The scales of synthetics
07 June 2016
Experts gather to debate the rise of synthetic financing in a world where the balance sheet is lord and master and must be obeyed
Image: Shutterstock
Can a synthetic financing business ever outgrow its physical counterpart and be run independently, and why?
James Treseler, global head of cross-asset secured financing, Societe Generale: Synthetics have a place in the secured finance country code, and have for some time. Historically, synthetics have allowed for market access for those whose arms were not long enough reach access markets. Where securities lending was not deemed an acceptable practice or where a local presence was required, synthetics seemed to be the natural alternative.
Physical financing, lending and borrowing and repo, is a cornerstone of finance and the capital markets as a whole, but increasingly they are becoming less than perfect mechanisms under the scrutiny of regulations dictating liquidity and scarce resource distribution.
Some data suggests synthetics have a greater presence in prime brokerage than traditional avenues. Revenues generated from physical prime brokerage, including activities surrounding futures, have been relatively flat since 2012, while synthetic prime brokerage has grown in consecutive years. It was reported there was a 22 percent increase in synthetic prime brokerage revenues from 2014 to 2015.
There are several reasons to believe that synthetics will overtake the market share of physical financing, including market access, future fiscal concerns, greater efficiencies and cost reductions, along with potential improved synergies surrounding liquidity and balance sheet.
However, there are significant attributes that need to be considered before jumping into a synthetic relationship, including increased counterparty risk or credit risk, forfeiting proxy voting, critical to activists, and for suppliers of synthetic prime brokerage, the need to be build out technology to support collateral transformation and optimisation.
Rob Lees, co-head of securities lending EMEA and global co-head of securities lending trading, Brown Brothers Harriman: The synthetic product has been traditionally rooted in its ability to provide market access and leverage. With global regulators creating additional cost pressures on the sell side, it is evident that synthetic trades can be used as a more efficient route to market from a balance sheet, liquidity and capital standpoint. That said, despite these positive conditions, the key challenges for synthetics are operational-, liquidity- and transparency-oriented. The ‘physical set-up’ has been well-established, scaled and battle-tested and the contractual, operational and regulatory component that underpins the physical world has been built for scale, cost and aggregation.
Separately, for many of our clients, the additional simplicity of legal set-up, collateralisation requirements and price discovery with wider market access has very clear benefits.
Ross Levin, managing principal, Primetech Management: As Basel III and its associated cost charges and leverage restrictions are being rolled out, the synthetic financing vehicle is going to become a more popular source for hedge fund financing.
The likely scenario is that a number of prime brokers will begin scaling back their hedge fund relationships, while some could start the process of completely getting rid of smaller hedge funds, as the short-term financing cost is going to be too high to maintain these relationships.
As a result, synthetic financing transactions that provide some balance sheets efficiency and potential capital reductions for prime brokers will become ever popular as hedge funds will still need a reliable financing source.
In my opinion, we could see synthetic financing outgrowing its physical counterpart, but, since the underlying basis for all synthetic trades are still physical transactions in a form of financing the hedging process, the physical side will not be undermined, but simply shifted over to a different side of a trade strategy.
Paul Wilson, global head of agent lending product and portfolio advisory, investor services, J.P. Morgan: The use of synthetics has grown and should continue to do so as market participants look to realise its balance sheet and capital benefits. Whether it will outgrow its physical counterpart remains to be seen.
This, however, is part of an ongoing change across the lending/financing industry as more capital, balance sheet and return-on-capital effective structures, transactions and business models, including central counterparties, are evaluated in order accommodate business.
Many agents are pursuing strategies that help address costs as well as increased interest and demands from beneficial owners to participate in securities lending.
This calls for innovation and investment, and may ultimately lead to a divergence in agents’ business models and capabilities.
Dane Fannin, head of capital markets, Asia Pacific, Northern Trust: This phenomenon is emerging already. The use of synthetic structures is increasing for a number of reasons that are unlikely to disappear anytime soon.
Firstly, in the wake of a new regulatory landscape, synthetic products tend to be more balance sheet-efficient than their physical counterparts given the ability to net down long and short hedged positions, thus reducing capital costs for the provider.
