«Good, Bad or Inevitable? The Introduction of CCPs in Securities Lending A White Paper on the issues, opportunities and implications for the ...»
Third, broker-dealers and investment banks are operating under increasingly stringent capital and balance sheet limitations. Securities financing transactions (which can involve significant usage of firms’ resources) face significant capital costs and balance sheet management issues and these are likely to become even more onerous through the pending changes to Basel II referred to above and any future changes to capital rules. A return to pre-crisis levels of securities lending would place major strains on many borrowers’ balance sheets, capital usage and counterparty risk capacity.
Fourth, the credit crisis has generated global concern over systemic risk in financial markets, particularly in relation to Over the Counter (OTC) markets. At the same time, the practice of short-selling has come under increased scrutiny globally, with restrictions on short –selling (both covered and naked short-selling) imposed at different times in a range of markets and market segments. Development of centralised trading and clearing facilities for securities lending provide a framework for more effective regulatory supervision and a basis for documentation of borrower compliance with short-selling rules. This is consistent with the approach that regulators take across multiple bank business lines.
In the following sections we examine the extent to which the introduction of CCPs to the securities lending markets is in alignment with the fundamental drivers of change in the industry, as well as the practical implications for the industry’s key constituents.
The CCP Paradigm The use of Central Counterparty (CCP) facilities has become widespread in equities, repo and exchangetraded options and futures markets worldwide. In these markets a close alignment between a centralised marketplace (an exchange or alternative trading platform) and a related CCP or CCPs is standard practice and considered to be an optimal market arrangement. Indeed, certain of the characteristics of CCPs that are at odds with traditional securities lending are entirely in line with existing beneficial owner activity in their other investment sectors.
On a global basis, regulators are pushing toward increased use of centralised clearing, particularly in relation to OTC derivatives products. For example, a recently released European Commission Consultation Paper on Derivatives and Market Infrastructures proposes mandatory use of CCP’s for “standardised derivatives contracts”. For instruments not classified as “standardised derivatives contracts”, the paper supports more stringent capital allocation and collateral haircut requirements as defined under the proposed revisions to Basel II.
CCP facilities are not unique to centralised market structures. Potentially relevant to the securities lending marketplace is the application of CCP facilities to OTC market structures. For example, launched in 1999, the LCH.Clearnet Swapclear service for OTC interest rate swap (IRS) transactions now clears approximately one third of the global IRS market with more than US $ 200 trillion in bilaterally arranged notional trades outstanding.
Purpose and functionality of a CCP
A CCP serves two primary functions; first (and foremost) the centralisation and mitigation of counterparty risk and second, the improvement of operational efficiency in post-trade processes. To achieve these objectives a CCP interposes itself between buyer and seller in each accepted transaction, becoming the seller to every buyer and the buyer to every seller. In this context the terms “buyer” and “seller” refer to the CCP member firms involved in the transaction, not to the end buyer and seller or to other intermediaries in the transaction. Hence, in the securities lending context, the question of whether an Agent Lender (or potentially a Beneficial Owner) becomes a Clearing Member (and a counterparty of the CCP rather than counterparty of a General Clearing Member/Clearing Member) becomes critically important, requiring individual analysis of the relevant Beneficial Owner, Agent Lender and potential General Clearing Member/Clearing Member circumstances.
While CCPs deploy differing processes to accept transactions presented by member firms, the CCPs currently offering securities lending services all utilise novation, a process by which a contract is created between the presenting member firms, replacing a provisional (prior to acceptance) trade and immediately transferred to the CCP. In the European context, CCPs typically offer three classes of membership: General Clearing Members, able to clear their own/client trades and offer clearing services to Non-Clearing Members, Individual or Direct Clearing Members able to clear their own /client trades and Trading or Non Clearing Members who clear through the services of and under the responsibility of a General Clearing Member. In the US model, a Clearing Member is able to clear for its own/client accounts and on behalf of non-member firms, under its responsibility. Figure 1 (below) illustrates the novation process in the European model, involving a transaction between an Individual Clearing Member and a Non Clearing member (under the responsibility of a General Clearing Member). The provisional trade created through the trading platform is replaced by a novated trade immediately on acceptance by the CCP.
The result of this process is the creation of two trades: (1) between the Individual Clearing Member as buyer and the CCP as seller, (2) between the General Clearing Member as seller and the CCP as buyer. In parallel a trade is automatically created between the Non Clearing Member and the General Clearing Member under the terms of their clearing agreement.
Figure 1. CCP Novation Process CCP Risk Management In a CCP market model the centralisation of counterparty risk offers key structural advantages.
First, CCPs are able to apply multilateral netting as opposed to the bilateral netting arrangements applicable in OTC settlement markets, significantly reducing gross risk exposure. Through becoming the counterparty to each member firm’s transaction, a CCP is able to offset all a member firm’s buy and sell transactions, effectively “netting” all the positions which would arise in a bilateral netting arrangement. Second, in addition to optimising netting potential, the CCP model reduces systemic risk by eliminating the potential for contagion in the event of default by a Clearing Member. This is achieved through the multilateral netting process isolating the defaulting member’s exposure to a single position with the CCP, against which the CCP holds margin collateral and the defaulting member’s guarantee fund contribution.
Fig 2 (below) illustrates the treatment of counterparty risk in a bilateral OTC market, without centralised clearing, contrasted with the treatment of counterparty risk in a CCP environment (Figure 3).
Figure 2. Risk Management under a Bilateral OTC Model Figure 3.
Risk Management under a Central Clearing (CCP) Model Source: World Federation of Exchanges Source: World Federation of Exchanges CCP Risk Mitigation In order to mitigate the risk of loss from counterparty default, CCPs deploy highly structured risk
management programs, typically including the following elements:
Membership Requirements and Member Monitoring
CCPs establish membership criteria based on minimum capital requirements, credit ratings or a combination of financial criteria. Additionally, membership requirements involve assessment of applicants’ operational readiness and compliance with CCP standards.
