Collateral Insights Ep 5: Part 2: Preparing for Uncleared Margin Rules (UMR)

[MUSIC]

Maddie Parmar: Welcome to Collateral Insights, a J.P. Morgan collateral services podcast series bring you the latest thought leadership, best practices, and trends impacting the securities, finance, and collateral ecosystem. My name is Maddie Parmar, Vice President of Collateral Services Product at J.P. Morgan. And I'm very pleased to be joined today by Amy Caruso, Head of collateral initiatives at ISDA.

Maddie Parmar: I will be speaking today about the very current topic of unclear margin rules, also known as UMR. In the last Collateral Insights podcast, we discussed what firms should be thinking about in preparation for UMR.

Maddie Parmar:  As a reminder the final phase of the regulation, phase six, will go live in September 2022 as expected, to bring into scope 700 entities globally across insurers, fund managers, pension funds, hedge funds and regional banks. Today, Amy and I will discuss how the industry is preparing for phase six and how we see the industry adapt in the years to come. So, welcome, Amy.

Amy Caruso: Thank you for having me, Maddie.

Maddie Parmar: So, Amy, with phase five go live firmly behind us, what have been your major takeaways?

Amy Caruso: So, we've been told by our phase five ISDA members, and even previous phases as well, that everything takes longer than you expect. And you really need to prioritize which counterparty relationships will reach that initial margin threshold first, so that you can inform your counterparties and custodians which relationships to onboard first. And which ones can wait until after September. We've also been told that the tail, so the length of implementation after September 1 is likely to be pretty long, lingering. So this isn't a September 2 where everyone can have a party and celebrate. It's going to take a little more time than that.

Maddie Parmar: That's right, Amy, Phase Five did have a long tail. And for certain in scope entities, the process is still continuing. From our own experience in Phase Five, the number of in scope pairings for participants was changing up until the very last minute. Right? So, given the sheer amount of legal that needs to be executed across the industry, I think knowing your priorities and executing on them is key. But with that context, how do you think the basics preparation is going in the industry?

Amy Caruso: Well, I do like to look at things in a positive light and our members are telling us that there is progress with, know your counterparty work with custodians and custodian onboarding. And we have an informal survey that shows that documentation completion is progressing. However, we also hear of firms who are just starting that and a calculation that determines if the legal entity and its affiliates are in or out of scope. And while the last day of May is when the data set really ends, we urge firms that if you think you're in scope, it's better to tell your counterparties and custodians now. Start getting the work done. It's not so bad of a call to receive in early June that, "Oh, actually, we're not out of scope and we can take it off the plate." Compared to calling in early June and saying, "Oh, we need to start from scratch right now." So, it's key to get moving if you haven't already.

Maddie Parmar: Yes, I agree. If you believe you're in scope, even if you're only trading derivatives in large volumes for which you need to exchange margin immediately. Have the conversation with your counterparties or the custodians because as Amy says, we expect the tail in phase six to be longer. Another nuance this time is that threshold monitoring will play a bigger role in basics as in scope entities may stay under the agreed thresholds for longer. So naturally this will elongate the UMR journey by industry participants. So, Amy, it sounds like this really isn't the end for UMR after September 2022. What do you think?

Amy Caruso: No, this is not the end. UMR will be an annual process going forward. New entities, growing entities, and entities that change trading strategies that could result in an ANA above $8 billion will need to go through the same process that phase six entities are going through now. This needs to be an ongoing program for the industry and firms need to ensure they have resources going forward and incorporate this process into their annual business operations.

Maddie Parmar: Completely agree, Amy. This will become business as usual going forward.

Amy Caruso: So, Maddie, what have been some of the best practices your clients have taken on?

Maddie Parmar: Like UMR touches many parts of the organization and we've seen firms on working groups across their treasury, risk, operation and trading teams to assess what their optimal collateral strategy is. And taking this step back assessment has helped firms, take a fresh look at their inventory pools across their entities to create a framework that will help them with what collateral they need, how much collateral they need, and when they need it. For example, I've heard of firms who will set up centralized processes to consolidate a list of all upcoming derivatives trading in one team. Who would then forecast using our pre trade analytics tool how much inventory is required and which counterparties will be margin efficient. I think experiences like this are very powerful and show how UMR have been the catalyst to coalesce firms around efficient resource management. So, Amy, what do you think's next for the industry?

