to different regulatory authorities. The acceptance of equities as collateral will likely
require a holistic legal analysis and coordination of any changes across these market segments
and by these regulators.

State Street Letter

State Street Bank and Trust Company
Two International Place
Boston, Massachusetts 02110
Telephone: (617) 664-2500
Facsimile: (617) 664-2660
J uly 31, 2002
BY ELECTRONIC MAIL
Mr. J onathan G. Katz
Secretary
Securities and Exchange Commission
450 Fifth Street, N.W.
Washington, D.C. 20549-0609
Re: Release No. 34-46019, File No. S7-20-02, Customer Protection - Reserves and Custody
of Securities (Rule 15c3-3)
Dear Mr. Katz:
State Street Bank and Trust Company (State Street) submits this letter in response to the
proposed rule amendment (Proposed Amendment) to Rule 15c3-3 of the Securities Exchange Act
of 1934 (Exchange Act). The Securities and Exchange Commission (Commission) published the
Proposed Amendment for comment in the Federal Register on J une 10, 2002. State Street has
reviewed the Proposed Amendment in detail and appreciates the opportunity to provide the
Commission with its comments.
State Street is a Massachusetts-chartered trust company and a member of the Federal Reserve
System. State Street
1
is one of the world's leading specialists in serving mutual funds, collective
funds, pension and retirement plans and other large institutional investors worldwide. As of J une
30, 2002, State Street
2
had $6.2 trillion in assets under custody and $770 billion in assets under
management, making it the third largest custodian worldwide and the seventh largest investment
manager worldwide. State Street is also one of the world's largest securities lending agents,
providing comprehensive securities lending services to large, financially sophisticated
institutions both in the U.S. and abroad. State Street has participated in securities lending
markets on behalf of its clients (State Street Clients)
3
since 1974.
State Street strongly supports and welcomes the Proposed Amendment. State Street urges the
Commission to issue as soon as possible a final rule and related exemptive order or orders
regarding the Proposed Amendment (respectively, Final Rule and Collateral Orders). State
Street also supports and welcomes the delegation of the Commission's authority to the Division

of Market Regulation (Division) so that the Division may issue Collateral Orders designating the
expanded types of collateral that may be pledged by U.S. brokers or dealers (each, a U.S. Broker)
when borrowing securities from securities lenders (directly or through their securities lending
agents, if applicable). If the Commission's authority is so delegated, State Street requests that the
Division act promptly in issuing such Collateral Orders. State Street believes that the prompt
issuance of the Final Rule and Collateral Orders will facilitate and promote efficient securities
markets, decrease costs, increase competition and enhance the liquidity of securities markets.
State Street requests that the Commission not delay the issuance of the Final Rule or Collateral
Orders under any circumstance. However, for the reasons set forth below, State Street urges the
Commission to grant, either concurrently with the issuance of the Final Rule or Collateral Orders
or on a date in the near future, the authority for any Qualified Institutional Lender (as defined
below) to negotiate the types of collateral that may be pledged by U.S. Brokers in any securities
lending transaction involving a securities loan by such Qualified Institutional Lender. A
"Qualified Institutional Lender," as used in this context, means any institutional securities lender
4

that either (i) is a qualified institutional buyer (QIB), as that term is defined under Rule 144A
promulgated under the Securities Act of 1933 (1933 Act), or (ii) owns and invests on a
discretionary basis at least $100 million in eligible securities as specified in Rule 144A of the
1933 Act.
5

