Basel III Could Lead to Use of CCPs for Securities Lending

While the bilateral market remains the norm for securities lending, concerns about exposure netting could lead to the use of central counterparties once the higher capital requirements under Basel III kick in.

According to a white paper by Finadium, using a CCP could help borrowers gain exposure netting opportunities, as transacting with one party removes some of the uncertainty of transacting with multiple parties. And by knowing their counterparty in advance of the stock loan, borrowers would be able to get a better idea of their cost of capital based on the transactions that are already outstanding with the CCP.

“When banks figure out fast ways to accurately measure their cost of capital in securities lending, which will largely be based around exposure netting under Basel III regimes, then they will know how, when and where securities lending CCPs are a good deal,” says Josh Galper, managing director at Finadium.

The benefits of using a CCP primarily fall to the borrowers, as lenders do not share the same capital concerns, but there could be some benefit to lenders if the fee structure differs between bilateral and CCP transactions.

“In this new age of capital requirements, if there is a two-tiered pricing model with CCPs being the better deal because borrowers get better capital treatment, and they’re willing to split some of that improvement with the lenders, then there would be an economic incentive for lenders to go to the CCP,” says Galper.

While CCPs may be a better deal for borrowers, there is little data to show that moving to this model has become a reality yet. The move to CCPs is likely to be the result of a herd mentality, as a fragmented market with some using CCPs and some not would make it more difficult to engage in securities lending. One possible push could come from regulators mandating the use of CCPs, as they have done with OTC derivatives transactions, and more recently, the Financial Stability Board recommended using CCPs for repo transactions.

“If regulators go to look at CCPs for repo, they’re probably going to look at it for securities lending too. It would make sense to look at both together although it may not happen that way in practice,” says Galper.

Other factors such as margin requirements may play into the decision to use CCPs, but Finadium sees the primary focus coming from a capital perspective.