Peer-to-peer securities lending has been identified as an emerging trend for a number of years, but with the prospects for several platforms far from certain it has proved perhaps more challenging than expected. Paul Golden reports.
Due to regulatory changes, traditional banking counterparts have pulled back from many transactions and as a result, a void has been created for certain trades for institutional cash and collateral providers.
In a report published in July 2016, BNY Mellon noted that ‘with broker-dealers being more selective in terms of financing, institutional investors may also find further opportunities in a peer-to-peer relationship, in which these buy-side firms are both the collateral provider and receiver’.
Almost two years on, John Wilson, managing director at BNY Mellon Markets says that liquidity is growing rapidly on DBVX, the peer-to-peer collateral trading platform acquired by BNY Mellon in 2016.
“We see DBVX as an opportunity to add structure and transparency through an electronic market with audit trails and controls built in, which improves efficiency of execution,” he explains. “Many market participants are active on the platform, including banks that use it as a distribution vehicle, which makes it easier for them to add clients. This is appealing to banks of all sizes, some of which might not have a massive salesforce or wide geographical presence.”
DBVX has put together a standardised legal framework which gives new participants consistent terms with all other participants in the community and generates savings in terms of time and cost of connecting to more counterparties on the same terms.
This does not remove the challenge of forming a credit view on a counterparty, although the prospect of centrally cleared repo is helpful since this would a useful credit leveller.
The platform is also being used to assess opportunity cost, helping clients measure what Wilson describes as credit slippage - the foregone price improvement or depth from their decision about who they will or will not trade with. If two buy-side firms agree to trade with each other, they might achieve price improvement by meeting in the middle because neither party is subject to bank capital charges.
“We now have consistent daily volume at levels that are about a five basis point improvement over the Fed's new secured overnight financing rate,” says Wilson. “Participants can settle bilaterally or utilise tri-party settlement with agents other than BNY Mellon, which is useful for those who might want to migrate existing business.”
Future plans include developing an intra-day repo market as well as offering indemnification through schemes that would allow for credit protection on repo.
Deutsche Börse Group global funding & financing sales senior vice president, Frank Odendall, accepts that although Eurex does not currently operate a peer-to-peer platform - choosing instead to focus on business-to-client solutions - interest in the concept is not hard to understand.
“We appreciate that certain buy-side entities could find it beneficial to trade with other non-banks directly given the continuous pressure on bank balance sheets, regulatory considerations or a perceived reduction in bid-offer spreads,” he says.
As for whether there are any reasons why some market participants might choose not to conduct business peer-to-peer, Odendall notes that in the absence of an effective credit mitigation mechanism, potential buy-side clients will probably not be able to transact bilaterally with each other.
This is due to the lack of a sufficiently large credit department, credit appetite or acceptable legal framework, he adds. “In addition, liquidity provision by some buy-side firms could be unreliable as they are typically not set up to provide continuous liquidity and in all market conditions.”
Odendall expects a few large entities to embrace the perceived opportunity of non-CCP peer-to-peer, but reckons significant adoption would be a surprise. “On the other hand, we assume that European buy-side entities - similar to their US counterparts - would start to embrace CCP-cleared repos in which banks could provide balance sheet more easily due to the high netting potential of CCP-cleared securities financing transactions whilst the buy-side could reduce credit, operational and liquidity risks and costs,” he says.
Douglas Brown, head of alternative financing for State Street observes that improved pricing for both parties in the transaction is an obvious attraction for peer-to-peer activity in the lending and repo space. “With respect to repo, there is the expectation that peer-to-peer activity could provide more stable liquidity,” he adds. “Furthermore, across both product segments, counterparty diversification and collateralisation levels can benefit both parties in the transaction.”
Clients may choose not to participate in peer-to-peer activity due to legal, regulatory or policy limitations; concerns about counterparty creditworthiness and stability; preference for anonymity to peers; limitations on acceptable collateral; and inability to support the operational and trading aspects of the transaction, as well as cost of implementation, explains Brown.
