Describe the current state of the US securities lending market?
At the end of 2017, Datalend reported that the US securities lending market reached an all-time high of $19 trillion worth of securities available for lending and that 2017 revenues exceeded $4.85 billion. Seeing an all-time high in securities available is evidence of widespread acceptance of securities lending, but I think market participants are eager to see higher utilisation rates. In Q3 2017, IHS Markit reported that five percent of US securities available for lending were out on loan with average balances around $525 billion. I’m receiving a lot of inquiries about how to expand the cleared securities lending business and we’ve had a number of new participants become highly engaged over the last year.
At the same time, it seems like there are several other initiatives and new businesses launching that aim to provide new and more effective securities lending programmes. My sense is that beneficial owners, who have historically used securities lending as a way to offset costs by lending out their securities, are increasingly looking at securities lending as a source of generating alpha. The rising volatility that we’ve seen over the last couple of months should help drive demand from short sellers and provide opportunities for higher utilisation and greater revenues for lenders.
How has the central clearing space evolved since the global financial crisis of 2008?
OCC is celebrating 25 years of its stock loan programme this year, and it’s interesting to look back on the history because there have been three different phases of growth and we’re on the cusp of our fourth wave. OCC’s stock loan programme was created in 1993 with the goal of providing margin savings to options market makers that were hedging their delta risk through the lending and borrowing of stocks. The second wave of growth began in the build up to the financial crisis when the primary driver of growth in OCC’s stock loan programme shifted from brokers seeking margin savings to brokers seeking credit substitution. When a stock loan is accepted by OCC, we step in and become the central counterparty between the lender and borrower. Our ‘AA+’ credit rating and neutral position as a central counterparty (CCP) that provides a financial guarantee allows lenders and borrowers to establish much larger positions within stock loan clearing than they typically can on a direct bilateral basis. It’s important to note though, that there is an ongoing relationship between the original lender and borrower to manage lifecycle events of the contract. In the wake of the financial crisis all firms took a much closer look at their counterparty risk. That review produced a new-found appreciation for the financial guarantee and counterparty credit substitution that OCC offers and, as a result, brought a big increase in the number of firms using OCC’s stock loan programme.
The third wave of growth began around 2012 as a result of regulatory reforms. Beginning with Dodd-Frank and continuing through today, regulators have recognised the relative safety and stability of clearing, and have built in preferential treatment and incentives for clearing. When I talk to clearing members, the margin offset and benefits from the credit upgrade are still valuable, but these days most firms cite the favorable capital treatment as the greatest benefit of our stock loan programme. Now, I see the clearing spaced poised for a fourth wave
of growth.
Historically, agent lenders and beneficial owners haven’t participated in clearing, but the opportunity for credit intermediation and preferential accounting treatment is driving an intense amount of interest from lenders. At OCC, we are working on expanding our membership requirements in order to permit access to a broader set of lenders. Once those changes are approved by the regulators I expect we’ll see another decade of growth.
Are the changes driven by regulation? If so, which ones and why?
The changes to the capital requirement calculation that were introduced by Basel and have been adopted here in the US are the most significant drivers for clearing. The regulators wanted to strengthen the capital markets by making sure that market participants were appropriately assessing counterparty credit risk and setting aside adequate amounts of capital to account for that risk. This is done by looking at the riskiness of different types of exposures as well as the riskiness of the counterparty to those exposures. Fully collateralised equity exposures, such as stock loans, are relatively less risky than other types of exposures, but the counterparty can have a significant impact upon the amount of capital that must be set aside. Exposures to corporations and broker dealers must use a risk weighting of 100 percent. Exposures to banks have a risk weighting of 20 percent. Exposures to a CCP have a risk weighting of two percent. For example, an agent lender bank lending $1 billion of stocks versus 102 percent in cash to another bank must set aside approximately $5.5 million in capital for credit risk and indemnification. The capital required for that same $1 billion exposure shoots up to about $24 million if the borrower is a broker dealer. If however the counterparty is a CCP, the capital requirement drops to about $0.4 million. The same capital requirements and savings also apply to borrowers. Cleared exposures are on average 95 percent cheaper than non-cleared exposures.
Another example is the US Federal Reserve single counterparty credit limit. Exposures to CCPs are exempted from this requirement.
What are the benefits of central clearing for beneficial owners?
Beneficial owners will see many financial benefits from central clearing. The cost of indemnifying against the default of a CCP is significantly cheaper than other counterparties. This will cause less of a drag on lending revenues. I expect lending revenues will also be higher as a result of the lower capital requirements for cleared exposures. Based on some calculations that spread could be 5 to 25 basis points for stock loans, which is roughly in line with the cleared vs. non-cleared rates seen in repo markets. Finally, also as a result of lower capital requirements by borrowers, beneficial owners are likely to find higher utilisation rates within clearing.
Is the cost of using a central counterparty prohibitive to beneficial owners?
From a fee perspective, definitely not. OCC currently charges $1 per new loan from the lender. Whether that same fee schedule will apply to agent lenders or beneficial owners hasn’t been determined, but OCC operates as a market utility and, governed by our users, prioritises cost controls, passing savings back to the users. For 2017, OCC declared a refund of nearly $80 million to its clearing members.
The unanswered question is whether or how beneficial owners may need to collateralise the risk of their cleared positions. Typically, clearing members with lending positions present downside risk to the CCP because of the requirement to return collateral. This risk is assessed as a margin requirement and is typically collateralised using treasuries or equities. Beneficial owners present a different risk profile than typical clearing participants, so the risk methodology is still under development. This may end up adding some cost of capital if collateral is required, but that will likely be met through pledging unlent equities so the cost is likely to be trivial, especially considering the financial benefits clearing can offer.
What other benefits are to be had going through a central counterparty?
Clearing is a highly automated and efficient process. Almost all of the interactions are message-based and straight through processed. This leads to less breaks and reduces the need to reconcile against multiple counterparties. The agent lender disclosure (ALD) process is also simplified, because agent lenders simply need to provide ALD files to the clearing house as opposed to all of their borrowers. From a borrower’s perspective, they see OCC as their counterparty and do not need to look through to the beneficial owner.
The clearing house also provides a greater level of resilience during times of market stress and volatility. During the financial crisis many participants got out of the market for fear that their counterparty could be the next to fail. This same fear-based reaction wasn’t seen within clearing due to the safety and security of having a ‘AA+’ S&P rated, systemically important market utility as counterparty.
What are your views on the market structure of the future for securities finance?
OCC is working on a set of market structure changes to strengthen and improve the process flow for cleared stock loans. We are working with vendors like Equilend and Loanet to enhance the pre-trade validation of terms and to automate the submission to clearing, which will have straight-through processing in to depository trust company and other custodians. This market structure will more closely resemble the market structure of exchange-based markets and will provide a greater level of accuracy and efficiency over the current bilateral market.
Centralisation and standardisation tends to lower costs over time and to increase liquidity. However, we recognise that there are important differences between securities finance and cash equity markets. Most important is the ongoing bilateral relationship between lender and borrower from the time that a loan is initiated to the time it is terminated. Preserving this relationship is a foundational design principle.
I think that the US securities financing market will continue to see growth in non-cash loans, particularly if regulators permit equities to be used as collateral. The triparty custodians have robust systems to provide operational efficiency while providing the security interest and control that lenders require.
It is also interesting to watch the development of peer-to-peer markets. For certain participants, I can see how that could be an attractive alternative and down the road it would be interesting to explore a cleared peer-to-peer market where a CCP would provide credit intermediation between beneficial owners and hedge funds.
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