Securities finance: the new reality

Securities finance: the new reality

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A slew of regulations has been driving uptake of collateral transformation, the service offered by banks and prime brokers to help asset managers meet margin requirements for central counterparty (CCP) transactions by exchanging less liquid assets such as corporate bonds or equities for liquid ones such as certain sovereign bonds.

Demand for evergreen and extendable structures on collateral transformation trades has grown strongly as borrowers seek relief under Basel III’s liquidity coverage ratio (LCR) requirements, which require banks to hold sufficient unencumbered high quality liquid assets (HQLA) to satisfy cash outflow needs over a 30-day stress period.

The LCR reform was introduced in January 2015 and has been coming into force in steps, rising annually, so that by January 2018, firms must hold 100% of the required LCR amount in HQLA.

Data on the US tri-party repo market collated by analytics firm IHS Markit shows that growth in trading volumes for all structured types – evergreen, extendable, puttable and callable – closely coincides with the multi-year phase-in period of the reforms.

Total daily volume generally remained below $1bn before the end of March 2015, when participants were first starting to report their LCR positions, but then rose quickly to over $15bn, topping $20bn as of mid-September 2016.

For all evergreen activity, regardless of collateral type, the average number of advance days’ notice given by counterparties before the closing of these trades has been consistently above the 30-day threshold for LCR, rising to just below 50 as of mid-September 2016.

Extendable structured trading activity shows a similar pattern with volumes beginning to rise after January 2015 and required days’ notice before closure clustering around the 30-day mark. The average daily cash volumes for extendables have been just short of $3bn.

“There has been a strong and sustained demand for these types of transactions and in many respects they are part of the day-to-day securities finance landscape,” says Alex Lawton, EMEA head of securities finance, State Street Global Markets.

“Obviously, the myriad of regulatory pressures drives this, but this demand also meets a search for incremental yield within beneficial owners. Interestingly, it is not only the widening of this demand across both tenor and collateral asset classes, but how each individual broker-dealer either interprets these regulations for their own institution or their predominant binding metric at a point in time. There hasn’t been a spike in demand, per se, rather a steady evolution of term structures over a number of years. As January 2018 approaches I only see this evolution continuing.”

January 2018 also marks the implementation of the Net Stable Funding Ratio (NSFR), another Basel reform to promote long-term resilience in banking, this time requiring banks to ensure they have stable sources of financing over a one-year time horizon based on liquidity risk factors assigned to their assets.

“For NSFR coverage, we see increasing interest for longer term financing deals – six-month evergreen or one-year evergreen, or similar extendable requests for 7-6-7 or 13-12-13 trade structures,” explains Ariel Winiger, head of securities finance services, Asia Pacific, equity & derivatives, Societe Generale CIB, adding that only a limited number of clients in Asia are offering these kind of tenors whereas the liquidity out of Europe and the US is slightly better.

For the most part, banks have got to grips with LCR, but NSFR is more demanding. “While the banking industry is now dealing with the short-term focused LCR, the NSFR regulations – due to come into force from January 2018 – bring new challenges,” says Alec Nelson, managing consultant at GFT. 

“The inclusion of short-term money market activity in NSFR calculations, with the resulting determination of an NSFR funding cost for them, is likely to cause disruption. As well as having to manage the use of HQLAs for collateral introduced by LCR, organisations will have to deal with changes in the behaviour of both borrowers and lenders of cash due to the new cost implications.”

“Relative to the use of other Fedwireeligible collateral types, we’ve seen Agency MBS, CMOs and debentures and strip collateral volumes decreasing as US Treasuries increase,” explains Steve Baker, director, securities finance product and consultancy, IHS Markit. “And while total Non-Fedwire-eligible collateral type volumes have been declining since mid-2015, equities volumes, which had been rising strongly and steadily since December 2011, have begun to decline since August 2015, but still hover above 7% of all collateral used.”

The total daily volume for equity evergreen trades from July to September 2016 inclusive accounted for approximately 33% of all evergreen trading activity, followed by corporate noninvestment grade bonds with 16% and corporate investment grade with 10%.

“In evergreens, we also see glaring contrasts between trades by collateral type,” explains Baker. “For instance, the average number of advance days’ notice required before trade closure for Fedwire-eligible collateral type activity has generally remained below the 30-day threshold for LCR, whereas nonFedwire-eligible collateral type activity has always been above this mark, at around 50 days since late March 2015. The requirement for banks to hold more HQLA is clearly having an effect on these trading activities.”

Risk reduction

The advent of these liquidity requirements has made financing for term more valuable and widened spreads over the course of the last 12-18 months. Basing trades on a series of staggered term transactions or an evergreen or extendable structure is also appealing to beneficial owners because it reduces the risk from sudden shocks in a volatile market. 

However, the spike in collateral transformation this year has not been as sharp as predicted, according to Virginie O’Shea, research director at Aite Group. “The delays to key Basel III and OTC derivatives reforms – clearing under the European Market Infrastructure Regulation (EMIR) and uncleared margining, in everywhere but a handful of countries – have suppressed demand for collateral transformation this year,” she says. “The industry expectation was that there would be much more activity than has materialised thus far but I anticipate this will change toward the end of 2016 and into 2017, as reforms progress.”

