Securities finance operations managers at US broker-dealers clearing their securities loan deals through the Options Clearing Corp. (OCC) could soon reduce if not eliminate time-consuming manual reconciliation work thanks to its new distributed ledger technology-based platform.
Once OCC’s new DLT-based securities finance infrastructure is up and running, its 72 broker-dealer users would have real-time access to the same information located on the DLT platform as their counterparties. The new platform to be hosted in the cloud, will replace a legacy system which underpins OCC’s two securities lending programs– Stock Loan/Hedge and the newer Market Loan. Development of the DLT-based system, designed by New York-based Axoni using its Axcore protocol, will start later this year with OCC targeting 2022 for launch.
Broker-dealers, which include the likes of Wall Street powerhouses Morgan Stanley, Credit Suisse, Citi and JP Morgan, would operate the nodes linking themselves to OCC’s DLT platform. They will have to adapt their existing systems to send and retrieve data to and from the network. The OCC will run the validator nodes that control the system’s governance and allow new participants to join. OCC has not disclosed the fees it will charge broker-dealers to license the software necessary to integrate their systems into the DLT-based network.
Launched as the first US clearinghouse for equity derivatives in 1973, the OCC is regulated by the Securities and Exchange Commission, the Commodity Futures Trading Commission and the Federal Reserve Board. The OCC started its Stock Loan/Hedge central counterparty service for securities loans in 1993 and its Market Loan program in 2009. Market Loan clears trades for a subsidiary of EquiLend Clearing LLC owned by electronic loan trading platform EquiLend. A spokesman for EquiLend in New York referred questions on EquiLend’s current and future use of the OCC service to the clearinghouse.
“We will seek regulatory approval to consolidate our two securities borrowing and lending counterparty programs Loan/Hedge and Market Loan into a single program combining the best elements of both which will run on the new DLT platform,” explains Matthew Wolfe, vice president of securities finance at OCC in Chicago. The two critical upgrades in the yet-to-be-named new merged system which will help OCC’s broker-dealer members reduce their administrative workload are OCC’s handling of interest payments and corporate action payments. The new platform would not affect the already short– same-day– settlement timeframe for securities loans.
The OCC is naturally hoping that its new DLT platform will boost the use of its securities lending counterparty service by broker-dealers and eventually bring custodian banks into the fold after more systems and membership requirements are changed. The current limited scope of participants constricts the potential for volume growth as the bulk of securities lending deals occur through custodian banks serving as agents to investment fund wanting to earn more revenues by lending securities to broker-dealers. Agent lenders earn a percentage of the fees and provide funds with indemnification against defaults by broker-dealers. As of April 30, the OCC’s balances for cleared securities lending deals stood at around US$72 billion representing only 13 percent of the total US equities on loan across the US. Of OCC’s two securities loan programs Stock Loan/Hedge represents about 98 percent of the volume.
In both the Stock Loan/ Hedge and Market Loan programs, OCC acts as the central counterparty guaranteeing the return of lent stock to the lender and the return of collateral to the borrower. OCC also values the stock loans on a daily basis to ensure the right amount of cash collateral is held by the lender. Stock loans cleared through the Stock/Loan Hedge program are first bilaterally negotiated between counterparties prior to settlement at Depository Trust Company (DTC), the US’ national securities depository. By contrast, stock loans in the Market Loan program are first submitted to the ECS’s electronic trading platform, known as a loan market, for matching. The loan market sends the matched loan information to OCC before the transaction is settled at DTC.
Should the borrower default on its obligation to return the loaned securities to the lender, the OCC will instruct the lender to execute a buy-in of the loaned stock using the cash collateral of the borrower. If the cost of the purchased stock is more than the value of the collateral, OCC will pay the lender the shortfall. If the lender defaults on returning collateral to the borrower, the OCC will tell the borrower to sell out the borrowed stock to return the collateral to the lender. If the proceeds the borrower receives through the sell-out aren’t enough, OCC will pay the borrower the difference. The new securities lending counterparty service will retain the bilateral negotiation and matching functions of Stock Loan/Hedge.
Here is where DLT enters the picture: “When OCC merges its two stock loan programs into a single program it will guarantee and settle interest payments among borrowers and lenders,” says Wolfe. “Because the OCC’s distributed ledger will hold the golden copy of the transactions, contracts and interest, participants can automatically synchronize to the golden copy, thus reducing or eliminating the current process of reconciling their books with each other and with the OCC.” The process typically takes a few hours with broker-dealers typically needing two back-office employees for each securities lending trader. Firms can spend at least US$1 million a year for all reconciliation work, by some industry estimates.
Although OCC does handle interest payments under its Market Loan program it doesn’t do so for its more popular Stock/Loan Hedge program, leaving broker-dealers to do the work on their own. In addition to reconciling their books with each counterparty, broker-dealers must also make multiple wire transfers to each counterparty. By netting the interest payments into a single wire payment at the end of each month, OCC will eliminate the time and costs involved with multiple wire transfers.
Yet another benefit of OCC’s DLT platform for securities finance operations managers at broker-dealers will be the clearinghouse’s adjustment of stock loan contracts for mandatory corporate actions, such as dividends. In the case of a cash dividend, the borrower must ensure that the lender receives the dividend. As part of the new stock loan counterparty program using the DLT-based platform, the OCC will guarantee and settle cash entitlements eliminating borrowers from having to do the work after reconciling their records with those of lenders. With the OCC making the adjustments to its records and sending out corporate action payments to the right counterparty, borrowers also don’t have to worry about handling cumbersome claims requests. Those requests are made by lenders when borrowers erroneously receive corporate action entitlements that belong to lenders, because of confusion over who owns the securities on the record date. That is the date set by the issuer of the securities for an investor to receive a corporate action entitlement.
The OCC’s Wolfe won’t disclose how much the clearinghouse will spend on the new DLT system. but he acknowledges that it will reduce operating costs by a yet-to-be determined percentage. It remains to be seen whether the efficiency translates into any rebates to broker-dealers from OCC’s excess revenues. However, if OCC is right the cost savings from reduced or eliminated reconciliation work alone should be substantial enough to keep middle-office operations folks and their bosses pretty happy.