GC Friday Interview: Marc Gerstein, Managing Director, Business Strategy at SL-x

SL-x recently gained regulatory approval to operate an on online trading platform for the securities lending and borrowing (SBL) market in Europe. The company, which plans to launch its online trading system for this market in May, says the system will enable transactions to be centrally cleared, thus creating significant operating cost savings by enabling participants to reduce the levels of capital they must hold to satisfy regulators, and to increase trading efficiency. Marc Gerstein, managing director, Business Strategy explains how this is possible.
By Janet Du Chenne(59204)
SL-x recently gained regulatory approval to operate an on online trading platform for the securities lending and borrowing (SBL) market in Europe. The company, which plans to launch its online trading system for this market in May, says the system will enable transactions to be centrally cleared, thus creating significant operating cost savings by enabling participants to reduce the levels of capital they must hold to satisfy regulators, and to increase trading efficiency.

To support the launch, Promontory Financial Group produced a white paper on the changing nature of agent lender indemnities under and the new capital rules. The white paper says that when the agent lender indemnifies the client against a qualified central counterparty, which is recognized by the regulator, or a qualified central counterparty’s (QCCP) contractual non-performance (e.g., in case of default) the risk based capital requirement is much lower than the capital requirement that would result from a similar bilateral transaction. On the other hand, says the whitepaper, a clearing member banking organization acting, as an agent for a client and that does not guarantee the QCCP performance would have no exposure to the QCCP and, accordingly, no risk weight would apply. In both cases, therefore, “providing the indemnification is cheaper for the AL in cases where the transaction is QCCP-cleared.”

Marc Gerstein, managing director, Business Strategy at SL-x explains how cost savings for agent lenders will be made possible in a centrally cleared world.

How do agent lenders’ indemnities decrease in a centrally cleared world?

MG: In (a bilateral market) in the event of the borrower defaulting the agent lender says they will make up the difference between the amount of money that you receive as collateral and the amount that it will cost to repurchase the stock on the market because if the stock has gone up in price in the meantime so there may be a gap in the amount of money [collateral] that’s available.

Now, lets fast-forward to a year in which there will be a central counterparty. The central counterparties are the regulators’ preferred market structure. They consider them safer, more reliable, having better information, more transparent, etc. And as a result, regulators have bestowed upon the qualified central counterparties a lower risk weight under Basel III and other rules, which means that the same nominal exposure on a risk weighted basis is much less expensive to an institution if that exposure is to a central counterparty than it would be if it was to an ordinary broker or some otherwise unrated institution. And so there’s a lot of money to be saved, which is a 97.18% saving on indemnities. [For example, the Promontory white paper explains that a risk weighting of 2% is used for an exposure to the QCCP.

This compares with capital charges for an agent lender under current implementation of the supervisory haircut approach and charges for an agent lender under the implementation under the Final Rules* of the supervisory haircut approach. Both of these approaches result in a blended risk weight of 80%, assuming that in both cases, 25% of collateral is put up by a counterparty carrying a 20% risk weight and that 75% of the collateral is put up by a counterparty with a 100% risk weight.

As the rules came out and people did the math and recognized that the capital costs associated with providing indemnities were going up dramatically, the immediate solution that was put forward in conference after conference was that the best way to solve the problem was to pass the charges associated with the increased capital onto the beneficial owners. Having looked at the capital problem we decided that if this becomes a centrally cleared world, one has two options: one is to take the regulator’s intent quite literally and abandon the need for indemnities entirely because the central counterparties were more reliable. We believe that is the preferred option because qualified central counterparties are the preferred solution and for a whole bunch of reasons we think they are dramatically safer — they are at the center of most fixed income equities, futures, options and swaps trading.

So we think that going without this protection is perfectly straightforward and certainly an intelligent option for people to consider. The other option is that if, for whatever reason, the beneficial owner either is required to or prefers to continue with the indemnity, in a centrally cleared world, according to the Promontory study, the amount of capital that has to be put up against that indemnity is a tiny fraction (3%) of what it would cost if that indemnity were to be offered in the over the counter world, by exactly the same math that causes the risk weight to be lower. It’s the same exposure, and there is a saving of 97% of the costs. So from our point of view, while going without an indemnity is a perfectly straightforward decision, and we think a rational one, any beneficial owner who would prefer or is required to have an indemnity, should be able to get one even if they have to pay for it at a tiny fraction of the [OTC] costs.

