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| Why Bank does not apply an {{gmslaprov|Event of Default}} to [[stock lending]] failures to deliver
| | {{Manual|MSG|2010|10|Clause|12|medium}} |
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| ====The position under the [[GMSLA]] and [[OSLA]] master agreements====
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| The [[Global Master Securities Lending Agreement]] provides that a [[failure to deliver]] securities is an {{gmslaprov|Event of Default}}. If a delivery failure occurs, the day after the delivery was expected the intended recipient can terminate and cover all open positions, meaning that the party expected to deliver the securities must pay the bid-offer spread on all open positions.
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| This is a significant difference from the [[Overseas Securities Lenders’ Agreement]], the predecessor to the {{gmslaprov|GMLSA}}. In the {{gmslaprov|OSLA}}, a failure to deliver was not an {{gmslaprov|Event of Default}}. Rather, a failure to deliver securities to initiate a loan is not a breach of agreement, and a failure to redeliver securities at the end of a loan allows the lender to buy in securities to cover the fail.
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| Under both the {{gmslaprov|GMSLA}} and the {{gmslaprov|OSLA}}, a failure to deliver collateral is an {{gmslaprov|Event of Default}}.
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| Delivery failures are a feature of the market
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| Deliveries frequently fail in the stock lending market - a 10% delivery failure rate is not uncommon, and can be over 50% in emerging markets. Making delivery failures an Event of Default would put participants in a perpetual state of default.
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| Delivery failures occur for a number of reasons:
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| *Operational failure, such as a mismatch of instructions
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| *A lender may lose the expected supply – for example a custodian may expect to lend but the owner of the securities sells before the loan settles
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| *A third party may fail to deliver to the party expecting to deliver under the securities loan
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| *Lack of availability of the securities to deliver, say, due to the shares going “special”
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| *Exceptionally, due to lack of funds at the deliverer
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| ====The purpose of {{gmslaprov|Events of Default}}====
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| The Events of Default are protections for use if a counterparty is in a potentially insolvent position. The context is that a non-defaulting party is able to immediately terminate all outstanding transactions prior to or on the commencement of insolvency proceedings and so end its exposure. Events of default are not intended for non-insolvency situations where the agreement may have been breached but the creditworthiness of a counterparty is not in question. In those circumstances, the parties can rely on the normal contractual remedies for breach of contract. Otherwise, allowing one party to declare an Event of Default allows extraordinary leverage over a minor breach – a failure to comply with a trivial term of the contract would allow a party to threaten to terminate all outstanding transactions. In the context of frequent delivery failures in a stock lending relationship, the moment a party wants to end the relationship it could pick one of the many delivery failures as grounds to terminate all trades and inflict considerable loss on the other party.
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| Importantly, the failures to deliver unrelated to solvency vastly outnumber those related to solvency. If a party wished to treat a failure to deliver as an indicator of insolvency, the instances where a true concern existed would be swamped by the false alarms where the delivery failure didn’t indicate a cause for concern.
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| A contrast must be drawn between delivery failures of the underlying security and delivery failures concerning collateral. A party has a choice whether to deliver securities as collateral. The party can select which collateral to deliver, and so can control the process better. If a party takes that choice and fails to deliver, the expected recipient is entitled to consider that the failure may represent a credit concern. In the market generally, most participants use cash collateral to avoid the risks involved with using securities as collateral.
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| Why does the GMSLA take a different approach to the OSLA?
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| When the GMSLA was being drafted in 1999, the International Stock Lenders’ Association released a draft that made a redelivery failure an Event of Default. ISLA members were concerned at the frequency with which borrowers failed to return securities at the end of loans, and wanted to tighten up on this. The London Investment Bankers’ Association (representing the intermediary market) responded that this was unreasonable. ISLA was determined that the Event of Default must remain, and as a compromise made a delivery failure to initiate a loan an Event of Default as well. This went against what lenders did in practice, as no lender would consider that if it failed to deliver to commence a loan that it had breached contract, let alone caused an Event of Default. Only if the lender agreed “guaranteed delivery” would a borrower consider that there was a breach of contract for a failure to deliver. Unfortunately, the final published version made all failures to deliver an Event of Default, and as a consequence the intermediary market generally has had to adopt the approach of amending the GMSLA to disapply a delivery failure being an Event of Default.
