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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 ANTICIPATING YOUR BUSINESS ENVIRONMENT At Securities Services, we support your business in adapting to ever changing regulations. Our expertise across the globe ensures your assets are serviced effectively in over 100 markets. www.securities.bnpparibas The bank for a changing world THE KNOWLEDGE XXXXXXXXXXX secfinmonitor.com 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 THE KNOWLEDGE XXXXXXXXXXX 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 secfinmonitor.com 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. 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 THE KNOWLEDGE XXXXXXXXXXX secfinmonitor.com MOST READ STORIES 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 When volatility is the norm, in-depth expertise provides stability. Customised investment solutions for institutional investors In an increasingly complex world, professional investors need a partner that can provide a single source of in-depth expertise in a wide range of areas: Sector-specific legal and regulatory expertise Broad range of fund and capital market products Proven strategic advisory experience For more information please call: +49 (0) 69 71 47 - 28 09 www.deka-institutional.com DekaBank Deutsche Girozentrale THE KNOWLEDGE XXXXXXXXXXX secfinmonitor.com MOST READ STORIES 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.” CoSMOS Collateral at its Core The future of collateral and liquidity management is here DATA & ANALYTICS REGULATORY TRADING & OPTIMIZATION CoSMOS provides a unique framework to harmonize collateral & liquidity data across business silos and functions in real-time. This integrated data coupled with flexible analytical engines and insightful visualization tools enable firms to optimize their most precious assets across the enterprise. Global regulations have raised the bar in expected collateral and liquidity management capabilities for financial firms. CoSMOS helps firms manage compliance to regulatory mandates while balancing them with economic drivers, enabling smarter decisions and allocation of collateral. CoSMOS is the next generation collateral trading & optimization platform that seamlessly integrates with existing business systems in real-time. CoSMOS supercharges collateral trading with sophisticated tools to manage inventory, agreements, margin, optimization and STP of collateral movements. www.transcendstreet.com [email protected] +1-646-820-7221 THE KNOWLEDGE XXXXXXXXXXX secfinmonitor.com MOST READ STORIES 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. THE KNOWLEDGE XXXXXXXXXXX secfinmonitor.com MOST READ STORIES 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 FINANCIAL SERVICES JUST GOT SOCIAL the professional SOCIAL NETWORK for the FINANCIAL SERVICES INDUSTRY NexChange connects professionals around the world, empowering them with top financial industry news, events, charts, and career development opportunities. nexchange.com 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 what matters and hear from market practitioners on the latest developments secfinmonitor.com classic services real-time services Global Leaders in Securities Finance Automation Financial Institutions from around the world have responded to Pirum’s creative approach by joining the secure on-line community. They have increased processing efficiency, reduced operational risk and improved profitability by using Pirum’s services to reduce manual processing. pirum.com | [email protected] Request your live demonstration online. exposure management ccp gateway