Download Intelligence in Securities Finance: Where Is It Going?

Issue 04 | June 2016
ALSO IN THIS ISSUE
The Future Of Balance Sheet Usage
For European Securities Finance
“To Boldly Go”: Keeping A Close
Eye On Securities Lending For
Asset Holders
secfinmonitor.com
Regime Change! The
Democratization Of The Clearing
Landscape
Intelligence
in Securities
Finance:
Where Is It
Going?
Blockchain
and Credit
Intermediation
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EDITOR’S NOTE
Josh Galper
Editor
[email protected]
Nicole Taylor
Business Development
and Publisher
[email protected]
© Securities Finance
Monitor 2016
C
hange has arrived. It’s no longer a theoretical idea in securities finance
and collateral management, but a practical reality. From repo shortages
and price spikes, to banks needing HQLA to shore up balance sheets, the
collateralized trading markets are seeing the tangible impacts of
regulation.
The next step of market evolution is building up the business models, operations
and technology that turn change from the enemy into an opportunity for growth.
A common theme in this edition of Securities Finance Monitor is that the scope
of change is broad, incisive, and seeping into almost every facet of the financing
and collateral world.
Our feature story covers the exodus of highly skilled personnel in securities
finance from banks and into other parts of the markets. While automation will
ultimately reduce the need for headcount, too much automation is a risk; in case of
a crisis, where will market participants turn for human expertise in fixing broken
systems? That question is not yet answered and may never be, until the crisis hits.
At that point, taking an inventory of where the best problem solvers can be found
in securities finance will be a top priority.
Market participants are experimenting with new approaches for solving new
regulatory problems: from Eurex’s ISA Direct model for the buy-side to Pirum’s
identification of Trade Date Transparency as a source of new income. We find
exchanges, CCPs and vendors actively engaged in bringing their natural advantages
to the market.
Banks meanwhile are seeing today’s changes and considering their own future.
In this issue, Societe Generale reflects on the future of balance sheet for European
securities finance, including new roles for exchange-based financing, netting and
Peer to Peer transactions.
Blockchain remains on our radar, in particular how the emergence of this
technology will change roles across banks, exchanges, Central Counterparties and
Central Securities Depositories. At least, blockchain is an efficiency play that could
also reduce capital costs by speeding up settlement and improving netting; at most,
blockchain could eliminate the need for long-standing vendors and practices in
some segments of the market. The seismic impact of blockchain has not yet been
felt, but this may be the biggest shake-up yet.
We hope this latest issue of the magazine spurs ideas and debate on and insight
into today’s changes, and tomorrow’s responses. We look forward to your feedback.
Josh Galper,
Editor
Issue 04 Securities Finance Monitor 01
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CONTENTS
ISSUE 04| JUNE 2016
Intelligence in
Securities Finance:
Where Is It Going?
A troubling thing is occurring as a result of the restructuring
of the securities finance market. It’s obvious that banks
are shrinking their headcounts, but where does this leave
intelligence in securities finance functions? page 14
MOST READ STORIES
Securities finance in the press
– perspectives from reporters
covering the industry
This year’s Finadium conference featured
a panel discussion about securities finance
and the press. The panel included capital
markets journalists and editors from the
Wall Street Journal, the Financial Times and
Bloomberg.
page 04
US$50 billion for DTCC repo
clearing? With new blockchain
project and more netting, maybe
the figure is US$25 billion
page 06
02 Securities Finance Monitor Issue 04
Bank collateral managers talk
transfer pricing and the central
collateral funding desk
page 06
The new roles of big and small
technology vendors in the
enterprise model of securities
finance
page 10
The German Maple tax probe:
what happened and lessons for the
future
page 12
secfinmonitor.com
FEATURES
The Real Innovation: From Banks
To CCPs To CSDs, Blockchain Will
Change The Business Of Credit
Intermediation
Over the course of nearly a century of
development, our capital markets system has
settled into a well-defined pattern in which
different types of institutions have particular
economic and operational roles to play.
page 18
The Future Of Balance Sheet Usage
For European Securities Finance
The European securities finance market is
changing due to regulations that range from
benign to severe; this is a well-known fact
across the industry. Balance sheet scarcity
is now palpable at both agent lenders and
prime brokers.
page 22
“To Boldly Go”: Keeping A Close Eye
On Securities Lending For Asset
Holders
Financial markets have witnessed the
evolution of new and enhanced regulations.
They have fundamentally changed the
securities lending market from one of a
mix of disparate regulatory frameworks
to central regulation through investor
guidelines, market directives and direct
policy.
page 25
Regime Change! The
Democratization Of The Clearing
Landscape
Agent Lenders And Prime Brokers:
Best Price Or Best Relationship?
In spite of working out some new and
complex dynamics, the relationship between
securities lending agents and the leading
prime brokers remains as tight as ever.
page 34
How Eurex’s New Buy-Side
Membership Model (ISA Direct)
Helps To Address Structural
Problems Resulting From The
Changing Structure Of The
Marketplace
The introduction of buy-side clearing models
means a potentially radical change in the
nature of risk in financial markets, with
improvements for all market participants in
the new regulatory era.
page 39
The SA-CCR For The Leverage
Ratio: Why It Matters And What
Needs To Happen Next
The Basel Committee has formally proposed
the idea that the Standardised Approach for
measuring counterparty credit risk (SA-CCR)
should be used in the Basel III Leverage Ratio
in place of the Current Exposure Method
(CEM).
page 43
INTERVIEW
An SFM
interview
with Bimal
Kadikar, CEO
of Transcend
Street
Solutions
Banks will see their clearing business
become bifurcated by tail risk and credit
intermediation, part of which will stay on
their balance sheet, alongside a service and
infrastructure piece that will be offered by
infrastructure providers.
page 28
Trade Date Transparency = Capital
Savings
Financial markets are paying attention to
capital and balance sheet as a top priority:
this fact is driving trading decisions and
redefining decades-old relationships.
We will see a lot more integration and
automation in the coming years across
securities finance, treasury, OTC derivatives,
and operations areas. Their silo-based
systems will come under a lot of stress.
page 32
page 46
Issue 04 Securities Finance Monitor 03
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Securities finance
in the press –
perspectives
from reporters
covering the
industry
This year’s Finadium conference
featured a panel discussion about
securities finance and the press. The
panel included capital markets
journalists and editors from the Wall
Street Journal, the Financial Times
and Bloomberg. The conference gave
us an opportunity to turn the tables
and ask these premier news
organizations important questions
about their coverage of the industry.
The panel drew many questions and
observations from our attendees, and
received excellent feedback. Our
panelists deserve a great deal of credit
for taking on the subject in front of
an audience that might be considered
challenging, if not on occasion
hostile.
This industry has a long and
sometimes contentious relationship
with the press. Practitioners often feel
that the industry receives little credit
from the mainstream press for its
importance in making the system
work, and receives a disproportionate
amount of blame for the things that go
wrong. Our panelists offered excellent
responses to these observations, which
the industry should consider in its
relations with the press and, by
extension, everyone who is influenced
by the press. These include the public,
regulators, government and political
figures.
The panelists offered several points
of advice:
Connect financing to the average
person. Securities finance activities
and processes are extremely technical
in nature and, as such, are relatively
04 Securities Finance Monitor Issue 04
difficult for outsiders to understand.
We have all experienced this in our
day-to-day lives… most of us, at one
time or another, have tried to explain
what we do and how it works – to
friends, family, regulators, auditors,
our own internal organizations – with
a frustrating lack of success. Our
panelists were pretty clear that, as an
industry, we naturally face an uphill
battle against public perception
because of this. People are just
naturally inclined to distrust that
which they do not understand.
Link financing to numbers. As
panelists noted, securities finance only
tends to come to the attention of the
press and the public when there is
something noteworthy to talk about
that will resonate with news
consumers. Securities finance often
attracts attention because of the big
numbers involved, and usually only
when something goes wrong, or has
the appearance of going wrong. One
way to think of it is: if securities
finance is like a utility serving the
larger financial system, it only attracts
attention when there is a problem.
After all, the press does not cover the
fact that water was successfully
delivered to customers for thousands
of days in a row (this is not news), but
they definitely cover it when a water
main bursts. The industry can help
promote the idea that problems are the
exception, not the rule, with numbers
to back up their case.
Be open. All of the panelists
indicated a desire and an openness to
work with industry professionals and
develop a stronger and deeper
understanding of the nuts and bolts.
Journalists, by job description, always
need information. They need
background, technical, general and
specific, detailed data related to stories
they are working on. Firms and
professionals in the industry would be
well-served to form bonds with the
journalists who best understand the
industry, and – if they have a message,
and a positive story to tell – to
proactively work with these journalists
to get the story out. At the end of the
day, the journalists on our panel
advised conference attendees to tell
their story, to be transparent to the
press and engage cooperatively.
On this basis, we advise Finadium
clients to work with their internal
organizations to develop a press
strategy that stresses proactive
engagement and transparency rather
than just crisis management. Our
press panelists were representative of
the financial press, and firms will find
journalists receptive to a better
understanding of facts that only the
industry really knows.
SOCIETE GENERALE PRIME SERVICES
PROVIDING CROSS ASSE T SOLUTIONS IN E XECUTION, CLE ARING AND
F I N A N C I N G AC RO S S E Q U I T I ES, F I X E D I N C O M E, F O RE I G N E XC H A N G E
A ND COMMODITIES V I A PHYSICA L OR SY N THE TIC INSTRUMEN TS.
CIB.SOCIETEGENERALE.COM/PRIMESERVICES
THIS COMMUNICATION IS FOR PROFESSIONAL CLIENTS ONLY AND IS NOT DIRECTED AT RETAIL CLIENTS.
Societe Generale is a French credit institution (bank) authorised and supervised by the European Central Bank (ECB) and the Autorité de Contrôle Prudentiel et de Résolution (ACPR) (the French Prudential Control
and Resolution Authority) and regulated by the Autorité des marchés financiers (the French financial markets regulator) (AMF). Societe Generale, London Branch is authorised by the ECB, the ACPR and the Prudential
Regulation Authority (PRA) and subject to limited regulation by the Financial Conduct Authority (FCA) and the PRA. Details about the extent of our authorisation, supervision and regulation by the above mentioned
authorities are available from us on request. © Getty Images - FF GROUP
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US$50 billion
for DTCC repo
clearing? With
new blockchain
project and more
netting, maybe
the figure is US$25
billion
We recently spoke with Murray
Pozmanter, Managing Director of
DTCC, about the post-trade
infrastructure’s announcement of a
repo blockchain project with Digital
Asset Holdings. We wanted to know
what it meant for market
participants both financially and
operationally. Here’s what we found.
The big opportunity for DTCC in
moving to a blockchain settlement
system for repo is netting. The more
netting, the greater the ability of
market participants to reduce their
costs. Currently, some 70% of FICC
(fixed income) trades are netted as
compared to 97% of NSCC (equities)
clearing activity. The reason for the
much lower FICC number is the start
leg of the repo. If transactions are
settled outside of DTCC’s batch system
then no netting can occur. The
blockchain project is meant to increase
the percentage of netted trades while
providing immediate transparency to
all market participants.
“Currently, DTCC gets the trade and
nets the off-sides with other activity,
but then the start leg gets settled
bilaterally away from the
clearinghouse. FICC is not part of the
settlement chain,” Pozmanter said.
“The problem statement for the
blockchain project is, how do we settle
the start side of the trade and get it
into the netting process?” It’s worth
noting that the start leg often gets
settled on Fedwire, which means DTCC
06 Securities Finance Monitor Issue 04
is going head-to-head against Fedwire’s
securities settlement services with its
blockchain for repo initiative.
Outside of blockchain, DTCC is
encouraging market participants to
use more regular start dates, forwards
and term trades instead of same day
starts to improve netting. Anything
besides a same day start can be netted,
adding to DTCC’s efficiency.
More netting for FICC’s repo activity
has a direct financial consequence for
market participants. Netting lowers
DTCC’s peak liquidity requirements,
which means that FICC can safely
provision a smaller liquidity facility
and meet its financial requirements
from Dodd-Frank, the Financial
Stability Oversight Council and IOSCO’s
Principles for Financial Market
Infrastructures. In December 2015, the
WSJ reported that DTCC was seeking
US$50 billion in additional capital to
support its repo clearing activity. That’s
at the current level of 70% netted
activity. If netting percentages move up
substantially, then the US$50 billion
figure could be reduced by as much as
half.
Operationally, blockchain solves
netting pain for market participants
but does not add any new processes.
“The first phase will include no
real-time netting but DTCC will soon
move to netting prior to the Fed’s
opening. The distributed ledger will be
available to clearing banks, IDBs and
market participants so all books and
records get updated simultaneously,”
said Pozmanter. Market participants
will still see the same file formats but
will have better views into real-time
position activity, and DTCC will still
use its existing trade capture
application.
How soon will all this happen?
Pozmanter says that DTCC is hoping to
launch a pilot project this summer and
go into production in late 2017. “We will
soon be able to bring up Digital Asset
Holdings’ system in DTCC’s
environment. The next step is to add
business intelligence and smart
contracts.”
Bank collateral
managers talk
transfer pricing
and the central
collateral funding
desk
With collateral being at the heart of
regulatory efforts to reduce
complexity, banks find themselves
needing to change organizational
structures. But how internal desks
will ultimately end up designed is
both a regulatory and business
consideration, said speakers at a
recent meeting in London, who also
shared the trials and successes of
efforts to make collateral
management efficient as an essential
service.
One major bank headquartered in
Europe has decided to take a
centralized approach, with some space
for granularity. The bank’s collateral
manager said the plan is to set up a
central collateral desk across all the
legal entities that will interact with the
Treasury for liquidity. The Treasury
will charge the business units for the
collateral needed for the “buffer
requirement” created by transactions.
Moreover, the central collateral desk
can reconstruct the trade, or do
another lower cost trade. It’s a
mentality that is a big departure from
traditional approaches.
“You can choose whether or not you
want to own the balance sheet usage of
(the trade), or you want to pay away
from that. Because in the old world, if
you told people that they were going to
make 70 basis points and they were
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going to be using a billion worth of
balance sheet, they were going to take
that trade. But in the new world you
would tell them how much they are
actually getting charged (and) they
might say you know what, you take the
whole thing. That means that central
desk will be sitting with all the
requirements and all the needs, and
they are going to be able to match
businesses up that never talked to each
other before because both parties get a
better deal,” he explained.
This approach is not without its
major complications, particularly
when it comes to the issue of: who
pays? “One of the things which is
probably the most difficult bit to get
agreement across, though we
technically have broken down silos,
and put everything into a global
markets division – so there should be
no difference between fixed income
and equities any more – (is) these
issues around business model,” he said.
