Lowering the barriers
03 May 2018
Jonathan Adams of Delta Capita explains that mutualisation in the securities finance industry is the key to lowering barriers to entry
Image: Shutterstock
There has been much talk about the world being on the brink of a Fourth Industrial Revolution and the rise of digital technologies creating market disruption, resulting in the disappearance of household names in certain industry sectors. Within financial services, however, arguably many view financial technology (fintech) as a school of piranhas nipping away at industry leviathans, begging the question: are they too small to have any real impact?
Yet in the world of securities finance, both the drive for increased industry transparency and cost efficiencies mean that further change is inevitable. This change will eventually stem from the identification of those functions and processes operating on shared technology, rather than simply the status quo of individual firms interfacing through enterprise technology with multi-jurisdiction settlement infrastructure. Furthermore, as more beneficial owners begin to view securities lending revenue as integral to the overall yield of their portfolios, the distribution model itself warrants some reinvention.
All those across the spectrum of industry participants acknowledge the need for transformation and the need to replace aging legacy systems, but have balked at the cost and project timeframes of enterprise upgrades, especially as the burden of regulatory change has absorbed resources that historically would have been dedicated for change. Furthermore, having had waited this long already, many are waiting to see what new approaches will emerge and how that will streamline the industry’s operating model and deliver efficiencies. Indeed, the shared model is emerging but market participants are waiting to see whom the winners are and what the impact will be.
Sophisticated distribution
The securities lending industry was created to avail the asset liquidity locked within the portfolios of buy-side institutions back to the professional markets. This proved hugely successful in generating securities liquidity to facilitate sell-side securities trading strategies for a pre-crisis speculative market. Substantial spreads were derived both from demand-driven value and speculative strategies that anticipated that demand. It was also a substantial source of securities collateral and an important factor in the development of the prime services industry.
Transactions were executed bilaterally between lenders and borrowers. Borrowers transacted bilaterally with each other or via interdealer brokers on a named give-up basis. Because not all market participants had the necessary contracts in place, ‘passthrough’ activity was also prevalent. There was limited requirement for disclosure of underlying principles by agent lenders to their sell-side borrower counterparties; borrowers were informed of the list of principals in the programme and were informed (to their credit risk departments only) post-settlement of their exposure of undisclosed principals. Agent lenders provided an optional indemnification to their beneficial clients for a nominal charge as part of their securities lending programmes, with a relatively limited charge to their balance sheets. Despite occasional, but serious occurrences that were associated with cash collateral reinvestment, securities lending was viewed overall as a low-risk, discretionary, value-add activity for beneficial owners.
Nevertheless, it was operationally burdensome. Billing discrepancies with resulting write-offs were the norm, and cash was the collateral of choice (where permitted), because securities collateral required a single deal capture per booking, manual daily valuation, and the risk of substitution.
On the whole, beneficial owners were risk averse, ambivalent about returns, and wanted a service that caused minimal interruption—a discretionary revenue stream to mitigate custody costs. For both lenders and borrowers, spreads were healthy and lending programmes took cash as collateral, which was invested in commingled investment programmes at a time when there were ‘real’ interest rates and regular interest moves by the key central banks.
Today’s post-crisis environment is very different. For banks, the significant regulatory burden dictates types of permitted activity and strict rules around the use of balance sheet. Agent lenders have to take a significant charge to their balance sheets for client indemnification, and offer principal lending programmes where they borrow the beneficial owners’ securities onto their own balance sheets before on lending to borrowers.
Distribution is now far more sophisticated, with the emergence of lending platforms (both bilateral and cleared), and on exchange volume repo trading activity is almost without exception cleared through central counterparties. These mutualised facilities have improved settlement efficiency, with billing write-offs now being the exception rather than the norm.
