«Good, Bad or Inevitable? The Introduction of CCPs in Securities Lending A White Paper on the issues, opportunities and implications for the ...»
Figure 5 CCP Market Structure Figure 5 (above) illustrates the choices presented to market participants in a CCP supported securities lending market.
Beneficial Owners are generally expected to rely on Agent Lenders to provide access to CCPs as an integral part of the lending service. However, the proposed Eurex Clearing service to the bilateral OTC market anticipates offering a Specific Lender Licence, available only to Beneficial Owners (although Agent Lenders would operate on behalf of Specific Lender licence holders). Holders of Specific Lender Licences will not be required to provide margin nor contribute to the CCP’s Guarantee Fund provided that the Specific Lender Licence holder maintains collateral received against securities loans within the CCP.
Agent Lenders (both custodian and third-party agents) have the choice of becoming Clearing Members, with direct access to the CCP, or of accessing the CCP through a General Clearing Member (Clearing Member in the US).In practice, the majority of the major Agent Banks are likely to operate through affiliated entities extending existing CCP participation to the securities lending service, thus benefiting from the CCPs’ low risk weighting.
Principal Borrowers (major prime brokers/ broker-dealers) are likely to already be CCP members through securities trading business lines and are expected to extend or add memberships to cover securities lending and benefiting from the CCPs’ low risk weighting.
End Borrowers are expected to access securities lending CCPs, in most cases, through their prime brokerage relationships. In some instances the end borrowers may acquire Non Clearing Member status, allowing direct trading access under a General Clearing Member (US Clearing Member) responsibility. However, major Hedge Funds meeting CCP membership requirements may be expected to take Clearing Member status on a direct basis.` It should be noted that the favourable treatment proposed under Basel II revisions for counterparty credit exposures within a CCP environment (0% risk weighting) apply to Clearing Members only (as they contract direct with the CCP). Thus in order to benefit from this treatment, market participants must become a Clearing Member. This will inevitably impact market participants’ decisions on whether to access a CCP directly or through a General Clearing Member/Clearing Member.
2. Critical Functionality
Unlike the purchase or sale of equities or fixed income securities where the clearing function is completed and final within a few days, securities loans are extended term transactions (almost entirely of open duration) with a series of ongoing obligations through the life of the loan and a “closing” as well as an “opening “transaction. As the counterparty to all member transactions, the CCP must treat all open loans as “pending contracts” until the closing transaction and effectively guarantee performance against the obligations of the loan.
Figure 6 (below) depicts the key functionality required from CCPs in securities lending. CCPs are positioned to offer guaranteed payments in respect of collection of increased collateral, of (manufactured) dividends and of loan fees /rebates. This ability represents an enhancement to market practice and a potential benefit to agent lenders that contractually fund clients irrespective of counterparty settlement and beneficial owners whose lenders apply actual settlement accounting.
Figure 6 Key Functionality for CCPs in Securities Lending
3. Operational Efficiency While the ongoing loan performance guarantee is a significant commitment, the potential to centralise the operational processes required to service that commitment represents a major opportunity to create post-trade efficiencies. The extent to which a CCP provides post-trade services beyond the minimum level required to meet the CCP’s performance guarantee may be considered optional but has significant implications for CCP’s potential to improve the general operational efficiency of the securities lending marketplace.
In the US securities lending market, collaboration between the CCP (Options Clearing Corporation), the electronic trading platform (Quadriserv AQS), the Central Securities Depositary (DTC)and the dominant US order routing and “books and records” system (SunGard’s Loanet) has produced an integrated link facilitating loan initiation and modification, settlement, mark to market processing and transaction reporting. The automated processing provided through the Loanet collaboration means that loans executed through AQS/OCC are subject to the same straight through processing (STP) treatment as OTC executions, creating significant efficiencies for users. Additionally, a further development from Loanet will allow access to the AQS electronic trading platform directly from the Loanet application (alongside order routing capabilities), facilitating consistent treatment of AQS/OCC and OTC business throughout the pre-trade, trade and post-trade lifecycle.
4. The Securities Lending CCP Providers
There are currently three CCPs active in the securities lending markets and one in development.
Options Clearing Corporation (US), LCH Clearnet and SIS x-clear in Europe all are operating live CCPs.
Eurex is developing CCP functionality for European markets. Appendix 1 profiles each of the CCPs.
CCPs: the Value Proposition in Securities Lending In this section we examine the principal arguments for the introduction of CCP services in the securities lending market and where applicable the contra arguments, review the value proposition for the key market constituents and analyse the fit with the fundamental drivers of change in the securities lending industry.
Arguments For and Against CCPs
1. Mitigation of Counterparty Credit Risk One fateful week in mid-September 2008 saw an actual borrower default (Lehman) and an agent lender (AIG, acting as agent for AIG principal entities) need rescuing by the US government. That same week also saw several other leading prime brokerage organisations extremely stressed and there were real concerns that other defaults would follow shortly thereafter. The first action of many market participants was to reduce the number of counterparty relationships they dealt with and to cut lines for those relationships where they did continue. While on the face of it this seems a reasonable approach, upon further examination it seems counter-intuitive. How can the right approach to reducing counterparty risk simply be to concentrate exposure to a smaller group of entities? Only firms that had eliminated Lehman risk prior to its default could make a claim to knowing which firms could be considered “safe” counterparties that they could continue to trade with.
