The securities lending dream
03 April 2018
Will upcoming government rules and regulation mean US financial services will be dancing in the dark or marking the beginning of some glory days?
Image: Shutterstock
Born to run securities lending?
Now is an unprecedented time for securities lending in the US. Not only is the industry faced with collateral reviews, it faces a wave of governmental change, headed by a controversial president aiming to deregulate its financial services.
From its own side of the pond, the US has the Dodd-Frank Act (also known as the Volker Rule) to consider, and from Europe, it has the Securities Financing Transactions Regulation (SFTR) to contend with.
Possibly, the most important regulation for collateral right now is Rule 15c3-3. First introduced in 1972 by the Securities and Exchange Commission (SEC), Rule 15c3-3 was initiated to protect client accounts in securities firms. Rule 15c3-3 cites the amount of cash and securities that broker-dealer firms must segregate in specially-protected accounts on behalf of their clients.
Broker-dealer firms must calculate the cash and securities they owe to clients and what clients owe to them. In the event that the amount owed to clients exceeds the amount owed from clients, the firm must keep hold of a portion in a special reserve bank account.
The SEC鈥檚 reasoning is to ensure that clients can withdraw the majority of their holdings on demand, even in the midst of a bank鈥檚 insolvency.
Peter Economou, head of markets, risk, and operations at eSecLending, says: 鈥淸Rule 15c3-3] could change the industry for the better.鈥�
鈥淸The] ability for US brokers/dealers to pledge equities as collateral and the permission for Registered Investment Companies to accept equities as collateral [...] will increase revenue opportunities for beneficial owners at risk levels well within existing tolerances.鈥�
He also says: 鈥淲e continue to believe that non-cash collateral will expand in asset types and preference to the borrower community. For some borrowers, the provision of USD cash as collateral is expensive; therefore, other options such as non-cash collateral are more attractive.鈥�
However, rules and considerations surrounding collateral are not the only challenge bearing down on US securities lending firms. Coming out of Europe, there is SFTR, expected to go live in 2019.
As George Trapp, head of client relations for North America at Northern Trust, global securities lending, explains: 鈥淎lthough the SFTR reporting regulation is specific to Europe, it will impact various securities lending participants in the US as well.鈥�
鈥淭he industry continues to make strides towards meeting the requirements, and vendors are engaged to facilitate collection and aggregation of the data elements required to be reported to the regulators.鈥�
The Wall Street shuffle
In 2010, the Dodd-Frank Wall Street Reform was signed into federal law by the Obama administration.
Though, the Obama administration brought in the Dodd-Frank Reform Act to damage control the crisis; making US financial services follow investor guidelines, it is clear Obama鈥檚 successor, President Donald Trump, has a different agenda through his recent executive orders and last year鈥檚 signing of the Financial CHOICE Act.
Just ten days after his inauguration day, on 30 January 2017, Trump signed an executive order titled 鈥淩educing Regulation and Controlling Regulatory Costs鈥�. The order stated that for every one new regulation that is proposed, executive departments and agencies must remove two in its place.
In addition, the Republicans initiated the Financial CHOICE Act in June last year, which was fiercely backed by the president, and is predicted to directly affect foreign banking entities.
It scales back the authority of the Dodd-Frank Reform to regulate large banks and also repeals the so-called Volcker Rule (created by former US Federal Reserve chairman Paul Volcker), which prevents government-insured banks from making bets with investments.
The Dodd-Frank Reform expanded federal laws to potentially handle insurance companies and non-bank financial companies, changing these types of liquidation laws, which could affect securities lending.
As Stephen Malekian, North American CEO at Elixium, states: 鈥淚t鈥檚 hard to muster a counter-argument that rolling back regulation won鈥檛 put the banks back to where they were pre-crisis.鈥�
鈥淲henever regulators and central banks intercede in markets and endeavour to make the banking system 鈥榞reat again鈥�, there are inevitable repercussions鈥�, he says.
Also weighing in, Timothy Smith, general manager of FIS, Kiodex and Astec Analytics says: 鈥淚t will probably be the case, as per usual, that the predicted dire consequences of removing Dodd-Frank will not arise, but neither will the exaggerated benefits of deregulation be as great as foreshadowed.鈥�
Only time will tell how future US government legislation will change the rules for securities lending specifically, though there are concerns about the Financial CHOICE Act and Trump鈥檚 influence in US financial services after a year of his becoming commander in chief.
For instance, according to a TABB Group report, released in February of this year, the US options market is stagnating as a 鈥渞esult of political and regulatory change鈥� in Washington DC.
The total volume in the US options market was 1.9 percent lower in 2016 than 2015, due to a lack of sustained volatility, TABB says.
