The Convergence of Risk and Securities Finance

Author: Mat Newman, VP Product Management, SunGard Adaptiv

Market best-practice dictates that the senior management of a firm understand the risks being taken, with investors demanding to know that this is the case. One consequence of the recent large losses in the securities lending areas of financial corporations is a heightened awareness by senior management of the need for sound and comprehensive risk management to achieve this.

To date the risks inherent in securities lending and repo activities have been considered low: the trades are fully collateralised, with exposure monitored on a daily basis which helps to mitigate credit risk; the term of transactions tends to be short, which helps to control interest rate and spread risk. Recent market events however have demonstrated the importance of enhanced risk controls, particularly in the area of cash re-investment. A risk-averse institution may elect to re-invest cash collateral in T-bills or the money markets to generate a moderate but secure rate of return, whereas more aggressive institutions may choose other asset classes. It was this choice of alternative asset classes (in this case in subprime-linked assets) which led to rare cases of severe loss when the credit markets collapsed.

While securities lending systems ensure that there is sufficient collateral cover, through the application of collateral margins, haircuts to the value of the underlying non-collateral securities, and daily margin calls, they concentrate on exposure management and may not incorporate the level of controls needed to fully manage all aspects of collateral risk. It is also likely that, in the case of re-investment of cash collateral, this may be tracked in another system as the cash from securities finance will only be one source of cash to be invested. The risks measured by a securities lending system will focus directly on the stock loans/repos and the associated collateral.

Recent events, however, illustrate the need for an institution to have a clear and comprehensive picture of their overall risk profile from all aspects of their business, in addition to managing risk within individual business silos. Such a picture is typically achieved by implementing a central enterprise risk management function.

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