Transfer pricing, he added, is the
key to making it work. But giving
authority to the Treasury to do it is
viewed as being “problematic”, he
added: “You need somebody who is
neutral, and if you make them a profit
center, they cease to be neutral. So that
part of the discussion with us has been
parked at the moment.” However,
getting buy in while implementing is
made easier when the underlying data
is available, which can pinpoint the
exact location that, for example, LCR
requirements are coming from. “You
08 Securities Finance Monitor Issue 04
are able to show that those are the
right returns rather than getting into
this usual dogfight about no, it’s too
expensive. Well it’s not too expensive if
there’s someone else in the firm that is
providing that price and they are
willing to take that other side,” he said.
One of the mid-sized European
banks, which also has a centralized
desk structure, said that the most
challenging aspect with cost transfer
pricing has been evidencing nonprofitable business models. “Those
discussions get really nasty,” he said.
“To say: well, when I add up all those
factors, I am sorry but the prices you
charge your client and the business
you have, it’s not profitable.”
Part of the solution for the bank has
been to send “lots” of business to CCPs,
though he admits that he has a “split”
mind because of the “tremendous” risk
the infrastructures manage. “Hundreds
of billions of exposures that CCPs have
to manage, but we don’t have 100 CCPs
in Europe, we have just two or three,
and you have to ask the question:
which exposure would you like to
have? Everybody’s one CCP? Or with
500 different kinds of clients with
different types of trading?”
A UK-headquartered bank said that
one solution could be to charge clients
on a fixed fee basis rather than within
a trading model. At the moment,
there’s also a major push to get clients
to move to cash CSAs to reduce the
leverage and net stable funding ratios.
The big question, said a member of the
bank’s capital and collateral
optimization team, is whether the repo
market is going to have the capacity to
transform the collateral.
“You’ve got counterparties that just
hold bonds, and you are telling them
you want them to move to cash-only.
Are they going to liquidate those
bonds? Are they going to leave the repo
market?” she said. “It doesn’t make any
sense that you are asking
counterparties that have bonds to
move to cash but you can’t also give
them the balance sheet in terms of the
repo facility.” She added that there are
ongoing discussions about moving the
repo business outside of the banking
sector in favor of more Peer to Peer
lending.
One bank located in the Nordic and
Baltic areas has not moved towards a
centralized desk model, opting instead
for a “virtual pool” of allowable
collateral assets. The onus will then be
on the collateral optimizer to look
through all the eligibility sets, and
suggest an allocation from the pool of
virtual collateral inventory. The next
step would be to implement the
suggested trades, and the bank is
relying on an automated STP function
yet to be built for efficiency on this
front.
It means that the current
organizational structure can be
maintained, the bank’s chief dealer
said. “We are still going to have an
equity finance desk, fixed income
liquidity desk, fixed income repo desk,
treasury desk…we believe that can still
work provided we have an optimizer
that can do the leg work for us.”
Currently the cost of collateralizing
does not hit the end trader directly, he
added. The bank is keen to change
that, and its partnering vendors will be
able to calculate the cost per
counterparty unit. “That real cost, we
want to give that back to the exposure
generators, and equally, if it’s a profit,
they get the profit.”
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The new roles
of big and small
technology
vendors in the
enterprise model
of securities
finance
As part of Finadium’s recent survey
on securities finance technology, we
devoted a significant portion of the
report to firms’ attitudes towards
vendors. The survey revealed some
important directions for both banks
and brokers and their technology
vendors, particularly as the sell-side
moves increasingly towards the
enterprise model in securities finance
operations and technology.
Our respondents agreed almost
universally that “many vendors
provide solutions to the same
problems.” This sounds like a generally
good state of play for banks and other
technology buyers. There are more
choices available than perhaps ever
before, which should lead to a healthy
competitive environment in which
service quality and service value are
driven upwards.
However, when we took the
question down to a more specific level,
we found much less agreement that
“vendors have solutions to most of my
problems.” Firms were ambivalent and
even slightly negative towards this
statement. This was consistent with
respondents’ contention that there is
no longer a one-size-fits-all set of
problems and solutions.
The upshot is that the devil is very
much in the details when it comes to
selecting securities finance vendor
solutions. While many vendors are
solving the same problems (in very
different ways), the problem set has
grown more complex and diverse over
time. This means there are specific
10 Securities Finance Monitor Issue 04
problems at individual firms where
vendors aren’t meeting firms’
expectations. There is a very real
dilemma out there for banks trying to
select the appropriate vendors for their
particular needs and for vendors
trying to build commercially viable
solutions that can be marketed to
multiple customers.
Vendors prefer
to “build once,
sell many times”,
while banks are
increasingly
looking for very
targeted point
solutions.
There’s also the momentum of
banks moving towards an enterprise
model of operations and technology in
securities finance. This is described in
a number of different ways: The Cloud,
SaaS, ASP, Hosted Services – pick the
buzzword of the week. But the
fundamental characteristic of the
enterprise model is a well-integrated
technical infrastructure that reduces
redundancy, abstracts and centralizes
core functions, and favors smaller
point solutions over large scale
systems.
This leads us to how different
vendors approach customer problem
sets in the marketplace, which can best
be described in terms of their adoption
of the enterprise model themselves.
Most longstanding systems and
vendors – sometimes called legacy
systems – exist towards the traditional
end of the curve. Their systems are big,
hearty, deep, full-featured and are
designed in many respects to operate
very much on their own. They tend to
be controlling primary systems and
upstream of other bank platforms.
These systems tend not to play well
with others and are often difficult to
both implement and to enhance (and
to get rid of).
The other end of the curve are
systems designed to be enterprise
ready. These tend to be smaller, very
specific to a particular problem, and
are quite happy being secondary and
downstream of core systems. These
systems cannot operate independently
and are reliant on other bank systems
to perform functions peripheral to the
problem they are designed to solve.
These systems tend to be more nimble
and often are easier to both implement
and enhance.
Unfortunately, there is no
Goldilocks Zone for the bank
contemplating a technology change, or
trying to select the vendor system best
for them. The technology buyer is
faced with a number of difficult
compromises: They must either
implement a big, full-featured system
that may be quite over-featured (and
over priced) for what they need – and
then invest in adapting other systems
to live with and not compete with the
big system. Or, they must settle for an
under-featured system that solves
important parts of the problem but
needs to be substantially augmented
by yet other systems or through
internal workarounds.
At the Finadium 2016 conference,
our technology vendor panel –
moderated by PWC with
representatives from EquiLend, Murex,
Trading Apps and Transcend Street
Solutions – revealed the very different
approaches to market solutions that
vendors are taking to customer
problems. We find no right answer for
the sell-side in navigating through big
and small vendors in securities finance
technology, but an understanding of
both internal challenges and vendor
positioning is a good place to start.
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The German
Maple tax probe:
what happened
and lessons for
the future
On February 7th 2016, the German
financial authority BaFin ordered
German operations of Maple
Financial frozen. According to
publicly available reports, between
2006 and 2010, Maple is alleged to have
committed a variety of violations
related to dividend stripping trades
that resulted in capital gains tax
underpayments. We provide further
information on what happened and
three implications for securities
finance going forward.
If the allegations hold up, and the
resulting tax payments and penalties
become payable, Maple will face
liabilities in excess of assets; Bafin
therefore judges the bank to be
technically in default. At time of
publication, Maple is only
acknowledging the existence of the
allegations and has expressed its
cooperation with the authorities.
Over and above the merits of the
specific case, there are three points of
wider interest in this case to the
securities finance marketplace:
The first is that this case is the first
significant global exercise and test of
the revised credit and counterparty
standards under the various Basel
agreements. While Maple Financial is
not necessarily a “too big to fail”
institution, it is operating globally in a
wide variety of markets, and has
exposure to firms in nearly every
aspect of securities finance. It is also
large enough that in some cases it may
be the larger of the two counterparties,
which should mean that a true default
would pose a threat to its smaller
counterparties. In this case, evidence of
12 Securities Finance Monitor Issue 04
a ripple effect is scarce: either Maple is
too small to really test the Basel rules
or the rules worked as designed.
Additionally, and closely related, is
whether or not firms were able to
quickly and relatively painlessly work
out collateralized positions with this
counterparty under new collateral
equivalency standards. There appears
to be no talk of losses from
counterparties, which suggests that
collateralization levels were high
enough to buy-in any positions when
necessary.
their authority: the rules are clear that
a sufficient reserve must be taken for
the worst case outcome. But there is no
evidence that Bafin or the tax
authority preferred to find a way to
negotiate a reserve requirement that
would allow the firm to continue to
operate at least long enough to work
out positions with their counterparties.
Other jurisdictions have been more
flexible, and more amenable to finding
a way to allow a firm in otherwise
good standing to avoid immediate
default, in order to avoid creating risks
The second is the preemptive nature
of the action. As noted above, BaFin is
looking at activities from between six
and 10 years ago. This, in itself, is not
particularly unusual – tax
investigations are known to be long
and lingering, often taking many years
to sort out. Arguments may arise that,
during the period in question, Maple
was in compliance with then-existing
rules (the alleged trades were
conducted under a well-known
loophole in the German tax code,
which has subsequently been closed).
What is very unusual is the
aggressiveness of the regulator in
preemptively shuttering the firm. This
may be viewed as either very
conservative – a risk mitigation action,
or a loud demonstration of power
– and a warning to the industry. BaFin
cannot be seen to have overstepped
and ripples throughout the system.
Lastly – derivative of the second
point – is whether or not this is the tip
of the proverbial iceberg. How many
firms may have similar, unannounced
or undetected trades stretching back
over the last decade or more? And, if
they do, will we see more enforcement
actions catching firms that are fully
compliant with today’s capital
standards, and struggling to find
reserves that just don’t exist?
The atmosphere towards securities
finance is highly politicized, especially
in Europe. It is likely that already
suspicious regulators will use the
Maple case as evidence for further
hardline positions whenever a
previous situation warrants
intervention.
THE KNOWLEDGE XXXXXXXXXXX
FEATURE
Intelligence in Securities
Finance: Where Is It Going?
A troubling thing is occurring as a result of the restructuring of the securities
finance market. It’s obvious that banks are shrinking their headcounts, but
where does this leave intelligence in securities finance functions?
BY JOSH GALPER, MANAGING PRINCIPAL, FINADIUM
14 Securities Finance Monitor Issue 04
secfinmonitor.com
B
ank staffing levels
The securities finance function of a future bank will have
fewer people on staff than it
does today. This is the result of
efficiency, technology and the cost of running the business. Financing activity will
remain vital; there will just be fewer people needed overall to take care of managing the process. We have already observed
that when desks merge across securities
lending, repo and OTC derivatives (creating “centers of excellence”), the people most
likely to be marginalized are specialists in
particular trade types. Efficiency breeds
standardization and vice-versa. This is not
necessarily bad but does mean that a certain sophistication or specialization exits
the market in the name of progress.
Industry associations like ISLA and
ICMA have captured some of the talent
while technology firms and consultancies
like Broadridge, FIS, Deloitte and Accenture have hired others. This reflects the fact
that some specializations are being outsourced because they are too expensive to
maintain in-house. Still, there is only so
much demand for product development
staff and relationship managers at technology firms, given that a small number
of specialists can serve dozens of institutional clients. Some securities finance professionals leave the market altogether and
turn to other endeavors, for example real
estate or helping loved ones at their small
businesses. The collective knowledge of
this group is being lost to the industry.
Buy-side growth
As banks lose the bench of people that
used to occupy a range of positions in securities finance, hedge funds and asset managers are picking up an important part of
the slack. We are witnessing today a largescale transmission of intelligence not necessarily away from the sell-side, which will
retain substantial know-how, but definitely towards the buy-side, which is
quickly upping its game in how securities
financing works. As a recent ICMA report
noted, in fixed income “while the sell-side
are downsizing, the buy-side is ‘up-sizing’.
Experienced sales people and traders who
were made redundant are now moving to
the buy-side to bring ‘the knowledge’
directly onto asset management desks.”1
The outcome of this process will be a more
democratic distribution of capabilities
across the buy-side and sell-side, with both
parties having a very good understanding
of mechanics and objectives.
Hedge funds are acquiring this knowledge not just by hiring but also through
higher order conversations they have with
their prime brokerage providers. As prime
brokers need their hedge funds to move
balances or execute certain trades in order
to minimize balance sheet exposure, hedge
funds are gaining deeper knowledge about
what makes them good clients and what
trades are too expensive to maintain from
a financing perspective. This expertise
flows back into portfolio construction.
Hedge funds are understanding that in
order to produce successful returns for
investors, they must now be very intelligent about how balance sheet mechanics
work at their partner banks.
The dispersal of intelligence across the
industry is not limited to hedge funds; traditional asset managers and insurance
companies are picking up smart people as
well. A good example is the traditional
asset manager that hires a derivatives processing specialist away from a top tier
bank. The asset manager has just gained
a level of expertise in derivatives that
would have taken many years to build
organically, if it could be built at all. The
derivatives specialist is happy to have a job
and lend their expertise to the new firm.
They also become a critical point person
for external negotiations in fee arrangements, Straight-through Processing best
practices and term sheet negotiation.
Impacts on technology vendors
and other service providers
As knowledge about securities finance
becomes more dispersed, there are implications for a wide range of other service
providers in the market. The big winners
in this group are technology providers to
hedge funds and other buy-side securities
finance desks. Big collateral management
systems for the buy-side will see users
demanding additional functionality, while
smaller vendors have already seen a pickup in business from a wide range of funds
that are upgrading their capabilities. New
technology requirements extend far
beyond the traditional price comparison
services that have long been popular; buyside firms will need better forecasting tools
and scenario analysis to understand the
financing impact of their current and
future trading positions.
Technology vendors to banks are not
losers in this transition, although they do
need to be smart about their value propositions. The winners in automation and
efficiency are technology firms that can
marry their silo-based systems back to
enterprise-wide technology offerings. Further, our research has found that large,
midsize and small banks do not necessarily view the technology landscape the same
way. Large banks have increasingly specialized needs and while they may think
that vendors can build for them and then
resell to the rest of the industry, this is not
necessarily true. The smaller the bank, the
more they think that institutions’ needs
are different across securities finance technology (see Exhibit 1). Technology vendors
selling to banks may actually have three
distinct audiences: large banks, midsize
banks and small banks. This would not
necessarily mean three entirely different
products but it would mean products with
enough differentiation that each would
need its own code base.
Adding it all up: there are three different levels of bank needs; and two or three
different types of buy-side requirements
across hedge funds, asset managers and
insurance companies. Therefore, technology vendors may be looking at a scenario
where they maintain six different versions
of their products for the industry. Not only
that, but the smaller the institution size a
vendor sells to, the less the vendor will be
able to charge. The new landscape creates
more potential buyers for securities
finance technology and intelligence, but
at a lower price point than the traditional
Issue 04 Securities Finance Monitor 15
THE KNOWLEDGE XXXXXXXXXXX
secfinmonitor.com
FEATURE
Exhibit 1:
Bank executive views on whether most firms have
similar securities finance technology needs
(Average response, scale of 1-5 with 5 as the most
important)
5
4
3
2
1
0
Small
Mid-size
Large
All
Source: Finadium, “Banks on Securities Finance Technology: A Finadium Survey,” March 2016
commercial model.
