Reflections of the CEO

Sustainability | Basel IV | UCITs 

As we begin to see what 2022 will look like from the perspective of our markets, we are already beginning to see several trends that are likely to dominate much of our work this year. However, amongst the expected regulatory consultations and inevitable focus on sustainability, I am also sensing something of a seismic shift that could potentially have far-reaching consequences for our industry, the relationship between lenders and borrowers.

The relationship between lenders and borrowers has always been complex; what looks like a simple loan of securities can be subject to distinct factors or variables that can alter the economics of a trade, as well as drive different risk and settlement profiles. Factors such as collateral acceptability, ability to engage in term transactions, and the tax position of the lender – they have all been material factors in channeling demand from borrowers. I have often said that ‘nobody ever lent a security that another did not want to borrow’.  To an extent, that is still true today however this relationship is changing.

Lenders in particular have to respond to the demands that the sustainability agenda is placing on the wider investment community. The ESG agenda is leading to a greater appreciation of active shareholder engagement in the form of voting, a better understanding of collateral from the perspective of sustainability, and a drive for enhanced transparency throughout the securities lending chain. In addition to these quite specific considerations in the context of securities lending, we are also beginning to see firms look at the sustainability credentials of counterparts at a firm or enterprise level. So-called ESG screening will mean firms may decide to reduce or cease trading with institutions that they feel are involved with brown or unsustainable products, companies, or industries. This could cause considerable disruption to our markets and potentially affect the availability of market liquidity to certain borrowers. Much of the work we have done in and around the sustainability agenda in the past twelve months, has been to build confidence across the investment community that it is possible to engage around these key areas but still actively lend securities.

For borrowers, the picture is also changing, as the arrival of Basel IV could deliver a very different looking securities lending market in the years to come. We have seen for some time now the importance of understanding your lending counterpart, and whether you can offset assets and liabilities in the context of bankruptcy close-out netting provisions. This simple premise has been the foundation of our legal opinions service. More recently however, there has been a greater appreciation of the exact legal form and status of one’s counterpart that has led to an increase in the breadth and depth of the lending counterparts we are being asked to consider in the analysis. This tells me that as firms look to implement the provisions of Basel IV and similar prudential regimes at the lowest level in their trading books, regulators are demanding more legal certainty to allow for the relevant capital treatment of a particular position or book.

Basel IV also brings with it significant changes to the way in which firms can calculate their residual counterparty risk profile, with new restrictions on the use of internal risk models. This means that in practice, lending entities that are unrated could face being charged at 100% Risk Weighted Assets (RWA) within the borrowers’ books. Without significant value in the trade, borrowers will most likely move away from these lenders unless they can moderate the impact of these changes on their capital usage. The most obvious way to do that at present is to switch these balances to a pledge collateral structure. However, as I have said before, UCITS, which probably represent the single largest asset construct in Europe, appear unable to accept collateral in this form. We note other initiatives to develop ratings for these institutions that would allow for more favourable capital treatments and continue to monitor developments closely.

As Basel IV begins to bite, we will see once again that UCITS are becoming further marginalised. Whilst this may appear a technical issue to some, the progressive impact on market liquidity within Europe will push lenders to look for an alternative supply of securities from outside of the region. I believe this raises important questions about the ongoing success of the CMU project across Europe and raises further questions about over market stability and systemic risk.

So, as we look at both sides of our market, it is clear that we are seeing different fundamentals shaping behaviour. Whilst I recognise and support what prudential regimes such as Basel IV and the wider sustainability agenda are there to achieve, it is important to think about unintended consequences and how we ensure that as we embrace these major regulatory and social initiatives, we don’t lose sight of the importance of what we bring to the wider capital markets eco-system.

In closing, I had one final thought. As we see growing complexity on both sides of the market, and at times the needs of the lender and the borrower diverging, perhaps it is time for a rethink of how market participants face each other…central clearing perhaps…?

Andrew Dyson

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