Regulators favour centralised clearing, but central counterparties have a tough job getting lenders to use them, finds Nicholas Pratt.
The use of central counterparty (CCP) clearing has become the clearing option of choice in many securities markets ever since the Lehman’s default highlighted the lack of transparency in bilateral and over-the-counter (OTC) transactions. This was especially so in the derivatives market where the use of CCPs has become mandatory for an increasing number of OTC derivative types.
The Lehman default was also a watershed moment in the securities lending market that suddenly caught the attention of asset owners who had not previously appreciated the potential risks in their lending programmes. However the use of CCPs has not gained any serious traction in the securities lending market despite the desire among lenders and beneficial owners for greater transparency.
At present there is just one CCP active in the European securities lending market, Eurex Clearing, which launched in November 2012 covering equities and fixed income securities in Germany and Switzerland. Since then Eurex has integrated its Repo-SecLend Market service as a flow provider, included three new equity markets in Belgium, France and the Netherlands, and signed an agreement with electronic trading platform SL-x to provide CCP services for its securities lending transactions, due to launch before the end of 2013.
SIX x-clear, part of the Swiss stock exchange SIX, is in the process of relaunching its clearing services for securities lending. It was previously one of the CCPs attached to SecFinex, an electronic platform for securities lending that launched in 2000 in the belief that the CCP model would become an increasingly popular method of clearing but eventually closed its doors in 2011 due to lack of traction.
SIX x-clear launched in June 2013 and is still in pilot phase with the Eurex Sec Lend platform and expects to go live in the second quarter of 2014. “We have implemented the platform from a technical perspective and we are able to support client testing, but there are still a few gaps to close with our risk models for the regulators,” says Tomas Kindler, head of clearing services at SIX x-clear.
The initial focus is on the home markets of Switzerland and Germany where Kindler feels there is a good mix of buy and sell side participants, notably a number of large Swiss insurers. For the lenders, the attraction of a CCP, says Kindler, is that it offers these lenders a wider universe of borrowers, as the individual counterparty risk is replaced by an AA-rated CCP in the case of SIX x-clear.
However, encouraging asset managers and beneficial owners to switch from bilateral trading to the CCP model will be a big task, says Kindler. “It is a fundamental shift, not least that it would involve electronic trading as well as more transparency. It has been slow progress. We have been engaging with the market; however, asset owners have not previously been interested in the CCP model so it will take some time.”
Using a CCP will also incur extra cost for the lenders and beneficial owners in either meeting the requirements for direct membership or employing a third-party clearing member. SIX x-clear may consider relaxing its criteria for certain asset managers and certain transactions.
Meanwhile, a key attraction of the Eurex Clearing CCP is that it enables lenders to preserve the bilateral relationship and trading set up they already have, partly through the use of automated post-trade service providers like Pirum, a CCP gateway module that enables bilaterally agreed trades to be fed into Eurex Clearing CCP for novation.
“Our selling point is that lenders have no change to the way they trade today,” says Jonathan Lombardo, head of global sales at Pirum. “The only change is the presence of a central clearer, Eurex Clearing, as your counterparty rather than a
One CCP that has no plans to enter the securities lending market is EuroCCP. “We have no plans for a securities lending CCP as there is no evidence of demand and we have not been approached by any beneficial owners,” says Diana Chan, chief executive at EuroCCP. The problem, she says, is that it is difficult to see what benefits a CCP can add beyond what is already provided through existing bilateral arrangements via custodians and central securities depositaries.
“It is challenging as a lending agent to demonstrate the advantage of a CCP to beneficial owners,” says John Arnesen, head of securities lending agency at BNP Paribas. “They are comfortable with the balance sheet strength, the transparency and the indemnification provided in the bilateral model. It is a tried and tested formula.”
The advantages of the CCP model, such as netting, are mostly aimed at borrowers while lenders will have to shift their credit exposure from multiple counterparties to one, despite the CCPs’ reputation as safe havens. And the idea of greater transparency could be provided by reporting trades to a trade repository. “Access to demand is what beneficial owners really want,” says Arnesen.
It could be argued that agent lenders should be doing more to make lenders aware of the potential benefits of using a CCP, something which has not been the case thus far. “Agent lenders are a crucial part in the equation but whatever clearing model is offered has to fit their business,” says Kindler. “The agent lending community appears reluctant to promote a CCP model that would impact their existing operational and revenue models.
This may change though given that new Basel III rules will require agent lenders to set aside more capital when offering indemnification to lenders in a bilateral securities lending model. Consequently, what was previously an advantage aimed mostly at borrowers could now equally apply to agent lenders and their clients.
The one factor that could change everything is regulation, especially if the use if CCPs were to be mandated, although this seems unlikely. Of more impact will be a potential change in the Basel III rules whereby indemnity provided by an agent lender to a beneficial owner will require an allocation of capital to be set aside.
This has driven a renewed interest in the potential benefits of using a CCP, says Pirum’s Lombardo. For the agent lenders that choose not to use a CCP, they can adjust the current revenue split with their beneficial owners to cover the additional cost of capital, which could trigger two possible scenarios, he says.
“The beneficial owner initiates an RFP [request for proposals] creating a new pricing competitiveness amongst agents, or else they completely retreat from securities lending programmes as it is not deemed an essential investment practice.
“There also is a further possibility that broker dealers can move capital intensive business to agents that can provide a level of capital relief thus resulting in a loss of revenue for those that cannot.”
The Basel III rules may not take effect until as late as 2018, nevertheless agent lenders will be looking to change their current practices in order to be fully acclimatised, says Lombardo, and he anticipates that agent lenders will engage more with their biggest asset managers primarily.
“There will be a two-tier market initially with CCPs being used in the broker to broker transactions but as beneficial owners and asset managers become more comfortable with the CCP model, they will start to lace more of their capital-intensive business through a centrally cleared model. They would rather move to CCP gradually than wait until they are forced to do it through regulation.”
©2013 funds europe