«Good, Bad or Inevitable? The Introduction of CCPs in Securities Lending A White Paper on the issues, opportunities and implications for the ...»
There are two generally voiced objections to the capital adequacy and balance sheet utilisation advantages of a move to CCPs in securities lending. The first relates to the typically slow progress in the implementation of regulation; objectors point to the lengthy implementation process for Basel II. The authors’ understanding is that Basel III is likely to receive the approval of G13 members, be welcomed by national regulators and implemented in a relatively fast-track manner. For example, in Europe it is anticipated that Basel III may be enacted through modification of the Capital Risk Directive (CRD) rather than through new legislation at member state level.
Second, objectors point out that the supply side of securities lending is driven by institutional investors, many of whom are not subject to Basel II regulation and are therefore not affected by capital allocation and balance sheet utilisation requirements. Agent Lenders similarly may be little if at all affected and the major beneficiaries are the broker-dealers operating on the demand side of the market.
Additionally, lenders typically benefit from Agent Bank indemnity against a shortfall in collateral in the event of borrower default, making the mitigation of counterparty credit risk through a CCP structure (reviewed above) less relevant to them as well. This objection takes us into complex and sometimes uncharted territory.
First, it is not clear that those institutional investors currently unaffected by capital adequacy/balance sheet regulation will remain in that position indefinitely. Solvency II (the updated regulatory requirements for insurance companies operating in the EU) is moving on a path similar to Basel II and it is expected that elements of the Basel II risk weighting regime will be included in insurance industry regulation, notably the increased risk weighting for exposure to large financial institution counterparties. Second, it is not clear that Agent Banks issuing indemnities to lenders against a shortfall in collateral are currently allocating capital against these liabilities. With the increased regulatory focus on capital adequacy and the significantly greater demands of Basel III it is even less clear that this will remain the case. Third, even in the event that capital allocation/balance sheet advantages apply primarily to the demand side broker-dealers, the additional demands of Basel III are likely to challenge and to potentially make financially unworkable the present securities lending business model, to the detriment of all market participants.
3. Trading, Transparency and Pricing A major cause of confusion in the discussion around the introduction of CCPs to securities lending is a tendency to treat centralised marketplaces (the electronic trading platforms) and centralised clearing (the CCPs) as pretty much the same thing. In securities and derivatives trading centralised marketplaces and centralised clearing are often aligned to create an efficient business model. However, centralised clearing also efficiently supports bilateral marketplaces in fixed income, interest rate swap (IRS) and, more recently, credit default swap (CDS) markets.
In the authors’ opinion, improvements in market transparency, price formation, pre-trade transparency and the potential for best execution are driven by the introduction of electronic trading platforms, not directly through the introduction of centralised clearing.
However, CCPs potentially bring improvement to market competitiveness through facilitating broader participation under Clearing Member responsibility. Additionally, CCPs are able to bring post-trade anonymity to the trading process. In many securities and derivatives markets a combination of electronic trading platform and CCP is regarded as the optimal trading model.
In the securities lending marketplace, the authors expect CCPs to both accelerate the growth of electronic trading platforms and to facilitate major change in the bilateral OTC market. Indeed, the OCC already supports both bilateral (OCC members) and AQS electronic trading platform business; in Europe, SecFinex offers a Private (bilateral /negotiated) market as well as the Order (anonymous bid/offer market). The Eurex Clearing CCP model currently in concept phase is designed to service the bilateral securities lending market.
The inclusion of the full spectrum of market participants into price formation will inevitably lead to more efficient market pricing.
Two areas of securities lending offer particular opportunity for application of the CCP model. First, a clear opportunity would be for firms to increase their use of CCPs in the run up to reporting periods or to switch significant balances to CCPs over short periods of time when balance sheet utilisation is at its most critical – quarter ends and year-ends. While a useful application, this has limited overall value, is not a sustainable business model for CCPs and would not be viable on its own. Second, exclusive portfolio arrangements form a very useful application for CCP models. The beneficial owner has already selected the borrower and the fee rate that the borrower will pay. For the life of the exclusive, the credit line utilisation is in effect a wasted resource for lenders and borrowers. Where trading platforms can provide the ability for “locked” trades which in effect give a bilateral twist to the trade execution and then give up the trade to a CCP, exclusives are an obvious candidate for CCP activity. Indeed, it could be that the advantages CCPs bring to the borrower side might even translate into higher exclusive bids, to the benefit of agents and beneficial owners.
4. Systemic Risk and Regulatory Supervision The credit crisis has generated global concerns over systemic risk in financial markets, particularly in relation to Over the Counter (OTC) markets. Regulatory initiatives worldwide are focused on restructuring OTC derivatives trading within centrally organised markets supported by central clearing. In addition to the perceived level of systemic risk inherent in OTC markets, regulators are concerned that the diffused nature of OTC business inhibits supervisory monitoring of market activity. The introduction of CCPs in securities lending directly addresses the mitigation of systemic market risk and provides a basis for improved regulatory monitoring.
Short-selling remains controversial and is subject to global scrutiny. Bans on short-selling have been imposed periodically in a range of markets and market segments, with adverse results for securities market participants and for the securities lending industry. The introduction of centralised market structures (through electronic trading platforms) provides an opportunity to implement effective monitoring and lessen concerns over short-selling as a market practice. While electronic trading platforms are the driver here, CCPs play a key supporting role, facilitating broader market participation and bringing post-trade anonymity to the market.
