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 Clinton
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 collateral.
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 transactions.
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 investors.
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 capital returns.
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% and 50%.
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 side.
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 resources.
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 solutions.
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 d’etre.
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 function.
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 returns.
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 stronger.
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 regulator.
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 chain.
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 shadows.
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 continue.
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
Nomura: Adapt or die
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