The bulk of securities lending in the future will be transacted via central counterparties (CCPs), one research firm has forecast.
Market volatility, regulatory concerns and the G-20 worldwide push towards the central clearing and exchange trading of OTC derivatives are the key impetus behind a possible change in the way market participants short sell, according to a new report from Celent titled 'Top trends in securities lending: The road to recovery and evolution'.
“Now that Dodd-Frank, the European market infrastructure regulation, and MiFID II are pushing OTC derivatives to be cleared centrally, the Financial Stability Board is exploring how to reduce systemic risk in securities lending, otherwise known to regulators as ‘shadow banking’,” the report read. "The first question that comes to mind is: Can securities lending follow in the same footsteps as OTC derivatives and use a CCP model to increase liquidity and address counterparty risk factors?”
Celent said since its introduction in 2009, the CCP model for securities lending had contributed to risk reduction and liquidity increases in other capital market avenues that are correlated to securities lending.
“The problem, however, arises when larger counterparts are brought toe-to-toe with smaller, less capitalised firms, which could result in larger market exposure,” the report read. “This takes away the advantage from the larger and more creditworthy counterpart and puts the ball in the smaller, less capitalised counterpart’s court.”
Celent has predicted the CCP venue to be a viable option for securities lending with the caveat that similar to other capital markets practices which have CCPs and exchanges, an OTC market would likely also exist.
“In the event a CCP model is mandated and the market moves to full implementation, custodians will still play a major role in the securities lending space; it would be highly unlikely for beneficial owners to go directly into the marketplace,” the report read. “Not to mention that an exchange model would require significant operational and technological investments for all parties involved; borrower, lender, intermediaries, and CCP.”
European short selling restrictions throughout 2011 and 2012 stemming from market volatility have curbed securities lending practices and drawn them to the attention of regulators around the globe. In the US, the Dodd-Frank Act’s Orderly Liquidation Authority puts credit limits on counterparties. Capital rules and short sale disclosure studies could have a major impact on securities lending market participants. Additionally, Celent said the so-called Volcker Rule ban on prop trading by deposit-taking institutions calls into question the ability of agent lenders to manage certain unregistered cash collateral reinvestment pools.
In Europe, Basel III potentially impacts the value of indemnification that a bank provides its securities lending clients, and encourages banks to consider credit CCPs. Additionally, greater transparency could discourage short sellers who prefer to remain anonymous, therefore resulting in fewer securities loans. Celent said European regulators’ abilities to intervene to eliminate or reduce short selling in times of stress legitimise the elimination of short selling during market crises may result in decreased borrower demand as short sellers worry about uniformity in market rules.