Digital securities finance
The case for transformation
With extensive market focus and engagement, we are just beginning to evidence the significant potential benefits of DLT and tokenization on securities finance. And even though our first steps are vastly impactful, in consolidating and distributing data, the impact is even greater in balance sheet improvements that are becoming possible through tokenization.
"[Digitization] fills a gap between the borrower and the lender. A gap that cannot be satisfied by either the borrower or the lender alone."
(Gary Klahr, EquiLend)
1. Operational efficiencies in lending: A compelling first step
Real time data management, with no exceptions
"We looked at many potential use cases but reconciliations and data stood out as the most pressing."
In a world of highly complex systems, email inboxes, and chat rooms, can anyone today really say they know where they stand with their lending, repos, and collateral at any given moment?
Like all transactional activities, the securities finance industry is first and foremost a data industry. Yet despite years of technology investments and regulatory pressures (most recently with the EU’s Securities Finance Trade Reporting regulation, or “SFTR”), almost all market participants continue to see data management, cleaning, and consolidation as a significant challenge.
In their 2022 Digital Transformation Working Group, EquiLend’s industry partners cited the data reconciliation challenge to be their most critical in the securities lending space, as they struggle to consolidate and manage data entered into trading, billing, and custody systems by different people at different times. “The lack of transparency regarding communication between parties is the primary culprit for [reconciliation] breaks, since it is not properly recorded”. In a highly decentralized market, it’s hard to underestimate the endless reconciliation activity that goes on throughout the trading day and overnight to bring together numerous positions registries across firms and between counterparties.
In this context, the value of distributed ledger technology (DLT) is immediately apparent. As HQLAx, JPMorgan, and Broadridge’s DLR have all shown, moving collateral onto a distributed ledger presents instant efficiencies in first facilitating a single, industry source-of-truth for all data, and then in enabling reliable, instantaneous movements of cash and securities between counterparties. EquiLend’s 1Source looks set to do the same for securities lending trades.
Simply achieving this level of data synchrony and transaction reliability is enough to justify extensive, market-wide technology investments. This is a massive first step in an industry that is still so manual today.
By EquiLend’s estimations, the use of single-source of truth technologies in this space could help the industry to realise efficiencies of over $100 million per year.
But this is far from the whole story, as the benefits of this synchrony extend throughout the entire organization into operations, treasury, balance sheet management, and other functions.
"The estimated industry-run rate savings exceed USD $100m annually."
Real risk management
As the OCC’s Securities lending pilot has demonstrated, high-quality, detailed data has far more value than simply removing exceptions. By creating a shared data model that is rich in characteristics, organisations can not only gain a better understanding of where they stand, but they also can begin to manage risks significantly earlier, and hence reduce the cost of risk and margining. They can also begin to manage risks that weren’t even visible before.
From following risks to proactively managing risks, the value of golden data is significant.
Beyond simple automation
“We think we’ve saved around 60% of our operating costs.”
In a world where every lent security, recalled security, or collateral movement requires several rounds of emails, phone calls, and chat messages, the potential for automation begins at the basics. If every security movement can require fewer emails, that’s a win for both counterparties.
However, with the solid foundation of a sophisticated, real-time data model in place (i.e., with DLT), the need for significant resources to manage the transaction disappears entirely. Instead of looking to automate 10% of emails or 25% of phone calls, brokers and lenders can look to DLT to entirely negate the need for the email or the phone call altogether. If everyone is trading from the same ledger, how can exceptions on static data or positions ever arise? “Traders can get back to spending more of their time on trading”
Against a backdrop of highly manual messaging and exception handling around the transaction, DLT can have a transformational impact on securities finance - impacting up to 60% of operational cost bases, by some brokers’ estimates.
But why stop there? In addition to trade processing, operations teams are also beset by manual processing around marking-to-market, collateral substitutions and securities recalls, all of which are essentially complex data management exercises performed today by “human APIs”.
In a distributed ledger environment where trades and collateral are visible using a consolidated, industry-wide record based on a standardized data model, all of these manual tasks become immediate opportunities for automation using smart contracts. If market conditions trigger a need for collateral substitution, smart contracts could trigger, manage, and report on the transaction without human involvement.
Rather than reducing manual interaction across the trade cycle, DLT and smart contracts can eliminate the need for it entirely, helping to optimize operational risk, reduce costs, and increase scale.
Regulatory flexibility?
If one area has upset the fragile equilibrium of securities finance operations in the last few years, it is the increase in regulatory reporting requirements.
