«Good, Bad or Inevitable? The Introduction of CCPs in Securities Lending A White Paper on the issues, opportunities and implications for the ...»
Good, Bad or Inevitable?
The Introduction of CCPs in Securities Lending
A White Paper on the issues, opportunities and implications for the securities lending industry.
Authors: Andrew Howieson, Howieson Consulting and Roy Zimmerhansl, Zimmerhansl Consulting
Table of Contents
Change in the Securities Lending Market
The CCP Paradigm
Purpose and Functionality of a CCP
CCP Risk Management
CCP Risk Mitigation
CCP Lines of Defence
CCP Post-Trade Services
CCPs in Securities Lending
CCP Development in the US Market
CCP Development in the European Market
The Securities Lending CCP Providers
CCPs: The Value Proposition in Securities Lending
Arguments For and Against CCPs
CCPs: Conclusions and Recommendations
Leveraging the CCP Infrastructure
The Global Challenge
Appendix 1: CCPs Active in Securities Lending
Appendix 2:Potential impact on Securities Lending of Proposed BIS changes to Basel II......(Appendix) 5
The potential for introduction of Central Counterparty (CCP) services in the securities lending markets has been under discussion for a number of years. During 2009 those discussions became a reality and CCPs in the United States and in Europe have launched securities lending facilities in collaboration with electronic trading platform providers.
While these are significant early stage developments, broad adoption of CCP services in the securities lending industry remains some way off. Indeed, debate on the merits of CCP services continues throughout the industry. To date, the opposing arguments have resembled ships passing in the night, with a lack of independent analysis and little resolution.
The objective of this white paper is to provide independent analysis to the arguments for and against industry-wide adoption of CCPs. This is not an academic paper –rather, the intent is to bring a practical, business-driven approach to analysis of the opposing arguments. The paper draws on discussions with representatives of key securities lending market participants, CCPs active in securities lending and regulatory authorities. Where appropriate the paper references material drawn from the extensive range of technical analyses relevant to CCP facilities in securities lending markets.
This is a critical time for the securities lending industry as markets begin to recover from the credit crisis, transparency and risk management become imperatives, short-selling and related lending practices come under unprecedented scrutiny and institutional investors re-examine the opportunities and risks inherent in securities lending. The authors believe that time is no longer on the industry’s side and that the adoption of CCP services merits serious and timely evaluation in the context of developing securities lending markets.
Central Counterparty (CCP) services have been introduced on both sides of the Atlantic, linked to electronic trading platform initiatives, but are some distance from broad adoption in securities lending and discussion continues throughout the industry on the merits of CCPs.
The introduction of CCPs in securities lending is in close alignment with the drivers of change in the industry:
increased attention to counterparty risk, tougher regulatory requirements in terms of capital allocation and balance sheet usage, new awareness of the costs to end users inherent in securities lending and regulatory concern over systemic risk and market supervision. CCPs do not directly drive improvements in market transparency and price formation but are supportive of electronic trading platforms through broadening trading market participation and providing post-trade anonymity.
Despite the demanding and product specific requirements of securities lending, CCPs are able to deliver the fundamental benefits for which they are designed, namely counterparty risk mitigation and improved operational efficiency. Optimisation of the CCP model in securities lending will require significant industry consultation and flexibility in application.
Proposed regulatory changes have made inevitable the broad adoption of CCPs in securities lending. Notably, proposed changes to capital adequacy guidelines in Basel III would present significant challenges to the existing securities lending business model and would inhibit growth in the industry. The broad adoption of CCPs in securities lending is not only inevitable but provides a major opportunity to reduce systemic risk, increase participant earnings and reduce the industry’s cost structure, while providing a foundation for sustained growth. Broad adoption of CCPs will contribute to growth in both electronic trading platform business and in bilateral OTC securities lending as the business will become less resource intensive allowing both to flourish in a growing marketplace.
This paper is targeted at a number of parties. The findings should be of interest to firms looking:
To generate incremental returns through a wider distribution network;
For a more efficient market where they can achieve more with fewer resources;
To reduce balance sheet and capital utilised in the conduct of securities finance business;
To reduce overall industry risk whilst improving market efficiency;
To be strategic thinkers looking towards the future rather than remaining rooted in the past.
While considerable uncertainty remains around the specifics of CCP adoption in securities lending, the introduction of CCPs presents an opportunity for competitive advantage, particularly to Agent Lenders and Principal Borrowers able to work with Beneficial Owners and End Borrowers to optimise their participation and to transfer significant lending volumes from a bilateral to a centrally cleared environment. Substantial use of CCPs can sit comfortably alongside bilateral business allowing the overall market volume to grow without placing unnecessary burdens on firm resources. The securities lending industry needs to be proactive in determining the optimal CCP configuration and working with CCP providers to achieve broad implementation.
Securities lending has often been described as a “back-office” or operational function. Certainly, the origins of organised securities lending in the 1970s owes more to expediting settlement and the development of an ancillary custodial service and less to an investment management or trading market discipline. Responding to the securities industry’s accelerating demand for borrowed securities to cover settlement failures and to support investment strategies involving short-selling, custodian banks commenced the development of organised lending programs which developed into key revenue generating divisions supported by significant operational, administrative and business resources.
