Purpose-for-Purpose (P4P) equity collateral in US markets – moving ahead or marching in place?

At the October, 2015 Risk Management Association (RMA) Conference on Securities Lending, the topic of non-cash collateral was featured on the agenda in several sessions. While equity collateral – and particularly purpose-for-purpose matched balance structures – can legitimately be thought of as form of non-cash collateral, it really is a fundamentally different practice than traditional non-cash collateral.

There are several important distinctions that make this structure especially beneficial. In the equity-for-equity structure:

  • Neither party holds a “collateral” leg to the transaction; both parties are lenders
  • Both parties can net down borrow and loan balances to the extent they match for purposes of capital calculations
  • Both parties receive the benefit of collateral equivalency for purposes of LCR calculations
  • Both parties (and their underlying customers) achieve short/fail coverage without incurring a fee
  • No cash or other financing (Fixed Income repo, etc.) is needed to acquire the needed collateral

But there are characteristics that make it especially difficult and risky to manage:

  • Securities borrowed must be for purpose, or both parties lose the benefit of netting
  • The collateral exchange occurs asynchronously (unlike a DVP/loan vs. cash), creating intra-day settlement and credit risk
  • By definition, collateral is fully re-hypothecated by both parties, meaning there is no reserved collateral obligation by either party
  • Because deliveries are non-DVP, the intra-day settlement/credit risk is not absorbed by the Central Securities Depository (for instance, DTCC)
  • The components of the structure must be rebalanced and replaced daily according to both price changes, and changes in “for purpose” status
  • A breakdown in any of the conditions or the process create large capital and credit exposure
  • Reporting and capital computations must explicitly identify purpose-for-purpose transactions and balances in order to achieve the benefit of the structure

Because of all of this, the reality is the market remains very much “two tiered” as it relates to the use of equity collateral and P4P structures. Over the last couple of decades, firms with the technical and financial resources have worked to develop extensive “workaround” solutions to make this practice somewhat manageable. These firms are of the size and possess the capital to absorb the increased risks involved when the workarounds don’t quite work. Even for these firms, the risks remain material, and are the object of a high degree of hands-on operational management.

The firms that have made these investments perceive – accurately – that they possess a certain operational and business advantage over other brokers, which makes them less than inclined to dilute their advantage by extending the benefits of the practice to the wider industry.

As often happens in our industry, the majority of firms perceive the risks and obstacles to be too great to overcome on their own – and they are seeking external leadership to help them. And so, the question is the same as it has been for many years: at what point does this become important enough to the “second tier” firms – the firms that are on the outside looking in – their vendors, and the utilities they rely upon, to develop the standards and infrastructure necessary to lower the barriers to entry? The changes needed are obviously material (if they weren’t, they wouldn’t be necessary), but fairly apparent – at least to us at Finadium.

The US securities lending industry is built on a high degree of automation, almost exclusively centered on DVP settlement through DTCC and other CSD’s. When it comes to cash-based transactions, standards and infrastructure have enabled a near complete mitigation of transactional and market risk, and further enabled firms, their vendors, and other industry utilities to develop operational processes that make cash-based securities lending an almost hands-off process. Clearly, any further evolution of the industry to make other forms of collateral equally automated must involve some equivalent infrastructure, and enhancements to the services provided by the utilities – CSDs, CCP’s – and the vendor systems. Until then, we will march in place.

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