Securities lending CCPs are at the intersection of major changes to liquidity and leverage in financial markets. Aside from requirements for increasing bank capitalization, Basel III is introducing new liquidity metrics such as the Liquidity Coverage Ratio (LCR) and Net Stable Funding Ratio (NSFR). These shake-ups have already begun to change relationships between borrowers and lenders in securities lending.
The aim of LCR is to create a safer financial system by demanding banks weather the storms of a 30-day market stress event. Cash inflows and outflows are measured, and firms are expected to hold precisely defined high quality liquid assets (HQLA) to meet cash requirements in a stress situation. Specifically, the stock of HQLA divided by the net cash outflow over the 30 days must be greater than 100%.
For prime brokers, it is expected that some risks will reduce and the duration of financing will increase, but costs will go up. Prime brokers now find themselves facing a situation where there might be a significant reduction in the internalization value they can realize from client activity. A report from J.P. Morgan, Leveraging the Leverage Ratio, points out that the ability to use assets of one customer to cover the shorts of another customer is reduced to 50% under the new rules. This is a change from historical practice, when it has been more efficient and less costly for prime brokers to use clients’ securities to cover other shorts than to borrow from an agent lender. This suggests increased borrowing from third parties for securities loans (or a move towards more CCP-cleared transactions for the initial trade).
For agent lenders, dynamic changes to the business model as a result of leverage ratio requirements under Basel III could make indemnification a scarce resource. Custodian banks will need to include some portion of the risk amount of the loan on its balance sheet and doing so will increase the denominator of the bank’s leverage ratio. If indemnification remains an industry standard, agent lenders could find CCPs a lot more attractive than before full indemnification costs were added to the business line’s P&L.
On the back of these regulatory push factors, studies from Eurex Clearing/Oliver Wyman and Promontory Financial Group indicate surprisingly large cost savings for prime brokers in the use of securities lending CCPs. While every institution will realize their own costs savings based on the securities that they are lending and the types of counterparties they are lending to, both studies strongly suggest that securities lending CCPs will produce demonstrative cost benefits to prime broker borrowers.
While not every market participant may agree, we are pretty convinced that securities loans over a CCP will be less expensive that bilateral transactions from a cost of capital perspective. There are still question marks over how market participants may adapt fee structures in order to capture cost of capital benefits from CCP usage and how pricing will change. What is likely at this point is that an active CCP strategy is better than no strategy at all. Further, regardless of the introduction of CCPs, securities lending is very likely to remain a negotiated business; firms that act early to ascertain the interests of key counterparties will be ahead of competitors as new regulations hit the industry’s traditional business model.
This article was commissioned by Eurex Clearing.