Equity financing's a critical role in a new world
Implementation of financial regulations is profoundly impacting capital markets. As well as fundamentally altering flows of liquidity, it is driving big changes in collateral management and securities financing. Banks, broker dealers and some asset managers, are at varying stages of integrating their collateral and financing activities. How well they do so – and in particular how they tackle the complex task of integrating equity finance – will affect future competitiveness.
Collateral optimisation is the Holy Grail. Collateral needs to be allocated and used as efficiently as possible. In order to achieve this, firms must centralise operational structures that historically have been separate. While integration has begun, it is at an early stage.
But as they move to compete in a world where the incoming EMIR, Basel III and Dodd-Frank regulations are making collateral the currency of capital markets, both the sell-side and to an extent the buy-side are focusing with greater urgency on centralisation. As they do so, equity financing has an important part to play, yet the bespoke nature of the equity business and corporate actions also make it the hardest part.
The importance of equity within the collateral mix has increased. In part, this is because firms are using a far wider range of collateral for margin in contemporary compulsory clearing than they did previously for activities such as securities lending activities. But also, equity financing has grown in significance as it supports relatively stable cash equities businesses, at a time when fixed-income related repo activities have shrunk.
During a recent panel discussion hosted by Euroclear, speakers were excited about collateral optimisation’s benefits, yet few are close to achieving them. Streamlining collateral management and security financing moves it closer to the treasury team, and fosters a more strategic approach. Collateral can be mobilised globally to support derivatives and futures businesses, and to improve sourcing of high-quality liquid assets under Basel III.
Substitution of equity and fixed-income assets increases the efficiency of collateral management. Simplistically, if a firm is short fixed-income but long equity, it can substitute equity assets rather than going to the expense of borrowing bonds. Additionally, centralised operations make it easier for banks to reduce risk-weighted assets calculations by clearing collateral trades through central counterparties.
Re-engineering collateral management
Collateral optimisation, and by association equity financing, is clearly becoming of greater interest to the C-suite. As collateral margining with clearing houses now directly affects the price of trades, so the trading desks are more directly involved with collateral optimisation. The more traditional support functions for margining and derivatives support sat in the back and middle offices.
A recent Euroclear paper offers a snapshot of firms’ progress in integrating operational functions, including equity finance. Historically, the operational structures behind derivatives, repo and securities lending activities were quite separate. But Collateral Management in Europe: Searching for Central Intelligence, published in May last year, reported that half of the firms interviewed during research had some degree of centralisation in place at the operational level.
Mid-tier firms have tended to make more progress towards global centralisation, backed by a single technology platform for managing collateral across business lines, according to the paper. This is likely because their operations are more manageable in size; the simpler the operational structure, the easier it is to centralise. Those remaining decentralised have not yet felt the urgency of the need to create a single view of collateral inventory across operational silos, though this is likely to change once EMIR and CRD IV have been fully implemented.
Yet some of the larger sell side firms are pioneering a more sophisticated approach, driven by an increasing need to optimise capital, balance sheet usage and liquidity, according to Martin Seagroatt, Marketing Director of 4sight Financial Software, a leading provider of collateral management and securities financing software. “There’s more demand for more advanced collateral management. Firms want to analyse the collateral pool on a more holistic basis and optimise it across a range of counterparties,” he says. “This analysis can also bring in liquidity and XVA calculations, as well as collateral cost. Some of the big sell-side banks are further ahead in this area.”
Only three firms surveyed for the collateral management paper, all of them large sell-side firms, had got this far. They had invested heavily in technology, including multifactor algorithms that work with variables such as geographic location of assets, equity corporate actions data, market data to enable mark-to-market valuation, and eligibility criteria for margining or posting of collateral to counterparties. Future projects included improving optimisation and building support for additional variables and scenario analysis capabilities.
Overcoming operational obstacles
When seeking to centralise collateral and security financing operations, the complexity of equity trading is one of the greatest obstacles. Corporate actions such as dividends and rights issues need to be managed and processed. What’s more, equities tend to trade mainly on national stock exchanges, and are held by local central securities depositaries (CSDs), yet they may be financed internationally on platforms such as Euroclear’s.
Automation lies at the heart of simplifying equity trading. Reconciling domestic trading with international financing can be a massive operational task. But the whole exercise can be automated by agreeing a set of rules with Euroclear through the Open Inventory Sourcing tool, which moves assets between Euroclear and CSD as they’re needed, keeping records automatically. Similarly, firms can automatically manage corporate actions and tax refunds.
Every firm is likely to have a different approach, setting different parameters for automation. Parameters might, for example, govern when to trigger a collateral substitution in the event of a corporate action.
Another area of complexity that can be simplified is moving collateral between triparty agents. Banks need to be able to access all their collateral, no matter where it’s held, in order to get the maximum benefits. Euroclear offers a collateral allocation interface with other triparty agents. This interface will realign assets held on behalf of clients to other triparty agents if and when needed.
Using a CCP
There is also an increasing trend towards centrally clearing securities lending trades. The reason is simple. Borrowers need to optimally allocate their available capital and centrally clearing these transactions allows them to benefit from reduced capital needs. In fact, the nature of the new regulations has raised much more fundamental questions from many borrowers. Effectively, taking into consideration the need to set aside substantial capital per trade, many borrowers have insisted that lenders look into clearing the lending transactions through a clearing house or risk having to find new counterparties to lend to as existing borrowers pull out.
Eurex's CCP service for securities lending, developed in partnership with Euroclear, is the only active cleared solution for borrowers and lenders looking to reduce their capital costs. Both the lender and the borrower clear the trade with Eurex, thus benefiting from reduced capital needs, and the collateral to support the trade settles through Euroclear’s robust triparty mechanism ensuring a reduced operational burden and optimal allocation of capital.
Protecting future competitiveness
In the next few years, it is likely that the regulations being implemented now will prove a watershed. Firms’ ability to identify, mobilise and substitute all types of collateral, across asset classes, will determine how well they can compete.
Collateral’s emergence as the markets’ basic currency, sparked mainly by the imposition of central derivatives clearing, is a fundamental change. It will drive far greater centralisation in collateral management – a trend that remains in its early stages.
Equity financing is a crucial part of this trend. Operationally, it is the most difficult part of collateral management to centralise. But integrating equity is not an option – without it collateral optimisation will not be complete and competitiveness will suffer.