Just like the dynamic that we wrote about a few years ago of mid-tier broker-dealers benefiting from SIFI counterparty credit limits, we are now wondering if these same rules will help third party agent lenders, particularly those operating independently (eSecLending), as part of non-SIFI banks (Brown Brothers Harriman). This dynamic may also, and paradoxically, encourage the launch of all new third party agent lenders. Here’s where we are going with the argument:
Dodd-Frank 165e allows the Federal Reserve to set limits on counterparty credit exposures. In turn, the Federal Reserve Board has proposed a two-tiered rule:
Tier 1: counterparty credit limit of 25% compared to the bank’s capital stock and surplus.
Tier 2: for SIFIs with over $500 billion in assets, a maximum credit exposure of 10% to another SIFI with $500 billion in assets.
Here’s a write-up on Dodd-Frank 165e from The Clearing House.
The Basel Committee has taken a similar approach in “Supervisory framework for measuring and controlling large exposures – final standard“, April 2014. Effective 2019, banks should have a counterparty credit limit of 25% of Common Equity Tier 1 (CET1) or Tier 1 capital. SIFIs will have a 15% limit of Tier 1 capital.
Applying this to agency securities lending, the exposure between two banks comes with counterparty default indemnification, where Agent Bank A, a SIFI, is lending to a prime broker, also a SIFI. While Agent Bank A has been spared the impact of the Leverage Ratio (for the most part), counterparty credit exposure limits remain a real threat. It is very possible that the parent bank of Agent Bank A would deem securities lending indemnification as not worth the credit exposure, figuring that better money could be made either by not providing indemnification or by utilizing that exposure for OTC derivatives or other business. Its quite unclear what Agent Bank A would really do, but limiting indemnified lending to another SIFI is a realistic scenario.
As we documented in “Return of the US broker-dealer middleman in securities lending, thanks to Dodd-Frank 165“, October 2012, a realistic option for agent lenders is to expand their counterparty lists to included smaller broker-dealers. These entities would typically be non-SIFIs and hence not subject to the 10% or 15% credit limit. We see this expansion happening already. When these entities don’t have their own demand for securities, they simply pass the loan along to a SIFI prime broker at a mark up.
But what would happen if a non-SIFI agent lender wanted to lend more to a big bank and could afford to offer a greater amount of indemnification, or laid off the cost of indemnification altogether in an insurance policy, AND was able to service a large number of small clients? Clients would be told that indemnification is there for the taking AND that loans would go directly to their preferred counterparties, not to a smaller broker-dealer in a pass-through arrangement. That’s not a bad deal. Or, what would happen if a new entity offered agent lender services with indemnification but with limited client service? This is an old business model idea but one that might have renewed credence in the era of counterparty credit limits. it may be particularly attractive to beneficial owners who do not merit a high level of client service.
The emergence of CCPs willing to accept beneficial owners as securities lenders offers this idea both support and detraction. On the one hand, a beneficial owner could sign up to a CCP and let a new, small agent lender handle all the operations and trading. In the US, trades could be funneled to AQS and cleared on a (hypothetical) Options Clearing Corp framework for the buy-side. On the other hand, Qualifying CCPs (QCCPs) are currently exempt from counterparty credit limit rules, which is a tremendous win for the CCPs. If SIFI agent lenders can run their business through exempt QCCPs then indemnification will remain pretty a very low cost service. The Basel Committee will revisit the QCCP counterparty credit limit exemption until 2016, but we think it will remain in some form or another.
While a long-shot for multiple reasons including client acceptance, we think that existing and even new agent lenders have an opening in the market as a result of counterparty credit rules. CCPs will help incumbents but also make way for low cost technology and operations solutions that rely on CCP acceptance of buy-side firms as direct clearing members. We’ll be watching this space.