We have written a few times lately about the potential impacts of Moody’s downgrading banks by one or two notches and what the impacts for funding, collateral and the buy-side might be (see our articles here and here. Today we look at what potential bank downgrades mean for securities lending and in particular for CCPs.
CCPs in securities lending have gotten more traction than some expected in their professional lifetimes but they are far from universally accepted. In the US, Quadriserv’s AQS system appears to have gathered steam among the broker-dealer community but has yet to penetrate in any meaningful way with US agent lenders or beneficial owners. In Europe, CCPs continue to emerge and we like the proposed Eurex model for collateral pledging quite a lot, but the demise of SecFinex did not provide much encouragement to the sector. All in all, it is fair to say that while CCPs remain theoretically attractive to regulators, they have not yet gained mass traction in the user community.
Bank downgrades could potentially change attitudes toward CCPs in securities lending. The impact of the downgrade will be to reduce the attractiveness of a bank counterparty in making a securities loan. Some downgraded banks may be taken off of acceptable counterparty lists, especially by nervous beneficial owners, and others may see credit lines reduced. While low leverage levels are contributing to prime brokers now being able to fund many of their own short requirements, in time this may change leading to constraints on a bank’s ability to borrow securities from agent lenders. A bank with a reduced credit rating may see its credit limits used up or limitations on the number of counterparties willing to do business with it just as their demand increases.
The idea of a CCP in mutualizing risk means that the downgraded bank would have an option, albeit one with expenses, for sourcing inventory outside of the bilateral system that requires their own credit rating to be judged. The AAA credit rating of the CCP provides a smoke screen for the varying credit ratings of participating members. As we and others have written about many times before, CCPs do not eliminate risk, they merely share it around. But, regulators are still swooning over CCPs and their risk management practices are viewed as superior to bilateral risk, hence the AAA rating. So get the smoke machine ready.
Banks that turn to CCPs because of low credit ratings may find that their counterparties are also banks with higher credit risk. Agent lenders may prefer to keep lending bilaterally to banks with stronger credit because they can. This may create a first tier and a second tier in the securities lending community, where agent lenders will lend everything they can to the first tier and only then turn to CCPs to lay off the remainder of their inventory at a slightly (or more than slightly) higher cost. This would have the effect of making the first tier even more attractive to hedge funds looking for lower-cost securities loans.
While regional differences would strongly influence the users of CCPs (margin differences being a major challenge), globally we think that bank downgrades could be an impetus for looking at CCPs as a new and important source of inventory and securities lending.