State Street strongly believes that such further relief sought for Qualified Institutional Lenders is
warranted because, among other reasons discussed more fully in this response letter, the
collateral requirements prescribed by Rule 15c3-3(b)(3)(iii) interfere with the ability of Qualified
Institutional Lenders (directly or through their securities lending agents, if applicable) to
negotiate for, and accept types of, collateral that would generate more revenue and allow
Qualified Institutional Lenders to better manage risk by constructing a portfolio of loans in
which the collateral pledged is more closely correlated to the loaned securities.
State Street believes that Qualified Institutional Lenders should be able to make their own
judgment as to what is in their best interests and should be able to structure the overall terms of
the particular securities lending transactions in the most appropriate fashion without the
imposition of an artificial constraint on the types of collateral that they may accept from U.S.
Brokers, particularly given the process by which securities lending transactions are effected
under State Street's securities lending program (State Street Program) and other comparable
institutional securities lending programs. To that end and as discussed more fully in this response
letter, State Street believes that the continued imposition of any such collateral requirements on
the State Street Clients and other Qualified Institutional Lenders will interfere with the
facilitation and promotion of efficient securities markets, increase costs for both the State Street
Clients and other Qualified Institutional Lenders and U.S. Brokers, reduce competition,
adversely affect the liquidity of securities markets, and result in certain securities lending
transactions being shifted off-shore to foreign brokers or dealers.
State Street believes that the Commission can most effectively implement such further relief
sought for Qualified Institutional Lenders by amending Rule 15c3-3 to exempt Qualified
Institutional Lenders from the collateral requirements prescribed by Rule 15c3-3(b)(3)(iii), or,
alternatively, by allowing the Commission's authority to be delegated to the Division so that the

Division may issue exemptive orders so exempting Qualified Institutional Lenders (QIL Orders).
If the Commission's authority is so delegated, State Street requests that the Division act promptly
in issuing such QIL Orders.
I. Overview
This letter responds in detail to the Commission's request for comment as to whether Rule 15c3-
3(b)(3)(iii) should limit the types of collateral that may be pledged by U.S. Brokers in borrowing
from institutional customers
6
or whether the collateral should be left to negotiation between the
particular institutional customer and U.S. Broker after adequate disclosure. The Commission also
requested comments with respect to several related questions in the event the types of collateral
were to be subject to negotiation by institutional customers and U.S. Brokers. Before addressing
the Commission's specific questions in detail, we have prepared for the Commission's
convenience a brief description of the process by which securities lending transactions are
effected under the State Street Program, and additional reasons that support the further relief
sought for Qualified Institutional Lenders. State Street believes that the process by which
securities lending transactions are effected under other institutional securities lending programs
generally is comparable to that employed in the State Street Program.
II. State Street Program
Each State Street Client appoints and authorizes State Street, as its agent, to lend on its behalf
securities that State Street holds as trustee or custodian
7
to certain borrowers (each, a Borrower)
8

in accordance with the terms of the particular State Street Client's agreement with State Street
(each, a Securities Lending Authorization Agreement). Each State Street Client also authorizes
State Street to enter into one or more securities loan agreements (each, a Securities Loan
Agreement) with a Borrower on behalf of the particular State Street Client, subject to certain
limitations prescribed in the Securities Lending Authorization Agreement. The Securities
Lending Authorization Agreement requires, for example, that (i) a Borrower be an entity
identified in the Securities Lending Authorization Agreement and approved by the particular
State Street Client; (ii) the collateral to be pledged by a Borrower be of the type approved by the
particular State Street Client; and (iii) the market value of the pledged collateral in relation to the
market value of the loaned securities satisfies specified minimum levels (generally not less than
100%), as approved by the particular State Street Client. State Street would like to emphasize
that the type of collateral pledged by the Borrowers and the minimum collateral coverage level
for such type of collateral must be authorized in writing by the State Street Client before State
Street will initiate any securities lending transactions using such type of collateral.
Each State Street Client authorizes State Street to negotiate the terms of each Securities Loan
Agreement with a Borrower, but subject at all times to the requirements prescribed in the
Securities Lending Authorization Agreement between the particular State Street Client and State
Street. If, in the context of any securities loan, State Street wishes to act in a manner inconsistent
with its Securities Lending Authorization Agreement with a particular State Street Client (for
example, by accepting on behalf of the particular State Street Client a type of collateral not
previously authorized in writing by that State Street Client), State Street may do so only with the
prior written authorization of that State Street Client.

