Central Clearing for US Sec Lending: Coming Soon?

Central clearing: it’s a well-established concept for settling equities, fixed-income and now swap transactions.

But not in the US securities lending market, where Eurex Clearing now wants to establish a new service, but could face an uphill climb, despite enlisting two of the world’s largest custodian banks BNY Mellon and State Street to help out.  Granted, OCC in Chicago operates a successful service for securities lending deals, but it caters to direct bank and broker-dealer participants — not the agency lending model. A succinct press release issued by parent derivatives exchange giant Eurex only suggesting an intent to work together is already generating plenty of questions and some understandable skepticism.

“We are in preliminary discussions over how the operating model will work but believe it will be beneficial for borrowers and underlying beneficial lenders,” says Mike McAuley, a managing director and global head of product and strategy for BNY Mellon’s securities lending business.

Prove it, counter operations managers at five US fund management firms contacted by FinOps Report. Until now, the US securies lending agent model has served borrowers, lenders and custodian bank agents both operationally and financially. Why fix what isn’t broken? they ask.

The primary goal of central clearing — to reduce the potential financial risk of a firm reneging on its settlement obligations — doesn’t hold water in the traditional securities lending market. One of the key reasons: in their agent role, custodians either prevent borrower default or compensate fund management firms should that happen. By contrast, central clearing typically involves a clearinghouse serving as a middleman in exchange for members contributing to a default fund which can be tapped in the event the margin posted is not sufficient to cover the value of the obligation involved.

What Risk?

Here is how the agent securities lending market works: the borrowers, typically broker-dealers, borrow securities from lenders, who are typically institutional asset-owners such as pension plans, endowments, insurance companies and even hedge funds. Custodian banks typically accept only the most creditworthy borrowers and take a percentage of the fees earned by the underlying lenders. They are also responsible for handling the administrative work involved with the transfer of securities and cash between the borrowers and lenders as well as executing the correct cash reinvestment — aka reinvesting the cash the borrower puts up as collateral in a pool of assets.

As the first line of defense against default, custodians will scrutinize the financial stability of borrowers rigorously and borrowers do post more than enough margin in case something goes wrong. As a last resort, custodians will go as far as to “indemnify” or guarantee the securities will be returned to the underlying beneficial lenders. So far, there have been no public reports of any custodians forced into the worse-case pay-out for borrower default.

Beneficial asset owners may have lost money in securities lending deals during the financial crisis — and sued their custodians including BNY Mellon — but that was not because of failure of the securities lending transactions per se. Rather it was due to plummeting prices of the assets in the collateral pool in which cash was reinvested to produce income for the lender. US securities lending deals are typically collateralized by borrowers with cash, instead of securities as often the case overseas.

New Regulatory Cost

If risk isn’t the key reason to use a central clearing model for securities lending, regulatory cost might well be. That is at least for custodians and broker-dealer borrowers faced with new constraints. Until now, the securities lending business remained relatively unregulated, but with regulators now paying closer attention to “off-balance sheet” transactions, that’s no longer the case.

Depending on how indemnification is taken into account when calculating leverage ratios under Basel III, it could require custodians to increase the regulatory capital they set aside for securities lending deals. Broker-dealers may also need to increase the regulatory capital they must put aside for borrowing transactions under the Dodd-Frank legislation because of higher leverage ratios. As a result, they may decide to do fewer securities lending deals. Or so goes the argument.

McAuley claims that custodians aren’t worried about the direct impact of regulations affecting securities lending deals. Instead, they see a potential oversupply of lendable assets, leaving investment funds unable to earn extra revenues from lending their idle securities. “Using a central clearinghouse will benefit funds wanting to increase the pool of borrowers with which they do business,” he says. Of course, McAuley also acknowledges that increasing the number of borrowers will also allow custodians to profit from more securities lending transactions.

Two operations managers at US broker-dealers acknowledge that they would likely benefit from central clearing of securities lending deals, possibly more than asset-owners. “Figuring out the cost-benefit will take some work. Access to lendable assets is just one factor. We would need to balance out the reduction in regulatory capital against the margin requirements of a clearinghouse,” one operations manager says. The numbers, he acknowledges, could come out in favor of central clearing.

