Securities Lending Guest Article - Operational Risk - Under Control?

I am very pleased to have been given permission by Rupert Perry, Chief Executive of Pirum, to reprint this Feature Article from the Spitalfields Advisors Yearbook 2008.  Rupert's article identifies and addresses the key issues and challenges faced by securities lending operations professionals.  

I have just finished a consulting assignment and it once again reminded me of the complexity and variation that exists in the management and administration of securities lending transactions.   The natural cycle of technology enhancements means that firms focus their resources internally first, then typically on trading and revenue generation and only then do they look at tools that can enhance counterparty risk management.  I think in today's world, those priorities may need to be reviewed.

Operational Risk - Under Control?

Operational risk is defined under Basel II as “the risk of loss resulting from inadequate or failed internal processes, people and systems, or from external events”. This is a very broad definition which covers all types of operational problems such as fraud, systems failure, breach of legal contracts, erroneous data and problems resulting from poorly designed (or executed) business processes.

But what does this mean in terms of securities lending?  Perhaps an easier way to think about the key operational risks is to consider them as being the gaps between what should happen in accordance with the signed legal agreement and what actually happens in reality. Or more bluntly, the main risk is that money is lost because mistakes/errors are not prevented (or detected quickly enough) or else required actions (e.g. requesting collateral adjustments or claiming manufactured income payments) are not taken at the appropriate time when particular events occur.

Effective control of operational risk requires senior management firstly to correctly recognise and quantify the risks that are faced and secondly to ensure that an effective set of controls is implemented to manage these risks. Finally, monitoring processes need to be in place to ensure the control procedures are being operated as intended on an on-going basis. Three of the key operational risks in securities lending which require controls are:

• Inaccurate/incomplete books and records
• Incorrect collateralisation leading to excessive
counterparty exposure
• Late payment of billing and dividends/coupons

Fortunately, these risks can be much more easily controlled with the benefit of industry standard automation services.

Accurate Books and Records

Accurate and complete books and records are fundamental to any securities lending operation. The consequences of errors in books and records range from trivial with a low likelihood of loss (for example a slightly incorrect loan value) to fundamental with a high likelihood of loss (for example when on-loan securities have not been recorded in
the books and records system).

The question senior management should ask is: How can I be sure that we can rely on our books and records beingaccurate and complete? All too often the answer is “My operations department looks after this”, but this does not give real assurance that the risk has been effectively controlled and management should be asking for evidence to be provided on a regular basis that the controls are indeed in place and working properly.

Running automated contract compare on a daily basis with all counterparties is the best way to control this risk and is recommended as best practice by ISLA (the International Securities Lending Association). Automated contract compare matches your records with those of your counterparties at close of business each day and identifies any discrepancies
automatically.

However, it is not enough to simply compare contracts every day – Any breaks which are identified need to be reviewed and fixed every day, with any new breaks being brought to the attention of the trading desk or other operations departments as appropriate. It is worth noting that if the operations team is not able to keep on top of the breaks, this can often be caused by insufficient automation of other operations processes.

To be sure that contract compare is being run, senior management should require a regular report from operations detailing the aged breaks which have not been resolved and the investigative work carried out on them to date. Where breaks are proving to be stubbornly persistent with any particular counterparty, this may need to be raised as a relationship issue by the appropriate relationship manager.

Minimising Counterparty Exposure

Prior to the Lehman default in September 2008, the risk of loss as a direct result of over/under collateralisation was generally thought to be very small. This was because excessive exposure only has the potential for loss if the counterparty defaults.

Now that there is a much greater level of awareness of counterparty risk, market participants are making significantly greater efforts to ensure their exposure is kept to a minimum. However, agreeing marks/exposure with a counterparty without automation is particularly difficult as every loan and collateral position has to be valued using an up-to-date market price/FX rate and margined appropriately.  Significant differences in any of these components will cause problems in the marks/exposure process.

Manual marking of cash collateralised stock loans is a particularly laborious process, as a new loan price must be agreed between lender and borrower every day and entered into each side’s books and records systems. However, the time that this takes means that some market participants choose to shortcut the process and only mark less frequently (say once a week) or else mark a select few transactions only to eliminate the overall net excess exposure.

Similarly, a manual tick back of all positions to try and identify the root cause of exposure differences is incredibly time consuming and is therefore avoided whenever possible. 

An automated real time marks processing and exposure reconciliation service makes it easy and efficient to mark every position each day and to fully reconcile all the components making up the exposure value. This allows the underlying cause of any differences to be highlighted and helps detect underlying data issues which need addressing (e.g. stale/missing market prices, missing static data for accrued interest, misbooked loans or returns).

Whilst most market participants tend to rely on the exposed party to call them to reduce their exposure, substantial differences in exposure should always be investigated, even if they are apparently in your favour.  Where an exposure difference results in a borrower believing they are under collateralised whilst simultaneously a lender thinks they are over collateralised, neither party has an incentive to call the other as they are both of the view that the exposure is in their favour, even though this is impossible.

Timely Payment of Billing and Dividends/Coupons

At the end of each month, both borrower and lender produce a billing statement which details the fees and rebates earned over the course of the previous month.  When both parties have accurate books and records, the bills will agree and payments can then be made immediately.

When billing statements are not agreed, payment is usually deferred, pending investigation of the discrepancies. Unfortunately, trying to identify the root cause of differences is like trying to find the proverbial needle in a haystack. However, these differences can be automatically highlighted and prioritised for investigation by using an automated billing reconciliation service. This ensures mistakes can be fixed promptly, allowing bills to be agreed and settled much sooner.

Similarly with dividend claims, these need to be agreed between borrower and lender to ensure payment on a timely basis. Using an automated claims service, borrower and lender claims are matched together which can then trigger automatic payment by the borrower. This allows staff efforts to be focused on fixing any problems with mismatching claims, ensuring payment is made sooner.

Rupert Perry is the chief executive of Pirum, a company which focuses on automating the operational processes of the International Securities Lending and Repo markets.  www.pirum.com