Breaking barricades
08 September 2015
Equity-heavy US broker-dealers could soon receive a regulatory boost
Image: Shutterstock
A significant regulatory barrier to US securities lending business has, for a long time, been Securities and Exchange Commission (SEC) Rule 15c3-3. This rule, as laid down in the Securities Exchange Act of 1934, essentially bars broker-dealers from using equities as collateral in securities lending transactions.
The rule has long been a target for reform because it is one area in which the US is behind. European and Canadian markets recognise equities as an acceptable form of collateral, for securities lending and repo. They do so because equities have proven to be highly liquid assets that can even outperform cash during times of crisis. Equities have a readily determined price, can be sold immediately, correlate highly to lent securities, and have higher margins than other typical forms of collateral. These were all arguments put forward in 2011 by the Risk Management Association (RMA), but a change to Rule 15c3-3 is yet to materialise.
Now, the RMA, along with the Securities Industry and Financial Markets Association (SIFMA), has taken up the mantle again and plans to submit a comment letter to the SEC proposing an update to Rule 15c3-3 that will allow broker-dealers to add equities to their collateral arsenals. It must be made clear that a change to this rule would be a long and complicated process, and the RMA and SIFMA should be applauded for putting the time and effort into lobbying for a change.
Rule 15c3-3 is complicated enough in itself, because it contains multiple requirements that broker-dealers have to comply with when borrowing the fully-paid or excess margin securities of their “customers”. The definition of “customer”, although not expressly stated, applies to agent lenders. At the same time, equity securities are not listed as a permissible category of collateral with the rule, and even if they were, a broker-dealer would have to make a net deposit in a reserve account every time it used equity securities as collateral in order to borrow securities to meet delivery obligations for customer transactions.
On top of Rule 15c3-3 in the US, the Employee Retirement Income Security Act, the Investment Company Act and several federal statutes would also have to be amended, because they affect the securities lending activities of pensions funds and investment companies, as well as lenders’ rights in the event of a counterparty default. The result is that any reform of Rule 15c3-3 would require a cross-regulator discussion—no easy task for the RMA and SIFMA, whose mission it is to push this reform through, at long last.
And push it through they should, according to many active in US securities lending. “Collateral providers are generally excited about pending changes to SEC Rule 15c3-3 because they will be able to more directly finance their equity inventories. We share the industry’s desire to expand or improve collateral profiles in a thoughtful manner that promotes reduced operational risk, price transparency, liquidity, and so on,” says Robert Chiuch, who is global head of equity and fixed income finance trading for the markets group at BNY Mellon.
Gregory Sorrentino, managing director and head of US equity finance at Nomura, says: “The equity for equity business is growing rapidly in the US equity finance broker-dealer community as a result of balance sheet constraints. So this is a relatively large add-on here in the US. If and when changes are implemented around 15c3-3, it would, in my opinion, benefit most firms and the overall US equity finance product.”
“General collateral trades via equity-for-equity makes sense on all levels, and can be highly automated. Perhaps the only type of trading that will be done in a cash capacity will be specials at some point.”
Unbalanced sheet
The balance sheet immediately stands out as a prime example of how equities as collateral in the US could be good for certain market players, particularly hedge funds. The headlines have been busy with news of some prime brokers shedding hedge fund clients because their relationships do not make sense in the new regulatory landscape. And it is these prime brokers, and by extension their hedge fund clients, that would stand to gain the most from reform of Rule 15c3-3.
Sorrentino explains: “With prime brokers being focused on return on assets (ROA) due to capital constraints stemming from the leverage ratio, any reduction in balance sheet usage through equity-for-equity trading would enable new business.”
“Under the current conditions, prime brokers are being forced to make some difficult decisions around picking which funds they can prime for based on client ROA. My hope is that with these changes, we will see an uptick in the overall US prime broker businesses.”
Despite the positives that such a rule change would bring, it could also bring a material change to the current dynamics in the US market.
