The securities finance industry has negotiated a time of significant market dislocation, with the Q3 19 US repo market spike followed less than six months later by the COVID-19 pandemic and significant market volatility that this engendered.
The securities finance industry has negotiated a time of significant market dislocation, with the Q3 19 US repo market spike followed less than six months later by the COVID-19 pandemic and significant market volatility that this engendered.
This experience has illustrated the ability of the securities finance industry to perform under stress conditions and to adapt its working practices under pressure. But, for Ben Challice, it is the transformation projects that J.P. Morgan has been running over a longer timeframe that will have a more dynamic and enduring impact on the future of collateralised finance.
Looking historically, Challice observes that the global collateral ecosystem had changed relatively slowly over several decades, despite advances in technology and product solutions that would enable collateral to be mobilised and allocated much more efficiently. The triparty collateral management space has operated in the past as a set of relatively closed ecosystems — dominated by the biggest players, J.P. Morgan and BNY Mellon, Clearstream and Euroclear.
“As a triparty collateral specialist, we have made a deliberate effort over the past four or five years to open up that collateral environment and to extend greater choice to users regarding how they apply those collateral services,” says Challice. For example, this will enable clients to use the triparty front end to perform the collateral optimisation and to support their pre-trade decision making, while extending the operational benefits that come with operating through a triparty service.
“With this in place, we are extending flexibility to the user to deliver collateral to a wider range of collateral takers and to improve connectivity within the collateral ecosystem,” he says. This includes the ability to post margin to central counterparties through J.P. Morgan’s CCP Margin Exchange, which launched in late 2020 with the aim of offering triparty connectivity to eight or 10 of the world’s major CCPs by the end of 2022.
“In addition to our efforts to open up the collateral environment, we focused on creating full interoperability between all collateral services modules supporting pre-trade analytics, ‘what-if?’ simulation capabilities, and integrating collateral optimisation with collateral movements”, Challice adds.
Inevitably, this transformation is shaped by client behaviour and by evolving needs on the part of core securities lending and financing clients. For asset owners and asset management clients, there is a continued drive to optimise risk-adjusted return from their securities inventory. For collateral providers, particularly the broker-dealer and prime brokerage communities, there is a requirement to mobilise cheapest-to-deliver collateral, to unlock new pools of underutilised assets, and a need to maximise financial resource efficiency.
As a business, J.P. Morgan has been bringing these lines of business closer together, aligning the needs of collateral providers more closely with those of collateral takers, reinforcing opportunities for alpha generation through the lending relationship and enabling the user to mobilise, allocate and transport collateral in a more optimal way.
Inevitably, this focus on transformation has also been driven by regulatory imperatives. BCBS-IOSCO Uncleared Margin Rules (UMR) for non-cleared OTC derivative transactions have been rolled out through a phased implementation since 2016 and, under Phase 6, will bring a greater number of buy-side firms into scope that had not previously been required to post initial margin and to manage variation margin in connection with their derivatives trading activity.
UMR Phase 5, which became effective in September 2021, impacted more than 300 firms, with the average aggregate notional amount (AANA) threshold set at US$50 billion. Phase 6 will lower the AANA threshold to US$8 billion, bringing a much larger community of buy-side firms into scope and requiring firms to identify which of their trading relationships will hit the US$50 million ceiling when each firm is required to post initial margin. Significantly, UMR rules also require that this IM is held in a segregated account at a third-party custodian.
This has resulted in a strong pipeline of buy-side firms approaching J.P. Morgan to provide an outsourced solution — reflecting that most buy-side firms may not have the operational infrastructure to manage these new inventory management style techniques in-house.
Product convergence
J.P. Morgan is well able to meet these requirements, Challice suggests, as a global custodian that has a large triparty business and integrated securities lending, financing and derivatives margin management functions.
A number of sell-side firms have already gone through comprehensive internal transformations designed to reduce fragmentation between internal product silos and to optimise their collateral use across derivatives trading, secured financing and securities lending activities. This has been key in helping these firms to unlock “trapped” assets, mobilising un-utilised or under-utilised collateral to bring greater efficiency to their secured financing activities.
For buy-side firms, while some large asset management clients have already been significant users of triparty services as collateral takers in securities financing or securities lending transactions, this penetration is likely to extend further as a wider range of buy-side firms fall into scope under UMR Phase 6. Many of these firms are expected to extend their current usage of the J.P. Morgan derivatives margining product from variation margin (VM) to initial margin (IM). Through use of the bank’s collateral transport platform, they can also mobilise and transform collateral — if it has greater lending value, or if it is the wrong type or in the wrong place to meet their collateral obligations — thus solving for their inventory management conundrum.
While there is convergence, this does not imply that there is homogeneity. Customers are moving at different speeds and have different levels of technical sophistication based on their business models and evolution. “Each customer is different and we offer a full set of modular outsourcing services to meet their specialised requirements,” says Challice.