Secondly, synthetic routes to market are often preferred in jurisdictions where traditional access is both complex and restrictive.
Thirdly, investors may prefer a synthetic solution where the administrative requirements for physical access are cumbersome (for example, short sale reporting).
Fourthly, funds adopting a UCITS format are prohibited from short selling physically and so are required to exclusively deploy synthetic arrangements to pursue traditional long/short strategies.
Market providers are not looking at these products independently, but rather are aligning their physical and synthetic businesses to allow for a more holistic solution in deploying capital efficiently.
Martin Seagroatt, marketing director, sales and marketing, 4sight Financial Software: As a technology vendor in this space, we are certainly seeing an increase in demand for systems to support the swaps lifecycle, mainly due to the balance sheet efficiencies of these types of products.
It is debatable how much of the securities finance market could eventually move to synthetic routes to market. Polls at industry events have tended to place this figure at no more than 25 percent of total market volume and, most likely, it’s a lot less.
Fran Garritt, director of securities lending and market risk, the Risk Management Association: For an equivalent economic exposure, market participants may seek the lowest-cost alternative. Since the economic crisis, the regulatory environment has created potential uneven cost structures between synthetic securities finance and physical securities finance transactions.
This is evident in the favourable treatment of synthetics versus physical with respect to risk-weighted Assets (RWA) under the standardised approach, although the new Basel proposal may bring them in line, and exposure under the single counterparty credit limits.
On the other hand, physical transactions utilising cash collateral have a negative treatment under the supplemental leverage, liquidity coverage, and net stable funding ratios. While there are some other potential opportunities to minimise these differences, we would expect some further transition into synthetic structures.
Anecdotal evidence indicates that there is increasing pressure to move in this direction. However, synthetic structures may require broker-dealers to hedge exposures, which would require continued physical transactions. Additionally, the liquidity in many synthetic trades and the limited ability to easily exit certain transactions will likely continue to keep many market participants preferring the physical alternative.
Overall, we expect a continued migration toward synthetic structures, but it is likely to be a long time, if ever, before they outgrow their physical counterparts.
William Donzeiser IV, founding member, the Opti Group: When looking at the single stock linear derivative space, in my opinion the answer is really yes and no.
A full service traditional cash prime provider typically has a complementary linear derivative offering. However, you can have a successful derivative-based business without ever becoming a full service cash prime broker.
This is an increasingly meaningful differentiator as banks focus on core competencies, pair back on non-core market offerings, and leverage synthetics for their own financial resource netting benefits.
While market access, bespoke structural characteristics, transaction taxes and legal considerations drive users to synthetics globally, which now trade seamlessly as direct market access or give-up in most markets, the structural hurdles of lack of equity ownership (ie, voting rights) and additional operational nuances will allow the cash prime balances to outpace synthetics for the foreseeable future.
One last note to add is that if you tally synthetic balances beyond the single stock base to include all asset classes traded as synthetic, while expanding the synthetic definition marginally to include high delta option pairs and single stock futures, that scale quickly begins to tip the other way.
Rory Zirpolo, managing director, Cantor Fitzgerald Securities Lending: Yes, provided these synthetic transactions are cleared through some central counterparty framework.
Take the example of interest rate swap rates, which have recently become cheaper than repo rates due to balance sheet costs and liquidity issues. This could easily happen in equity financing, too, as indemnification costs for lenders could put a strain on lendable supply in markets, which would drive spreads up relative to synthetic costs, making the synthetic option all the more attractive.
Glenn Horner, managing director, State Street: We expect the long-range trend to be significantly greater growth within the synthetic securities finance business than its physical counterpart. After a major contraction during the financial crisis, physical securities finance business growth has been less than robust.
Given the regulatory pressure on these transactions, especially ones collateralised with cash, we expect this trend to continue for the foreseeable future. Bank’s balance sheets, heightened liquidity requirements, and increasingly more conservative risk-based capital (RBC) treatment, will likely limit any future growth of the physical securities finance business.
As such, we anticipate that future growth will naturally migrate to the synthetic securities finance business, which generally receives more favourable regulatory treatment under both Basel and local regulatory initiatives.
