2015 is shaping up to be the year of the securities lending CCP; banks, agent lenders and beneficial owners are all now preparing themselves for this important market move. The driver of change is that Basel III, Dodd-Frank and EMIR are starting to sink in, and borrowers need to optimize their capital usage. While repetitive to say, it remains true that the more seriously banks look at capital, the more they are evaluating all available alternatives for capital cost management. Market attitudes towards securities lending CCPs have evolved as well, and in 2015, a part of the capital solution will be found on these platforms.
Securities lending CCPs bring some clear benefits to the market. The biggest is capital efficiency; borrowers can lower capital costs in many instances by transacting with a CCP as opposed to with bilateral counterparties. CCPs support a continued push towards straight-through processing, as centrally cleared transactions can flow through to middle and back office processing automatically. This increase in STP efficiency can directly reduce operating costs. Regulators are also in a CCP-frame of mind across all products. The more that market participants themselves decide to reduce risk and support transparency by using the CCP, the happier regulators that appear to react.
The securities lending market already boasts two functional securities lending CCPs. Eurex Clearing’s Lending CCP is the first to offer clearing licenses to both buy-side and sell-side firms in Europe, the US and other selected countries. The buy-side version is limited to lenders only, and includes a range of options including allowing agent lenders to act on their client’s behalf. Keeping agent lenders involved and promoting their operational, pricing and collateral movement expertise is an important part of the Eurex Clearing model. Pirum supports Eurex Clearing by offering connectivity between the Lending CCP and end-users, delivering a comprehensive post-trade life-cycle management solution and the highest possible level of straight-through processing. A US CCP model for securities lending by the Options Clearing Corporation is sell-side only, and has seen explosive growth over the last 18 months.
There has been a notable change in European beneficial owner and agent lender attitudes towards securities lending CCPs in recent months, although North American beneficial owners have yet to take serious notice. European agents and asset owners report that in place of suspicion, lenders are now taking CCPs seriously and are in the discovery phase of due diligence.
An important reason for this is a start to conversations between securities lending agents and beneficial owners, in particular those at fund complexes and insurance companies. If agent lenders are pursuing the conversation, their clients will pay attention. It is fair to say that funds and insurance companies are cautiously optimistic about CCP success in securities lending. Pensions are still most likely to not fully understand CCPs today.
While CCPs are gaining acceptance, agents and asset owners have noted several ongoing questions. The greatest concern is risk: how is risk calculated and how can the lender be sure that assets are safe. Even though beneficial owners may comfortably trade options and futures with these same CCPs, securities lending at first seems a world apart. It takes some time to understand that CCPs work similarly at heart across products.
There are also questions on how buy-side collateral is held. If collateral is pledged, what happens in the event of a borrower default? If collateral is held by a CCP, is the beneficial owner exposed to the default fund of all members? Could different securities be returned than the securities lent?
Another concern is who the counterparty is. Beneficial owners report wanting to know their counterparties and agent lenders generate profits from differentiated pricing across counterparties. They stress that they are not overly interested to lend to lower rated counterparties just because there is a CCP, but rather would prefer lending to the same counterparties and helping provide the balance sheet relief that CCPs offer. Some have argued that a CCP negates the benefit of knowing the counterparty for risk purposes and may serve to level the pricing playing field, bringing costs down for small players and up for big players. However, the Eurex model in particular reflects the bilateral market by allowing preferred counterparties to negotiate directly with one another, via Pirum’s gateway solution, then send the trade to the Lending CCP for clearing.
How valid are these concerns? In fact, some are more important than others, and it may depend on agent lenders to help their clients understand what matter and what doesn’t. A new factor will soon be CCP stress tests in a Cover-2 (two major defaults at once) or greater scenario. This is where CCPs justify their stability and where beneficial owners and agent lenders may gain the greatest comfort.
For counterparties and pricing, we have seen CCP models operate with and without central marketplaces. In a central market there is pricing transparency. CCPs may also accept bilaterally negotiated transactions for clearing, where agent lenders and beneficial owners have full control over both counterparty and loan fees. The scenarios can vary depending on user needs. The decision to use the CCP and at what price may at times depend on the cost impact to both counterparties and the collateral being offered.
Across beneficial owners, in particular fund managers and insurance companies, there is a growing sentiment that the CCP may reduce or eliminate the need for counterparty default indemnification. In Finadium’s 2014 survey of asset managers and insurance companies, 44% of respondents said that indemnification would not be needed with central clearing of securities loans. Another 34% were undecided. Our November and December 2014 survey of institutional investors showed too few with an understanding of the core issues to make a determination.
Finadium has spoken with over 50 beneficial owners in the second half of 2014. In the course of these conversations, we found that less than 20% knew what CCPs were in detail. Agent lenders by and large are speaking now with their large and sophisticated clients about CCPs. Reporting from beneficial owners shows no agent lender business plans in place, but agents are heading in this direction including working out costs, operations and risk models.
We expect though that 2015 will mark a turning point in CCP usage driven by borrower capital cost needs. Agent lenders and beneficial owners are starting to get up to speed in order to maintain volumes and revenues. As more agent lenders and beneficial owners educate themselves about securities lending CCPs, the greater we expect that momentum will build.
This article was commissioned by Eurex Clearing and Pirum.