CLEARING: Counterparty politics

The use of central counterparties is increasingly prominent in many OTC markets but rarely features in European securities lending. Nicholas Pratt looks for an explanation.

Europe’s securities lending market has remained largely indifferent to a broader post-financial crisis move towards using central counterparties (CCPs) for clearing. There are few providers and little appetite among potential lenders to move away from the current bilateral practice. 

At present there is just one active CCP in Europe’s lending market, Eurex Clearing, which launched its service in November 2012. The CCP initially covered equities and fixed income securities in Germany and Switzerland and subsequently expanded into equity markets in Belgium, France and the Netherlands.

In 2013, Eurex Clearing also signed an agreement with SL-x, an electronic trading platform for securities lending, to provide CCP services for its transactions. However, despite gaining approval to operate across 17 European capital markets including the UK, SL-x ceased trading in September 2014 after its private equity backing was withdrawn. 

Nevertheless, those involved in various CCP-based initiatives remain positive about the prospects for greater adoption. According to Gerard Denham, vice president, Eurex Clearing, the interest in CCPs for securities lending is gathering pace as the capital costs savings and credit risk benefits of trading via a CCP become apparent. “Numerous market participants within the securities lending market have concluded their cost-benefit assessments and are implementing their strategy for the adaptation to central clearing using Eurex Central Clearing’s lending CCP,” he says.

Securities financing banks, such as ING, Morgan Stanley and SEB, have already joined the service and several others, including Citi, Natixis, BNP Paribas Arbitrage and Societe Generale, are expected to sign up in the coming months, says Denham. He is also confident that more broker-dealers, global custodians and asset managers will continue to join throughout 2015.

One of the challenges CCP operators face in trying to encourage adoption from the buy-side is that beneficial owners and asset managers are reluctant to give up the benefits of their existing bilateral arrangements and embrace a new centralised model. 

Eurex Clearing has consequently tried to ensure that it offers asset owners a service that minimises disruption. One option allows traders using the Eurex Repo SecLend Market – an electronic communications network – to direct their loan transactions for novation to Eurex Clearing via the Eurex Repo SecLend Market trading screens. 

Another route available to market participants is via the Pirum CCP Gateway, which compares loan transactions between bilateral counterparties and performs a validation to establish that the trade meets the criteria for central clearing. Pirum’s real-time service transmits the loan transactions via its CCP Gateway to Eurex Clearing’s Lending CCP for novation.

“The changes required to users’ trading and technology systems are relatively low impact as Eurex Clearing’s Lending CCP preserves the characteristics of bilateral trading and therefore minimises the effect of moving to a new trading model,” says Denham.

Jonathan Lombardo, head of global sales at Pirum, believes there has been a seismic shift in market sentiment towards the use of a CCP for securities lending. He cites the levels of engagement from both borrowers and lenders, and the formation of a dedicated working group for the operational aspects of central clearing by the International Securities Lending Association, as evidence of greater interest. 

“Part of the turnaround in sentiment this year has been due to the extensive amount of education that has gone on with both asset owners/lenders and the borrowing community,” says Lombardo.

The question though is whether this interest and engagement has resulted in new membership. Lombardo talks of a “healthy pipeline for 2015” and expectations of more flow being executed via a CCP next year, but he also recognises that there is only one CCP provider in Europe’s securities lending market. 

“That is not to say that current CCP platforms are not watching and waiting to see what market take-up is and then assess the potential of entry,” says Lombardo. “One consideration is that the securities lending market is small compared to other products presently utilising central clearing such as OTC [over-the-counter] derivatives, FX [foreign exchange] and the cash market. I think the question that ultimately arises is whether there is sufficient demand for multiple CCP providers in securities lending at the moment.”

“We continue to see CCPs evolve in the sec-lending market,” says Paul Wilson, global head of client management and sales for agency lending at JP Morgan. “In a world where capital costs are growing, the rationale of using a CCP to lower those costs is becoming more apparent. But while there is greater scrutiny of the CCPs, there are still not many people using them.

“The CCP universe will expand and over time they will develop a broader service offering. And as the economics become more attractive, participants will start to gravitate towards using CCPs,” says Wilson.

In the short term this shift will most likely come from banks and brokers that are facing rising capital costs, smaller balance sheets and constraints in their use of leverage and see CCPs as a way to alleviate those challenges. For agent lenders and beneficial owners, this is not such a compelling argument.

“The principle-to-principle business fits far easier in a CCP model than the beneficial owner-to-agent lender-to-hedge fund business,” says Wilson. “There will eventually be a place for multiple CCPs in the European marketplace but it will take time.”

The securities lending market is not currently an area of focus for clearing provider SIX x-clear. There has been a slight change in the securities lending market’s perception of CCPs, says Tomas Kindler, head of clearing at SIX Securities Services, but this has not translated into greater adoption. Furthermore, the majority of securities lending business on CCPs has been limited to broker-to-broker transactions. 

“They have not involved the lenders or the agent lending community, which is a much tougher nut to crack,” says Kindler. “When you are looking to push an OTC market like securities lending into an electronic trading environment, it is all about being able to break up that cosy bilateral relationship. So it is essential to have the support of the agent lending community.”

This will not be easy. The greatest argument for using a CCP for securities lending is the increase in capital requirement, but that is more aimed at borrowers than lenders. What may help, says Kindler, is to first develop an electronic market for securities lending. Should this happen, using a CCP for clearing securities lending trades would not be as great a step for lenders currently operating in an OTC bilateral world.  But the failure of SL-x has illustrated how far off such a development may be.

The same might be said when assessing the likelihood of a regulatory mandate for central clearing in securities lending. Such a scenario would change the market overnight. It was the prospect of a regulatory mandate that appeared to spark the initial manoeuvring from the clearing providers back in 2012. Of course, two years later only Eurex Clearing is active – something that may suggest that other providers did not see enough of a business case to commit to establishing a CCP without a regulatory mandate. 

The Financial Stability Board, currently chaired by Bank of England governor Mark Carney, recently said it had no plans to make any such mandate and would instead expect market dynamics to draw people to CCPs. What is more likely is that there will be mandatory reporting of securities lending, but whether this then leads to the mandatory use of CCPs is not evident.

Not everyone has given up on the chances of a regulatory mandate. “To the best of our knowledge the mandating of CCPs for securities lending is not presently in scope,” says Pirum’s Lombardo. “But as derivative products, such as OTC, come under more scrutiny… it may only be a matter of time before securities lending is covered under the same umbrella.”

Lombardo also thinks that regulation addressing indemnification could prove influential for the asset owners and potential lenders and refutes the idea that, in the absence of a regulatory mandate, the fate of CCPs rests on whether asset owners are prepared to pay a premium for the extra risk mitigation that a CCP provides. “We really do not perceive there being an extra cost for participation from the asset owner/lender side. What we do feel is that there is potentially a premium to those that use a CCP for capital- and risk-weighted assets efficiency. 

“The real driver for CCP usage will be dictated by the borrowing community but regulation centring on indemnification may open that channel for asset managers and owners to rethink participation from a costing perspective.”

©2015 funds europe



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