«Good, Bad or Inevitable? The Introduction of CCPs in Securities Lending A White Paper on the issues, opportunities and implications for the ...»
Yet at the same time, financial services firms can look back and find numerous examples of new process adoption and the absorption of additional costs that became the corner stone to their ability to dramatically improve return on firm resources and increase volumes exponentially in subsequent years. “Invest now in order to reap future benefits” should be the mantra of those firms looking to be the leading providers in future.
This complex intra-firm cost/benefit situation requires the intervention of Senior Management in order to drive enterprise wide strategic decision making in support of the broad adoption of CCPs.
Further, critics of CCPs in securities lending point to the costs associated with CCP transaction fees and margin provision for both lender and borrower. CCP transaction fees and margin related costs do represent new costs, however, potentially substantial financial benefits are derived through the introduction of CCPs in securities lending.
Financial benefits are driven by (a) release of capital allocated to bilateral counterparty exposures, generating capital to support additional bilateral securities lending or redeployment to other business activities, (b) reduction of balance sheet usage through netting of CCP related receivables/payables, increasing Tier 1 capital ratios and making capital available to support increased bilateral securities lending or other business activities, (c) reduction of costs related to securities lending operations and technology through utilisation of CCP hub-link facilities and centralised operational processes, (d) increased market volumes resulting from broader market participation, increased counterparty credit and balance sheet capacity.
It is beyond the scope of this paper to define a CCP related financial projection for each class of market participant, much less for individual lenders or borrowers. However, it is clear that a broad move to CCP facilities in securities lending would bring potentially substantial financial benefits to the industry. ETFs provide an interesting microcosm of the potential impact of electronic trading platforms and CCP. ETF borrowing and lending is often inhibited by a lack of liquidity. According to July data from SunGard Astec Analytics, AQS activity accounts for more than 50% of lending traded volume for 144 of 805 US ETFs for which ASTEC holds data. For a further 43 ETFs, AQS trading volume accounts for a third or more of total volume.
The specific reasons for the outsized market share in this asset class are not clear, but the cumulative results are a powerful signal of the potential benefits available to users.
This provides an opportunity to rethink aspects of the current securities lending model, which may be unsustainable following introduction of the proposed Basel amendments. Even without the introduction of further amendments, it is clear that the capital and balance sheet impact of securities lending has had more focus in the past two years than ever before. Market participants will be forced to shift trading towards structures that are more capital and balance sheet friendly and without structural change, securities lending risks losing market share.
9. Agent and Beneficial Owner Issues There must be an acknowledgement that agents would have to engage with their underlying beneficial owner clients to identify, address and make changes to their bilateral documentation in order to participate in CCPs. Examples of amendments would include the elimination of one day pre-pays and the requirement for agents to hold a minimum of 100% (or higher) collateral. These requirements were put in place in order to eliminate intra-day risk and to ensure adequate collateralisation. The CCP risk structure eliminates the need for these features. The effort required to implement these changes will vary based on agents’ individual businesses, but it should be recognised as substantial for most if not all agent lenders. The work in this area should not be underestimated, yet it is a near certainty that some beneficial owners will be caught within future regulatory nets for capital reserves and agents will be forced into taking action for at least these entities. Further, the issue of capital reserves for agent indemnification remains a subject that has garnered growing regulatory interest and as other, higher priority items clear regulators’ radar screens, the subject may come to the forefront.
Additionally, there remains a lack of clarity around how Beneficial Owners will participate in the CCP model, with questions related to whether collateral is held by the CCP and if so whether it will be segregated and pledged to the Agent Lender or Beneficial Owner, and whether margin collateral held by the CCP can be similarly treated. A general assumption has been that Agent Banks would work through (General) Clearing Members, in some cases their own organisation but it may be advantageous for an Agent Bank to participate as a Clearing Member or for a Lender to participate directly. The Eurex Clearing model proposed for bilateral securities lending offers direct Lender participation under a Specific Lender licence, with potential exemption from margin requirements.
CCPs: Conclusions and Recommendations
US Market Place The US securities lending marketplace has a number of features which are supportive to the development of a securities lending CCP. First and foremost, the US is the single largest and most active equity lending market. Loans can be considered overnight loans that are rolled over on a daily basis. There is a huge universe of market participants actively involved in securities lending, and many of these firms are active as both borrowers and lenders, increasing the value of offsetting of positions. Further, there are fewer variables in terms of dividend rates, collateral and post-trade processing. All of these factors point to a more straightforward implementation of CCPs and a considerable community of organisations that stand to benefit from large scale implementation. The further economic buy-in to AQS from a number of market participants and interested parties means that there are vested interests in the success of the business that can help direct volumes to the trading platform and therefore through to the CCP.
The fact that the OCC already operates a securities lending CCP to support options market makers means that there is a baseline of business that provides a viable operating model. The existing flows should provide some market participants with a firm-level incentive to add conventional securities lending flows to the CCP activity.
European Markets The European CCP environment is more fragmented and complex. Securities lending volumes are spread across a large number of markets with many counterparties in different legal jurisdictions. Often these counterparties include smaller firms that have unique access to local market supply or individual demand.
Credit approval can be more difficult to achieve and even when successful, absolute lines may be small.
