The intraday credit risk challenge
15 April 2025
With securities financing tools playing an ever more critical role in optimising financial resources for banks, Dipak Chotai of JD Risk Solutions, and Richard Glen of HQLAX, discuss intraday credit risk and the significance of DLT to mitigate this challenge
Image: stock.adobe.com/Oulaphone
The increased demand for collateral 鈥� high-quality liquid assets (HQLA) in particular 鈥� driven by regulatory changes over the last decade, have intensified the importance of collateral transformation and the usage of securities financing tools.
Dipak Chotai, founder of consultancy JD Risk Solutions, notes that 鈥淗QLA holdings at European banks have increased by well over 鈧�1 trillion since the introduction of Liquidity Coverage Ratio requirements in 2015, and regulatory initial margin received is over US$250 billion more than in 2017鈥�. He emphasises that 鈥渢he costs for banks would be immense without the ability for banks and dealers to transform and reuse assets and collateral鈥�.
The recent 鈥楥redit Risk in Capital Markets鈥� whitepaper 鈥� made in collaboration with JD Risk Solutions and HQLAX 鈥� focuses on the specific challenges for securities lending transactions which execute Free of Payments (FoP), without settlement risk mitigation and suggests that the intraday credit exposures generated could be as high as US$119 billion.
HQLAX and JD Risk Solutions identify two primary sources of intraday credit risk in securities lending transactions. The first arises from settlement risk, ie the risk of one party failing to deliver securities to another, and they suggest that this could generate as much as US$80 billion of exposure per day.
The second source identified is from potential future exposures (PFE), and 鈥渋s the risk that may arise as a result of market moves at a future point in time鈥�. These market moves can impact each side of a securities lending transaction, via both a potential change or uncertainty surrounding the value of the collateral used, or the changing price of the lent securities themselves.
Credit risk is not a new topic to securities lending. The authors remind us in the whitepaper that it was credit risk fears that drove AIG鈥檚 securities lending counterparties to return securities and request a return of US$24 billion of cash collateral in 2008, driven by AIG鈥檚 investment strategy of cash collateral, where 65 per cent of these proceeds had been invested in mortgage-backed securities (MBS), asset-backed securities (ABS), and collateralised debt obligations (CDOs).
HQLAX and JD Risk Solutions also highlight the challenges created by the current settlement infrastructure and how the importance of intraday credit extended by settlement agents to market participants is needed to prevent settlement taking significantly longer or consuming large quanta of pre-funded liquidity.
How regulation may respond
鈥淩egulation often reacts to the factors that resulted in previous crises but, like energy, you cannot make risk disappear,鈥� says Chotai.
鈥淭here鈥檚 no free lunch 鈥� parties ultimately transfer risk from one form to another, and from one party to another. Margin for uncleared derivative transactions has significantly helped reduce counterparty risk, especially for large investment banks, but as seen in September 2022 with the UK liability-driven investment crisis, liquidity risk and cost, especially for buy side firms, has increased substantially as a result.鈥�
There is no place where this has been more evident than in the response to the global financial crisis of 2007-08, with the introduction of Basel 2.5 focusing on credit valuation adjustment (CVA) reserves, followed by Basel III, with a spotlight on liquidity and funding, and then finally, the introduction of mandatory clearing and margin requirements for uncleared derivative transactions.
The whitepaper notes that intraday risk management has become a more prominent feature for both market participants and regulators over the last decade and has been specifically discussed in the context of liquidity risk and market risk.
Following the recent default of Archegos capital management, a Basel Committee on Banking Supervision (BCBS) consultation focused on counterparty credit risk management, suggested that banks should establish intraday exposure monitoring, without imposing specific requirements on the banks themselves.
For Chotai, the question of what happens next with regards to intraday risk management, presents three options. 鈥淔irstly, regulators could choose to do nothing more than reiterate the non-binding guidance that they have presented so far 鈥� unless of course a risk event occurs, contributed by intraday credit risk,鈥� he explains.
鈥淪econdly, regulators and supervisors could monitor the risk more closely by requiring banks to prepare additional disclosures, as they have done to monitor climate risk. Finally, regulators could introduce more explicit capital requirements for intraday credit risk to incentivise mitigation.鈥�
The additional capital requirements in the third scenario are not insignificant. 鈥淥ur analysis suggests that the capital requirements for borrowing securities in securities lending transactions could attract an additional US$48 billion of risk-weighted assets in aggregate across the banking sector using a standardised approach,鈥� says Chotai.
With these requirements, the question remains as to why regulators have not yet focused on intraday credit risk.
Chotai responds: 鈥淭here are two main reasons. Firstly, there has not yet been a significant event where intraday credit risk has been the primary cause. We didn鈥檛 have intraday liquidity requirements until around a decade ago, as there was less sensitivity to intraday liquidity risk until that point in time.
