Data Explorers: Creeping case for CCPs – Panacea or Boadicea?
10 June 2011 London
Image: Shutterstock
Ostriches put their heads in the sand so let’s instead put our head to the task of the CCP debate. We know regulators are keen on this model and there are at least three published or imminent articles looking at the suitability of a central counterpart for securities lending. Even if the securities finance market is focused on other issues, other people are talking about this for you; it is on the agenda whether people like it or not. Much of the talk so far is sorely lacking in detail so we will approach this issue through the eyes of the four players in the short selling chain but let’s start with the regulator.
Regulators
First up, we will start with the rationale of the regulators. At the crux of the Bank of England’s desire to see changes in the securities lending markets was the speech made by Deputy Governor, Paul Tucker, in January 2010 where he set out five ways that securities lending could learn from the credit crisis. It was this speech that prompted the B of E to produce a short paper on CCPs that was discussed at the March quarterly meeting where the industry airs its views with the Bank.
http://www.bankofengland.co.uk/publications/speeches/2010/speech420.pdf
Interestingly, a central counterpart is mentioned as a tool to meet just one of his areas of concern and would have no bearing on the other four areas in need of improvement (many of which are now being addressed). That said, it was his first point, but he equally admits that it may not be suitable ‘as may well be the case for some types of security.’ Dovetailing his comments on considering whether securities lending, ‘might lend itself to central counterpart clearing’ are two phrases arguing for ‘greater transparency’ and ‘aggregate data’ to be published. However, rather than pushing this whole market onto a CCP platform, it is worth asking whether there are other means to ensure more information is made more widely available as much of the data is already being aggregated.
Beneficial Owners
The owners of the assets that drive the securities lending market are arguably the most powerful players in the chain and the least enthusiastic about a CCP. To see the ideological divide between proponents of CCPs and their detractors, look at the tone behind this comment by OneChicago’s David Downey in this week’s issue of Securities Lending Times
http://www.securitieslendingtimes.com/sltimes/SLTimes_issue_27.pdf
David says that a loan is, “actually a disposition of an asset – whereby they get their forward agreements”. While not inaccurate, this is not how the CIO of a pension fund would describe it. For them, securities lending represents a temporary transfer of an asset that they remain the owner of. They continue to be the official shareholder and thereby responsible for collecting dividend income and retaining the right to recall the shares back to vote with their reputation at stake should the borrower abuse their use of this asset. Buying and selling things requires much less directing; as long as you agree with the price and deliver and or receive the asset in question nothing matters. Life is rather different when lending something. As such, the more control they have over who borrows their shares and under what terms the better. Having spent the last few years tightening up their lending guidelines, it is understandable why they now question the value of forging this vice like grip by lobbing their shares into a CCP.
Hedge Funds
Hedge Funds are the most eager for a CCP structure to exist and they are early adopters of the AQS service that uses the OCC as the clearing backstop. CCPs offer them the ability to borrow anonymously – a big plus where secrecy allows them to keep their edge. According to the OCC’s website, securities lending volume is up 47% year over year with 330,777 new loan transactions.
http://www.optionsclearing.com/about/press/releases/2011/06_01.jsp
The buy side and especially the very biggest funds have long been eager to deal as directly as possible with the asset owners if it offers lower borrowing costs. At the same time, the prime brokers remain a core service provider and one they do not wish to ostracize for all the other services they offer.
Custodians
On the record, Custodians are happy to make use of CCPs and have no religious objection – if their clients are happy. In reality, the CCP offers no great benefit to the major global custodian community whose deep relationships with the brokers and well staffed teams of traders are geared up for a bilateral OTC market. They would argue, convincingly, that if it ain’t broke, don’t fix it.
Collateralized lending of shares has occurred trouble free for decades. They even made money from the bankruptcy of Lehman due to the liquidation of LEH’s collateral, which was carefully chosen and marked to market on a daily basis, leaving them in surplus. In fact, if you stress test (using our Risk Adjusted Returns framework) a model portfolio of loans against every major 20th century shock, you only lose money when interest rates rise yet bonds drop. So, why the need for a CCP when risk is well managed as things stand?
Prime Brokers
This is a mixed bag. Certain synthetic prime brokers (Soc Gen, the former Fortis) have backed CCP structures such as Sec Fin Ex. However, the main brokers, hitherto, have been fairly disinterested. This may change as Basel III and Dodd Frank pull the rug from below their feet if a CCP leads to less balance sheet usage.
Final Word
It is high time we addressed this issue and in future pieces we can address more specific issues such as whether certain instruments lend themselves to CCPs more than others, like bonds. Also, certain types of counterpart will make use of CCPs more than others. Then, as the market fragments between OTC and CCP, there will eventually be a coming together when the offering is good enough to drive all of the activity.
For now, the most powerful players in the securities lending market have contented themselves to automate some of their less juicy trading and operations, via Equilend for example for easy to borrow names, while leaving the rest as it always has been.
While withholding tax rates differ around the world and securities lending entails mucky corporate actions activity it will be some time before a dominant equity CCP comes to the fore. Also, there is much work to do to move the minds of the Beneficial Owners.