5. A More Liquid Market A wide community of borrowers and lenders all able to deal with each other through the credit mitigation afforded by CCP use would inevitably lead to a more liquid market. The current market dynamics can be likened to an hour glass with the top section filled with the assets of thousands of beneficial owners, the bottom section representing the thousands of end user borrowers and the grains of sand (the securities themselves) being squeezed through a narrow, constraining middle section comprised of very few agent lenders and prime brokers. These constraints are overwhelmingly down to two reasons: credit concerns and bilateral relationships. The former can be addressed through the utilisation of a CCP where assets can flow more freely from beneficial owners through to end borrowers. The latter is a valid choice, but in itself does not exclude the utilisation of a CCP for some parts of a firm’s securities lending activity.
It is often said that beneficial owners have no interest in CCPs as they seldom, if ever raise the subject. This is hardly surprising given that CCPs are largely an inter-professional market mechanism enhancing the market infrastructure. In the same way, beneficial owners do not demand interoperability amongst depositories or the use of book entry rather than physical certificate settlements. These organisations have an expectation that their professional service providers act in the clients best interests and the wider best interests of an optimal market structure that will provide a platform for continued operation.
The broad introduction of CCP services has the potential to facilitate the requirements of both beneficial owner and dealer communities. First, the broader and more liquid market place facilitated by CCP backing for electronic trading platforms responds to beneficial owners’ demand for improved risk adjusted returns from lending. Second, as discussed at a Roundtable session during the recent International Securities Lending Association (ISLA) conference, securities lending represents a resource-heavy business in terms of balance sheet and capital usage. Without structural changes, the discussion group predicted a reduction of the overall business size and the migration of similar economic exposure to less resource intensive transaction alternatives.
6. CCPs and Certainty of Payment The use of CCPs would eliminate the intra-day risk that is the sole purpose behind one day pre-pays that are a requirement for large segments of the agency lending community. This would represent a useful cost saving for borrowers and eliminate the risk borrowers carry for this uncollateralised counterparty exposure.
The obligations defined by CCPs for loan recalls results in the imposition of automatic buy-ins within specified tolerances laid out by each of the CCPs. While there can be no doubt that this could result in some pain for market participants, the certainty of execution would be another important step towards improved market discipline.
With respect to income payments and other entitlements, agents today are often are in the situation where they are funding beneficial owners while awaiting payment from borrowers. CCPs eliminate this waiting period by debiting the borrower and crediting the lender using the “golden position” maintained by the CCP.
7. Industry-wide Operational and Technology Costs Securities lending is regarded as a relatively high cost industry. In the bilateral trading market a lack of standardisation, with the maintenance of multiple parallel but differing arrangements between participating firms adds to operational and technology costs. The introduction of CCPs to securities lending provides a significant opportunity to address costs- from maintenance of multiple counterparty credit assessments through trading to operational processes. CCPs are positioned to offer cost-effective straight-through processing, acting as a hub-link, and provide efficient net settlement through automated linkages to Central Securities Depositaries (CSDs) and International Central Securities Depositaries (ICSDs).
Post-trade operational functions such as loan and collateral mark to market, processing of corporate actions and billing of fees and rebates can be more efficiently handled in a centralised environment.
In the authors’ opinion, the efficiency and cost-effectiveness of operational and technology processes will have a key impact on the pace of movement to the CCP model in securities lending. As noted in the CCPs in Securities Lending section of this report, collaboration in the US 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 processing system (SunGard’s Loanet) has produced an integrated link, effectively extending STP processing efficiencies developed for the OTC bilateral market to the AQS/OCC market.. This degree of industry co-operation is a positive move toward greater efficiency in securities lending operations and technology. In the European markets, with multiple CCP services (and competing CCPs in several markets) industry co-operation will be vitally important to secure effective interoperability between CCPs and optimise cost-effectiveness in operations for industry participants.
A securities trading continuum that commences with automated cash market execution through STP short covering in a risk-contained, resource efficient environment is a desirable outcome for the industry. Such conditions currently exist for other financial products yet in today’s equities markets, securities lending is the missing link in the process.
8. Cost/benefit issues inherent in adopting the CCP Model Over the past ten to fifteen years many firms have looked at securities lending as a cost or service centre – an integral part of a larger picture that generates profits elsewhere rather than as a stand-alone profit centre.
Securities lending is a critical part of the prime brokerage product, but for most investment banks it is the PB product itself that is the primary driver behind lending to hedge funds. Where firms are principally driven by proprietary trading, the profit is intended to be made in that area and borrowing securities is driven by costeffectiveness considerations rather than the need to make a profitable spread. This subtle change in attitude has meant that the focus for many securities lending desks has been on allocating internal costs and resources to other areas.
The use of CCPs would therefore benefit either the firm at large or the larger business line of prime brokerage rather than securities lending directly. The value of improved capital treatment and balance sheet impact resulting from CCP usage by the securities lending groups may not accrue to their direct benefit, yet it is the securities lending groups that would be required to undertake the not insignificant changes necessary for wide scale CCP implementation.
The recent environment has meant that the focus has often been on reducing costs or on a limited capacity / desire to take on new projects. The implementation of large scale usage of CCPs requires some change of practice for front, middle and back office operations and prevailing business priorities have not included many new projects or taking on additional costs. This is a short term view that can be seen as obvious and practical– too much work, not enough staff and a clear preference for reducing costs rather than adding them.