Credit quality is the lifeblood of banks. Understanding business models and structuring credit to support them is the key to a successful bank. Unfortunately, in the custody world, credit is being abused. Quite simply, the eagerness for unbundling, on both client and supplier side, albeit for diametrically opposed reasons, could lead to increased liquidity risks especially across the broker-dealer segment.
Some enthuse about unbundling as a way to reduce settlement cost. But, if it is at the risk of financial stability, that is highly dangerous. Others, mainly on the supply side, see unbundling as a tool for added revenues, but, if it risks degrading client credit quality, such value is illusory.
The key credit under discussion is settlement liquidity. It has never come free or unlimited. Intraday risk is a component of settlement pricing on transactions while asset-servicing risks are covered through ad valorem fees. For most banks, were they to place a cost on intraday settlement facilities, they would look at the yield curve between the overnight and, most likely, three-month fixed markets. And to that base cost they would add the cost of risk, which would vary from day to day according to their own exposures, credit model and risk assessment of the relevant potential borrower.
Unbundling settlement operational cost from liquidity is simple in theory. In many markets, where brokers self-clear, it is already happening. Brokers get intraday settlement limits from banks to cover their exposures in the relevant settlement systems. The trouble with such structures is two-fold. In some systems, the number of settlement banks that can be used is limited, and this creates a dangerous dependency between the broker-dealer and its effective monopoly provider. The broker-dealer can generate alternative liquidity through other lines or through intraday repos and other transactions, but any shortage of supply, even temporary, in many systems can be highly visible to the outside world. Delaying settlement through a short-term, even momentary, liquidity deficiency is highly dangerous and can have an adverse effect on the availability of alternative sources of funding. And that leads to the second problem with this structure, which is that many of the lines are on demand and thus not dependable.
When a broker transacts through a clearing agent, their agent bank will have a fundamentally different approach to their credit. They still depend on the robustness of the broker for repayment, but, short term, the settlement over their books repays the intraday exposures they incur through the vagaries of settlement flow. A lien, or alternative method of charge, is normally taken over the broker assets. A view is formed about the quality of settlement, whether suitably distributed across clients and counterparties, government debt dominated by value or equity biased, and then across major stocks or not. In other words, allied to a clear understanding of the likely maximum exposures needed, for instance for caps in the future T2S environment, the clearing agent has a sound understanding of the broker business model, credit need and sources of repayment. Although direct capital may not be needed for the intraday exposures assumed, the aggregate of intraday risks does affect capital structures as well as bank funding strategies. The fee income earned across the brokerage relationship drives the credit appetite of the supplier for exposure to intraday and longer-term facilities. Although there is no religiously upheld direct lien between liquidity provision in a market and clearing facilities, there is a link between fee income and such provision. As all banks seek to deleverage and cull credit-dominated relationships, the availability or dependability of standalone intraday facilities will continue to be under scrutiny.
The key brokerage challenge is the imperative for the broker, over time, to have secure sources of intraday funding. A result of the unbundling process and charging for risk is the likelihood that such credit will be at bank option and subject to bank credit assessment from time to time. A clearing agent will recognize, in their fixed rate cost of settlement and the term nature of such arrangements, that they have a moral, if not legal, obligation to support normal activities of the relevant brokerage house on a term basis and at a constant price. It is doubtful that such commitment is maintained in the unbundled structure. Short-dated credit facilities should be seen as the equivalents of any proposed standalone liquidity lines. Their cost can vary dramatically, with perhaps CDS prices being a realistic surrogate for likely price volatility. And their availability will be unbundled from the actual settlement flows, and credit appetite is also likely to be less flexible.
On the custodial front, the bulk of facilities need to be unsecured, but, for most buy-and-hold firms, demand is more modest than for the brokerage sector and thus the challenge of gaining unsecured and reliable facilities that much simpler. However, firms that have substantial broker-dealer flows, whether ICSDs or global custodians, could well find the issue more of a challenge in the future.
In the prime brokerage market, especially, the regulators have voiced concern at the mismatch of assets and liabilities. In the settlement environment, would not a similar assessment mean that brokers and other firms may need to show more clearly that they have adequate liquidity sources for a term period to cover day-to-day settlement demand? Although a term arrangement for clearing may go some way to satisfy such concerns, especially where notice periods are enshrined in the agreement, an unbundled one with a separate on-demand source of liquidity may, sadly, prove insufficient.