A main sticking point in NSCC’s plan to create an equity finance CCP is how margin will be collected from lenders of securities. This is already a known factor in the FICC’s sponsored repo market, with some hedge funds preferring bilateral transactions over CCP-cleared in order to avoid a 2% margin rather than 25 bps or even 0 bps for a bilateral trade. But in equity finance, we make the argument that agent lenders and beneficial owners should work to clear this hurdle for their own self-interest.
Unlike the advent of equities as collateral under SEC rule 15c-3, which has been six months away for the last five years, we actually think that NSCC (National Securities Clearing Corporation, a division of DTCC) will roll out their equity finance CCP in the near future. They are well delayed from the initially planned mid-2020 roll out but there have been understandable reasons (see: COVID-19). It seems to us that the biggest problem at this point is how margin will be collected.
In a conversation with NSCC in December 2019, we discussed the problem that some agents have presented on asking their clients to put up margin for the default fund. The push-back from agents has been that their clients will not be willing to post margin, nor does the agent want to post it on their behalf. There does not appear to be much give on NSCC’s side, as they are bound by risk management and regulation to collect margin, and this is separate from any fees that NSCC would charge for its regular services. Since cash collateral will go back to the lender, NSCC needs the default fund contribution to cover any potential losses. In conversations we held with four agent lenders, three were visibly concerned about posting margin while the fourth was indifferent. See our January 2020 research report, Are You Ready for DTCC’s Equity Finance CCP?, for more on this.
We think that the easiest way to solve this problem is for NSCC to retain 2% of the cash collateral going from the borrower to the lender, or that the lender gets 102% and the borrower posts additional to the clearing fund. The amount put up by the borrower won’t matter in the end and should be offset by the intrinsic value/rebate rate. It may actually be cheaper for the borrower to post a mix of securities and cash to the lender and the CCP than post 102% cash to the lender. For agents and beneficial owners, it also won’t matter if the rates are lower than the bilateral market if unused inventory is now being lent (would you rather get nothing on 0% utilization or something for 50%?). An important point for us is that the lender isn’t “posting” collateral – we think that is a non-starter. But if margin gets diverted on its way to the lender or if extra funds are put up by the borrower, then every market participant would know this was happening and lender fees would adjust accordingly. There will be costs to the CCP model as well, but our view is that the expected benefit to agent lenders and their clients in utilization would vastly outweigh the new cost structure.
We think that agent lenders should push for this deal with some urgency. It’s not a question about whether the CCP model is better than bilateral, but rather the fact that beneficial owner revenues have been eaten away by a) COVID-related Fed intervention, and b) the impressive gains that banks have made in resource optimization. Beneficial owners and agent lenders have been in a pitched competitive battle with Total Return Swaps and prime broker internalization for years, and they aren’t doing great. In an October 2020 report, Total Return Swaps and Bank Resource Optimization, we found that synthetic financing revenues at major prime brokers has outstripped securities finance revenues, but DataLend and IHS Markit data from FY 2020 show that beneficial owner revenues have fallen by a notable percentage. If all but a handful of agent lenders and beneficial owners are going to thrive in the current market environment, their product needs to be cheaper for banks on the balance sheet than a TRS or internalized inventory.
For banks, the CCP model is cheaper than anything else going for bank balance sheets, including, say some in the PB space, internalization. To revitalize utilization and hence revenues, agent lenders should push to rectify the hole left in 2010 when OTC derivatives were forced onto exchanges but securities finance and repo were left to their own devices. We think it would have been better for equity finance if they too were forced to clear anything standardized at that time. It didn’t happen, and that’s okay, but this is a fine time to solve that problem.
Agent lenders and beneficial owners can accept that the NSCC margin model won’t be ideal, but that benefits in utilization and post-trades processing efficiency, not to mention reduced costs for indemnification, could return a luster to securities finance that is currently dulled. NSCC has said from the start that their plan was to target unused GC inventory, but we see no reason why the entire US market wouldn’t move in this direction. For the sake of our beneficial owner consulting client revenues and the industry as a whole, we hope this can happen sooner rather than later.