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August 23, 2005

Looking Around Corners: Regulators hope to avoid another MJK blowup

By John Hintze

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  • Looking Around Corners: Regulators hope to avoid another MJK blowup

(Traders Magazine, August 2005) -- Pershing, the Bank of New York's correspondent clearing unit, will take the plunge.

It will be part of the initial wave of broker-dealers testing the initial phase of a new infrastructure to standardize the securities lending world's murky corners. An instance of fraud lurking in those corners made headlines in 2001 after the meltdown of MJK Clearing.

These new stock lending standards, however, are going to present broker-dealers and other stock loan market participants with significant challenges. They will likely realign the stock lending business, but will also raise questions.

"I wonder if it really solves the problem that arose with MJK. It will certainly improve transparency, but I'm not sure if I see yet how it will reduce risk," according to Angi Meyers, svp and head of North American product development at Northern Trust Securities Lending, a unit of giant custodial bank Northern Trust.

The initiative was prompted by the collapse of MJK Clearing, a midsize clearing firm that borrowed a volatile stock directly from a small broker-dealer. MJK's due diligence was clearly lacking. So when the stock collapsed and its counterparty lost its capital, MJK followed suit, leaving the clearer's correspondents suddenly without a clearing firm.

The stock loan business has grown markedly in recent years with the emergence of hedge funds and other sophisticated investors actively shorting stock.

Broker-dealers borrow the stock from the stocks' beneficial owners, who are often institutional money managers. Broker-dealers lend to their short-selling customers, making a tidy spread on the difference between the cost to borrow the securities and the return on lending them out.

Until now, the stock lending business has been built on relationships. These are built between securities borrowers and either directly with the stocks' beneficial owners, or with agency lenders. The latter is usually a large bank that has custody of the lenders' securities, and then lends them to borrowers.

But now new lending standards will prevent another MJK cause celebre, or so the industry hopes.

The Agency Lending Disclosure Taskforce, an industry collaboration organized by consultancy Capco, has been working on the lending standards project since early 2003. The New York Stock Exchange and the NASD issued guidance, respectively in June and July. They were alerting the industry to the regulators more demanding interpretation of existing requirements.

The project's goal is to standardize and increase the transparency of credit and regulatory capital information that passed between counterparties in stock lending transactions.

The standardization represents a shift from a largely person-to-person industry to a more automated, transparent one. However, as is often the case, automation appears more likely to create additional work for stock lending participants than to lessen it.

"It's an extremely complex initiative overall because of the sheer number of parties involved," adds Meyers of Northern Trust.

Northern Trust deals with some 600 custodial clients, such as pension funds, endowments and mutual funds. It places securities in its custody, and, in turn, it lends them out to the Chicago-based bank's 70-to-80 large broker-dealer customers.