The implementation of SFTR in 2021 created an industry-wide rush to begin tracking and reporting on transactions to the regulatory standards required by the European Commission and ESMA. In some cases, expensive new data lakes were implemented, while in many, the limits of spreadsheets were tested further, as firms rushed to comply by assembling disparate data sets in Excel.
Since then, the European “Central Securities Depositories Regulation” (CSDR) has created the need for new data tracking, and the 10c-10 regulation in the US looks set to create a whole new requirement for transaction reporting. The common theme? Regulatory reporting is growing and each wave is different, meaning that compliance with the latest rule is no longer a cost-effective objective. Compliance with the next several waves of rules is what matters now.
In this context, the use of a distributed ledger presents a uniquely scalable solution to an increasingly acute problem. For those that can, regulators can simply open their own node on the relevant blockchains in order to see and extract the data they need to oversee market conduct. For those that are still getting there, smart contracts can be used by market participants to extract and prepare regulatory reports automatically and with minimal risk.
As our recent experiences with SFTR have shown, preparing for regulatory disclosure requirements is a costly and painful exercise. By using smart contracts and regulatory nodes, we can not only make regulatory reporting simpler, but we also can potentially remove the need for it entirely, thereby removing one of the most acute pain-points of our time.
“The industry missed a huge opportunity to automate reporting with SFTR. Now we have another chance to get it right with tokenization.”
Front-foot client servicing
The problems of securities finance are not limited to the movement of securities between counterparties. Even holding a lent or pledged security is problematic, given the constant flow of corporate events that are happening on those securities.
Those close to the asset servicing side of securities finance are intimately aware of the complexities of communicating, reconciling, and processing event information on dividends, for example, when they relate to stocks on loan or to pledged collateral. At best, an event may trigger a recall (itself entirely manual today) and, at worst, they require complex data comparisons between counterparties (most often by email), calendar reminders, email chasers, and manual data re-entry across different systems. Either way, a single corporate event can require days of people’s time to handle, with the risk of failure a constant threat.
In a DLT world, event information can be mapped and shared instantly on the ledger, meaning that everyone in the chain (from prime broker to hedge fund) sees and can manage the same information, without needing verification or chasing.
“Manufactured dividends are the nightmare of my life, but hopefully not for long.”
(Leading US prime brokerage)
Opening up new markets
If we can get it right at the institutional level, why can’t we extend securities finance into the wealth and retail spaces?
At present, the challenges associated with the data issues above would be multiplied to the point of failure if we tried to manage lending between hundreds of thousands of segregated accounts. Reconciliation issues would become unworkable and lending desks would slow to a standstill.
With the above problems solved, reconciliations eliminated, and smart contracts in place, the risk points that hold us back today would be reduced to zero. Leveraging the benefits of tokenization, could we not offer lending and borrowing of crypto currencies to retail investors, for example? Operationally, yes.
2. Transforming treasury: A vast new frontier
The industry’s journey on tokenization in securities finance has so far focused heavily on realizing the operational benefits set out above. But it is rapidly becoming clear that these operational efficiencies will be dwarfed by the transformational effect of tokenization on banks’ and lenders’ balance-sheets, as DLT begins to impact every level of funding and capital management.
Step 1: Reducing intraday exposures
"An average global SIFI probably spends USD $50-100 million a year moving securities and collateral around.”
Today’s securities finance trade or collateral movement is expensive. Almost every transaction is made as a pair of unsynchronized free of payment (FOP) movements, meaning that every single movement is a major drain on the balance sheet. Using this model, the exposure triggered by these payments receives the same tier 1 balance sheet treatment as unsecured credit for the entire time that the two legs of the transaction are open.
Additionally, there are more movements than needed. Faced with the lack of certainty around settlements (i.e., whether securities and collateral will be in the right account at the right time), collateral managers often end up over-provisioning in order to create a buffer supply in key risk areas.
Today’s banks are facing a high funding cost per trade, multiplied by more trades than should be necessary.
Through tokenization, banks and lenders can transform their daily funding by leveraging faster and more reliable settlements on a chain.
By tokenizing securities and bringing them onto a chain (either natively or using a digital representation of a traditional asset), counterparties can move from unsynchronized FOP settlements to seamless delivery versus payment (DVP) exchanges of securities, thereby radically lessening the funding costs of each trade.
Then, by ensuring that each security will be exactly where it is needed, exactly when it is needed, they can also eliminate the need to over-provision, and hence use only the exact amount of collateral that their counterparties require.
Tomorrow’s benefits: Lower funding costs per trade, for fewer trades. A simple equation that translates into savings of around $50-100 million across the industry today.
