Tuesday, December 1, 2020

Banking Leaders set to Control 'Shadow Exposures'

Supply Chains in Securities Finance to be Clarified and Stabilized

Author: David Schwartz J.D. CPA

Shadow banking is history, say banking leaders, a thing of the past. New compliance and risk management systems based on the Securities Finance Transaction Regulation (SFTR) and the industry’s evolving Common Domain Model (CDM) will enable financial service providers to regulate their clients' exposure to counterparties with far more specificity than ever before possible. Originally accepted as a regulatory imposition, bankers are now viewing the SFTR reports of their loan principals as a platform to help state pension funds and others meet their ESG and tax compliance goals with unprecedented precision — along with proof of funding.
The data in SFTR reports is shining a light on formerly opaque markets and could spark a renaissance of innovative financial services. By matching the transaction records of lenders and borrowers, prime brokers and lending agents can now offer a modular array of sophisticated add-on services that address some of the most pressing challenges facing securities borrowers and lenders (e.g., meeting the demands of ESG investing and regulators' new tax audit sweeps). These can be wrapped as a package or customized for the benefit of individual clients.
State Street’s Alpha front-to-back-office platform is one example of how a modular approach allows service providers to stay ahead of the curve on what institutional investors and their advisors need most so as to deliver in an integrated and seamless fashion. They are pitching a thesis that interoperability is the key to providing a captivating client experience, in every sense of the term. 
Other banks are known to be working toward the same goal of integrating fintech in innovative ways.  Even the Chinese government is working on a global blockchain to serve as the backbone of a financial services infrastructure. This Chinese initiative has received very little attention in the financial media. Western banking firms should be at the forefront of this technological revolution in finance. The question is, who among the banks will seize these opportunities first?
End-to-end Principal Matching
SFTR data is bringing a new level of transparency to securities finance, by clarifying a supply chain previously criticized as "shadow banking” and heavily litigated since the financial crisis. This new data makes it possible to infer principal-to-principal loans, even when made through financial intermediaries, by matching Unique Transaction Identifiers (UTI), ISINs, and related data from principal lender and borrower SFTRs. On the most basic level, securities loan tracing is impossible due to the fungibility of modern securities that are cleared through central counterparties for prime brokers with fluid stock record systems. But principal matching can achieve the same end-to-end clarity when a shared ledger is derived from a permissioned blockchain, populated with the contractual loan details of their cooperating lenders and trusted borrowers. Such a distributed system's applications are legion, opening the door to a broader value proposition in securities finance. 
At present, end-to-end matching is merely a concept in the world of securities finance. But soon, it may become a necessity. Indeed, regulators like ESMA, the U.S. Department of Labor, and the U.S. Securities and Exchange Commission are already creating compliance hurdles that can only be met by employing this kind of end-to-end matching. The good news is that securities lending agents and prime brokerage firms are already rising to the challenge and developing a whole new menu of value-added services. For example, over the summer, securities lending intermediaries quickly stepped up and added SFTR compliance services to their offerings. Now, with investors' ever-increasing appetite for ESG investing and renewed efforts by the EU to police withholding tax refund schemes, lending agents and prime brokers should start thinking about what role they can play to help their clients meet these new challenges.  
Fintechs with strong blockchain and distributed ledger technology (DLT) capabilities can play a role as well. A central feature of shared ledger technologies like DLT is their end-to-end, supply chain tracking capability, widely publicized in IBM’s Walmart and Maersk projects. Controlled transparency, as well as tracking, is also a major attraction in the planned TIW shared ledger at DTCC. Nearly instantaneous updates are a sina qua non for peer-to-peer blockchains, which should lower the costs of resolving breaks in the trade reconciliation and proof process.  
More and more financial firms are discovering the benefits of adopting blockchains and DLT into securities lending supply chains. Developers point out that permissioned blockchains are no more complex than web servers, although designing for a consortium of users is a challenge. 
Recognizing Opportunities
Securities lending intermediaries are evaluated based on their ability to meet clients' unique needs and transaction flows. Indeed, a customized package of services is the very heart of the client relationship in securities finance. Now that higher capital charges have forced many lending clients out of the market for borrower default indemnification, it is incumbent on agents to offer new risk management services. Similarly, balance sheet constraints have forced prime brokers to prioritize the posting of non-cash collateral for their hedge funds’ securities loans. Thus, an ability to direct loans from reliable lenders with collateral flexibility through to preferred and trusted counterparties will become an imperative for lending agents and prime brokers alike. End-to-end matching can achieve those mutually complementary goals. 
SFTR reporting was just one way agents and prime brokers can help reduce their clients' regulatory burden. Now with the EU proposing sweeping audits of securities lending data around dividend record dates in search of tax cheats, agents have an opportunity to help their lending clients certify to regulators the validity of their loans and avoid the risk of time-consuming and unnecessary audits.   
EU Audit Compliance Services
New techniques that employ SFTR data make it possible to map securities lending transactions end-to-end, as described above. Applying these methods and tools to SFTR data for spike periods, intermediaries can certify their clients' benign activity, allowing NCAs and taxing authorities to concentrate on the remaining data for further investigation. It is tough to see how lenders in the EU could fail to see value in having their loans culled from potentially suspicious trade data.  
Meeting Clients' ESG Needs
As ESG investing becomes more critical to lending clients, clients' RFPs will evaluate service providers to the degree their programs can manage and report compliance. 
How can lending agents and prime brokers help their clients with ESG investing? Some have already expanded their services to include screens and procedures to foster their clients' ESG goals, including:
  • approval of counterparties 
  • non-cash collateral filtering
  • recalling loans for proxy votes
  • collateral reinvestment restrictions. 
But those services are just the beginning. Knowing for what purposes borrowers are using lent securities will become critical to ESG investors. Agents that can verify that borrowers are not putting clients' securities to uses that violate their ESG principles will have quite an advantage. 
SFTR and CDM present the securities finance industry with powerful tools to banish shadow banking to the history books. For those willing to embrace the new transparency of securities finance afforded by this new flood of data, coupled with fintech like blockchain and DLT, the competitive advantages are obvious.  


Categories: Commentary, Cross-Post