High Line Advisors LLC

management ideas for banks and broker-dealers

Money fund and repo reform: fix both for the price of one

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While the SEC concerns itself with reform of money market funds and the Federal Reserve calls for reform of the tri-party repo market, let us recognize the link between the two and the potential to address both concerns with a single solution: cleared repo.

Money funds need a safe place to invest without credit risk, without the need to manage or liquidate collateral, and with guaranteed return of cash on schedule.

While the tri-party repo market remains central to the lending of cash by corporations and mutual funds largely to banks and broker-dealers, it remains subject to credit shocks and concentrates liquidity demands on the two agent banks without the responsibility or the means to liquidate collateral.

Moving the repo market onto a central clearinghouse or counterparty (CCP) can be done in such a way as to  to insulate lenders from collateral management and default risk, while at the same time eliminating daylight exposure for banks.

With the core of money fund investment (lending) going through a CCP, the SEC can have both transparency and confidence in fund liquidity. Likewise, the FRB can share in that transparency as well as the certainty that loans are continuously backed by collateral.

SEC’s Schapiro Cancels Vote on Money-Fund Curbs – WSJ.com http://on.wsj.com/PdEAs0


Written by highlineadvisors

August 23, 2012 at 1:28 pm

Clearstream GSF 2012

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Clearstream Global Securities Finance Summit 2012

Market Observers’ Panel, Luxembourg, 18 January 2012
Remarks made by: Jeff Penney, Senior Advisor, McKinsey & Company


As the first “market observer” on this panel, I’d like to give an overview of the current state of funding activity, primarily from a US perspective.

For me, four questions frame the issues for our panel:

  1. How can lenders be certain to get their cash back, despite weakened borrowers?
  2. How can banks achieve better capital efficiency despite more stringent requirements?
  3. How can collateral be expanded in illiquid markets? And finally,
  4. How can regulators get the transparency they need?

These are not trick questions. But they may share a common answer.

Audience question #1.

I’d like to begin by putting a question to the audience. Most everyone here is involved in securities finance as a borrower, lender, regulator, or industry observer like those of us on this panel. The question is: what is your primary concern with financing? I give you five possible answers:

  1. Access (the availability of cash)
  2. Durability (the term, reliability or stability of funding)
  3. Credit (of the borrower, or the agent lender or triparty custodian)
  4. Collateral (its form, liquidity, haircuts, or rehypothecation)
  5. Operational risks (valuation, collateral substitution, or timing)
Audience voting results

Audience voting results

Most of the concerns we’ve just listed are present in the system of financing we have today. The securities funding transactions we rely on are collectively referred to as the “shadow banking system,” a term that casts a negative light on the markets. It may be bad news to some that the shadow banking system is not going away. The good news is it can be made far safer than it is today.The shadow banking system is not going away.

Part of the concern about shadow banking is that it is not well understood. In a paper published just over a year ago entitled “Regulating the Shadow Banking System,” Gary Gorton and Andrew Metrick of Yale University provide a useful definition of “the main institutions of shadow banking:

  1. money-market mutual funds to capture retail deposits from traditional banks,
  2. securitization to move assets of traditional banks off their balance sheets, and
  3. repurchase agreements (“repo”) that facilitate the use of [collateral] in financial transactions as a form of money.”

Even if securitization activity is muted, money market mutual funds and the repo market are deeply embedded in our financial system and critical to its functioning.

Use of the term “shadow banking” has evolved since the financial crisis. Lately, it’s being used by banks to label high margin businesses such as securitization and direct lending that banks fear losing to unregulated entities like hedge funds.

This situation should not deter us from making improvements to the money markets. Secured lending is the means by which people with cash to invest, including individuals in retail mutual funds, look for returns by making short-term, collateralized loans.

Secured funding is not so secure anymore.

Unfortunately, market participants think that “secured funding” is not so secure anymore.

Before I became an advisor, I managed an equity finance and prime brokerage business. In managing risk, my first rule was to never finance something I did not trade. Because when a borrower defaulted, the only way to get the bank’s cash back was to liquidate the collateral that was pledged to secure the loan.

If you are comfortable with the collateral and the haircuts you’ve applied, you don’t care as much about the credit of your borrower or counterparty. The problem is that most lenders are NOT comfortable with collateral, and feel much more exposed to the credit of the borrower and its ability to return the lender’s cash.

Credit concerns persist.

Concern about credit is at the core of the liquidity crisis today. No one wants to make a loan that will be paid back with collateral rather than cash. The inability to trade collateral — not knowing what its worth or where to sell it — means the lender is exposed to the credit of the borrower.

