Since the 2008 meltdown commentators have highlighted the importance of the cost of capital and the pressures created by new liquidity ratio rules. The fear has been that these changes will reduce the volume of business that can be transacted, and ultimately restrict the ability of the banks to react to the changing landscape quickly enough in the event of further market upheavals.
The securities lending and repo markets have thrived over the years. A key feature of these markets is their ability to adapt and to generate opportunities from the changes in the marketplace. Responsiveness has always been a characteristic of the individuals operating in both the repo and securities lending markets. This is because the foremost function of the securities finance industry is to support market liquidity. Generating an efficient and liquid market should be every regulator’s objective.
Current market practices still require the market liquidity to cover shorts, so auto borrowing facilities and fee-based borrowing will still exist, but with the tax advantages of the yield enhancement trades reducing over time, the traditional borrow / loan intermediary activity will also reduce.
Agency lenders offering indemnities are also likely to be affected as the balance-sheet cost of providing the indemnity is predicted to increase significantly. The result of this is expected to be the need for greater spreads before trades are initiated and most probably a significant reduction in the number of smaller (less profitable) institutions involved as lenders in this business.
Firms faced with regulatory reforms demanding better management of balance sheet liquidity ratios, the need to collateralise derivatives as stipulated by the European Market Infrastructure Regulation (EMIR), and a more sophisticated client base demanding cross asset margin management, are beginning to integrate traditionally separate functions.
Expertise in the management of exposures has long been the responsibility of the back office. Managing the long inventory to use as collateral to cover the banks’ obligation is part of the everyday middle office operational process, and the inefficiency and cost of this process has never been considered prohibitive.
Front-office collateral trading is quite different, creating the most efficient financing for the bank and using the assets to maximise the profit while minimising balance-sheet usage and covering risk. The current need to integrate these functions will affect both stock loan trading desks and collateral operations, and will require a greater level of business and operational cooperation. This will mean merging traditional business silos in order to gain a single view across all collateral assets.
The securities lending markets have historically proven themselves to be very resilient and adaptive to change. While it is likely that regulatory reform will affect traditional business lines, either by pushing operational costs up or by reducing efficiencies, it will also create new forms of trading opportunities.
Crucially, these new opportunities will provide flexibility in an industry that is otherwise dominated by the prescribed rigidity of the centrally cleared model.