Unfortunately, we do not see securities
finance professionals gravitating towards
the regulatory side of the business. While
buy-side firms and vendors intelligently
recognize that they can bring on highly
qualified and already trained talent from
banks, regulators appear to draw mostly
from their internal pools. This can be a
frustrating experience for the securities
finance industry, which regularly sees new
regulations released that have damaging
and poorly understood impacts. After-thefact conversations with regulators can mitigate much of this damage, but having a
securities finance person on staff at a regulatory agency could avoid the problem in
the first place. This however is not the trajectory we see in the marketplace today.
Industry implications
A highly efficient, automated marketplace with no operational errors needs
only one sort of specialized expertise to
keep it operating. However, there are no
markets like this – that is a fantasyland for
academics and utopian planners. Every
functioning market experiences breakdowns from time to time. This is when the
expertise of securities finance profession-
16 Securities Finance Monitor Issue 04
als becomes critical. As banks reduce headcount, they will lose the staff that knows
how to anticipate, prevent and fix problems. Some of these people will wind up at
technology firms, consultancies and other
service providers and can help out on occasion, but other tricks of the trade may get
lost.
On the trading desk, the more that technology and automation come into play, the
more that the trading desk’s function will
be to manage the technical process rather
than interact with other humans in order
to optimize a transaction. Traders who
know how to structure a complex transaction may or may not pass that knowledge
on to their younger colleagues. Sudden
headcount reductions make the possibility of lost knowledge ever more likely.
These changes do not make securities
financing at banks worse overall, but they
do mean a greater reliance on standardization than today for getting business
done. Banks and buy-side firms need to
ready themselves for a model of one-sizefits-all in financing, rather than the customization and client service that may
have been the norm three to five years ago.
Smaller big banks (although still pretty big)
and more technology mean that a stand-
ardized model is the easiest to run, and
may be the only game in town if headcount
reductions go too far.
For buy-side firms, an increase in overall intelligence is a net positive. We have
discussed in the past that buy-side firms
need to take more responsibility in being
their own bank. Getting more involved in
securities finance, with intelligence starting at portfolio construction going through
to balance sheet impacts, is a very good
thing.
The future securities finance industry
will have a greater dispersion of intelligence in the market than today. A dropping headcount at banks means more
smart people at other types of firms, or
moving into other, perhaps entirely unrelated, markets. Those who remain will be
well-served to make note of today’s operational fixes, workarounds and less frequently seen trade structures before the
knowledge is lost to them. Nothing is for
free – a loss of sophistication is often the
price of efficiency. Banks need to work
hard to ensure that while much is gained
from the lean and efficient new world
order, the depth of excellence is not lost.
Reference:
1 “Evolutionary Change
The future of electronic
trading in European cash bonds,” ICMA, April
2016, available at http://www.icmagroup.org/
assets/documents/Regulatory/Secondarymarkets/Evolutionary-Change---the-future-ofelectronic-trading-in-european-cash-bondmarkets-20-April-2016.pdf
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THE KNOWLEDGE XXXXXXXXXXX
FEATURE
The Real Innovation: From
Banks To CCPs To CSDs,
Blockchain Will Change
The Business Of Credit
Intermediation
Over the course of nearly a century of development, our capital markets system
has settled into a well-defined pattern in which different types of institutions
have particular economic and operational roles to play.
BY RICK STINCHFIELD, SENIOR CONSULTANT, FINADIUM
A
1950’s era capital markets professional transported forward in time to 2016 would be
dazzled by the sheer scope of
the business. We casually
move trillions of dollars in the blink of an
eye around the globe using technology. Our
time traveler would understand that the
system has evolved through changes in
technology, changes in how the global
economy works and increasing scale, while
recognizing that fundamentally, nothing
about what the markets do had changed
since the 50s. Banks still do banking things,
brokers and agents still do brokerage
things; clearinghouses still do clearing
things and exchanges still do exchange
things.
In other words, all this evolution had
primarily changed “how” things are done
without significantly changing “what” is
actually being done, or “who” is doing it.
Fast forward 10 years from today however, and that might not be true anymore.
Technology, and in particular blockchain,
is changing not just how financial markets work, but what is being done and who
is doing it. The traditional roles of banks,
brokers, Central Counterparties (CCPs) and
18 Securities Finance Monitor Issue 04
Central Securities Depositories (CSDs) are
changing. Some of these players may in
fact become redundant in parts of the system they have comfortably dominated for
centuries.
To understand how these changes will
occur, we first look at who the players are,
what they do, and why they exist in the
first place. We’ll then look at how blockchain technology could disrupt those roles
and what the end state might look like.
This article presumes a basic understanding of blockchain and distributed ledgers
already; for those unfamiliar, a quick
Google search will get you up to speed, or
visit SecuritiesFinanceMonitor.com and
search for blockchain.
Roles in today’s capital markets
There are several major roles in today’s
capital markets environment, each dominating particular aspects of the trade lifecycle as it has developed over the last few
decades or more. In our world today, there
are institutional roles aligned with trading, settlement and – the ultimate driver
of worldwide markets – credit (see Exhibit
1).
Trading is the realm of banks, brokers
and other agents who facilitate market
access to buyers, sellers, borrowers and
lenders. These institutions provide information, advice, investment management,
technology, reporting, regulatory compliance and transaction processing. They enable parties in a capital markets transaction
to make trades, whether utilizing cash on
hand, or through the extension of credit.
Trading occurs on either a formalized and
standardized basis, through exchanges
(regulated private-access clubs) or in OTC
markets.
Trading clients are frequently using
banks and brokers only electronically. That
is, banks are technology, compliance, data
and credit providers, but seldom are they
directly initiating the trade on behalf of
the customer. Either the customer has
their own computerized interface wired
into the trading infrastructure, which then
forwards trades on to the exchange (or the
OTC trader), or the customer is using an
interface provided by the bank or broker
to place their trades.
Settlement is where matters start to get
more complicated for operations; trading
is just talk and a handshake until the assets
actually change hands, when the seller
secfinmonitor.com
Exhibit 1: Three Functional Roles of Capital Markets Institutions CCP – Central
Counter Party CSD – Clearing House
Exchange
Investor
1
1
3
CCP – Central Counter Party
2
3
2
CSD – Clearing House
Investor
Sources: Finadium
needs to deliver the goods and the buyer
needs to pay for them. In the pre-modern
world, banks were always located in close
proximity to exchanges and within walking distance from one another. It was not
simply for the prestige of the address on
the letterhead that firms were located in
these districts, but for the very practical
reason that they needed to be. Once a trade
was agreed and recorded, each bank was
responsible for bilaterally settling the
transaction with their counterparty. A
human being walked from one bank to the
other with a satchel full of stock certificates, and returned to their office with a
certified bank check. Subsequently, they
physically took the check to another bank
to cash it and hoped there were sufficient
funds available. To reduce the complexity
and uncertainty of physical settlement,
banks jointly established Clearing Houses,
what we now call Central Securities
Depositories.
CSDs are a central, shared location for
club members that make settlement more
predictable, more efficient and less risky.
CSDs provide an audited and reconciled
“golden copy” of trade records – checking
to make sure that the parties are in agreement as to terms, and ensuring that there
are no surprises when it comes time to
actually settle the trades. A key feature of
a CSD is that in the aggregate nothing ever
changes: at the end of the settlement day
everything is known to have worked properly if the net result is zero. Each member’s
debit is offset by another member’s credit.
This is one of the proofs that everything
worked properly at the end of the day.
CSDs are meant to be efficient but not
too efficient; there is a time lag built into
settlement to allow for banks to have a
comfortable window of time to figure out
how to raise the cash (or other assets)
needed for trades that are settling two to
three days in the future. The penalty for
this delay is risk… a lot can happen in the
two or three days between trade and settlement, an uncertainty that creates the
need for some way to mitigate and mutualize the risk associated with unsettled
obligations.
Credit intermediation is the business
of ensuring that both sides of a trade have
a credit worthy counterparty. Central
Counterparties (CCPs) are relative latecomers to the capital markets business, but
have become a fan favorite with regulators, governments and the court of public
opinion since the 2008 Global Financial Crisis. Banks may also provide credit intermediation in bilateral markets without
clearing services, although this is increasingly unattractive as regulatory capital
costs increase for these transactions.
In the same way that exchanges guarantee the integrity of the trade, and CSDs
guarantee the integrity of the settlement,
CCPs guarantee the integrity of the credit
extended between trade and settlement.
CCPs are essentially insurance companies:
club members provide capital (insurance
premiums) that the CCP holds in reserve
against the potential credit default (a loss
claim) by one or more members. Each
member is exposed not to the original
buyer or seller in the trade but to the CCP
who stands in the middle.
Our time traveler from the 1950s would
recognize the credit intermediation function of the CCP, though CCPs did not then
Issue 04 Securities Finance Monitor 19
THE KNOWLEDGE XXXXXXXXXXX
FEATURE
Exhibit 2: Future Functional Roles of Capital Markets
Institutions
1
Investor
1
Blockchain Trading &
Investor
Settlement Network
CCP – Central Credit Provider
2
2
Blockchain Credit &
Funding Network
Funding Bank
Funding Bank
Sources: Finadium
officially exist. This is a role that was once
informally occupied by very large banks
and famous bankers like John Pierpont
Morgan, who intervened in markets to
guarantee banking system credit during
the Panic of 1907.
Blockchain’s impact and the
future state
The most significant change promised
by blockchain technology is unification
and integration of several parts of the trade
lifecycle into a single seamless process.
Today, the capital markets business follows
a series of discrete steps – from trade to
settlement to funding – that involve clearly
defined responsibilities. In the future,
those responsibilities will become less distinct, more integrated and will no longer
be quite so step-by-step. They have the
potential to become virtually simultaneous. A blockchain-based capital markets
system would look very different to our
time traveler in 2026.
Trading and settlement partly merge
in a blockchain based system; the roles of
exchanges and CSDs combine and are
20 Securities Finance Monitor Issue 04
replaced by the blockchain network itself.
The technology, including the records it
contains, is the meeting place for buyers
and sellers as well as the secure mechanism for transferring assets for payment.
There is no distinction or time lag between
trade and settlement. A trade, once agreed,
settles immediately without recourse to
any form of intermediation or secondary
mechanical process.
Banks including brokers and agents
will maintain an important role in trading. These institutions will continue to provide regulatory compliance, reporting, data
and information, and trading tools. By
owning this intermediary ground, banks
will continue to feed customer trades to
the blockchain network just as they feed
exchanges and CSDs today. Their electronic
role will continue to grow however, to the
point that they may become exclusively
bystanders and approvers of client activity, primarily revolving around the fact
that they remain the controller of credit
and credit-backed funding to the trading
customer.
Technology owners will play a critical
role in the future blockchain network,
which may be today’s exchange or CSD. The
network owner will provide access and
ensure that the rules governing the trading process are functioning according to
spec. They will provide tools and processes
to add new assets to the network (for
instance, the issuance of additional stock
by a corporation), as well as tools to tidy
things up when things like mergers and
bankruptcies occur.
The role is more of a technical service
provider than an actual participant in the
process. This isn’t much of a stretch from
today, given that virtually all trading and
settlement already occurs on a book entry
basis – just pieces of data moving from one
account to another within the CSD. Moving from the CSD to the blockchain may
be just a change in network manager.
Credit Intermediation is the most
important area for change with blockchain. It is in this realm that the lofty idealism of the blockchain network for trading and settlement starts to settle back
towards the muddy earth, in particular
around the immediacy of previously dis-
secfinmonitor.com
tinct processes.
Instantaneous settlement versus payment, for example, leaves us with a major
problem, which is that the lion’s share of
trading doesn’t actually happen with ready
cash laying around in investors’ bank
accounts. Most trading relies upon the
credit extended by a broker or bank, money
that the bank must subsequently borrow
to fund the settlement of the trade. As
noted, today these institutions generally
have a window of time to find that funding, which they primarily do by borrowing the necessary cash from other banks
versus collateral… all of which happens
long after the trade has happened.
If the trade and settlement have already
happened or are going to happen a split
second from now, then funding must be
had now. If the bank doesn’t have the
required cash at the very moment of the
trade, they must borrow it. If they are going
to borrow it, they must have access to
credit. If another institution is extending
credit, it expects to receive collateral they
can hold against a potential default. Here,
the role of the CCP comes back into play.
But in our blockchain world, the CCP is no
longer the central counterparty between
banks (because the trades settle directly
without intermediation), but the central
credit provider that extends credit, receives
collateral, and guarantees instantaneous
settlement funding when banks and brokers do not have sufficient assets of their
own to fund trades done against investor
credit.
In the final analysis…
This credit function, to our time traveler, will be the final proof that the system
really has fundamentally changed and that
blockchain technology really was revolutionary. Every part of the trade lifecycle
will occur almost simultaneously. Credit
will be extended instantly, instantly
secured by collateral, which will instantly
provide the funding to instantly settle
trades.
Still, there might be some big questions
whether by eliminating the risks created
by inefficiency, we have taken on risks created by too much efficiency. While the
inefficiencies that exist in 2016 (and existed
in 2008) create risks, they also provide a
certain level of predictability and a time
cushion to resolve and react to problems.
Blockchain purists will argue that you can
never have too much efficiency and that it
prevents problems from happening in the
first place; traditionalists will argue that
such an elegant system can just as efficiently drive the system to its knees, not in
days or weeks, but in the blink of an eye.
This, ultimately is the promise and concern of what the blockchain era in capital
markets will be. This is the balance that
will need to be struck by our industry and
institutions within the industry as their
roles are “disrupted” and revolutionized
over the next several years. Will there be
an unintended price to pay for the changed
roles that blockchain will bring to the markets, or will the system have been so technically perfected that problems can no
longer happen? Time will tell.
Issue 04 Securities Finance Monitor 21
THE KNOWLEDGE XXXXXXXXXXX
FEATURE
The Future Of Balance Sheet
Usage For European Securities
Finance
The European securities finance market is changing due to regulations that
range from benign to severe; this is a well-known fact across the industry.
Balance sheet scarcity is now palpable at both agent lenders and prime brokers.
What is less clear is what the future landscape looks like for banks that act as
both borrowers and lenders in securities and cash transactions. In this article,
I present my view of the current landscape for balance sheet and what the next
three years could look like.
BY JAMES TRESELER, GLOBAL HEAD CROSS ASSET SECURED FINANCING, SOCIETE GENERALE
T
he amount of leverage that
banks use has fallen dramatically since 2008. The average
leverage of six major banks
was 31.8X in 2008, and is currently 14.4X (see Exhibit 1). We are unlikely
to see increases any time soon.