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| What is the protection for an expected recipient if a delivery failure occurs?
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| Deliveries in stock lending typically occur free of payment, with the cash moving after the shares are confirmed as settling. This is for 3 principal reasons:
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| 1. The cash collateral is frequently not in the same currency as the domestic market of the security, meaning that a delivery versus payment could not be arranged.
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| 2. Attempting to match payment instructions to delivery instructions on a DVP basis would increase an already high failure rate.
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| 3. The high failure rate means that if cash were due to move at the same time or prior to the shares moving, the cash would frequently be transferred against shares that fail. As mentioned earlier, if the lender fails to deliver shares to initiate the trade, the normal intention of parties is that no loan would be initiated. So it would be anomalous for cash to be transferred to the lender for a securities loan that might never occur.
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| In practice, each day market participants determine the securities and collateral that have settled and are currently held by each party, calculate the value of those securities and collateral at the most recent market close available to that party, and make a collateral call for any shortfall. If a party were expecting a delivery of securities, it would not have delivered cash overnight when the securities were due to settle but would instead be waiting until the following day to pay the cash against a margin call by the deliverer. If the securities were never delivered, the consequence would be that the amount of the margin call against the expected recipient would be reduced. (Or if securities prices on other stock loans had moved in the expected recipient’s favour, the expected recipient’s call against the failed deliverer would be increased.) If the failed stock loan were the only trade between the parties, then:
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| (i) If the failure was by the lender at the start of the loan, no loan would be entered into, and neither party has any exposure.
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| (ii) If the failure was by the borrower at the end of the loan, the lender would not return the cash, and each party has the same exposure that it did the previous day (other than market movements on the securities).
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| UBS’s approach
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| UBS considers that the correct approach is that under the OSLA agreement:
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| 1. A delivery failure by a lender when initiating a loan has no consequence – it is neither an Event of Default, nor a breach of contract.
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| 2. A redelivery failure by a borrower at the end of the loan is not an Event of Default. Rather, the lender is free to buy in the securities using the procedure under section 9.4 of the GMSLA.
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| 3. A failure by either party to deliver collateral when required is an Event of Default.
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| UBS believes that this correctly addresses the credit concerns that a party may justifiably have under a stock lending relationship, while also reflecting the intentions of the transacting parties when entering into securities loans.
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2010 Global Master Securities Lending Agreement
A Jolly Contrarian owner’s manual™
Resources and navigation
Clause 10 in a Nutshell™
Use at your own risk, campers!
10. Events of Default
10.1 The following events happening to a Party (the Defaulting Party) will be an Event of Default but (barring Automatic Early Termination) only once the Non Defaulting Party has notified the Defaulting Party:
- 10.1(a) Failure to Deliver: The failure, when required under Paragraph 5, of:
- (i) either party to pay or repay Cash Collateral; or
- (ii) the Borrower to deliver any other Collateral to the Lender;
- 10.1(b) Unremedied failure to manufacture Income: Lender or Borrower fails to manufacture Income on Loaned Securities or Collateral when due and has not remedied that failure within three Business Days of notice from the Non Defaulting Party requiring remediation;
- 10.1(c) Mini-Closeout failure: Either party failing to pay any sum when due following a mini-closeout (that is, under paragraphs 9.1(b) or 9.2(b) or 9.3;
- 10.1(d) Act of Insolvency: An Act of Insolvency occurring to Lender or Borrower. If Automatic Early Termination applies, if anyone presents a winding up petition or appoints a liquidator, it will be an Automatic Early Termination and the Non Defaulting Party need not serve written notice.
