Could you talk about the development of ISLA, and how the association is progressing?
It was flattering to be asked onto the board, and I realise now, being from the inside, how many things the institution is doing. I think the regular and increasing development of the regulatory initiatives and dimension of the International Â鶹´«Ã½ Lending Association (ISLA) is absolutely remarkable. The association has managed to develop connections through networking with very targeted people within regulatory bodies.
Since I joined, I have been impressed by both the quantity and the quality of the contribution that ISLA is bringing to the market. There are a lot of things that the market doesn’t even see, but ISLA is permanently pushing initiatives, lobbying, talking to regulators and putting together our feedback when it comes to contributing to market consultations.
I think they are quite well respected by regulators and benefit from a very positive image, which is key to lobbying. Advocating for our market’s interests is what we have to do these days to ensure our future is taken into account in what the regulators are putting together.
What is ISLA working on at the moment?
We are working on a couple of different things. The first one is concerned with the Financial Stability Board (FSB), which is about to publish its final recommendation as part of the working group on shadow banking. There is a very practical and detailed workshop that has been put together around the data that we will need to send to trade repositories when this is up and running. We are coordinating our thoughts with the Risk Management Association (RMA) in order to define what level of granularity we will need to provide to the trade repositories, and to propose something to the FSB. We are looking at each piece of the data—the securities lent, the collateral matrix, the maturity of the trade—in order to define how we are going to report the data, and whether it is going to be individual or pooled. We will try to propose something based on the existing framework.
There are other questions that we have just received from the FSB around floor haircuts, so we are going to contribute to that. There was also recent discussions that we had around the leverage ratio, and the applicability of netting. The last and most recent update that we are talking about is the paper that the European Commission published at the end of January, as part of the FSB working group around transparency, reporting to trade repositories, rehypothecation, and disclosure to end investors.
Why did you split principal lending into equity and fixed income? Why is BNP Paribas confident in the future of fixed income?
In the past we were split between agency and principal, which was very important for us because a Chinese wall between the two products is vital, to make sure we respect the compliance aspect of the business.
As far as the principal book is concerned, we realised around two years ago that, with the way regulation is moving and liquidity has also been evolving throughout the last two years, that we were in charge of two businesses, which were becoming more and more different.
On the fixed income side, what we were used to doing in the past was very flow business: lending fixed income assets on an open basis against cash, through securities lending or repo. But this very quickly moved into something much more structured, taking into account the demand relating to Basel III, the leverage ratio, new capital requirements, European Market Infrastructure Regulation (EMIR), and the additional need for collateral. The quality of the assets and the duration of the trades were making it very different from what we are doing with equities, which is still quite a flow business.
The decision was then taken to separate the two. The specifics of the equity market are very related to what happens in the market and the activity of the stock, whereas the fixed income business that we call STIR—short term interest rates—now encompasses repo, securities lending on fixed income assets, and liquidity trades where we are structuring the business with ad hoc confirmations.
How will lending change if it does enter a phase where interest rates begin to rise?
As far as the fixed income business is concerned, and as far as cash collateral is concerned, obviously the level of the rates and the curve are key drivers for generating revenues. So in the fixed income lending market, if interest rates were to rise at some point, it might have an impact on the cash interbanking market, and as a consequence could drive up demand, and could push up the general collateral repo rates or lending rates.
The other consequence of rising interest rates, which might be more applicable in the US, is that if interest rates are going up and yields are going up as well, there might be much more interest in lending securities against cash with cash reinvestment programmes. It is something that has been addressed by the FSB in its report.
On the one hand, there might be some more juice to be made in the market, but on the other hand, regulation is scrutinising cash reinvestment more closely. The guidelines are probably going to be much more formalised and conservative, and I believe the times where some lenders were lending securities only to get cash in order to reinvest might not be the future of the market.
Is lack of innovation detrimental to the business?
I don’t honestly think that there is a lack of innovation. When I look at what the market, and we at BNP Paribas have been doing over the last two or three years, I see a lot of new structures, set-ups and trades that have been put in place. The way we trade today, especially in the fixed income market, has nothing to do with what we were doing three years ago.
It has been completely revamped—we moved from a pure flow business to something much more structured whereby we had to sit down with our legal and risk people in order to put something together which we believe answers the needs in the market. Innovation will still be needed in the future, though, because the barometers will change again.
Do you think that beneficial owners are taking advantage of new processes available to them?
It’s a tough question. I think they do, because there are a lot of players in this chain, but at the end of the day it’s the beneficial owner that holds the securities, with demand coming from the market. So the beneficial owners that are still in the game understand the new dynamics of the market and do benefit from new processes—they know that there is a regulatory pressure. For some beneficial owners, it might be more and more difficult to benefit from lending—that’s a fact.
For example, for UCITS funds, the framework imposed by the European Â鶹´«Ã½ and Markets Authority (ESMA) is going to make things much more difficult to them to enter the market and take full benefit of what can be done today. There is a very concrete inconsistency, regulatory-wise: if you are a UCITS fund, ESMA rules require that you can only enter re-callable securities lending, and cannot lend on a term basis. That is understandable, as the regulator is trying to protect the man on the street in ensuring maximum liquidity in case of a massive redemption or stress test.
On the other side of the equation, when you are sell side and want to fulfill your liquidity ratios—specifically the liquidity coverage ratio (LCR)—you need to borrow securities on the 31 day plus maturity. As you can see, there is an inconsistency. The UCITS fund will not be able to take advantage of this window and to get the full benefit of the return. For them to be able to lend to the sell side, they must find somebody in the middle who can take the risk.
Having said that, there are other players that might be less restricted from a regulatory standpoint—specifically, sovereign wealth funds, insurance companies (even though Solvency II might change things a little bit), or central banks could benefit from this, and fuel the market with stable assets.
What is happening in triparty repo?
We are having a lot of discussions with triparty agents around two things: firstly, intraday cash. The intraday cash, as an agent lender, is an issue—let’s face it. We know intraday cash can turn into overnight cash, and it could be an issue, regulatory wise, for some of our clients. There is something about cash that is quite counterintuitive. Cash should be considered as the most liquid asset you can get as collateral.
However, when you receive cash as collateral and you don’t have the ability to reinvest that cash (because it is an accident, or is reported too late for you to do anything with it), you swap a net exposure into a gross exposure. If you receive securities as collateral, then at the end of the day you net what you have lent with what you have reserved, and these are assets you can liquidate, and then buy your securities back.
When you lend securities against cash, even though it is very liquid, if you don’t do anything with it you end up with a gross exposure on where the cash is. So it is very problematic for some of our clients to end up with a gross exposure on the books of the triparty agent.
The second change around triparty repo, is that collateral matrices are becoming more and more complex. They are becoming more granular, and the quality of collateral that we are pushed to receive by the brokers is going down, because high-quality liquid assets are already mobilised for term trades. If you want to increase your business, or be a little bit more innovative, you have to go down in the matrices. This is all making matrices much more difficult to implement and monitor. This is a trend, and I think triparty agents need to be prepared for this, because they will need to manage more complex matrices in the future.
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