This post continues our thinking about the oddity that is the US Dodd-Frank 165 regulation. Last week we looked at how CCPs are counterparties under the capital exposure limits of Dodd-Frank. Today we’ll look at how this expected law could mark the return of the broker-dealer middleman in US securities lending.
Owing to low leverage, the group of broker-dealers that have acted as middlemen in a securities lending transaction between an agent lender and a prime broker borrower hasn’t seen much traction lately. There are still net lenders to the street, but the demand for intermediaries to access securities is at a real low; the demand just isn’t there. The heyday for these middlemen was 2007 and 2008 – they were genuinely busy due to less technology, more telephone and email work required to find a stock, and some client-driven restrictions on counterparty lending limits. We knew people who proudly called themselves broker-dealer finders, even though the finder term had come into disfavor and has some unpleasant legal associations. In any event, being a broker-dealer middleman was a legitimate role in the securities lending market when times were good.
But before the final death knell is sounded, we think that Dodd-Frank offers a curious route to reinvigoration of the broker-dealer middleman in US securities lending. This is firmly in the category of unintended consequences of regulation. The wrinkle is that capital exposure limits may make it not possible for an agent lender bank with a large capital base to continue to do all of its current business with some of its favorite counterparties, say Morgan Stanley for example. The big bank’s 165 limits could handle it, but Morgan Stanley has a smaller capital base and will be constrained by the appropriate limit base (10% in this case, for the sake of argument). MS’s hedge fund clients still want to borrow stock though and need the prime broker to source inventory where it can.
Playing this forward, both the bank and MS want to continue their securities lending relationship as-is but 165 rules constrain them. One possible option would be use a CCP (up to each party’s own capital limits), but then the agent lending group of the bank will say that their ’40 Act and ERISA clients can’t use the CCP, so that option get scuttled. The bank securities lending group might also be told that their bank parent wants to move their Morgan Stanley credit line to a more profitable enterprise, at least from the risk capital allocation perspective. What are the bank and Morgan Stanley to do for securities lending transactions?
This provides a nice re-entry point for the broker-dealer middleman. A well-rated but not A or AA entity, the intermediary broker-dealer is still a legitimate counterparty for the bank and does not violate most beneficial owner client agreements. It’s own balance sheet is not large enough to support a very large volume of transactions, but it is unlikely to engage in the same volume of OTC derivatives business that the bank and Morgan Stanley have going. This eases balance sheet constraints. On the other hand, the middleman and Morgan Stanley do almost no business together. This leaves no capital exposure constraints for either side of that transaction.
While hypothetical, we can see this situation occurring without too much trouble owing to the strange push-pull of regulation in financial markets. For those struggling through a weak year at a small but credit-worthy broker-dealer, hang on – we see good news coming in your direction.