Waiting for Details

Eurex is not willing to comment further on its press release, leaving fund mangement firms in the dark about how to calculate the possible costs of its proposed US service against the benefits. However, if Eurex’s European central clearing model for securities lending transactions provides any indication of its strategy in the US, fund management firms would be signed up for a “specific lender” license, instead of becoming members. That means they would not have to put up any initial or variation margin.

Who would have to post margin? Only borrowers that would likely benefit from substantial capital relief. Under the Eurex model, custodian banks such as BNY Mellon would still serve in an administrative and agent role or even become members of the clearinghouse. From all appearances, that’s not the case with the OCC’s model. 

“Keeping agent lenders involved and promoting their operational, pricing and collateral movement expertise is an important part of the Eurex clearing model,” writes research firm Finadium in a January article appearing on its website. The article sponsored by Eurex Clearing and software firm Pirum in London also goes on to say that the US CCP model for securities lending offered by OCC has seen “explosive growth” over the last eighteen months, but involves sell-side firms only.

Officials at OCC were unavailable for comment at press time, but a spokeswoman for the organization directed FinOps to its website, where recent press releases seem to reinforce the OCC’s continuing commitment to its current class of members. OCC’s Stock Loan/Hedge program allows clearing members to use their borrowed and loaned securities to reduce their margin requirements at the clearinghouse, while a separate program known as Market Loan allows OCC to process stock loan positions of its members as the central counterparty.

Lender Reactions

What do fund managers and the beneficial owners think of Eurex’s announcement with BNY Mellon and State Street? Given Eurex’s lack of substantive details on how its proposed central clearing service in the US would work, buy-side firms are looking for a lot more granular information before they exhibit much enthusiasm, as evidenced by the reactions from the five US fund management shops contacted by FinOps.

“If we don’t know who our counterparty brokers are, we may refuse to rely on the central clearing model. We do know our borrowers now and our clients are comfortable with them,” says one operations manager. Says another, “We would need to weigh the benefit of doing business with additional borrowers who might not be as creditworthy as the handful we use now.” One more factor fund managers must consider: whether the potential higher cost of indemnification or even the potential reduction in indemnification passed on by their custodians will be enough to motivate them to replace the current so-called “bilateral” mode of doing business with a central clearing model.

However, the most serious concern to lenders appears to be a regulatory quagmire. Can beneficial assets owners — pension plans and mutual funds — governed by the Department of Labor and Securities and Exchange Commission respectively participate in securities lending agreements involving a central counterparty? Two New York experts in securities law, who declined to be identified, tell FinOps that they would be “hesitant” to advise managers of investment funds governed under ERISA or the Investment Company Act of 1940 to participate in Eurex Clearing’s US program. “I would be far more comfortable if there were DOL and SEC guidance on the matter,” says one New York attorney specializing in investment fund regulations.

The attorney even speculated that Eurex’s plan could not succeed in the US without the blessings of the DOL and SEC because of the hefty participaton of pension plans and mutual funds in the US securities lending market. “I’m wondering if one of the reasons Eurex won’t comment on its US offering is that it still needs to iron out the kinks with regulators,” he said, noting that any regulatory approval may come with strictures that affect the operating model. McAuley acknowledges that regulatory issues involving funds governed under ERISA and the Investment Company Act would need to be resolved. Officials at the Risk Management Association, whose securities lending committee is also seeking legal clarity, were unavailable for comment at press time.

Given the size of BNY Mellon and State Street’s lending book of business, Eurex has certainly started marketing its initiative with a bang, at least to custodians and borrowers who might bring their own fund manager customers to the table. However, it is unclear whether that will be enough to generate a groundswell of participation from others.

Speaking at a press briefing yesterday, Patrick Colle, chief executive of BNP Paribas Securities Services, says that as a newcomer to the US securities lending market, his bank has yet not received any interest from fund manager customers or their asset-owner clients on central clearing for securities lending transactions. And understandably so. “It’s not about mitigating risk, but the potential increase in the leverage ratio,” he speculates. While Colle would not comment specifically on BNY Mellon and State Street, he acknowledges that some custodians could face a far higher leverage ratio from their securities lending business than others.

Equilend, a popular electronic securities lending and borrowing platform used by over 100 custodians and borrowers, says it will play ball with any clearinghouse, but only if there is sufficient interest from its customers. “When there is demand from the industry to use CCPs we will absolutely be part of the solution,” says chief executive Brian Lamb. “We are committed to working with the industry to identify the best CCP model and how we can help to facilitate trade flow among our clients via the CCP model.”