The market today
The European securities finance market is nearing the end of a transition from
not needing to be overly concerned with
balance sheet, to balance sheet as a foremost preoccupation. This is a monumental shift in how financing works. The busi-
Exhibit 1:
Bank average financial leverage, 2006-2015
Goldman Sachs
Credit Suisse
Citi
100
80
Morgan Stanley
Deutsche Bank
JP Morgan
60
40
20
0
2006
2007
2008
2009
2010
Sources: financial reports, Morningstar, Finadium analysis
22 Securities Finance Monitor Issue 04
2011
2012
2013
2014
2015
ness has been built on a bank’s central role
in credit intermediation; the strength of
that tenet is being shaken by limitations
on how much balance sheet banks can
expend.
We have seen a collateral squeeze, but
not in fixed income as we might have
expected three years ago. Worries about
HQLA have receded as the collateral transformation trade allowed banks to swap
equities for eligible government bond collateral. This is possible because beneficial
owners have accepted the risk/reward
characteristics of the trade. The squeeze
that is happening now is a shortage of
equity collateral. This is not yet significant
but is building up in a slow wave. For
example, we used to pay to lend equity
(negative repo); now we charge (positive
repo) as this asset class has an intrinsic
value. This is a real change in the market’s
supply and demand behavior.
While balance sheet is the number one
driver of business model change, it is not
the only place to look to see market evolution; new external forces continue to mean
that our businesses will adjust to take
advantage of new conditions. For instance
secfinmonitor.com
tax regulation changes in Germany have
resulted in a substantial decrease in securities lending on German underlyings.
While the US remains the most profitable
securities lending market (followed by
France), new attention will be paid to Italy,
the Nordics, Hong Kong and Japan through
2016 and 2017.
There is also a new peak in corporate
action optionality, where issuers can allow
a choice of cash or stock at a discount as a
dividend payment. The lack of European
regulations harmony on scrip dividend
elections creates room for a securities
finance trade. Stock dividend or scrip
trades provide, through the embedded
option offered, a new opportunity for revenue generation.
Exhibit 2:
Single stock futures volumes (Millions of contracts)
1,100
1,000
900
800
2013
2014
2015
Source: World Federation of Exchanges
The market in three years
The most important feature of tomorrow’s market will be the need for banks to
avoid using balance sheet in transactions.
This prevailing mandate will impact a
wide range of activities not limited to, but
certainly including securities finance.
Trading on exchanges (synthetic financing), netting and direct or Peer to Peer
transactions are all possibilities, with some
more likely than others.
Exchange-based financing
The day is coming soon where we no
longer refer to exchange-based or centrally
cleared financing as synthetic, but instead
just call it regular old financing. Use of an
exchange basically takes advantage of a
wide marketplace of buyers and sellers
who each want something out of the trade.
For investors seeking cash, futures products that mimic a securities finance transaction like Single Stock Futures or the
CME’s Basis Trade Index Close (BTIC) let
cash borrowers commit to a financing rate
for a fixed trade, then unwind at a fixed
point in the future like a margin loan.
Already, global volumes of single stock
futures passed the 1 billion mark in 2015,
according to the World Federation of
Exchanges (see Exhibit 2). Versions of the
BTIC contract are coming to Europe shortly
on other exchanges. On the other side,
securities borrowers can often get the economic exposure they are looking for without a physical loan. This provides flexibility, especially when the balance sheet difference to a bank between a physical stock
borrow and clearing a futures trade could
be a meaningful slice of the investor’s
profit.
Looking out three years, I expect that
centrally cleared repo and securities lending will gain a solid foothold in the market for the same reasons that listed derivatives products make sense: lower balance
sheets. These markets are already working
out their offerings to specifically meet the
needs of banks providing clearing with
Independently Segregated and Legally Segregated Operationally Commingled
accounts that provide balance sheet relief
to brokers, while letting us meet our clients’ needs. It is no surprise that CCPs are
working on cleared securities loans and
repo that include the buy-side. It is in the
best interest of their broker clients to get
this done.
Whether we’re discussing a securities
loan, repo, cleared OTC derivative or a
listed derivative, I expect that the cleared
financing market will be where the main
action is, with prime broker balance sheets
reserved for trades that don’t fit into any
centrally cleared model.
Netting
My view of netting is that you take it
where you can get it, and that means doing
the most business with the biggest players.
Taking this logic to its natural conclusion,
that means doing as much business on
CCPs as possible. While this is not always
possible, the easy analysis is that CCPs
aggregate more business in one nettable
pot than any other market participant. If
all or most banks and investors can be
gathered together, then this will provide
substantial benefits.
Peer to Peer or Agency Prime Brokerage
borrowing and lending
A potential new direction for the market will be asset holders lending securities
and cash to hedge funds and other asset
holders directly without a bank providing
credit intermediation. The argument in
favor of these trades is that bank credit services are expensive and getting more so;
every securities loan or repo financing
trade impacts balance sheet, and banks
only have so much to go around. In a Peer
to Peer transaction, which may still be
indemnified by an agent lender, the credit
exposure is between the lender and the
end-user borrower. This sounds good on
paper.
In practice however I view these trades
Issue 04 Securities Finance Monitor 23
THE KNOWLEDGE XXXXXXXXXXX
FEATURE
as having a limited market. They already
exist – some estimate the market to be as
much as US$200 billion today – but the biggest market participants, their risk committees and their Boards still want banks
in the middle of any trade. Besides credit
intermediation, banks are major matchmakers in the middle of a trade: they
aggregate substantial information in these
bilateral markets much like exchanges in
centrally cleared markets. Taking a bank
out of the process means that borrowers
and lenders would need to work much
harder to find one another.
This is not just a question of convenience, but rather the result of the deep due
diligence that has already occurred
between asset holders and banks. I cannot
envision a large pension plan willing to
conduct due diligence on 50 or 100 hedge
funds. One or two, yes, but not enough to
create a dynamic marketplace with multiple buyers and sellers.
It is possible that a bank/Peer to Peer
hybrid could develop (“Agency Prime Brokerage” is what Finadium called it in a
recent research report), but this would still
take some work. In this model, a bank continues to perform its matchmaking function but steps out of the credit intermediation business. This is a major change and
calls into question the role of the bank; in
truth, any service provider or technology
company could make a market as agent.
The importance of the bank’s role is its
ability to switch between agent and principal as the situation demands. This supports continuity for borrowers and minimizes the disruption of their trades. Technology companies operating with no capital cannot provide the same service.
Acting as agent in prime brokerage, a
bank may perform due diligence to allow
lenders and borrowers onto its network
and would manage operations and valuation, but the credit exposure part of the
trade would reside with lenders and borrowers. Our borrowers would not mind,
so long as they could replace borrows in
case of recalls. Lenders would still need to
get comfortable with the idea though. A
supportive community of agent lenders
could move the needle
forward.
A new fundamental
feature for the securities finance business
The role of securities
finance market participants
in credit intermediation will
redefine what the business
means going forward. This is
both a practical matter and a
big picture consideration of
what it means to be a bank in
the post Basel III (or Basel IV)
era. We can no longer rely on
balance sheets to preserve
our role in the ecosystem, but
rather need to lean more
heavily on the important
relationships and markets
we have built that are less
balance sheet reliant and
more dependent on a deep
understanding of lender and
borrower needs. We will still
24 Securities Finance Monitor Issue 04
use balance sheet, but may see it as a backstop when other means fail, including
exchanges, netting and Peer to Peer or
agency prime brokerage models. This is a
complex time for the securities finance
industry; winners will be the firms that
can take early advantage of changing balance sheet requirements to create new
models.
JAMES TRESELER
Author
Managing
Director and Global
Head of Cross Asset
Secured Funding
Societe Generale
Corporate &
Investment
Banking (SGCIB)
James Treseler has worked with SGCIB
for 16 years in various roles surrounding
the secured finance industry. Based in London, he has held his current role of Managing Director and Global Head of Cross
Asset Secured Funding since 2012, managing teams comprised of traders, flow traders and sales in Hong Kong, Tokyo, Paris,
London, New York and Montreal. Cross
Asset Secured Financing is a specialist
team found within SG CIB’s Capital Markets group which handles a wide range of
financing, market access and investment
optimisation solutions focusing on various asset classes. Prior to joining Societe
Generale, James traded reinvestment products at State Street Bank Corporation.
James earned his undergraduate degree
with majors in Economics and Finance
from Franklin Pierce University and his
Masters Degree in Finance from the Olin
School of Management at Babson
University.
secfinmonitor.com
“To Boldly Go”: Keeping A Close
Eye On Securities Lending For
Asset Holders
Financial markets have witnessed the evolution of new and enhanced
regulations. They have fundamentally changed the securities lending
market from one of a mix of disparate regulatory frameworks to
central regulation through investor guidelines, market directives and
direct policy.
BY ROSS BOWMAN, MARKET AND FINANCING SERVICES, BNP PARIBAS SECURITIES SERVICES
Issue 04 Securities Finance Monitor 25
THE KNOWLEDGE XXXXXXXXXXX
FEATURE
W
ith the express mandate
to create stability across
financial markets, these
new regulations are
also compelling asset
owners to re-evaluate the risk vs. return
dynamic within their securities lending
programs, and how they effectively measure performance success.
Securities lending as a non-correlated alpha generator
Asset owners today are confronted with
insufficient returns across many capital
market activities. For insurance companies specifically, the ratio of return on liability-driven investments to risk has been
too low for too long. This prolonged period
of ultra-low interest rates is now biting
hard and negatively impacting long-term
investors, in particular those whose investments are concentrated in government
bonds. To intensify the situation, insurance companies are subject to portfolio
allocation rules which provide little scope
to look further afield in search for yield.
So while earnings are depressed across
many products and insurers have to consider a narrower range of investment
options, the returns on offer in today’s
markets are no longer sufficient to support the long term investment strategies
that insurers have relied on in the past.
Furthermore, with global interest rates set
to stay low, and in some cases negative, for
the foreseeable future, investors have to
take a fresh look at investment strategies
and where value can be extracted on a risk
adjusted basis.
The current interest rate environment
has a second, counter effect on insurance
company liabilities; as risk-free discount
rates move ever lower, this shift automatically increases liabilities, exacerbating the
asset/liability investment gap.
Insurance companies are not alone in
the search for investment yield. Investors
across all markets not only face the challenge of diminishing returns with low
interest rates, but more critically, protection against the erosion of principal, in a
negative interest rate environment.
26 Securities Finance Monitor Issue 04
Pension fund investors operate with a
similar long-term liability profile to insurance companies. In the private pension sector in particular, an increasing number of
schemes in recent years have reduced the
offering of defined benefit schemes in
favor of defined contribution schemes as
shifting demographic trends have compelled investors to realign attainable
returns with projected liabilities. Similar
changes are also afoot in the UK public sector pension market, where Local Government Pension Schemes are now pooling
investments and aligning strategies in an
effort to reduce operational costs and generate investment economies of scale.
Additionally, central bank and sovereign wealth fund (SWF) investors have also
suffered from a ‘perfect storm’ of low/negative global interest rates, geo-political tensions and risks and slowing global growth
driving a dramatic slump in global commodity prices; an asset class where many
SWF investors have typically grown in size
to the value and position they enjoy today.
To address the mounting pressure on
investment return and principle, asset
owners are driven to take a closer look at
investment portfolios for intrinsic value
and return in areas that may have, up until
now, been underexplored.
Notwithstanding the compelling regulatory and market headwinds investors see
today, opportunities to generate securities
lending revenue remain strong. Many
investors are well placed to benefit from
the variety of different market conditions
and trading strategies available in the securities lending market today. In particular,
opportunities remain strong in the economic divergence taking place across
APAC and Emerging Market economies as
a result of the shift in global growth and
commodity demand dynamics, through
targeted European equity activity focusing
on M&A ‘specials’, equity SCRIP dividends
and the lending of High Quality Liquid
Assets (HQLA) across the fixed income
markets.
A weaker EUR/USD coupled with an
array of ECB asset purchasing programs
have helped stimulate lacklustre Eurozone
economies; the benefits of which will
materialize through an increase in cash
equity market volatility with corresponding borrower demand. Additionally, the
weak Swedish Krona has also helped stimulate economic growth in the Nordic
region, supporting lending fees and
demand across investor lending programs
for 2016.
Does size matter?
In recent years, the overall size of securities lending programs has become less
of a focus for lenders as regulation has curtailed bank and broker-dealer proprietary
trading activity and balance sheet usage,
resulting in the volume of quality securities supply to the market outstripping
demand. Lenders are now looking to identify and take advantage of different revenue opportunities deriving from market
conditions and strategies. Capital markets
and investors today find themselves operating in unchartered waters. This unique
environment has resulted in a fundamental change to the rationale for securities
lending activity. Once considered an activity providing a ‘top-up’ revenue stream for
asset owners in a positive spread and
investment environment, it is now being
viewed by many as a critical consideration
to optimizing the performance of a pool
of long-term investments.
Equity
With a continuing trend towards tax
harmonization across European markets,
institutional investors establishing discretionary securities lending programs are
benefitting from the increased level of control and flexibility they have over their programs, while at the same time tailoring
them to deliver upside revenue potential
from all available trade opportunities.
Demand remains strong to borrow midcap and small-cap equities to ensure transactional settlement of directional short
positions, and high fees continue to reflect
this demand. By remaining in a securities
lending program, asset owners will continue to benefit from the high spread, low
volume activity that generates additional
secfinmonitor.com
income to their funds. Additionally, SCRIP
dividend opportunities continue to flourish as a means of rewarding equity investors, and borrowing fees also reflect this
demand. The shifting global economic
growth patterns seen today will ensure
market activity and demand across specific assets will remain for the foreseeable
future.
Fixed income & HQLA lending
The regulatory demands placed on
banks under Basel III continue to drive
demand to borrower HQLA, such as government bonds and supranational bonds,
with combination demand seen in open
and term loan transactions. Specifically,
the European Central Bank (ECB) Public
Sector Purchasing Programme (PSPP) has
fuelled borrowing demand for European
Government Bonds (EGBs) in the securities lending market and asset owners typically holding HQLA, such as insurance
companies, central banks and sovereign
wealth funds remain well placed to benefit from this demand and well positioned
to consider term lending opportunities of
varying maturity.
Opportunities also continue to prevail
for asset owners of corporate debt, as the
global contraction in commodity and
energy markets continues to produce high
spread specials. Moreover, the ECB’s Corporate Sector Purchase Programme (CSPP),
set to begin in June 2016, is beginning to
fuel an increase in foreign debt issuance
into the European corporate market in
anticipation of the CSPP driving down borrowing costs for corporations able to issue
debt through subsidiaries in euros. These
developments alone are creating significant opportunities for asset owners searching for yield, in such a low interest rate
environment.