The group explains that this was due to the inauguration of 鈥渞egulatory-sceptic President Donald Trump [who] has caused a decline in market correlation鈥�.
However, according to Economou, option activity has 鈥減icked up slightly in February and March in lockstep with the increased volatility, as measured by the Vix index. We anticipate increased options activity throughout 2018, as long/short players re-enter the market this year鈥�.
Option activity looks like it鈥檚 rising positively, however, that鈥檚 only one slice of the American securities lending pie to digest.
Tougher than the rest
Post-crisis and under the Trump Presidency, what does the next few years hold for US securities lending, are we able to even predict it?
Despite some heavy regulation headaches and the actions of a controversial president, securities finances are still showing positive growth and positive discussion as we are now well into 2018.
In January 2018, the debate on the controversial leverage ratio rules under Basel III was reopened, showing a consideration for concerns within securities lending.
The rule, which many think currently stifles securities lending activity in the US, requires equity capital to be held against assets, including cash, on an unweighted basis.
Conflicting views around the appropriateness of the measures, which are less strict in other major markets such as the EU, has been ongoing since the rules implementation began in 2014.
Several major US banks, including BNY Mellon and State Street have waded in on the issue with calls to review scope of the ratio.
Trapp says: 鈥淎 US proposal addressing the Basel revisions to the standardised approach would be a key development for the industry.鈥�
Elsewhere, the OCC has calculated that its securities lending activity was up 39 percent in new loans from February last year with 224,374 transactions for February.
It revealed that its year-to-date average daily cleared contract volume is up 39 percent from 2017 with 23,934,996 contracts.
As Trapp says: 鈥淲e are positive about the prospects for the US securities lending market this year. Market volatility has increased, leading to more trading opportunities, and the breadth of specials is widening.鈥�
鈥淚n addition, beneficial owners are coming back into the market and/or increasing their asset participation, bringing additional supply to support these trading opportunities.鈥�
Trapp also states that moving forward, and in addition to regulations being a continued focus for the industry, the industry鈥檚 adaption to automation will be important.
He adds: 鈥淒istributed ledger technology will improve the transparency and efficiency of the market [...] as confidence continues to grow in the technology, it could also open up future opportunities around account structures, regulatory reporting and digital issuance.鈥�
Economou says: 鈥淲e are seeing improvement in the early part of 2018 as the rules and regulations have become known, and borrowers have incorporated the impacts into their securities borrowing businesses.鈥�
Now is an unprecedented time for securities lending in the US. Not only is the industry faced with collateral reviews, it faces a wave of governmental change, headed by a controversial president aiming to deregulate its financial services.
From its own side of the pond, the US has the Dodd-Frank Act (also known as the Volker Rule) to consider, and from Europe, it has the Securities Financing Transactions Regulation (SFTR) to contend with.
Possibly, the most important regulation for collateral right now is Rule 15c3-3. First introduced in 1972 by the Securities and Exchange Commission (SEC), Rule 15c3-3 was initiated to protect client accounts in securities firms. Rule 15c3-3 cites the amount of cash and securities that broker-dealer firms must segregate in specially-protected accounts on behalf of their clients.
Broker-dealer firms must calculate the cash and securities they owe to clients and what clients owe to them. In the event that the amount owed to clients exceeds the amount owed from clients, the firm must keep hold of a portion in a special reserve bank account.
The SEC鈥檚 reasoning is to ensure that clients can withdraw the majority of their holdings on demand, even in the midst of a bank鈥檚 insolvency.
Peter Economou, head of markets, risk, and operations at eSecLending, says: 鈥淸Rule 15c3-3] could change the industry for the better.鈥�
鈥淸The] ability for US brokers/dealers to pledge equities as collateral and the permission for Registered Investment Companies to accept equities as collateral [...] will increase revenue opportunities for beneficial owners at risk levels well within existing tolerances.鈥�
He also says: 鈥淲e continue to believe that non-cash collateral will expand in asset types and preference to the borrower community. For some borrowers, the provision of USD cash as collateral is expensive; therefore, other options such as non-cash collateral are more attractive.鈥�
However, rules and considerations surrounding collateral are not the only challenge bearing down on US securities lending firms. Coming out of Europe, there is SFTR, expected to go live in 2019.
As George Trapp, head of client relations for North America at Northern Trust, global securities lending, explains: 鈥淎lthough the SFTR reporting regulation is specific to Europe, it will impact various securities lending participants in the US as well.鈥�
鈥淭he industry continues to make strides towards meeting the requirements, and vendors are engaged to facilitate collection and aggregation of the data elements required to be reported to the regulators.鈥�
The Wall Street shuffle
In 2010, the Dodd-Frank Wall Street Reform was signed into federal law by the Obama administration.
