By John Arnesen, consultancy lead at Pierpoint Financial Consulting
If there has been one thing impressed on me in the last month attending a series of Securities Finance Industry conferences, it is that executing a lending transaction is a relatively straightforward part of the lending challenge. There are a host of pre-trade requirements to establish such as beneficial owner authorisation for lending contracts, credit line approval to borrowers, the GMSLA, the beneficial owner on-boarding approval process with borrowers (a process that can take up to six months) and the setting up of standard settlement instructions to name but a few of the heavy lifting considerations that must be in place before that first loan can be executed.
It is, however, the post trade lifecycle of securities finance transactions that attracts the most attention given the somewhat complex nature of lending in which the loan can radically change during its duration from mark to market, partial returns, collateral switching daily, marking to market the collateral, reallocation from one beneficial owner to another due to a substitution or recall, corporate events from a coupon or dividend manufactured payment and a host of other events which an operations team would have no hesitation explaining in more detail to their front office traders.
The prevalence of these functions has increased exponentially over the years and the rise of services to ease the burden of these processes through automation has made them both easier and less costly to manage. The success of this can be measured in a number of ways, not least by the very fact that $2 trillion of securities go through the above noted processes every day is testament enough that the market is working relatively well.
However, from a revenue generating perspective, 2019 is not as lucrative a year as 2018. Concurrently, the ogre of SFTR development that began a few years ago is consuming a huge amount of resources and investment dollars this year in preparation for a 2020 go live date. Herein lies the problem. Securities finance revenue is not a fixed annuity product and no one can predict with accuracy how much revenue will be generated the following year. Markets can be unfavourable, clients can come and go, new business comes at a premium if at all. Most revenue budget exercises are set for growth as it’s more than awkward to go through the budget process and explain to senior management that the business will be delivering less revenue each year for the foreseeable future. Try that and watch how quickly resources evaporate. Faced with solving for this issue some participants have begun to look at ways in which the robust infrastructure they have built could be used to plug the revenue gap left by traditional lending.
Direct or peer-to-peer lending is one innovative way in which agent lenders or platform-based utilities can match supply and demand for institutional client lenders. Providing a means for one asset manager to lend assets to another or an insurance company for example and vice versa expands the routes to market available to traditional clients and, if passing through the pipes of an agent lender it doesn’t disintermediate them entirely from the transaction. This is particularly true where the agent is providing the post trade services described in the paragraph above.
Typically, this type of transaction would have been driven by demand from a broker/dealer but with capital constraints and other considerations being what they are, it may prove too expensive for the borrower. Moreover, if the agent isn’t providing any credit protection in the transaction, the collateral acceptability is only constrained by the lender’s risk appetite and the agent can reduce its capital costs by eliminating indemnification.
Peer-to-peer lending may not suit all institutional investors. It requires more direct oversight and involvement and some of the risk mitigants offered by the agency lending route will be forgone. To date, it appears take up has been slow but there is no shortage of providers looking to establish a presence in this space. We understand that Delta One, a product of Dynamex Trading, went live this summer and leverages their options strength. In the autumn of 2018, Asterisk Networks was launched aiming to entice institutions that would historically enter the market via the agency route and match them with a host of counterparties across an electronic trading platform and provide for post trade services.
It was with some interest I read of State Street’s launch of Direct Access Lending which will not only match lending clients with those that use its enhanced custody platform but include a feature in that State Street will continue to indemnify the activity. So, peer-to-peer with a twist that should attract interest. No doubt others are eyeing this closely and may follow suit. In an environment of flat to declining earnings, providing access and leverage to the strength of the operational structures that agent banks have built over many years looks like an interesting move which merits analysis.