As mentioned, strong revenue opportunities persist for investors lending HQLA,
but what is accepted as collateral is fundamental to the success of the transaction.
With the pressure on banks and brokerdealers to manage their balance sheets
over regulatory reporting periods, in line
with prescribed liquidity and funding
ratios, the ability of lenders of HQLA to
accept collateral of a lower credit quality,
is key to these loan opportunities. Such
loan transactions are often referred to as
‘collateral upgrade/downgrade’ transactions and there are several factors that
lenders should consider when reviewing
both open and term lending opportunities
accordingly. Asset owners should expect
their lending agents to develop and operate a well-structured and counterparty
diversified lending program with a laddered investment approach to term opportunities; optimizing the attainable risk
adjusted returns for the asset owner.
finance industry is already witnessing
advances in the application of new routes
to market for asset owners, utilizing central counterparties (CCPs) and synthetic
trading techniques. Banks and financial
institutions are also beginning to explore
the possibilities behind the application of
distributed ledger technologies, such as the
blockchain. Such innovations, if adapted
and implemented for the mutual benefit
of all market participants, will create further opportunities and ultimately investment returns for asset owners.
The future: “Live
long and prosper”
The message is as true today as it was
in the 1960s sci-fi television series, Star
Trek: the key to living long and prosperously in the changing markets depends on
the continuing development of revenue
enhancing investment strategies and technological innovation. This idiom remains
true for the continued success of any
financial product and service.
As interest rates have fallen across
global markets to the levels seen today,
investment practices and approaches to
how we think, provide both challenge and
opportunity for investors. As an industry
that has been subject to a paradigm shift
in oversight and focus through a mix of
regulatory frameworks and best practice
origins, to quite possibly one of the most
heavily regulated investment practices in
today’s markets, the ability to seek opportunity and adapt to changing market conditions are key to the survival and success
of a securities lending program.
Consequently, asset owners across multiple investment categories are still taking
advantage of the investment returns available through a well-designed and managed
securities lending program. Markets, by
their very nature, will always change, and
so will the challenges they present and
opportunities they provide. The securities
ROSS BOWMAN
Author
Ross has worked
in the financial services industry for 26
years, specialising in
the
securities
finance and collateral management
industry since 2001. Ross joined BNP Paribas Securities Services, Market and Financing Services (MFS) division in February
2014, to lead business development strategy for institutional investors across
EMEA.
Issue 04 Securities Finance Monitor 27
THE KNOWLEDGE XXXXXXXXXXX
FEATURE
Regime Change! The
Democratization Of The
Clearing Landscape
Banks will see their clearing business become bifurcated by tail risk and credit
intermediation, part of which will stay on their balance sheet, alongside a
service and infrastructure piece that will be offered by infrastructure providers.
BY MICHAEL CYRUS, HEAD OF COLLATERAL TRADING, DEKABANK
T
he economics of clearing have
changed dramatically over the
course of the last few years.
The old business model operated in an environment where
liquidity, balance sheet and capital played
no or only a minor role; the business model
was characterized by economies of scale
on the broker dealer level. Large brokers
operated global clearing platforms for
smaller financial institutions and larger
corporations, which would in turn do
uncollateralized business with their franchise clients. However, in the new world,
liquidity, balance sheet and capital have
become increasingly limited. Clearing
costs are now a function of these scarce
resources and consequently, the traditionally scalable and global business proposition has been crushed.
The clearing landscape is evolving
towards a new paradigm: from a hierarchical network structure towards a more
democratic clearing landscape. Smaller,
regional and medium sized banks will selfclear, as will parts of the buy-side and
larger corporates. Also, we will be seeing
the establishment of more regional CCPs.
This is a substantial change from the historical business model.
The traditional model and the
28 Securities Finance Monitor Issue 04
hierarchical market structure
The traditional, scalable revenue model
followed a relatively simple formula “⅓ ⅓ - ⅓”:
•
•
•
One-third of the P&L was generated
through execution fees on the back
of the clearing business.
One-third of the P&L resulted from
the liquidity / collateral overhang
when several clients posted collateral
to the broker dealer based on their
respective positions (“gross collateralization”), whereas the broker dealer
just posted collateral for his aggregated client position with the CCP or
exchange (“net collateralization”).
Eventually, one-third of the revenue
stream was generated through
liquidity term transformation: while
the overcollateralization may have
had an ultra-short-term legal maturity, e.g. overnight, you could easily
argue that the overall volume was
stable over time.
Consequently, the Treasury department
would credit you with a 3-, 6- or 9-month
internal ALM credit / Funds transfer price.
Where Treasury refused this, clearing
desks often had a mandate to re-invest
their cash collateral in the money markets,
thereby transforming overnight overcollateralization funds into 3-, 6- or 9-month
assets on their own.
In this traditional setting, counterparty
risk was not considered an issue: The broker dealer was indemnified by way of collateral while at the same time considered
too big to fail from the perspective of the
smaller financial institution using the
clearing service. Moreover, counterparties
could terminate the relationship by
mutual consent, at least in a bilateral trading relationship. A service disruption due
to counterparty default or cessation of the
service was considered unlikely, but even
then, you could easily switch your service
provider or derivatives counterparty. There
was no such thing as a Leverage Ratio (in
particular in Europe) and / or the cost of
balance sheet utilization was negligible.
The capital impact was minimal due to
overcollateralization, frequent margining
and daily pricing.
Given these prerequisites, pricing was
just a mark-up on per-ticket cost. Given
the large infrastructure investments and
a more or less fixed cost base needed to set
up a clearing business, higher volumes
meant lower per ticket costs. The initial
investment could lie between US$10 million for a light weight, single product offering to US$150 million for a “follow the sun”,
secfinmonitor.com
Stage 1
A hierarchical clearing
landscape
Regional
/ Medium
Banks
Broker
Dealer /
Large
Banks
Corp.
Fin.
Inst.
The traditional
model was
hierarchical and
centralized: Broker
dealers and large
banks dominate
access to CCPs.
Smaller clients are
intermediated and
do business with
franchise clients on
an unsecured basis.
Stage 2
A disintermediated clearing
landscape
Broker
Dealer /
Large
Banks
Fin.
Inst.
Corp.
Put Risk / Clearing
broker Risk will
ensure that regional
and medium sized
banks will go selfclearing to avoid
interruption of
clearing services
Corp.
CCP
Regional
/ Medium
Banks
CCP
scalable, multi-product solution. Clearing
desks massively competed for market
share.
In a nutshell, the clearing landscape was
and partly still is:
1.
2.
3.
Hierarchical: CCPs connect to few
large banks or broker dealers, which
will in turn clear business with
smaller financial institutions that do
their business (unsecured) with their
franchise clients on an uncollateralized basis.
Monopolized: Few clearing brokers/
direct clearing members and few
CCPs dominate the market.
Global: CCPs, exchanges and clearers
established and offered multi-currency, global products for global players. Regional players connect to this
global landscape mainly through the
global banks and broker dealers.
Now, regulation is about to attack these
three pillars of the current landscape and
will democratize the market, smash
monopolies and de-globalize parts of the
financial landscape.
First game changer: mandatory
clearing encourages
self-clearing
The rationale for making clearing mandatory seems to be straightforward: enforcing transparency, collateralization, standardization and a level playing field for
derivatives. But the introduction of mandatory clearing also creates a put risk for
the non-clearing member. Take two counterparties agreeing to enter into a 40-year
bilateral swap. Both parties engage in a
principal relationship between each other.
You could stop putting on new business
with your trading counterparty and you
could also agree to unwind this trade
mutually, but you could not just walk away
from this relationship.
In contrast, when a bank uses a Direct
Clearing Member (DCM), the DCM interacts with the Bank only on an agency basis.
The DCM is no longer a principal counterparty to the transaction; he is an agent providing a service. Moreover, the DCM can
terminate this agency service within a rel-
atively short time frame (e.g. 60-day termination period, depending on the documentation) even if the Non-Clearing Member
(NCM) has fulfilled 100% of its obligations
in a timely manner and is not an imminent default candidate. The DCM can prevent the NCM from adding more trades
(even if they are risk reducing) and ask for
higher collateralization for the existing
portfolio. Even worse: if the NCM does not
manage to move / port its portfolio to a different DCM within the 60 days after the
agency agreement is terminated, the DCM
can declare a default and start a close-out
process. Adding insult to injury, a local regulator may subsequently fine the NCM as
he does not comply with mandatory clearing requirements any longer.
In other words: The DCM can exercise
a put option on the NCM at any time and
for no specific reason. This is like writing
a put option on your own business, where
the determination of the exercise price is
left to the option buyer. It exposes NCMs
to discontinuation risk, giving rise to gap
/ tail risk (high impact, low frequency),
which is pretty difficult – if at all possible
Issue 04 Securities Finance Monitor 29
1
THE KNOWLEDGE XXXXXXXXXXX
FEATURE
– to risk manage. “Porting”, the process of
moving the derivatives portfolio to another
DCM, may be difficult depending on the
overall number of DCMs.
Second game changer: increasing regional fragmentation of
the CCP landscape undermines
global business models
Coming out of the crisis, governments
and societies around the world have
understood that a global infrastructure
without regional safety valves could place
regional markets and societies at the
mercy of a global system spinning out of
control. Consequently, regulators have
tried to disentangle global financial markets and place more emphasis on robust
regional risk practices and sound regulations that dovetail with global governance
regimes. To give some examples:
•
During the Eurozone debt crisis some
governments found that their collateral became ineligible on global
CCP’s. Access by regional banks
Stage 3
A democratized clearing
landscape
Reg. /
Small
Banks
CCP
•
became restricted and increased the
liquidity drain from already heavily
constrained regional markets.
Regional banks could probably still
participate as counterparties, but
could not post regional government
debt and / or faced escalating collateral
and
higher
margin
requirements.
Regional retail liquidity before the
crisis was used to support global
liquidity pools. Banks operated these
pools prior to the crisis, moving
liquidity around the globe 24/7 as
part of a global ALM approach that
significantly increased the velocity
of liquidity. Regional regulators
found that this was impossible to risk
manage as globally operating ALM
managers were overwhelmed when
liquidity became an issue on a global
scale. Consequently, regulators are
now increasingly trapping regional
retail liquidity in their respective
local jurisdictions.
FI‘s,
Corp
30 Securities Finance Monitor Issue 04
Within the clearing landscape local regulators want to have “their” markets
cleared in “their” CCPs. They want exposures risk managed in alignment with
local requirements and regulations. Correspondingly, the number of regional CCPs
seems set for an increase: in OTC clearing
we had one CCP during 1999 – 2010, rising
to around 6 during 2010 – 2014 (two in the
US, three in Europe and one in Japan). Now,
we see regional CCPs going live in Spain,
Hong Kong, Singapore, Australia, Chile and
Brazil, among others. As all these regional
CCPs have their own regulatory regimes
and compliance challenges, this makes
global clearing models extremely expensive to operate and to risk control. As such,
any bank will ask itself whether it is really
necessary to offer these kind of services to
its respective franchise.
Third game changer: Escalating
cost pressures will force many
DCMs to exit their clearing
business or only offer it to top
tier clients
Evaporation of
revenues from
overcollateralization and
liquidity transformation,
escalating cost pressures
through capital and
balance sheet utilization
and increasing regional
fragmentation of the
clearing landscape will
lead to less hierarchy
and increasing
democratization as
more and more market
participants opt for
self-clearing in their
respective incumbent
markets.
1
secfinmonitor.com
“The global houses dominating the market place will be
less important. In other words, the end of the hierarchy
means a more democratized and more robust market
infrastructure.”
The economics for banks offering global
clearing business have deteriorated. Netting benefits have been taken largely away
from clearing businesses through increasing account segregation. Also, liquidity
with short legal maturities does not
improve the liquidity position of banks any
longer as ratios like the LCR and NSFR take
a strictly legal view with respect to liquidity in- and outflows. Hence, taking in ultrashort term money for a term transformation (as the economic maturity on a portfolio basis could be considered longer than
the legal tenor of the underlying transactions) does not work as it used to. Still, the
economics from term transformation have
been reduced by flat and / or negative
interest rates. Hence, two pillars of the former business model - netting benefits and
liquidity transformation - have been
smashed.
An even bigger threat to the economics
of clearing for DCMs is represented by
explicit balance sheet and capital requirements when doing cleared or OTC derivatives. Regulators made balance sheet and
capital much scarcer with efforts such as
the Leverage Ratio, Capital Buffers, Fundamental Review of the Trading Book, review
of risk accounting practices, and many
other regulations. Take a DCM operating
a client derivatives exposure of around
EUR 5 billion. The RWA charge takes orientation from the exposure calculation
and hence, RWA would come in at exposure x 8%. To keep calculations simple, let
us assume that the DCM operates with capital costs of approx. 10%. The overall cost
from these simple numbers would easily
add up to EUR 5 billion x 8% x 10% = EUR
40 million (Exposure x RWA x Cost of Capital). The aforementioned investment into
infrastructure would come on top of this
number. Consequently, banks will only
offer client clearing to their top-tier clients
and exit other relationships. DCMs will
probably retain credit intermediation
businesses that justify return on equity but
will certainly exit infrastructure and services business that could be offered by nonbank service providers at lower cost.
Managing the end of the
hierarchy
Mandatory clearing represents a put
risk for the NCM not considered an issue
before. This tail risk can be compared to a
put option sold to a DCM, where the DCM
can also determine the strike price. If the
DCM executes this put option in its own
discretion, the NCM has to port its portfolio to another DCM or become self-cleared;
quite a challenge in stressed markets and
difficult to manage (low frequency / high
impact event). This put risk will encourage self-clearing for smaller and medium
players currently clearing through a DCM
or looking to ensure compliance with mandatory clearing requirements.
We will see a regionalization of the
clearing landscape with more local CCPs.
This will ensure that regional banks connect to regional CCPs directly, as opposed
to the current model where regional banks
connect to global banks or broker
dealers.
We will see DCMs exiting their global
client clearing businesses for cost reasons,
rather than offering traditional risk intermediation products where return on capital can be justified.
All of the above will contribute to less
hierarchies, and a more regional and
diversified clearing landscape. The global
houses dominating the market place will
be less important. In other words, the end
of the hierarchy means a more democratized and more robust market
infrastructure.
MICHAEL CYRUS
Author
Michael Cyrus is
Head of Collateral
Trading at Deka
Bank.
Collateral
Trading at Deka
Bank encompasses
Fixed Income Repo,
Securities Lending, Equity Finance, Structured Collateralised Solutions and FX. Prior
to this current role, he was head of Short
Term Products at Deka.