Step 2: Re-shaping intraday balance sheet management
But removing unnecessary costs and volumes from their balance sheets is perhaps just the first, tactical step in the journey towards balance sheet transformation.
As Broadridge’s DLR has shown, the next step is in moving large amounts of daily liquidity away from either pre-funding or unsecured and uncommitted credit lines (such as overnight and day-light overdraft facilities), towards more dynamic, cost-efficient, secured funding through repos and swaps.
While different firms finance their daily obligations in different ways, many turn to overdraft facilities as a core mechanism to fund their core operations and / or peak volumes. One bank may pre-fund 90% of their standard trading day requirements, but then use a bank overdraft for the remaining 10% (including any peaks), and thereby face significant pre-funding opportunity costs and extensive bank credit balance sheet costs. This creates a double-negative, made necessary by the fact that traditional treasury and funding mechanisms are slow to process and offer limited value on an intraday basis.
The surety of securities movements that tokenization brings can be transformational in this context, facilitating highly agile and dynamic funding on the basis of secured credit (such as repos). With dynamic, intraday (read: minute-by-minute ) funding opportunities, banks’ liquidity and reserves can become as dynamic as their obligations. If a firm needs USD $100 million at 11:03 a.m., then they can fund exactly that amount, – and mobilize the remainder of their funds to generate returns. If they then need USD $160 million at 11:05 a.m., then they can source the additional liquidity through intraday repos, with the complete security that the funding will be there at the exact moment it is required.
The result: No more bank overdraft funding, greater mobilization of existing funds, and access to cheaper, more capital-efficient funding when needed.
“With security of repos and delivery, you can replace large amounts of credit with secured, intraday funding.”
Step 3: Everything becomes intraday
“By connecting time zones globally, liquidity can be managed on an intraday basis the entire time.”
Once intraday overdrafts are a thing of the past, the last major funding cost for most banks is their overnight credit‚ an expensive source of funding due to the 8-12 hour time commitment that ”overnight” entails.
But, as UBS have demonstrated, it is always daytime somewhere. By leveraging Broadridge DLR’s global connectivity and 24/7 system availability, UBS have successfully begun to replace their US overnight funding with cross-border, intraday repos in Asia. By building on top of the legacy payment systems and custodians that have prevented the dynamic movement of funding overnight, DLR has created a 24/7 platform that makes all global collateral available for intraday financing, even in the shortest of time-frames. If a US bank needs funding for 20 minutes at 1:38 a.m. ET, then they can source that through an intraday repo and have the whole transaction unwound minutes later.
No more costly 12-hour capital commitments. Just cost-effective, minute-by-minute funding as and when needed.
Risk management in a crisis
Beyond business-as-usual, recent experience has shown that the core value of DLT and tokenization stands out during times of market stress, and this value is growing every day.
In the last 12 months, the LDI Gilt crisis and the run on Silicon Valley Bank have both highlighted the critical need for collateral to be moved faster and more safely than ever before.
A unique combination of social media and instant payments in the retail space means that today’s bank runs happen in hours, not days. If cash funding can now leave a bank in seconds, then no bank can wait hours to mobilize its collateral. When there is an urgent need to release liquidity, it is critical that collateral be as fast to move as cash, so it is impossible for banks and collateral holders to rely on systems that take days to move collateral between accounts.
As we have seen twice already in 2023 alone, times of stress are when the dark arts of treasury and operations become a board-level priority. Thus, the potential impact of DLT and tokenization runs all the way through the organisation. In facilitating instant and reliable movements of securities between market participants, digitization is not about saving a few headcount or dollars - it is about ensuring the viability of banks in the 21st century.
“If cash can move instantly now but collateral can't, then we have a huge technological imbalance at the heart of our markets.”
The end of collateral movements?
Looking ahead, why do we even need to exchange collateral at all?
The central value of collateral is in securing an obligation. To ensure that the lender can receive recompense for their credit in the event of a default, cash and securities are moved into the lender’s care so that the assets can be easily mobilised if needed. But this movement of assets is a legacy of history, not an inevitable process.
In a digitized environment, focus can shift from tokenizing collateral to tokenizing the obligation, creating a massive transfer of balance-sheet value. If a collateral-giver could pledge cash to their counterparty by recording their obligation on a chain, then the need for the actual movement of the pledged cash would disappear. Because cash on balance-sheet is fungible, the liquidity and treasury benefits of the collateral-giver retaining this cash would be vast.
We are a long way from having the legal and capital treatment frameworks to support this level of flexibility, but this example only serves to highlight the fundamentally transformational potential of DLT and tokenization in securities finance. Watch this space.