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The November meeting of the Bank of England's Securities Lending Committee (SLC) observes that CSDR settlement fines are “bigger than expected” and “are not washing through the system as easily as anticipated”.
Following on from dialogue in the Bank of England’s December Money Markets Committee, the November meeting of the SLC reflected on the “high” level of settlement fails in the securities lending industry and the rise in settlement fails following the September UK mini budget.
The Committee noted that this problem has existed in the industry for years and that Central Securities Depositories Regulation (CSDR) penalties – introduced with enactment of the CSDR settlement discipline regime in February 2022 – have not resulted in a significant improvement so far.
SLC members indicated that improvements in technology are likely to have the greatest impact in addressing this problem since the industry continues to be held back by its “reliance on rigid archaic systems”.
This issue was given detailed consideration in a panel at the ISLA post-trade conference in London on 1 November 2022 and at the Securities Finance Times Technology Symposium three weeks later.
The Committee received a presentation on tokenised collateral and discussed the potential that tokenisation offers for reducing collateral fails. It noted that the primary constraint to date has not typically been the technology, but rather the regulatory and legal uncertainty around this form of ownership which has created challenges from a compliance standpoint.
ISLA is currently preparing a research paper that will examine the complexities relating to transfer of legal ownership and legal certainty of new owner records when working with tokenised assets.
More broadly, the Committee discussed the continuing impact of the UK mini-budget, and related rise in gilt yields and market volatility, on securities lending markets. The Committee noted a greater number of queries from asset owners during the liability-driven investment (LDI) crisis as they reassessed the flexibility that their lending contracts gave them to recall securities. This prompted some beneficial owners to temporarily cease lending, according to the SLC minutes.
The gilts sell-off also triggered a rise in enquiries from LDI funds that are seeking to review their funding arrangements. One consequence is that some funds are exploring opportunities to access funding through peer-to-peer (P2P) channels, alongside their existing arrangements.
The Committee considered the capital cost for agent lenders of providing indemnification for lenders in securities lending transactions, indicating that some agent lenders had “decreased business” owing to the significant capital cost that they bear, commonly estimated to be around 13bps, in providing this indemnity. Consequently, the Committee indicated that the provision of indemnification by agent lenders might be expected to become less prevalent in the future.
Evaluating the potential impact of Basel IV capital adequacy provisions on securities financing transactions, some members of the committee stated that the EU stance on implementing output floors may raise the capital overhead for corporate and buy-side clients – particularly unweighted corporates, pension funds, sovereign wealth funds and mutual funds – penalising borrowing from unrated EU-based funds and potentially motivating borrowers to source securities through alternative channels, including funds based outside of the EU.
ISLA has proposed use of 60 per cent risk-weighted assets (RWA) for unrated counterparties rather than 100 per cent RWA – and has suggested that banks should be allowed preferential risk weighting until 2023. It also recommends using international standards to identify whether trade counterparties have sound access to liquidity.
The SLC indicates that these constraints are likely to trigger further discussion on use of central counterparties to provide greater capital efficiency in lending arrangements, along with use of credit benchmarks to alleviate risk weighting.
Reflecting on the Basel framework, the Committee noted greater use of pledge-based collateral over time, with data from Securities Financing Transactions Regulation (SFTR) reporting indicating that, for June, 16 per cent of EU collateral was under pledge – up from 12 per cent – and the corresponding figure was 18 per cent for the UK.
Reflecting on activity through securities lending markets over the preceding year, the SLC concludes that 2022 was a “satisfactory year” for securities lending, with DataLend reporting record volumes – although the Committee noted a contraction in demand for GC gilts over the period.
