Synthetic finance gains traction
07 June 2016
Expectations are that synthetic transactions will continue to grow to help offset regulatory pressures, says James Treseler of Societe Generale
Image: Shutterstock
Synthetic financing, including vehicles such as total return swaps, portfolio swaps and contracts for difference, is not a new tool but one that has gained momentum over the past three years. The barrage of regulation since the financial crisis has forced both buy- and sell-side firms to review their operations and look for more cost-effective solutions to ease the burden of the more onerous requirements.
This marks a contrast to the past when the tool was typically used by firms to gain access to markets where they did not have a local presence. The trend can be seen in a recent survey by consultancy Finadium, which showed that in 2015 synthetic financing revenues rose by 43 percent, relative to 2012 figures, to an estimated $7 billion across nine leading prime brokers. By contrast, revenues for its physical counterpart grew more slowly during that time period, climbing only 22 percent to around $3.9 billion, just 61 percent of synthetic revenues.
There are several legislative forces at work. For example, on the buy side, there has been an increasing number of funds registering under UCITS in order to better access retail and institutional flows. However, these types of funds are only permitted to short sell using synthetic financing types of transaction.
Another key driver is the capital regulations under Basel III, such as the liquidity coverage and net stable funding ratios. They dictate that swaps are more easily accounted for than physical securities financing loans. Previously, a bank would have been able to cover the position of clients that went short with others that were long. Today, the liquidity charge means that there is less opportunity for them to be cost efficient by internalising the trades. The result is that margins are being squeezed and balance sheets constrained.
The Financial Transaction Tax (FTT), often dubbed the Robin Hood and Tobin tax, may also provide an impetus for increased use of synthetic trades. The aim is to impose a sweeping levy and capture a wide range of transactions including securities, derivatives, repos and stock lending. Loans, spot foreign exchange transactions, spot commodities and new issues, as well as transactions with the European Central Bank, central counterparties and central securities depositories, are excluded.
However, to date, the FTT has only been implemented in Italy and France. Dissension in the ranks has stopped it being rolled out across the eurozone, causing several delays to implementation. The original start date of 1 January 2014 was pushed back to this January and then the summer, although it is unclear whether the latest deadline will be met. Currently, Germany, France, Italy, Austria, Belgium, Greece, Portugal, Slovakia and Spain are still supporters, but Estonia pulled out of the original 11-nation group, and Slovenia raised questions about whether the tax, as proposed, would raise enough revenue to make it worthwhile for smaller countries.
The European Commission and a technical working group are now reassessing how much revenue the levy could raise, depending on what kinds of assets would be made part of the tax base. If the tax is adopted, many financial institutions are expected to use synthetic financing because it will shift the responsibility of paying the taxes to the prime broker since the assets would not be physically bought and sold.
The other main advantages of synthetic finance are that swap transactions can be done off-balance sheet and hedges can be netted across multiple counterparties under Basel III. This is not the case with physical securities finance trades such as repos and stock loans, which can only be netted on a single counterparty basis from a balance sheet perspective. In addition, the netting means that synthetic trades also are more efficient when calculating a firm’s leverage ratio.
As with any financing tool, there are also the negatives that investors should be aware of. The collapse of Lehman Brothers in 2008 underscores the dangers of counterparty risk and why it remains one of the key threats. Lessons have been learnt but investors still need to conduct rigorous due diligence into the financial health of an organisation as well as its ability to recruit and retain the skillsets needed to adapt to the changing market conditions.
For example, a synthetic desk cannot rely on using bank capital, but needs to create its own liquidity within the confines of a cost-constrained environment. The team needs to be able to enhance netting opportunities and develop specialist collateral management capabilities. The latter has grown in importance as regulations such as the European Market Infrastructure Regulation (EMIR) take hold. The stricter margin regime will mean that many fund managers will have to post initial and variation margin for the first time.
Collateral management can be broken down into various components, including optimisation, or making the best use of the available assets across the entire firm to satisfy all collateral requirements. The focus is to manage the collateral supply and demand on a holistic basis in the most efficient manner possible. The other aspect is collateral transformation, whereby lower quality assets are upgraded into central clearinghouse-eligible collateral via the securities lending and repo markets.
It can be a more expensive proposition, but increasingly equities are being added to the mix because high-quality liquid assets such as corporate and sovereign bonds can also be utilised for other purposes.
Although physical trades will continue to be a significant part of the market, expectations are that synthetic transactions will continue to grow to help offset the pressures being imposed by the US Dodd-Frank Act, EMIR, Basel III and other global legislation.
