As the industry continues to respond to changing market conditions and the implementation of additional regulation—such as the final phases of uncleared margin rules (UMR), the Íø±¬³Ô¹Ï Financing Transactions Regulation (SFTR) and the Central Íø±¬³Ô¹Ï Depositories Regulation (CSDR)—we are seeing record interest in outsourced services such as securities financing and collateral management. The ability to look across standalone services, or integrate them operationally, is a major topic with both the buy and sell side.
What does the term ‘trading services’ mean as it relates to securities services, collateral management and agency lending?
Trading services businesses, in the context of securities services, are those with a transactional nature or that have a trading bias to them, but where the provider acts as agent for the client. While they complement the activities that are post-trade in nature—such as custody or fund services—they can also be undertaken independently.
Íø±¬³Ô¹Ï lending and collateral management have been outsourced to agents for many years, but now firms are increasingly looking to agents for help in managing other activities such as repo/reverse repo, middle-office functions and even cash trade execution. A heavier regulatory burden on the buy-side, narrowing margins and rapid technological developments are fueling this expansion.
Similarly, in securities financing, regulatory and market changes in the last decade have been the primary drivers of this evolution. With heightened demands for collateral and the need to mobilise inventory across borders and entities to make sure that it’s in the right place or of the right type, securities financing and collateral management are increasingly two sides of the same coin. As UMR nears the final phases of implementation, the need to deploy an integrated approach to financing and an end-to-end approach to managing collateral will be critical for clients needing to meet their new margin requirements.
How does this relate to securities financing?
First, securities financing is experiencing extraordinary interest, mostly driven by industry evolution in response to regulation. However, the experience of market participants can be quite different based on where they sit.
The buy side is coping with well-publicised pressure on fees, especially in the passive/exchange-traded funds space. With the search for yield high on everyone’s agenda, the alpha that lending securities can provide can no longer be ignored—even by those who have traditionally been anti-short selling. Furthermore, the need to think about and mobilise collateral is ever more pertinent in the face of uncleared margin rules. Íø±¬³Ô¹Ï financing transactions provide an important mechanism to achieve readiness and maintain compliance.
Meanwhile, sell-side activity is continuing to demonstrate shifts in demand and banks and broker dealers are becoming ever more sophisticated in managing their different, variable constraints, such as balance sheet, liquidity and capital. While these manifest themselves in changing types and sizes of demand, these firms are simultaneously focused intently on other parameters such as counterparty type, collateral eligibility and tenure, etc. As a result, sell-side firms are demanding an ever-increasing range of solutions, such as collateral pledge and central clearing, in order to meet their evolving needs.
Second, the conundrum of expanding supply versus more sophisticated, targeted demand, whilst the markets lack conviction and there is a dearth of corporate activity, means that spreads, and thus lending revenues, are compressed.
Third, technology and data continue to change the way business gets done. While often beneficial, this could also be disruptive—and this is just as true in securities financing as it is in our daily lives. Specifically, the need for better automation and improved data analytics are in great demand across the board. These services will become even more important as the industry grapples with the transaction reporting that comes with SFTR for the first time. Although that starts in Europe, it’s evident that the effects will not only be felt globally but will also be compounded once the increased burden of settlement efficiency through CSDR ultimately begins.
How are these trends affecting client behaviour?
The increased complexity that market participants are dealing with across the board has meant that the role played by securities lending has moved upstream in clients’ investment and collateral decision-making process and framework. The old approach of an operational ‘turn my programme on and let it run’ approach to lending is waning. Now client dialogue is focused on how securities financing and its associated data can be incorporated into pre-trade decision making, and agent lenders are constantly challenged to service an ever-expanding list of client requirements.
More firms are also evaluating their outsourcing options and thinking through those decisions much earlier. They are focused on whether and how a service provider can provide front-to-back, pre- and post-trade turnkey solutions, rather than carry the immense operational burdens associated with building and managing a sophisticated financing function in-house. Moreover, with additional regulations such as SFTR, CSDR and UMR coming into force, the demand for outsourced and unified agent lending and collateral management solutions is likely to increase.
As the interplay between financing and collateral becomes more complex, how is that relationship changing?
Over recent years, banks and broker dealers have become much more efficient in managing their inventory, or collateral, and thus their financing needs, in the face of the various financial resource constraints. They do this by constantly evaluating the sources and uses of their pools of long and short inventory and using SFTs or derivatives to ensure the inventory is being utilised in the most efficient manner, i.e. by moving it around or transforming it.
The buy-side is now having to think about this, perhaps for the first time, as their activities fall in-scope for phases four, five, and now six, of the uncleared margin rules. They will need to post segregated initial margin, likely in the form of securities (as opposed to their variation margin which is mostly in the form of cash). Therefore, the traditional premise of a buy and hold asset manager — who lends securities but doesn’t expect that process to interfere with his investment process — now has an additional driver of demand for that same pool of securities if they intend to use them to meet their margin obligations. In that case, the asset manager, or their agent, needs to understand the dynamic between alpha generation from lending securities and the cheapest-to-deliver requirements for posting collateral. This dynamic is constantly evolving, so real-time data, analytics and a mobilisation mechanism are essential.
A simple example is one where a security posted as collateral becomes hard to borrow. In this instance one would clearly want to replace it as a collateral asset and lend it into the market for a fee. This becomes very difficult if there is not clear visibility into where your assets are at all times. Additionally, if you have different actors involved, such as an agent lender, agent collateral manager or an in-house repo trading desk, as well as multiple custodians, then further complexity arises. They could easily begin ‘bumping’ into one another by having different demands over the same pool of inventory; failing on a stock loan or repo is very bad, but failing on a margin call would be substantially worse.
The ideal solution for a buy-side firm would be to have the ability to view and manage the pool of assets holistically, like many banks and broker dealers do today, to determine the optimal use. If a firm doesn’t have the appetite to manage this increasingly burdensome process in-house, whether that be from an expertise or cost point of view, then utilising an agent who has the appropriate product set across lending, financing and collateral should be its goal.
As an agent, how are you addressing these demands?
At J.P. Morgan, we’ve made significant investments in creating a fully flexible, custody-agnostic platform which allows us to handle a range of pre- and post-trade activities on behalf of our clients, helping them achieve their individual financing, collateral and middle-office objectives.
In addition, we are creating a collateral transport layer that offers for the most efficient use of asset allocation across lending and collateral, including a fully automated post-trade lifecycle. This gives institutions the flexibility they need to manage a variety of securities financing requirements, singly or in combination, based on their specific needs.
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