Looking at our crystal ball, we think we see some potentially good news for securities finance for the rest of 2013. Granted, some of this is avoiding potential disasters, but given the rough spell of the last five years, this too is welcome. Below we present three scenarios we see that could improve the fortunes of securities financing activities over the next six to eight months.
1) The Euro 11’s FTT falls apart. The squabbling has been front page news, France’s FTT has pulled in far less than expected and Italy’s FTT has (along with a tough election) all but halved equity market volumes. On top of this, Sweden’s disastrous history with its FTT and the hard lessons of Britain’s Stamp Tax, which created the now robust Contracts for Differences market, suggest that FTT’s aren’t all they are made out to be. The US and other trading partners are also unhappy with the current FTT plans. This all suggests to us that the odds are better than 50/50 that the Euro 11’s FTT disappears altogether, or is sufficiently watered down that it doesn’t really impact financial markets.
2) France and Italy change their minds. Given these two countries’ new interest in promoting growth over austerity and the general weak performance of their FTTs, we see a scenario where the FTT’s are repealed. Finance ministers look at the numbers and realize that more financial market trading actually generates more tax revenue than the FTT, which curtails this activity. The analysis might be a little complicated and would need to extend to retail investors, capital gains taxes and taxes paid by brokers, but we think it is an exercise worth performing.
3) Expanded collateral requirements for non-cleared derivatives make life easier for banks and counterparties. In February 2013, the Basel Committee on Banking Supervision and IOSCO published “Margin requirements for non-centrally cleared derivatives.” While this was called the Second Consultative Document, we are thinking of this as close to the final version. The BCBS and IOSCO took a kindly approach towards corporate bonds and equities as collateral for non-cleared derivatives:
“Another approach would be to permit a broader set of eligible collateral, including assets like liquid equity securities and corporate bonds, and address the potential volatility of such assets through application of appropriate haircuts to their valuation for margin purposes. Potential advantages of the latter approach would include (i) a reduction of the potential liquidity impact of the margin requirements by permitting firms to use a broader array of assets to meet margin requirements and (ii) better alignment with central clearing practices, in which CCPs frequently accept a broader array of collateral, subject to collateral haircuts. After evaluating each of these alternatives, the BCBS and IOSCO have opted for the second approach (broader eligible collateral).”
Since we’ve seen firms adjust their haircut upwards for corporate bonds and equities (110% collateralization in securities lending for equities, for example), we think that the markets will adapt their procedures for these asset classes in a way that regulators will accept. This reduces the expectation of a collateral squeeze by some unknown percent, and we don’t think this will affect the fortunes of collateral transformation by any harsh degree. Here’s why:
— The ability of, say, US insurance companies to post corporate bonds as collateral for non-cleared derivatives means that they do not have to hunt for outside collateral either through new purchases, lines of credit or transformation, BUT
— Plenty of the market will still need to post collateral on CCPs for cleared OTC derivatives, and most CCPs still prefer government bonds. Some banks may also limit the percent of corporate bonds and equities that they will take. The amount of government bonds that we think are potentially lendable in the securities lending market against lower quality collateral is $1.48 trillion, and this is much, much lower than even the lowest amount of estimated collateral still needed in the market (including CCPs, non-cleared derivatives and bank high quality liquid assets). Net net, we don’t see much of a hit to the potential for transformation. We keep this opinion even if the percentage of Level 2 and 2B assets under the Liquidity Coverage Ratio is raised to greater than 40% and 15%, respectively. There is just still too much expected demand so long as beneficial asset holders and repo cash providers like the returns they are getting.
While the markets have certainly seen a restructuring, we believe that there is reason to be optimistic about the remainder of this year. Even trade repositories, ESMA’s mandate that asset managers retain only “reasonable” securities lending revenues, and changes to div arb aren’t enough to sour us at this point.