This article has been published in Fund Europe magazine April 2021
Hampered by a lack of standardisation, the securities finance market is now undergoing a technological transformation that aims to reduce fragmentation, lower risks and increase revenues for many actors, finds Bob Currie.
In a white paper 18 months ago, the International Securities Lending Association (Isla) and law firm Linklaters proposed that the securities lending market is at a crossroads. The market is becoming ever-more complex and regulation more onerous. Processes and systems that previously served the market relatively well are now becoming more cost and time-intensive.
The white paper – called ‘The Future of the Securities Lending Market: An Agenda for Change’ – predicted costs and risk will continue to increase, potentially to unsustainable levels. This means that standardising, automating and streamlining processes is more important than ever.
How did the industry arrive at this crossroads? Adrian Dale, Isla’s head of regulation and market practice, tells Funds Europe that, as a new product area with capacity to generate attractive revenues, securities lending teams were given considerable freedom within their organisations when they structured and managed lending businesses. This resulted in variation of operating models across the industry, with market participants developing their own methods for dealing with each stage in the lifecycle of a securities loan transaction.
Owing to the fragmentation, much of the interaction between market participants – as well as within organisations – is manual and non-standardised. There is significant duplication of workflow, bringing delays, inefficiencies, inflated costs and higher risk at a time when revenue and margins are under pressure. (More details are in the Isla/Linklaters follow-up paper, ‘The Future of the Securities Lending Market, Advancing the Digital Debate’, March 2021.)
Major regulatory projects such as the Securities Finance Transaction Regulation have prompted the industry to reflect on its operational practices, but many non-standard processes remain and this, says Dale, limits opportunity to deliver ‘plug and play’ developments between and with firms.
“However, we are optimistic that adoption of a ‘common domain model’ [CDM – more details below], establishing a common data template for data transfer, will encourage interoperability between legal entities and between the different systems that firms maintain internally,” he adds.
Harpreet Bains, global head of product, agency securities lending at JP Morgan, says that a primary challenge in applying technology has been to improve collateral mobility across siloed businesses and locations that, traditionally, have not been well connected.
The key is to deliver interconnected technology and integrated data that provides a holistic view of positions, collateral inventory and liquidity status on a single platform, and it is buy-side firms in particular, says Bains, that “still do not have an enterprise-wide view of these resources”.
Significantly, the role of the agent lender has been pushed upstream in buy-side decision-making processes. Data and insights from securities lending are becoming integral to investment decision-making – particularly as firms apply ESG overlays to their investment strategies.
“We are delivering data and tools that assist front-office investment decisions and that help asset managers to fulfil their engagement responsibilities as shareholders,” says Bains.
Alongside this, investments to eliminate manual processing and reduce operational risk are a high priority and these typically feed straight through to the bottom line.
This is as important for the agent lenders as it is for fund managers that use them. “In securities lending, cost reduction has been important to ensure that lending strategies remain competitive against challenge from balance sheet-friendly synthetic lending arrangements,” says Bains.
Victor O’Laughlen, BNY Mellon’s digital business leader for clearance and collateral management, says siloed approaches to business development have impaired fluid movement of collateral and liquidity – and technology will be key to a solution.
“In many cases, clients built their fixed income and equity technology and business processes separately and therefore have complex legal entity and account structures,” he says. “[When] these two asset classes operate on different underlying infrastructure, this can create challenges in optimising and mobilising collateral and minimising funding costs.”
Against this background, firms are prioritising the need for a transparent view of their assets and liabilities and an improved utilisation of their inventory for collateralisation.
“This is evident in the breadth of funded collateral optimisation programmes that exist this year versus 2020,” says O’Laughlen. “In many cases, clients are using technology to achieve this goal, as well as simplifying their legal entity and account structures to increase their overall liquidity while reducing operating costs.”
In fundamental terms, understanding the sources and uses of collateral and where it can be deployed most efficiently is still important for industry actors, says Ben Challice, global head of trading services at JP Morgan.
However, collateral management and securities lending functions have moved closer together.
“Securities lending is not just about generating additional revenue for asset owners – it is also about taking advantage of the temporary transfer mechanism that securities lending offers to move [or transform] assets when they are in the wrong place or the wrong type,” he says.
In this environment, a securities lending platform must offer flexibility to accommodate different types of customer. Some have their pre-trade capabilities in-house, maintaining their own securities lending and financing desks, but relying on their custodian to handle post-trade commitments, such as settlement, corporate actions processing and reporting. Others, typically smaller and mid-sized buy-side firms, have fully outsourced their pre-trade and post-trade requirements.
Challice anticipates that more and more clients will need to manage their collateral optimisation decisions due to Uncleared Margin Rules – rules that require firms to post initial margin and variation margin for over-the-counter (OTC) derivatives transactions that are not centrally cleared. Challice says that many large sell-side firms and buy-side clients have invested in developing this collateral optimisation capability in-house – though buy-side actors may do this now by partnering with a specialist vendor or outsourcing to a collateral manager.
In 2018, Deutsche Börse Group and Luxembourg-based fintech HQLAᵡ announced a cooperation for securities lending and collateral transformation hosted on R3’s Corda blockchain product. This aims to bring greater efficiency in the movement of high-quality liquid assets (HQLA) – a priority for market participants to meet margin, clearing and other requirements known technically as the ‘liquidity coverage ratio’ and the ‘net stable funding ratio’, which under Basel III require banks to maintain a buffer of liquid assets to cover their short-term obligations and longer-term periods of stress.