They provide efficiencies from a balance sheet, liquidity and capital perspective, but investors are encouraged to do their homework and assess not only the financial soundness of the prime broker, but also its acumen and ability to develop the right solutions.
This marks a contrast to the past when the tool was typically used by firms to gain access to markets where they did not have a local presence. The trend can be seen in a recent survey by consultancy Finadium, which showed that in 2015 synthetic financing revenues rose by 43 percent, relative to 2012 figures, to an estimated $7 billion across nine leading prime brokers. By contrast, revenues for its physical counterpart grew more slowly during that time period, climbing only 22 percent to around $3.9 billion, just 61 percent of synthetic revenues.
There are several legislative forces at work. For example, on the buy side, there has been an increasing number of funds registering under UCITS in order to better access retail and institutional flows. However, these types of funds are only permitted to short sell using synthetic financing types of transaction.
Another key driver is the capital regulations under Basel III, such as the liquidity coverage and net stable funding ratios. They dictate that swaps are more easily accounted for than physical securities financing loans. Previously, a bank would have been able to cover the position of clients that went short with others that were long. Today, the liquidity charge means that there is less opportunity for them to be cost efficient by internalising the trades. The result is that margins are being squeezed and balance sheets constrained.
The Financial Transaction Tax (FTT), often dubbed the Robin Hood and Tobin tax, may also provide an impetus for increased use of synthetic trades. The aim is to impose a sweeping levy and capture a wide range of transactions including securities, derivatives, repos and stock lending. Loans, spot foreign exchange transactions, spot commodities and new issues, as well as transactions with the European Central Bank, central counterparties and central securities depositories, are excluded.
However, to date, the FTT has only been implemented in Italy and France. Dissension in the ranks has stopped it being rolled out across the eurozone, causing several delays to implementation. The original start date of 1 January 2014 was pushed back to this January and then the summer, although it is unclear whether the latest deadline will be met. Currently, Germany, France, Italy, Austria, Belgium, Greece, Portugal, Slovakia and Spain are still supporters, but Estonia pulled out of the original 11-nation group, and Slovenia raised questions about whether the tax, as proposed, would raise enough revenue to make it worthwhile for smaller countries.
The European Commission and a technical working group are now reassessing how much revenue the levy could raise, depending on what kinds of assets would be made part of the tax base. If the tax is adopted, many financial institutions are expected to use synthetic financing because it will shift the responsibility of paying the taxes to the prime broker since the assets would not be physically bought and sold.
The other main advantages of synthetic finance are that swap transactions can be done off-balance sheet and hedges can be netted across multiple counterparties under Basel III. This is not the case with physical securities finance trades such as repos and stock loans, which can only be netted on a single counterparty basis from a balance sheet perspective. In addition, the netting means that synthetic trades also are more efficient when calculating a firm’s leverage ratio.
As with any financing tool, there are also the negatives that investors should be aware of. The collapse of Lehman Brothers in 2008 underscores the dangers of counterparty risk and why it remains one of the key threats. Lessons have been learnt but investors still need to conduct rigorous due diligence into the financial health of an organisation as well as its ability to recruit and retain the skillsets needed to adapt to the changing market conditions.
For example, a synthetic desk cannot rely on using bank capital, but needs to create its own liquidity within the confines of a cost-constrained environment. The team needs to be able to enhance netting opportunities and develop specialist collateral management capabilities. The latter has grown in importance as regulations such as the European Market Infrastructure Regulation (EMIR) take hold. The stricter margin regime will mean that many fund managers will have to post initial and variation margin for the first time.
Collateral management can be broken down into various components, including optimisation, or making the best use of the available assets across the entire firm to satisfy all collateral requirements. The focus is to manage the collateral supply and demand on a holistic basis in the most efficient manner possible. The other aspect is collateral transformation, whereby lower quality assets are upgraded into central clearinghouse-eligible collateral via the securities lending and repo markets.
It can be a more expensive proposition, but increasingly equities are being added to the mix because high-quality liquid assets such as corporate and sovereign bonds can also be utilised for other purposes.
Although physical trades will continue to be a significant part of the market, expectations are that synthetic transactions will continue to grow to help offset the pressures being imposed by the US Dodd-Frank Act, EMIR, Basel III and other global legislation.
They provide efficiencies from a balance sheet, liquidity and capital perspective, but investors are encouraged to do their homework and assess not only the financial soundness of the prime broker, but also its acumen and ability to develop the right solutions.
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