State Street also conducts extensive due diligence on behalf of the State Street Clients with
respect to each Borrower both prior to and after lending securities of any of the State Street
Clients to the Borrower and imposes certain requirements on the Borrower under the applicable
Securities Loan Agreement, including those described above. For example, with respect to any
Borrower, State Street (i) conducts ongoing credit analyses to monitor the Borrower's
creditworthiness; (ii) establishes and monitors limits on the amount of securities loaned to the
Borrower at any particular time; (iii) requires that collateral be transferred to State Street on or
prior to the time that securities are transferred to the Borrower; (iv) requires a daily mark to
market of all loaned securities; (v) requires the Borrower to transfer additional collateral to State
Street for the benefit of the State Street Clients if the minimum specified collateral level is not
satisfied; and (vi) requires, if the Borrower is a U.S. Broker, compliance with the Commission's
net capital rules. All State Street Clients are currently advised and acknowledge and agree that, if
a Borrower is a U.S. Broker, the provisions of the Securities Investors Protection Act of 1970
(SIPA) may not protect the State Street Client with respect to any loan of its securities and that,
therefore, the collateral transferred to the State Street Client with respect to such a loan may
constitute the only source of satisfaction of the obligation of the U.S. Broker in the event the
U.S. Broker fails to retransfer the loaned securities.
For the information of the Commission, we highlight that as a result of this level of due diligence
and the protections and processes built into the State Street Program, no State Street Client has
ever suffered a loss because of a default by a Borrower of its obligations under the relevant
Securities Loan Agreement.
State Street believes that other securities lending agents enter into agreements similar to the
Securities Lending Authorization Agreement and the Securities Loan Agreement in respect of
Qualified Institutional Lenders that participate in their institutional securities lending programs
and the borrowers that borrow securities of such Qualified Institutional Lenders. State Street
similarly believes that the level of due diligence conducted by other securities lending agents on
behalf of their Qualified Institutional Lenders with respect to such borrowers both prior to and
after lending securities of those Qualified Institutional Lenders generally is comparable to the
diligence that State Street conducts with respect to Borrowers on behalf of the State Street
Clients.
III. Current Rule Impact
Rule 15c3-3(b)(3)(iii) currently dictates the pledge of cash or U.S. government or certain other
securities.
9
This has the tendency to require U.S. Brokers either to acquire qualifying securities
or to liquidate other securities for cash or borrow cash which, in turn, results in increased costs
that would not otherwise be the case if other securities in the existing inventories of U.S. Brokers
could be pledged as collateral. This adversely reduces the profitability of the transaction from the
perspective of both the Qualified Institutional Lenders and the U.S. Brokers. To the extent U.S.
Brokers can provide collateral that is in their existing inventories or is otherwise less costly from
either a capital or expense perspective, then U.S. Brokers will be able to pay Qualified
Institutional Lenders a higher fee for borrowing a particular security against that form of pledged
collateral. In doing so, this will reduce the costs incurred by U.S. Brokers and enhance the

