Securities Lending Haircuts and Indemnification Pricing

TL;DR

This paper develops a quantitative method to relate securities lending haircuts with indemnification costs, enhancing risk management by aligning collateral levels with credit risk appetite in securities markets.

Contribution

It introduces a model linking haircut levels with indemnification costs, applying it to US Treasuries and equities for improved risk assessment in securities lending.

Findings

Quantified the relationship between haircuts and indemnification costs.

Applied the model to US Treasuries and equities.

Provided a framework for risk-based collateral management.

Abstract

Securities borrowing and lending are critical to proper functioning of securities markets. To alleviate securities owners' exposure to borrower default risk, overcollateralization and indemnification are provided by the borrower and the lending agent respectively. Haircuts as the level of overcollateralization and the cost of indemnification are naturally interrelated: the higher haircut is, the lower cost shall become. This article presents a method of quantifying their relationship. Borrower dependent haircuts satisfying the lender's credit risk appetite are computed for US Treasuries and main equities by applying a repo haircut model to bilateral securities lending transactions. Indemnification is designed to fulfill a triple-A risk appetite when the transaction haircut fails to deliver. The cost of indemnification consists of a risk charge, a capital charge, and a funding charge, each corresponding to the expected loss, the economic capital, and the redundant fund needed to arrive at the triple-A haircut.