Amy Caruso: Well, I think taking some of what you shared, Maddie, and optimization is next. Now that can mean many different things to different firms, but looking at ways to be more efficient with collateral inventories, as you just mentioned, and also collateral management operations will definitely be a trend in our industry in the next few years. Whether a firm takes an approach to do an in-house overhaul to work with an external vendor or an outsourcer administrator will definitely see implementation of data standardization, such as using the common domain model across OTC and other types of collateralized products, in addition to seeing restructuring of teams and systems and even metrics.

Maddie Parmar: Yes, that's a good point, Amy. And to be efficient, both, operationally and from an inventory perspective. Because actually, you said, needs to hit a certain critical mass, and also eligibility sets need to be flexible where possible. After UMR firms might find that a greater proportion of their balance sheet is encumbered than in previous phases and their collateral mix, as well, is more diverse and hence optimally using their resources going forward will become increasingly valuable. Any closing thoughts, Amy?

Amy Caruso: Just for folks who are in phase six to progress as quickly as possible. And resources that are available whether on the ISDA margin info hub, ISDA create as an online negotiation tool, or the ISDA SIMM for their initial margin calculations.

Maddie Parmar: Thank you to all our listeners for taking time to join this podcast today. It's been our pleasure. And any further information, of course can be coordinated by your sales and client service representatives here at J.P. Morgan, and please feel free to reach out to them. I would also advise that this communication is provided for information purposes only. It's not intended as an offer or solicitation of the purchase, sale, or tender of any financial instruments. Please visit JPMorgan.com for more information. And please note that JP Morgan disclosures apply and are available on www.JPMorgan.com/disclosures. JP Morgan Chase and CO. All rights reserved.This episode was recorded on Wednesday, the sixth of April 2022. Thank you very much for listening.

[END OF PODCAST]

Collateral Insights Ep 4: Preparing for UMR (Uncleared Margin Rules)

[MUSIC]

Katie: Welcome to Collateral Insights, a J.P. Morgan collateral services podcast series bringing in the latest thought leadership, best practices, and trends impacting the securities finance and collateral ecosystem. My name is Katie Emerson, and I am based in London, in the platform sales organization at J.P. Morgan, leading the sales effort for our collateral management products here in Europe. And I have the pleasure of moderating today. I'm very pleased to be joined by Rob Evans, America's head of collateral management, and Sagar Patel, the America's head of our tri-party product, both of which fall under our collateral services banner as part of our trading services business here at J.P. Morgan. Today we'll be speaking about a very current topic, the one of the uncleared margin rules, also known as UMR or SIMM. And we'll be exploring some key themes, innovative developments, and lessons learned from previous phases of the regulation. This is a very hot topic in the market, as phase five went live on the 1st of September 2021, and the final phase of the regulation, phase six, will go live on the 1st of September 2022. The segregated initial margin rules commenced in September 2016 and has been a phased-in implementation based on participants' aggregate average notional amount, the AANA, which is inclusive of all their affiliates. As we head into phase six, the AANA amount is eight billion, which brings into scope over 700 entities globally across insurers, fund managers, pension funds, hedge funds, and regional banks. So, welcome, Sagar and Rob.

Sagar: Thanks, Katie.

Katie: Great to have you both. Welcome, Rob.

Rob: Thank you.

Katie: So, Sagar, starting with the basics and to lay the foundations, what are the common solutions out there today for posting initial margin?