Nevertheless, some elements have remained unchanged; with technology only evolving on a functional basis to keep pace with product evolution with limited innovation. A shift in attitude by the larger buy-side firms has occurred, with a desire for greater transparency and value from the securities lending industry. This desire has been supported with the emergence of electronic multi-user distribution channels, which has slowly begun to challenge the traditional distribution model with some distribution across lending platforms, leaving market professionals to structure the bespoke activity. However, with price transparency remaining a contentious issue for some beneficial owners, last summer the US State Pension Fund Industry, supported by the Federal Reserve, took steps to address this by looking to see if those beneficial owners could be supported by a dedicated distribution platform. Closer to home, the Bank of England securities lending committee also met not so long ago to explore the very same topic.
Specifically, by viewing securities lending revenue as part of the overall value of a portfolio, rather than a discretionary value-add, the buy-side is beginning to see that shared technology solutions could reduce barriers to entry, enable direct lending, and obtain increased price transparency, whilst retaining the safeguards currently provided by the traditional lending programmes (acknowledging that specific strategies would remain with the professional lending community).
Regulation has required that banks adhere to strict usage of their balance sheets, and have set basis point return targets on their activity. Borrowers require greater transparency with regards to underlying principles with a view to undertaking pre-trade checks. Furthermore, the demand drivers for the banks and broker-dealers are no longer about supporting proprietary speculative activity, instead supporting the demand from prime broker clients and shoring up their balance sheets to ensure they meet risk weighted asset (RWA) and liquidity coverage ratio (LCR) targets.
So, what’s next?
Pre-trade
Further mutualisation? Will beneficial owners, who previously felt the too high barriers to entry of managing their own lending programme, choose to lend on a shared facility? Will borrowers be able to electronically match their demand to the aggregated individual supply of each? What would an ‘Amazon’ for securities finance require?
Post-trade
The big ‘next step’ for the securities finance industry is not necessarily distribution, more post-trade services. Unlike the processing of cash markets (principal trading activity in fixed income and equities), which has seen some outsourcing to post-trade processing utilities, post-trade services for securities finance still resides firmly inside firms. Historically, businesses have been reluctant to risk either outsourcing or relocating this function to another location given the complex trade lifecycles and teamwork of both front, middle and back office that exist when managing lengthy, open-ended transactions in particular.
Another hurdle that is slowly abating is the reluctance of firms to embrace cloud-based technology.
In the past, highly effective middle and back office functions offered a competitive advantage. A firm that could demonstrably show demonstrate accurate fee, rebate history, or exposure calculations could essentially force their billing or margin call. Likewise, firms that could demonstrate settlement efficiency through effective inventory management could ensure that fail costs were not attributed to them; indeed, it was a source of revenue to deal with counterparties with a poor settlement record.
Post-trade processing is no longer a profit centre. However, due to the emergence of non-differentiating services including platforms, trades cleared via central counterparties (settlement netting), contract and billing comparison services, and higher-quality inventory management. Yet the technology cost burden for these non-differentiating services is increasing. Why? Simply, the already heavy costs to support older technology. Functions that have improved post-trade processing and can support new products are built outside the core application, meaning development and maintenance occurs over multiple applications rather than a single application.
In an environment that has become less focused on profit and more on return on use of balance sheet, cost remains an issue. However, the idea of sharing technology seems more appropriate given that post-trade functions would now benefit from technology synergy. Market participants can formalise an established single-process approach, albeit via the use of different and separate enterprise technologies. Not only does the market as a whole enjoy improved efficiency, individual firms can also benefit from a pay-per-use model enabling costs to follow revenue, removing the burden of fixed costs.
Outsourced services and technology do not suffer the same competition of resources that occur with an enterprise technology environment that has to support multiple business lines and applications. Instead, they enjoy a single focus and priority development. Moreover, participants are functionally kept in sync and initiatives can be researched and resourced via industry consortia.
Looking forward, tokenised assets, blockchain, and machine learning are all expected to revolutionise the financial services industry still further. Mutualised managed services solutions should therefore be seen as an interim step, providing an approach in which utility providers can run a platform in a flexible, feature-filled, efficient and cost-effective way.
