Events of Default - GMSLA Provision

Why Bank does not apply an Event of Default to stock lending failures to deliver

The position under the GMSLA and OSLA master agreements

The Global Master Securities Lending Agreement provides that a failure to deliver securities is an 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.

This is a significant difference from the Overseas Securities Lenders’ Agreement, the predecessor to the GMLSA. In the OSLA, a failure to deliver was not an 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.

Under both the GMSLA and the OSLA, a failure to deliver collateral is an Event of Default.

Delivery failures are a feature of the market

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.

Delivery failures occur for a number of reasons:

• Operational failure, such as a mismatch of instructions
• 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
• A third party may fail to deliver to the party expecting to deliver under the securities loan
• Lack of availability of the securities to deliver, say, due to the shares going “special”
• Exceptionally, due to lack of funds at the deliverer

The purpose of Events of Default

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.

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.

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.

Why does the GMSLA take a different approach to the OSLA?

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.

What is the protection for an expected recipient if a delivery failure occurs?

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: 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. 2. Attempting to match payment instructions to delivery instructions on a DVP basis would increase an already high failure rate. 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.

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: (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. (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).

UBS’s approach

UBS considers that the correct approach is that under the OSLA agreement: 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. 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. 3. A failure by either party to deliver collateral when required is an Event of Default.

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.