- 10.1(e) Breach of warranty: any Lender’s Warranty, or any of the Borrower’s Warranties except the ast one (14(e), about voting on Borrowed Securities) is materially incorrect when made or “deemed”;
- 10.1(f) Repudiation: Either party admitting that it cannot or will not perform any of its obligations hereunder where, upon completion of formalities, that non-performance would be an Event of Default;
- 10.1(g) Seizure of assets: a material part of its assets are ordered to be transferred to a trustee by a regulatory authority under any legislation.
- 10.1(h) Regulatory default: It is declared in default by the appropriate authority or is suspended or expelled from any securities exchange or other self-regulatory organisation, or is suspended from securities dealing by any government agency, for not meeting any requirements relating to financial resources or credit rating;
- 10(i) Other unremedied breach of agreement: Either party defaults on any of its other obligations under this Agreement and does not remedy them within 30 days of the Non Defaulting Party’s written notice requiring remedy.
10.2 Each Party must formally notify the other it if suffers any Event of Default or potential Event of Default.
10.3 There are no remedies for any Event of Default other than those set out in this Agreement.
10.4 Subject to the Failure to Deliver and Consequences of an Event of Default clauses, neither Party may claim consequential losses if the other Party breaches this Agreement.
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Full text of Clause 10
10. Events of Default
10.1 Each of the following events occurring and continuing in relation to either Party (the Defaulting Party, the other Party being the Non-Defaulting Party) shall be an Event of Default but only (subject to sub paragraph 10.1(d)) where the Non Defaulting Party serves written notice on the Defaulting Party:
- 10.1(a) Borrower or Lender failing to pay or repay Cash Collateral or to deliver Collateral on commencement of the Loan under paragraph 5.1 or to deliver further Collateral under paragraph 5.4 or 5.5;
- 10.1(b) Lender or Borrower failing to comply with its obligations under paragraph 6.2 or 6.3 upon the due date and not remedying such failure within three Business Days after the Non Defaulting Party serves written notice requiring it to remedy such failure;
- 10.1(c) Lender or Borrower failing to pay any sum due under paragraph 9.1(b), 9.2(b) or 9.3 upon the due date;
- 10.1(d) an Act of Insolvency occurring with respect to Lender or Borrower, provided that, where the Parties have specified in paragraph 5 of the Schedule that Automatic Early Termination shall apply, an Act of Insolvency which is the presentation of a petition for winding up or any analogous proceeding or the appointment of a liquidator or analogous officer of the Defaulting Party shall not require the Non Defaulting Party to serve written notice on the Defaulting Party (Automatic Early Termination);
- 10.1(e) any warranty made by Lender or Borrower in paragraph 13 or paragraphs 14(a) to 14(d) being incorrect or untrue in any material respect when made or repeated or deemed to have been made or repeated;
- 10.1(f) Lender or Borrower admitting to the other that it is unable to, or it intends not to, perform any of its obligations under this Agreement and/or in respect of any Loan where such failure to perform would with the service of notice or lapse of time constitute an Event of Default;
- 10(g) all or any material part of the assets of Lender or Borrower being transferred or ordered to be transferred to a trustee (or a person exercising similar functions) by a regulatory authority pursuant to any legislation;
- 10(h) Lender (if applicable) or Borrower being declared in default or being suspended or expelled from membership of or participation in, any securities exchange or suspended or prohibited from dealing in securities by any regulatory authority, in each case on the grounds that it has failed to meet any requirements relating to financial resources or credit rating; or
- 10(i) Lender or Borrower failing to perform any other of its obligations under this Agreement and not remedying such failure within 30 days after the Non Defaulting Party serves written notice requiring it to remedy such failure.
10.2 Each Party shall notify the other (in writing) if an Event of Default or an event which, with the passage of time and/or upon the serving of a written notice as referred to above, would be an Event of Default, occurs in relation to it.
10.3 The provisions of this Agreement constitute a complete statement of the remedies available to each Party in respect of any Event of Default.