Global regulations, such as the DoddFrank Act and EMIR, tend to push trades towards central counterparty clearinghouses (CCPs), where economies can be gained from the improved management of higher volumes of collateral, allowing participants more scale, leverage and RWA savings.

“Over time there have been mixed views but generally both the buy side and sell side see the benefits of central clearing,” says James Slater, global head of securities finance, BNY Mellon. “What has not emerged are clear models that are widely embraced. The degree of margining contributed from the buy side is still to be worked out, for example. Banks and dealers are constrained in the new regulatory environment and are trying to optimise their activities such as by using central clearing, while the buy side are having to deal with increasing collateral demands from evolving margin rules that is forcing them to consider issues such as managing collateral, financing or raising the quality of collateral.”

“The buy side has traditionally relied on the sell side for market intermediation, but is now constrained by capital rules, and how that unfolds from here is the million dollar question,” adds Slater.

Many corporates have been exploring afresh the tri-party option, attracted not only by its operational efficiency but also risk mitigation, optimisation, processing and reporting. “The main players have been pushing their pricing, flexibility and improvements in their capability,” says Ralph Sutter, consultant at GFT. “Despite low, flat or even negative rates, more and more treasurers continue to choose secured lending for favourable yields pick-ups.

“As beneficial owners deal directly with tri-party agents, they deposit the cash, and it is then lent out through evergreen repo structures. Tri-party is cost effective for the buy and sell side and despite internal or external set up challenges, the benefits are tangible. For example, we can see similar approval and agreement difficulties in the equities or bond lending clearing programme via tri-party as regulations continue to drive new structures with a view on capital cost. Seen as unattractive by many participants a few years ago, we observe today a steady growth in participation. We expect tri-party repo and the three-to-six-month repo liquidity for corporates to grow further.”

Historically, there has always been a greater acceptance in non-US markets of securities as collateral. Over the last few years beneficial owners have been bombarded with education about collateral flexibility, and as a result there is greater adoption of non-cash collateral.

Another boost to the use of equity as collateral in the US would be the potential change to Rule 15c3-3, which would allow US borrowers to give equities as collateral. This would be cheaper and more efficient than cash.

Across Europe, market participants are beginning to look for broader collateral schedules and asset class flexibility, such as a mix of equities, bonds and cash, to optimise their collateral usage. This widening of acceptable collateral can deliver incremental yield for beneficial owners matching brokerdealer financing asks. 

Broadening of collateral in the equity space has extended from the traditional main indices, through to secondary indices, ETFs and emerging market equity collateral.

There is some appetite for higher quality emerging market equities as collateral, primarily from pension funds and sovereign wealth funds that have longer horizons and want to pledge these against either government bond or equity loan transactions. Currently however the European and US central counterparties do not cater for Asian underlyings.

Cash collateral remains popular in markets where there is significant liquidity, such as Japan and Europe, where central bank policy has been supportive. When QE ends, funding will become more expensive, as has evolved in the US over the last two years.

“We have certainly seen greater demand to use non-USD cash collateral for securities finance activities,” adds Lawton. “The headwinds on short-term cash have meant that it can be cheaper to pledge cash rather than to repo in the required collateral or access a broker dealer’s treasury for securities to pledge as collateral. I expect this demand to continue especially in euros and yen. The challenge will be what the agent lender can do with that cash collateral. If they only have the ability to reinvest in short dates themselves then this transposes a broker problem into a lender one. The implied rebates that a lender would have to charge to make this economically viable, would potentially reduce cash as the ‘cheapest to deliver’ option.”

Winiger adds: “It’s true that a lack of yield has somewhat changed the way cash is re-utilised or in some cases, cash is even left idle in custody accounts if the interest rate is still 0%. It’s important though to look at the interest income on a riskadjusted basis including the collateral exchanged, if any, to determine the best way of deploying cash. It’s also worth mentioning that custodians tend to pass on negative interest rates on cash long positions to their clients, which provides an incentive for the cash holder to put their money to work.”

The market has also been impacted by money fund reform, as many prime fund investors have moved into the Treasury fund space. This has reduced financing for banks and dealers and impacted the costs of related transactions.

Rising costs

The European Securities Financing Transactions Regulations (SFTR) proposed reporting regime also comes into effect in 2018, and could prove another drag on activity. This requires all securities financing transactions to be reported to recognised trade repositories. ESMA has published a long and detailed technical consultation document on the subject. Additionally, many lenders face increased reporting and disclosure of SFTs as part of their prospectus and annual and half-yearly reports and accounts.

“The appetite of beneficial owners to lend securities in the current zero interest rate environment has never been greater, as they look to riskadjusted returns from fundamental or intrinsic market demand factors rather than from reinvestment strategies,” says Paul Wilson, managing director at JPMorgan. “But the regulatory impact on borrowers and banks is suppressing activity as there is greater supply to lend than to borrow.

“If you accept the dynamic of oversupply across the industry, where a lender is not making pro-active changes to their lending activities, all things being equal their revenues are going to fall. Overlaid with this is the increased costs lenders face from transaction reporting and increased disclosure whereby some may just decide it is no longer worth it. This may appear to be a negative but over the medium term the same level of revenue could be shared between fewer lenders, so they would earn more. Small mutual funds, UCITS funds and pension funds are likely to be first to reassess because the impact for them may be more material. It is likely that large pension funds and sovereign wealth funds, of say over $25bn AuM, won’t be so similarly affected.”



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