While this trend will persist into the future, we expect that the physical securities finance business will be the larger piece of the pie and the two businesses will be inextricably linked due to hedging requirements for the foreseeable future
James Treseler, global head of cross-asset secured financing, Societe Generale: Synthetics have a place in the secured finance country code, and have for some time. Historically, synthetics have allowed for market access for those whose arms were not long enough reach access markets. Where securities lending was not deemed an acceptable practice or where a local presence was required, synthetics seemed to be the natural alternative.
Physical financing, lending and borrowing and repo, is a cornerstone of finance and the capital markets as a whole, but increasingly they are becoming less than perfect mechanisms under the scrutiny of regulations dictating liquidity and scarce resource distribution.
Some data suggests synthetics have a greater presence in prime brokerage than traditional avenues. Revenues generated from physical prime brokerage, including activities surrounding futures, have been relatively flat since 2012, while synthetic prime brokerage has grown in consecutive years. It was reported there was a 22 percent increase in synthetic prime brokerage revenues from 2014 to 2015.
There are several reasons to believe that synthetics will overtake the market share of physical financing, including market access, future fiscal concerns, greater efficiencies and cost reductions, along with potential improved synergies surrounding liquidity and balance sheet.
However, there are significant attributes that need to be considered before jumping into a synthetic relationship, including increased counterparty risk or credit risk, forfeiting proxy voting, critical to activists, and for suppliers of synthetic prime brokerage, the need to be build out technology to support collateral transformation and optimisation.
Rob Lees, co-head of securities lending EMEA and global co-head of securities lending trading, Brown Brothers Harriman: The synthetic product has been traditionally rooted in its ability to provide market access and leverage. With global regulators creating additional cost pressures on the sell side, it is evident that synthetic trades can be used as a more efficient route to market from a balance sheet, liquidity and capital standpoint. That said, despite these positive conditions, the key challenges for synthetics are operational-, liquidity- and transparency-oriented. The ‘physical set-up’ has been well-established, scaled and battle-tested and the contractual, operational and regulatory component that underpins the physical world has been built for scale, cost and aggregation.
Separately, for many of our clients, the additional simplicity of legal set-up, collateralisation requirements and price discovery with wider market access has very clear benefits.
Ross Levin, managing principal, Primetech Management: As Basel III and its associated cost charges and leverage restrictions are being rolled out, the synthetic financing vehicle is going to become a more popular source for hedge fund financing.
The likely scenario is that a number of prime brokers will begin scaling back their hedge fund relationships, while some could start the process of completely getting rid of smaller hedge funds, as the short-term financing cost is going to be too high to maintain these relationships.
As a result, synthetic financing transactions that provide some balance sheets efficiency and potential capital reductions for prime brokers will become ever popular as hedge funds will still need a reliable financing source.
In my opinion, we could see synthetic financing outgrowing its physical counterpart, but, since the underlying basis for all synthetic trades are still physical transactions in a form of financing the hedging process, the physical side will not be undermined, but simply shifted over to a different side of a trade strategy.
Paul Wilson, global head of agent lending product and portfolio advisory, investor services, J.P. Morgan: The use of synthetics has grown and should continue to do so as market participants look to realise its balance sheet and capital benefits. Whether it will outgrow its physical counterpart remains to be seen.
This, however, is part of an ongoing change across the lending/financing industry as more capital, balance sheet and return-on-capital effective structures, transactions and business models, including central counterparties, are evaluated in order accommodate business.
Many agents are pursuing strategies that help address costs as well as increased interest and demands from beneficial owners to participate in securities lending.
This calls for innovation and investment, and may ultimately lead to a divergence in agents’ business models and capabilities.
Dane Fannin, head of capital markets, Asia Pacific, Northern Trust: This phenomenon is emerging already. The use of synthetic structures is increasing for a number of reasons that are unlikely to disappear anytime soon.
Firstly, in the wake of a new regulatory landscape, synthetic products tend to be more balance sheet-efficient than their physical counterparts given the ability to net down long and short hedged positions, thus reducing capital costs for the provider.
Secondly, synthetic routes to market are often preferred in jurisdictions where traditional access is both complex and restrictive.
