A recent research report from Finadium finds that due to regulatory changes affecting capital treatment, agent lenders face a future that could include multi-tiered pricing models, increased competition from synthetic products from prime brokers and dealing with internal structural changes as banks merge divisions.
In terms of pricing changes, the way that capital rules will affect the treatment of indemnification and which may prompt increased usage of central counterparties (CCPs) for securities lending could lead to a four-tiered pricing model, says Finadium, but only for a few large, sophisticated clients at first.
The most expensive tier would be for bilateral transactions that require indemnification, due to the high borrower exposure risk weight. Next would be bilateral loans without indemnification, which happens sometimes today, but “an expansion of this model would free agent lenders from the capital costs associated with their own risk exposures to borrowers. This would reduce costs for clients and/or allow more profitable loans to counterparties,” says Finadium.
The other two tiers involve the use of CCPs, one with indemnification and one without. With indemnification, agent lenders could still achieve a 97% savings in capital costs, according to the Promontory Financial Group in a report sponsored by SL-x. Lastly, using a CCP without indemnification would prompt the greatest capital savings, and could be viable assuming the risk waterfall methodology of a CCP holds up. While agent lenders may be concerned over their relevancy in an unindemnified CCP environment, beneficial owners indicated to Finadium that they would not be inclined to go at it alone.
Aside from how they choose to price their services and how they compete amongst each other, agent lenders are facing increasing competition from Delta One (which trade derivatives without options) and synthetic financing desks from prime brokers. While these are not new offerings, Finadium’s own research, combined with data from nine large banks, found that these have grown in the last two years, both on their own and relative to securities finance and margin loan transactions.
From 2012-2014, these nine banks saw a 35% increase in prime brokerage revenues, which included a 50% increase in Delta One and synthetic financing revenues, while traditional prime finance, including securities lending and margin loan revenue, increased only 14% during that period. Overall, Delta One has grown from 58% of Finadium’s analyzed prime brokerage revenues in 2012 to 65% in 2014.
“This shift is driven by prime brokers looking for lower capital charges and perhaps concerned about counterparty credit exposure limits,” says Finadium.
In Finadium’s conversations with banks over the third quarter this year, 35% were evaluating merging their securities lending and repo businesses, and others have already merged or are considering merging agency lending and prime brokerage, or possible custody and Capital Markets, as banks look for greater efficiencies.
“For agency lending, while losing independence may hurt, the potential for cross-selling could add creative opportunities for lending professionals,” explains Finadium. “One opportunity we see is to use the agent lenderʼs relationship to form a cross-fund securities finance operation at the client site. This would move past individual portfolio managers, who can at times be an obstacle to lending, and bring in the entire firm to manage funding activities that may overlap securities lending, swaps and futures basis trades.”
However, there could be some legal issues with merging divisions, as securities lending has some exemptions, such as banks not being considered dealers when acting as securities lending agents cash collateral reinvestment pools not being considered banking entities under the Volcker Rule. As a result, some banks may look to joint ventures rather than merging divisions, concludes Finadium.
Agent Lenders Could Change Pricing Model, Face More Competition From PBs
A recent research report from Finadium finds that due to regulatory changes affecting capital treatment, agent lenders face a future that could include multi-tiered pricing models, increased competition from synthetic products from prime brokers and dealing with internal structural changes as banks merge divisions.