He joined DekaBank from RBS London,
where he was global Co-Head of Short
Term Markets and Financing responsible
for Repo, collateralised Funding, FX and
Interest Rate Prime and ETD. Before RBS,
Michael was Head of Credit Financing and
Collateral Trading (CFCT) at Dresdner
Bank in London focusing on Emerging
Market Repo, Equity Finance, Tri-Party
Repo and synthetic financing in fixed
income and credit markets. He started his
career at Dresdner Bank in Frankfurt.
Michael has a wealth of experience in the
short term money, repo and securities
lending and financing markets as well as
in treasury operations. He holds a degree
in economics from the University of
Hamburg.
Issue 04 Securities Finance Monitor 31
THE KNOWLEDGE XXXXXXXXXXX
FEATURE
Trade Date Transparency =
Capital Savings
Financial markets are paying attention to capital and balance sheet as a
top priority: this fact is driving trading decisions and redefining decades-old
relationships. Banks and other regulated institutions are looking closely at each
aspect of capital costs and are finding some unusual conclusions, especially in
what used to be the quieter collateral operations corners of their enterprises.
BY RAJEN SHETH, CEO, PIRUM SYSTEMS LTD.
T
he reasons behind this focus
are well known: Basel III and
related domestic regulations
mean that capital charges eat
into the profitability of every
transaction. Taking the Liquidity Coverage
Ratio as one example, an outstanding liability increases the denominator, pushing
bank capital ratios lower. On the other
hand, an outflow of cash, a High Quality
Liquid Asset, will decrease the numerator,
again pushing the LCR ratio lower. Banks
can respond to these pressures by increasing fees – which they do up until competitive or client-driven limitations kick in –
and by managing their businesses for the
greatest capital efficiency.
Trade date transparency is the latest
area where banks can save on their capital costs and, as an added benefit, increase
their internal efficiencies. Trade date
transparency is not an area that gets much
attention; in fact, it is part of the generally
amorphous idea of Big Data and can get
lost in the weeds. When looking at reducing capital costs however, the details matter, and this is where trade date transparency is important.
The mechanics of trade date
transparency
The current process of evaluating trade
date transparency in securities finance
and collateral management is a batch
32 Securities Finance Monitor Issue 04
cycle. Banks see collateral positions a full
24 hours after trades have occurred and
collateral has been moved. This is good and
certainly better than nothing. However,
seeing a position the day after it happens
leaves room for error and increased cost
in both operations and collateral
optimization.
Moving to same day transparency is
another matter altogether. In a same day
or near real-time model, banks see positions before they are charged in an overnight payment cycle. This means that
errors or a revised decision on outstanding collateral can be corrected before payment occurs. The ability to flag these issues
on trade date means that post-trade issues
can be avoided before they even happen.
Taking one example of how this transparency saves actual capital, let’s look at a
scenario of a securities lending transaction against government bond collateral.
When a bank borrows stock, it must post
collateral that comes with a charge; a central Treasury group charges for each Dollar, Euro or Yen outstanding. This might
be a static financing charge or a sliding
liquidity fee based on the collateral. In
either case, bank business units need to
make certain that they are posting the
right amount of collateral in order to not
be overcharged.
While most securities lending positions
are reconciled by the borrower, the lender
and a tri-party agent, what happens when
reconciliations fail? If a borrower has
US$100 million in collateral posted but has
already returned stock, there is a US$100
million position where the central Treasury group is charging the business unit. If
this extends even one day, that can become
a tangible fee. Extending the cost over
month-end amplifies the cost. There are
direct implications not just in the fees
charged to the business unit but also what
else could have been done with that collateral at the bank enterprise level. This is
a loss twice over. There is also an RWA
impact, as the borrower has maintained
an uncollateralized exposure to a counterparty at a 100% risk weight. This factor rolls
up into every capital calculation that utilizes RWA as a building block.
While this example may seem like an
outlier, we find that it happens more often
than people think. The reason is that reconciliations are typically a manual process.
The more manual intervention, the more
missing collateral opportunities can occur.
Even with next day automated reconciliation, an error could be on the books overnight and accrue a capital charge. This is
the same conversation as outstanding fails
in equity or listed derivatives markets: fails
mean that banks need to reserve capital
for expected settlements, and the longer
the settlement time, the more capital needs
to be set aside.
secfinmonitor.com
Figure 1: How Pirum’s Real-Time Services Work
Source: Pirum
The cost of inefficiency
Banks stand to save plenty by making
their collateral settlements as accurate as
possible. According to the leading securities lending data aggregators, there are
now some US$900 billion in non-cash securities lending positions worldwide. Arguably, the majority of these positions are
managed by tri-party agents. Further,
according to a recent study by DTCC-Euroclear GlobalCollateral Ltd, the industrywide collateral settlement fail rate for OTC
derivatives is 3%. Taking a lower figure for
tri-party collateral of 1%, that would suggest that there are US$9 billion in collateral mis-allocated or posted incorrectly on
a daily basis in securities lending.
This US$9 billion figure leads us to an
industry-wide cost of fails. Presuming a 10
basis point internal charge for collateral,
bank business units pay US$9 million a day
for their collateral errors. At 360 billing
days a year, that comes to US$3.24 billion
on an annual basis. This says nothing
about RWA or lost opportunities.
The Pirum Advantage
At Pirum, we are delivering real-time
services to our customers globally with
demonstrated benefits to capital costs. Our
view is that transparency doesn’t point fingers; it just shines light on opportunities
for capital improvement. Our clients
report the following tangible benefits:
•
Increased control
•
•
•
•
•
•
•
Improved transparency
Avoid pre-pays, which mitigates the
impact of RWA
Improved communication of collateral requirements with the funding
desk
Reduction in key staff dependencies
for manual intervention
Increased automation, which means
greater desirability as a financing
counterparty
Reduced volume sensitivity
An auditable activity trail
Trade date transparency is a building
block process: Pirum users start with the
end of day Contract Compare on a batch
cycle. This lets users get their bills in earlier. A move to real-time services means
receiving a file every 10-15 minutes that
shows differences from the previous day’s
position (see Exhibit 1). If contracts are correct on trade date, that impacts billing and
affects the collateral that is being posted:
errors that are caught on trade date stop
at trade date. This is operational efficiency,
with the goal of stopping errors before they
turn into a capital charge downstream.
There is a direct connection between
collateral efficiency and capital savings. By
achieving real-time, trade date transparency in collateral positions, banks can save
real money by reducing capital charges
from central Treasury and by freeing up
collateral for other purposes. In the current era of capital conservation and bal-
ance sheet management, trade date transparency provides an opportunity for business users to generate real savings.
RAJEN SHETH
Author
Rajen
Sheth
joined the two cofounders of Pirum
in 2003 in order to
develop the company’s products, services and client base
serving the securities finance post-trade
world. In October 2014 he was appointed
CEO. Rajen started his career in financial
technology as a software programmer followed by a variety of IT management roles
including Head of Prime Broker IT at
Lehman Brothers and Head of Post-trade
Cash Equity IT at UBS.
Issue 04 Securities Finance Monitor 33
THE KNOWLEDGE XXXXXXXXXXX
secfinmonitor.com
FEATURE
Agent Lenders And Prime
Brokers: Best Price Or Best
Relationship?
In spite of working out some new and complex dynamics, the relationship
between securities lending agents and the leading prime brokers remains as
tight as ever. Agent lenders and prime brokers are cooperative partners in a
market environment that remains challenging, especially as regulatory capital
costs become more integrated in the pricing of agency lending services and bank
borrowing decisions.
BY JOSH GALPER, MANAGING PRINCIPAL, FINADIUM
34 Securities Finance Monitor Issue 04
FINADIUM
EXECUTIVE TRAINING
WE TRAIN
Broker-dealers, beneficial owners, asset
managers, agent lenders, custodians, insurance
companies, corporations, accountancies,
regulators and financial industry technology
providers.
Our course specialties include securities
finance, repo, collateral management, prime
brokerage, custody, regulation, technology and
investments.
YOU GAIN
Providing industry training to your team can
help you differentiate your business from
the competition, achieve and sustain high
performance and empower your people to
develop their full potential.
CONTACT US:
www.finadium.com/training
THE KNOWLEDGE XXXXXXXXXXX
secfinmonitor.com
FEATURE
A
long the way however, a new
twist has emerged in how
agent lenders decide on counterparties for lending decisions. It used to be that agents
and prime brokers could agree on terms,
for example a quantity of General Collateral (GC) loans in exchange for specials, or
access to valuable loans in exchange for
collateral transformation trades or cash
invested in repo. This was considered the
basis of a two-way relationship that benefitted both parties. The new dynamic is
based on price, with the overall relationship still important but not always as
important as the fee that a borrower is
willing to pay. This change has important
implications for the future of the securities lending market.
Exhibit 1:
Assets on loan at agent lenders, 2011 and 2016
(Percent)
The best price argument
While it is easy to say that the borrower
offering the best price is always the best
36 Securities Finance Monitor Issue 04
2016
60
40
20
0
Top Four
Other Agent Lenders
Beneficial Owners with Lending
Desks
Sources: financial
Agency lending trends
Finadium recently conducted a survey
of nine global agent lenders. As part of this
project, we collected data on outstanding
loans. We found that while the top four
agent lenders are still responsible for half
of all lending today, their concentration of
business has fallen since 2011 as GC balances have decreased (see Exhibit 1). An
increasing focus on the specials market
means that in terms of the percentage of
loans outstanding, other agent lenders
have increased their market share. Beneficial owners with their own lending desks
still lend about the same amount as they
did previously but their market share has
slightly increased relative to the drop in
GC.
Agents report that their top three borrowers take up an average 44% of all loans,
with the range running from 20% to 60%
(see Exhibit 2). The top 10 borrowers take
up an average 81% of loans with much less
variation across agents: the figures range
from 60% to 85%. If there was ever any
question about how much agent lenders
and the largest prime broker borrowers
still need each other, that can be put to rest.
2011
80
Exhibit 2:
Borrower concentrations at agent lenders
(Percent)
100
80
60
40
20
0
Top 3
Top 10
Sources: financial
borrower, the market does not uniformly
see it that way. Agent lenders have multiple criteria for what makes a good borrower, and while best price is at the top of
the list, so are operational efficiency and
steady balances over time (see Exhibit 3).
In fact, only half the agents we spoke with
cited best price as a top priority for determining a good borrower. Agents want borrowers who are easy to work with, have
invested in their technology systems, and
can support the objectives of both agents
and their beneficial owner clients. This
combination of borrower traits is what creates loyalty and support from the agent
lender community.
The MiFID II factor
For some agents, particularly those in
Europe, best price on individual trades is
increasingly the priority over other factors.
The driver for this is MiFID II and beneficial owner tools that offer transparency on
a daily basis. MiFID II requires asset hold-
THE KNOWLEDGE XXXXXXXXXXX
FEATURE
Exhibit 3:
Agent lender opinions on what makes a good
borrower (Count of responses)
6
5
4
3
2
1
0
Best price
Ops
efficiency
Steady
balances
Breadth of
demand
Collateral
flexibility
Other
Meet agent
business lender client
with the firm
needs
Open
dialogue
Sources: financial
Note: Agent lenders may have selected more than one response
ers to show that they received the best price
in the market, and while securities lending is not specifically part of MiFID II, it is
assumed to be included until otherwise
specified. This means that agent lenders
can be evaluated with a similar level of
scrutiny as equity or options brokers. It is
a high bar to cross for agent lenders, especially when the best revenue opportunity
can mean a long-term loan at a rate that
is lower than what might be on the screen
on any given day. By trading at anything
other than the best price, agents need to
justify their actions, and this may be operationally cumbersome.
The MiFID II factor works in the reverse
as well. We recently saw a tax trade where
the loan was concentrated into three days
across the dividend date. The rate was
exceptionally high, which meant that the
agent lender handily outperformed the
market. We saw the same trade occurring
across several weeks as well, with agents
earning their clients a solid return but not
outperforming on best price for the specific dividend days. This is a situation
where the relationship won out, and where
best price for two or three days may have
yielded better, worse or the same as a trade
over a longer period. Under MiFID II, agent
lenders must determine what is best for
beneficial owners overall.
38 Securities Finance Monitor Issue 04
The relationship argument
We also heard from agent lenders that
relationship was still very important, as
reflected in borrowers who could keep balances on over time and be relied on for
certain geographies or asset classes. It is
fair to say that this aspect of the business
remains very important for agent lenders
and influences their decisions on allocating hard to borrow securities to prime broker borrowers. There is also a new element
of collaboration in the market, and agents
report that borrowers who can openly discuss their challenges are most likely to be
better lending partners all around. There
is a rationale to the claim that relationship
elements of the lending business have
declined, but it isn’t really the case. There
is still a good amount of subjective decision-making in choosing lending
counterparties.
How does best price vs. best
relationship get decided going
forward?
The big theme going forward will be
how balance sheet benefits are split
between prime broker borrowers and
agent lenders; this is where agent lenders
will decide whether best price or best relationship matters most. While collaboration across the industry is at a high mark,
agents note that dealers are not ready to
offer meaningful price improvement for
loans that offer balance sheet benefits.
These include loans with preferred collateral types, Basel-friendly term trades or
CCP usage. Until or unless dealers are willing to offer agents a share of these benefits, agents and beneficial owners have no
carrot incentive to change their policies.
The other alternative is the stick: either do
the trade at the dealer’s price or do no business at all. This is a tough call.
The securities lending market between
agent lenders and prime broker borrowers continues to function very well: operational efficiency is high and getting better; new technologies are expected to drive
further benefits; and there is comfort
between both sides of the trade to work
together when problems arise. The longstanding dynamic of tension in pricing
and balances is not yet close to the breaking point, say agents, but this is where they
look first when concerned about what the
market may hold. As regulatory change
becomes more ingrained at banks, 2016 and
2017 are expected to push this tension to
new and difficult places. Agent lenders do
not expect their prime broker borrowers
to show up with higher prices overnight,
but rather hope that evolving market
dynamics help all parties maintain stable,
reliable franchises, which include borrowing fees that keep beneficial owner clients
actively engaged in the business.
secfinmonitor.com
How Eurex’s New Buy-Side
Membership Model (ISA Direct)
Helps To Address Structural
Problems Resulting From The
Changing Structure Of The
Marketplace
The introduction of buy-side clearing models means a potentially radical change
in the nature of risk in financial markets, with improvements for all market
participants in the new regulatory era.
BY PHILIP SIMONS, GLOBAL HEAD OF FIXED INCOME AND FX DERIVATIVES SALES, EUREX
Issue 04 Securities Finance Monitor 39
THE KNOWLEDGE XXXXXXXXXXX
FEATURE
M
arket structure results
from a wide range of
inputs, from the preferences of individual firms
to the rules that govern
each trading venue. At no time in the past
however has regulation driven market
structure like today: bank risk has been
substantially reduced, but at a price. Banks
are now more reluctant than in the past
to provide services for their buy-side clients that involve renting out their balance
sheets, or they are providing services but
at much higher fees to cover capital costs.
