For years, we’ve been hearing that equity collateral in broker-to-broker securities lending is a coming new standard…. Any day now…. We’re moving in that direction…. The advantages are so obvious it has to happen…. We can’t afford for it not to happen….
Well, we’re still hearing it. In some small ways it has been happening but it would be a pretty hefty stretch to say it’s become anything like a standard way of doing business. When it comes to securities lending in the US, cash is most definitely still king. This is despite the compelling facts that:
- Technically speaking, “rebates” on cash investment really don’t exist anymore. Cash investment returns are so low that lenders no longer pay much if anything in “rebates”. The business has essentially become a fee-based business utilizing an oxymoron – the “negative rebate.” A rebate that is “negative” is just a fee under another name. Yet, it’s a fee based on the amount of cash collateral rather than the actual value of the securities lent. This is much to the benefit of the lender, and much to the cost of the borrower and his underlying customers. If one really thinks it through, the lender is now getting paid three times – once on the cash investment, again on the fee for the securities lent, and a third time on the fee for the collateral markup (i.e., mark price rounding and/or the 102%) on the cash.
- The borrowing broker and his customer are now hit for larger capital utilization costs than ever before. Under Liquidity Coverage Ratio (LCR) calculations and other, ever more stringent capital reserve rules, the cost of using cash collateral against less liquid collateral (equities) has increased dramatically.
- Firms are struggling even to understand these additional costs, and the industry has yet to effectively or accurately price in the cost of capital in lending fees.
- Larger reserves of high-quality equity collateral – general collateral (GC) – are parked in position at broker dealers than ever before, just waiting for someone to find a use for them. Brokers are sitting on literally billions of dollars of equity collateral. Meanwhile they are financing cash or dipping into firm capital in order to borrow securities.
Given all this, we are left to wonder why haven’t equity collateral arrangements really taken hold? Why hasn’t Equity for Equity (E4E) and Purpose for Purpose (P4P) gained wider adoption? Why is it still an outlier for the US securities lending industry?
The answers are straightforward, and fundamentally revolve around risk and operational process. Equity collateral changes the risk equation (and who carries the risk) in fundamental ways, and is far less of a Straight-through Process than cash collateral.
In what ways?
- Our operational infrastructure – the industry utilities, the vendors, core systems, practices and technology – have all been built around the delivery versus payment (DVP) model. The existence of the DVP through the central depository and clearing utility – Depository Trust and Clearing Corporation (DTCC) – has reduced or eliminated daylight exposure in securities lending. The intraday risk all lies within the clearing corporation. This is clearly recognized by DTCC – so well recognized, in fact, that in the last three years DTCC has taken profound steps to control and reduce their exposure through the Settlement Matching initiative.
- Our Risk and Credit departments and their systems are very comfortable allowing DTCC to assume all the daylight exposure. In an equity collateral arrangement, we are delivering large amounts of collateral free of payment (FOP) and relying on the good faith and diligence of our contra party to deliver an equivalent value of collateral back to us in some timely manner. Until that happens, we are taking the daylight exposure in-house. Put another way, the asynchronous exchange of collateral raises a credit and settlement risk red flag that doesn’t exist in the DVP environment.
- Few US-centric systems exist that can a) dynamically and properly value and identify this exposure in real time; b) monitor and tie together the asynchronous deliver/receive settlement data within the risk environment; and c) control and manage the timing and flow of these transactions to mitigate the exposure. The vendor systems and the utilities don’t provide much in the way of support for controlling this risk, which ultimately leaves it to human beings to handle in a high-touch, manual process across several systems.
- Core systems, vendors and utilities can be thin in their capacity to automate the mark to market process. Cash collateral mark processing is wonderfully and almost fully automated through the vendor facilities. Non-cash mark processing is often labor intensive and manual. To automate this process would require systems to know thing they do not currently know – like a firm’s excess availability and how that aligns with a contra party’s needs – in order to make the exchange of collateral an automated or even a semi-automated process.
- Because non-cash was always non-standard and exceptional, the technology and infrastructural support has been something of an afterthought. To a large degree the functionality that does exist has been shoe-horned into the business process and the supporting systems. Most purpose-built US securities lending systems try to understand non-cash/fee-based loans and borrows by treating them as pseudo-cash transactions in one way or another.
- Most systems cannot easily understand the distinction between a) contract value for purposes of calculating fees and b) contract value for purposes of calculating collateral owed to the lender. Obviously, for cash collateral transactions these are one in the same thing.
- Many systems still want to calculate fees based on the required collateral value (RQV), like a cash collateral loan. Alternatively, they try to calculate RQV like a “100% exact” cash loan. Either way, firms end up having to work around this problem by doing one or the other calculation away from their core systems.
Hmmm… What to do?
Firms are reluctant to invest money in solving these problems, for very understandable reasons. The scale of the business is small. It’s easier and less risky to just handle it manually until it grows. When it grows they will have to do something, but not now. Of course, it can’t and won’t grow because it can’t scale, not without heartier support! This is a classic circular argument, a chicken and egg syndrome. So here we remain, just about where we have been for at least a decade.
Everyone wants to build to standards but no one wants to be the frontrunner that makes big investments that may or may not align with whatever practices and standards ultimately do develop. The vendors and utilities are just as reluctant to invest heavily until and unless the industry itself can define standards for them. Vendors and utilities require standards against which to build. They can neither afford nor risk building systems and enhancements that may need to be chucked out the door and rebuilt when all is said and done.
Who then is going to set the standards that everyone involved – the brokers, the vendors and the utilities – need in order to build the support to scale the business? Unlike non-optional regulatory requirements, there is no mandate. So everyone – brokers, utilities and vendors alike – is waiting on the sidelines to see just how this is going to turn out, and just how it’s all going to be made to work.
There may not be a regulatory mandate, but there is a compelling business case to be made for tackling this issue once and for all. Every stakeholder will derive real financial benefit – straight to the bottom line.