10.4 Subject to paragraphs 9 and 11, neither Party may claim any sum by way of consequential loss or damage in the event of failure by the other Party to perform any of its obligations under this Agreement.
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Related agreements and comparisons
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Related agreements: Click here for the same clause in the 2018 Pledge GMSLA
Related agreements: Click here for the same clause in the 1995 OSLA
Comparison: Click to compare the 2010 GMSLA and 2018 Pledge GMSLA versions of this clause.
Comparison: Click to compare the 2010 GMSLA and 1995 OSLA versions of this clause.
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Content and comparisons
10. Events of Default
- 10.1 List of Events of Default
- 10.1(a): Failure to pay Collateral
- 10.1(b): Unremedied failure to manufacture payments
- 10.1(c): Failure to pay or deliver
- 10.1(d): Insolvency
- 10.1(e): Breach of warranty
- 10.1(f): Repudiation
- 10.1(g): Seizure of assets
- 10.1(h): Suspension from exchange
- 10.1(i): Unremedied failure to perform
- 10.2 Notification of Events of Default
- 10.3 Complete statement of remedies
- 10.4 No consequential loss
In the 2018 Pledge GMSLA we wave good by to the 2010 GMSLA’s Automatic Early Termination provision — which was only really there to slake the consciences of those worried that netting might not work. In a pledged security arrangement, it is much more old-fashioned and traditional; you’re not really relying on the cute, clever-dickish type of close-out netting that is so warily eyed by ruddy-cheeked German insolvency administrators, no no need for an AET-35 unit.
To compensate, there’s a new “breach of security agreement” Event of Default at 10.1(j). Which is nice.
Summary
Note that (unlike the ISDA Master Agreement an event only becomes an Event of Default once the Non Defaulting Party has given the Defaulting Party notice of it.
The dog that didn’t bark in the nighttime
More interesting than the Events of Default that are there are the ones that are not: There is no:
Why not?: Unlike an ISDA Master Agreement, generally, securities financing transactions are generally short-dated (if repos) or callable on notice (if stock loans) and (unlike an ISDA, where margin is a function of an independent credit support arrangement which may or may not be there) daily margin is a structure feature of the transaction. If your counterparty suffers any kind of credit deterioration, your margin (or its failure to pay it) should cover you, and if it doesn’t, you can immediately — or at least quickly — get out of your exposure. If they unwind okay—great. If they don’t, you have them bang to rights on a Failure to Pay. Simples.
Your more perfidious counterparties might want to start crow-barring these events in — at least, ones like Illegality — especially if you, like many brokers, are in the habit of doing trades on term. An Illegality event ought not poop the nest, but a credit deterioration-related default events like DUST or Cross Default may, seeing as the very point of the term trade is to prove to your accountants you have stable financing of your margin loan operations.
Failures to deliver Securities under a 2010 GMSLA are not Events of Default because failure to deliver securities to initiate a Loan is not a breach of agreement, and if a Borrower fails to redeliver Equivalent Securities at the end of a Loan, the Lender may buy in Securities to cover the fail, and may execute a mini close-out, but that is not an Event of Default either.
But a failure to deliver Collateral at inception or to redeliver Equivalent Collateral on termination is an Event of Default.
Deliveries frequently fail in the stock lending market for many reasons:
- Operational failures, such as a mismatch of instructions;
- A Lender may lose its expected supply (for example a rehypothecating prime broker intending to rehypothecate client’s securities where the client recalls and sells the securities sells before the Loan settles)
- A market counterparty may fail against the party expecting to deliver under the Loan
- Market events may cause a lack of liquidity — for example if the shares go “special”
Making delivery failures an Event of Default would put participants in a perpetual state of default even though there were no credit concerns for the "failing” counterparty. Events of Default are really only meant to address counterparty insolvency risk: The innocent party can immediately terminate all outstanding transactions upon an Event of Default and so end its exposure.