profitability of a transaction for U.S. Brokers, while also increasing the revenue for Qualified
Institutional Lenders, and thereby will benefit both parties to the transaction.
In addition, Rule 15c3-3(b)(3)(iii) currently interferes with the ability of the Qualified
Institutional Lenders to manage risk. For these large sophisticated institutional securities lenders,
an important goal is to create a portfolio of loans that is appropriately matched against the
collateral that has been pledged from both risk and return perspectives. This matching process
takes into account a variety of factors, including the volatility of not just the collateral pledged
but also of the respective loaned securities and the correlation of the expected price movements
between the collateral pledged and the loaned securities. By dictating the specific types of
eligible collateral, Rule 15c3-3(b)(3)(iii) interferes with this matching process and the ability of
the particular Qualified Institutional Lender to achieve the desired correlation necessary to obtain
the optimal level of risk and return.
IV. Customer Relationship
State Street believes that the relationship between institutional securities lenders, including
Qualified Institutional Lenders, and U.S. Brokers does not represent the typical "customer-
broker" relationship contemplated by Rule 15c3-3. Rather, State Street believes that there are
persuasive technical and policy reasons for concluding that Qualified Institutional Lenders and
other institutional securities lenders that lend their securities to U.S. Brokers should not be
deemed to be customers within the meaning of Rule 15c3-3. As a technical matter, Rule 15c3-
3(a)(2) defines "securities carried for the account of a customer" or "customer securities" that are
entitled to the protections of Rule 15c3-3(b) (including the provisions regarding required
collateral for securities borrowing transactions) as (i) "securities received by or on behalf of a
broker or dealer for the account of any customer and securities carried long by a broker or dealer
for the account of any customer" and (ii) "securities sold to, or bought for, a customer by a
broker or dealer." Securities held by a Qualified Institutional Lender or other institutional
securities lender, as applicable, for loan to a U.S. Broker are typically held in custody by a bank
or trust company. These loans generally are made to allow the U.S. Broker to deliver the loaned
securities to a third party (to cover a short sale or a fail transaction) rather than to hold them at
the U.S. Broker for the account of the Qualified Institutional Lender or other institutional
securities lender, as applicable.
10
Thus, these securities loans do not appear to fall within the
literal language of this definition or the intended application of the customer protection
provisions of Rule 15c3-3.
11

From a policy perspective and consistent with the intent and scope of the language of Rule 15c3-
3, Qualified Institutional Lenders and other institutional securities lenders have no reasonable
expectation that they will be afforded the protections of Rule 15c3-3. Furthermore, Qualified
Institutional Lenders are financially sophisticated, knowledgeable about securities lending
transactions and otherwise fully capable of analyzing the risks (which risks State Street believes
are quite small in these types of transactions) and rewards associated with securities lending
transactions and the types of collateral that may be acceptable to them. In fact, Qualified
Institutional Lenders are best suited to select the collateral for the particular securities loan (i.e.,
selecting collateral that is most closely correlated to the securities loaned from a price movement
perspective). Accordingly, while State Street fully recognizes the Commission's desire to address

the treatment of securities lenders not otherwise eligible for SIPA and Rule 15c3-3 protections, it
is not necessary to impose such collateral requirements on Qualified Institutional Lenders under
these circumstances.
12

State Street believes that the effect of the foregoing is either to unnecessarily deprive the State
Street Clients and other Qualified Institutional Lenders of opportunities to loan securities to U.S.
Brokers or to otherwise increase the costs of securities lending transactions because of the
limitations imposed on collateral that U.S. Brokers may pledge and thereby reduce the overall
profitability for both the State Street Clients and other Qualified Institutional Lenders and U.S.
Brokers. Also, as noted above, the imposition of these collateral requirements has the tendency
to shift a certain number of securities lending transactions off-shore to foreign brokers or
dealers.
13
This, in turn, unnecessarily raises complex cross-border tax issues for the State Street
Clients and other Qualified Institutional Lenders.
In conclusion, State Street believes that the collateral requirements prescribed by Rule 15c3-
3(b)(3)(iii) frustrate competition, undercut the efficiency of securities markets, increase
borrowing costs, reduce the profitability of the securities lending transaction for both parties,
decrease the liquidity of securities markets and may, by causing certain securities lending
transactions to be shifted off-shore, expose the State Street Clients and other Qualified
Institutional Lenders to greater risks than would otherwise be the case if they could effect such
transactions with U.S. Brokers.
V. Additional Support for Qualified Institutional Lender Exemption
In addition to the foregoing, State Street believes that there is ample justification to support a
determination by the Commission that the collateral requirements prescribed by Rule 15c3-
3(b)(3)(iii) should not apply to the State Street Clients and other Qualified Institutional Lenders
and thus to exempt such Qualified Institutional Lenders from those requirements. State Street
urges the Commission to consider each of the following factors in determining that such an
exemption is warranted for Qualified Institutional Lenders:
(i) The Commission has elsewhere determined, by rule, that the protections afforded by
other Commission rules are not appropriate for, and thus has specifically exempted from
their coverage, certain categories of investors based on their financial sophistication and
large size. See, for example, QIBs under Rule 144A of the 1933 Act, "qualified investors"
under the Exchange Act and "qualified purchasers" under Section 3(c)(7) of the
Investment Company Act of 1940.
(ii) The State Street Clients are financially sophisticated and knowledgeable about
securities lending transactions, and they, in conjunction with State Street, are fully
capable of analyzing the types of collateral that the Borrowers may pledge in borrowing
securities from them and assessing what is in their best interests from both risk and return
perspectives. State Street believes that this is also the case with respect to other Qualified
Institutional Lenders.

