Securities Lending Risk How To Prevent History From

Securities Lending Risk How To Prevent History From Repeating Itself Irving Klubeck April 2011 ©Copyright 2010, Pershing LLC, a subsidiary of The Bank of New York Mellon Corporation. Member FINRA, NYSE, SIPC. Trademark(s) belong to their respective owners. For professional use only. Not for distribution to the public. The information contained herein, including any attachments, is proprietary to, and constitutes confidential information of Pershing LLC. It may not be reproduced, retransmitted or redistributed in any manner without the express written consent of Pershing. A Presentation to Fiduciary & Investment Risk Management Association

Outline Brief history of the Securities Lending Market Risk Identification Risk Mitigation Rules to Live (Survive) By ©Copyright 2010, Pershing LLC, a subsidiary of The Bank of New York Mellon Corporation. Member FINRA, NYSE, SIPC. Trademark(s) belong to their respective owners. For professional use only. Not for distribution to the public. The information contained herein, including any attachments, is proprietary to, and constitutes confidential information of Pershing LLC. It may not be reproduced, retransmitted or redistributed in any manner without the express written consent of Pershing. Your Business Without Limits® 2

Securities Lending Today > Multi-trillion dollar business > Truly international > Has moved from fee generation to portfolio leverage (in US) > Seen as relatively low risk ©Copyright 2010, Pershing LLC, a subsidiary of The Bank of New York Mellon Corporation. Member FINRA, NYSE, SIPC. Trademark(s) belong to their respective owners. For professional use only. Not for distribution to the public. The information contained herein, including any attachments, is proprietary to, and constitutes confidential information of Pershing LLC. It may not be reproduced, retransmitted or redistributed in any manner without the express written consent of Pershing. Your Business Without Limits® 3

Needed for a Lending Market > Legal framework > Safe settlement system > Market standards > Market transparency and liquidity > Adequate accounting treatment > Regulation to prevent abuses > Reasons to borrow ©Copyright 2010, Pershing LLC, a subsidiary of The Bank of New York Mellon Corporation. Member FINRA, NYSE, SIPC. Trademark(s) belong to their respective owners. For professional use only. Not for distribution to the public. The information contained herein, including any attachments, is proprietary to, and constitutes confidential information of Pershing LLC. It may not be reproduced, retransmitted or redistributed in any manner without the express written consent of Pershing. Your Business Without Limits® 4

Significant Market developments 19 th Century > Probable birth of securities lending in London 1950 s > Some limited lending in a few countries 1960 s > Active inter-dealer market in US develops > Increased short selling > Increased number of fails > First formal equity lending transaction in London ©Copyright 2010, Pershing LLC, a subsidiary of The Bank of New York Mellon Corporation. Member FINRA, NYSE, SIPC. Trademark(s) belong to their respective owners. For professional use only. Not for distribution to the public. The information contained herein, including any attachments, is proprietary to, and constitutes confidential information of Pershing LLC. It may not be reproduced, retransmitted or redistributed in any manner without the express written consent of Pershing. Your Business Without Limits® 5

Significant Market developments 1966 > Dematerialization of US treasuries begin > FRB begins eliminating physical certificates > FRB begins its book-entry system 1970 s > US custodial banks start lending on behalf of their customers > New trading strategies spur demand (convertible bond arbitrage, tax arbitrage) > Matched book repo starts to develop ©Copyright 2010, Pershing LLC, a subsidiary of The Bank of New York Mellon Corporation. Member FINRA, NYSE, SIPC. Trademark(s) belong to their respective owners. For professional use only. Not for distribution to the public. The information contained herein, including any attachments, is proprietary to, and constitutes confidential information of Pershing LLC. It may not be reproduced, retransmitted or redistributed in any manner without the express written consent of Pershing. Your Business Without Limits® 6