An advantage of the centralised structure relates to a CCP’s ability to monitor member firms positions across the range of markets cleared by the CCP and to promptly initiate actions to increase collateral requirements or to unwind positions in distress situations.
CCPs apply margin requirements against all accepted transactions, comprising initial margin and variation margin. Initial margin is calculated to cover risk under normal market conditions, with variation margin covering subsequent market movements relating to positions and related collateral.
Variation margin is calculated on at least a daily basis, with intra-day and real-time monitoring increasingly employed.
Margin requirements apply to both Clearing Members (representing Lender and Borrower) in a novated securities lending transaction, as the CCP guarantees both return of the loaned securities and the related collateral. Margin requirements (additional collateral) should not be confused with the collateral requirement (principal collateral) agreed between the lender and borrower in a securities lending transaction.
Guarantee Fund Requirements CCPs require member firms to maintain individual contributions to a Guarantee Fund (or Clearing Fund), calculated to cover exposure to significant default beyond a defaulting member’s available margin collateral.
CCP Lines of Defence A CCP’s multi-level defence against counterparty default would normally be applied as follows in a
Figure 4 CCP Lines of Defence Figure 4 (above) depicts the principal lines of defence deployed by CCPs against the risk of counterparty default. It should be noted that there is some degree of variation between the CCPs. For example, Eurex Clearing deploys a CCP Reserve Fund and SIX x-clear deploys 50% of CCP free reserves, both as a fourth line of defence (prior to application of Guarantee Fund contributions of remaining members).
CCPs are single purpose entities, formed specifically to provide clearing services. Default of clearing members is rare and a CCP default has never occurred. Under the proposed BIS changes to Basel II, banks’ collateral and mark to market exposures to CCPs (and exchanges) meeting the criteria of CPSS/IOSCO will qualify for a 0% risk weight (currently under discussion-potentially increased to a 1-3% risk weight), reflecting the regulators’ preference for and confidence in the use of CCPs in mitigating counterparty risk.
CCP Post-Trade Services
As a result of their central position in the marketplace, CCPs are well placed to reduce post trade complexity through acting as a hub-link and by standardising processes. In the trade settlement process, CCPs are able to utilise automated linkages to Central Securities Depositaries (CSDs) and International Central Securities Depositaries (ICSDs) and to operate on an efficient net settlement basis.
CCPs in Securities Lending In common with derivative asset classes, securities lending presents a series of challenges (and opportunities) to the introduction of CCP facilities. In this section we examine the unique requirements relevant to CCPs in securities lending, the extent to which CCPs are currently meeting or are planning to meet those requirements and in Appendix 1 provide profiles for the CCPs active in securities lending.
CCP Development in the US market
In the United States, securities lending CCP services are currently provided by the Options Clearing Corporation (OCC). From 1993, OCC has operated a Stock Loan Program, clearing loans arranged by members on a bilateral basis and received as matched transactions from the DTC. From January, 2009 OCC has provided a CCP service to the AQS Stock Lending Market. AQS is an electronic securities lending trading platform owned by Quadriserv. AQS offers trading in loans related to more than 5,000 equity, ETF, index and ADR instruments.
As of June 2010, through the OCC combined Stock Loan Program and AQS Securities Lending Market Program some 1200 transactions are processed daily, with 6900 contracts outstanding valued at $12 billion. The transaction volume transmitted by AQS to OCC is actually in the region of 1500 including rerates and other relevant transactions. There are 65 Clearing Members in the combined program as well as 18 non-clearing members in the AQS market.
Key features of the OCC Stock Loan Program and AQS Stock Lending Market CCP facilities are summarised in Appendix 1.
CCP Development in the European Markets In Europe, the electronic securities lending trading platform SecFinex has partnered with LCH.Clearnet for the Belgian, French, Dutch and Portuguese markets and with SIS x-clear for the UK, Austria, Denmark, Finland, Germany, Norway, Sweden and Switzerland. SecFinex offers a Private (bilateral negotiation) market, an Order (anonymous bid/offer) market and an Auction (by invitation) market for Asian, European, UK and US equities loans. In June 2010 the SecFinex trading market posted aggregate offers in excess of EUR 5 billion, aggregate bids in excess of EUR 2 billion and average loans outstanding in excess of EUR 400 million.
Additionally, Eurex Clearing is currently developing a securities lending CCP service designed to support the bilateral OTC market and has partnered with Quadriserv to support a planned Euro AQS trading platform.
Key features of the LCH.Clearnet CCP service for the SecFinex market, of the SIS x-clear CCP service for SecFinex and of the planned Eurex Clearing bilateral OTC service are summarised in Appendix 1.
1. Market Structure As noted in the Introduction to this paper, the securities lending marketplace demonstrates a relatively complex participant structure, with (at least) four major constituents: (A) the Beneficial Owners, many of whom lend through agents but some of whom lend directly through affiliated entities, (B) the Lending Agents (custodian banks and third-party providers), (C) the Principal Borrowers (the Prime Brokers and other sellside firms) and the End Borrowers (principally Hedge Funds and sell-side firms’ proprietary trading desks).
Additionally, the US market in particular features specialist market-makers and broker-dealer firms active on both sides of the market. The CCPs presently offering securities lending clearing operate market structures which essentially maintain the roles of the four key market constituents. It should be noted that only Clearing Members become counterparties to the CCP and benefit from the CCPs low risk weighting, making the selection of access method to the CCP critical for Beneficial Owners and Agent Lenders.
Figure 5 (below) illustrates the broad market structure applicable to a CCP supported securities lending market.