“At the same time, the needs of the buy side continue to expand. In addition to wanting a secure arrangement when investing short-term cash, clients also face newer rules for cleared and uncleared derivatives, which have put added emphasis on maintaining quality collateral. 

Clients understand that central clearing is potentially one of the solutions and, accordingly, I believe we will see further discussion around this topic.” 

Universal appeal 

Finding a model that is suitable for all involved remains a key challenge. “In particular, buy-side providers of liquidity, including those who are lenders of cash and receivers of collateral, do not really want to participate in any kind of default fund, nor are they interested in posting margin,” says Slater. 

Though largely dealer-oriented to date, the arrival of new buy side-facing margin requirements for derivatives could be a game-changer as far as central clearing is concerned. 

“As more of these accounts are required to begin posting margin around their hedging contracts involving swaps or similar strategies, it’s possible that attitudes could begin to evolve,” he says. 

Due to recent money fund reforms, several hundred billion dollars’ worth of cash continues to flow out of prime funds and into Treasuries. At the same time, banks have been holding fast to quality liquid assets as protection against tougher liquidity requirements. 

“Banks no longer have the capacity to intermediate as in years past, and this in turn will increase the market’s reliance on repo as a vehicle.” 

To maintain market efficiency, then, it will be necessary for the industry to find workable solutions. “On the one hand, we could see more buy-side accounts involved in peer-to-peer repo transactions and learn to accept and manage the credit risk associated with that type of activity,” says Slater. 

“The alternative would be the development of a clearing model that is acceptable to the buy side, and we start to see more transactions taking place through CCPs. Point being, the need is definitely there.” 

Determining which buy-side members should be part of the CCP fellowship is paramount, says Slater. “Many believe that it needs to go beyond just money funds. For instance, many insurance firms purchase long-dated interest rate swaps as a hedging mechanism. They’re being increasingly challenged to write life insurance policies without having access to sufficient repo financing, which will hamper their ability to grow.” 

Risk, of course, is another concern, particularly around default fund contributions and whether changes to existing protocols would be acceptable to the buy side. “Or perhaps a different model evolves in which the dealer or bank handles the default funding, leaving the buy-side account responsible for posting margin only,” posits Slater. 

If lending transactions are being centrally cleared, does that not eliminate the need to indemnify altogether? “There are many who believe that owners still need to be indemnified no matter what, and in fact there are a number of buyside accounts that legally require it,” observes Slater. 

“So I think there is still a lot of work that needs to be done, especially since there is no easy way to move a market that is as varied and complex as securities finance into a centrally cleared environment. Yes, the seeds have been planted, and there is substantial interest in having centrally clearing continue to develop – however, it is imperative that we have a model that is structured with care and is allowed to gradually evolve over time.” 

CCP Inevitability 

In April, EquiLend, the New York-based provider of trading and operations services for the securities finance industry, officially linked its securities lending platform to Eurex Clearing’s Lending CCP service, allowing clients to route transactions for novation and downstream processing. While still in its nascent phase, Brian Lamb, EquiLend’s CEO, sees volumes gradually increasing down the road. 

“It’s a post-trade solution that allows us to take trades that have already been on the books and novate them to Eurex, which clients believe represents greater out-of-the box value to participants than a front-end solution,” says Lamb. 

At the same time, Lamb believes EquiLend’s efficiency-boosting Next Generation Trading (NGT) platform, launched last year, will allow clients with CCP access to do so on a front-end basis as well. “We’re currently printing some 1200 trades per day, including various warm, hot and GC issues, and we will ultimately have the ability to connect to any number of CCPs that clients choose,” says Lamb. 

Despite ongoing industry reticence, Lamb believes that balance sheet costs, risk weighting as well as tougher capital adequacy requirements lend an air of inevitability to the CCP movement. 

“Things are only headed in one direction, and we all know the reasons why these kinds of solutions need to become reality,” says Lamb. “Regulation has been coming for some time now, and it’s finally here, and yes, there have been a few unintended consequences. However, the markets are trying to adapt. 

It’s an interesting time – the whole beneficial owner/agency lending relationship is changing, particularly around indemnification, which of course has become more expensive to offer in this new environment. And the CCP is one method for potentially mitigating that extra cost.” 

Any concerns around counterparty risk will gradually ease as counterparties become acclimated to central clearing, says Lamb. “Additionally, there is real incentive for dealers to help figure out a solution that accommodates lenders – right now it does not,” he says. 

“With the right clearing facility, lenders can expect a continuation of current business volume, perhaps even more so, and in turn dealers will have access to their supply. So there’s a lot of active conversations going on right now in this space, and we fully intend to be front and center once the proper solution arrives.” 

Bottom line, says Lamb, is that anyone who wants to remain actively involved in securities finance has a vested interest in helping to achieve a well-balanced central-clearing solution. “We’re not quite there yet, but we are making progress,” he says. 

“If you want proof, just look at the OCC’s hedge program, which is bigger than ever, and agents aren’t involved yet. So even though it’s really just a dealer-driven phenomenon at present, the industry’s hope is that a solution is identified to accommodate all parties.”