With securities financing tools playing an ever more critical role in optimizing financial resources for banks, Dipak Chotai of JD Risk Solutions, and Richard Glen of HQLAᵡ discuss intraday credit risk, how regulation may evolve in the future, and how emerging technologies such as DLT could offer solutions to mitigate these risks, in their latest whitepaper, Credit Risk in Capital Markets.
The increased demand for collateral and HQLAᵡ in particular, driven by regulatory changes over the last decade, have intensified the importance of collateral transformation & the usage of securities financing tools in this context.
Dipak Chotai, founder of consultancy JD Risk Solutions, notes that "HQLA holdings at European banks have increased by well over €1 trillion since the introduction of LCR requirements in 2015, and regulatory initial margin received is over $250 billion more than in 2017”. He emphasises that “the costs for banks would be immense without the ability for banks and dealers to transform and reuse assets and collateral”.
The paper focuses on the specific challenges for securities lending transactions which execute Free of Payments (FoP), without settlement risk mitigation and suggests that the intraday credit exposures generated could be as high as $119 billion.
HQLAᵡ and JD Risk Solutions identify two primary sources of intraday credit risk in securities lending transactions. The first arises from settlement risk or the risk of one party failing to deliver securities to another, and they suggest that this could generate as much as $80 billion of exposure per day.
The second source identified is from Potential Future Exposures (PFE), and “is the risk that may arise as a result of market moves at a future point in time”. These market moves could impact either the borrower of securities and provider of collateral, or the lender of the securities themselves, depending on the change in the value of the collateral or securities themselves.
Credit risk is not a new topic to securities lending. The authors remind us in the whitepaper that it was credit risk fears that drove AIG’s securities lending counterparties to return securities and request a return of $24 billion of cash collateral in 2008, driven by AIG’s investment strategy of cash collateral, where 65% of these proceeds had been invested in mortgage-backed securities (MBS), asset-backed securities (ABS), and collateralised debt obligations (CDOs).
HQLAᵡ and JD Risk Solutions also highlight the challenges created by the current settlement infrastructure and how the importance of intraday credit extended by settlement agents to market participants is needed to prevent settlement taking significantly longer or consuming large quantums of pre-funded liquidity.
“Regulation often reacts to the factors that resulted in previous crises but, like energy, you cannot make risk disappear” says Chotai. “There’s no free lunch - parties ultimately transfer risk from one form to another, and from one party to another. Margin for uncleared derivative transactions has significantly helped reduce counterparty risk, especially for large investment banks, but as seen in September 2022 with the UK LDI crisis, liquidity risk & cost, especially for buy side firms, has increased substantially as a result.”
There is no place where this has been more evident than in the response seen to the Global Financial Crisis of 2007-2008, with the introduction of Basel 2.5 focusing on credit valuation adjustment (CVA) reserves, followed by Basel 3, with a spotlight on liquidity and funding, and then finally, the introduction of mandatory clearing and margin requirements for uncleared derivative transactions.
The whitepaper notes that intraday risk management has become a more prominent feature for both market participants and regulators over the last decade and has been specifically discussed in the context of liquidity risk and market risk.
Following the recent default of Archegos capital management, a Basel Committee on Banking Supervision (BCBS) consultation focused on counterparty credit risk management, suggested that banks should establish intraday exposure monitoring, without imposing specific requirements on the banks themselves. For Chotai, the question of what happens next with regards to intraday risk management, presents three options. “Firstly, regulators could choose to do nothing more than reiterate the non-binding guidance that they have presented so far – unless of course a risk event occurs, contributed by intraday credit risk”. “Secondly, regulators and supervisors could monitor the risk more closely by requiring banks to prepare additional disclosures, as they have done to monitor climate risk”. “Finally, regulators could introduce more explicit capital requirements for intraday credit risk to incentivise mitigation”.
The additional capital requirements in the third scenario are not insignificant. “Our analysis suggests that the capital requirements for borrowing securities in securities lending transactions could attract an additional $48 billion of Risk Weighted Assets in aggregate across the banking sector using a standardised approach” says Chotai.
With these requirements, the question remains as to why regulators have not yet focussed on intraday credit risk. “There are two main reasons. Firstly, there has not yet been a significant event where intraday credit risk has been the primary cause. We didn’t have intraday liquidity requirements until around a decade ago, as there was less sensitivity to intraday liquidity risk until that point in time. Secondly, and until recently, there weren’t any options to mitigate intraday credit risk in securities lending transactions without reducing volumes and deleveraging the system or substantially changing how financial market infrastructure operates around the world” responds Chotai.
“The key challenge is that the systems and infrastructure were never designed to work in this way – it’s like using 100-year-old copper telephone lines to deliver high speed internet” says Chotai. Richard Glen, solutions architect at HQLAᵡ agrees: “Today, the fragmented regional custody network obliges large global banks to physically move securities across the different venues, locations & timezones to meet their collateral obligations. This results in imprecise, costly and inefficient collateral management with real bottom-line costs”.
Glen continues: “Solutions leveraging DLT enable banks to mobilize pools of securities without cross-custodian movements, and to achieve simultaneous ownership exchanges using either Delivery vs. Delivery (DvD) or Delivery vs Payment (DvP) as a part of a books and records update. This helps to mitigate the risk of creation of intraday exposures during the settlement process itself as well as enhancing the resilience of a banks operating model”.
The whitepaper also notes that DLT can help to solve for a number of post-trade risk scenarios, in addition to mitigating credit risk. It allows for instantaneous and synchronised exchange of ownership at precise moments in time. “Settlement time is becoming the new settlement date”, adds Glen. Historically, trades had a specific value date on which they were due to settle and firms have no control as to when securities or cash would be delivered or received. However, by using DLT, firms can specify the exact point in time at which a transaction should settle making the process more certain and predictable. “DLT can facilitate the development of new markets, such as intraday DvP repo, as it allows participants to agree exact opening times and closing times to the nearest minute”, Glen says.
The whitepaper further explains how DLT helps firms to optimize their inventory management workflows, irrespective of the deposit location or asset type. “The technology can support a multitude of funding and financing arrangements from securities lending or repo to the posting of initial or variation margin”, confirms Glen. He continues: “The way DLT can help solve optimisation challenges is not only expected to reduce the operational burden of cross-venue settlement and their associated costs, but also to impact balance sheet consumption in a positive way through these enhanced optimisation capabilities”.
In terms of market adoption and future vision, the white paper underlines the importance of industry collaboration and interoperability. “Distributed collateral ledgers offer interoperability by design. Recent cross-chain end-to-end experiments and trials have successfully demonstrated these capabilities, enabling market participants to create an ecosystem where atomic settlement of traditional and digital assets may be supported without restricting freedom of choice”, Glen concludes.
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