By Raymond Blokland, practice lead at Benelux
As a result of the financial crisis in 2008, a lot of new regulations have come our way with the purpose of reducing, monitoring and controlling credit risk exposure between parties in the financial markets. Gone are the days where we could lend securities uncollateralised, just on the basis of credit lines. This practice was conceptually in line with the continuing practice of placing deposits with banks – in other words, if I am willing to place an unsecured deposit of cash with Bank X, making an uncollateralised loan to the same bank is the same risk exposure. It is obviously a good thing that these practices ceased long before the 2008 crisis.
Collateral management is nowadays organised in a very efficient manner. Commonly held and moved around in Triparty collateral accounts, as far as it concerns non-cash collateral. The most frequently used model is that the borrower is holding most, if not all of its collateral with one triparty provider. That provider can simply move around the collateral between the client/lender accounts of the borrower via book-entries, rather than actual physical movements. Potential exposures are very quickly covered since nothing physically moves. The new pledge structure goes even one step further because the collateral will then stay in an account in the borrower’s name with a security interest in favour of the lender. And although that structure seems to be rock solid and leaves the lender in full control of the collateral, it nevertheless gives a capital reduction benefit to the borrower. The same reduction, so I am told, as would have been achieved by making use of a CCP as middleman. But in the case of the pledge, it is only about signing a legal document and opening up a custody account. Quite simple to implement, I would say. And when the borrower has a benefit so should the lender. In other words, bring on these higher fees and lending volumes!
Anyway, since we are now at the subject of pledge it brings us to UMR or the Uncleared Margin Rules. According to the current timeline, we are now at phase 4, with 5 and 6 coming up in 2020 and 2021. Phase 6 is particularly interesting as it targets the smaller players in the OTC derivatives market. Are they ready for it and can they handle the requirements of calculating and providing Initial Margin and Variation Margin? Obviously, many providers are already coming up with all kinds of solutions and holistic collateral products to make sure that institutions including phase 6 firms can meet their requirements and are able to operationally handle all of these new processes. “Just hand over the process to us and we will take care of it in a safe and efficient manner (at a small fee of course...)”
But hold on. Portfolio managers have already been using listed derivatives for many decades. This is mainstream in modern portfolio management. Margin management for these kinds of derivatives is therefore also mainstream. I am pretty sure that that process and the operational organisation around it is already in place and can also be used for UMR.
What has all of this got to do with securities lending, you might ask? Well, if we look at the list of the various derivatives that are subject to UMR, we also find Equity Swaps and Equity Forwards. When these instruments are used in the securities finance space, they are often referred to as synthetic securities lending. Commonly used by (prime) brokers to trade amongst themselves or with their clients (aka synthetic prime brokerage). Not so commonly used by the traditional beneficial owners however. I believe strongly that this is a lost opportunity. Synthetics can be used in many different ways and it is often the route to earn revenues on financing trades or on securities that cannot be loaned in a traditional manner. And by traditional, I mean, where for example an agent only provides a physical securities lending solution. By some estimates, synthetic transactions represent half of the total value of securities finance transactions.
Beneficial owners have full control over their assets including listed- or OTC derivative positions, and therefore have the advantage when it comes to potentially being active in synthetic securities lending. This is a huge advantage which should be monetised as it will create additional real alpha. Let UMR not be another missed opportunity.