Dividend withholding taxes complicate income processing and would require CCPs to adapt and provide innovative solutions. Traditional securities lending collateral profiles are far more variable across bilateral relationships in Europe than is the case in the US. Historically firms have been largely one directional in that the majority of entities are either borrowers or lenders. Borrowers have been reluctant to divert resources from client business to low margin intermediary business. All of these issues play a part in the slow penetration of CCPs to date in Europe.
Yet at the same time they also speak to the potential value wider CCP usage would bring to the market.
Rather than book, monitor, administer and collateralise trades across multiple counterparties across numerous different markets, concentrated activity within one or a small number of CCPs would smooth operational processes. Further, the combination of trading platforms and CCPs gives some firms a low impact way of expanding their distribution of assets to borrowers. The credit intermediation aspect of CCPs could help revolutionise and level the playing field for smaller organisations across many of the local European markets by giving them access to borrow securities or distribute long positions to firms where trading would otherwise not be possible or economically practical. The introduction of two- way business would add value in balance sheet and collateral offset terms as well as new income opportunities.
Leveraging the CCP Infrastructure The combination of trading platform and CCP in its basic form is designed to augment and enhance rather than replace the bilateral securities lending market. Indeed, it is a commonly held view that the combined fixed income repo and bond lending businesses could only have reached its current size with the contemporaneous introduction of trading platforms and CCP. Yet the possibilities extend beyond conventional securities lending. An example of the potential extension of the infrastructure can be seen today with cash funding. AQS clearing members are able to lend securities against the CCP guarantee and receive cash as collateral, to be used for general treasury funding purposes. The position of the cash borrower and securities lender can then be netted on a position and risk basis against all of the other open CCP positions. This is a logical next step for such facilities and it should be easily accommodated within each of the trading platform/CCP structures.
The Global Challenge Nevertheless, for both the US and Europe the challenge remains to capture the attention and interest of agent lenders and their beneficial owner clients. Unlike the fixed income repo markets, the equity securities lending business will always be largely reliant on agents and their clients for the breadth and depth of supply across the globe. This requires further industry engagement, changes to some aspects of the CCP services, acceptance that capital and balance sheet rules will change and a willingness of industry participants and stakeholders to consider new business practices and processes. Without the resource efficiencies that CCPs could bring to the securities lending marketplace it is apparent that the industry will be limited in its capacity to exceed the market peaks experienced in 2007.
The following section summarises the authors’ specific findings and recommendations in respect of broad adoption of CCP services by the securities lending industry.
1. The broad usage of CCPs in securities lending is inevitable for at least a proportion of the business, given the regulatory preference for centralised clearing and the proposed amendments to capital adequacy under Basel III.
2. The mitigation of counterparty risk, capital allocation and balance sheet usage advantages of CCP adoption are substantial under current regulations, pending amendments to those regulations, and potentially even more important under Basel III. Without broad use of CCPs, capital and balance sheet restrictions will not support growth in securities lending and it may not be possible to sustain the economics of the current business model.
3. CCPs will support the growth of both electronic trading platforms and the bilateral OTC market for securities lending, contributing to market transparency and increasing liquidity by allowing broader direct participation. The more efficient usage of firm resources will allow increased activity to occur without stretching resources beyond the breaking point and ensure that return on capital and return on balance sheet utilisation is enhanced.
4. Securities lending requirements present challenges but these challenges can be met by CCPs through industry consultation and CCP model flexibility.
5. CCPs offer certainty of payment, eliminating the need for one day pre-pays and improving the collection process for dividends and fees/rebates.
6. CCPs offer significant scope for reduction in operational and technology costs in securities lending over time.
7. Changes to the current securities lending model will be required to maximise the benefits of CCP usage. For example, the value of Agent Lender indemnification for transactions under a CCP model warrants serious review.
8. Competitive advantage is available to Agent Lenders and to Principal Borrowers able to transition significant amounts of bilateral securities lending business to CCP environments, thereby freeing capital and balance sheet resources for increased securities lending or other business activities.
Principal borrowers may display a preference for business with lending Agents able to transact through a CCP model. This will involve a willingness to re-define the securities lending business model where appropriate and to be pro-active in facilitating participation of Beneficial Owners and End Borrowers in the CCP market model. The securities lending industry needs to be proactive in determining the optimal CCP configuration and working with CCP providers to achieve broad implementation. Agent Lenders need to proactively work with Beneficial Owners to convey the potential benefits of the CCP business model and to determine the most suitable options for Beneficial Owner participation.
9. Trade Associations must take a leadership role in identifying the issues and help take the industry forward. Inevitably some market sectors and some firms within each sector will be more willing and able to take a leading role. Nevertheless, trade associations are invaluable in identifying issues, opportunities and helping shape industry best practice.
10. Regulatory influence with respect to capital, balance sheet usage and liquidity provisioning has historically focused entirely on banking institutions. It is clear that the regulatory net will widen to include other financial institutions possibly including insurance companies and pension funds. This will promote further usage of CCPs for these organisations as well.
Contact Us The CCP White Paper project can be contacted at email@example.com Alternatively, you can reach the authors
Appendix 2: Potential impact on securities lending of Proposed BIS changes to Basel II
Key proposals in 5 areas:
1. The quality, consistency and transparency of the capital base will be raised
2. The risk coverage of the capital framework will be strengthened: