Case Study Analysis: Canadian Record Date Securities Lending & Risk Management

Anonymous

Let’s walk through a very complex case study analysis about a business-as-usual practice in the Prime Brokerage & Securities Lending world: Canadian Record Date Securities Lending. Typically, brokers like to arrange borrows prior to record date such that their hedge funds on the other side of the trade can take short duration positions in order to take advantage of incremental price discrepancies in the stock during this period. Borrowers tend to reach out in advance in order to shore up positions and lock in pre-negotiated financing rates that remain consistent throughout a pre-determined trade "term" i.e., the borrower negotiates a loan duration and daily financing rate with the agent lender for the entire duration of the loan because it is guaranteed to remain on the books from the borrower's perspective through the duration of the trade. Hence, Prime Brokers (Borrowers) seek stability and reduced operational noise when looking to put these trades on the books as a result of the fact that agent lending client sells & recalls could significantly impact the other side of their trade and in many cases, it becomes increasingly more difficult to cover/borrow additional shares for these trades as it gets closer to record date. Another thing to note is that these trades typically roll off and are returned by the borrower partially or fully within two days after record date passes- however the financing rate automatically adjusts to GC the day after record day regardless of when the shares are returned. From the Prime Broker’s (Borrower) standpoint, in order to even engage in these types of transactions, the Agent Lender’s client must elect cash, not stock, for the corporate action. The reason why is because, if the Prime Broker borrows these shares over record date and the Agent Lender’s client makes a stock election, the Prime Broker would ultimately be encumbered with an unforeseen significant liability on their balance sheet- additional shares- to which the broker would then need to go out into the open market and attempt to sell off. This would essentially be the equivalent of being bought in- thus, the risks associated with these trades are further highlighted. Usually, these are high revenue generating, but also very high-risk transactions for an agent lender to engage in because of the fact that they rely upon a corporate action (Dividend Payment & Record Date)- which thus engenders significant corporate action liability risk in terms of the underlying client making a particular election for the corporate action (I.E. Cash vs. Stock etc). Similarly, there is a high degree of Operation risk that lies with the Custodian bank whose responsibility it is to actually process the client's election in a timely manner, yet in many circumstances the clients of Agent Lenders (I.E. portfolio managers at institutional asset managers) can switch their election up until 3:59pm on record date- which again, makes these types of trades extensively complex and risky to engage in. Nonetheless, they are very common because of how much revenue is earned by all counterparties- Prime Brokers from their hedge fund clients and the Agent Lenders from the Prime Broker (I.E Borrowers). The biggest issue with regards to the custodian bank's processing responsibility and the Agent Lender's client’s particular election on the Corporate Action surrounds communication- neither the client nor the custodian bank will proactively reach out and tell you what the election is or, if it happens to change at any time prior to the deadline. As the Agent Lender, you must proactively reach out to all counterparties in order to obtain accurate information- which sometimes can be difficult and impossible if people do not answer their phones or respond to emails appropriately and timely. Using this as the foundational premise, let’s explore the following case study where an Agent Lender and a Prime Broker engaged in one of these types of transactions that ultimately experienced a multitude of issues. After reading through this scenario, please construct an extensive, analytical and comprehensive strategy for how to navigate similar situations in the future from both the Agent Lender and the Prime Broker's (I.E The Borrower's) perspective. Please be as extensive and detailed as possible. Here is the hypothetical case study scenario: A Prime Broker borrowed 5,000,000 shares of a Canadian Stock from an Agent Lender for a record date dividend arbitrage trade, 6 days prior to the record date. The Agent Lender and the Prime Broker negotiated a financing rate of -1.05 or 105 basis points upon the cash collateral of roughly 250,000,000 in this case. In terms of duration, the trade would be on the books for the entire 6-day period, including through the record date. Then it would roll off at the end and the broker would return the shares. From a revenue standpoint, the Broker would pay the Agent Lender roughly 3,500 per day for these shares, making the total gross revenue generated for the trade about $21,000. The Agent Lender and this particular Prime Broker have developed a strong business relationship over the past few years, with a consistent flow of big trades like these. The Trader at the Prime Broker is an “Old-Timer”, who has been in the Securities Lending business for almost 25 years, meanwhile the Trader at the Agent Lender is a “Young-Gun”, who has only been around for a few years- though he is has garnered praise from many in the industry and is widely perceived as a knowledgeable & trustworthy counterparty to engage with. The two execute the trade and put it on the books, following typical business as usual operational procedures. Fast forward to the record date. The Trader at the Agent Lender is proactively and persistently checking with both the portfolio managers at his client, as well as the corporate actions department at the custodian bank- State Street, to make sure that the client has elected cash for the corporate action. The Trader at the Agent Lender is well aware of the operational risks associated with these transactions, and begins shoring up his efforts when he arrives in the office at 5:30am. Throughout the day he keeps in close contact with the Trader at the Prime Broker via Bloomberg chat, letting him know whether or not an election has been received or confirmed as of yet. As the day progresses, the broker becomes increasingly anxious, because they simultaneously want the shares, and at this point they also really need them for their client, however they also need to know what the election is because of the fact that they would need to return the shares in the even a stock election is made by the Agent Lender’s client in order to avoid a massive liability- and the DTCC closes around 3:00pm est. The likelihood of a return clearing through beyond 2:45pm, would even be very slim. Ultimately, the Agent Lenders client elected cash at 2:30pm, and the trader at the Agent lender was able to confirm this over the phone with State Street bank, and immediately relayed the info to the broker. However, the client changed their election to stock at 3:30pm, after DTCC ceases to process settlements and the point at which the broker could have returned the shares ends. The head of trading at this broker receives notification of a stock election liability, and immediately becomes enflamed, using fiery rhetoric in a lengthy written monologue via the Bloomberg group chat. The trader at the Agent Lender, responds using his diplomatic poise and strategic negotiation abilities- explicating the intricacies of arbitrage and record date lending to a professional who supposedly had more experience than him. The head of trading at the broker was under the assumption that they would never be responsible for any risk in any transaction, regardless of the circumstance- which is contrary to their contractual agreement in the GMSLA. Ultimately the broker assumed the liability and the two counterparties engaged in business as usual transactions the next day- the “Young Gun” at the Agent Lender was proud of how he defused this situation but there are many lessons to be learned from this case study.

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Prime Finance Strategist

This case study highlights the inherent risks and complexities involved in securities lending transactions that are contingent upon the timing of corporate actions, specifically dividend payments and record dates. The scenario between the Agent Lender and the Prime Broker showcases the intricacies of Canadian Record Date Securities Lending and underscores the importance of proactive communication, precise coordination, and understanding of contractual obligations. Below, I will outline a comprehensive strategy for both the Agent Lender and the Prime Broker to navigate similar situations in the future, emphasizing risk management, operational efficiency, and relationship management.

Strategy for the Agent Lender

  1. Enhanced Communication Protocols:

    • Establish a more robust communication framework with custodian banks and portfolio managers to ensure timely updates on corporate action elections. This could include scheduled check-ins and deadline reminders for election decisions.
    • Implement a real-time notification system, utilizing technology to alert all parties involved (including the Prime Broker) as soon as an election change occurs.

  2. Improved Client Education:

    • Educate clients on the impact of last-minute election changes on securities lending transactions, emphasizing the financial and operational risks involved.
    • Develop guidelines for clients outlining best practices for corporate action elections in the context of securities lending.

  3. Advanced Risk Assessment Tools:

    • Utilize or develop predictive analytics tools to assess the likelihood of election changes based on historical data, market conditions, and client profiles.
    • Implement a risk assessment protocol for accepting trades around record dates, considering the volatility and past election behavior of the client's securities.

  4. Contractual Safeguards:

    • Review and potentially revise the Global Master Securities Lending Agreement (GMSLA) to include clauses that specifically address the risks associated with corporate action elections.
    • Incorporate penalties or indemnities for late election changes that impact the securities lending transaction.

  5. Operational Flexibility:

    • Develop a strategy for rapid response to election changes, including the ability to source alternative shares or unwind positions efficiently.
    • Strengthen relationships with multiple custodians to increase operational flexibility and reduce dependency on a single provider.

Strategy for the Prime Broker (Borrower)

  1. Due Diligence and Risk Analysis:

    • Conduct thorough due diligence on the Agent Lender's processes for handling corporate action elections and their historical performance in managing such events.
    • Perform a risk-benefit analysis of engaging in securities lending transactions over record dates, considering both the revenue potential and the associated liabilities.

  2. Clear Communication of Requirements:

    • Clearly communicate the necessity of cash elections for corporate actions to the Agent Lender at the outset of the transaction.
    • Establish a mutual understanding of the implications of stock elections and agree on protocols for handling last-minute changes.

  3. Contingency Planning:

    • Develop and maintain a comprehensive contingency plan for situations where a stock election occurs, including predefined strategies for mitigating liabilities.
    • Ensure adequate liquidity is available to cover potential liabilities arising from stock elections.

  4. Enhanced Monitoring and Coordination:

    • Implement a system for continuous monitoring of corporate action elections and maintain open lines of communication with the Agent Lender throughout the transaction period.
    • Coordinate closely with internal teams (e.g., risk management, operations) to prepare for and respond to election changes.

  5. Contractual Review and Negotiation:

    • Review the terms of the GMSLA to understand the obligations and liabilities in the event of a stock election.
    • Negotiate terms with the Agent Lender that fairly distribute the risks associated with corporate action elections.

Conclusion

For both parties, it's crucial to balance the pursuit of revenue opportunities with the management of operational and financial risks. This case study serves as a valuable lesson in the importance of clear communication, thorough preparation, and strong contractual foundations in securities lending transactions. By adopting a proactive, informed, and collaborative approach, both Agent Lenders and Prime Brokers can navigate the complexities of Canadian Record Date Securities Lending more effectively, mitigating risks while capitalizing on the opportunities it presents.