If it’s a small charge then who pays for it is much less of an issue and people can go on with their business without having to put nearly as much energy into figuring out where the money is going to come from.

In our business we think we have a compelling business proposition with the technology we have created and a marketplace with transparent information. So we think there are advantages in the transition that we are articulating, but on the issue of indemnities, which are one of the sticking points when the new rules go into effect for the over the counter market, we think there are good reasons to prefer the centrally cleared solution because it makes that problem far less worrisome because the costs are much lower.

For banks that are subject to the leverage ratio and are bound by it the benefits of the risk weighting that I am describing don’t apply in exactly the same way. That has to do with the fact that the regulators have said we are going to judge you by two standards: the leverage ratio and the risk based ratio and you have to come up with the capital for the higher of the calculations, whichever they happen to be. But even for leverage bound banks, if the indemnity disappears – [that is] if the agent lender no longer guarantees the performance of the central counterparty — then the costs disappear entirely.

There are no capital costs, because if you don’t make a promise they can’t charge you capital for the possibility that you may have to pay up, and that’s the entire story. One way or another this goes from a problem that consumed a great deal of attention to something that shouldn’t be a problem.

How does the SL-x model enable agent lenders to lower their capital charge?

MG: Our business proposition is based on three components. First we have a rich and innovative front-end transaction and negotiation and trading system that is designed specifically for the securities lending market place and a number of features are patented. It enables people to do things that they could never do before, which are very important. They can negotiate differently. They can operate on a variety of different ways of revealing their identity or remaining anonymous. There are a whole bunch of things you can do that you can’t do in an over the counter market, including simultaneous negotiations with multiple people. In addition, we’ve made a significant investment in automation technology. We can give people a preview of what they would get if they run automated matches against the available supply, which is something they can’t do in the current market place, and that’s also patented. With our system you can keep adjusting those parameters because it’s not just a price driven market: its price and collateral, and there are lots of different elements to the combinations you can create. At the other end, at the back end of the system, is the connection to the qualified central counterparty. And that connection is what provides the capital savings on the indemnity side or on the prime broker side, which are substantial.

The third proposition is subtle, which is the creation of the real time marketplace that connects borrower and lending institutions. In the over the counter market, there is very little transparency. People don’t know what’s going on in the market place and they only find out what other people have done a day or a day and a half later when other information providers produce information on what’s happened the day before. So unlike people who trade equities or bonds and look at a screen to see what’s going on, this is a market that lives in the dark for 24 hours. Our system has many elements of a real time marketplace, although the market participants are very clear in their desire not to have pre-trade transparency because price is not the most important factor in these transactions.

So we designed the system to support the way that this business actually operates in which lenders are always lenders and borrowers are always borrowers. It’s a marketplace where people play their traditional roles as opposed to a traded marketplace like equities in which the same traders are both buyers and sellers at every point in the market. So you can imagine, of course, when you create a real-time marketplace some people will change the parameters upon which they are trading based on what they need, and the market will move depending on the interests of the participants. In that environment there are going to be people who have a view into that market place, the participants in the system. And those people who are not participants in the system will not have a view about that real time market place until the day later when they get the information in the usual way. So we believe, based on other marketplace experience, that there will be variations between the real time market and the historical market that begin to emerge, and that will draw interest from the over the counter market into the real time market.

How do you see indemnities evolving in a centrally cleared world?

MG: I’m hoping that the stock lending community will evolve to the point where they don’t see this indemnity as necessary at all. I think the community in general wants to have confidence that the markets are fair and reliable and robust. The QCCPs are the regulators preferred mechanism for ensuring the markets are safe, and the reason they can do that is that they are designed for that purpose. They are designed to be reliable even if there are failures of a number of clearing members that constitute the participants in that clearing
house; that is, they are robust in the face of these failures. In the case of Lehman Brothers, the centrally cleared portion of the holdings that Lehman had were successfully and quickly dealt with. So that was an early indication, and the rules that exist today are more robust than the rules that existed then. I would like to see a day that the indemnity is history because all participants see it as unnecessary.

*On July 6, 2013, the Board of Governors of the Federal Reserve System (Federal Reserve) and other U.S. banking supervisors issued final versions of several of the June 2012 proposed rules on regulatory capital. Federal Reserve and other US banking supervisors noted that aspects of the capital framework impacting repo-style transactions are still under discussion at the Basel Committee on Banking Supervision (BCBS). It is therefore likely that the new US Final Rules will be modified when international agreement is reached at the BCBS.

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