January 2012

• Welcome
• Adapting to Change in OTC Derivatives
• Securities Lending Rebounds in 2011
• Regulation
• Outlook

Welcome

We look at two big topics this month. One is the introduction of central clearing for most OTC derivatives contracts. Europe’s investing institutions must be ready by the end of 2012 at the latest. Optimising collateral management and liquidity will be important for all participants.

Securities lending will play a part in this process and our second article looks at the rebound that has occurred in securities lending during 2011. Regulation is playing a significant part in the evolution of the industry as well and this, along with the future outlook, is covered.

Adapting to change in OTC derivatives

Fergus Pery
Global Head of Collateral Management
Global Transaction Services, Citi

New rules requiring centralised clearing for interest rate and credit default swaps, together with daily valuations and mandatory collateralisation for all other OTC trades, are set to transform the derivatives landscape. In Europe, the EMIR rules will apply to most financial institutions from 2013. But firms with U.S. counterparties, or potentially those trading US underlying, may be affected by mid-2012 as the U.S. Dodd-Frank Act takes effect.

Pension funds are likely to be exempt from having to clear their OTC positions through central counterparties (CCPs) for three years, though they will still be subject to the valuation and collateralisation requirements. Many may decide to go to central clearing in any event, as changes to bank capital charges once Basel III becomes effective in 2013 are likely to add significantly to the cost of OTC transactions that are not centrally cleared, in our view.

All firms will need to appoint a clearing broker to trade CCP-eligible derivatives. But the big challenge will be to manage margining and collateralisation in the new environment, both for the clearing brokers and for the continuing bilateral relationships for non-eligible trades. Operational complexity will soar. At present, firms may have credit support annexes (CSAs) in place with some counterparties only. Margin calls may be weekly or high thresholds may apply before any margin is moved. Parties may often rely on counterparty marks for valuations.

In the new world, margin calls will be daily. Thresholds will be reduced to zero. CSAs will be essential for all counterparties and firms must value their trades independently. Collateral costs will impact more heavily. Firms will look to use any eligible stock in preference to cash wherever possible. Optimising the use of collateral, possibly through a collateral upgrade, will be a major challenge.

While some firms are building new middle-office infrastructure to manage these processes, others are looking to use a third-party service provider. Delegating the process to an external service provider is simple as CSAs will contain all the required documentation. At Citi, our OpenCollateral solution provides comprehensive core margin and collateral services spanning all of a client firm’s collateral relationships – be they ISDA, GMRA, OTC clearing brokers, prime brokers. It integrates easily with existing client risk management and back-office infrastructure.

OpenCollateral also integrates with the client’s external custodian accounts toautomate settlement of collateral movements. It manages the rehypothecation of securities collateral received to minimise the use of client inventory. And it is linked to Citi’s collateral upgrade services – which draw on Citi’s worldwide securities lending offering – and to Citi’s OTC derivatives middle-office services, which provide post-trade servicing and daily valuations.

The variable cost base of using a service provider for collateral management offers great flexibility. If a firm subsequently reduces its use of derivatives, it will not face having to write off its investment in expensive processes. For many institutions, there is increasing pressure to show good governance. The key is to define what can and should be done in-house and what is best handed over to an expert provider with the scale and skills to manage the process efficiently.

Securities Lending Rebounds in 2011

Gavin Callan
EMEA Head of Securities Finance Client Management
Global Transaction Services, Citi

In 2011, there was a considerable rebound that has occurred in securities lending. Our year-on-year lendable balances have risen significantly on the back of new client wins and we continue to see increased RFP issuance from institutions that stopped lending during the crisis or that are entering into securities lending for the first time.

A consistent theme from our new and existing clients is the need for customised solutions to meet their requirements. The requirements apply to many different aspects of securities lending ranging from the fundamental structure, e.g. discretionary lending, exclusive lending or a combination of both, all the way through to specific details such as the frequency, medium and content of reporting provided. Citi’s OpenLend^SM offering has evolved on the basis of an open architecture approach which is enabling us to deliver flexible solutions to clients including AGF, Diamond Hill and Empire Life who have all recently joined our programme.

Risk management continues to be a pivotal part of our programme. The recent market volatility reinforces the importance of the key protective measures that are incorporated into our OpenLend offering. Examples of these include mitigating daylight risk for our lenders, the daily mark-to-market process of both loans and collateral as well as the excess margin that lenders receive as a further layer of protection. Complementing these fundamentals is the full transparency that is offered through our state-of-the-art reporting system and our ongoing communication with clients including recent client roundtable events in Luxembourg and Milan.

Regulation

The impact of new regulations is a common theme across many industries at present and securities lending is no exception. The number of regulations that could impact the industry either directly or indirectly is broad and includes the EU short selling rules and Solvency II. Although the definitive impact of the regulations cannot be determined at this stage, certain developments are emerging such as the increased demand for collateral transformation or "upgrade" services referred to in the article above. Another area worth highlighting that could have a fundamental impact on the industry is the possible introduction of CCPs. From a beneficial owner’s perspective, some questions remain unresolved such as the risk profile of the structure and the costs associated with introducing this mechanism. For a more in depth overview, we have a produced a paper on CCPs and this is available on our website.

Outlook

In the short term, market volatility will have a bearing on the returns generated from securities lending as we go into 2012. Looking further ahead, the upcoming regulatory changes will impact the industry including the creation of new demand drivers which will lead to new revenue opportunities. Another key area of growth will be in emerging markets as more of them permit securities lending. Citi is ideally placed to capture these opportunities with our local proprietary branch network and we were recently rated Number One in the "Market Capability: Emerging Markets" category in the Global Investor/ISF 2011 Equity Lending Survey for the second year running.

For further information and regular updates regarding securities lending including our paper on CCPs in securities lending, please visit our website www.openlend.transactionservices.citi.com.