(iii) The terms of the Securities Lending Authorization Agreements and the overall
process by which securities lending transactions are effected under the State Street
Program provide considerable protections to the State Street Clients. State Street believes
that this is also the case with respect to securities loans effected by other securities
lending agents for other Qualified Institutional Lenders that participate in their
institutional securities lending programs.
VI. Responses to the Commission's Specific Questions
Although we have addressed in part some of the specific questions raised by the Commission in
its issuance of the Proposed Amendment, the following responses address the specific questions
raised by the Commission on this aspect of the Proposed Amendment:
(i) Whether Rule 15c3-3(b)(3)(iii) should limit the types of collateral that must be
supplied by U.S. Brokers in borrowing from an institutional customer or whether the
collateral should be left to negotiation between a particular institutional customer and
U.S. Broker after adequate disclosure?
For the reasons discussed above, State Street believes that, in the context of securities
loans from a Qualified Institutional Lender, the collateral should be left to negotiation
between the particular Qualified Institutional Lender (directly or through its securities
lending agent, if applicable) and the U.S. Broker after adequate disclosure. State Street
believes that this approach is in the public interest, is entirely consistent with and will
further carry out the Commission's goals of adding liquidity to the securities markets and
lowering borrowing costs for U.S. Brokers, will benefit the State Street Clients and other
Qualified Institutional Lenders by providing them with additional lending opportunities
and the resulting associated additional revenue and will promote more efficient securities
markets and reduce the overall costs in connection with securities lending transactions for
the benefit of both these securities lenders and borrowers. This approach will also reduce
the number of securities lending transactions that would otherwise be shifted off-shore to
foreign brokers or dealers.
(ii) If the latter, should the ability to negotiate collateral be limited to a certain category
of institutional customers?
Yes, the ability to negotiate collateral should be limited to Qualified Institutional Lenders
because, among other reasons, Qualified Institutional Lenders, in conjunction with their
securities lending agents, if applicable, are fully capable of analyzing the types of
collateral that U.S. Brokers may pledge in borrowing securities from Qualified
Institutional Lenders and assessing what is in their best interests from both risk and return
perspectives.
14

(iii) How should the Commission define this category?
Please see the definition of Qualified Institutional Lender, as described more fully above.

(iv) What disclosures would be necessary if the collateral were left to negotiation?
State Street does not believe that additional disclosure requirements are necessary. This is
because a State Street Client and State Street would discuss and agree upon the types of
collateral that may be acceptable to the particular State Street Client. As discussed more
fully above, State Street, as the particular State Street Client's agent, cannot accept any
type of collateral that is not authorized in writing by that State Street Client. State Street
believes that other Qualified Institutional Lenders and their securities lending agents
would engage in similar discussions and analyses and implement similar procedures.
(v) Should there be any required minimum amount of collateral to protect the
institutional customer and the U.S. Broker?
A minimum amount is not necessary in State Street's judgment; however, as an
administrative matter and consistent with the current practice of State Street and other
securities lending agents and certain requirements prescribed by provisions of the Code,
15