In the reduced counterparty scenario, it is likely that the percentage of a firm’s securities lending business each remaining counterparty represented would be an increase over the pre-Lehman period, reinforcing the concentration risk. This is inconsistent with common practice whereby when firms merge, existing credit lines are not aggregated. Rather, the new credit line would be less than the sum of the two previous lines. In that way the new merged entity would represent a reduced percentage of the overall business exposure, even where the larger firm could be considered “stronger”.
The two approaches – one concentrating risk, the other attempting to reduce firm risk, are at odds with each other.
The CCP takes a different approach. By widening the universe across the larger community and ensuring transaction level margining, CCP usage allows firms to indirectly increase their counterparty network and mutualise the risk across a wider audience.
The proposed modifications to Basel II, published by the Bank for International Settlements (BIS) and likely to be fully adopted by the G13 member countries refer specifically to “exposures arising from derivatives, repos and securities financing activities” and state “the strengthened counterparty capital requirements are designed to increase incentives to move OTC derivative exposures to central counterparties and exchanges”.
In the securities lending context, use of a qualified CCP allows for replacement of bilateral counterparty credit risk with the equivalent of AAA risk for all Clearing Member exposures.
Some Agent Lenders have argued in favour of bilateral credit exposures on the basis that the ability to select counterparties on a bilateral basis allows them to deal only with counterparties they consider credit worthy while CCP membership creates an (indirect) exposure to names they may not consider credit worthy. This argument is unconvincing for two reasons: first, under the bilateral model credit exposure has been increasingly concentrated with a limited number of major counterparties and renewed market growth will be difficult to accommodate within this model while the degree of concentration runs contrary to accepted risk dispersal theory. Second, CCPs are specifically designed to mutualise and mitigate risk, as explained in the CCP Paradigm section of this paper. CCPs deploy (typically) six lines of defence against a Clearing Member default and, in contrast to a bilateral arrangement, are structured to actively manage risk exposure to Clearing Members and to take clearly defined remedial action as soon as a Clearing Member fails to meet margin or other commitments. For this reason qualified CCPs are treated as AAA rated entities for counterparty risk purposes.
Introduction of CCPs to securities lending provides an opportunity to convert significant amounts of bilateral credit exposure to the equivalent of AAA rated exposure. Counterparty credit lines are a scarce resource and credit line utilisation has been a hot topic for both lenders and borrowers for many years, exacerbated by the Lehman default. CCPs allow participants to reduce credit line utilisation and have the opportunity to benefit from increased trading opportunities. There are three areas where CCPs bring value to this aspect of every firms business and a fourth that applies to borrowers.
Better use of existing credit lines. As the CCP becomes the zero (or close to zero)risk weighted counterparty to all novated transactions, no credit lines are used. This leaves credit availability for transactions that are agreed bilaterally or to be used by other business lines of the firm.
In a bilateral environment where credit lines are full, firms would simply cease trading. The CCP scenario gives market participants the ability to continue to trade.
Where no credit lines exist – either as a result of a specific choice not to engage in trading, or where firms have no relationship, users of CCPs can trade.
Where firms have traditionally been essentially borrowers, the opportunity to become lenders with a single (or few) CCPs as counterparty, with little or no balance sheet or capital costs, offsetting collateral necessary for borrowing activity and capturing an additional revenue spread on top becomes compelling.
2. Capital Allocation and Balance Sheet Usage The proposed revisions to Basel II referred to above present major challenges to the current securities lending business model. Appendix 2 illustrates the scope of the proposed changes to Basel II relevant to securities lending and includes a hypothetical example of potentially significantly increased Capital Allocation requirements for securities lending transactions.
The introduction of CCPs to the securities lending market provides an opportunity to convert significant amounts of bilateral credit exposure to a 0% (or close to 0%) risk weighted environment, with a significant positive impact on Clearing Members’ capital adequacy. As illustrated in Appendix 2 this positive impact is likely to be significantly greater given the implementation of Basel III in its proposed form. While the example presented in Appendix 2 is necessarily hypothetical (as advanced approaches require knowledge of the individual circumstances of firms making the calculations), it is illustrative of the extent to which Basel III can be expected to challenge the current securities lending model. There is no question that regulators want to see as much bilateral exposure as possible moved to CCP environments and the Basel III proposals are supportive of that objective. The move toward a 0% (or at most 1-3%) risk weight may eliminate the effect of differing exemptions to risk weight allocation models granted by regulators, reducing resulting regulatory arbitrage and potentially increasing acceptance of the CCP model.
Similarly, the introduction of CCPs to securities lending potentially offers significant advantages to Clearing Members in terms of balance sheet usage, with the potential to record amounts receivable /payable to a CCP on a net basis (this is after the position and margin netting carried out by the CCP), freeing balance sheet capacity for use in increased securities lending or other business activities.
It should be noted that, in the US market, broker-dealers ability to offset receivables against payables on securities loans novated to a CCP for financial reporting purposes is dependent on confirmation of extension of Financial Accounting Standards Board ( FASB) Accounting Standards Codification section 815-10-45 (formerly FASB Interpretation No.39) to include securities loans in addition to repurchase agreements and derivative transactions.
Securities lending contracts are generally not considered as derivative instruments under FASB definitions.
However Quadriserv has advanced the case, in a written submission to the FASB, that when securities lending transactions are cleared through a CCP operating a master netting agreement, resulting receivables and payables should be treated in the same way as payables/receivables associated with derivative instruments and be similarly eligible for offset in financial reporting.