Professor Gorton uses the term “information insensitive” to describe the type of collateral that is most attractive for securing loans. If the collateral is well understood and no market participants have an information advantage over others, lenders can be more confident that they will get their cash back.

Government securities used to be the best collateral, with the least sensitivity to information. Mortgage securities became “information sensitive” during the financial crisis, and hence were no longer accepted as collateral. Today, sovereign bonds have become “information sensitive,” and their value as collateral has been impaired. (I highly recommend Gary’s book, “Slapped by the Invisible Hand” as a walk through the valley of shadow banking.)

When the collateral isn’t good enough and the credit rating of the borrower is weak, cash lenders withdraw from the system. This is the slow-motion “run on the banks” we are currently experiencing.

A growing number of market participants will protect themselves by withholding their cash. For example, US mutual funds have reduced exposure to European banks and sovereigns, putting pressure on dollar funding and forcing Europe’s central banks to intervene further.

In the repo market, lenders are still able to single out individual borrowers and cut off their sources of funding, even when those same borrowers have adequate collateral to post. This situation occurred very recently after the failure of MF Global. Access to liquidity is once again the critical concern of banks and broker-dealers.

Liquidity concerns now outweigh capital adequacy.

So much regulation has been concerned with capital adequacy rather than liquidity. Felix Salmon of Reuters, in his blog entry of November 25, 2011, put it quite concisely:

“Give an insolvent bank enough liquidity, and it can live indefinitely. Remove liquidity from a bank, and it dies immediately, no matter how solvent it might be or how high its capital ratios are.”

Despite the early focus of legislation on capital, regulators seem to be turning their attentions to the liquidity problems facing banks and broker-dealers.

The US repo market has far to go.

The US market itself has far to go in terms of improvement. Everyone here is no doubt aware that in May of 2010, the Federal Reserve Bank of New York authored a white paper on the tri-party repo system and convened a task force to address a number of concerns raised in that document. The taskforce has not disbanded, but may have reached reasonable limits of its ability to address the regulator’s concerns.

On a positive note, the taskforce developed a 13-point confirmation matching process that has reduced trade breaks. Perhaps the most important achievement was agreement to eliminate the unwind process in longer-dated repos, allowing for collateral substitution rather than a complete termination and restarting of the transaction. The taskforce also sped up the timing of trade allocations.

Some critical concerns of the regulator remain unaddressed. The most important issue is intraday credit exposure borne by the tri-party banks on new transactions. Another concern raised by the regulators is the “pro-cyclicality” of collateral. Pro-cyclicality points to changes in the value of collateral over time, and the unreliability of static haircut schedules. In fact, the regulator suggests that static schedules led to substantial over-leverage, particularly on certain types of collateral that was not eligible for funding directly from the central bank.

One option of the regulator is to limit the forms of collateral in the tri-party system, which would be very disruptive. Better to find a robust solution that increases, rather than decreases, the acceptable forms of collateral.

Cleared repo is a viable solution.

A successful repo solution will have to do three things.

  • First, each item of collateral must be evaluated independently rather than relying on haircut schedules. This approach requires an understanding of the liquidity and volatility characteristics of each individual collateral security.
  • Second, there must be robust procedures for the liquidation of collateral and return of cash to lenders.
  • Third, collateral substitution should be used in place of rehypothecation to minimize intraday credit exposure. The agent bank should release cash or collateral only as other collateral comes in. To give borrowers and lenders adequate flexibility, the systems must support multiple intraday settlements, rather than one large settlement at the end of the day.

Tri-party repo reform will never address the risk of a run on any single bank or broker dealer that can occur in a bilateral, OTC system. As a practical matter, the new technology required to support these three issues (security-level valuation of collateral, liquidation mechanics, and intraday settlement of substitutions) will take years, given the pressure on bank earnings and other compliance requirements.

The next question is whether renovation of the tri-party system is really the answer, or whether we should introduce an entirely new architecture based on central clearing.

A central counterparty clearinghouse for repo, or CCP, solves these problems. The European model has proven this theory in recent weeks, as US borrowers cited cleared repo in Europe as their most reliable source of funding when they were excluded from the bilateral system in the US on the basis of their perceived credit rather than their collateral.

Capital efficiency can be achieved through a CCP.

When liquidity is stabilized by a CCP, we can turn our attention to capital efficiency. Bank capital is under increasing pressure from regulation, and banks are concerned a CCP will raise collateral requirements, adding to the squeeze on capital.

