The biggest change in US securities lending in the last twenty years

This Presidents Day marked the 20th anniversary of the changeover to Same Day Funds from Clearinghouse Funds settlement at DTCC, a day that marked the definitive end of an era in securities lending. How the industry is approaching today’s challenges has direct parallels and lessons from that event 20 years go.

Any reminiscence with a long-time desk professional will eventually get around to this subject, accompanied by a sad shake of the head and some comment like “that’s when the good times ended.” We have since lost even the concept of “Clearinghouse” funds, but essentially it meant that funds settling today at DTCC were not “good” for purposes of purchasing federal market instruments (i.e., bills and bonds) until the next business day. The funds needed to clear through the various settlement banks before they could be used for reinvestment purposes. This fact created enormous overnight risks within the system, major reinvestment complications and – as is always true where there are inefficiencies in the market – great opportunities for the savvy professional to use a technical market inefficiency to the profit of their company.
In the decades leading up to the actual solution to the problem – which was to normalize settlement between equity and fixed income marketplaces – the industry developed a deep, complicated and elaborate set of practices to work around the problem. Those who best understood the problem and the workarounds profited, while those who didn’t quite grasp it paid the price. The same is true today in terms of capital and balance sheet utilization, non-cash and equity collateral, “regulatory arbitrage”, fully paid lending, etc., etc., etc.
This was a change driven mainly by the explosive dollar volumes of securities lending in the early 1990s, and the risks and problems created by the difference in settlement methods between the equity and fixed income financing markets. It created an opportunity for “float” – reinvestment arbitrage – that disadvantaged the ultimate lender as represented by the big lending banks, while contributing to the meteoric growth in rebate earnings at the big borrowing brokers.
At the same time, it did much to make the matched book/conduit business extremely lucrative. Clearinghouse funds led to things like Weekend and Goto Rates; First Day and Last Day Payors; Thursday flips, Friday reborrows; “billed not earned” and “earned not billed” income over month end. Next day funds made certain operational processes and practices like callbacks on returns on some days of the week “make or break” in terms of desks making their numbers for an entire month… getting stuck in position when sitting between a first and a last day payor over a single weekend could make the difference between a monthly profit or a monthly loss.
Clearinghouse funds made profitability analysis something more than a simple calculation of a spread, and added a dimension of temporal esoterica to the job of the stock loan trader that sometimes made it more profitable to pay a higher rate than they were receiving. Clearinghouse funds made our special Good Friday market holiday a significant profitability concern and factor, and could turn long weekends into big bonuses for those who knew how to make the most of them – or major losses for those who didn’t.
For decades, the industry invested millions of dollars in systems, human capital, business processes, automation, analysis and research, all to figure out how work around the gap between Same Day and Next Day Settlement, and how to make a profit and narrow the risks occasioned by that gap. And then, all that investment in workaround solutions to a fundamental market inefficiency was made obsolete over one long weekend in February of 1996.
It’s important that we think back on these seminal events in the history of our industry and ask ourselves: are getting to the root of the problem in our quest for solutions to today’s problems, or are we just creating workarounds that perpetuate the condition? How much do we really want to invest in workarounds when that investment will become moot once we really do solve the core problem?

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