Significant Market developments 1973 > DTC Founded > Took over CCS which was beginning electronic settlement of trades > Provided custody for banks and brokers > Accelerated dematerialization 1974 > Bankhaus Herstatt failure > “Great Awakening” to settlement risk ©Copyright 2010, Pershing LLC, a subsidiary of The Bank of New York Mellon Corporation. Member FINRA, NYSE, SIPC. Trademark(s) belong to their respective owners. For professional use only. Not for distribution to the public. The information contained herein, including any attachments, is proprietary to, and constitutes confidential information of Pershing LLC. It may not be reproduced, retransmitted or redistributed in any manner without the express written consent of Pershing. Your Business Without Limits® 7

Significant Market developments 1981 > Amendments to ERISA permitted many pension funds to begin lending 1980 s > Large increases in government securities markets of many countries > Increases in trading > Demand building for efficient repo and lending markets ©Copyright 2010, Pershing LLC, a subsidiary of The Bank of New York Mellon Corporation. Member FINRA, NYSE, SIPC. Trademark(s) belong to their respective owners. For professional use only. Not for distribution to the public. The information contained herein, including any attachments, is proprietary to, and constitutes confidential information of Pershing LLC. It may not be reproduced, retransmitted or redistributed in any manner without the express written consent of Pershing. Your Business Without Limits® 8

Significant Market developments 1982 > Collapse of Drysdale Securities prompts many changes in markets > Contracts standardized by BMA (now SIFMA) > Accrued interest collateralized > Standard margins established > Disclosure of lenders’ identity (reluctantly) ©Copyright 2010, Pershing LLC, a subsidiary of The Bank of New York Mellon Corporation. Member FINRA, NYSE, SIPC. Trademark(s) belong to their respective owners. For professional use only. Not for distribution to the public. The information contained herein, including any attachments, is proprietary to, and constitutes confidential information of Pershing LLC. It may not be reproduced, retransmitted or redistributed in any manner without the express written consent of Pershing. Your Business Without Limits® 9

Drysdale Securities > Scheme created to reap interest profits from uncollateralized portion of government securities borrows > Scheme fails when investments ‘go south’ and coupons cannot be paid > Lending Banks eat the losses > Lesson: Know your Collateral – always assume default of counterparty > Lesson: Follow the Money ©Copyright 2010, Pershing LLC, a subsidiary of The Bank of New York Mellon Corporation. Member FINRA, NYSE, SIPC. Trademark(s) belong to their respective owners. For professional use only. Not for distribution to the public. The information contained herein, including any attachments, is proprietary to, and constitutes confidential information of Pershing LLC. It may not be reproduced, retransmitted or redistributed in any manner without the express written consent of Pershing. Your Business Without Limits® 10

Significant Market developments 1982 > Collapse of Lombard Wall > Court rules that repos are collateralized loans and court permission needed to sell 1984 > Failure of Lion Capital > Failure of RTD Securities > NY school districts badly hurt ©Copyright 2010, Pershing LLC, a subsidiary of The Bank of New York Mellon Corporation. Member FINRA, NYSE, SIPC. Trademark(s) belong to their respective owners. For professional use only. Not for distribution to the public. The information contained herein, including any attachments, is proprietary to, and constitutes confidential information of Pershing LLC. It may not be reproduced, retransmitted or redistributed in any manner without the express written consent of Pershing. Your Business Without Limits® 11

Significant Market developments 1985 > ESM Government Securities fraud > Bevill, Bressler, Schulman fraud > New bankruptcy laws > Flight from “Trust Me” or HIC repo and growth of triparty custody 1986 > Passage of GSA ©Copyright 2010, Pershing LLC, a subsidiary of The Bank of New York Mellon Corporation. Member FINRA, NYSE, SIPC. Trademark(s) belong to their respective owners. For professional use only. Not for distribution to the public. The information contained herein, including any attachments, is proprietary to, and constitutes confidential information of Pershing LLC. It may not be reproduced, retransmitted or redistributed in any manner without the express written consent of Pershing. Your Business Without Limits® 12

