Failure to pay Collateral - GMSLA Provision

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GMSLA Anatomy

In a Nutshell Clause 10.1(a):

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;

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2010 GMSLA full text of Clause 10.1(a):

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;

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2010 GMSLA: Full wikitext · Nutshell wikitext | GMLSA legal code
Pledge GMSLA: Hard copy (ISLA) · Full wikitext · Nutshell wikitext |
1995 OSLA: Full wikitext · Nutshell wikitext | GMSLA Netting
Let me Google that for you: Guide to equity finance | ISLA’s guide to securities lending for regulators and policy makers

2010 GMSLA 1 · 2 · 3 · 4 · 5 · 6 · 7 · 8 · 9 · 10 · 11 · 12 · 13 · 14 · 15 · 16 · 17 · 18 · 19 · 20 · 21 · 22 · 23 · 24 · 25 · 26 · 27 · Schedule · Agency Annex · Addendum for Pooled Principal Agency Loans
2018 Pledge GMSLA 1 · 2 · 3 · 4 · 5 · 6 · 7 · 8 · 9 · 10 · 11 · 12 · 13 · 14 · 15 · 16 · 17 · 18 · 19 · 20 · 21 · 22 · 23 · 24 · 25 · 26 · 27 · 28 · Schedule · Agency Annex
Stock Loan owner’s manuals: GMSLA · Pledge GMSLA · OSLA

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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).

Failures to deliver are not Events of Default

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:

  1. The cash collateral is not usually in the same currency as shares, meaning that a delivery versus payment is not practical anyway.
  2. Requiring DVP would increase an already high failure rate.
  3. 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.