Sagar: From a custodial perspective, there's a couple solutions, right? One being tri-party, which was the main solution adopted by the earlier phases. Traditionally, tri-party is used to optimize eligibility tests and post collateral for repo and securities loans, but back in 2016, phase one counterparties started posting initial margin via tri-party, as those firms were already connected to tri-party in one shape, or form. And also, tri-party's pretty versatile and automated. So, it was the obvious solution at that point. The other custodial solution is third-party accounts, right? These are simple, controlled accounts where the specific collateral movements are instructed, deliveries and receives, in and out by the parties. And it doesn't have the extra functionality of tri-party, such as optimization, eligibility, testing, and so forth. Those accounts start to be more widely used after the initial phases. Now, less of a custodial solution but more of an approach is the internal versus outsourcing. Many firms started to think about their overall approach to collateral management in general, since they are now required to post something new, which is initial margin; so, when overall it means saying anything from cleared, uncleared, variation margin, initial margin. Also, should they use external vendors for some components of the process? Should they outsource middle office and back office functions? So pretty much thinking about and reassessing the broader operating workflow, right? We've seen many firms using the reg requirement as a catalyst to change their workflow and utilize new solutions.

Katie: And… and in terms of how the solutions have evolved since phase one, Rob can you tell us a bit more what we’re seeing in this space?

Rob: Yeah, thanks Katie. I think building on what Sagar said, in phases one to four, we really largely saw firms managing the process via tri-party and then also managing a lot of the operational aspects of UMR themselves, utilizing like in-house solutions. I think with phase five there's definitely been more of a mix, so we've seen some clients using the tri-party solution as with phases one to four, but then also seeing some use the third-party solution, where they're posting collateral into third party accounts and receiving collateral in tri-party. So, I think that to some like the operational kind of nuances of setting that up have been challenging. We've also seen a greater demand for having one integrated solution that covers all aspects of the requirement. That's everything from calculating the requirement either via SIMM or grid, managing results in disputes and reconciliations that happen off the back of that, and then also managing that process of messaging between the different custodians for third party accounts and, the tri-party agents. What we see is offering like a menu of services that the organizations can pick and choose. In addition to all the things that I just talked about there, there’s some sort of value and services that, are out there where firms can either, monitor their threshold in relation to initial margin, and then also, you know, have pre-trade analytics, where they can assess what the impacts of a trade decision could be. And then finally, another new one we've seen is around like mobilization of collaterals. So, having the ability to easily move collateral between a custodial location and then either a tri-party agent or a third party-controlled account. Taking into consideration other trading decisions that counter party or client may be operating under. So, I think that really we've seen that trend continue into phase six and, all of those things are really, you know, being brought to the forefront when we speak to clients that are coming into scope.
Katie: Thanks Rob, but now I know certainly here in Europe and I'm sure it's the same for you, in the Americas, we commonly get asked what, you know, specific considerations do we think are going to be important for firms heading into phase six. Is there anything specifically, you know, that clients should be thinking about, as we move into this next phase?

Rob: I think this concept of forbearance is at the forefront at the moment, and forbearance being able to continue to trade with a counter party following this September 1st deadline, but without the documentation as long as you keep yourself below the thresholds and you're able to manage getting into compliance as you approach that threshold. In conjunction with having efficient processes for monitoring things that we really see being, at the forefront, with the levels set on that $50,000,000 margin threshold it can be allocated across entities. Another thing that we've seen in phase five and, again, expect to see in phase six is that, firms that are operating multiple entities will try, and allocate that threshold efficiently in order to be able to stay below the threshold for as long as possible to really apply the largest threshold to the entities that have the most trading activity. Leading into that then is, if you are gonna go down the route of forbearance and you are gonna try and delay impact and the ability to be able to monitor as you approach that threshold it is really, really important and, we see a lot of firms utilizing the Acadia threshold monitoring tool in order to do that. One of the options is to be able to use broker calculations rather than actually doing the calculations yourself which, on the face of it, seems like a great idea but it can present a bit of a challenge in that, not all counter parties out there, are feeding their calculations to that tool. If that is something that is being considered, it's definitely worth checking with counter parties upfront. There are a lot of benefits of actually doing your own calculation upfront anyways, so firstly you obviously prepare should you cross the threshold at any point. Then it also opens us up to things like analytics which I mentioned a moment ago. So, analytics being, ‘what if' tools that allow you to... really assess the impact of placing a new trade with a particular counter party, look at how you allocate trades across counter parties as you're... approaching those thresholds to really, delay or reduce your impact, understand where you'll be following the impact of, of executing that trade. And finally if you are, you know, going for monitoring only, then obviously you really need to plan for the length of time that it is gonna take you to get the required documentation and processes in place and to really factor that into your plans overall.

