We’ve heard now from five different agent lenders that they have set up or are setting up swaps desks to transact with dealers instead of lending securities. This raises a number of questions about how the set up works operationally and who needs to approve. (Also, we’re holding a client webinar this Wednesday on the synthetic prime brokerage market.)
The impetus for agent lenders to want to deal swaps is easy to understand. Since Basel III rules were released in 2010, there has been a sharp imbalance in capital costs for regulated entities between securities loans and OTC equity derivatives (Total Return Swaps, Portfolio Swaps, etc.). Based on 2022 data, we found that prime brokers earned 55% of their equity finance revenues from synthetics vs. 45% from “physical” securities finance and margin activity.
In analyses we conducted in 2015 and 2020, we found that by both the 2010 rules and 2017 revisions, it was a no-brainer that if a dealer could transact on the swaps desk with a hedge fund client, this resulted in better balance sheet outcomes than the same trade as a securities loan. The situation was even better if the dealer could hedge the other side of the trade using internal inventory or finding a natural counterparty. While the proposed US Basel III Endgame rules modify some of the calculations in favor of securities loans, an analysis we conducted in October 2023 still shows the benefits of the swap trade. While the same statement of “TRS is always better” cannot be made for every portfolio and every situation, bank behavior shows that there is a preference towards the swap side.
For agent lenders, the ability to lend their own clients’ securities to a proprietary trading desk is a first step in making the swap trade happen. Most beneficial owners have now approved their agent lenders to lend to an internal affiliate, typically a prime broker (think Goldman Sachs Agency Lending lending to Goldman Sachs Prime Brokerage). There are some limits – we’ve heard 40% of volume as one metric – and pricing needs to be at market with no benefits to the affiliate. We’ve done reviews of several of these programs and have never found a problem.
The mechanics here are that the agency lending desk needs to lend to a proprietary internal desk, which we can call an affiliated prime brokerage group. That PB group can then engage in a swap transaction with an internal client or an external prime broker. This is a win for the agent lender no matter who the end-client is since more inventory is borrowed from the beneficial owner without the client having to approve a new contract or counterparty themselves.
Once a prime broker has the loaned security, they can use it for a hedge fund to cover a short sale or as a hedge for a swap. Now the trade exposure is calculated using the SA-CCR instead of the RWA of borrowing from a beneficial owner. The prime broker still has the counterparty exposure RWA of the agent lender/proprietary trading desk, but that’s better than, for example, a 100% risk weight of a mutual fund. Plus the prime broker can net down their market exposure, which is critical for a variety of risk control factors including the Liquidity Coverage Ratio, Net Stable Funding Ratio and Leverage Ratio.
Another option is that agent lenders arrange for each beneficial owner client to have an ISDA agreement with a participating borrower and the agent conducts the swap on their behalf. In this model, the agent has no balance sheet exposure (there is no agent-affiliated proprietary lending desk) but does need to get the client to approve and sign new paperwork, typically at the trading desk level. We have not seen an instance where, once a Board has approved swaps as part of the regular business, that the Board would need to again approve swaps done with borrowers by agent lenders on an agency basis. If the Board isn’t involved then this eases the process, but there is still paperwork to be done and borrowers may have counterparty credit risk considerations when dealing with the underlying client.
At the close of the trade, the transaction reverses, the swap is unwound and the beneficial owner gets their security back. Importantly, there is no change to the beneficial owner in any part of the securities lending transaction. This is a big deal from our vantage point as consultants to beneficial owners.
While a good deal for bank balance sheets and utilization of beneficial owner inventory, the loser in the preference for swaps over securities loans is market liquidity. This however is a fault of regulators, who for the last 14 years have set the rules up to benefit swap transactions over securities loans that support transactions in equity and fixed income cash markets. You can’t blame agent lenders or banks for that state of affairs, and they are responding to market conditions as best they can. As more volume moves to swaps however, maybe this will be an opportunity for regulators to make deeper changes in how risk is calculated between these two economically similar products.