Peer pressure


BNY Mellon explains how peer-to-peer trading is transforming securities finance

Securities finance has developed into an important front-office tool supporting the financing and collateralisation of many investment activities. Yet in the face of regulatory and market pressures, agent lenders are further adapting their approach to help meet client investment needs. Thus, while the objectives of investing cash on behalf of clients or releasing cash remain the same, the mechanisms to achieve this are evolving.

Cash release

Cash release* is as straightforward as it sounds: a securities lending agent, typically a bank, which holds a beneficial owner’s cash collateral, allows the firm to access a portion of the funds.

“The agent lender is holding and reinvesting cash collateral on behalf of the buy-side beneficial owner,” says James Day, business executive for securities finance, covering Europe, the Middle East and Africa at BNY Mellon. “The agent lender may release a portion of the cash collateral to be managed and invested directly by the beneficial owner.”

Day continues: “Cash release is efficient. It allows the beneficial owner to access cash that the agent lender is holding on behalf of the buy-side firm. It unlocks trapped liquidity from buy-side firms’ portfolios, which also helps the market overall. Then there’s expense—otherwise buy-side firms might have to draw liquidity from unsecured credit lines or other financing transactions which could potentially cost more.”

Obtaining cash release is dependent upon the nature of the assets within the beneficial owner’s portfolio. Day says: “To use cash release effectively, beneficial owners should work with their agent lender to understand the level of cash loans they could sustain given their lendable portfolio. Securities lending trades are typically overnight transactions, and loan values can vary. This means that the level of cash collateral available for release can also vary. Beneficial owners have to make sure they have the right type of assets to generate a steady demand from borrowers.”
Alternatives emerge

The long-standing market structure in which banks and broker-dealers are matched with buy-side firms to source cash or securities is becoming increasingly challenged.

Heightened capital standards and new liquidity charges introduced since 2008 have imposed constraints on bank/broker-dealer balance sheets, limiting their capacity to intermediate in the securities finance market.

At the same time, new collateral regulations are also having an impact on the buy side, which is now required to post collateral on more transactions. The combined effect has been to drive up the buy side’s need to access liquidity at the very time when broker-dealer balance sheet capacity is constricted and costs have increased.

This has prompted the need to look for other ways to address this growing mismatch between supply and demand, and peer-to-peer securities financing alternatives are emerging as an increasingly important supplementary source of much-needed new liquidity to the market. As the name suggests, peer-to-peer transactions directly connect asset owners on either side of the transaction.

The BNY Mellon markets team has been at the forefront of the development of peer-to-peer securities finance alternatives and expect this valuable new liquidity source for cash and securities to grow in size and influence.

Larry Mannix, chief investment officer responsible for cash collateral reinvestment at BNY Mellon, explains: “Broker-dealers have reduced capacity due to capital regulations, and their matched books are not as large as they once were. As a result, we are seeing more interest from collateral providers to have direct relationships with cash providers without intermediation.”

Bill Kelly, global head of agency securities finance, says: “Along with that, the demand for collateral and liquidity is growing, so market participants are seeking additional avenues to source the cash and/or securities liquidity they need. Developing a network of peer-to-peer alternatives is one attractive option.”

“We are seeing many more requests from non-traditional collateral providers looking for cash providers,” explains Mannix. “These non-traditional counterparties range from real estate investment trusts, insurance companies and pension funds to sovereign wealth funds and hedge funds.”

Having more collateral providers gives beneficial owners more options for placing their cash, but these non-traditional counterparties can bring new challenges.

“Sometimes these non-traditional counterparties don’t fit the typical mold of a traditional A-1/P-1 rated repo counterparty that a beneficial owner is used to approving,” says Mannix. “It may be difficult to find publicly available financial information for some of these counterparties, and for some non-traditional counterparties, the information may not be sufficient for a thorough review.”

However, having more collateral providers brings some benefit to the market.

“Any new source of cash or collateral increases overall market liquidity,” adds Mannix. “And, if a beneficial owner is more open to non-traditional counterparties, there might be more opportunities for cash collateral reinvestment. As these opportunities expand, depth of market and scale could be added through electronic platforms.

