Market participants are currently experiencing the most
significant seismic shift in banking practice and regulation
since the Great Depression. The renewed focus on capital and
liquidity regimes will ultimately achieve its aim of lowering
systemic risk among institutions, but there are more nuanced
consequences to regulation.
The securities financing industry will not be insulated from
these headwinds, and the relationship between borrowers and
lenders will be changed forever.
"The price of doing the same old thing is far higher
than the price of change" – Bill
So welcome to the new paradigm. Regulation is here, and its
effects are already being felt. Its purpose is broadly twofold
– firstly enhancing transparency and disclosure and
secondly eradicating systemic and liquidity risk that can build
up in the machine. Some of the most impactful regulations
facing the securities financing industry are as follows.
Basel III/CRD IV will result in higher capital
requirements for banks and the associated liquidity coverage
ratio (LCR) and net stable funding ratio (NSFR) will affect
behaviour. Basel III will be phased in by 2018 but we are
likely to see early adoption.
Dodd Frank Act/Section 165(e) will limit the
amount of concentration a lender can have to one counterpart
and the Volcker rule will affect the re-investment of cash
Financial Stability Board (FSB) proposals
focusing on transparency, minimum haircuts, minimum standards
for cash reinvestment and recommendations on rehypothecation
practices will also be significant headwinds.
A European financial transaction tax (FTT), if
passed in its current form, will severely limit secured finance
The European Securities and Markets
Authority (Esma) stipulates that participants will
need to disclose more about their securities lending activities
and ensures more of the revenue is passed back to
Finally, the European Markets Infrastructure
Regulation (Emir) is designed to increase the
stability of the over-thecounter (OTC) derivative markets and
will change the collateral dynamic forever.
Cost of capital
One of the major influences on the securities finance
landscape for the coming period will be the cost of, and return
on, capital. Regulators traditionally viewed stock loan and
repo markets on a simple exposure basis. The series of Basel
accords markedly changed this view with its capital- based
transaction approach. Beyond these regulatory capital pressures
there will also be a continued focus on cash or liquidity
On the buy side the majority of securities
lenders traditionally offer beneficial owners borrower-default
indemnification to provide enhanced security. This
indemnification will shortly be defined as a credit exposure
and will translate into a higher capital requirement with some
estimates suggesting the industry could shrink by between 30%
Some maintain that these indemnifications were given away too
cheaply and not enough value has been accrued, so the question
now is whether lenders will be forced to charge beneficiaries
for the enhanced protection or whether we will see fee splits
adjusted to reflect the change. In either case, one of two
outcomes will emerge.
Either a tipping point, where the return diminishes to such an
extent that participants will pull out of lending entirely; or
we will see an acceleration of the trend away from the standard
general collateral (GC) attribution model towards a more
intrinsic value model where clients only want to participate in
higher margin activity.
A solution already tabled is the use of an insurance policy.
However, this is fairly limited, expensive and not available to
all types of institutions. A potential opportunity from this
lack of indemnification, however, is that there is a widened
bandwidth in terms of collateral flexibility and term appetite
which will translate into higher returns for the supply
On the sell side the new capital environment
is largely implemented and we are already seeing behavioural
changes. Regulation is forcing banks to put aside more capital
as a proportion of riskweighted assets (RWA) so contributors to
this benchmark are being more closely scrutinised.
Increasingly, the inability to net with a counterpart seriously
restricts banks’ ability to trade with them. This
is amplified by the agent lender disclosure (ALD) conundrum.
The inability to determine the capital requirement at the time
of trading will add further pressure on financial
A lender’s ability to provide more clarity to the
undisclosed model will surely be a competitive advantage and
avoid a potential swing to more principal and/or disclosed
Given the increased capital requirement environment, qualified
CCP (QCCP) solutions are also gaining momentum. A recent paper
suggested that a QCCP solution would considerably reduce the
agent lender’s capital requirement, although the
spectre of margin requirement remains the unresolved. From a
borrower perspective the advantages are clearer cut, given the
QCCP’s low risk weighting.
The challenge to adopting the CCP model has always been
liquidity and access. Given these advantages it is highly
likely we will see the QCCP solution gaining pace.
