James Slater
BNY Mellon

Drew Nicol and BNY Mellon’s James Slater discuss the results of a joint research study with PwC exploring buy-side opinions on central counterparties, incoming collateral rules and the rise of peer-to-peer lending

Buy-side participants appear to be warming to the idea of a central clearing option in the marketplace. What’s changed?

As central clearing continues to advance in financial markets, regulators are showing greater interest in how they can support or promote their development, especially in the securities financing space.

For example, the Federal Reserve Bank of Chicago dedicated roughly a third of its recent symposium on financial markets to the role of central counterparties (CCPs). That gives you an idea of how engaged regulators are becoming on central clearing issues and how they are creating a dialogue with the industry on how best to move forward.

Through our research study with PwC, we learned that the buy side was surprised that central clearing in the securities financing market has not advanced at a quicker pace.

Many respondents noted they had experience with central clearing in other products and when questioned as to why this hadn’t expanded into securities financing, it became clear that the buy side was somewhat unsatisfied with some of the operating models that were initially proposed.

Study respondents reported that classic concerns relating to CCPs still persisted in the market. What would you consider these to be?

The current securities financing CCP models are predominantly sell side to sell side. The buy side is not very active at all.

A lot of that has to do with the risk dynamics of the models available. Central clearing for securities financing transactions was developed for the sell side with some scale, but the model for the buy side is still evolving. It’s certainly starting to take shape, but at a slower pace.

The Fixed Income Clearing Corporation’s (FICC) sponsored membership programme is gathering more interest, while Eurex and EuroCCP, along with others in Europe, are also advancing their models.

The buy side is attracted to these solutions because of the risk management and creditworthiness of CCPs, but buy-side participants don’t want to tie up a portion of their cash by contributing to default funds. They also don’t want to share in the mutualisation of risk, partly from a principled standpoint but also because some buy-side firms are prohibited by law from doing so. For example, ‘40 Act funds are clear that they simply cannot be involved in the mutualisation of risk or provide assets as collateral. That’s why some of these funds are showing interest in the FICC sponsored membership programme because it offers a way around that regulatory hurdle.

Pension funds and insurance companies described the ongoing existence of credit indemnification as a critical consideration in their continued participation in the market. How do you see that playing out?

If you want broad participation of the buy side then the market will need to provide a solution for credit enhancement or intermediation. A lot of mid-sized corporate or public pension funds don’t tend to have large credit departments with experienced teams to evaluate the creditworthiness of all the counterparties that a lending programme might expose you to.

This means that lenders rely quite heavily on the indemnifications offered by their agents in order to satisfy their own internal risk management standards.

Peer-to-peer lending was mentioned as a key area of interest for both sides of the transaction. What are your thoughts on this emerging trend? Is it likely to gain traction?

Peer-to-peer is definitely an area of strongly growing interest and there was a great deal of enthusiasm among buy-side participants over the vast amounts of liquidity that could be unlocked through these platforms.

Finding counterparties and then negotiating individual trade documents is a fairly intensive process, and therefore there’s a significant amount of interest in the development of technological solutions to streamline this process. BNY Mellon has developed a cash and collateral marketplace known as DBVX.

We expect to host other banks on this platform as well as non-dealers that will be able to deal directly with non-traditional counterparties. We expect DBVX will supplement existing sources of liquidity for the buy side rather than supplant them. DBVX will standardise financial legal terms in its documentation to allow for much more straightforward transactions. This standardisation will also take away a lot of the friction in negotiations.

Additionally, participants will also benefit not only from the price transparency that comes with using an electronic marketplace but also by marrying up risk management with pre-trade anonymity. The entire buy side is looking to protect themselves by finding new sources of liquidity and new counterparties. The exploration of both central clearing and peer-to-peer trading are two parallel avenues that are being explored to achieve that goal. In both instances, simplicity and ease-of-use came very high in the list of priorities of both buy- and sell-side participants looking for solutions to pursue.

Were there any surprises in the survey’s results?

Honestly, I’ve been surprised and impressed by the progress the buy side has made in developing an understanding of the problems we face as a market and how proactive they are in taking steps to mitigate them.

The fact that more than half of respondents have either created a central funding and liquidity desk, or are in the process of doing so, shows how seriously they are taking the situation.

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