Lowering barriers to entry
Given the trade lifecycle complexity of securities finance transactions, and that regulatory obligations have competed with firms’ technology spend, pre-trade, and post-trade mutualisation can keep the focus on the development of the global securities finance marketplace. Mutualisation is key to lowering barriers to entry, both in terms of new entrants and new jurisdictions.
Yet in the world of securities finance, both the drive for increased industry transparency and cost efficiencies mean that further change is inevitable. This change will eventually stem from the identification of those functions and processes operating on shared technology, rather than simply the status quo of individual firms interfacing through enterprise technology with multi-jurisdiction settlement infrastructure. Furthermore, as more beneficial owners begin to view securities lending revenue as integral to the overall yield of their portfolios, the distribution model itself warrants some reinvention.
All those across the spectrum of industry participants acknowledge the need for transformation and the need to replace aging legacy systems, but have balked at the cost and project timeframes of enterprise upgrades, especially as the burden of regulatory change has absorbed resources that historically would have been dedicated for change. Furthermore, having had waited this long already, many are waiting to see what new approaches will emerge and how that will streamline the industry’s operating model and deliver efficiencies. Indeed, the shared model is emerging but market participants are waiting to see whom the winners are and what the impact will be.
Sophisticated distribution
The securities lending industry was created to avail the asset liquidity locked within the portfolios of buy-side institutions back to the professional markets. This proved hugely successful in generating securities liquidity to facilitate sell-side securities trading strategies for a pre-crisis speculative market. Substantial spreads were derived both from demand-driven value and speculative strategies that anticipated that demand. It was also a substantial source of securities collateral and an important factor in the development of the prime services industry.
Transactions were executed bilaterally between lenders and borrowers. Borrowers transacted bilaterally with each other or via interdealer brokers on a named give-up basis. Because not all market participants had the necessary contracts in place, ‘passthrough’ activity was also prevalent. There was limited requirement for disclosure of underlying principles by agent lenders to their sell-side borrower counterparties; borrowers were informed of the list of principals in the programme and were informed (to their credit risk departments only) post-settlement of their exposure of undisclosed principals. Agent lenders provided an optional indemnification to their beneficial clients for a nominal charge as part of their securities lending programmes, with a relatively limited charge to their balance sheets. Despite occasional, but serious occurrences that were associated with cash collateral reinvestment, securities lending was viewed overall as a low-risk, discretionary, value-add activity for beneficial owners.
Nevertheless, it was operationally burdensome. Billing discrepancies with resulting write-offs were the norm, and cash was the collateral of choice (where permitted), because securities collateral required a single deal capture per booking, manual daily valuation, and the risk of substitution.
On the whole, beneficial owners were risk averse, ambivalent about returns, and wanted a service that caused minimal interruption—a discretionary revenue stream to mitigate custody costs. For both lenders and borrowers, spreads were healthy and lending programmes took cash as collateral, which was invested in commingled investment programmes at a time when there were ‘real’ interest rates and regular interest moves by the key central banks.
Today’s post-crisis environment is very different. For banks, the significant regulatory burden dictates types of permitted activity and strict rules around the use of balance sheet. Agent lenders have to take a significant charge to their balance sheets for client indemnification, and offer principal lending programmes where they borrow the beneficial owners’ securities onto their own balance sheets before on lending to borrowers.
Distribution is now far more sophisticated, with the emergence of lending platforms (both bilateral and cleared), and on exchange volume repo trading activity is almost without exception cleared through central counterparties. These mutualised facilities have improved settlement efficiency, with billing write-offs now being the exception rather than the norm.
Nevertheless, some elements have remained unchanged; with technology only evolving on a functional basis to keep pace with product evolution with limited innovation. A shift in attitude by the larger buy-side firms has occurred, with a desire for greater transparency and value from the securities lending industry. This desire has been supported with the emergence of electronic multi-user distribution channels, which has slowly begun to challenge the traditional distribution model with some distribution across lending platforms, leaving market professionals to structure the bespoke activity. However, with price transparency remaining a contentious issue for some beneficial owners, last summer the US State Pension Fund Industry, supported by the Federal Reserve, took steps to address this by looking to see if those beneficial owners could be supported by a dedicated distribution platform. Closer to home, the Bank of England securities lending committee also met not so long ago to explore the very same topic.