Katie: Thanks Rob, that was like very helpful as quite to looking at phase six, and, thinking about some key considerations over the coming months. There’s one of the topics that comes up again and again is eligibility and sourcing eligible collateral. How are firms in your near phases thought about funding collateral and… what options do you see existing as we move forward?

Rob: Again there is kind of definite differences between phases one to four and what we've seen in phase five. So one to four, we primarily saw, you know, high-grade government securities being utilized with phase five definitely opened up to slightly broader portfolios, securities, more interesting corporate bonds more interesting equities. It's worth remembering that there really is quite a broad range of securities all eligible under the rules. Some other context is that, some by side firms you've spoken to, you've traditionally only used cash for variation margin. Not really that familiar with the process of using securities in the first place. Is that something that's very new for them to be able to get set up operationally, in order to do that. There's considerations for using alternative platform types like equities and corporate bonds, so needing to have the operating processes to manage, the recalls of those assets should there be like a corporate action, upcoming on those securities. They are, obviously, subject to concentration limits, which, some firms may not be familiar with. And it's important to be able to have your systems and operational processes, to manage those at all. I think, on the kind of sourcing side of things, we will talk about there being ever increasing demands on various sources of collateral, and I think that this is definitely, gonna be a challenge for some. There is demand for firms looking at, agents to help them, enter into collateral transformation trades in order to be able to source the right types of collateral. When you're going down that route, though, you know, of integrating either, you know, a financing strategy and lending alongside managing securities collateral, what you really need is efficient processes to make sure that you don't have conflicts on the same types of securities. So, collateral mobilization, becomes really important there. So, I think it's with that backdrop that we talk about also convergence of varying, collateral transactions. And the need to really care for the amount of securities across different types of obligations. And of course, liquidity and yield generating activity. Firms can look to custodians to help them manage that integrated, agency financing and collateral management solution.

Katie: Sagar, I'd be keen to hear from you what you see as some of the key developments from a product functionality perspective in this space. What's changed? There's been a lot of developments since phase one. Can I hand it over to you to give us a few highlights? 

Sagar: Overall with the evolution of the phases. One of the key ones for us was, what we call the affiliate rule solution. We're one of the first to sort of create it. Actually we have three solutions specifically. And what the affiliate rule is, it's a provision to avoid long-wait risk when the third-party custodian is involved on either side of the trade. We're an affiliate of the custodian’s party to the trade, specifically. Right? So the account holding the collateral must be totally independent of the counter parties involved in the prolonged trade. Now, most custodians are impacted, right? It's cause most custodians have large trading books, where their affiliates are trading, these derivatives and are facing, counter parties, or the clients of the custodians, right? So, to address this, we created a few solutions that'll satisfy the rule requirement while minimizing the impact to our clients. We'll continue to manage 100% of our clients’ collateral, right? And all the processes associated with it. But onward pledge the affiliate related collateral to an independent location. These are the three solutions and asset location that I referred to. We're using the brains of try-party, eligibility testing, optimization. But we're using a bilateral settlement model where we're sending the collateral that's for the affiliate to an independent location.  Now, also, you know, besides having that collateral independent location, also what's very important is making sure there's appropriate default processes built in. Obviously, these are in place between our clients and those independent locations, as well as ourselves. That was one of the keys, developments from our side. That's been very beneficial for our clients.

Katie: Yeah, absolutely. I'd agree. This was a key area focus in phase five, and then heading into phase six was a by-side clients that want to be able to face after to one custodian or one try-party agent and have a comprehensive solution. Carrying on with this, what do you think was the most challenging aspect of the phase five implementation, Sagar? And, as we look ahead, what's your advice? Can you give to the phase six participants as they, are really now engaged in their preparations?