Significant Market developments Late 1980 s/Early 1990 s > Legal uncertainty, unfavorable tax treatment, regulatory road blocks in most countries outside of US and UK > US and UK firms begin developing offshore lending markets 1990 > Group of Thirty publishes report calling for reduction of barriers to securities lending ©Copyright 2010, Pershing LLC, a subsidiary of The Bank of New York Mellon Corporation. Member FINRA, NYSE, SIPC. Trademark(s) belong to their respective owners. For professional use only. Not for distribution to the public. The information contained herein, including any attachments, is proprietary to, and constitutes confidential information of Pershing LLC. It may not be reproduced, retransmitted or redistributed in any manner without the express written consent of Pershing. Your Business Without Limits® 13

Significant Market developments 1991 > Legislative changes in the UK permit pension funds and unit trusts to lend 1994 > Sharp rise in US interest rates cause many lenders to lose money > “Great Awakening” to the possibility of loss in securities lending accounts ©Copyright 2010, Pershing LLC, a subsidiary of The Bank of New York Mellon Corporation. Member FINRA, NYSE, SIPC. Trademark(s) belong to their respective owners. For professional use only. Not for distribution to the public. The information contained herein, including any attachments, is proprietary to, and constitutes confidential information of Pershing LLC. It may not be reproduced, retransmitted or redistributed in any manner without the express written consent of Pershing. Your Business Without Limits® 14

Significant Market developments 1994 > Revision of the UCC > Recognition of the “virtual security” 1995 > Collapse of Barings PLC because of rogue trader Nick Leeson > “Great Awakening” to the fact that even well-capitalized, industry giants, can default ©Copyright 2010, Pershing LLC, a subsidiary of The Bank of New York Mellon Corporation. Member FINRA, NYSE, SIPC. Trademark(s) belong to their respective owners. For professional use only. Not for distribution to the public. The information contained herein, including any attachments, is proprietary to, and constitutes confidential information of Pershing LLC. It may not be reproduced, retransmitted or redistributed in any manner without the express written consent of Pershing. Your Business Without Limits® 15

Significant Market developments 1997 > Malaysia suspends securities lending 1998 > Rescue of LTCM > Black swans exist > Systemic risk can be huge > Esoteric instruments create big problems ©Copyright 2010, Pershing LLC, a subsidiary of The Bank of New York Mellon Corporation. Member FINRA, NYSE, SIPC. Trademark(s) belong to their respective owners. For professional use only. Not for distribution to the public. The information contained herein, including any attachments, is proprietary to, and constitutes confidential information of Pershing LLC. It may not be reproduced, retransmitted or redistributed in any manner without the express written consent of Pershing. Your Business Without Limits® 16

Significant Market developments 1999 > Euro created giving impetus to cash collateral in Europe Mid 1990 s thru today > Globalization of markets > Many countries creating favorable lending environment > Huge growth in derivatives fueling demand for borrowing ©Copyright 2010, Pershing LLC, a subsidiary of The Bank of New York Mellon Corporation. Member FINRA, NYSE, SIPC. Trademark(s) belong to their respective owners. For professional use only. Not for distribution to the public. The information contained herein, including any attachments, is proprietary to, and constitutes confidential information of Pershing LLC. It may not be reproduced, retransmitted or redistributed in any manner without the express written consent of Pershing. Your Business Without Limits® 17

Significant Market developments 2001 > SIPC liquidates MJK Clearing > SEC demands compliance with KYC rule > “Great Awakening” to the importance of knowing your customer > Industry-wide effort to develop ALD begins (implemented in 2006) ©Copyright 2010, Pershing LLC, a subsidiary of The Bank of New York Mellon Corporation. Member FINRA, NYSE, SIPC. Trademark(s) belong to their respective owners. For professional use only. Not for distribution to the public. The information contained herein, including any attachments, is proprietary to, and constitutes confidential information of Pershing LLC. It may not be reproduced, retransmitted or redistributed in any manner without the express written consent of Pershing. Your Business Without Limits® 18

