High Line Advisors LLC

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Posts Tagged ‘clearing

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.


The “Clearing” Broker vs. The “Prime” Broker

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We are often questioned on the definition of “prime brokerage.” The various names by which banks and broker-dealers label a collection of products and services (prime services, prime finance, equity financing and services, etc.) hint at the fact that there is little consistency among market participants. The scope of such business units variously includes or excludes execution, clearing, and/or financing of physical securities (equity and fixed income), OTC derivatives, and listed futures and options. Inconsistency makes it difficult for regulators to measure and for managers to benchmark themselves to competitors.

In the article entitled The Future of Prime Brokerage, we suggested that prime brokerage could be defined as the center of both client service and secured funding for a bank or broker-dealer. With stock loan, margin lending, and total return swaps all essentially exchanging equity securities for cash or vice-versa, consolidating the management of these secured funding transactions (along with equity repo, forwards, and high-delta options and option combinations) minimizes risks and optimizes the balance sheet. We also suggested that this concept can be extended beyond the equity asset class into liquid fixed income securities that are financed via comparable instruments (usually repo).

We also argued that prime brokerage can be the consolidation point for client activity across the bank or broker-dealer, thereby facilitating reporting, portfolio-level financing, and consolidated margin. In so doing, prime brokerage provides the single point of post-trade client service for all institutional investors.

Prime brokers generally do the clearing for trades that they accept from executing brokers on behalf of their clients. The scope of the prime brokerage relationship is defined by the set of products that the prime broker can clear. At a minimum,  prime brokers clear cash equity trades themselves (“self-clearing”) rather than relying on a correspondent. Many prime brokers also accept listed equity derivatives, which gives their clients more flexibility and convenience. Some primes (such as NewEdge) emphasize clearing of listed derivatives.

The enactment of the Dodd-Frank legislation in the US has brought focus on the clearing of listed derivatives. The management of listed futures and options clearing within banks and broker-dealers varies, which may affect the product scope of the prime brokerage offering at a bank or broker-dealer:

  • Alignment with institutional equities builds on the core knowledge of exchange mechanics and electronic trading in the equities business;
  • fragmentation by asset class puts profit and loss from various contracts into the related product area, e.g. revenue from interest rate futures booked into the rates business and from equity index futures into the equities business;
  • management as a stand-alone business line (including execution and clearing) due to the unique nature of listed derivatives and their risk and collateral requirements over the life of the contracts;
  • alignment with traditional prime brokerage businesses, for management of portfolios using listed derivatives for risk mitigation and serving firms who borrow securities and cash in support of market-making activities.

As banks and broker-dealers seek to optimize their respective balance sheets and capital requirements, just as institutional investors will seek portfolio-level margin and consolidated service and reporting, the distinction between the “prime” broker and the “clearing” broker may vanish. With more products moving to exchanges or central counterparties (CCPs), centralized optimization of the bank or broker-dealer’s funding in the context of CCP requirements and heightened controls over customer collateral is critical.

We advocate the management of clearing activity for all trading products within the prime brokerage or prime “services” operation. The definition of “prime brokerage” then extends to three specific utilities across global markets:

  1. Securities finance
  2. Client service
  3. Clearing

Of these functions, securities finance compliments a sales and trading (execution) business in the related securities, usually equities. Similarly, clearing compliments an execution business in listed derivatives. Among various banks and broker-dealers globally, players may emphasize one or the other, or both lines of business. For example, European banks operating in the US may be significant players in listed derivatives but not in cash equities, favoring a prime brokerage business built on clearing. Smaller broker-dealers may deal in cash equities but not derivatives. With a smaller balance sheet, such broker-dealers may emphasize the client service aspect of prime brokerage and source financing for their customers in the wholesale markets. The largest banks may have the largest scope, serving clients active in cash as well as derivatives, from execution through to clearing and custody.

When should execution as well as clearing, custody, and secured financing be a part of prime brokerage? We would suggest that when financing of an asset is the primary component of setting price (spread) and margin (haircuts), then the execution component of the product is a candidate for integration with prime brokerage in order to apply common practices for secured lending transactions. Incorporation of execution functions may be difficult for prime brokerage businesses built on post-trade margin financing, just as it may be difficult for fixed income repo or equity derivatives trading desks to appreciate the commonalities of their products with margin and securities lending.

If prime brokerage is used as a firm-wide utility and not as part of a product silo, broader linkages to execution services (defined by electronic trading tools, exchange connectivity, and clearing) allow for straight-through-processing and better operating leverage for banks and broker-dealers. By increasing the number of products that a covered by clearing, financing, and reporting, the prime broker will have a more complete value proposition for asset managers and a greater ability to manage collateral and risk exposures.

A final note on the distinction between the clearing “function” and the clearing “platforms” at a bank or broker-dealer. The clearing “function” is performed on behalf of trading clients and may require financing (the lending of cash and/or securities) to facilitate settlement, either of which are a natural fit within prime brokerage. The clearing “platforms” are the technologies on which the clearing is done. The management (maintenance and operations) of the platforms may be performed outside of prime brokerage, such as within the GTS business of Citi, or the TTS business of JP Morgan. In these instances, the platforms may be used by the firm’s own global markets businesses as well as offered to the firm’s other clients, who may be broker-dealers themselves.

Written by highlineadvisors

October 18, 2010 at 5:03 pm

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