Beneficial owners are in a tough spot with securities lending CCPs. For years they have thought that CCPs were unattractive – loss of counterparty control, uncertain operations and too much margin were deal killers. Agent lenders were generally supportive of this view. But the market has fundamentally changed due to regulations, and that means that old ways of thinking are no longer sound for a successful lending organization. We look at five interrelated areas where beneficial owners should review their approach to CCPs: distribution, beneficial owner costs, agent lender costs, borrower costs and transactional pricing.
1) Distribution. In the new world of limited SIFI credit exposures, CCPs are the golden child, blessed with a formal exemption by the Basel Committee in “Supervisory framework for measuring and controlling large exposures,” April 2014 (at least for an “observation period.”). G-SIBs can have only a 15% credit exposure limit to one another, but the sky is the limit on CCPs. The upshot for securities lending is that for certain groups of banks in certain conditions (for example, J.P. Morgan Agency Lending providing indemnification in a loan to Goldman Sachs Prime Brokerage), a CCP may be the only and best way to get the loan completed. Is it just a hidden tax on securities lending without much extra benefit? Maybe, but it is also the way that business is going to be done in the future. It’s not an if, it’s a when. We were actually taken aback to hear a panel of agent lenders and prime brokers say the same thing at the Finadium Annual Conference in March 2014, but there you have it.
2) Beneficial lender costs. A big argument against CCPs has been margin requirements for beneficial owners. Eurex Clearing’s Lending CCP has gotten this solved for non-cash collateral by creating a specific lender license that exempts the buy-side from posting collateral. This applies for European and US institutions at present. We strongly advocate these non-margin or margin pledge arrangements as the only viable way to encourage broad lender participation in securities lending CCPs. There is also a new charge for using the CCP that amounts to a couple of basis points at most. The interlinking point here is that for the extra cost, lenders get better distribution than they will get in the bilateral market.
3) Agent lender costs. Readers of Securities Finance Monitor are now familiar with the SL-x sponsored Promontory analysis on securities lending indemnification capital costs and CCPs. The upshot is that capital costs for agent lenders using a CCP and still providing indemnification go down by a substantial amount. Promontory came to 97% as their figure. Eurex Clearing and Oliver Wyman did something similar and found 18 bp in savings. Whatever number you pick, there will clearly be dramatic capital charge reductions when using a CCP than conducting a bilateral transaction.
4) Borrower costs. Just as agent lenders will have lower capital charges for their liabilities (indemnification), borrowers will also have lower capital charges; Eurex Clearing and Oliver Wyman estimate an 80% savings using their Lending CCP. In this case however, the reduction comes when borrowing from a highly rated counterparty (the CCP) where netting is possible instead of a lower rated one (the beneficial owner itself). Some beneficial owners may be shocked to hear themselves talked about as a poorly rated counterparty, but in the new world order, netting and credit ratings are close to the be-all, end-all when making a borrowing decision. In some cases, several borrowers are now talking about only transacting over a CCP for a proportion of their trades and leaving the bilateral world largely behind in order to capture the cost savings.
5) Pricing. As we presented in our September 2013 research report, “A Cost/Benefit Analysis Roadmap for Securities Lending CCPs,” we continue to think strongly that CCPs will create a two-tiered pricing market. The better market will be on the CCP – borrowers will see cost savings and agent lenders and beneficial owners will argue that some of those savings should accrue to their accounts. Conversely, bilateral transactions will be more expensive for borrowers, who will in turn pay less for their loans. Beneficial owners that want the better rate will migrate to CCPs.
Are securities lending CCPs a case of “Terminator: Rise of the Machines” taking over the market? No, they aren’t. Bilateral transactions will still have a role for years to come. But we are at a point when beneficial owners should start to figure out a CCP strategy if they don’t have one. Taking a passive role at this point opens the door to business risk.
This article was commissioned by Eurex Clearing.