“I think the scale of the growth in this segment of the market will be determined by the structures that are put in place,” he says. “Larger scale growth could occur if credit intermediation, counterparty anonymity and selection, strong liquidity and stability, and operational ease are key tenets of the product offering.”
When asked why firms might use his platform rather than a P2P provider, GLMX CEO and co-founder Glenn Havlicek notes that the dealer/client relationship has long been the bedrock on which the secured finance market rests.
“As such, our objective is to make existing dealer-to-client repo market flows more efficient and less error-prone,” he says. “We have developed technology to deliver a more efficient means of connecting existing counterparties, without lessening the critical value the sell-side provides. Our goal is not to replace dealers, but instead to create a more efficient model for the buy and sell-side communities to interact.”
When asked whether he is concerned about competition from centrally cleared institutional tri-party services, Havlicek notes that GLMX is not in the business of clearing or even of suggesting clearing mechanisms to its clients.
“We firmly believe that secured finance markets are more ripe for innovation than they have ever been and we are beginning to see wide adoption of fintech services,” he says.
Brooke Gillman, managing director client relationship management at eSecLending describes peer-to-peer lending and repo as a growing trend amongst institutional investors, particularly pension funds.
Peer-to-peer lending and repo trading opportunities offer attractive risk versus return profiles, as well as the ability to transact with strong creditworthy entities as many peer counterparts have a higher credit profile than the traditional banks, she says.
“We are seeing more interest from beneficial owners on both sides of the lending and borrowing transaction, with securities and cash driving demand to satisfy liquidity and funding requirements, to provide increased yield and broaden counterparty distribution channels.”
One of the obvious challenges facing beneficial owners that wish to participate in peer-to-peer transactions is formally approving each other from a credit and counterparty perspective, as many have requirements to transact with rated entities. Some beneficial owners have solved this challenge by developing internal processes and policies to review, approve and monitor non-rated entities. Additionally, there are new credit risk data providers emerging.
Peer participants also require solutions to address the legal, operational and trade administration components of securities financing transactions, as well as to maintain the required indemnification insurance for counterparty default, adds Gillman, who reckons the amount of business conducted on peer-to-peer platforms will increase over time.
“However, the issue is that these peer-to-peer platforms do not address the key challenges beneficial owners face to engage in these trades,” she says. “As previously mentioned, solutions are required to address credit approvals, legal documentation, operational administration and trade support as well as indemnification insurance in order to truly be able to increase the amount of peer-to-peer transactions flowing through trade platforms.”
Technology alone doesn’t support these types of trades - a network of peers that are pre-cleared to transact with one another and have the legal, operational and indemnification infrastructure in place is what will allow for significant increases in peer-to-peer securities financing transactions.
It has been suggested that peer-to-peer might appeal to specific market participant preferences, such as pension funds who want to deal with other pension funds rather than banks.
However, Odendall notes that banks do not only provide liquidity but also credit intermediation, which is difficult to address in a satisfactory matter in non-CCP cleared peer-to-peer markets.
“Therefore, we offer CCP-cleared repo and securities lending to buy-side entities,” he says. “This way we address bank balance sheet capacity and counterparty credit risk considerations. In addition, connecting to CCP-cleared securities financing markets should also provide access to new trading counterparties for many buy-side entities as operational restrictions often limit the possible number of trading counterparties in a non-CCP cleared environment.”
Brown says he can see why similar market participants might want to face each other from the standpoint of understanding the risk of the entity they are facing, but wouldn’t expect much business to occur if the relationships were that narrow.
In some client sectors there is limited shorting activity, limited need to invest cash in repo, limited financing activity, or a preference to not share confidential information with peers, creating the expectation of a market where participants face peers across the various client segments.
According to Gillman, pension funds are ideally suited to transact with other pension funds since many are already collaborating with their peers in the securities financing market and more broadly in other areas of investing. “Peer-to-peer securities lending and repo will not replace traditional banking transactions, but we do anticipate continued incremental trade opportunities for pension clients,” she concludes.