This fear may be justified in the short term, but in the long run, CCPs can provide capital efficiency in the form of margin relief, if they clear the right combination of products.

No CCP risk manager will provide margin relief across asset classes. The correlations, volatility, and liquidity characteristics are not reliably predictable. And, diversification as a risk reduction strategy has limited value in today’s markets.

Margin relief is only possible from offsetting positions in the same security. The most directly offsetting trade combinations are a derivative and the transaction that funds it. When the funding trade ends and its collateral can be used to settle the derivative at maturity, the risk in the transaction is reduced dramatically.

In an example provided by the Options Clearing Corporation (OCC), the net margin requirement for government bond repo plus a short interest rate futures position of comparable maturity would be 70% smaller than if the two trades were margined separately. The lower margin requirement is made possible because the bond can be delivered into the futures settlement.

A cleared repo solution can drive margin requirements down when it shares a CCP with the related derivative products. This is the fundamental reason that banks should support putting more, not less, into central clearing.

Collateral can be expanded to include equities.

I serve on the Advisory Board for Quadriserv in the US, where we’ve found another opportunity for margin relief: specifically, when a position in equity options is hedged with stock borrowed through the same CCP. The margin requirement for the two positions combined is dramatically lower than for the options position and stock loan viewed separately.

Where funding is concerned, there is no difference economically between an equity repo and a stock loan transaction. Financing of bonds as well as equities can be served by the same solution.

The closing of SecFinEx has raised questions about whether a CCP model for stock loan can succeed in the US. In contrast with Europe, the US has the advantage of a single currency, one CCP, and one settlement processor in DTCC.

It now appears that the major leap forward in equity finance will not come from changes to customer stock loan, but from the expansion of equity repo among dealers. It is interesting that a solution intended for stock borrowers can also help cash borrowers, but the immediate need for interbank funding is more likely to drive the success of a CCP for equity finance than stock loan market reform. While market participants have resisted change to tri-party repo and stock loan conventions, the prospect of funding equities through a CCP has generated a more enthusiastic response.

Collateral Expansion

Collateral can only be expanded if it is “information insensitive” and fungible. Different collateral securities can become equivalent by applying the appropriate haircut to each individual security. In this scenario, CUSIP or security-level risk management is required not only to set haircuts as a function of liquidity and volatility, but also to liquidate securities.

A CCP with security-level risk management can handle bonds and equities alike. Ultimately, linkages between CCPs can allow for collateral to be moved in support of obligations in other markets, asset classes, and currencies. This is the ultimate vision of cleared financing.


In summary, I’ll return to the four questions I posed at the top:

  • First, How can lenders be certain to get their cash back, despite weakened borrowers? A CCP can guarantee the return of cash and provide an anonymous platform for borrowers who produce adequate collateral.
  • Second, How can banks achieve better capital efficiency despite higher requirements? Capturing financing along with related derivatives within CCPs allows for dramatic margin relief and return of capital.
  • Third, How can collateral be expanded in illiquid markets? Rather than relying on schedules, central risk management that applies haircuts to individual collateral securities can pave the way for CCP-based equity repo as a compliment to the current systems.
  • And finally, How can regulators get the transparency they need? To my mind, there’s one answer for all four of these questions: CCPs provide a single point of contact for regulators to evaluate the number of transactions, the parties engaged in them, and the adequacy of the collateral pool. The CCP also provides a focal point for central bank support, should it become necessary.

Perhaps most exciting for the future of our industry is the vision for CCPs to connect across border to meet the needs of borrows for cash and lenders for secure returns.

Written by highlineadvisors

January 28, 2012 at 5:06 pm

What constitutes a “full-service” Equities business?

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[Part 4 of Equities Context and Content]

Mature Equities businesses offer a complete array of products and services under the umbrella of Equities. The full-service Equities model incorporates five diversified business lines, each of which has a set of products and services that capture revenue in various forms:

    Origination business based on corporate relationships, resulting in direct underwriting and placement fees and indirect revenues from investor clients seeking to participate in their allocation. Examples include: common and preferred equity, convertible bonds, and private placements.
  2. FLOW
    Agency risk transfer business resulting in commissions and the potential for reduced expenses due to internalization. Examples include: “high-touch” and/or electronic order handling in cash equities and listed derivatives.
    Financing businesses resulting in accrual of spreads in excess of cost of funding. Examples include: prime brokerage, securities lending, repo, and OTC derivatives.
    Principal trading businesses, including market-making and client facilitation, resulting in revenues from bid/offer spreads and directional risk-taking. Examples include: underwriting, block trading, aspects of program trading, listed options market-making, and certain proprietary trading strategies.
    Low-risk, operationally-intensive agency business resulting in fee income tied to balances or transactions. Examples include: custody, administration, cash and collateral management.


