Peer-to-peer securities lending and State Street’s solution: Direct Access Lending
29 October 2019
Peer-to-peer securities lending and State Street’s solution: Direct Access Lending
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Overview of peer-to-peer market/product
As the securities lending market continues to evolve, a constant theme that beneficial owners and alternative funds have broached with providers is peer-to-peer securities lending. Beneficial owners are seeking new avenues to increase distribution to boost securities lending revenue, while alternative funds are looking for ways to expand access to supply and to unlock the economic benefits of decreasing reliance on bank or broker-dealer balance sheets.
Over the years, different market participants have sought to enable bespoke exclusive trades between a single beneficial owner and an alternative fund. However, the structures that have been brought to market have failed to maintain the fundamental protections and service levels to which beneficial owners and alternative funds have become accustomed. Thus, no single scalable structure has been embraced by the broader market for mainstream client consumption.
When approaching the opportunity to facilitate peer-to-peer securities lending, State Street started with the knowledge gained from operating both an agency lending programme on behalf of beneficial owners and a prime brokerage-like business, called Enhanced Custody, on behalf of alternative funds. The result is Direct Access Lending, a managed peer-to-peer service model, that is facilitated by State Street and leverages its securities lending programmes, providing transparency and economic benefit for those involved entities without further operational burden to clients. The product offers a seamless peer-to-peer model, supported by the operational efficiency and expertise of a managed securities lending programme.
Implications for agency lending clients
Agency lending clients generally choose providers that can offer three key functions:
• The distribution or utilisation of securities loans required to maximise earnings
• Credit and risk protections, such as borrower default indemnification
• Operational and trading excellence
First, the most liquid and largest securities lending market is in the US, and many alternative strategies maintain large, US equity stock borrow components. Consequently, the best opportunity to pair significant volumes of peer-to-peer loans is with US equities. Focusing on this market will both allow for improved agency lending utilisation of general collateral (GC) while ensuring liquidity of loans in the programme for both lenders and borrowers. Also, because these portfolios generally have low utilisation for most beneficial owners, the peer-to-peer transactions should be incremental to a participating agency lending client.
Second, any peer-to-peer securities lending relationship involves the introduction of new counterparty types to the beneficial owner community. Generally, the largest borrowers of securities are hedge funds operating different varieties of long/short equity strategies. These clients make up the bulk of most prime broker clients forming a large portion of the enhanced custody client base, but they are new borrower types for the beneficial owner community and most agency lending programmes. In order to mitigate some beneficial owners’ concerns about this new borrower type, State Street is utilising a portfolio margining approach to establish collateral levels and will maintain counterparty default indemnification for these peer-to-peer transactions.
Third, beneficial owners require trading support to ensure distribution of securities at appropriate rates, and operational support to manage activities like corporate actions, collateral receipt and returns, and settlements. This lack of support has been one of the core issues with other peer-to-peer securities lending models proposed. State Street’s Direct Access programme flows through the agency lending structure, meaning all loans through the platform will receive the operational and trading support provided today to beneficial owners, and no operational changes are required of the beneficial owners to participate in peer-to-peer loans.
Implications for Enhanced Custody clients
Prime brokerage clients generally choose providers who can offer access to a stable supply of securities at an agreeable fee, operational support required to manage a securities borrowing program and a stable credit counterparty. Direct Access Lending, through the utilisation of the infrastructure built for the Enhanced Custody business, offers all three components while maintaining the benefits of peer-to-peer lending.
First, the main reason an alternative fund would be interested in a peer-to-peer securities lending model is to trim the borrowing and financing costs associated with securities borrowing. By focusing on the liquid US equity market, Direct Access Lending offers a large, stable pool of supply from which to borrow, and by borrowing directly from the beneficial owner, a fee more similar to the rate in the securities lending wholesale market.
State Street has found that the potential for lower borrow fees is not sufficient to garner alternative funds’ interest in a peer-to-peer securities lending product. Alternative funds do not have the operational and technical infrastructure in place to borrow from a typical agency lending programme. Agency lending borrowers must review and process daily recalls, mark to markets, corporate actions, and contract compare files amongst other daily tasks. If an alternative fund was required to build their own support to manage a peer-to-peer borrow, it’s likely the costs associated would outweigh the economic benefit. For this reason, State Street is offering the trading and operational support provided by Enhanced Custody personnel to serve in an administrative role on behalf of the alternative funds. Beyond operational support, all Direct Access borrowers will also be Enhanced Custody clients, meaning State Street can step in to help ensure loan stability.
Finally, State Street’s Agency Lending programme forms the ideal base of supply for a peer-to-peer lending programme; broad in scope and depth of holdings and committed to securities lending. Direct Access Lending provides borrowers the opportunity to borrow securities only from beneficial owners they are comfortable with, and full transparency into the underlying lender for the purposes of credit and risk monitoring.
Closing
When approaching a peer-to-peer securities lending model, State Street surveyed market participants offering competing products, beneficial owners as well as alternative funds to assess what would constitute a successful securities finance product for this market. Speaking with clients helped sharpen the focus on a product that accomplished the headline goal of peer-to-peer exposure.
Technology platforms exist that can easily match a security that a beneficial owner holds with an alternative fund seeking to borrow it, but don’t have the trading, operational support, and scale required for both sets of clientele to participate. The goal with Direct Access Lending was to solve for both sets of client concerns, while delivering to market a unique, managed peer-to-peer securities finance product. As the securities lending market and State Street’s various securities finance products continue to evolve, Direct Access Lending should be seen as an avenue to allow prudent peer-to-peer lending across a variety of markets and asset classes where participants trade.