In financial markets, this means that
liquidity has decreased while volatility has
increased. As banks work to meet the next
round of Basel III and domestic rules,
including the introduction of the Net Stable Funding Ratio (NSFR), these regulations
will further tighten trading and clearing
conditions.
Eurex’s ISA Direct model introduces a
new way of doing business that will help
reduce bankISA
balance
sheet pressures. Our
Direct model
offering is based on Individual Segregated
Accounts (ISA) that fully mitigate the risk
of default for clearing members. In our
model, the buy-side creates a direct contractual relationship with Eurex Clearing
as the central counterparty (CCP) (see
Exhibit 1). Eurex Clearing members act as
the clearing agent, providing mandatory
and voluntary services, retaining their client relationships and ability to earn revenues, but are no longer exposed to the
counterparty risk of their buy-side client
as they are not guaranteeing their performance. Eurex Clearing takes on the role of
principal in facing off against the buy-side,
which means that the capital and balance
sheet impact is greatly reduced in terms
of RWA and Leverage Ratio for the bank
acting as clearing agent. This is an important new model for reducing capital costs
across a wide variety of tradable instruments including futures, cleared OTC
derivatives, repo and securities lending.
ISA Direct is a new way for clients, clearing firms and Eurex Clearing as CCP to
interact that could become a major game
changer in financial markets. The impacts
Overview of ISA Direct model
are far and wide, and affect not just cleared
products but the bilateral market as well.
The change affects more than clearing and
settlement operations; the implications
reach deep into trading, investment strategy, collateral transformation and market
structure across the financial services
industry. We have already identified three
areas where ISA Direct is likely to change
market structure: swaps pricing, collateral
management and cross-product trading.
Interest Rate Swaps pricing goes
positive
The swaps pricing market is currently
in some disarray - negative swaps spreads,
CCP basis and higher capital costs all hurt
liquidity and the ability of end users to
hedge at attractive levels. There are also
issues associated with negative rates as
well as the difference between EONIA and
the true funding cost, both of which are
impacting valuations of OTC IRS.
In the US dollar market, Interest Rate
Swaps are currently
yielding
negative
April
2016
returns to US Treasuries reflecting the fact
Exhibit
1: contractual relationship between ISA Direct client and CCP with Clearing Agent
Direct
Overview
of ISA
Direct
model
providing
certain
service
functions on behalf of the ISA Direct client
ISA Direct client
Direct contractual relationship
CCP
Initial focus on
•
Insurance and
financial
services
companies
•
Pension funds
•
Asset managers
Clearing Agent
Provision of operational
services by Clearing Agent
to ISA Direct client
Transaction
Management
New client model with a new
principal client relationship
between buy-side clients and
the CCP
Cash
Management
•
Default fund contribution
•
Default management
obligation
Collateral
Management
Existing Clearing Member acts
as Clearing Agent
ISA Direct clients have to meet
admission criteria equivalent to
regular Clearing Members with
extended servicing functions by
the Clearing Agent
Source: Eurex Clearing
www.eurexclearing.com
40 Securities Finance Monitor Issue 04
4
secfinmonitor.com
that regulatory changes have altered the
fundamentals of swap pricing. Central
clearing has transformed the nature of
counterparty credit risk by ensuring that
OTC IRS trades continue even if a bank
defaults. The removal of credit risk means
that the spread between swaps and treasuries is now a reflection of the difference
in capital costs plus supply and demand.
This has led to many asset managers
and hedge funds withdrawing from one
of their traditional investment strategies
and hedges against stressed market tail
risk, the spread widening trade: buy treasuries, pay fixed swap.
What has made this even less attractive
is the negative carry resulting from repos
trading higher than LIBOR, which is not
how markets are supposed to trade.
Secured debt, like a mortgage, is supposed
to be less expensive than unsecured debt
like credit cards. However, the reliance on
bank balance sheets and the real-world
impact of regulatory costs has made
secured repo more expensive than unsecured LIBOR, which in many cases is based
on a hypothetical rate and not observed
transactions. This has severely reduced the
bilateral activity in these types of trades,
which in turn prevents traders from arbitraging out inefficiencies in bond market
pricing.
What if instead of bilateral repo as the
hedge, a centrally cleared repo or equivalent risk-based transaction could occur
that did not take up bank balance sheet?
In this case the extra capital cost of the repo
would be reduced and allow repo to be
below LIBOR, where it belongs (see Exhibit
2). Since repo is currently more expensive
than LIBOR because of the added balance
sheet cost, removing this encumbrance
should solve the pricing problem.
In the ISA Direct model, buy-side firms
and the CCP are principals to the trade
with the bank playing a service provider
role. While there are still some costs to the
bank in trading derivatives and repo
through an exchange/CCP, these costs are
much lower than in the bilateral market.
It stands to reason then that derivatives
and repo with ISA Direct should allow
Interest Rate Swaps and repos to be profitable again.
ISA Direct should not only help reduce
the amount of balance sheet required, it
should also improve pricing due to lower
capital costs.
Reduced collateral requirements
Arguably, lower balance sheet costs for
banks mean less friction in the markets
and more transactional volume. When
looking at futures, OTC derivatives, repo
and securities lending as one basket of collateralized trading opportunities, the ISA
Direct model shows immediate benefits
when clearing firms can help clients minimize collateral exposure on the CCP. This
is the basic idea of a CCP that clears across
multiple products.
As more derivatives trading activity
occurs, both buyers and sellers have higher
collateral demands. Repo and securities
lending on the other hand deliver collateral supply to the market. Being able to
generate cash from securities to cover variation margin or being able to invest cash
Derivatives: Capital costs for providing (client) clearing services can
beExhibit
substantially
reduced via direct clearing models
2:
Derivatives
andannual
corresponding
Derivatives
clearingclearing
models andmodels
corresponding
capital costs forannual
a clearingcapital
agent
clearing
agent
Example
based on
~5 year duration, directional EUR IRS swap portfolio
costs for a
Capital cost of clearing agent (bps of IM)
Client clearing
Exposure
Client
IM
Leverage
ratio
Exposure
Clearing
agent
DF
~25-701
CCP
IM
RWA
~14
~80%+
Direct clearing
Exposure
Client
CCP
IM
Trading activity
Clearing
agent
DF
Leverage
ratio
~3
RWA
~3
~85%-95%+
Capital costs for providing default fund
and possible margin financing
Source: Eurex Clearing
Note: example based on ~5-year duration, directional EUR IRS swap portfolio
1. Depends on final Leverage Ratio rule (use of SA-CCR with collateral offset leads to reduced costs of ~25 bps vs. ~70 bps
1. Depends on final leverage ratio rule (use of SA-CCR with collateral offset leads to reduced costs of ~25 bps vs. ~70 bps based on current proposal with CEM
based on current proposal with CEM
www.eurexclearing.com
1
Issue 04 Securities Finance Monitor 41
THE KNOWLEDGE XXXXXXXXXXX
FEATURE
secured against securities that can be
reused to cover initial margin help to make
the market more efficient. This is one of
the most significant practical challenges
that many buy-side firms face with the
introduction of mandatory clearing and
collateralization of non-cleared derivatives. For banks, the ability to net these
transactions through a single counterparty
- the CCP, with matching currency, security and settlement system - allows them
to benefit from lower collateral requirements and lower capital exposures.
Cross-product trading
Each financial product has its own role
to play in the markets. Futures are best for
highly standardized products while OTC
derivatives fare best for more client-specific trading and hedging opportunities.
Repo meets the needs of both cash borrowers and collateral borrowers, while securities loans deliver high quality collateral
and enable short selling opportunities.
There is no reason to think that one product should win out over another, but rather
they are all part of a working whole. The
responsibility of banks and investors is
finding the right model and the right trading instrument to meet an investment
strategy.
ISA Direct helps by maintaining and
widening access to a variety of traded products, each of which has a valuable and
legitimate role for investor strategies.
Some bilateral products may be difficult
for bank balance sheets, but by reducing
capital constraints on a CCP, a clearer picture of the costs and benefits emerge. Swap
futures won’t replace OTC derivatives but
they do have a role to play in helping banks
hedge gap risk, and as a warehouse for
investors switching positions. Basis trades
on bond futures help maintain efficient
markets. Banks looking to finance illiquid
assets already know that these products
do not clear well, but a range of products
on a CCP can help bridge the gap between
traditional listed products and the OTC
derivatives world, and between on
exchange and off exchange. ISA Direct not
only takes this existing role of the CCP and
42 Securities Finance Monitor Issue 04
makes it less expensive for banks and their
clearing clients, it also enables a wider
variety of clients to trade with each other
across all product lines because they can
use a single membership with a single
operational, legal and risk framework.
ISA Direct builds healthy
markets
ISA Direct is really about building
healthy, robust markets that work in a new
market structure defined by regulation.
Healthy markets are not just talk; they are
critical for the functioning of governments
and private companies. In Europe, we have
23 bond markets that operate as part of the
European Union, reliant on each domestic market functioning as best it can. When
one part of these markets does not work,
that creates a potential lack of liquidity
that can threaten the underlying health of
the whole.
In European bond markets specifically,
each individual domestic market needs a
mix of cash, repo, futures and OTC derivatives, as well as domestic collateral to cover
initial margin. There also needs to be
access for domestic and international market participants across these products.
Eurex Clearing works with domestic Central Banks, government agencies and local
market participants to build up each individual market structure; strong domestic
markets are the building blocks for a
strong European market.
By keeping the functional role of a bank
intact while reducing balance sheet costs,
ISA Direct supports the growth of a new
way to look at market structure. Balance
sheet costs have already changed important dynamics in pricing, trading and
liquidity for both bilateral and exchangetraded products. Arguably, this has not
been beneficial for issuers, investors or
banks themselves and has been in part
responsible for reducing liquidity in the
markets as banks have withdrawn from
market making and reduced their balance
sheets. Given the high costs of client clearing, coupled with the withdrawal of a
number of firms, we have also seen an
increase in concentration risk to the larg-
est banks - with 70% of client money in the
US held by the top five FCMs. ISA Direct
helps to solve the problems of liquidity and
concentration risk by bringing more trading counterparties directly together at a
reasonable price in a way that utilizes less
capital and balance sheet.
A healthy market needs a balance of
buyers, sellers and liquidity providers. By
supporting this fundamental restructuring in the market, where cost and pricing
reflects capital costs and counterparty
exposure, ISA Direct is working to build a
successful future market structure.
PHILIP SIMONS
Author
Philip Simons has 30 years of experience
in the financial industry where he started
life as a swaps trader before moving to the
clearing world, initially heading up the
clearing business at UBS followed by Cargill. Philip later moved into the custody
and collateral management space at
J.P.Morgan before joining Deutsche Börse
Group. Philip initially joined as head of the
Clearing Sales and Relationship Management Section and is now Global Head of
Fixed Income Trading & Clearing Sales for
Eurex covering both the Exchange and the
Clearing House. Philip is responsible for
building strong relationships with clients,
attracting new trading and clearing members and promoting new products and
services.
secfinmonitor.com
The SA-CCR For The Leverage
Ratio: Why It Matters And What
Needs To Happen Next
The Basel Committee has formally proposed the idea that the Standardised
Approach for measuring counterparty credit risk (SA-CCR) should be used in
the Basel III Leverage Ratio in place of the Current Exposure Method (CEM).
This is not necessarily a good thing, although it does resolve criticisms of the
CEM’s limitations in recognizing margined vs. un-margined transactions, as
well as bilateral vs. CCP cleared. While this sort of detail gets into the weeds of
regulation and models for risk-weighted assets (RWA), it is also a change that
can make or break a bank’s capital adequacy as the numbers get close to the
limit.
BY JOSH GALPER, MANAGING PRINCIPAL, FINADIUM
Issue 04 Securities Finance Monitor 43
THE KNOWLEDGE XXXXXXXXXXX
FEATURE
T
his article explains the SA-CCR,
its modifications for the Leverage Ratio, and the next steps
that the Basel Committee
should take to clean up a few
outstanding issues.
What is the SA-CCR?
The SA-CCR is a model for banks to
measure their exposure to OTC derivatives.
The SA-CCR will replace both the CEM and
the Standardized Method effective January 1, 2017 as a means of measuring Exposure at Default (EAD). We have found in
our consulting work that the SA-CCR yields
a better cost treatment for banks than the
two previous regulatory methods. Banks
using an Internal Market Model however
are certain to dislike the SA-CCR. There will
likely be differences in international regulators’ interpretation of the SA-CCR, but
such differences are limited for now.
The formula for identifying EAD was
published by the Basel Committee in “The
standardised approach for measuring
counterparty credit risk exposures,” Basel
Committee on Banking Supervision in
March 2014 (revised April 2014).1. It is a mix
of market and regulatory inputs as defined
by regulators. The formula is:
EAD=a*(replacement cost
(RC)+potential future exposure (PFE))
Banks then take their EAD calculation
and multiply by a risk weight that is determined by a schedule set by regulators. This
produces a value for RWA. Sovereign governments have a 0% credit risk, meaning
that RWA would be zero, while hedge
funds could have a 100% risk weight.
The SA-CCR allows netting but only
within hedging (netting) sets: interest rate
derivatives in a single currency; FX derivatives for each currency pair; credit derivatives; equity derivatives; and commodity
derivatives for energy, metals, and agricultural and other commodities. A great benefit to banks with exposure to both long
and short side transactions is the possibility to net off exposures. Although the CEM
also allowed netting, the Basel Committee
44 Securities Finance Monitor Issue 04
has responded to arguments that CEM netting was too simplistic, albeit easier to
understand than the SA-CCR.
A Modified SA-CCR for the
Leverage Ratio
In their consultative document, “Revisions to the Basel III Leverage Ratio Framework,” published in April 2016, the Basel
Committee stated their preference for a
modified SA-CCR in place of the CEM for
banks to measure their exposure to OTC
derivatives for the Leverage Ratio measure.2 The Leverage Ratio considers all onand off-balance sheet liabilities; when the
rules are finalized, the SA-CCR will become
the model that banks use to measure their
OTC derivatives liabilities.
The use of the SA-CCR in the Leverage
Ratio will produce mixed results for banks
in freeing up balance sheet; this is not as
good as the SA-CCR in modeling OTC derivatives exposure for other risk purposes
compared to the CEM. The problem is that
the Leverage Ratio disallows the use of collateral when considering liability
exposure.
The Leverage Ratio is meant to be a nonrisk based measure of risk, unconnected
to liquidity metrics or other variables. A
fundamental premise of this metric is that
“banks must not take account of physical
or financial collateral, guarantees or other
credit risk mitigation techniques to reduce
the [Leverage Ratio] exposure measure.”3
The requirement to disregard collateral is
in conflict with other regulations surrounding collateralized transactions,
including the IOSCO/Basel rules on noncleared margin and measuring counterparty credit risk. This is a deliberate decision by the Basel Committee, and collateral is also not considered in the Current
Exposure Method calculations of OTC
derivatives for the Leverage Ratio.