Chiuch says: “Where there is a potential hurdle—and this is something that needs to be carefully contemplated in the dynamics between lenders and borrowers—is the overall impact of the new capital rules on such transactions. If you look at the current landscape, most equity collateral businesses occur outside of the US, with the highest concentrations out of Europe, the Asia Pacific and Canada.”
“On the face of it, this change may initially provoke or lead to a global rotation in balances. We would, therefore, expect a global rebalancing in the equity collateral space as some participants go more directly to the US market.”
The same regulations that are increasing capital costs for prime brokers are also affecting agent lenders and their clients, and this could be made more severe if the market changes as predicted.
“On the surface, it’s not hard to envision a higher volume of equity collateral directly moving towards the US market,” says Chiuch. “The challenge, however, will lie in the pricing. The capital requirements under Basel III attach a 100-percent capital charge for non-bank entities delivering risk-weighted assets. This would mean that the change to Rule 15c3-3 would have to factor that into that equation.”
“A global rotation of equity collateral providers could—in theory—result in a rotation out of banks that currently attract a 20 percent capital charge, in terms of these collateral pools, to non-bank entities. By accepting equities as collateral from non-bank entities in the US, for instance, agent lenders would essentially attract five times the capital charge on those same transactions.”
As ever, whether or not a counterparty will participate in this kind of business remains entirely its decision.
Sorrentino says: “It’s really going to be an individual’s choice and will depend on the kind of collateral they want to accept. Both sides would have to agree on the types (grades) of equities they will choose to use. For instance, lenders may say they want equity for equity, but will only do it on S&P 500 type names. The risk appetite is going to be subjective.”
Julie Hubbard, head of US sales and relationship management for securities lending at Brown Brothers Harriman, adds that any potential change to Rule 15c3-3 is more of a concern for general collateral lenders since regulation has further increased funding costs for borrowers in what was already a low margin activity.
“However, intrinsic value lenders will be able to continue to demand cash as the higher margin nature of these trades means borrowers can withstand the funding costs of raising cash collateral,” she says.
For Chiuch, the likelihood is a more dynamic pricing model than the market currently experiences. “The pricing will have to adapt and evolve accordingly. The market will have to consider agent lenders’ appetites to absorb increased capital costs. That said, this rule change is yet another step in the secular evolution of the marketplace. The market will adapt, as it has before.”
The rule has long been a target for reform because it is one area in which the US is behind. European and Canadian markets recognise equities as an acceptable form of collateral, for securities lending and repo. They do so because equities have proven to be highly liquid assets that can even outperform cash during times of crisis. Equities have a readily determined price, can be sold immediately, correlate highly to lent securities, and have higher margins than other typical forms of collateral. These were all arguments put forward in 2011 by the Risk Management Association (RMA), but a change to Rule 15c3-3 is yet to materialise.
Now, the RMA, along with the Securities Industry and Financial Markets Association (SIFMA), has taken up the mantle again and plans to submit a comment letter to the SEC proposing an update to Rule 15c3-3 that will allow broker-dealers to add equities to their collateral arsenals. It must be made clear that a change to this rule would be a long and complicated process, and the RMA and SIFMA should be applauded for putting the time and effort into lobbying for a change.
Rule 15c3-3 is complicated enough in itself, because it contains multiple requirements that broker-dealers have to comply with when borrowing the fully-paid or excess margin securities of their “customers”. The definition of “customer”, although not expressly stated, applies to agent lenders. At the same time, equity securities are not listed as a permissible category of collateral with the rule, and even if they were, a broker-dealer would have to make a net deposit in a reserve account every time it used equity securities as collateral in order to borrow securities to meet delivery obligations for customer transactions.
On top of Rule 15c3-3 in the US, the Employee Retirement Income Security Act, the Investment Company Act and several federal statutes would also have to be amended, because they affect the securities lending activities of pensions funds and investment companies, as well as lenders’ rights in the event of a counterparty default. The result is that any reform of Rule 15c3-3 would require a cross-regulator discussion—no easy task for the RMA and SIFMA, whose mission it is to push this reform through, at long last.