Thirdly, investors may prefer a synthetic solution where the administrative requirements for physical access are cumbersome (for example, short sale reporting).
Fourthly, funds adopting a UCITS format are prohibited from short selling physically and so are required to exclusively deploy synthetic arrangements to pursue traditional long/short strategies.
Market providers are not looking at these products independently, but rather are aligning their physical and synthetic businesses to allow for a more holistic solution in deploying capital efficiently.
Martin Seagroatt, marketing director, sales and marketing, 4sight Financial Software: As a technology vendor in this space, we are certainly seeing an increase in demand for systems to support the swaps lifecycle, mainly due to the balance sheet efficiencies of these types of products.
It is debatable how much of the securities finance market could eventually move to synthetic routes to market. Polls at industry events have tended to place this figure at no more than 25 percent of total market volume and, most likely, it’s a lot less.
Fran Garritt, director of securities lending and market risk, the Risk Management Association: For an equivalent economic exposure, market participants may seek the lowest-cost alternative. Since the economic crisis, the regulatory environment has created potential uneven cost structures between synthetic securities finance and physical securities finance transactions.
This is evident in the favourable treatment of synthetics versus physical with respect to risk-weighted Assets (RWA) under the standardised approach, although the new Basel proposal may bring them in line, and exposure under the single counterparty credit limits.
On the other hand, physical transactions utilising cash collateral have a negative treatment under the supplemental leverage, liquidity coverage, and net stable funding ratios. While there are some other potential opportunities to minimise these differences, we would expect some further transition into synthetic structures.
Anecdotal evidence indicates that there is increasing pressure to move in this direction. However, synthetic structures may require broker-dealers to hedge exposures, which would require continued physical transactions. Additionally, the liquidity in many synthetic trades and the limited ability to easily exit certain transactions will likely continue to keep many market participants preferring the physical alternative.
Overall, we expect a continued migration toward synthetic structures, but it is likely to be a long time, if ever, before they outgrow their physical counterparts.
William Donzeiser IV, founding member, the Opti Group: When looking at the single stock linear derivative space, in my opinion the answer is really yes and no.
A full service traditional cash prime provider typically has a complementary linear derivative offering. However, you can have a successful derivative-based business without ever becoming a full service cash prime broker.
This is an increasingly meaningful differentiator as banks focus on core competencies, pair back on non-core market offerings, and leverage synthetics for their own financial resource netting benefits.
While market access, bespoke structural characteristics, transaction taxes and legal considerations drive users to synthetics globally, which now trade seamlessly as direct market access or give-up in most markets, the structural hurdles of lack of equity ownership (ie, voting rights) and additional operational nuances will allow the cash prime balances to outpace synthetics for the foreseeable future.
One last note to add is that if you tally synthetic balances beyond the single stock base to include all asset classes traded as synthetic, while expanding the synthetic definition marginally to include high delta option pairs and single stock futures, that scale quickly begins to tip the other way.
Rory Zirpolo, managing director, Cantor Fitzgerald Securities Lending: Yes, provided these synthetic transactions are cleared through some central counterparty framework.
Take the example of interest rate swap rates, which have recently become cheaper than repo rates due to balance sheet costs and liquidity issues. This could easily happen in equity financing, too, as indemnification costs for lenders could put a strain on lendable supply in markets, which would drive spreads up relative to synthetic costs, making the synthetic option all the more attractive.
Glenn Horner, managing director, State Street: We expect the long-range trend to be significantly greater growth within the synthetic securities finance business than its physical counterpart. After a major contraction during the financial crisis, physical securities finance business growth has been less than robust.
Given the regulatory pressure on these transactions, especially ones collateralised with cash, we expect this trend to continue for the foreseeable future. Bank’s balance sheets, heightened liquidity requirements, and increasingly more conservative risk-based capital (RBC) treatment, will likely limit any future growth of the physical securities finance business.
As such, we anticipate that future growth will naturally migrate to the synthetic securities finance business, which generally receives more favourable regulatory treatment under both Basel and local regulatory initiatives.
While this trend will persist into the future, we expect that the physical securities finance business will be the larger piece of the pie and the two businesses will be inextricably linked due to hedging requirements for the foreseeable future
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