This will irrevocably change the current borrower lender
bilateral dynamic. Interestingly, the likely shift to the QCCP
model will increase the amount of collateral tied up in margin
at CCPs, exacerbating the so-called collateral crunch and also
potentially resulting in a greater concentration of risk that
the regulation is attempting to reduce.
Another headwind will be the inability for businesses to net as
a result of the Basel III leverage ratio proposal. This lack of
netting will translate to a greater perceived use of balance
sheet and will inevitably mean this inefficiency will have to
be passed on to end users in more realistic pricing.
Gross treatment also has an unintended consequence as it will
incentivise market participants to conduct higher-margin
business and by extension higher risk activities, once more
directly in contradiction to the Basel raison
The cost of doing business is likely to increase while at the
same time the overall profitability and fee pool available to
the banking sector is at a cyclical low. One solution to
improving efficiency and return on financial resources is
wholesale desk and infrastructure integration and the
development of an enterprise wide collateral management
Earlier this year Nomura, under the leadership of Steve Ashley
as head of global markets, integrated the equity and fixed
income functions into a single Global Markets group
encompassing all asset classes. This structure gives us a
cohesive global view of all financing activities across
products, enabling us to dynamically allocate resources between
products according to market opportunity, and thereby maximise
Operating under a single structure breaks down silos and leads
to a more cohesive dialogue with counterparts and clients,
agnostic of asset class. Our belief is that others will follow
in our footsteps in combining their markets business to
optimise resources and boost profitability.
Levelling the playing field
The recent financial crisis did not affect all banks
or economies to the same degree, and was most damaging in the
US and Europe. A number of countries remained unaffected, with
Russian, Canadian, South American and Asian institutions
ultimately remaining relatively unscathed, and in some cases
This makes the G20 adoption of a collective accord even more
remarkable. As a result of these factors we are starting to see
a geographical drift in the securities finance industry
correlated to the tidal shift in macro-economi c powe r .
Already, we have seen a greater internationalisation and
entrance into securities finance of many banks including, but
not exclusively, institutions based in China, Canada and
Brazil. This is likely to gather pace.
Equally, historic regional advantages in terms of credit
ratings are beginning to weaken, which is further encouraging
new entrants into the market. The recent deposit insurance law
(DIL) change in Japan, which explicitly makes provision for
government intervention in a crisis event, saw
Nomura’s credit rating enhanced.
This will further level the playing field from a geographic
perspective, especially given the rating agencies’
actions in other regions. One notable challenge to the
internationalisation trend is the role of the local
As we have seen in the UK the regulators are now taking a
significantly more proactive stance towards bank supervision
and oversight. We believe the global booking hub model (often
residing in London) is outdated and increasingly there will be
a tendency for securities finance businesses to return onshore
to their home jurisdiction.
New trading strategies
This level of change will inevitably drive new
trading strategies in the security finance industry. It is
likely that collateral requirements driven by Emir coupled with
the new CCP environment will create a new demand stream,
especially if the forthcoming collateral crunch is to be
believed. Whether this belies a lack of collateral in the
system or an oversupply of cash, we will soon see.
The requirements of capital driven regulation in the form of
LCR and NSFR, rewards term and will encourage new entrants into
the secured finance industry. Maybe we will at last see
corporate treasuries enter the market as well as more hedge
funds becoming active buyers in the repo market.
There is no doubt that this potential outperformance will
encourage the unlocking of untapped and trapped collateral
within the system. Over the past five years we have seen a
contraction in the structured arbitrage market as banks have
withdrawn due to reputational risk concerns. Some of this risk
has been absorbed by the launch of a number of specialist hedge
funds which has added a further dynamic to the demand
The lack of leverage in the market has seen levels fall to
historical lows in a number of countries and the pendulum swing
away from the supplier.
This coupled with the requirement to make better returns makes
it increasingly likely that we will see a number of banks
re-enter this market. An unfortunate consequence of the
increasing regulation and capital taxation industry could be
the potential drive of trading structures deeper into the
Already a significant proportion of securities finance
transactions are conducted away from traditional stock loan or
repo trading, and this synthetic trend is likely to
Times are changing, and the full impact of regulation
on borrower-lender relationships, market structure and
liquidity is yet to be seen. The only constant is change, and,
as an industry, it is imperative we continue to adapt and
evolve to meet the challenges of the new environment to ensure
a healthy securities financing market.
by Phil Morgan, Global Markets Financing, Nomura