The HQLAᵡ model aims to support collateral transformation trades – for example upgrading lower quality to higher-quality collateral – but without the need to transfer securities between custody accounts of the trading parties. Instead, a tokenised transfer of ownership takes place on distributed ledger technology (DLT), while the underlying securities remain static and are kept off blockchain.
The platform is accessed via Eurex Repo’s trading system, with Deutsche Börse standing as a “trusted third party” to the transaction, holding baskets of securities at tri-party agents and custodians on behalf of market participants.
HQLAᵡ chief operating officer Nick Short tells Funds Europe that the project implementation has remained broadly consistent with this original prototype.
“The basic principle remains the same: keeping the underlying securities where they are and completing exchange of ownership on a layer above, specifically through tokenised transfer on a DLT-based registry. We are now expanding that original operating model in small, incremental steps as we bring new strategic partners on to the platform. These each have different needs and are connecting to the platform in slightly different ways – and HQLAᵡ is delivering the interoperability required to connect together these previously fragmented pools of collateral.”
HQLAᵡ CEO and co-founder Guido Stroemer said the aim of the platform is to create value and enable market participants to access this value via their existing infrastructure. Implementation had to be simple and avoid a ‘big bang’ change requirement.
It costs large banks a lot of money to provide HQLA backing to meet their liquidity coverage ratio requirements and other regulatory ratios, notes Tilman Fechter, head of banking, funding and financing at Clearstream. If they do not mobilise and allocate collateral efficiently, this can add substantially to their funding costs.
This has traditionally been a fragmented market, with clients finding it difficult to find an integrated collateral management solution that meets their needs across all global locations and areas of collateralised trading in which they are active. But, Fechter says, “we believe HQLAᵡ is now offering a solution that meets this requirement”.
Critical mass is building on the platform. Commerzbank, UBS and Credit Suisse have been active in the project since 2018 as early adopters and, alongside involvement from Deutsche Börse Group, there other major tri-party collateral players, notably Euroclear and JP Morgan.
In January 2021, HQLAᵡ completed a €14.4 million funding round with BNY Mellon, Goldman Sachs, BNP Paribas Securities Services (BNPPSS), Citi and Deutsche Börse Group. These companies will also connect to the platform and play different roles, for example with BNY Mellon as a tri-party agent and agent lender, and Citi as custodian. This brings additional trade flow and tri-party business to the platform.
Bains at JP Morgan believes that tokenised collateral transactions are a stepping stone between current traditional asset infrastructure and future digital assets that may be issued directly on to blockchain. “The HQLAᵡ project or our own intraday repo initiative has capacity to improve mobility for assets that are hard to unlock owing to existing barriers in the settlement infrastructure,” she says. “As the market develops, this offer will become even more attractive through enabling more efficient use of intraday credit and liquidity.”
According to Bains, these benefits come without a radical overhaul of the collateral management ecosystem. This will integrate relatively easily with the existing infrastructure, plugging into existing operational models with minimal disruption.
BNY Mellon’s O’Laughlen says that tokenisation is at an early stage, but it will grow to be more mature and have broader utility over time. “I think there’s a real sense of promise with the technology, not only for our clients but also for regulators and other stakeholders in the collateral marketplace.”
In relation to repo and securities finance, O’Laughlen believes collateral mobility is a real-use case for the technology as it helps to standardise non-standard data and to automate workflow between market participants who need to have transparency and reconciliation capabilities to manage the risk associated with their transactions. There is also capital and liquidity cost reduction that can be achieved over time.
Jens Hachmeister, who is responsible for issuer services and new digital markets at Deutsche Börse Group, notes that when securities are digitised and the processes for digital issuance and settlement are, to a high degree, standardised, this will deliver the next level of market efficiency. “The benefits will extend beyond issuance, delivering efficiency gains across the full lifecycle of the instrument, including secondary trading and post-trade obligations,” he says.
Common Data Model
The International Swaps and Derivatives Association (Isda) has been active in the OTC derivatives market in promoting a common digital representation of the steps, or ‘lifecycle events’, associated with a derivatives transaction. The is the Common Domain Model – or CDM – and it provides a common data representation of transaction events.
Put another way, it’s a common template or set of fields that the industry will use to share trade information and other key data. This should reduce the burden of reconciliation and lower the risk of mismatches or settlement failure caused by inconsistency in how data fields are used.
Isla has been working with Isda and the International Capital Markets Association to apply CDM to securities lending transactions. To this end, it completed a pilot with REGnosys, its technology vendor for the CDM project, in November 2020.
Isla director of market infrastructure and technology David Shone indicated much had been achieved in a short period. The pilot project demonstrated the reusability of this model, meaning Isda CDM for derivatives transactions can be reapplied, with some refinement, to securities lending.
It also confirms how accurately the securities lending industry can describe its activity using the CDM, providing a model that works for a wide range of market participants, including lender and borrower, agent lenders, tri-party agents and lending platforms.
Isla’s objective is to set in place the central elements of its CDM model by mid-2021.
Goldman Sachs also recently announced the launch of a data management and governance platform, known as Legend, which is hosted in the public cloud on infrastructure maintained by the Fintech Open Source Foundation (Finos). Several other investment banks, including Deutsche Bank, Morgan Stanley and RBC Capital Markets, were involved in a six-month pilot to support data standardisation and collaborative data modelling, again building on the Isda CDM model, using a shared version of the Legend platform.
Now, with the Legend code available as open source, other organisations or individuals can operate their own implementations of the platform.
© 2021 funds europe