Changes in the market often present an array of business opportunities, including the chance to diversify into other products and services that generate revenue and add value for customers. New regulations and an expected economic shift could open the way for central securities depositories to play a larger role in securities lending and repurchase agreements.
Custodian and investment banks, market makers, broker-dealers and asset managers borrow securities to cover short positions and lend cash to support financing transactions. To pick up yield and increase liquidity, they lend their securities temporarily in return for a cash deposit from the borrower. In addition, securities lending and borrowing is an important part of the settlement process, especially in the case of illiquid bonds and equities, and during stressed market conditions.
The securities lending market is massive. Markit Group Ltd.'s securities lending data set covers $13 trillion in lendable inventory comprising more than 20,000 equities and 200,000 fixed income securities in the programs of more than 20,000 institutional funds. It includes more than 3 million intraday transactions going back 10 years. Repo is similar to, and sometimes a substitute for, securities lending. According to Finadium, a specialist research and advisory firm, the global repo market is valued at $13.78 trillion.
CSDs are typically experts in managing securities, and they offer complex settlement and liquidity services. But the role and ambitions of CSDs is changing. CSDs are beginning to offer web-based direct services to issuers such as corporate event management, e-voting and IPO book building, as well as portfolio management services for investors. These are new ways for CSDs to diversify their business at times when securities trading volumes dip. In addition to their traditional role, CSDs are well-placed as intermediaries in securities lending and borrowing, matching, repo settlement as well as collateral optimization and transformation. In markets where there is no clearinghouse, CSDs also are often responsible for clearing, managing the associated risks by collecting margin and collateral. CSDs also are involved in dividend, interest and principal payment processing, as well as corporate actions and the pledging of shares and securities.
Economic and regulatory changes will likely create opportunities for CSDs in securities lending and repo. Over the last few years, low interest rates and Europe's long-term refinancing operations have put a damper on the market. According to the International Capital Market Association's European Repo Market Survey published in March 2013, the European repo market declined by 11.9% in 2012. Some believe the downward trend might have been helped by short-selling bans. But interest rates are expected to increase in the foreseeable future, and that could lead to a rebound in securities lending and repo.
Mandatory central clearing of OTC derivatives is being phased in during 2013 in the U.S. and is expected to be phased in during 2014 in Europe. It is estimated that there will be an additional requirement of up to $2.5 trillion in eligible collateral, assuming that every participant posts all collateral gross. This shortage could climb to $6 trillion over the next four years. However, TABB Group believes this amount could be closer to $20 billion, suggesting that efficiencies already achieved by centrally clearing swaps need to be discounted.
These additional collateral requirements are expected to lead to a shortfall of eligible collateral to post against these positions, likely causing collateral optimization and transformation services to be in high demand. Through optimization, firms can identify surplus collateral and free up valuable liquidity across listed and cleared derivatives. Firms can maximize value from securities finance transactions, where they can lend a portfolio of assets, pledged as collateral, in return for cash (with a spread payment to the borrower). This arrangement provides the lender with access to funding without the need to liquidate any underlying positions in non-cash assets held.
Collateral transformation allows customers to post a wider range of collateral than a clearinghouse can accept. Let's say the clearinghouse accepts only cash and government notes, but the customer has only corporate bonds to offer. The member firm can accept the corporate bonds as collateral, post government notes on the customer's behalf with the clearinghouse, and then charge the customer a fee for the service.
CSDs are well-placed to help clearinghouses, clearing members and their clients meet these new collateral management requirements. Customers can automatically make securities available to CSDs for securities lending transactions. Further, CSDs can manage the pool of available securities as well as the players and accounts needed for lending and borrowing. The business can be structured in different ways, employing extensive risk management functionalities, limiting the borrowing of securities to avoid failed settlements, and/or partnering with a local clearinghouse.
Considering the size of the market and the number and types of securities involved, automation and robust technology are critical to ensure fault-free settlements. CSDs must have accurate reference data. They need to connect with market participants, custody banks, third-party clearers and trading venues via international standard protocols, and generate reports for these and other stakeholders. They must be able to configure their settlement model and cycling frequencies on the instrument and market level, and integrate with collateral management systems. They need to have strong risk management and internal control processes and procedures.
With economic changes upon us, the opportunity could be substantial. In addition to the challenges of new service offerings, CSDs face increasing regulatory pressure to increase their risk management capabilities; interlink with other markets; support Target 2 Securities cross-border settlement; and build regional linkages, just as examples. Add to this the fact that CSDs are facing increasing competition.
In order to offer these advanced and sometimes untraditional services to its customers, CSDs need to revamp their technology. The task is sometimes overwhelming. Often legacy systems cannot bend to meet the requirements of new demands of efficiency (straight through processing and low cost of technology ownership), regulation and business diversification. CSD information technology investment over the next few years will have to be significant. When competition is increasing and costs are rising CSDs profitability will be challenged, but with smart technology purchases and the right partners, they can grow and thrive.
Henri Bergström is NASDAQ OMX Group Inc.'s principal product manager CSD, market technology, in addition to chairman of the board of NASDAQ OMX Armenia markets, exchange and CSD.