As we all know, it was the re-investment of cash collateral that created distress at the time of the credit crisis. With this activity now handcuffed to the least risky over night assets, it seems that the systemic risk is not there just to justify so much upheaval to force the whole market onto a CCP. If transparency is what regulators want, is is worth asking whether there are far easier ways to achieve this?
Regulators
First up, we will start with the rationale of the regulators. At the crux of the Bank of England’s desire to see changes in the securities lending markets was the speech made by Deputy Governor, Paul Tucker, in January 2010 where he set out five ways that securities lending could learn from the credit crisis. It was this speech that prompted the B of E to produce a short paper on CCPs that was discussed at the March quarterly meeting where the industry airs its views with the Bank.
http://www.bankofengland.co.uk/publications/speeches/2010/speech420.pdf
Interestingly, a central counterpart is mentioned as a tool to meet just one of his areas of concern and would have no bearing on the other four areas in need of improvement (many of which are now being addressed). That said, it was his first point, but he equally admits that it may not be suitable ‘as may well be the case for some types of security.’ Dovetailing his comments on considering whether securities lending, ‘might lend itself to central counterpart clearing’ are two phrases arguing for ‘greater transparency’ and ‘aggregate data’ to be published. However, rather than pushing this whole market onto a CCP platform, it is worth asking whether there are other means to ensure more information is made more widely available as much of the data is already being aggregated.
Beneficial Owners
The owners of the assets that drive the securities lending market are arguably the most powerful players in the chain and the least enthusiastic about a CCP. To see the ideological divide between proponents of CCPs and their detractors, look at the tone behind this comment by OneChicago’s David Downey in this week’s issue of Securities Lending Times
http://www.securitieslendingtimes.com/sltimes/SLTimes_issue_27.pdf
David says that a loan is, “actually a disposition of an asset – whereby they get their forward agreements”. While not inaccurate, this is not how the CIO of a pension fund would describe it. For them, securities lending represents a temporary transfer of an asset that they remain the owner of. They continue to be the official shareholder and thereby responsible for collecting dividend income and retaining the right to recall the shares back to vote with their reputation at stake should the borrower abuse their use of this asset. Buying and selling things requires much less directing; as long as you agree with the price and deliver and or receive the asset in question nothing matters. Life is rather different when lending something. As such, the more control they have over who borrows their shares and under what terms the better. Having spent the last few years tightening up their lending guidelines, it is understandable why they now question the value of forging this vice like grip by lobbing their shares into a CCP.
Hedge Funds
Hedge Funds are the most eager for a CCP structure to exist and they are early adopters of the AQS service that uses the OCC as the clearing backstop. CCPs offer them the ability to borrow anonymously – a big plus where secrecy allows them to keep their edge. According to the OCC’s website, securities lending volume is up 47% year over year with 330,777 new loan transactions.
http://www.optionsclearing.com/about/press/releases/2011/06_01.jsp
The buy side and especially the very biggest funds have long been eager to deal as directly as possible with the asset owners if it offers lower borrowing costs. At the same time, the prime brokers remain a core service provider and one they do not wish to ostracize for all the other services they offer.
Custodians
On the record, Custodians are happy to make use of CCPs and have no religious objection – if their clients are happy. In reality, the CCP offers no great benefit to the major global custodian community whose deep relationships with the brokers and well staffed teams of traders are geared up for a bilateral OTC market. They would argue, convincingly, that if it ain’t broke, don’t fix it.
Collateralized lending of shares has occurred trouble free for decades. They even made money from the bankruptcy of Lehman due to the liquidation of LEH’s collateral, which was carefully chosen and marked to market on a daily basis, leaving them in surplus. In fact, if you stress test (using our Risk Adjusted Returns framework) a model portfolio of loans against every major 20th century shock, you only lose money when interest rates rise yet bonds drop. So, why the need for a CCP when risk is well managed as things stand?
Prime Brokers
This is a mixed bag. Certain synthetic prime brokers (Soc Gen, the former Fortis) have backed CCP structures such as Sec Fin Ex. However, the main brokers, hitherto, have been fairly disinterested. This may change as Basel III and Dodd Frank pull the rug from below their feet if a CCP leads to less balance sheet usage.
Final Word
It is high time we addressed this issue and in future pieces we can address more specific issues such as whether certain instruments lend themselves to CCPs more than others, like bonds. Also, certain types of counterpart will make use of CCPs more than others. Then, as the market fragments between OTC and CCP, there will eventually be a coming together when the offering is good enough to drive all of the activity.
For now, the most powerful players in the securities lending market have contented themselves to automate some of their less juicy trading and operations, via Equilend for example for easy to borrow names, while leaving the rest as it always has been.
While withholding tax rates differ around the world and securities lending entails mucky corporate actions activity it will be some time before a dominant equity CCP comes to the fore. Also, there is much work to do to move the minds of the Beneficial Owners.
As we all know, it was the re-investment of cash collateral that created distress at the time of the credit crisis. With this activity now handcuffed to the least risky over night assets, it seems that the systemic risk is not there just to justify so much upheaval to force the whole market onto a CCP. If transparency is what regulators want, is is worth asking whether there are far easier ways to achieve this?
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