In understanding the current dynamics of the securities lending markets and the debate over the introduction of CCP facilities, it is important to contrast the development of securities lending as an arrangement between the custodian banks (as well as a limited number of direct lenders) and the leading broker-dealers with the investment and trading led development of equities, fixed income and other securities markets. Securities lending still comprises primarily a series of bilateral relationships rather than a marketplace as is standard in equity, fixed income and derivatives markets.
To a degree, securities lending has moved toward recognition as an investment management discipline. A number of institutional investors have recognised lending as a significant source of alpha revenue generation and worked with custodian agents and third-party agents to develop lending programs geared toward their specific investment objectives and disciplines. This positive development has accelerated following evidence of lack of awareness of and involvement in the detail of lending programs by some beneficial owners demonstrated in the 2008-9 fallout from the credit crisis, particularly related to cash reinvestment programs.
The industry is currently experiencing heightened beneficial owner awareness and involvement which is expected to bring securities lending closer to broad alignment with investment management disciplines and heightened awareness of trading practices in securities lending.
If securities lending programs in general have moved toward investment management disciplines, trading itself has remained essentially a series of bilateral arrangements between agent lenders and major brokerdealers. These arrangements have been influenced by factors not found in other trading markets, including “ratio lending”, the linkage between take-up of GC (general collateral or readily available securities) and availability of Specials (or hard to borrow securities).
The continuing emphasis on bilateral arrangements between agent lenders and major broker-dealers (essentially the prime brokers) shapes the characteristics of the current trading market and exerts a profound influence on the debate over development of CCP facilities in securities lending.
Change in the Securities Lending Marketplace
There is no question that Securities Lending has developed into a major global market with linkages to securities and derivatives markets worldwide. At year-end 2009, lendable equity assets were estimated at $
5.3 trillion globally, with an estimated $700 billion on loan. While still substantial, these numbers reflect a reduction of almost 50% from the lending market peaks experienced in 2007.
Change has come slowly to the securities lending market which has always been regarded as “different”.
Electronic trading platforms have been introduced in the US (Quadriserv) and in Europe (SecFinex) and have made headway in their respective markets. However, bilateral relationships between the custodian agents and the prime brokers continue to dominate the trading aspects of securities lending, contributing to a
number of generally recognised deficiencies when compared to other markets:
1. The absence of a central order book and of centralised transaction reporting leads to a lack of transparency, affecting beneficial owners and end borrowers. Pricing is inefficient and reflects high intermediary costs resulting from the necessity of manual search and maintenance of multiple counterparty credit arrangements.
2. Given the thousands of beneficial owners supplying securities and the thousands of end user hedge funds and proprietary traders borrowing securities, the bilateral trading focus of the current market for securities lending results in a concentration of counterparty exposure among a limited number of major prime brokers and agent lenders. Generally, such a pronounced lack of diversification is of increasing regulatory concern, best evidenced by the recent moves focused on penalising large counterparty exposure through extra capital provisioning. The market has evolved into a structure which is viewed by some as oligopolistic in nature.
3. The lack of a central market place for securities lending contributes to high operational and technology costs in the industry. Operational functions such as collateral valuation and maintenance, administration of recalls and returns, monitoring and processing of corporate actions can reasonably be expected to be more cost-efficient in a centralised market environment rather than in a series of parallel processing environments. Even with the increased use and penetration of external vendor reconciliation services, there is no doubt that increased standardisation and availability of “golden” figures from a CCP can be expected to lead to improved operational and reconciliation processes.
4. Securities lending is an OTC business on a global scale, with limited direct oversight of trading markets. Regulatory oversight is particularly difficult to accomplish in a diffused trading market with no central data repository. In times of market stress this difficulty in monitoring securities lending transactions has contributed to regulators’ decisions to impose blanket restrictions on securities short selling activities and can be expected to influence further regulatory controls.
5. Business volumes have decreased substantially from the heights reached in 2007 with an estimated fall by as much as 50%. This has added pressure for market participants and contributed to the focus for many firms to cut back rather than invest for the future.
If change has always come slowly to securities lending, a series of differing but related factors is now driving an accelerated demand for change in the industry.
First, a result of the credit crisis has been a reappraisal of the risks and rewards inherent in securities lending.
Beneficial owners are increasingly focused on maximising the intrinsic value of earnings from securities lending and aware of the risks inherent in generating large volumes of lending in order to receive cash for reinvestment purposes. This renewed focus on intrinsic earnings argues in favour of a transparent, competitive marketplace with efficient pricing and best execution standards.
Second, a further result of the credit crisis, exacerbated by the Lehman default, is an increased focus on counterparty risk. Concerns over the measurement and management of counterparty risk are broad and global in nature, with particular scrutiny of risks arising from OTC businesses including derivatives, repurchase transactions and securities financing. The Bank for International Settlements (BIS) Consultative Document “Strengthening the resilience of the banking sector”, issued in December 2009, is explicit: “The risk coverage of the capital framework will be strengthened....the strengthened counterparty capital requirements are designed to increase incentives to move OTC derivative exposures to central counterparties and exchanges”.