A comprehensive offering allows such firms to compete globally for all client segments and to address the entire available revenue pool. As shown in Table 2, McKinsey estimates the global revenues that may be directly linked to Equities at over $120 billion in 2010.

Figure 2 illustrates the five Equities business lines in a way that circumscribes the revenue pool:

Table 2

Table 2: Equities-related revenue pools / Figure 2: Equities revenue map

Diversification can reduce earnings volatility and reliance on new issue activity. Of the five dimensions, flow commissions in cash and derivatives account for 39% of the pool, a fact that leads all competing firms to focus on execution capability. With more than twice as much revenue at stake overall, diversified firms not only access the related pools, but may also have an advantage competing for flow.

The capabilities or limitations of a larger firm directly impacts the ability of its Equities business to compete in each of the five dimensions. For example, the firm’s ability to allocate balance sheet and capital to its Equities business allows Equities to offer financing products or to carry inventory in convertible bonds. Similarly, Corporate Banking could drive new issue supply through the Equities business via its capital markets efforts.

Written by highlineadvisors

November 9, 2011 at 12:41 pm

Why does the firm context matter?

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[Part 3 of Equities Context and Content]

There are five bank or broker-dealer businesses that can significantly enhance a firm’s Equities business. The capabilities and resources “owned” by these other business units can provide a competitive advantage in attracting equity investors:

    Direct lending and corporate finance can produce two of the resources most valued by investors: new issues and access to corporate management. The Equities business can in turn provide market color on previously-issued equities and related derivatives to bankers and their corporate clients, earning mandates for share repurchases and block trades. The two business units can also share the cost of Research within applicable regulatory limitations.
    Retail can be a powerful contributor to an Equities business through the direction of order flow and stock loan balances. A captive source of liquidity and commissions provides a boost to the sales and trading unit, and a unique supply of hard-to-borrow securities can differentiate the prime brokerage unit. A retail distribution network may be viewed favorably by both corporate clients awarding new issues and block trades, and asset managers seeking capital.
    Trading capabilities in complimentary asset classes can provide research, market color, and occasional trade facilitation for equity investors. Single-name credit products such as corporate bonds and credit default swaps can provide investors with deeper insight into corporate capital structures. Index, currency, and rate products offer investors a means to hedge macro exposures in their portfolios. Commodities trading expertise can also provide macro insights as well as deeper understanding of companies in the energy, agriculture, and metals sectors. Broader trading capabilities can provide solutions for cash and liquidity management in repo, government securities, and corporate commercial paper.
    Custodial Banking can strengthen relationships with both corporate and investor clients. On the corporate side, credit lines, treasury services, cash management, and payments processing can lead to increased access to management and participation in new issues. On the investor side, clearing, collateral management, custody, securities services, and fund administration can result in operational dependencies between the firm and its investor clients. Banks with a deposit base may enjoy a higher credit rating, thereby enhancing the ability of an Equity business to compete in prime brokerage and over-the-counter derivatives.
    There are a number of regulatory constraints and perceived conflicts that weigh on the synergies between an Equities trading business and a related Asset Management subsidiary; however, a percentage of agency order flow from the Asset Management arm may be directed to the Equities business, and access to stock loan supply can support its prime brokerage and derivatives trading efforts. Partnership in the creation of equity-linked ETFs and structured notes can generate product supply for retail and wholesale investors. Apart from trading, Asset Management provides a means to monetize Research, in some cases alongside of investor clients.

Figure 1 illustrates some of the contributions of these five business units to the traditional business of Equities and its clients:

Figure 1

Figure 1: How Firm Context for Equities Enhances Investor Value

Clients care about what a bank or broker-dealer can do for them overall, without concerning themselves with a firm’s internal product boundaries or management organization. When broader capabilities are called for, collaboration with other internal business units becomes critical to the success of the Equities franchise.

What do investor clients really want?

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[Part 2 of Equities Context and Content]

The needs of investor clients are complex and involve much more than the execution of orders. By convention, clients rely on their execution commissions (and, in some cases, financing balances) to obtain additional resources from their brokers. As clients ascribe less value to pure execution, they are directing the bulk of their commissions toward more valuable services and scarce resources.

