SEC Approval Sets Stage for Central Clearing in Securities Finance

With approval from the Securities and Exchange Commission to provide central clearing of securities financing transactions (SFTs), the National Securities Clearing Corp. (NSCC) aims to give buy-side institutions a more efficient and secure way to participate in the market while improving participants’ capital efficiency and mitigating systemic risk.

The equity clearing subsidiary of central counterparty (CCP) infrastructure operator Depository Trust & Clearing Corp. (DTCC) said its SFT Clearing Service will “support the central clearing of clients’ SFTs intermediated by sponsoring members or agent clearing members, as well as the central clearing of SFTs between NSCC full-service members.”

Lenders and borrowers will also be able to submit pre-established, bilaterally settled SFTs for clearing.

The intention is to “create buy-side access models that don’t really exist, in our view, in other centrally cleared-type structures,” explained Laura Klimpel, general manager of DTCC’s Fixed Income Clearing Corp. and head of systemically important financial market utilities (SIFMU) business development for DTCC. Market participants’ desire to expand their “universe of counterparties” is a motivator.

Laura Klimpel

However, longstanding fee structure may have to change to build volume.

DTCC has approved Broadridge and Provable Markets as “SFT submitters” for the yet-to-be-launched service. It said in June that it was working to ensure connectivity for users of FIS (formerly Loanet).

Avoiding Contagion

Accessing clearing services requires significant documentation, operational changes and testing in the client onboarding process, Klimpel noted. Advantages over bilateral trades include cost, capital, balance-sheet and operational efficiencies, along with accompanying CCP risk controls.

“There’s risk to the system when all the participants in the bilateral world have to do buy-ins or sell-outs, and that gets mitigated with clearing,” Klimpel said, adding that there will be less risk of contagion.

Buy-side beneficial owners of securities lend those securities mostly through agent lenders, typically major banks such as State Street, BNY Mellon and JPMorgan. They, in turn, support trades with participants on the demand side, usually brokers’ clients who want to borrow the securities, and they split the fee with the beneficial owners. The NSCC would enable such transactions, novated through the CCP.

Assessing the Costs

Josh Galper, managing principal of Finadium, said NSCC’s clearing model would require agent lenders to post a default fund contribution (DFC) to the CCP to guarantee client trades, in addition to indemnification costs recorded on the balance sheet and human resources, technology and operations costs.

“The additional cost of CCP margin may not appear necessary if the bilateral market continues to work well,” the consultant said.

BNY Mellon supports clearing for securities lending and participated in the NSCC SFT project working group, said Michael McAuley, the bank’s managing director and global head of product strategy. However, he added, agent lenders favored a model in which securities, not cash, are provided as collateral that can be pledged back to the CCP in the event of the beneficial owner’s default, eliminating the need for a DFC.

Michael McAuley

“So despite the CCP and trade submitter charges, [the securities] approach is more economically viable from the agent’s perspective,” McAuley said.

With a cash model, securities borrowers get the benefit of balance-sheet netting along with risk-weighted-asset (RWA) relief.

Fee-Structure Issues

McAuley said that agent lenders on average earn 10% to 20% of the revenue generated by the securities lending transaction. Clearing costs and fees added in the cash model can make a trade uneconomical.

In addition, the DFC component can vary because it is calculated using a value-at-risk (VaR) methodology. The resulting contribution, expressed as a percentage of the notional trade value, would be in high single digits in times of low volatility, and potentially double digits in volatile periods.

Requiring DFCs could thus slow adoption of the CCP until the market settles on alternative fee structures, McAuley said, which could include stock borrowers’ paying a premium to use the CCP, or the beneficial-owner lenders covering the DFC.

Still, NSCC’s service is expected to draw some market participants in. Galper believes “a vanguard of clients” understands what a CCP could offer and may be willing to negotiate different terms with their agent lenders that would free up additional capital and enable the agent lender to post the required margin, or they may go through a sponsor instead of an agent lender.

Approvals and Access

Wider adoption may take time, Galper added, given that most securities lending clients and their corporate boards, whose approval would likely be required to change the longstanding fee structure, have other priorities.

Broadridge anticipates continuing to onboard clients through the summer, according to Darren Crowther, general manager of Securities Finance & Collateral Management. Besides connecting to FIS’s post-trade platform, Broadridge is connecting its own trading platform and third-party trading systems, similar to the relationship between EquiLend and the Options Clearing Corp., which has cleared brokerages’ securities lending transactions for decades. Provable Markets, instead, offers an alternative trading system over which customers can borrow and lend securities and clear the transactions through the NSCC.

Crowther said that supply is coming mostly from agent lenders and their beneficial-owner clients, and Broadridge is also in discussions with asset managers that lend directly. On the demand side, he said, Broadridge is talking to both tier 1 and tier 2 investment banks for which netting reduces their risk-weighted asset requirements.

Agent banks have noted the challenge presented by having to post margin, Crowther said, and each bank will have to determine whether the potential for additional sales outweighs posting margin.

“We're seeing in many cases that the business case does stack up,” he said. “They have been able to increase volumes or change the dynamic in such a way” that they can benefit.

Besides RWA and capital-efficiency benefits, Crowther said, smaller tier 2 organizations can overcome constraints caused by their lesser credit standing and enter into trades with bigger counterparties. Those in tier 2 “can access liquidity they couldn’t before,” Crowther observed.

Sponsored Repo Model

The NSCC is also permitting a model similar to its existing sponsored repo service, in which a third-party brokerage clearing firm posts margin on its client’s behalf and charges the client a fee, but provides no indemnification.

Galper noted there are several issues complicating the decision to adopt the clearing firm model, including whether clients will be willing to pay a fee per transaction and their comfort with indemnification effectively coming from the CCP, and which brokerage firms would be willing to offer such as service.

“State Street and BNY Mellon have some of the largest agency clearing programs, and they’re also the biggest players in the sponsored repo business,” Galper said. “But do they want to offer sponsored securities lending?”

McAuley said BNY Mellon is reviewing the rule changes and assessing the opportunities of offering sponsored repo via NSCC: “It has to work economically, but now instead of low-volatility Treasury securities, you’re dealing with much more volatile equities.”

The NSCC service puts the industry’s T+1 (one day after the trade date) settlement goal in reach for securities financing transactions. “Broadridge, along with other vendors and clients, is looking at the move to T+1 and identifying changes needed across the financial markets ecosystem,” Crowther said. This will involve “collaboration and discussions with vendor platforms" that make up that ecosystem.