Magazine Issues » May 2013

CLEARING AND SETTLEMENT: Strategic moves – or not

Palm sphereThe emergence of two new CCPs in the securities lending market has raised the question of whether central clearing offers any true benefits to asset owners and lenders. Nicholas Pratt examines the evidence.

Central counterparties (CCPs) have become a key feature of the capital markets ever since the Lehman Brothers default. Yet they have seldom been used in the securities lending market despite the
fact that the collateral demands of central clearing could lead to an increase in securities lending activity (see Funds Europe, April 2013).

In 2009, Euro CCP and SIX Securities both worked with Sec Finex, a web-based securities lending platform owned by NYSE Euronext, to provide a CCP facility; however, SecFinex closed its doors in December 2011 because of a lack of interest from participants. Now though, there are two new CCPs.

In November 2012, Eurex Clearing launched a CCP service for securities lending. It is available for equities and fixed income securities in Germany and Switzerland with plans to extend the service to France, Belgium and the Netherlands later this year.

According to Gerard Denham, the clearing business development executive, the creation of the new CCP has been market-led and, therefore, designed to offer participants more benefits. For borrowers, there is the reduction of capital requirements that comes with the CCP model. For agent lenders, allying with a CCP service is a strategic move, says Denham.

For beneficial owners, he argues that the Eurex CCP will be attractive because it allows them to participate directly in the market rather than via a clearing member and will have no margin requirement. “They can acquire a lending licence and face no additional cost. They will have to receive a pledge of non-cash collateral at a triparty agent which will be fully segregated.”

Meanwhile, SIX Securities Services, the post-trade services arm of the Swiss Exchange, plans to relaunch in June and is piloting a facility with Eurex SecLend. The CCP will have some enhanced features around collateral reuse, daily mark-to-market and full segregation of assets.

The initial focus will be on the Swiss and German markets, says Thomas Kindler, head of clearing services. He says there is more interest in central clearing than was the case two years ago because of the regulatory push for higher capital requirements in securities lending. By trading via a CCP rather than bilaterally, these capital requirements would be reduced, although this is a benefit aimed more at borrowers than lenders.

For beneficial owners, the main benefit of a CCP is the flexibility in distribution, says Kindler. “In a bilateral trade you have to take a close look at your counterparty. Some beneficial owners, especially Swiss insurers, for example, are limited in that there are not enough trusted counterparties that meet their risk requirements. A CCP can step into that role and provide more security.”

The benefit of distribution is one echoed by Jonathan Lombardo, head of global sales at Pirum, a provider of automated post-trade services for the securities lending market and which is also providing a post-trade reconciliations platform to feed bilaterally agreed trades to the Eurex Clearing CCP.

Lombardo also highlights the fact that the Eurex Clearing model allows the existing bilateral relationship to continue and is not an anonymous trading model. And a special lenders licence offered by Eurex Clearing allows the beneficial owners to become clearing members sparing them the expense of having to post collateral. “Eurex has taken a lot of time and effort to understand what is needed for beneficial owners to participate.”

The biggest challenge for CCPs, says Lombardo, is persuading the agent lenders to inform the beneficial owners that they exist. “Agent lenders need to increase the education of the beneficial owner community by presenting the full scope of Eurex Clearing’s lending offering enabling asset owners to draw their own conclusions.”

Not all CCPs are entering the securities lending market though. Diana Chan, chief executive at EuroCCP, says it is unclear what benefits a new CCP could offer asset owners beyond what is already provided by agency brokers, custodians and international central securities depositaries through the existing bilateral model.

“The transacting parties are also used to getting a whole host of services from a triparty agent or custodian, such as collateral administration, investment and autosubstitution – admittedly at a cost – which they may not get from a CCP. Also, under a CCP arrangement, if the lenders will still be employing a custodian or agent lender, the CCP is an additional intermediary in the process and one which will need to be remunerated.”

There is also the issue of indemnification. “I cannot imagine a scenario where the agent lenders will be willing to indemnify a CCP because of the size of the sums involved,” says Paul Wilson, international head of client management and sales for trading services at JP Morgan.

However, Lombardo sees the indemnification issue as a selling point for CCPs because asset owners will no longer have to pay margin to agent lenders for indemnification but instead have the credit protection that comes from central clearing. It, therefore, comes down to whether asset owners have more faith in the creditworthiness of global custodians or CCPs.

Nevertheless, it remains a challenge for many agent lenders to generate interest from potential lenders in a CCP. “I am completely neutral about the use of a CCP,” says John Arnesen, head of securities lending agency at BNP Paribas Securities Services. “I have resources available to develop the use of them but I have not had any beneficial owners knocking on my door asking to use a CCP.”

One of the accusations levelled at agent lenders is that they are not doing enough to promote the CCPs because of a fear that central clearing will reduce their role. But, says Arnesen, if there is any disintermediation, it will not involve the agent lenders.

“We offer the absorption of set-up costs, indemnification, compliance and post-trade reporting and I don’t think any but the largest asset managers who are more likely to lend directly would be prepared to give all of that up.”

In addition to an open debate on the changing risk profile that results from using a CCP, Arnesen would also like to see the trading volumes of the CCPs published to see how many agent lenders are using them and to see the type of liquidity being traded. For example, who are the early adopters? Is the majority of volume simply broker-to-broker, or is there a good mix of beneficial owners and sell-side borrowers?

The CCPs have also argued that they provide beneficial owners with a wider range of counterparties to deal with and the chance to increase their securities lending activity. However, especially regarding equities-based lending, the issue is the demand from rather than the access to potential borrowers and Arnesen is not convinced that CCPs will stimulate the extra demand from borrowers.

Arnesen says some fixed income lending may be attractive on the CCP model where an agent and borrower transact bilaterally and then give up a trade to a CCP but in general, some equities lending transactions may be too complex to be suitable for CCPs.

He can also imagine a possible two-tier market developing where a specific number of vanilla type transactions would be more economical if they are put through a CCP and then a number of boutique CCPs would compete for this business with the larger of the competitors eventually winning out.

For their part, the CCPs appear to be prepared to bide their time. Kindler recognises that a shift in the market from bilateral to central clearing will take time and that it is “a long-term process”.

But if a repeat of the SecFinex scenario is to be avoided, there will need to be more debate on the relative merits of different business models, regular publication of usage statistics from the CCPs and a continued promotion of central clearing from the regulators.

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