Notwithstanding this focus on service flexibility, Challice also points to the scale benefits offered through J.P. Morgan’s integrated custody, collateral and securities financing operations. For example, BlackRock, the world’s largest asset management company by assets under management, is one of a number of large global buy-side firms that uses J.P. Morgan as its global custodian. While BlackRock uses its own in-house securities lending and liquidity management teams to manage its lending and financing trading activities, they rely on flow through the post-trade services provided by J.P. Morgan.
More broadly, the bank is monitoring opportunities to bring new asset pools into its securities lending and financing programme — working with wealth management clients, for example, to bring securities held in private investor accounts into the J.P. Morgan securities lending programme.
Recognising the growth in its business volumes over the past four years, Challice highlights the importance of the major investments that J.P. Morgan has made in its technology stack since 2017.
“Without this investment, the organisation would potentially have struggled to manage the business expansion and the sharp rises in volatility that have been witnessed at various points over the past 24 months,” says Challice. “This has been important in helping clients to maintain stability throughout the pandemic and the volatile geopolitical conditions, in part caused by the war in Ukraine, that we are now witnessing.”
In line with this message, J.P. Morgan has announced in public statements that it plans to spend upwards of US$12 billion on technology investment during 2022. On a recent analyst call, chief financial officer Jeremy Barnum said that J.P. Morgan is stepping into a “phase of acceleration” of investment spending, given the levels of competition that confront the bank. This was confirmed by chief executive Jamie Dimon, who said that the bank expects to “spend a few bucks” to beat its competitors.
Behind this talk of expansion, it is apparent that securities finance is not immune to the business pressures that have impacted custody and other asset servicing functions over a number of years. Competition generates pressure on business margins and participants face an ongoing battle to improve returns while managing cost — at the same time sustaining their commitment to product innovation, to upgrading technology and managing regulatory overheads.
For lenders, the challenges have centred on negotiating the spread compression that has impacted lending revenues owing to asset oversupply, and the need to manage cost pressures in the context of the increasing complexity involved in providing this service (owing to adherence to regulations such as the Securities Financing Transactions Regulation, the Central Securities Depositories Regulation and the second Shareholder Rights Directive for example). As a service provider, this has reinforced the importance of improving automation levels across the securities lending value chain and driving out operational risk and cost.
Digital integration
More broadly, steps towards digitisation continue to change how collateral management is performed. The digitisation of key legal and operational data has been important to support fast, efficient data exchange with counterparties and service partners — thereby enhancing straight-through processing rates across collateral processes and minimising STP breaks and manual touch points across the securities lending or financing transaction.
This has included steps to digitise collateral schedules, thereby enabling collateral selection and optimisation procedures to work more efficiently, while facilitating users’ ability to meet CCP margin requirements via the J.P. Morgan CCP Margin Exchange (see further in SFT Issue 301).
In bridging the integration of digital assets more fully into the collateral management world, Challice describes the collateral managers’ role as being a translation layer between the old world of physical settlement and a new, digitally-enabled world where assets can settle friction-free on blockchain.
“In this environment, we view our role as being one of collateral token agent, rather than simply as a triparty agent,” he says. The central book of record held on distributed ledger technology provides a permissioned, centralised record of ownership of tokenised collateral transactions. J.P. Morgan applied this principle to launch a blockchain-based solution for intraday repo transactions in December 2020, utilising ethereum-based DLT technology developed by the firm’s Onyx team.
Alongside this, J.P. Morgan has become an investor in HQLAX through the series-B funding round that concluded in June 2021 and which raised €14.4 million. J.P. Morgan connected initially to the HQLAX platform as triparty agent in 2021 and has been connecting its agency securities lending business to this platform during 2022.
The collateral mobilisation element is paramount, Challice indicates. The intraday repo service explicitly helps organisations to solve the intraday liquidity challenges that, in previous times, they were often forced to meet through unsecured lending. HQLAX helps users to meet their requirement for mobilisation of baskets of high-quality liquid assets and to meet their collateral transformation needs in line with their capital adequacy, liquidity coverage and net-stable funding ratio requirements under Basel III.
Investment in data services and the ability to work with big data is essential in enabling these developments. “This aligns with the strategic priorities of the Securities Services division, where steps to develop data-led solutions for our clients remain high on our development agenda,” says Challice. This centres on promoting data standardisation and in establishing a single source of truth — not necessarily built on DLT, but always offering a single, golden source copy of the data in a centralised location, often cloud-based, to ensure this can be accessed by all permissioned stakeholders.
From a securities finance perspective, this is important in delivering to users an integrated view of their positions, collateral and liquidity. The bank is also investing to bring a wider range of delivery mechanisms to the user, including greater use of application-programming interfaces (APIs) to sharpen two-way system-to-system connectivity and to enable users to update collateral schedules or lending parameters directly from their collateral and risk management platforms. This is also supported by ongoing investment in its web-based user interfaces ‘Securities Finance Central’ and ‘Collateral Central’, which are accessed via J.P. Morgan Markets to enable access to data updates and programme analytics.