Where the creditworthiness of a counterparty is not in question the innocent party can rely on normal contractual remedies for breach of contract.
Allowing a party to declare an Event of Default allows extraordinary leverage for what is often a technical or minor breach.
Compare that with Collateral delivery failures. The Borrower can choose what it delivers as Collateral. If, having done so, the party still fails to deliver, the recipient has grounds for a credit concern.
What is the protection for delivery failures then?
Deliveries in stock lending are usually free of payment: cash collateral moves after the shares settle. This is for 3 reasons:
- The cash collateral is not usually in the same currency as shares, meaning that a delivery versus payment is not practical anyway.
- Requiring DVP would increase an already high failure rate.
- Because of the high failure rate, the cash would frequently be transferred against failed settlements, presenting an inverted credit risk.
In practice, each day participants determine the securities and collateral that are currently held by each party, calculate their values as at market close, and make a collateral calls for any shortfall. A Borrower expecting to be delivered securities would wait for them to settle before paying away cash against a margin call by the Lender. If they were not delivered, the margin call against the Borrower would be reduced.
All other things being equal:
- If a Lender failed to settle at inception there would be no loan and neither party would have any exposure.
- If a Borrower failed to settle at redemption, the Lender would not return Collateral, and (but for intraday market moves) each party would have the same exposure it had previously.
General discussion
10.1(a): Failure to pay or deliver
Noting the exception for redelivery of Equivalent Securities or Collateral,[1] the failure to pay or deliver Events of Default under the 2010 GMSLA are:
There are great tales of worthy fellows around the market trying to tweak this provision because, by apparent oversight, it doesn't capture a failure to return Equivalent (non cash) Collateral.
But this is not an accident, for the same reason a failure to redeliver Equivalent Securities isn’t an Event of Default. Indeed, it is a plainly deliberate omission. The drafters were careful to capture the payment or repayment of cash, and deliveries and further deliveries of Collateral, but not the return of Equivalent Collateral.
A counterparty may have on-lent, or on-collateralised, with non-cash Collateral it has been posted. It may have exactly the same difficulties in getting hold of it to redeliver as a borrower may in getting hold of Equivalent Securities. So the remedy is to withhold the return of securities, buy in and mini close-out under 9.2 which gives the aggrieved party equivalent rights, but not the right to close out the whole agreement (until there’s a failure of the mini-close out settlement amount itself).
10.1(b): Unremedied failure to manufacture Income
Note the tedious back and forth of notices here.
- First, the Income has to be due under the Collateral or Loaned Securities.
- Then the person obliged under Paragraph 6 to manufacture the Income back has to fail to do so, on that due date.
- Then the aggrieved party has to tell the delinquent one — note: it is not yet technically a “Defaulting Party” as there is a grace period — that it has failed to make that payment, and ask it to make the payment within three Business Days.
- Then the delinquent party has to fail to remediate the manifactured Income payment by close on the third Business Day after that notice. Then the aggreived party can notify the delinquent party — whereupon it becomes a “Defaulting Party” — that it is, finally, an Event of Default.
10.1(c) Minicloseout failure
See commentary above under 10.1(a).
For which you will need the definition of Act of Insolvency, which is not quite the same as the definition of Bankruptcy in the ISDA Master Agreement. I suspect this was just a matter of professional pride for ISLA’s crack drafting squad™, and its ninja forebears when they crafted the equivalent provision in the 1995 OSLA, on which this provision is based
10.1(e): Breach of warranty
Why exclude the 14(e) warranty about not having the primary purpose of voting on the Securities? Search me.
See also
Template:M sa GMSLA 10
References
- ↑ See 9.1(b) and 9.2(b).
- ↑ For a jauntily metaphysical examination of the nature of hard cold folding green stuff — why it is, by nature, profoundly different to any other financial instrument, see our article on cash.
- ↑ From those assets that meet the eligibility criteria in the Schedule; moral of story: don’t allow yourself to be too tightly constrained on eligibility criteria.