MJK Clearing > Beginning in 1999, reputed Saudi arms dealer and co-conspirators raise cash by manipulating the price of GENI (from $1. 67 to $25) and lending shares to Deutsche Bank through Native Nations Securities and ultimately other unsuspecting BDs > Numerous BDs then on-lend and/or on-finance the cash loan using GENI as collateral > On September 25, 2001 shares in GENI are deemed (relatively) worthless and all parties attempt to mark the loans to the market > Native Nations fails and MJK uses customer cash to meet the stock loan margin call > MJK fails triggering largest SIPC bailout in history > Deutsche agrees to pay fine of $270 Million and finder is convicted of fraud > Lessons: Know your customer, Follow the Money > Preventive Measure (for Native Nations): Did this meet the Reg T purpose test? > Preventive Measure (for MJK): Assuming default is the collateral too concentrated? ©Copyright 2010, Pershing LLC, a subsidiary of The Bank of New York Mellon Corporation. Member FINRA, NYSE, SIPC. Trademark(s) belong to their respective owners. For professional use only. Not for distribution to the public. The information contained herein, including any attachments, is proprietary to, and constitutes confidential information of Pershing LLC. It may not be reproduced, retransmitted or redistributed in any manner without the express written consent of Pershing. Your Business Without Limits® 19

Significant Market developments 2007 > Sub-prime crisis > Crash of ABCP market > Losses in many securities lending accounts > Another “Great Awakening” to the risks in securities lending > SEC indicts Securities Lending traders in Finder skimming ©Copyright 2010, Pershing LLC, a subsidiary of The Bank of New York Mellon Corporation. Member FINRA, NYSE, SIPC. Trademark(s) belong to their respective owners. For professional use only. Not for distribution to the public. The information contained herein, including any attachments, is proprietary to, and constitutes confidential information of Pershing LLC. It may not be reproduced, retransmitted or redistributed in any manner without the express written consent of Pershing. Your Business Without Limits® 20

Finder Indictments > 38 people indicted by SEC for skimming more than $12 million in profits utilizing finders from 1998 to 2006 > 5 also indicted for securities fraud > Morgan Stanley’s practices prohibited paying finders for securities lending transactions but a rogue trader did so without management’s knowledge > Lesson: Know your people, know your business ©Copyright 2010, Pershing LLC, a subsidiary of The Bank of New York Mellon Corporation. Member FINRA, NYSE, SIPC. Trademark(s) belong to their respective owners. For professional use only. Not for distribution to the public. The information contained herein, including any attachments, is proprietary to, and constitutes confidential information of Pershing LLC. It may not be reproduced, retransmitted or redistributed in any manner without the express written consent of Pershing. Your Business Without Limits® 21

Significant Market developments 2008 > Australian Securities Lending Scandal > Lehman Brothers files for Chapter 11 > SEC Emergency Orders Banning Short Selling in Financial Stocks > Large Prime Brokers become Banks 2009 > SEC Roundtable on Securities Lending ©Copyright 2010, Pershing LLC, a subsidiary of The Bank of New York Mellon Corporation. Member FINRA, NYSE, SIPC. Trademark(s) belong to their respective owners. For professional use only. Not for distribution to the public. The information contained herein, including any attachments, is proprietary to, and constitutes confidential information of Pershing LLC. It may not be reproduced, retransmitted or redistributed in any manner without the express written consent of Pershing. Your Business Without Limits® 22

Securities Lending in 2010 > Still relatively safe > In need of more automation to manage cost of compliance > Some risks have returned because of globalization, e. g. settlement risks > Need of constant vigilance as product evolves > Increased scrutiny from all SROs > Dodd Frank Section 984(b) requires rulemaking re: transparency ©Copyright 2010, Pershing LLC, a subsidiary of The Bank of New York Mellon Corporation. Member FINRA, NYSE, SIPC. Trademark(s) belong to their respective owners. For professional use only. Not for distribution to the public. The information contained herein, including any attachments, is proprietary to, and constitutes confidential information of Pershing LLC. It may not be reproduced, retransmitted or redistributed in any manner without the express written consent of Pershing. Your Business Without Limits® 23

