During the CCP panel at the IMN Beneficial Owners Conference in San Francisco (which I moderated), there was an unspoken message: how do we break the news that eventually using CCPs may not be optional?
The usefulness of CCPs in repo has been accepted for a while, but in securities lending, the story is a bit different. Most beneficial owners spend a small portion of their time on securities lending. Some have put it at 10 or 15% of their day. Going to their board to explain changes in the business model, risk waterfalls, Basel III as it relates to CCPs, etc. is not on the top of list.
Finadium research has found that Europeans are farther along the sec lending CCP knowledge curve than US investors and those with extensive experience in derivatives (insurance companies, for example) are more comfortable with CCPs than others.
Beneficial owners question exactly who they will be dealing with versus the certainty of bilateral trades. The sec lending CCP model seems great for collateral vs collateral trades, but for cash vs collateral, it is still a work in progress. Stories about having to post margin don’t help (the new class of lenders licenses remove risk mutualization and posting of margin). What if a CCP blows up? The sec lenders, CCPs, and broker-dealers have good answers to all these questions, but they don’t lend themselves to sound bites.
The other (related) elephant in the room is indemnification. Some argue that CCPs should make indemnification moot. More on that tomorrow.
The effort to promote CCPs comes from the broker-dealers who, facing balance sheet constraints (and to a lesser degree RWA problems), are looking for ways to minimize their regulatory capital footprint. Using CCPs will help, especially for balance sheet netting (where the CCP is the counterpart to each trade, making Fin 41 netting that much easier). But while beneficial owners can sympathize with the broker-dealers, they don’t always care. The existing model works just fine, thank you.
But the problem will eventually become one about access or no access. The business is changing and to keep the pipes open, it has to be more capital sheet friendly to the intermediaries. Banks will slowly rationalize which clients they deals with. It won’t be a matter of changing the fee split — it will be more fundamental that that.
Regulators are perfectly happy to see securities financing businesses shrink, so there won’t be much help from that quarter.
There are other models that will emerge, including ones that remove broker-dealer intermediation altogether. These kinds of direct lending propositions and synthetic solutions may have great appeal to some clients and we hope they get traction. There will be room for more than a single model and one should never underestimate the power of innovation.
CCPs have been on the agendas of sec lending conferences for a while, but the needle hasn’t really moved appreciably on acceptance. It feels like the biggest impediment is the assumption that it works now, so why fix it? Beneficial owner have not had the hard conversation with the regulators about how things have to change…yet. Maybe that is what is needed to move things along?