CCPs blown along by regulatory winds and pragmatism

Back in mid June we lifted the kimono on the central counterpart debate, or lack of, and today return to the theme after hearing the views of CCP proponent and electronic trading venue, SecFinex.

 

As you can see in today’s accompanying video interview, their head of Sales, Jonathan Lombardo, makes a robust and dispassionate case for how central counterparts can add value to the securities financing markets without dramatically changing how things are currently done. We know that regulators and hedge funds like this “best price” route to market so we mainly focus on why the Beneficial Owners and their Custodian agents should engage with this model. Some of the key points are as follows.

 

 

Some would argue that this community have too much control. But, given it is their assets that drive the whole securities financing process, the beneficial owners have rightly set their own rules. This has led to them receiving indemnities against any (non cash collateral related) loss and the ability to choose which counterparts are allowed to borrow their shares. But the new regulations being put forward in BASEL III make it harder for banks to offer these indemnities since each one will use up precious capital. Secondly, it is no longer the case that the top two prime brokers control over 50% of the demand such that it is easy to hand pick 10 counterparts that will ensure 98% of the likely borrowers are covered. Today’s market is more fragmented.

 

The SecFinex electronic trading service claims to address both trends. Beneficial owners may prefer to lend via the security of a central counterpart (where the risk is mutually shared by all the members) if their agent is unable to offer them an indemnity due to capital constraints. In particular, if the largest asset owners swallow up the few indemnities available, the smaller beneficial owners may be left with little choice but to lend via a CCP if they want to avoid undue counterpart risk.

 

On the counterpart front, Jonathan makes the point that an asset owner can have the best of both worlds. They can continue to lend the bulk of their shares to their chosen counterparts via the pre-existing Custodial lending desk route but, in order not to miss out on the demand coming from brokers not on the approved list, they can lend a portion of their stocks via the CCP. Given that these shares are being borrowed at the best price via this centralized facility, there is no need for the beneficial owner to worry about the credit risk of the ultimate borrower, as the credit risk lies with the CCP.

 

When theory meets reality the challenges will start. Custodians will have to think carefully about which list of securities to offer to which types of borrower and it may take some time for this to be optimized. No one wants a situation whereby the Custodian has placed the securities that their number one broker desires in the CCP and vice versa. As we know, it is operationally challenging to be able to dangle the same list of securities in front of both audiences at the same time.

 

 

 

Having dealt with the pragmatic ways a CCP benefits the asset owners, we then moved on to discuss the case for the banks who lend the shares. Of course, if a CCP opens up a new avenue to enable more securities to be lent, as already discussed, the Custodians make more money given they take a share of the income from each loan. On top of this, SecFinex allows its members to undertake direct or “non anonymous” trading. Recognizing that the existing modus operandi will not change overnight they have catered for those who want to trade in the old way but using the electronic platform. This will go some way to assuaging the fears of the big Agent Lenders who are particularly keen to do certain trades with certain counterparts during the all important dividend season. This approach can work for the allocation of hard to borrow names too.

 

Only banks are eligible to trade through a CCP so there is no sense that Custodians are bypassed. An asset manager cannot lend their shares via a CCP without a banking license and membership. Of course, the resources required by the Custodian will change if electronic trading takes off, but there is a long way to go and it is going to take some skill to work out how best to combine the old ways with the new.

 

 

As SecFinex admit, CCPs are even more useful for this community since they enable borrowers to get hold of securities with the minimum usage of their bank’s balance sheet. Since BASEL III states that any transactions cleared via a CCP receive a 0% allocation of capital, this is clearly the optimal route to market. Even before the recent dramatic falls in bank share prices, any way to take the strain off the balance sheet was the way to go. With smaller market capitalizations, the need by banks to borrow securities without capital charges is even more important.

 

 

So where are we now? There is clearly some way to go given that SecFinex are hosting $200-300m of European equity loans against the $180bn that is reported to Data Explorers. Clearly, there are very strong regulatory winds blowing the market in the direction of electronic trading via CCPs. A critical milestone to encourage Agent Lender’s to adopt this product will be a definitive set of details and dates to emerge regarding the cost of offering indemnities. But, if we assume this is a case of when and not “if”, the only real barrier to adoption is time. With everything going on in finance right now, some patience will certainly be required.