Specifically, by viewing securities lending revenue as part of the overall value of a portfolio, rather than a discretionary value-add, the buy-side is beginning to see that shared technology solutions could reduce barriers to entry, enable direct lending, and obtain increased price transparency, whilst retaining the safeguards currently provided by the traditional lending programmes (acknowledging that specific strategies would remain with the professional lending community).
Regulation has required that banks adhere to strict usage of their balance sheets, and have set basis point return targets on their activity. Borrowers require greater transparency with regards to underlying principles with a view to undertaking pre-trade checks. Furthermore, the demand drivers for the banks and broker-dealers are no longer about supporting proprietary speculative activity, instead supporting the demand from prime broker clients and shoring up their balance sheets to ensure they meet risk weighted asset (RWA) and liquidity coverage ratio (LCR) targets.
So, what’s next?
Pre-trade
Further mutualisation? Will beneficial owners, who previously felt the too high barriers to entry of managing their own lending programme, choose to lend on a shared facility? Will borrowers be able to electronically match their demand to the aggregated individual supply of each? What would an ‘Amazon’ for securities finance require?
Post-trade
The big ‘next step’ for the securities finance industry is not necessarily distribution, more post-trade services. Unlike the processing of cash markets (principal trading activity in fixed income and equities), which has seen some outsourcing to post-trade processing utilities, post-trade services for securities finance still resides firmly inside firms. Historically, businesses have been reluctant to risk either outsourcing or relocating this function to another location given the complex trade lifecycles and teamwork of both front, middle and back office that exist when managing lengthy, open-ended transactions in particular.
Another hurdle that is slowly abating is the reluctance of firms to embrace cloud-based technology.
In the past, highly effective middle and back office functions offered a competitive advantage. A firm that could demonstrably show demonstrate accurate fee, rebate history, or exposure calculations could essentially force their billing or margin call. Likewise, firms that could demonstrate settlement efficiency through effective inventory management could ensure that fail costs were not attributed to them; indeed, it was a source of revenue to deal with counterparties with a poor settlement record.
Post-trade processing is no longer a profit centre. However, due to the emergence of non-differentiating services including platforms, trades cleared via central counterparties (settlement netting), contract and billing comparison services, and higher-quality inventory management. Yet the technology cost burden for these non-differentiating services is increasing. Why? Simply, the already heavy costs to support older technology. Functions that have improved post-trade processing and can support new products are built outside the core application, meaning development and maintenance occurs over multiple applications rather than a single application.
In an environment that has become less focused on profit and more on return on use of balance sheet, cost remains an issue. However, the idea of sharing technology seems more appropriate given that post-trade functions would now benefit from technology synergy. Market participants can formalise an established single-process approach, albeit via the use of different and separate enterprise technologies. Not only does the market as a whole enjoy improved efficiency, individual firms can also benefit from a pay-per-use model enabling costs to follow revenue, removing the burden of fixed costs.
Outsourced services and technology do not suffer the same competition of resources that occur with an enterprise technology environment that has to support multiple business lines and applications. Instead, they enjoy a single focus and priority development. Moreover, participants are functionally kept in sync and initiatives can be researched and resourced via industry consortia.
Looking forward, tokenised assets, blockchain, and machine learning are all expected to revolutionise the financial services industry still further. Mutualised managed services solutions should therefore be seen as an interim step, providing an approach in which utility providers can run a platform in a flexible, feature-filled, efficient and cost-effective way.
Lowering barriers to entry
Given the trade lifecycle complexity of securities finance transactions, and that regulatory obligations have competed with firms’ technology spend, pre-trade, and post-trade mutualisation can keep the focus on the development of the global securities finance marketplace. Mutualisation is key to lowering barriers to entry, both in terms of new entrants and new jurisdictions.
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