SEC Rule 15c3-3: Bringing equities to bear
Rob Chiuch and John Templeton of BNY Mellon Markets discuss the potential impact of allowing equities to be used as collateral in the US
Of the many cliches in the financial markets, none is more overused than ‘level playing field’. But in the US securities financing marketplace—unlike elsewhere—large segments of the community can neither post nor accept equities as collateral. This is especially noteworthy given that the securities lending market in US equities is by far the world’s largest, with $6.37 trillion in lendable assets at the end of 2016, according to IHS Markit data.
This seeming misalignment that affects lenders and borrowers in the global market could be resolved, with potential changes to the US Securities and Exchange Commission’s (SEC) Rule 15c3-3, which may enable US-based collateral providers to more directly support their activities. Furthermore, equity investors such as ‘40 Act and Employee Retirement Income Security Act (ERISA) funds may consequently experience new growth in demand. But there are challenges and additional changes required.
Collateral providers in the US are excited because, on the surface, the rule change potentially reduces their financing costs, as they’re naturally long in equities. Given that most equity collateral driven businesses are based outside the US, with the highest concentrations being in Europe, Asia Pacific and Canada, Rule 15c3-3 will likely result in a shift back towards the US.
Under Rule 15c3-3, broker-dealers cannot currently pledge equities as collateral, but there is an expanded long inventory of equity assets out there that they now want to engage. Compounding the challenges, many beneficial owners such as ERISA and ‘40 Act accounts cannot accept equities as collateral under existing rules. The US market as recently as 10 or 15 years ago was predominantly a cash market in which participants would mostly borrow securities versus dollars. Today, it is about half-cash and half non-cash collateral.
However, while we share the industry’s enthusiasm a potential change—and the desire to promote price transparency, increase liquidity, and reduce operational risk—we are concerned about the impact of the new capital rules on these transactions.
The challenge will lie in the pricing. Under Basel III, there is a 100 percent capital charge on agent lenders when, for instance, an agent lends securities to non-bank entities that in turn deliver securities (equities in this case) as collateral. A regional rotation of equity collateral flows could in theory result in a shift out of banks that currently attract a 20 percent capital charge, in terms of these collateral pools, into non-bank entities. By accepting equities as collateral from non-bank entities in the US, for instance, agent lenders would, as it stands, attract five times the capital charge on those same transactions.
The most likely solution is a more dynamic pricing model, with pricing adapting to reflect agent lenders’ appetites to absorb the capital costs.
It’s not just the capital impact that needs to be considered in the potential changes. The revisions have encouraged US broker-dealers to re-examine establishing triparty collateral management links for their US equity lending desks. Triparty collateral management is used extensively throughout the securities finance markets globally due to the operational efficiencies it creates for all participants.
While triparty is used extensively globally, it is used on a limited basis by the equity lending desks of US broker-dealers. There are a number of reasons for this, including that the equity desks need to source Rule 15c3-3-eligible assets to be posted as collateral (since equities are not eligible).
The typical mechanisms to source eligible assets are raising US treasuries (USTs) and Ginnie Mae agency bonds (also known as GNMAs) from a broker or an affiliate (and delivering equities bilaterally to collateralise that transaction), or requesting that the repo desk raise USD cash (and selling equities through triparty in that transaction). The eligible collateral is then posted to the agent lender to collateralise the equity securities loan.
Since the USTs/GNMAs are not trading assets of the equity desks, the operational efficiencies are of more limited benefit. This has meant that building links into triparty collateral management systems was never a high priority for these desks in an environment of strained IT and operational budgets.
If equities are approved, then the current bilateral collateral process becomes highly inefficient for both the borrower and lender, as prior to the release of the loan to settlement the lender needs to confirm that it has received the right amount of eligible collateral. Lenders do this manually today with highly liquid and fungible collateral such as USTs, but it would not be scalable to do this for equities due to restrictions that the lenders need to manage (indices, concentration limits, exclusions, and so on). Screening for these restrictions is a highly efficient process through triparty, where advanced technology is used in order to ensure that eligible and sufficient collateral is delivered to the lender.
On this basis, a number of borrowers and lenders are currently reviewing the steps necessary to bring their US equity lending businesses live into triparty, including reviewing documentation, establishing user access, and testing instructions and reporting for automation.
Non-cash collateral boost
Finally, we refer to Newton’s Law—for every action there’s an equal and opposite reaction. As risk weighted asset-related challenges and Rule 15c3-3 possibly evolves into less of a binding constraint for lenders and borrowers, and the street grows increasingly long of equities, the natural effect will be that, generally, activities surrounding the financing of equities in return for US dollars could decline. The balance of cash to non-cash collateral for US participants could tilt towards non-cash. This is further exacerbated by a shallower yield curve in the US and diverging monetary policies between the US and other nations, thereby constraining re-investment spreads.
It would benefit broker-dealers because they wouldn’t have to raise cash to pledge as collateral and they could utilise internal inventory that they have from their hedge fund clients, for instance. Notwithstanding capital cost and pricing implications, this kind of evolution could be a game changer from a stock loan perspective in the short term.