requiring collateral under revised Rule 15c3-3(b)(3)(iii) with a market value of at least
100% of the market value of the securities loaned would be entirely acceptable to State
Street.
***
In sum, State Street respectfully urges the Commission to issue as soon as possible the Final
Rule and Collateral Orders. State Street welcomes the delegation of the Commission's authority
to the Division so that the Division may issue Collateral Orders designating the expanded types
of collateral that may be pledged by U.S. Brokers when borrowing securities from securities
lenders (directly or through their securities lending agents, if applicable). By doing so, State
Street believes that efficient securities markets will be facilitated and promoted, costs will be
decreased, competition will be increased and the liquidity of securities markets will be enhanced.
State Street similarly urges the Commission to implement the further relief sought for Qualified
Institutional Lenders,
16
either concurrently with the issuance of the Final Rule or Collateral
Orders or on a date in the near future. State Street requests that the Commission do so either by
amending Rule 15c3-3 to exempt Qualified Institutional Lenders from the collateral
requirements prescribed by Rule 15c3-3(b)(3)(iii), or, alternatively, by allowing the
Commission's authority to be delegated to the Division so that the Division may issue QIL
Orders. By doing so, the Commission will afford Qualified Institutional Lenders, acting directly
or through their securities lending agents, the ability to negotiate the appropriate types and level
of collateral with U.S. Brokers. If Rule 15c3-3(b)(3)(iii) is left unchanged in this regard, there
will continue to be inefficiencies in the securities markets and higher costs in securities lending
transactions and U.S. Brokers and the State Street Clients and other Qualified Institutional
Lenders will continue to be placed at a significant competitive disadvantage.
In the event that the Commission's authority is delegated, either with respect to Collateral Orders
or QIL Orders, State Street requests that the Division act promptly in issuing such Collateral
Orders or QIL Orders.

State Street appreciates the opportunity to comment on the Proposed Amendment and to seek
further relief for Qualified Institutional Lenders. State Street would be pleased to respond to any
questions that the staff of the Commission may have.
Very truly yours,
/s/ Michael P. McAuley
Michael P. McAuley
Vice President
Global Securities Lending
cc: Annette Nazareth, Director, Division of Market Regulation
Michael Macchiaroli, Associate Director, Division of Market Regulation
Randall W. Roy, Special Counsel, Division of Market Regulation
Securities and Exchange Commission
Maureen S. Bateman, Executive Vice President and General Counsel
Charles C. Cutrell, Senior Vice President and Associate General Counsel
Scott M. Sefton, Vice President and Managing Counsel
State Street Bank and Trust Company
______________________________
1
Any reference to State Street in this sentence includes State Street's affiliated companies on a
worldwide basis.
2
Id.
3
The State Street Clients are comprised of a diverse group of large, sophisticated institutions,
including registered investment companies, foreign entities, public and private employee
benefit plans, charitable foundations and endowment funds.
4
Natural persons would not qualify as Qualified Institutional Lenders in any event.
5
For example, a large foreign public charity that does not qualify as an organization under
Section 501(c)(3) of the Internal Revenue Code of 1986, as amended (Code), or does not fall
within any other category listed in Rule 144A would nevertheless qualify under this subclause
(ii). This subclause (ii) is not intended to circumvent or otherwise alter any other
requirements or limitations applicable to an entity that is a QIB because it falls within one of
the categories of eligible entities specified in Rule 144A. For example, foreign banks must
have an audited net worth of at least $25 million as specified in Rule 144A(a)(1)(vi) and a
trust fund subject to Rule 144A(a)(1)(i)(F) may not include the assets of individual retirement
accounts or H.R. 10 plans as specified in Rule 144A(a)(1)(i)(F).
6
For the reasons discussed more fully below, State Street believes that Qualified Institutional
Lenders should not be deemed "customers" for purposes of Rule 15c3-3.
7
State Street also provides third party (non-custodial) lending services in which State Street
acts as lending agent for those State Street Clients, the assets of which are held in the custody

