The pros and cons of CCPs in securities lending

The Bank of England’s new Quarterly Bulletin (click here) devotes ten pages to the subject of securities lending. On the one hand it is nice to see the UK’s central bank spending some time trying to better understand the business and to see them put in writing that, “it can improve market liquidity, potentially reducing the cost of trading and increasing market efficiency.” On the other hand, they are doing so for a reason: “by increasing the interconnections between institutions it can pose potential risks to financial stability….participants have attempted to address some of these risks, and fundamental changes to market infrastructure are being discussed, such as the use of central counterparties.” We can deepen the CCP discussion by showcasing a couple of answers to questions raised by our clients after our last piece on this subject (click here) – and are grateful to SecFinex for their answers.

The classic first question goes like this: “As an owner of shares, I currently receive collateral when they are lent. Is it really the case that I have to give up collateral/capital when lending shares in a CCP since this is a major turn off?”

SecFinex: The status quo (of beneficial owners receiving collateral) remains unchanged in the SIX x-clear centrally cleared markets (Germany, Switzerland, Austria, Norway, Denmark, Finland, Sweden). In the LCH model (France, Belgium, Netherlands, Portugal), the BO continues to receive its collateral, but could be asked to provide margin. Traditionally, lenders receive an arbitrary 5% margin to cover market volatility encountered while liquidating collateral in the event of a borrowers default. In a CCP model, risk management is performed in real time using models that are robustly stress tested to a 99% confidence level. Margins provided by both borrowers and lenders to a CCP, together with these risk models, enable the CCP to guarantee lenders will get their loaned securities back, and that borrowers will get their collateral back at no loss.

Editor: In other words, asset owners may have to put up margin when lending via LCH, but with this comes a guarantee you won’t lose money. They may receive margin at present (excess collateral) but this doesn’t necessarily imply less risk. The CCP is saying “don’t be fooled that just because you have a 5% margin you are protected from losing money – you are safer with us.” As pointed out by JP Morgan’s Paul Wilson, (click here), the issue then becomes – who do you trust more? A large commercial bank that has government guarantees or a private, non state supported company like a CCP? But the CCP is at no risk of any spill over losses or contagion from other parts of its business, unlike a bank. Then again, CCPs are relatively unproven and new. It comes down to a matter of opinion...

Beneficial Owner: “Under what circumstances am I asked to provide margin in LCH and what instruments can I use?”

SecFinex: In the LCH model, which is cash collateral only, the lender receives the cash. The CCP guarantee is that securities and collateral will be returned to their rightful owners, therefore the lender represents a risk that will require margin collection to allow the CCP to mitigate that risk of lender default. There are two types of margin, Initial Margin (IM) and Variation Margin (VM). In both CCPs the VM is basically market price movement of loan and collateral. They will collect VM from one party and pass to the other to maintain the agreed level of collateral vs. loan.

IM is collected to manage counterparty and market risk taking in to account volatility in securities loaned or taken as collateral. The amount will depend on how the loan and collateral are assessed, size of position, size of total book and counterparty rating among other things. As a benchmark, LCH comes in at about 10.6%, but remember it is the clearing member that is responsible for providing this margin to the CCP, using its own assets. A Beneficial Owner would usually make use of a general clearing member (GCM) to provide access to the CCP. It is the GCM that will call the BO for margin and determine what assets are eligible (shares, bonds cash etc). It is the relationship between the BO and GCM that determines arrangements for margin provision. In SIX, as long as the collateral is kept in the account at SIS then the lender poses no risk to its GCM. This is because the legal construct provides that in the event of a BO default, the GCM will have control of the collateral and can unwind the positions, returning the collateral to the borrower and the returned shares to the lender. (In the event of the GCM default, the lender has title to the collateral). This structure means that the GCM does not need to call margin from the BO.

Editor: In other words, the beneficial owner may be able to lean on their Agent Lender/Custodian to provide margin on their behalf. The willingness of general clearing members to post margin on behalf of the BO clients is therefore crucial in making the CCP model acceptable to them. However, questions still remain when SecFinex claim that a Custodian can use “its own assets,” if that Agent does not have such a thing.

Beneficial Owner: who manages the cash that we receive as collateral when lending via LCH?

SecFinex: Cash collateral is passed to the beneficial owner or its Custodian Agent to invest in their normal reinvestment program.

Prime Broker: Our homework has shown that the additional initial margin and increased trading costs as well as the deposit for insuring the system completely outweigh the benefits of capital reduction or 0% weighting for risk weighted assets calculations. Also, the dividend business is 90% of revenue for many beneficial owners and we doubt this trading will move to a CCP, even if you can do bilateral trading, because the increased margin and costs will make the trades unprofitable. What do you say?

SecFinex: Each firm will have different capital requirements. As an ICM (individual clearing member) a CCP offering delivers real time risk assessments on collateral, counterpart and asset. There is a guarantee of asset return or a cash equivalent (indemnity) and a capital and RWA adjustment close to zero. At worse, trading via a CCP could incur a 2% capital charge compared to a minimum balance sheet charge of 20% for bi-lateral trading that can be as high as 100%. As for regulatory changes, they are inevitable and firms can either adhere to an early adapter approach or face the regulators requirements at a later date. In percentage points, the cost is minimal in comparison to what will be required to continue the bi lateral approach for yield enhancement, specials and GC. As we have stated before, this is not a 100% solution for anyone’s business, but should be a tool to help you better manage your capital, credit and risk requirements. On the cost of the deposit to insure the system, general clearing members (who can trade on behalf of clients as well as themselves) typically get charged 5m CHF (5.5m USD) and individual clearing members (who can only trade on their own behalf) pay around 1m CHF.

Some other points to consider:

- Additional margin, at least in the SIX x-clear model, enables the borrower to put up 100% collateral. The margin is calculated by the CCP and could be anywhere between 2% and 6%, so there is a possibility that less margin will be required

- Addressing increased trading costs, one must consider savings that could be achieved at the post trade, mark to market, month end fee settlements, collateral management, etc. In addition, price discovery, access to liquidity pools they might not otherwise have access to and the ability to bypass credit lines when at capacity.

- The borrower gets a guarantee his collateral is returned and the CCP unwinds the positions. The borrower does not get involved in the process, except of course to return borrowed securities, but at least he does not have to go to market to sell / buy loans / collateral

Editor: In other words, borrowers need to take into account the bigger picture when assuming that increased trading costs make a CCP pointless. If you factor in a reduced operations head count due to the CCP’s ability to process all corporate actions and settlement then it begins to make more sense - for some types of borrower than others. A CCP makes most sense for those banks with very stringent rules on use of balance sheet and those who also have an unattractive credit rating.

In summary, this debate is far from over. The expressed preference for CCPs from regulators is likely to encourage greater lender adoption as regulator interest means it won't go away. But there remains a gulf in terms of understanding and trust if CCPs are to address the concerns of the lender community without a regulatory stick to enforce action. For our part, we will continue to put questions to both sides.