Though, the Obama administration brought in the Dodd-Frank Reform Act to damage control the crisis; making US financial services follow investor guidelines, it is clear Obama鈥檚 successor, President Donald Trump, has a different agenda through his recent executive orders and last year鈥檚 signing of the Financial CHOICE Act.
Just ten days after his inauguration day, on 30 January 2017, Trump signed an executive order titled 鈥淩educing Regulation and Controlling Regulatory Costs鈥�. The order stated that for every one new regulation that is proposed, executive departments and agencies must remove two in its place.
In addition, the Republicans initiated the Financial CHOICE Act in June last year, which was fiercely backed by the president, and is predicted to directly affect foreign banking entities.
It scales back the authority of the Dodd-Frank Reform to regulate large banks and also repeals the so-called Volcker Rule (created by former US Federal Reserve chairman Paul Volcker), which prevents government-insured banks from making bets with investments.
The Dodd-Frank Reform expanded federal laws to potentially handle insurance companies and non-bank financial companies, changing these types of liquidation laws, which could affect securities lending.
As Stephen Malekian, North American CEO at Elixium, states: 鈥淚t鈥檚 hard to muster a counter-argument that rolling back regulation won鈥檛 put the banks back to where they were pre-crisis.鈥�
鈥淲henever regulators and central banks intercede in markets and endeavour to make the banking system 鈥榞reat again鈥�, there are inevitable repercussions鈥�, he says.
Also weighing in, Timothy Smith, general manager of FIS, Kiodex and Astec Analytics says: 鈥淚t will probably be the case, as per usual, that the predicted dire consequences of removing Dodd-Frank will not arise, but neither will the exaggerated benefits of deregulation be as great as foreshadowed.鈥�
Only time will tell how future US government legislation will change the rules for securities lending specifically, though there are concerns about the Financial CHOICE Act and Trump鈥檚 influence in US financial services after a year of his becoming commander in chief.
For instance, according to a TABB Group report, released in February of this year, the US options market is stagnating as a 鈥渞esult of political and regulatory change鈥� in Washington DC.
The total volume in the US options market was 1.9 percent lower in 2016 than 2015, due to a lack of sustained volatility, TABB says.
The group explains that this was due to the inauguration of 鈥渞egulatory-sceptic President Donald Trump [who] has caused a decline in market correlation鈥�.
However, according to Economou, option activity has 鈥減icked up slightly in February and March in lockstep with the increased volatility, as measured by the Vix index. We anticipate increased options activity throughout 2018, as long/short players re-enter the market this year鈥�.
Option activity looks like it鈥檚 rising positively, however, that鈥檚 only one slice of the American securities lending pie to digest.
Tougher than the rest
Post-crisis and under the Trump Presidency, what does the next few years hold for US securities lending, are we able to even predict it?
Despite some heavy regulation headaches and the actions of a controversial president, securities finances are still showing positive growth and positive discussion as we are now well into 2018.
In January 2018, the debate on the controversial leverage ratio rules under Basel III was reopened, showing a consideration for concerns within securities lending.
The rule, which many think currently stifles securities lending activity in the US, requires equity capital to be held against assets, including cash, on an unweighted basis.
Conflicting views around the appropriateness of the measures, which are less strict in other major markets such as the EU, has been ongoing since the rules implementation began in 2014.
Several major US banks, including BNY Mellon and State Street have waded in on the issue with calls to review scope of the ratio.
Trapp says: 鈥淎 US proposal addressing the Basel revisions to the standardised approach would be a key development for the industry.鈥�
Elsewhere, the OCC has calculated that its securities lending activity was up 39 percent in new loans from February last year with 224,374 transactions for February.
It revealed that its year-to-date average daily cleared contract volume is up 39 percent from 2017 with 23,934,996 contracts.
As Trapp says: 鈥淲e are positive about the prospects for the US securities lending market this year. Market volatility has increased, leading to more trading opportunities, and the breadth of specials is widening.鈥�
鈥淚n addition, beneficial owners are coming back into the market and/or increasing their asset participation, bringing additional supply to support these trading opportunities.鈥�
Trapp also states that moving forward, and in addition to regulations being a continued focus for the industry, the industry鈥檚 adaption to automation will be important.
He adds: 鈥淒istributed ledger technology will improve the transparency and efficiency of the market [...] as confidence continues to grow in the technology, it could also open up future opportunities around account structures, regulatory reporting and digital issuance.鈥�
Economou says: 鈥淲e are seeing improvement in the early part of 2018 as the rules and regulations have become known, and borrowers have incorporated the impacts into their securities borrowing businesses.鈥�
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