Additionally, credit risk is mitigated through the provision of collateral to the cash investor by the borrower. For example, a pension fund can provide government securities to secure cash it has borrowed to meet margin calls.”

DBVX

DBVX is a peer-to-peer collateral trading platform acquired by BNY Mellon in 2016. DBVX aims to bring collateral providers together with cash providers electronically. The platform should also help asset owners finance their collateral requirements, source eligible collateral or invest their cash in a secured deposit.

Mike Curran, global head of foreign exchange services, who has also assumed a leadership role for the US launch of DBVX, says “The DBVX platform can bring participants the benefits of scale, simplicity and standardisation of legal documentation, price transparency with pre-trade anonymity and straight-through processing efficiencies.”

“For buy-side firms, opportunities for price improvement may result from being able to transact directly with other buy-side firms, while banks could realise a distribution benefit by connecting to new clients in targeted segments and geographies more cheaply and easily.”

DBVX is a streamlined means of transacting among buy-side firms, but it also introduces the challenge of exposure to counterparty credit risk.
Curran says: “With electronic platforms like DBVX, buy-side firms will have to manage bilateral credit risk with prospective counterparties, unless they choose a central counterparty (CCP) settlement.

“However, while there might be an initial hesitancy around accepting the platform’s standard documentation rather than using customised legal terms and bespoke schedules, faster and simpler counterparty diversification, offering greater liquidity, will be compelling.”

The CCP model

CCPs are becoming key players in the modern financial markets, and they are making inroads in peer-to-peer securities finance where the CCP sits between two buy-side firms looking to enter into a transaction with one another.

Mike Landolfi, securities finance product and strategy manager at BNY Mellon, says: “The CCP securities lending model is still very much in its infancy, but it will be an integral part of the future of securities finance. Counterparties agree to a trade and novate the trade through a CCP. The CCP then becomes the counterparty to the transaction, bringing regulatory benefits for the original counterparties.”

The key benefit of having a trade novated through a central clearinghouse is that the CCP stands in the middle of the trade acting as buyer to the seller and vice versa.

Landolfi says: “The CCP model can help with managing credit risk because it’s the risk averse CCP on the other side of the trade and not the traditional broker-dealer entity. Additionally, transactions through a CCP can allow for better capital treatment thereby leading to a deeper market with greater demand and better utilisation.”

Clearing securities financing trades can involve a larger commitment on the part of buy-side firms relative to other peer-to-peer options, however.

Landolfi observes: “Specific to the CCP model, buy-side firms will have to agree to the CCP’s terms and conditions, and this can require additional legal and credit work. Some CCP models may utilise unique collateral requirements for the buy-side firm or their agent lender such as direct or indirect default fund contributions or initial margining.”

“The CCP model is evolving quickly. How it will function and the roles everyone will play are still being finalised but the buy side should definitely keep an eye on this space.”

Peer-to-peer securities financing is a field going from strength to strength today. In the years ahead, buy-side firms can expect to see greater innovation. The future is bright.

“Peer-to-peer alternatives have the potential to help clients supplement their book of liquidity to meet their needs,” Kelly concludes. “Undertaking reverse repo, cash release or indeed sourcing eligible collateral via electronic peer-to-peer platforms like DBVX gives buy-side firms additional flexibility to ladder their cash and solve for their unique liquidity requirements.

*Subject to credit approval by BNY Mellon

Intended for institutional and professional use only.

In the US, DBVX will be a registered Alternative Trading System operated by BNY Mellon Capital Markets, LLC, member FINRA, SIPC. In EMEA, DBVX will be operated by BNY Mellon Capital Market EMEA, Ltd. Once regulated, it will be operated as a Multilateral Trading Platform by BNY Mellon Markets Europe Limited.

The views expressed within this article are those of the author only and not necessarily those of BNY Mellon or any of its subsidiaries or affiliates, which make no representation as to the accuracy, completeness, timeliness, or fitness for a specific purpose of the information provided in this document. Material contained in this article is intended for information purposes only and not to provide professional counsel or investment advice on any matter. No statement or expression is an offer or solicitation to buy or sell any products or services mentioned.

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