As the securities lending market continues to evolve, a constant theme that beneficial owners and alternative funds have broached with providers is peer-to-peer securities lending. Beneficial owners are seeking new avenues to increase distribution to boost securities lending revenue, while alternative funds are looking for ways to expand access to supply and to unlock the economic benefits of decreasing reliance on bank or broker-dealer balance sheets.
Over the years, different market participants have sought to enable bespoke exclusive trades between a single beneficial owner and an alternative fund. However, the structures that have been brought to market have failed to maintain the fundamental protections and service levels to which beneficial owners and alternative funds have become accustomed. Thus, no single scalable structure has been embraced by the broader market for mainstream client consumption.
When approaching the opportunity to facilitate peer-to-peer securities lending, State Street started with the knowledge gained from operating both an agency lending programme on behalf of beneficial owners and a prime brokerage-like business, called Enhanced Custody, on behalf of alternative funds. The result is Direct Access Lending, a managed peer-to-peer service model, that is facilitated by State Street and leverages its securities lending programmes, providing transparency and economic benefit for those involved entities without further operational burden to clients. The product offers a seamless peer-to-peer model, supported by the operational efficiency and expertise of a managed securities lending programme.
Implications for agency lending clients
Agency lending clients generally choose providers that can offer three key functions:
• The distribution or utilisation of securities loans required to maximise earnings
• Credit and risk protections, such as borrower default indemnification
• Operational and trading excellence
First, the most liquid and largest securities lending market is in the US, and many alternative strategies maintain large, US equity stock borrow components. Consequently, the best opportunity to pair significant volumes of peer-to-peer loans is with US equities. Focusing on this market will both allow for improved agency lending utilisation of general collateral (GC) while ensuring liquidity of loans in the programme for both lenders and borrowers. Also, because these portfolios generally have low utilisation for most beneficial owners, the peer-to-peer transactions should be incremental to a participating agency lending client.
Second, any peer-to-peer securities lending relationship involves the introduction of new counterparty types to the beneficial owner community. Generally, the largest borrowers of securities are hedge funds operating different varieties of long/short equity strategies. These clients make up the bulk of most prime broker clients forming a large portion of the enhanced custody client base, but they are new borrower types for the beneficial owner community and most agency lending programmes. In order to mitigate some beneficial owners’ concerns about this new borrower type, State Street is utilising a portfolio margining approach to establish collateral levels and will maintain counterparty default indemnification for these peer-to-peer transactions.
Third, beneficial owners require trading support to ensure distribution of securities at appropriate rates, and operational support to manage activities like corporate actions, collateral receipt and returns, and settlements. This lack of support has been one of the core issues with other peer-to-peer securities lending models proposed. State Street’s Direct Access programme flows through the agency lending structure, meaning all loans through the platform will receive the operational and trading support provided today to beneficial owners, and no operational changes are required of the beneficial owners to participate in peer-to-peer loans.
Implications for Enhanced Custody clients
Prime brokerage clients generally choose providers who can offer access to a stable supply of securities at an agreeable fee, operational support required to manage a securities borrowing program and a stable credit counterparty. Direct Access Lending, through the utilisation of the infrastructure built for the Enhanced Custody business, offers all three components while maintaining the benefits of peer-to-peer lending.
First, the main reason an alternative fund would be interested in a peer-to-peer securities lending model is to trim the borrowing and financing costs associated with securities borrowing. By focusing on the liquid US equity market, Direct Access Lending offers a large, stable pool of supply from which to borrow, and by borrowing directly from the beneficial owner, a fee more similar to the rate in the securities lending wholesale market.
State Street has found that the potential for lower borrow fees is not sufficient to garner alternative funds’ interest in a peer-to-peer securities lending product. Alternative funds do not have the operational and technical infrastructure in place to borrow from a typical agency lending programme. Agency lending borrowers must review and process daily recalls, mark to markets, corporate actions, and contract compare files amongst other daily tasks. If an alternative fund was required to build their own support to manage a peer-to-peer borrow, it’s likely the costs associated would outweigh the economic benefit. For this reason, State Street is offering the trading and operational support provided by Enhanced Custody personnel to serve in an administrative role on behalf of the alternative funds. Beyond operational support, all Direct Access borrowers will also be Enhanced Custody clients, meaning State Street can step in to help ensure loan stability.
Finally, State Street’s Agency Lending programme forms the ideal base of supply for a peer-to-peer lending programme; broad in scope and depth of holdings and committed to securities lending. Direct Access Lending provides borrowers the opportunity to borrow securities only from beneficial owners they are comfortable with, and full transparency into the underlying lender for the purposes of credit and risk monitoring.
Closing
When approaching a peer-to-peer securities lending model, State Street surveyed market participants offering competing products, beneficial owners as well as alternative funds to assess what would constitute a successful securities finance product for this market. Speaking with clients helped sharpen the focus on a product that accomplished the headline goal of peer-to-peer exposure.
Technology platforms exist that can easily match a security that a beneficial owner holds with an alternative fund seeking to borrow it, but don’t have the trading, operational support, and scale required for both sets of clientele to participate. The goal with Direct Access Lending was to solve for both sets of client concerns, while delivering to market a unique, managed peer-to-peer securities finance product. As the securities lending market and State Street’s various securities finance products continue to evolve, Direct Access Lending should be seen as an avenue to allow prudent peer-to-peer lending across a variety of markets and asset classes where participants trade.
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