According to the BCBS, the modified SACCR will “restrict the recognition of collateral by allowing only eligible cash variation margin (CVM) exchanged under the
specified conditions set out in paragraph
25 of the Basel III Leverage Ratio Framework,” and will set the potential future
exposure (PFE) to 1 in order to explicitly
not recognize the value of collateral.4 However, margining gets some recognition in
the SA-CCR’s margining period of risk
(MPOR).
Including or disallowing collateral is
critical to understanding the impact of this
modified SA-CCR on the Basel III Leverage
Ratio. A recent analysis by Yvan Robert and
Matthieu Maurice of Accenture found that
the SA-CCR’s capital charge would beat the
CEM and a bank’s Internal Market Model
for a longer dated maturity only when collateral was considered.5 The Accenture
study, like others including our own, is
stylized and relies on a hypothetical exposure, typically not netted. The importance
of this work is to show the impact that collateralization has on the outcomes of various models.
Considering the bigger impact
of the SA-CCR in the Leverage
Ratio
While banks may or may not benefit
from the use of the SA-CCR in their Leverage Ratio calculations, and some may fare
worse if they have few netting opportunities, moving to the SA-CCR introduces
some new ideas and opportunities to
financial risk modeling. The big idea of the
SA-CCR, and the trend of the Basel Committee over the last year, is greater standardization across all financial models. The
Basel Committee is reducing bank reliance
on internal models where possible. We see
this in the mandate for the SA-CCR, as well
as streamlined decision making for the
Expected Shortfall Method alongside VaR
for measuring market risk exposure. Placing the SA-CCR in the Leverage Ratio is
another way to get banks worldwide to use
the same model, which helps create an
apples-to-apples approach to understanding bank risk. The Basel Committee is continually undermined in this desire by
national regulators and their carve-outs
for domestic needs, but the general goal is
one model type for each application in the
banking industry.
secfinmonitor.com
What’s Next:
an SA-CCR for
securities
finance
When it comes to adjusting rules for
Securities Finance Transactions (SFTs,
including securities lending and repo),
there’s a gap in the Basel Committee’s analysis. Our analysis of the regulatory costs
of the SA-CCR for OTC derivatives vs. securities loans for the same economic outcome finds that OTC derivatives are the
winner by far; there is a 232X benefit to a
bank for conducting a cleared OTC derivative transaction instead of a bilateral
securities loan under the US Supplementary Leverage Ratio (see Exhibit 1).
This situation could lead to every bank
seeking OTC derivatives transactions
where appropriate in favor of physical
financing, which in the end results in poor
liquidity for physical markets and
improved liquidity for derivatives markets.
This is exactly the opposite of what regulators should want to happen. In a November 2015 Finadium research report, “Securities Lending, Market Liquidity and
Retirement Savings: The Real World
Impact,” we found that a reduction in securities lending and hence short selling volumes would cost investors US$61 billion in
excess transaction costs annually across
seven major equities markets.6 The outcomes are identifiable from the current
state of affairs.
A logical solution to this problem is to
create a SA-CCR for Securities Finance
Transactions that encapsulates credit risk
exposure and can be netted down, with a
result that is equivalent to the cost of OTC
derivatives.
Already regulators have heard concerns
from securities finance market participants, resulting in revisions to the standardized approach for credit risk in December 2015.7 This eases the capital burden for
agent lenders in securities lending but
does nothing to reduce costs for banks
making the choice between securities
Exhibit 1:
Capital requirements for the Leverage Ratio in a
securities loan with cash collateral vs. equivalent
swap transactions
(US$)
700,000
600,000
500,000
400,000
300,000
200,000
100,000
0
US Supplementary
Leverage Ratio
Basel III Leverage Ratio
Uncleared swap
Cleared swap
Sources: Finadium
loans and OTC derivatives in providing clients with leveraged market exposure.
Changes can still be made however, and
a desire for reducing variability and
increasing standard, industry-wide methodologies should encourage the use of the
SA-CCR in other applications. It might be
worse than the Internal Market Model or
better than the Current Exposure Method,
but in the end, a judicial application of
equivalent methodologies should result in
greater market stability for investors.
Basel Committee on Banking Supervision, June
2011, available at www.bis.org/publ/bcbs189.pdf
4 “Revisions to the Basel III Leverage Ratio
framework, Consultative Document,” Basel
Committee on Banking Supervision, April 2016,
available at http://www.bis.org/bcbs/publ/d365.
pdf
5
“Measuring Counterparty Credit Risk
Exposure,” Yvan Robert and Matthieu Maurice,
Accenture, April 1, 2016
6 “Securities Lending, Market Liquidity and
Retirement Savings: The Real World Impact,”
Finadium, November 2015, publicly available at
http://finadium.com/pdfs/finadium_
seclending_real_world_impact.pdf
7 “Revisions to the Standardised Approach for
credit risk, second consultative document.”
Basel Committee on Banking Supervision,
References:
December 2015, available at https://www.bis.
1 “The standardised approach for measuring
org/bcbs/publ/d347.htm
counterparty credit risk exposures,” Basel
Committee on Banking Supervision, March
2014 (revised April 2014), available at http://
www.bis.org/publ/bcbs279.pdf
2 “Revisions to the Basel III Leverage Ratio
framework, Consultative Document,” Basel
Committee on Banking Supervision, April 2016,
available at http://www.bis.org/bcbs/publ/d365.
pdf
3 “Basel III: A global regulatory framework for
more resilient banks and banking systems,”
Issue 04 Securities Finance Monitor 45
THE KNOWLEDGE XXXXXXXXXXX
INTERVIEW
An SFM interview with Bimal
Kadikar, CEO of Transcend
Street Solutions
We will see a lot more integration and automation in the coming years across
securities finance, treasury, OTC derivatives, and operations areas. Their silobased systems will come under a lot of stress. Firms that embrace this change
smartly and focus on developing a strategic operating environment with a sharp
focus on execution will be clear winners.
Josh Galper: Bimal, good to
speak with you. Could you
explain the mission of Transcend Street Solutions?
Bimal Kadikar: Transcend Street
Solutions’ mission is to create innovative technology that simplifies Wall
Street’s complexity. We specialize in
capital markets and in particular
collateral and liquidity management
solutions. Securities finance businesses
are going through a major shift driven
by regulatory and economic forces;
they are evolving into collateral and
liquidity trading businesses across
asset classes. Our aim is to assist firms
through this evolution and develop
their competitive advantage through
our state of the art technology.
Galper: What is Transcend Street
Solutions approach towards the
complex space of Collateral and
Liquidity Management?
Kadikar: The evolution to collateral
and liquidity trading requires a
number of changes in firm operating
models and infrastructure. We have
carefully designed our approach to
help firms through this evolution as
46 Securities Finance Monitor Issue 04
seamlessly as possible by developing
their collateral and liquidity management capability without mandating
major changes or complex retirement
projects. Our technology solution,
CoSMOS, operates as the glue in the
existing ecosystem and will allow
firms to evolve quickly while leveraging their current investments.
We have designed CoSMOS as a front
office trading platform with a specific
focus on front-to-back connectivity.
Besides innovative technology, we have
focused on building value-added
functionality that helps firms connect
their disparate data across multiple
businesses and systems.
We are a team of passionate and
experienced technologists who are
driven to deliver a solution to an
industry segment that is in the most
need. We work closely with our
partners to establish scalable architecture and execute with agile pace for
delivering business value aligned to
their needs and priorities.
Galper: There are many collateral
management systems in the
market. What makes CoSMOS
stand out?
Kadikar: There are many solutions in
Galper: Where are you and your
team coming from?
Kadikar: We are technologists with
the evolving space of collateral that
have a siloed approach, but they do not
do justice to the needed solution. As
mentioned earlier, our ability to
the battle scars of Wall Street. I come
from Citi, where I led large technology
organizations such as Fixed Income,
Electronic Trading, Prime Finance,
Futures and OTC Clearing. In my last
four years at Citigroup, I ran the
Collateral, Liquidity, and Margin
initiative, and my experience there was
the spark that led me to start Transcend Street Solutions. Our team has a
unique blend of technology skills and
experience, as well as a pedigree of
solving complex challenges and
building global platforms in repo
trading, cash and derivative processing,
and low latency electronic trading.
This diverse background has helped us
build one of the best collateral and
liquidity trading systems in the
market.
secfinmonitor.com
“Transcend Street Solutions’ mission
is to create innovative technology that
simplifies Wall Street’s complexity.
We specialize in capital markets and
in particular collateral and liquidity
management solutions.”
operate within the existing ecosystem
enables us to quickly add business
value based on priorities and pain
points. We focus on connecting
disparate collateral data sources across
the businesses and functions to build a
solid foundation for the business. Our
thoughtful business data models and
integration technology make this a
very efficient process for our clients.
We apply our decision support services
and user friendly dashboards to power
this data into actions that can be
driven by users for specific business
needs.
In terms of functionality, we provide
seamless access to information that is
usually fragmented across many
different systems or not available in
the firm. CoSMOS provides comprehensive functionality to intelligently
mine collateral agreements, robust
real-time view of inventory across the
enterprise, visibility of margin calls
across margin centers and ability to
optimize various demands through
customizable optimization algorithms.
Liquidity analytics functionality allows
firms to implement sophisticated
sources and uses models that can
incorporate LCR rules for optimal
capital impact. This state of the art
functionality and our architectural
approach allows firms to leave their
existing platforms unchanged but still
elevate their collateral and liquidity
trading capabilities, preparing them
for the new era.
Our noninvasive approach to this
business problem, our state of the art
technology with emphasis on real-time
trading, and comprehensive business
functionality with powerful dashboards make us entirely unique from
the other players in this space.
Galper: You’ve mentioned data,
decision support and user dashboards. Could you tell me more
about how it all comes together?
Kadikar: We see a three-step process
in building next generation collateral
and liquidity data management to
support a variety of different business
requirements across business areas.
First there is harmonization and
integrity of the data – that is the
middleware. This includes all collateral
agreements (ISDA CSAs, MSLAs,
financing transactional data, CCP
schedules, etc.), trades, positions,
settlement ladders, margin and
exposure data, reference data for
securities, accounts, legal entities,
market data, etc. Bringing together the
data is a foundational component and
is quite challenging, but we have a lot
of experience in getting this done and
have developed targeted technology to
make this easier for our clients.
The second part is analytics and
decision support services that operate
on this data. This is how you evolve
from “Data -> Information”. When you
get to decision support, that is where a
collateral substitution or optimization
process can result in quantifiable cost
savings or new opportunities.
The third and most visible part is the
rich user dashboards. Our dashboards
bring information to users in a
business friendly and actionable way.
Bimal Kadikar is a founder and
CEO of Transcend Street Solutions,
an innovative technology company
focused on building next generation
collateral and liquidity management
solutions. Prior to founding Transcend Street Solutions, Bimal served
in several senior roles at Citi Capital
Markets Technology Division, where
he managed global teams and projects with budgets of $500+ million
in supporting multi-billion dollar
businesses.
Bimal led the technology organization for Citi’s prominent Fixed
Income Currencies and Commodities businesses globally. He was
also tapped to build Prime Finance,
Futures & OTC Clearing business
technology platforms as part of Citi’s
push to expand these business areas.
Many of these technology platforms
have won industry accolades and
client recognition, helping Citi grow
in these businesses significantly over
the years.
Bimal also led a high profile initiative of driving Collateral, Liquidity
and Margin strategy globally at Citi,
partnering with multiple business
and cross- functional areas such as
Global Treasury, Repos, Securities
Lending, Prime Finance, Futures &
Clearing, Margin Operations, Securities Services and Technology.
Issue 04 Securities Finance Monitor 47
THE KNOWLEDGE XXXXXXXXXXX
secfinmonitor.com
INTERVIEW
In addition, allowing users to control
how decision support services should
operate really drives the evolution of
“Data -> Information -> Action”. Our
main goal is to provide a powerful
technology platform and give users
control via our dashboards.
This modular paradigm allows our
clients to address their known challenges right away, but it also provides
peace of mind that they can extend
this platform for tomorrow’s unpredictable challenges with ease.
Galper: Data integration is a
major industry challenge. How
does Transcend Street help?
Kadikar: We have focused on developing integration tools that easily
allow for real-time transformation of
data. We provide a straight-forward
interface that allows users to map data
between two systems. We enrich and
validate data flow in real-time based
on rules and configurations.
Our data quality dashboards provide
the user with typical data problems on
the platforms such as trade exceptions,
mismatched accounts, reconciliation
differences, etc. Our design philosophy
is that “sunlight is the best disinfectant”. Providing easy visibility on data
quality issues allows appropriate users
to fix those issues and, over time, the
platform becomes significantly more
powerful.
48 Securities Finance Monitor Issue 04
On top of our superior technology, a
key differentiator is our experience of
solving these challenges in multiple
firms of varying complexities. Together
with our experience and our technology, we make this journey a lot more
efficient and cost effective than most
alternatives.
In general, we operate from firms’
internal infrastructure and connect to
internal systems, vendors and industry
utilities as needed. We have worked
hard to make this integration simple
using our innovative modules,
common adapters and integration
technologies.
Galper: How does Transcend
Street work with market infrastructure providers like Broadridge, BNY Mellon or DTCC?
Kadikar: We connect to many of the
Galper: How do you see this
evolution to collateral and
liquidity trading playing out in
the next few years?
Kadikar: These are exciting times as
major infrastructure providers and
vendors on behalf of our clients. We
connect to settlements and clearance
industry players through SWIFT
messaging in real-time, and to triparty
agents for agreements, allocation, and
other relevant information.
Besides industry utilities, CoSMOS
connects to firms’ front- and backoffice systems for specific transactional
data. For example, we connect to
back-office providers such as Broadridge for the full stock record and
transactions in real-time as well as
front office systems of repos and sec
lending activity. We connect to margin
centers to collate margin calls and
collateral balances across legal entities.
We have developed standard adapters
for many of the common vendors in
this space to make integration as easy
as possible.
economic environment, regulatory
pressures and technological advances
are creating entirely new opportunities
for the industry. This is a big change
and, like any large scale change, it
needs to be navigated carefully. There
will inevitably be winners and losers,
but we strongly believe that an enterprise-wide collateral and liquidity
management function to drive optimization of cost and capital is a key
differentiator in the industry. We will
see a lot more integration and automation in the coming years across securities finance, treasury, OTC derivatives,
and operations areas. Their silo-based
systems will come under a lot of stress.
Firms that embrace this change
smartly and focus on developing a
strategic operating environment with a
sharp focus on execution will be clear
winners.
Where great minds meet
News, analysis and opinions on
securities finance and collateral
management published daily
Learn how market events and
regulations will affect your
business, keep up to date with
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