鈥淪econdly, and until recently, there weren鈥檛 any options to mitigate intraday credit risk in securities lending transactions without reducing volumes and deleveraging the system or substantially changing how financial market infrastructure operates around the world.鈥�
What technologies bring
鈥淭he key challenge is that the systems and infrastructure were never designed to work in this way 鈥� it鈥檚 like using 100-year-old copper telephone lines to deliver high-speed internet,鈥� Chotai highlights.
In agreement, Richard Glen, solutions architect at HQLAX, says that today, the fragmented regional custody network obliges large global banks to physically move securities across the different venues, locations and timezones to meet their collateral obligations. He believes this results in imprecise, costly and inefficient collateral management with real bottom-line costs.
Glen continues: 鈥淪olutions using distributed ledger technology enable banks to mobilise pools of securities without cross-custodian movements, and to achieve simultaneous ownership exchanges using either delivery-versus-delivery or delivery-versus-payment as a part of a books and records update.
鈥淭his helps to mitigate the risk of creation of intraday exposures during the settlement process itself as well as enhancing the resilience of a banks鈥� operating model.鈥�
The whitepaper also notes that distributed ledger technology (DLT) can help to solve a number of post-trade risk scenarios, in addition to mitigating credit risk. It allows for instantaneous and synchronised exchange of ownership at precise moments in time.
鈥淪ettlement time is becoming the new settlement date,鈥� adds Glen. Historically, trades had a specific value date on which they were due to settle and firms had no control as to when securities or cash would be delivered or received. However, by using DLT, firms can specify the exact point in time at which a transaction should settle, making the process more certain and predictable.
鈥淒LT can facilitate the development of new markets, such as intraday DvP repo, as it allows participants to agree on exact opening times and closing times to the nearest minute,鈥� Glen says.
The whitepaper further explains how DLT helps firms to optimise their inventory management workflows, irrespective of the deposit location or asset type.
鈥淭he technology can support a multitude of funding and financing arrangements from securities lending or repo to the posting of initial or variation margin,鈥� Glen confirms. 鈥淭he way DLT can help solve optimisation challenges is not only expected to reduce the operational burden of cross-venue settlement and their associated costs, but also to impact balance sheet consumption in a positive way through these enhanced optimisation capabilities.鈥�
In terms of market adoption and future vision, the whitepaper underlines the importance of industry collaboration and interoperability.
In his conclusion, Glen comments: 鈥淒istributed collateral ledgers offer interoperability by design. Recent cross-chain end-to-end experiments and trials have successfully demonstrated these capabilities, enabling market participants to create an ecosystem where atomic settlement of traditional and digital assets may be supported without restricting freedom of choice.鈥�
Dipak Chotai, founder of consultancy JD Risk Solutions, notes that 鈥淗QLA holdings at European banks have increased by well over 鈧�1 trillion since the introduction of Liquidity Coverage Ratio requirements in 2015, and regulatory initial margin received is over US$250 billion more than in 2017鈥�. He emphasises that 鈥渢he costs for banks would be immense without the ability for banks and dealers to transform and reuse assets and collateral鈥�.
The recent 鈥楥redit Risk in Capital Markets鈥� whitepaper 鈥� made in collaboration with JD Risk Solutions and HQLAX 鈥� focuses on the specific challenges for securities lending transactions which execute Free of Payments (FoP), without settlement risk mitigation and suggests that the intraday credit exposures generated could be as high as US$119 billion.
HQLAX and JD Risk Solutions identify two primary sources of intraday credit risk in securities lending transactions. The first arises from settlement risk, ie the risk of one party failing to deliver securities to another, and they suggest that this could generate as much as US$80 billion of exposure per day.
The second source identified is from potential future exposures (PFE), and 鈥渋s the risk that may arise as a result of market moves at a future point in time鈥�. These market moves can impact each side of a securities lending transaction, via both a potential change or uncertainty surrounding the value of the collateral used, or the changing price of the lent securities themselves.
Credit risk is not a new topic to securities lending. The authors remind us in the whitepaper that it was credit risk fears that drove AIG鈥檚 securities lending counterparties to return securities and request a return of US$24 billion of cash collateral in 2008, driven by AIG鈥檚 investment strategy of cash collateral, where 65 per cent of these proceeds had been invested in mortgage-backed securities (MBS), asset-backed securities (ABS), and collateralised debt obligations (CDOs).
HQLAX and JD Risk Solutions also highlight the challenges created by the current settlement infrastructure and how the importance of intraday credit extended by settlement agents to market participants is needed to prevent settlement taking significantly longer or consuming large quanta of pre-funded liquidity.
How regulation may respond
鈥淩egulation often reacts to the factors that resulted in previous crises but, like energy, you cannot make risk disappear,鈥� says Chotai.
