Regulatory changes put in place following the financial crisis of 2008 have broadly reshaped the U.S. repo market but few reforms outside of the Intermediate Holding Company requirement have impacted the US equity finance markets. Given this relative lack of government intervention, market participants have their own opportunity to create settlement solutions aimed at providing efficiency and integrity to equity finance.
The fixed income financing space has been dramatically reconfigured since the market upheaval of 2008. Although the crisis was fundamentally driven by an erosion of lending standards and therefore asset quality in the residential mortgage space, critics correctly identified the repo market as a tool that allowed dealers and hedge funds to employ unsafe levels of leverage in trading of those lesser quality assets. Repo was originally designed to fund extremely liquid positions on a short term basis but over time, the product was adapted to fund non-liquid assets. While legally structured and fit for purpose, practitioners lost sight of the illiquid nature of those assets and set haircuts at levels better suited for US treasuries than subprime mortgage backed securities. This first mistake was compounded by the short term tenor of the trades in question, often as short as overnight. Assuming that ‘retail’ would continue to roll over these trades regardless of market conditions proved a fatal error for firms needing funding.
It is likely that the market would have addressed many of these issues on its own even without regulators dictating market reforms; banks are pretty good at abandoning business models that prove unprofitable. But the scale of disruption brought on by the Global Financial Crisis gave regulators room to enact stringent structural reforms including tri-party repo reform, the LCR, NSFR, leverage ratios, RWA calculations and the Volcker Rule. Some of the consequences of these reforms have been a reduction in the portion of banks’ balance sheets dedicated to the repo product, a shift to central counterparties, longer term funding and greater haircuts for non-liquid assets, and a sharp reduction in the directional risk associated with match book trading.
Equity Finance and 15c3-3 vs. Repo
Repo desks’ distant cousins, the equity finance/prime brokerage trading desks, have largely been spared in the tidal wave of market reforms. As complicated as the repo market may seem, to a fixed income practitioner the equity finance market has always been and remains a conundrum. Historically, most banks separated their repo and equity finance desks; often placing them floors apart. The two areas rarely share common clients. Equity finance relied upon a separate settlement venue and settlement dynamics. DTC settlement and terms such as debit caps, memo segregation, client versus house assets and Rule 15c3-3 confused repo traders and ensured that equity finance staff possessed critical knowledge that would guarantee them job security.
Some of the new regulations that reshaped the fixed income markets did in fact impact the equity finance markets as well: the Intermediate Holding Company requirement of Dodd-Frank being the most prominent. Faced with a requirement to separately capitalize a US holding company and operate under a less generous leverage ratio, many foreign banks moved a large share of their US trading ‘offshore’. While this may complicate their interaction with US clients, there could be an upside as maintaining trading books on the parent’s balance sheet may allow dealers to take a more global view of their collateral optimization. It seems unlikely that banks will reverse this migration in the near future.
Aside from these regulations, equity finance has remained largely unchanged for decades. Their regulatory structure dates from the 1930s and their settlement venue and format from the 1970s. The crisis which led to their biggest reform, the stock market crash of 1929, occurred long before most current market participants were even born; the protests that may have accompanied their creation have long faded.
The big theme of US equity regulation is the protection of clients’ interests, and Rule 15c3-3 is an excellent example. Under this rule, the only collateral that clients may accept in exchange for the securities that they lend to a dealer is either USD cash or US treasury securities. Both of these are problematic from the point of view of the borrower. Historically, dealers’ repo desks as well as equity finance desks were generally happy to borrow securities against cash. That all changed when banks were forced via regulation to shrink their balance sheets. Borrows done versus cash collateral served to ‘gross up’ dealers’ balance sheets. A borrow versus non-cash collateral on the other hand can be ‘balance sheet neutral’. But pledging US treasuries in an effort to trade on a non-cash basis causes two problems: the cost of the borrow increases significantly because this is a collateral downgrade trade; and netting can only be affected if both securities settle in the same location. That requires dealers to reposition USTs into DTC; a move that can consume precious daylight liquidity.
Dealers lending equity securities between themselves are largely exempt from these requirements. Hence, in the interdealer space, banks can exchange one equity for another and not gross up their balance sheet while covering shorts at an advantageous price. This results in a constant tradeoff between balance sheet optimization and lower costs in the case of dealer to dealer short covering and customer service, as well as market anonymity in the case of borrowing securities from clients. It is not a stretch to say that however well-intentioned 15c3-3 is, it encourages interdealer borrows at the expense of retail due to the lower balance sheet cost.
A fundamental change to 15c3-3 may arrive but it could still take some time. For many years, market participants have lobbied the SEC to modify Rule 15c3-3 to allow dealers to pledge equities as collateral against borrows from their clients. This proposed modification has been discussed at virtually every securities lending and repo conference over the past five years. Yet, change always seems to be six months away; the regulatory equivalent of an evergreen financing trade. But even if the equity finance market reaches the long sought Promised Land, the world is unlikely to change overnight as the requirement to accept only USD cash and US Treasuries has been hard coded into the prospectuses of numerous mutual funds, ERISA regulations and many state investment guidelines. SEC approval is only a first step: Board approvals, Department of Labor approval and state by state legislation will be necessary for the market to take full advantage of a change in 15c3-3.
Using Existing Infrastructure to Improve the Equity Finance Business
In the dealer to dealer space, banks will often find that the value of the securities they have lent to another dealer exceeds the value of the securities they have borrowed back. In this instance one dealer will cover its collateral shortfall to the other using equities from its end of day longs. This allows dealers to optimize the collateral they hold; avoiding the use of higher quality collateral, for example US Treasuries, which can then be funded at a lower rate.
Selecting, pricing, communicating and settling those movements is time constrained and generally manual at this time. Automating these deliveries will add efficiency and accuracy to this process. Creating that automation in anticipation of a modification in 15c3-3 will pay their own sort of dividend down the road. While it is certainly possible for individual dealers to automate the current manual process, this would appear to be a challenge that is best suited for a utility solution.
Whether trading remains onshore in the case of US broker dealers or is moved to European balance sheets in the case of foreign banks, equities can be efficiently integrated into a global collateral management and financing model. US equities can be mobilized directly from a bank’s DTC account into the international triparty environment of Euroclear Bank. Once there, dealers will be able to access additional financing counterparties or integrate those positions into a global collateral optimization model.
Both collateralizing equity stock borrows in real time in an automated environment and efficiently repositioning equity securities into the global collateral ecosystem to achieve true global collateral optimization are already possible. DTCC-Euroclear GlobalCollateral Ltd. offers a Collateral Management Utility that can mobilize US equities between DTC market participants in real time. This allows the automation of equity pledges and repositioning of US equities into Euroclear’s triparty service where they can be combined with a bank’s global inventory. Downstream, this facilitates allocating that inventory to financing and margin exposures in a globally optimal manner. While these solutions were originally developed for the US fixed income market, they are readily available to add efficiency to the US equity finance markets.
This article first appeared in Securities Finance Monitor on July 18, 2019.