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Opportunities and Challenges for Hedge Funds in the Coming Era of Optimization
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on the netted exposure of all contracts held open
with the CCP at the end of each trading session. The
amount of that posting is likely to be smaller than
the “explicit” cost of setting aside indemnification
coverage for each individual transaction.
Collateral & Risk Concerns around
CCPs Remain
Although a viable solution, the idea of centralized
clearing of securities lending transactions has not
yet won broad industry support. Three main issues
emerged in the survey interviews.
First, lenders are hesitant to consider the solution.
At present, agent lenders do not post any margin
on positions and until the formal implementation of
the Basel III rules in 2018, they will not be mandated
to account explicitly for the cost of indemnification.
Therefore, the move to a central clearing model will
be quite expensive, requiring more capital outlays in
a market where margins are already thin. Moreover,
the current proposals on the balance sheet treatment
of these outlays do not meet the industry’s goals of
reducing their exposure. If this remains the case,
there is likely to be only limited support from lenders
and most survey participants felt that the move to a
CCP model would have to be demand-led.
Second, asset owners are concerned about having
their exposure shift from a bank entity to a third
party. This is seen as adding unnecessary risks
into the equation. Most asset owners exert strong
oversight on their bank lenders, particularly in the
year’s post-GFC. There are deep relationship ties
between most asset owners and their lenders that
give the asset owner confidence about their ability to
ensure fair treatment in case of a problem. This is
also extensive risk oversight and regular due diligence
performed to ensure the creditworthiness and
stability of their lending partners. This has helped
many asset owners make the case to their boards
and investment committees about the safety of their
lending programs.
The way in which collateral is treated by the CCPs
is the third concern, but key regulations that have
emerged post-GFC may help to address many of those
concerns—at least for U.S. tri-party repo clearing—and
these enhancements could begin to shift thinking
about extending the tri-party clearing model to a
broader set of securities lending transactions.
An extensive set of tri-party repo reforms has been
enacted in theU.S. where tri-party repo has historically
accounted for two-thirds of repo market activity.
These reforms sought to improve the stability, reduce
the use of intraday credit and enhance the reliability
of the collateral pool post-crisis. They included the
introduction of functionality to eliminate the extension
of intraday credit provided by the two clearing banks
(JP Morgan and Bank of New York Mellon) known as
“auto-substitution” which allowed for the near real-
time substitution of securities collateral supporting
the tri-party transaction. Dealers were required
to account for a potential loss in secured tri-party
funding in their liquidity risk management and stress
test scenarios, including efforts to lengthen and
stagger the maturity of other bilateral financing.
Operational enhancements were also introduced
into the system to reduce the requirements for
intraday credit usage from the clearing banks. Such
changes included ending the daily unwind of cash and
collateral for non-maturing trades and redesigning
the process for maturing trades in a more liquidity-
efficient manner.
According to the FRBNY, changes in process and
practice have already resulted in a sharp reduction in
intraday credit usage, from 100% of daily volume in
late 2012, to about 20% of daily volume in Q1 2014.
In dollar terms, the two clearing banks are providing
over a trillion dollars less in intraday credit to market
participants on a daily basis today than in February
2012. By the end of 2014, the FRBNY expects that
“ I think the CCP model is very likely,”
— Asset Owner—Money Manager
“ CCPs are new. They are something new for our
risk management team to assess. They like the
transparency. If they are comfortable doing it
for derivatives, we should be comfortable doing
for another asset class. We should be able to
combine the two and trade with a counterparty
and use the CCP as just a clearing agent,”
— Asset Owner—Money Manager
“ We have resisted central clearing for ages, but
we’re beginning to think that this may be less of
an issue. 12 months ago, everyone would have
said no and now some people are saying maybe,”
— Industry Trade Organization
“ We are investigating a securities lending CCP.
We may be more interested in the clearing
as opposed to the trading side. We view our
participation as a trial,” — Agent Lender