2008: the year that the Lehman Brothers filed for bankruptcy. Of course, this major economic event hit headlines across the globe, though the extent of the value of the assets sitting with the organisation at the time may have passed under the radar for some - $639 billion to be precise. In that same year, we saw the Madoff Investment scandal, whereby former NASDAQ Chairman Bernard Madoff admitted that the wealth management arm of his business was an elaborate $50 billion Ponzi scheme.
Both events drew global and regulatory attention to asset safety and segregation. Questions such as “how quickly can investors’ assets be returned in the event of a CSD failure?” and “how can we ensure that these assets are adequately protected in the case of counterparty default?” were quickly being asked. Today, clients and regulators continue to seek the answers to these queries – banks want to know who the underlying asset holder is, what sort of infrastructure it is, what sort of agent bank it is, and importantly, what types of risks that institution carries forward.
The segregation conundrum
Earlier in the year we conducted research amongst leading CCPs (Central Counterparty Clearing houses) and global and domestic banks in Europe to delve further in the issue of asset safety. We found that 50% of those questioned are now facing more client requests for asset segregation. Further to this, almost two thirds (64%) of respondents said that they found that having both custody and investment lines combined represented a problem – this concern is a key driver in the request for segregation.
However, this type of separation has had a knock-on effect in the realm of quality collateral – half of respondents surveyed believe that asset segregation contributes to the collateral shortfall. The argument being that when securities sit in segregated accounts, the stock remains the property of the underlying client, so their permission is required to move such assets out of the account. By contrast, when assets are placed in an omnibus account, typically in the name of the agent bank, the agent can move these securities in and out, usually to support the trading activity of the underlying clients, and its own clients’ collateral requirements.
It follows that clients typically request having their collateral separated so that their assets are only used to collateralise their own transactions, rather than to the benefit of the wider agent. Whilst this type of segregation ultimately increases transparency it comes at the expense of collateral efficiency and the balance-sheet liquidity of banks. The picture blurs a little further when you add regulations such as Dodd-Frank and EMIR. These focus on the transparency of collateral to facilitate greater volumes of OTC derivatives cleared through CCPs, but are then arguably incompatible with Central Securities Depository Regulation (CSDR) which promotes asset segregation.
Doing your due diligence
Insolvency laws lie at the heart of the effective recovery of client assets, though variations of this regulation both nationally and within the EU, add a degree of impracticality.
Depending on the domicile of the agent bank, local insolvency law will apply , though this might not be the same as the insolvency law that applies to the underlying client. In short, a global securities portfolio would fall under different local insolvency laws, in the event of a “worst-case scenario”. Over a quarter (28%) of those we surveyed say that they don’t feel confident that they could accurately assess the risk profile of agent banks, including aspects such as creditworthiness, operational procedures, risk management models and security policies.
This final point is key. Regulators must create a different value proposition for a market infrastructure which is highly regulated and compulsorily highly capitalised. At SIX Securities Services, we would like to see harmonised insolvency law solely for market infrastructures. Such an approach would encourage the sharing of technology - distributed ledger technology (DLT) in particular - and differentiate the regulation requirements, so these infrastructures are not regulated as banks.
The role of technology
Given the scale of the challenge presented by the increasing demand for asset safety, DLT represents a real opportunity for technology to provide a solution. Market infrastructure participants would act as the ultimate keepers of record for the holdings and the transactions for the underlying clients. Agent banks could then purchase this functionality from the market infrastructures, thus maintaining the client relationship, whilst also providing their expertise and value across the complete range of securities services products. This would be a genuine disruptive change to the industry.
In order for the financial ecosystem to thrive, the concerns and demands of asset owners, clients and regulators alike must all be balanced and met in the fairest way possible. The industry is taking asset safety concerns seriously, but there is still a question mark around the status quo scenario of complete reliance on service providers. At SIX Securities Services, it is our role to continue to address these issues in order to provide safe, secure and robust solutions for our clients.