鈥淭here鈥檚 no free lunch 鈥� parties ultimately transfer risk from one form to another, and from one party to another. Margin for uncleared derivative transactions has significantly helped reduce counterparty risk, especially for large investment banks, but as seen in September 2022 with the UK liability-driven investment crisis, liquidity risk and cost, especially for buy side firms, has increased substantially as a result.鈥�
There is no place where this has been more evident than in the response to the global financial crisis of 2007-08, with the introduction of Basel 2.5 focusing on credit valuation adjustment (CVA) reserves, followed by Basel III, with a spotlight on liquidity and funding, and then finally, the introduction of mandatory clearing and margin requirements for uncleared derivative transactions.
The whitepaper notes that intraday risk management has become a more prominent feature for both market participants and regulators over the last decade and has been specifically discussed in the context of liquidity risk and market risk.
Following the recent default of Archegos capital management, a Basel Committee on Banking Supervision (BCBS) consultation focused on counterparty credit risk management, suggested that banks should establish intraday exposure monitoring, without imposing specific requirements on the banks themselves.
For Chotai, the question of what happens next with regards to intraday risk management, presents three options. 鈥淔irstly, regulators could choose to do nothing more than reiterate the non-binding guidance that they have presented so far 鈥� unless of course a risk event occurs, contributed by intraday credit risk,鈥� he explains.
鈥淪econdly, regulators and supervisors could monitor the risk more closely by requiring banks to prepare additional disclosures, as they have done to monitor climate risk. Finally, regulators could introduce more explicit capital requirements for intraday credit risk to incentivise mitigation.鈥�
The additional capital requirements in the third scenario are not insignificant. 鈥淥ur analysis suggests that the capital requirements for borrowing securities in securities lending transactions could attract an additional US$48 billion of risk-weighted assets in aggregate across the banking sector using a standardised approach,鈥� says Chotai.
With these requirements, the question remains as to why regulators have not yet focused on intraday credit risk.
Chotai responds: 鈥淭here are two main reasons. Firstly, there has not yet been a significant event where intraday credit risk has been the primary cause. We didn鈥檛 have intraday liquidity requirements until around a decade ago, as there was less sensitivity to intraday liquidity risk until that point in time.
鈥淪econdly, and until recently, there weren鈥檛 any options to mitigate intraday credit risk in securities lending transactions without reducing volumes and deleveraging the system or substantially changing how financial market infrastructure operates around the world.鈥�
What technologies bring
鈥淭he key challenge is that the systems and infrastructure were never designed to work in this way 鈥� it鈥檚 like using 100-year-old copper telephone lines to deliver high-speed internet,鈥� Chotai highlights.
In agreement, Richard Glen, solutions architect at HQLAX, says that today, the fragmented regional custody network obliges large global banks to physically move securities across the different venues, locations and timezones to meet their collateral obligations. He believes this results in imprecise, costly and inefficient collateral management with real bottom-line costs.
Glen continues: 鈥淪olutions using distributed ledger technology enable banks to mobilise pools of securities without cross-custodian movements, and to achieve simultaneous ownership exchanges using either delivery-versus-delivery or delivery-versus-payment as a part of a books and records update.
鈥淭his helps to mitigate the risk of creation of intraday exposures during the settlement process itself as well as enhancing the resilience of a banks鈥� operating model.鈥�
The whitepaper also notes that distributed ledger technology (DLT) can help to solve a number of post-trade risk scenarios, in addition to mitigating credit risk. It allows for instantaneous and synchronised exchange of ownership at precise moments in time.
鈥淪ettlement time is becoming the new settlement date,鈥� adds Glen. Historically, trades had a specific value date on which they were due to settle and firms had no control as to when securities or cash would be delivered or received. However, by using DLT, firms can specify the exact point in time at which a transaction should settle, making the process more certain and predictable.
鈥淒LT can facilitate the development of new markets, such as intraday DvP repo, as it allows participants to agree on exact opening times and closing times to the nearest minute,鈥� Glen says.
The whitepaper further explains how DLT helps firms to optimise their inventory management workflows, irrespective of the deposit location or asset type.
鈥淭he technology can support a multitude of funding and financing arrangements from securities lending or repo to the posting of initial or variation margin,鈥� Glen confirms. 鈥淭he way DLT can help solve optimisation challenges is not only expected to reduce the operational burden of cross-venue settlement and their associated costs, but also to impact balance sheet consumption in a positive way through these enhanced optimisation capabilities.鈥�
In terms of market adoption and future vision, the whitepaper underlines the importance of industry collaboration and interoperability.
In his conclusion, Glen comments: 鈥淒istributed collateral ledgers offer interoperability by design. Recent cross-chain end-to-end experiments and trials have successfully demonstrated these capabilities, enabling market participants to create an ecosystem where atomic settlement of traditional and digital assets may be supported without restricting freedom of choice.鈥�
NO FEE, NO RISK
100% ON RETURNS If you invest in only one securities finance news source this year, make sure it is your free subscription to 麻豆传媒 Finance Times
100% ON RETURNS If you invest in only one securities finance news source this year, make sure it is your free subscription to 麻豆传媒 Finance Times