Table 1 shows the capabilities of a bank or broker-dealer, some or all of which may be meaningful to an institutional investor:

Table 1

Table 1: Components of an Investor Client Value Proposition

The table also illustrates two challenging aspects of Equities businesses: First, that there is no direct revenue associated with many of these resources and services. Second, that these resources and services can lie beyond the traditional purview of Equities management. A successful Equities business must deploy the full capabilities of its firm and direct them at investor clients to access all potential sources of revenue, direct and indirect.

Equities Content and Context

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We are launching a series and associated white paper entitled “Equities Content and Context: Comparative Business Models Among Banks and Broker-Dealers.”

“Don’t get involved in partial problems, but always take flight to where there is a free view over the whole single great problem, even if this view is still not a clear one.”  —  Ludwig Wittgenstein
“What you see is what you get.” — Flip Wilson

Article at a Glance

Declining revenues and pending regulation are forcing firms to review their Equities businesses. Competing Equities businesses differ greatly from firm to firm in the breadth of capabilities. As a result, some firms may be unable to access revenue pools that make competitors appear more successful in comparison. A closer look at how a firm’s strengths appeal to specific client segments can reveal why an Equities business is underperforming relative to the market or its peers. An understanding of “boutique” models can provide insight for large banks and smaller broker-dealers alike, whether they are contemplating further investment or a pull-back.

The value of an Equities business to investors is largely dependent on the capabilities of the firm in which it operates. Despite an advantage in breadth of capabilities, large firms that fail to deliver a wide range of products may end up with boutique-like results. Small firms forced to compete on a limited product set can still distinguish themselves in specific market segments.

This article explores the following questions as they relate to managing an Equities business:

  • What do investor clients really want?
    What are the products, resources, and services that are most valuable to their business?
  • Why does the firm context matter?
    How can other business lines contribute to the success of an Equities franchise?
  • What constitutes a “full-service” Equities business?
    What do the largest, mature Equities businesses offer to clients? What additional revenues do they capture?
  • How is client value converted into revenue?
    How are products positioned as client solutions?
  • How do Equities businesses align with investors?
    Which clients is the firm most likely to attract?
  • What are the partial or “boutique” Equities business models?
    How do firms successfully differentiate? How can a regional or sector-based strategy succeed?
The article and its diagrams will be provided here in subsequent posts. If you can’t wait for the serialization, download the full article here.

Out of the Shadows: Central Clearing of Repo

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High Line Advisors has published a white paper entitled Out of the Shadows: Central Clearing of Repo – A Transparent Market Structure for Cash Borrowers and Lenders.

“Although personally I am quite content with existing explosives, I feel we must not stand in the path of improvement.” — Winston Churchill

Article at a Glance

Repurchase agreements (repo) are the largest part of the “shadow” banking system: a network of demand deposits that, despite its size, maturity, and general stability, remains vulnerable to investor panic. Just as depositors can make a “run” on a bank, repo lenders can take their money out of the market, thereby denying the lifeblood of cash to broker-dealers (stand-alone or those owned by banks or bank holding companies), which rely on leverage to operate.

The entire shadow banking system has been demonized as a place where loans are hidden within derivatives among nonbank counterparties rather than displayed on the balance sheets of traditional, regulated banks. In reality, the shadow banking system is a legitimate market for secured financing, in which cash is lent in exchange for collateral. Repo in particular has many positive attributes, including disclosure on the balance sheet; nevertheless, the financial crisis exposed several flaws in the secured financing markets in general and repo in specific, and the Federal Reserve System ultimately interceded with liquidity to prevent the further collapse of banks and broker-dealers.

While not categorized as a “derivative,” repo is an over-the-counter (OTC) contract that shares many key characteristics with derivatives, including a reliance on its counterparts to meet obligations over time. The inability of regulators to measure activity in OTC derivatives resulted in the passage of the Dodd-Frank legislation, which requires that certain instruments be moved to a central counterparty clearing house (CCP). As the nexus of all trades, a CCP provides visibility to regulators and credit intermediation for all market participants.

The benefits of central clearing are directly applicable to the repo market and are crucial to the global money markets that are relied on as a safe, short-term investment for individuals and institutions alike. Central clearing is needed to provide lenders with guaranteed return of cash without sensitivity to collateral or credit. A CCP also lays the groundwork for lenders to interact directly with borrowers in a true exchange with transparent pricing.

Central clearing of repo can also provide capital efficiency and more stable funding for banks and broker-dealers. Ultimately, a CCP for repo can evolve into a hub of funding activity for many forms of liquid collateral, thereby bringing the majority of the shadow banking system into full view.

Download a PDF of the article here.

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