Global financial regulation is focused on reducing systemic risk and central clearing is one of the ways in which regulators plan to achieve this. Currently central clearing has been implemented in the US and EU for the most standardized OTC derivatives contracts. The Financial Markets Act in South Africa has made provision for the establishment of central clearing houses and it is anticipated that by 2018 a central clearing house may be authorized to begin clearing standardized OTC derivatives. However there are currently no regulations requiring the clearing of securities lending transactions.
The main benefit of clearing is that it mitigates counterparty credit risk, as transactions are booked through a central clearing house, which is a regulated entity and is structured in such a way that it is deemed to be ‘bankruptcy remote’. Thus parties entering into a transaction through a clearing house no longer face the risk that they may suffer losses if their counterparty defaults, as the clearing house performs the defaulting party’s obligations (from the pool of collateral that the defaulting party has posted to the clearing house), thus mitigating losses.
So, if clearing provides such an efficient method to reduce systemic risk, then why not apply it to other standardized financial products, like securities lending or repurchase transactions?
Some of the major clearing houses in the US and Europe are already offering clearing services for securities lending transactions, and have reported an increased use in the service since its inception. The clearing houses are noting that often the beneficial owners of stock undergo a rigorous counterparty credit check against all potential borrowers, resulting in only a handful of borrowers being able to transact in this space. But if the transactions are booked through a central clearing house (with its strict membership criteria and margining rules), this counterparty credit risk is so vastly mitigated that many more borrowers are able to transact. Having a wider range of borrowers increases volumes, rates and ultimately profitability from securities lending activity. It seems that the lending central clearing house is able to effectively protect the beneficial owner from the risk of loss, resulting from the borrower defaulting, as the clearing house acts as a credit intermediary and takes on the counterparty credit risk, and guarantees the return of loaned securities and collateral. The clearing house also saves the beneficial owner and agent lender much of the operational burden of doing these lending transactions.
Borrowers could also benefit by using the services of a clearing house as banks under the new global regulatory standards are subject to a much higher capital requirement and liquidity capital ratio. If a securities lending transaction is done through a central clearing house there is a 0% risk weighting under the Basle III regulation applied to this transaction, meaning banks are likely to give much better pricing to borrowers if a transaction is cleared. Borrowers will therefore be able to free up capital required for securities lending transactions and can optimize their capital.
Whilst regulators have certainly considered and discussed the possibility of implementing mandatory central clearing to the securities lending market, to date this has not been done. Some consider that introducing a clearing house into the securities lending market will only result in yet another counterparty that has to be evaluated for its credit risk. Other institutions believe clearing will improve efficiencies from a capital requirement point of view and will make their securities lending business model more sustainable, and thus they will opt for clearing regardless of what regulations will be required.
DeriviDoc offers training courses on the legal and operational aspects of central clearing in the OTC derivatives market. Join one of our upcoming courses to learn more about this important new development, which will change the way in which OTC derivatives (and potentially other financial instruments like securities lending transactions) are traded:
Central Clearing - The Operational and Legal Aspects
The Legal Documentation Required for Clearing