How Did We Get Here? >“You can always trust Americans to do the right thing — once they’ve exhausted all the other possibilities. ” – Winston Churchill ©Copyright 2010, Pershing LLC, a subsidiary of The Bank of New York Mellon Corporation. Member FINRA, NYSE, SIPC. Trademark(s) belong to their respective owners. For professional use only. Not for distribution to the public. The information contained herein, including any attachments, is proprietary to, and constitutes confidential information of Pershing LLC. It may not be reproduced, retransmitted or redistributed in any manner without the express written consent of Pershing. Your Business Without Limits® 24

Developed Lending Markets Today Legal Framework > Good bankruptcy and lien laws in most areas (international at times a problem) Safe Settlement System > Virtually all book-entry settlement/ DVP > Much automated tracking and automated payment of distributions on lent securities > Extensive use of triparty facilities > Automated marking of a large number of equity loans (US) ©Copyright 2010, Pershing LLC, a subsidiary of The Bank of New York Mellon Corporation. Member FINRA, NYSE, SIPC. Trademark(s) belong to their respective owners. For professional use only. Not for distribution to the public. The information contained herein, including any attachments, is proprietary to, and constitutes confidential information of Pershing LLC. It may not be reproduced, retransmitted or redistributed in any manner without the express written consent of Pershing. Your Business Without Limits® 25

Rules and Regulations > Reg SHO – Regulation enacted to reduce fails and eliminate naked short selling. – Rule 204 forces mandatory close-out by failing broker > Reg T – The Federal Reserve Board regulation that governs customer cash accounts and the amount of credit that brokerage firms and dealers may extend to customer for the purchase of securities – Defines acceptable purposes for borrowing shares > 15 c 3 -3 – Possession and Control of Securities or otherwise known as the “Customer Protection Rule” – Recent changes are still in a proposal period > 17 A 13 – Quarterly mailing of open borrow and loan confirmation > Dodd Frank ? ©Copyright 2010, Pershing LLC, a subsidiary of The Bank of New York Mellon Corporation. Member FINRA, NYSE, SIPC. Trademark(s) belong to their respective owners. For professional use only. Not for distribution to the public. The information contained herein, including any attachments, is proprietary to, and constitutes confidential information of Pershing LLC. It may not be reproduced, retransmitted or redistributed in any manner without the express written consent of Pershing. Your Business Without Limits® 26

Developed Markets Today Numerous market standards > Standard cut-off times > Standard recall periods > Standard contracts > Standards for exchanging information (ALD – US) Market transparency and liquidity > Transparency varies among markets but getting better > Large supplies give good liquidity ©Copyright 2010, Pershing LLC, a subsidiary of The Bank of New York Mellon Corporation. Member FINRA, NYSE, SIPC. Trademark(s) belong to their respective owners. For professional use only. Not for distribution to the public. The information contained herein, including any attachments, is proprietary to, and constitutes confidential information of Pershing LLC. It may not be reproduced, retransmitted or redistributed in any manner without the express written consent of Pershing. Your Business Without Limits® 27

Developed Markets Today Reasons to borrow > Slowed since 2008 Adequate accounting treatment > Loans not treated as sales > Tax laws follow the accounting rules, in general Regulation to prevent abuses > Adequate – (differences of opinion) > Active industry groups working to improve product ©Copyright 2010, Pershing LLC, a subsidiary of The Bank of New York Mellon Corporation. Member FINRA, NYSE, SIPC. Trademark(s) belong to their respective owners. For professional use only. Not for distribution to the public. The information contained herein, including any attachments, is proprietary to, and constitutes confidential information of Pershing LLC. It may not be reproduced, retransmitted or redistributed in any manner without the express written consent of Pershing. Your Business Without Limits® 28

