ISLA Seeks Comment On CCP Service
June 9, 2009
The International Securities Lending Association has published a white paper outlining the potential merits of a central counterparty service in the European securities lending and borrowing arena.
The London-based trade group, which also offered recommendations on how such a central counterparty (CCP) could work, invited industry comment by June 30. The ISLA Web site is http://www.isla.co.uk/
While central counterparty services are common in the equities arena and gaining steam in the over-the-counter derivatives market, they are still in their infancy in the securities lending market. Electronic platforms Quadriserv and SecFinex have announced they will offer CCP services in the European market while LendEX does so in the U.S. only.
The ISLA said that a CCP would reduce capital requirements for firms that act as principals in the securities lending market; lower the use of credit lines; and widen the group of counterparties. However, those benefits are likely to help only principal intermediaries – those borrowing securities as part of a prime brokerage – far more than lenders and their custodian bank agents.
“Many lenders are not subject to regulatory capital requirements and are protected from counterparty risk by over-collateralization and, in many case, indemnities from lending agents,” said the ISLA. “For agent lenders, securities lending is off-balance sheet.”
The ISLA said that to win support from lenders and their agents, any CCP model would have to ensure access to a wider pool of borrowers without resulting in higher costs or increased risk exposure.
The ISLA offered two models for how a CCP might work. In the case of a full-service model, the lender and borrower would manage their securities lending and borrowing positions either with the CCP – in the case of firms that are clearing members – or with their clearing member. By contrast, a CCP following a “narrow model” would only provide simple credit enhancement services; the securities lending transactions would continue to be managed bilaterally between the two original counterparties to the trade.
Although the full service model would bring the most efficiencies, the CCP and clearing members would need large and sophisticated back offices to manage post-trade processes such as collateral management, recalls, corporate actions, collection of fees and dividend payments.
The narrow model would be more achievable in a short time frame. However, involving six parties in each trade – the lender, lender’s agent, agent lender clearing member, CCP, borrower’s clearing member and borrower – would add complexity and additional costs to the process. That is because each party would need to earn some return from what is typically a relatively low margin business.
The ISLA recommended that any CCP should not limit the maximum trade size, charge less than E1 per trade; offer transparent membership criteria for clearing and non-clearing members and accept trades from all securities lending platforms as well as ones conducted bilaterally. Lenders, according to the ISLA, should not be required to take on any counterparty risk on their clearing member and not be required to post margin to either the CCP or their clearing member.
Industry reaction to the ISLA’s paper was lukewarm. “A generic ISLA one-size-fits-all statement isn't necessarily an accurate guide to the future,” said Roy Zimmerhansl, principal of Zimmerhansl Consulting Services, a Surrey, U.K-based consultancy specializing in securities lending and borrowing. Zimmerhansl was also the former director of Icap’s i-Sec platform.
“We agree with most of the statements made by the ISLA and have already implemented almost of its recommendations,” said Greg DePetris, co-founder of New York-based Quadriserv, whose AQS platform will use “full-service” CCP models.
However, DePetris disagreed with the ISLA’s recommendation that lenders not be required to satisfy their own margin requirements. “We believe that all market participants should collateralize their own risk and there are highly cost effective, well understood tools at our disposal that will allow this to occur,” he said.
Now in a “controlled pilot mode” in the U.S, AQS relies on the Options Clearing Corp. as its CCP for U.S. equities. AQS will use Eurex Clearing, the clearing arm of derivatives exchange Eurex to clear U.K., German and Swiss equities next year.
Josh Galper, managing principal of Concord, Mass-based consultancy Finadium, praised the ISLA for taking a proactive step in determining the merits of CCPs in the securities lending and borrowing market. However, he believes it will take some time before they gain widespread acceptance.
“Intermediaries may see some merit, but the real move toward CCPs will come when beneficial asset holders – lenders – and hedge fund borrowers want to reach the market directly or have their agents do it for them,” Galper said. A recent survey, conducted by Finadium, showed that most large asset managers have not heard of CCPs in the securities lending market.
