Undergoing a renaissance
Practice lead Mark Barnard and senior consultant Simon Davies of The Field Effect consider creating opportunities out of the return of securities finance The holistic value proposition that securities finance offers to all corners of a trading floor has materially changed over the last decade. Driven by the consolidation to multi-asset class desks, the outsourcing of funding activity to the treasury department, reduced appetite for some tax-driven trading, and vendor solutions for conventional stock borrow—the securities financing desk has seen its relative importance to the firm diminish. Reassuringly, there are a number of opportunities for the securities finance desk to revitalise itself, we will explore them while also looking at a major upcoming regulation—the Securities Financing Transactions Regulation (SFTR).
How can securities finance rebuild its internal brand and reinvent itself as an intrinsic part of a trading floor? Is it possible to elevate its status from being viewed as a reduced service function to a business enabler for both proprietary and client facing trading activities?
Securities finance desks are uniquely positioned across a trading floor to positively influence many of the binding constraints that hinder all trading activity. One way this can be achieved is by reducing capital consumption by restructuring the way short positions are covered and long positions are financed. Further value can be provided by executing funding transactions that comply with liquidity ratio requirements, and directing discretional business to the firm’s key clients. This allows the securities finance desk to act as a business enabler and generates significant value across the trading floor.
The challenges of increased capital consumption and funding costs and the binding constraint of balance sheet limits are a constant concern. While there is no simple solution, the securities finance desk can assist in alleviating some of the burden by providing inventive term funding opportunities, which typically offer lower funding costs than can be provided by the treasury department.
Structurally, many organisations have weaknesses in their front-to-back processes, which prohibit their ability to maximise the value contained within their balance sheet. This inefficiency often stems from the silo nature of firms and jurisdictional differences in regulatory requirements. These weaknesses manifest themselves as an over dependency on raising unsecured funding via the money markets desk, whilst rehypothecatable unencumbered assets reside on the balance sheet generating no value. The goal for many firms is to define asset ownership, movement of assets between a centralised treasury function and silos, and to ensure appropriate incentivisation for trading internally. Creating an incentive model that positively motivates asset owners to rehypothecate is critical in developing an internal market where assets are freely traded. The incentive model should not be solely limited to one dimensional transfer pricing. If correctly constructed, it should allow for the exchange of liquidity, balance sheet and fee-based revenue reflective of the value derived from the use of the asset. Due to the securities finance desk setting the value of the incentive levels, they are uniquely placed on a trading floor to curb funding levels and balance sheet usage, while reducing operating costs for the entire trading division.
For many, the cost of capital has materially eroded the profitability of transactions. Firms are faced with the realisation that certain activities are no longer financially viable without assistance from the securities finance desk to reduce capital consumption and funding levels. In some instances, firms have looked to offset the cost to execute business by moving towards trading strategies that incorporate more esoteric assets or structures, thus creating more complexity in the operating model while increasing the level of risk in the organisation.
In the scramble to ensure front-middle office compliance with new capital requirements and risk ratios (see Basel III), many firms have adopted inefficient and overly conservative approaches to managing liquidity coverage and net stable funding ratios. Often, firms do not have the desired level of data transparency from collateral management systems to optimally utilise the assets they have on their balance sheet, this lack of clarity often contributes to an excessively conservative attitude to capital requirements and an inefficient buffer management processes. A holistic group-wide collateral trading policy, coupled with an enhanced use of available in-house data may help a firm reduce capital consumption and realise improved profitability of traditional over-the-counter trades, curbing the temptation to seek higher returns in ever more exotic trades.
Firms should be considering how to leverage the securities financing desk to benefit from intra and cross-divisional synergies. A multi-asset class collateralisation policy across the firm will allow the posting of the ‘cheapest to deliver’ permissible collateral for every deal. While this is commonly considered the optimal outcome, the introduction of a new concept, ‘cheapest to receive’, further reduces collateral costs and provides for a more diverse allocation of non-cash collateral.
Value can also be derived from the securities finance desks where their multi-asset class approach to collateral management can be overlaid on non-secured financing transactions. For example, initial and variation margin management would greatly benefit from a mindset that considers the use of multi-asset class collateral as standard.
The traded structures, asset class diversity and geographical coverage of a securities finance desk are one of, if not the most, expansive of any trading desk. The securities finance desk can offer multiple off-balance sheet opportunities for long or short stock desks. Synthetic and upgrade trades can offer material savings to businesses that consider balance sheet limits to be a binding constraint to growing their business. In addition, the ability for securities finance desks to align clients and other trading desks may provide further synergies or new business opportunities.
Generally, the securities finance desk should no longer position themselves as a facilitator of long or short equity or fixed income trading activity, it should be viewed as a creator of value for all businesses that exist on a trading floor. However, we should also be aware of and turn our attention to an upcoming regulatory hurdle in SFTR.
The regulatory technical standards for SFTR were published in March and are currently with the European Parliament for ratification. Once published in the Official Journal of the EU, market participants will have 12 months to prepare for the new reporting requirements. We estimate the ‘go-live’ date to be October 2018. At a high level, 153 fields must be reported for any new secured finance trade or any change to an existing trade. Crucially, both sides of the trade must report data to a trade repository. Therefore, some reconciliation will inevitably be required. We have categorised the ‘pain points’ associated with SFTR implementation into three broad areas.
Reporting: Most data points are already captured by firms, but approximately 40 percent are identified as new, so where will these be captured? Where will enhancements need to be made? Often there is no common taxonomy of terms. One firm’s ‘SBL’ is another’s ‘sell-buy back’. Unless the industry standardises these terms, both sides of the trade may be reporting the same data but calling it something different. What will the exception handling process for problem trades be? Will we have a reconciliation process? How is the unique trade identifier created and shared? What happens if you are reporting to different trade repositories? What happens when one side of the trade is not required to report (ie, not covered by the regulation)? What tolerances will be in place for differing amounts and rounding issues? A significant amount of process and technology re-work is required both internally and at a market level.
Lifecycle events: Following on from reporting, some of the required fields include collateral amounts and mark to markets. These figures are likely to change materially and often, reporting these events during the lifecycle of a trade is important. Different counterparts don’t necessarily deal with trades in the same way. If a counterpart splits a trade for reporting purposes, or terminates and replaces, what effect is this going to have on your reporting structure? How do firms agree on splits/terminations/replacements? Are trade repositories equipped to deal with the significant volumes that not only additional new trade reporting requirements will bring but also all lifecycle events?
Business impact: While transaction reporting won’t be anything new (see the second Markets in Financial Instruments Directive), the technology architecture, information model and process model will have to change significantly. With additional trade repository costs, and difficulties in matching up trading approaches between firms, there may be significant impacts on business strategy, while more aggregated data will help break down firm silos and increase transparency. We have identified 15 different functional areas alone that will need significant rework. There are emerging vendor solutions that will hopefully automate part of the process but none of them offer a full end-to-end solution. Some work will be required within the bank on defining and implementing a target state model for functions, information, organisation, control and processing to deal with SFTR. Defining a target operating model will allow you to interrogate which approach is best for you. The next step is to create a roadmap and business case to secure and justify investment for implementation.
Even though there is a regulatory hurdle on the way, the future is bright for securities finance. It is, or should be, an integral part of any firm’s strategy to counter capital and liquidity inefficiency. It is, or should be, a method by which the firm can source required capital to satisfy regulatory requirements. Considering securities finance as a method of moving towards a more group-centric post-silo operating model will pave the way to more efficient business. This requires change and change can be difficult. The good news is that we’re here to help.
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