Securities Lending Flow Interest (Rebates) Beneficial Owner Collateral Investment Agent Lender Broker Dealer Cash (Collateral) ©Copyright 2010, Pershing LLC, a subsidiary of The Bank of New York Mellon Corporation. Member FINRA, NYSE, SIPC. Trademark(s) belong to their respective owners. For professional use only. Not for distribution to the public. The information contained herein, including any attachments, is proprietary to, and constitutes confidential information of Pershing LLC. It may not be reproduced, retransmitted or redistributed in any manner without the express written consent of Pershing. Proxies Dividends Short Seller New Owner Dividends (Manufactured) Your Business Without Limits® 29

Risks Hiding in Plain Sight > Counterparty > Collateral > Investments > Chasing Yield > Tax Effect of Dividends (Manufactured) > Currency Risk > Current Laws, Rules and Regulations ©Copyright 2010, Pershing LLC, a subsidiary of The Bank of New York Mellon Corporation. Member FINRA, NYSE, SIPC. Trademark(s) belong to their respective owners. For professional use only. Not for distribution to the public. The information contained herein, including any attachments, is proprietary to, and constitutes confidential information of Pershing LLC. It may not be reproduced, retransmitted or redistributed in any manner without the express written consent of Pershing. Your Business Without Limits® 30

Some Risks Not So Obvious > Regulatory Changes Pending > IRS changes > Dodd-Frank Impact > Shareholder Advocacy > Sovereign Risk > Anything Manual > Impact of Transparency ©Copyright 2010, Pershing LLC, a subsidiary of The Bank of New York Mellon Corporation. Member FINRA, NYSE, SIPC. Trademark(s) belong to their respective owners. For professional use only. Not for distribution to the public. The information contained herein, including any attachments, is proprietary to, and constitutes confidential information of Pershing LLC. It may not be reproduced, retransmitted or redistributed in any manner without the express written consent of Pershing. Your Business Without Limits® 31

Finders Transparency Securities Lending Lessons Learned? Orange Co Malaysia Rapid Inflation Interest (Rebates) LTCM Sub-Prime Beneficial Owner Collateral Investment Barings, MJK Lehman Agent Lender Australia Broker Dealer Cash (Collateral) Bankhaus Herstatt Drysdale ©Copyright 2010, Pershing LLC, a subsidiary of The Bank of New York Mellon Corporation. Member FINRA, NYSE, SIPC. Trademark(s) belong to their respective owners. For professional use only. Not for distribution to the public. The information contained herein, including any attachments, is proprietary to, and constitutes confidential information of Pershing LLC. It may not be reproduced, retransmitted or redistributed in any manner without the express written consent of Pershing. Short Sale Ban Short Seller Shareholder Activism Proxies Dividends New Owner Tax Laws Dividends (Manufactured) Your Business Without Limits® 32

Rules to Live (Survive) By… > KYC (Know your counterparty) > KYC (Know your collateral) > Know your term > If, “Information is Power”, and “Time is Money”, then Timely Information is how fortunes are made and lost > Follow the Money (and you’ll understand the value/risk) > If it seems too good to be true, someone is probably getting ripped off > The Money’s in the Money > What you don’t know can kill you ©Copyright 2010, Pershing LLC, a subsidiary of The Bank of New York Mellon Corporation. Member FINRA, NYSE, SIPC. Trademark(s) belong to their respective owners. For professional use only. Not for distribution to the public. The information contained herein, including any attachments, is proprietary to, and constitutes confidential information of Pershing LLC. It may not be reproduced, retransmitted or redistributed in any manner without the express written consent of Pershing. Your Business Without Limits® 33

The Four Most Dangerous Words… >“This time is different” ©Copyright 2010, Pershing LLC, a subsidiary of The Bank of New York Mellon Corporation. Member FINRA, NYSE, SIPC. Trademark(s) belong to their respective owners. For professional use only. Not for distribution to the public. The information contained herein, including any attachments, is proprietary to, and constitutes confidential information of Pershing LLC. It may not be reproduced, retransmitted or redistributed in any manner without the express written consent of Pershing. Your Business Without Limits® 34