Panelists at the March 19 Finadium Conference in New York brought up an interesting concept: the demand for bilateral vs. cleared funding products isn’t one or the other but really a continuum of options that market participants can choose. The best options at any one time may be bilateral, cleared or a mix. We look at some of the dynamics that are pushing or pulling the market in either direction.
Towards centrally cleared
The easy answer here is regulation. Attendees at the Finadium conference thought that the reason that CCPs for securities lending and repo would gain traction was due to balance sheet. This is a sell-side capital problem and maybe a regulator’s problem; it certainly is not a buy-side problem. It is easy to say that the greater constraints the sell side experiences in balance sheet management, the more they may seek to turn to funding on centrally cleared platforms. They will then have to make it worth the while of their buy-side counterparts to play along.
We also see product innovation as encouraging the market to consider centrally cleared products as a funding mechanism. Exchange for Physicals on Single Stock Futures have not gained traction as a banking product. There are many reasons for that including the hesitation of prime brokers to support Single Stock Futures in general over physical securities loans. The new wave of product innovation, including Single Treasury Futures and marketplaces like TrueEx and Eris Exchange that allow hedge funds and cash investors to trade derivatives directly, whether as a cleared OTC derivative or as a future, with a bank as a clearing agent, may encourage more market participants to take centrally cleared products seriously. The diversity of new products for funding is genuinely interesting at this time.
The idea of moving to centrally cleared products for funding on a broad scale is new. These products face an uphill battle in even the best of circumstances, which in fact they may be seeing now. We will not know for some years to come how successful individual products will be in replacing bilateral funding activities. What we do know is that they are being taken seriously and market participants are signing up for them as a backstop.
The bilateral funding markets are deep and highly liquid. Although market participants are restructuring and some have reduced or even closed their funding businesses, the markets overall remain exceptional pools of liquidity. We track US$18 trillion worth of collateral held across all products globally including repo and other transactions specifically for funding. If things are going well, why change them? Even if corporate treasuries reduce the capital allocation provided to these businesses, they remain profitable and are powerful incentives for clients to do business with a given bank.
The market momentum is towards bilateral transactions: it will take a big push for centrally cleared products to dislodge bilateral transactions from their perch. There have been some successes, notably the Options Clearing Corporation’s significant growth in average daily volume on their securities lending CCP, or the importance of the DTCC’s GCF trading for smaller broker-dealers relying on funding from the top tier. The easiest products to adopt are funding or financing activities that simply switch the same products from a bilateral relationship to a CCP.
It will be very different for banks to do client business away from the bilateral market for other products unless they really need to. The hardest ones will require new operations and technology, but these very same products may yield the greatest results in funding growth over the long term. The more liquidity in funding, the cheaper the cost; alternatives for funding both existing products and new product alternatives on a CCP may produce outsized benefits.