‘Cost sells a lending CCP’, or even, ‘cost kills a lending CCP’—this impression might be predominant to anybody following the recent discussions and articles around central counterparties for securities lending, but this simplistic approach obviously fails to put the topic in a broader context within securities financing. The CCP subsequently isn’t seen as an opportunity to rise to the severe challenges that the industry currently faces.
‘Cost sells a lending CCP’, or even, ‘cost kills a lending CCP’—this impression might be predominant to anybody following the recent discussions and articles around central counterparties for securities lending, but this simplistic approach obviously fails to put the topic in a broader context within securities financing. The CCP subsequently isn’t seen as an opportunity to rise to the severe challenges that the industry currently faces.
In real life with market participants, we have experienced a slightly different approach; an extended decision making process, in which the ability to manage a variety of liquidity scenarios efficiently is considered as the deciding factor. Of course, the cost structure of a CCP matters and is of true importance, but it is treated from a trading rather than an operations point of view. In general, participants are looking to achieve economies of scale and therefore a lower cost structure achieved by adding additional liquidity to a standardised CCP environment. This is an environment in which the absolute cost levels of a CCP determine the transaction types suitable and the targeted volume intended for a CCP trading book.
As of today, a typical CCP evaluation is embedded within a scenario where market participants consider shifting liquidity for the standardised part of their trading activity from the established bilateral market to a CCP structure. With bilateral credit lines exhausted, expansion of liquidity access is of the same importance as any potential cost savings.
Therefore the resulting assessments cover all aspects of the value chain of trading, clearing, collateral management and settlement, and consider the related cost and risk structure in relation to the profit margins achievable by the intended trading and liquidity scenarios.
The issue of ‘liquidity’ opens the consideration of the implications of a CCP to the trading organisation and the processes to generate liquidity. While the bilateral market is characterised by a countless number of mini-liquidity pools, corresponding to a portfolio of one-to-one lending contracts, the one-to-multiple contract structure of a CCP-organised market provides a systematic advantage by pooling liquidity to a single credit relation. A CCP therefore creates the possibility of an advanced and efficient trading organisation, which might be characterised by price transparency, deep markets, best execution and anonymous trading patterns.
In addition, the development and maintenance of a bilateral individual contract structure requires a time- and cost-intensive credit assessment and legal approval process within the banks. A CCP structure ideally requires only one credit assessment to get connected to multiple counterparties, thereby providing significant time and setup cost savings within the pre-trading phase.
A CCP effectively takes over the credit assessment for the participants in the CCP-organised market. The corresponding contractual and credit line structure of the bilateral market is complex and that complexity itself is the source of potentially inefficient use of credit lines. This is of course a sin in the days of reduced balance sheets and internal competition for credit lines.
After the cost structure of the pre-trading and trading phase, participants consider the clearing costs related to liquidity and volume scenarios. In order to be able to scale unlimited liquidity, participants are looking for:
Unlimited, direct access to the CCP rather than limited, indirect access via a clearing member;
Delivery guarantees from the CCP for all outstanding transactions; and
A principal trade-off between additional margin cost and capital relief.
Last but not least, participants consider one-time costs such as CCP connectivity and integration costs, and we have found that whenever the setup costs are cash-flow relevant, the availability of budget drives the timing of a CCP integration project.
Nevertheless, we expect the lending CCP to become a vital part of the flow-business within the securities lending market because each of the involved market participants (beneficial owners, agent lenders and broker-dealer) can realise economies of scale by using a CCP. Since most of the broker-dealers are already CCP and clearinghouse members, it will be very interesting to see which of the agent lenders in Europe will be the first to make a strategic step and open the door for its beneficial owners to access a lending CCP.
To summarise, cost matters, but brightness of liquidity is what sells a lending CCP to the market.