And push it through they should, according to many active in US securities lending. “Collateral providers are generally excited about pending changes to SEC Rule 15c3-3 because they will be able to more directly finance their equity inventories. We share the industry’s desire to expand or improve collateral profiles in a thoughtful manner that promotes reduced operational risk, price transparency, liquidity, and so on,” says Robert Chiuch, who is global head of equity and fixed income finance trading for the markets group at BNY Mellon.
Gregory Sorrentino, managing director and head of US equity finance at Nomura, says: “The equity for equity business is growing rapidly in the US equity finance broker-dealer community as a result of balance sheet constraints. So this is a relatively large add-on here in the US. If and when changes are implemented around 15c3-3, it would, in my opinion, benefit most firms and the overall US equity finance product.”
“General collateral trades via equity-for-equity makes sense on all levels, and can be highly automated. Perhaps the only type of trading that will be done in a cash capacity will be specials at some point.”
Unbalanced sheet
The balance sheet immediately stands out as a prime example of how equities as collateral in the US could be good for certain market players, particularly hedge funds. The headlines have been busy with news of some prime brokers shedding hedge fund clients because their relationships do not make sense in the new regulatory landscape. And it is these prime brokers, and by extension their hedge fund clients, that would stand to gain the most from reform of Rule 15c3-3.
Sorrentino explains: “With prime brokers being focused on return on assets (ROA) due to capital constraints stemming from the leverage ratio, any reduction in balance sheet usage through equity-for-equity trading would enable new business.”
“Under the current conditions, prime brokers are being forced to make some difficult decisions around picking which funds they can prime for based on client ROA. My hope is that with these changes, we will see an uptick in the overall US prime broker businesses.”
Despite the positives that such a rule change would bring, it could also bring a material change to the current dynamics in the US market.
Chiuch says: “Where there is a potential hurdle—and this is something that needs to be carefully contemplated in the dynamics between lenders and borrowers—is the overall impact of the new capital rules on such transactions. If you look at the current landscape, most equity collateral businesses occur outside of the US, with the highest concentrations out of Europe, the Asia Pacific and Canada.”
“On the face of it, this change may initially provoke or lead to a global rotation in balances. We would, therefore, expect a global rebalancing in the equity collateral space as some participants go more directly to the US market.”
The same regulations that are increasing capital costs for prime brokers are also affecting agent lenders and their clients, and this could be made more severe if the market changes as predicted.
“On the surface, it’s not hard to envision a higher volume of equity collateral directly moving towards the US market,” says Chiuch. “The challenge, however, will lie in the pricing. The capital requirements under Basel III attach a 100-percent capital charge for non-bank entities delivering risk-weighted assets. This would mean that the change to Rule 15c3-3 would have to factor that into that equation.”
“A global rotation of equity collateral providers could—in theory—result in a rotation out of banks that currently attract a 20 percent capital charge, in terms of these collateral pools, to non-bank entities. By accepting equities as collateral from non-bank entities in the US, for instance, agent lenders would essentially attract five times the capital charge on those same transactions.”
As ever, whether or not a counterparty will participate in this kind of business remains entirely its decision.
Sorrentino says: “It’s really going to be an individual’s choice and will depend on the kind of collateral they want to accept. Both sides would have to agree on the types (grades) of equities they will choose to use. For instance, lenders may say they want equity for equity, but will only do it on S&P 500 type names. The risk appetite is going to be subjective.”
Julie Hubbard, head of US sales and relationship management for securities lending at Brown Brothers Harriman, adds that any potential change to Rule 15c3-3 is more of a concern for general collateral lenders since regulation has further increased funding costs for borrowers in what was already a low margin activity.
“However, intrinsic value lenders will be able to continue to demand cash as the higher margin nature of these trades means borrowers can withstand the funding costs of raising cash collateral,” she says.
For Chiuch, the likelihood is a more dynamic pricing model than the market currently experiences. “The pricing will have to adapt and evolve accordingly. The market will have to consider agent lenders’ appetites to absorb increased capital costs. That said, this rule change is yet another step in the secular evolution of the marketplace. The market will adapt, as it has before.”
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