of other global custodians.
8
The Borrowers that borrow securities of the State Street Clients are principally U.S. and
foreign banks, foreign brokers and dealers and U.S. Brokers that typically borrow securities
to cover failed trades, effect short sales and complete other similar transactions. The
Borrowers do not have any discretion or control in any event over the types of securities of
any State Street Client that may be loaned to them.
9
Under the provisions of Rule 15c3-3(b)(3)(iii), cash and U.S. Treasury notes and Treasury
bills constitute eligible collateral; however, other securities are also permissible based upon
interpretive guidance from the staff of the Commission with respect to Rule 15c3-3(b)(3)(iii).
See NYSE Interpretation Handbook, Interpretation /01 to Rule 15c3-3(b)(3). See also Public
Securities Association (available March 2, 1989). Irrevocable letters of credit issued by banks
also are permissible collateral under Rule 15c3-3; however, they generally are not used as
collateral for a variety of reasons, the most compelling of which is the costs Borrowers
typically incur with respect to the provision of such collateral.
10
The Exchange Act Release No. 46,019 (May 31, 2002), Fed. Reg. 39,642 (J une 10, 2002)
notes that Rule 15c3-3 "requires broker-dealers to take steps to protect the securities that
customers leave in their custody" (emphasis added). In the case of securities borrowed from a
Qualified Institutional Lender or other institutional securities lender that has established a
separate custodial relationship with a bank or trust company, it would seem counterintuitive
to view the U.S. Broker (which generally will use the borrowed securities to satisfy a delivery
obligation) as the customer's custodian. We note that Regulation T, as promulgated by the
Board of Governors of the Federal Reserve System, permits U.S. Brokers to borrow securities
subject to the provisions of Regulation T without complying with the provisions of
Regulation T if such borrowings are "for the purpose of making delivery of the securities in
the case of short sales, failure to receive securities required to be delivered, or other similar
situations." See 12 C.F.R. 220.10(a).
11
U.S. Brokers have no discretion or control over the decision by the institutional securities
lender to lend securities and are subject to the terms of a securities loan agreement, which
imposes significant obligations on the borrowing U.S. Brokers. (Please see Section II for a
discussion about the Securities Loan Agreement between State Street, as agent for the State
Street Clients, and the Borrowers.) The negotiation of the terms of these securities loan
agreements, including the eligible types of collateral that may be pledged, are conducted on
an arms' length basis and involve parties that are sophisticated in securities markets and
related transactions.
12
The Commission may also determine that it similarly is not necessary to impose collateral
requirements on other institutional securities lenders in light of (i) the unique nature of the
relationship between U.S. Brokers and other institutional securities lenders in the context of
securities lending transactions, (ii) the overall level of sophistication of institutional securities
lenders and (iii) the lack of any expectation by institutional securities lenders of any
protections under Rule 15c3-3.
13
It is State Street's understanding that brokers and dealers in the United Kingdom and most of
the European securities lending markets generally are not subject to rules comparable to Rule
15c3-3(b)(3)(iii); thus, these foreign brokers and dealers may pledge as collateral a wide

variety of securities that are not currently permitted under Rule 15c3-3(b)(3)(iii) and current
interpretive guidance from the staff of the Commission with respect to Rule 15c3-3(b)(3)(iii).
14
The Commission may also determine that it similarly is not necessary to impose collateral
requirements on other institutional securities lenders for the reasons discussed elsewhere in
this response letter.
15
These Code provisions apply to securities lenders that are tax-exempt and therefore
potentially subject to unrelated business taxable income (UBTI). See Sections 512(a)(5) and
514(c)(8) of the Code, which provide a safe harbor from UBTI for securities lending income
if certain conditions are satisfied, including posting collateral equal to at least 100% of the
market value of the loaned securities.
16
As noted above, the Commission may determine that the further relief sought for Qualified
Institutional Lenders is also appropriate for other institutional securities lenders in the context
of securities lending transactions.

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Equities As Collateral Study

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March 2011

As a byproduct of being appropriately documented for regulatory purposes and as a result of

Financial Risks and Mitigants

AdequateSecurity. If a primary purpose of collateral is to provide security or

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