The Bank of England’s (BoE’s) Securities Lending Committee released minutes from its November 2022 meeting.
The Committee noted that 2022 was a satisfactory year for securities lending. Datalend reported record volumes, although demand for general collateral gilts decreased. Agent banks also decreased business due to the cost of capital usage for indemnified lending versus returns.
Utilization has been focused on sub-10 year gilt issues with increased demand following the market disruption in September / October. An increased number of queries from beneficial owners arose during the LDI crisis as they queried the level of flexibility in their lending contracts in the event they needed to recall their securities. This led to some temporarily ceasing lending.
Despite the recent record months in terms of volumes, Risk Weighted Asset (RWA) constraints remain a problem for many of those in the industry. In particular the interaction with Basel III/IV is coming more into focus.
Levels of fails
Post the mini-budget, there was an increase in securities lending fails on returns and resulting penalties under the Central Securities Depositories Regulation (CSDR). The Committee noted CSDR penalties are bigger than expected – and not washing through the system as easily as anticipated.
Levels of fails remain high, which means the level of penalties remain high, particularly in Europe. There is discussion around increasing the level of fines, but other avenues need to be explored, such as allowing partial settlements. Fails are largest by volume in the equity space, but are most common in corporate bond lending, though settlement rates have fallen across all products.
The Committee noted that this problem has existed in the industry for years, and CSDR penalties have not made a large improvement thus far. The Committee discussed some potential drivers for high levels of fails which included: technical issues, liquidity of the underlying security and deliberate fails. The Committee noted that technological improvements were clearly the most important way to improve this issue, due to reliance on rigid archaic systems. The Committee noted that better investment was therefore needed, and that the trend of managing books to zero balances might have to be reviewed so firms could carry cash buffers to account for fails.
The Gilt sell-off saw many more enquiries from LDI funds that are looking at actively reviewing their funding models – and asking how to access greater liquidity. This has been seen particularly noticeable in the peer to peer lending space.
The Committee noted that the provision of indemnities might be expected to drop in the future. It costs around 13bp for agent lenders to provide indemnities, and investor understanding of these indemnities is not that strong. It may be that in future firms other than banks will provide these indemnities.
Tokenized collateral
The Committee received a presentation outlining the basics of tokenized collateral. Tokenised collateral is a bond or equity moving as an object token, on a public or private block chain network. There are two methods of tokenisation: native and nonnative. Native tokenisation requires more legal structural change whereas non-native tokenisation fits more readily within current legal frameworks but requires improved additional development to be compatible with reporting requirements.
Tokenization, it was suggested, may be able to resolve the issue of collateral fails. Settlement speed can be improved potentially to T+0, although intraday cash movements can be difficult due to segregated cash deposit accounts. The lack of digitalized cash further compounds the problem. It was felt that the main challenge has not actually been the technology but rather the regulatory and legal uncertainty around this form of ownership making compliance difficult. the International Securities Lending Association (ISLA) is in the process of issuing a paper which highlights the main challenges of regulatory and legal certainty of new owner records. Client money rules and asset rules add further complexity. Corporate actions remain a challenge for lenders and beneficial owners.
Basel IV and output floor
It was noted that Basel IV will require changes to risk calculations and minimum haircuts. Some members felt that the EU position on implementing output floors may increase the capital requirements particularly for unweighted corporates, pension funds, sovereign wealth funds and mutual funds. This might impact unrated funds in the EU who may be disadvantaged resulting in borrowers sourcing securities outside of the EU. This reduces transparency and impacts liquidity.
ISLA is proposing to the EU that banks should be allowed preferential risk weighting up until 2032 and to use international standards to determine if counterparties meet high quality liquidity requirements. In addition, ISLA will propose use of 60% risk weighted assets (RWA) rather than 100% RWA for unrated counterparties. Further discussion will centre on using a credit benchmark to alleviate risk weighting or using clearing houses and CCPs.
Eurex have been considering increased collateral for pledge in comparison to title transfers. In June, EU collateral reported under SFTR showed 16% under pledge for title whilst the UK showed 18%. This was an increase from 12% previously and is a result of the Basel framework. There is concern that within the unrated UCITS, where pledge is not possible, this may result in reduced availability from lenders due to the cost of implementation.