High Line Advisors LLC

management ideas for banks and broker-dealers

Posts Tagged ‘non-market risk

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.

Streamlining Equities

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High Line Advisors has published an article entitled Streamlining Equities: Ten Operating Strategies for Competing in Today’s Markets. A PDF of the article is available here.

“Whosoever desires constant success must change his conduct with the times.” — Niccolo Machiavelli

Article at a Glance

Equity sales and trading (“Equities”) is a core business for many banks and broker-dealers, on its own merits and because of its synergies with corporate banking and wealth management. Like all capital markets businesses, Equities under increasing pressure from electronic trading, reduced leverage, increased capital requirements, regulation of over-the-counter derivatives, and limitations on proprietary trading.

New operating conditions call for a leaner operating model to protect revenue and maintain growth, starting with a reevaluation of the product silos that require so many specialists. Profitability also depends on the firm’s ability to deliver resources to clients and capture trades with greater efficiency. Success requires re-thinking the entire legacy organization, looking at new ways to combine or expand roles, and reevaluating the skills that are needed on the team.

These ten initiatives in sales, trading, and operations, can help management streamline the Equities organization for greater top line revenue and increased operating leverage:

  1. Recast “Research Sales” for delivery of all products and firm resources
  2. Create “Execution Sales” to maximize trade capture across products
  3. Rebalance Coverage Assignments to foster team selling for client wallet capture
  4. Fortify Multi-Product Marketing to maximize product penetration and client wallet share
  5. Deploy Sector Specialists to generate alpha and raise internal market intelligence
  6. Implement a Central Risk Desk to consolidate position management and client coverage
  7. Merge Secured Funding Activity to manage collateral funding and risk
  8. Centralize Structured Products to eliminate redundancy and internal conflict
  9. Reengineer Client Integration for speed and control of non-market risks 
  10. Normalize Client Service to eliminate duplicate processes and improve client experience

Rules of Prime Brokerage Risk Management

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We’ve assembled a list of guiding principals for managing risk in a prime brokerage business, covering the areas where prime brokers are most likely to get into trouble. We encourage the community to contribute to or debate this list. Anonymous contributions may be emailed to feedback@highlineadvisors.com.

  1. Margin Lending: Don’t finance what you don’t trade. If you don’t have price discovery or can’t orchestrate a liquidation of the collateral, don’t make the loan.
  2. Margin Lending: Lend against assets, not credit. The ability to value collateral should be a core competency of any prime broker or repo desk, while expertise in credit extension (unsecured lending) is not. Be aware of the boundary between secured and unsecured risk, as lower margin buffers increase credit exposure in extreme (multi-sigma) market events. If you don’t have possession (custody) of the asset, don’t finance it.
  3. Margin Lending: Finance portfolios, not positions. Diversification of collateral is a significant risk mitigator.
  4. Margin Lending: Accept everything as collateral, but don’t necessarily lend against it. Cover your tail risk with a lien on anything you can get, but don’t add to the problem by lending against less liquid positions.
  5. Margin Lending: Be aware (beware) of crowded trades. The liquidity assumptions used to determine margins may be insufficient when like-minded hedge funds simultaneously become sellers of the stock. This goes beyond positions in custody, but those held by other prime brokers as well. Ownership representations are reasonably required.
  6. Secured Funding: Eliminate arbitrage among similar products. Maintain consistent pricing and contractual terms when borrowing securities or entering into swaps, repos, margin loans, or OTC option combinations with customers.
  7. Customer Collateral: Accept only cash collateral for derivatives. If non-cash collateral is offered, convert it to cash (via repo), apply only the cash value against the requirement, and charge for the cost of the conversion. Cash debits and credits are the best way to manage margin/collateral requirements across multiple products and legal entities.
  8. Contractual Terms: Treat clients that do not permit cross-default or cross-collateralization among accounts as if they were as many distinct clients. If you can’t net or offset client obligations, don’t give margin relief for diversification.
  9. Derivatives Intermediation: Do not provide credit intermediation unless you understand credit risk (again, most prime brokers do not) and charge accordingly. When intermediating derivatives operations, do not inadvertently insulate customers from the credit of their chosen counterparties.
  10. Funding Sources: Raise cash from collateral, not corporate Treasury. Strive to be self-funding, raising cash lent to customers from securities pledged by customers. Practice “agency” lending (from cash raised from customer collateral) over “principal” lending (from unsecured sources of cash, like commercial paper).
  11. Term Funding Commitments: Don’t be the lender of last resort unless you understand what it means, want to do it, and get paid properly for it. Only the largest banks with substantial cash positions under the most dire circumstances may be in a position to offer unconditional term funding commitments. Does any broker-dealer qualify?
  12. Sponsored Access: Have robust controls for high-frequency direct market access, including gateways to enforce trading limits.
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