Sagar: I'll pair the advice and challenges in the same thoughts. So, I guess one thing is pick your solution as soon as possible. Phase six is in September of next year, but that's fast approaching. And there's many parts with implementing the overall workflow. And you may have multiple custodians’ internal teams impacted, technology vendors, and counter parties, and that just complicates the whole overall implementation in general. So, it's important you have enough time in that way to design the model and the solution, but also sub the solution as early as possible, accounting for any sort of pickups or unexpected scenarios. They may require problem solving across multiple parties, not just internally within your own organization. So just build some time into that. In the past, we've seen clients pick solutions or change their models late in the game, and those had impacts to service providers and their respective counter parties so, you know, periodization implications, are key to consider. So, speed is key. Another thing is when you're managing the initiative itself, structure the right internal teams and project teams, right? Make sure there's clear ownership throughout. Strong project management and governance is important. I think metrics are important, as well. So, you can get very granular with metrics. But what I would say is to develop metrics which are easy to compute, but also have a meaningful indication of where the project stands. Along with metrics, and the project management, transparency is key. Make sure the right people have a lot of sight into the overall status of the project, and they have accountability, quite frankly. And, about accountability, in terms of deadlines. Hope people queue them. Whether it's internal with our counter parties, our service providers, make sure the expectations are clear to all. And lastly, resources aren't abundant, so you may need to prioritize and sequence deliverables. Be pretty smart about it. Like I said, there's many moving parts, so, sequencing and prioritizing is important. And, I'll say one last thing. I think Rob alluded to this earlier. In terms of like, specific jurisdictions, people to consider the funding implications of the eligibility schedules that they're negotiating with their counter parties. So, ensure you're working with your own operations teams, your own collateral teams. You're thinking about the practicalities of sourcing the collateral and posting the specific types of collateral. From an agent perspective, anyways, that caught operations teams slightly by surprise. Is in relation to the 15% concentration, with certain jurisdictions and eligibility requirements. Now, a standard 15% limit across the board means up to seven different securities from seven different issuers that are required. So, some securities have large, minimum denominations, so, which essentially means when exposures are very low between your counter parties, clients may have to over fund securities and receive zero collateral value, for a large part of the whole. And it's just to, just to collateralize a counter party. So, that's just an example of something to think about early on.

Katie: That's really helpful. Rob, it'd be good to hear your thoughts on this topic, as well, in terms of challenging aspects of phase five, and sort of guiding us as we head into phase six.

Rob: I agree with all of these things. I think we need to remember that phase six is vast change in scope in terms of the number of entities and the number of pairings. And, in phase five, the most challenging part really was that legal framework, in terms of the timing of that and the negotiation between our clients and their counter parties, just due to the sheer volume of agreements that they were looking at. It might sound simple, but prioritization is gonna be key. Prioritizing relationships based on the trading activity. Really just focusing on key and material terms, and not underestimating the amount of time that it's gonna take to actually follow up with counter parties. There's a lot more back and forth on these agreements than we were expecting given that they are industry standard documents. I kind of linked into that thing around eligibility. I think it's also really important to consider what either the collateral system that you use, or your collateral provider can support and consider the impact of those, of those decisions, so like work consultatively with whoever is providing you with those services just to make sure that everything that you're agreeing is in scope. A lot of people underestimated the amount of time it was gonna take to actually build out the required file, file formats for SIMM and Grid. So, wherever your trades currently reside, which will ultimately end up feeding a calculator, really making sure that you are getting to grips with or working with a provider that, that already understands the taxonomy of how you're gonna map those trades over from, you know, how they're currently formatted to the formats that are needed to, to calculate, SIMM in particular. I’d say, speak to your existing potential service providers and counter parties early on. There's a wealth of knowledge out there that's been accumulated, it's been phases one through five. And I think we're now in a position where people really do know what they're doing and they know what to expect. So, you know, do lean on those out there that, that have that knowledge and can really, work consultatively with you. Reaffirming what Sagar said, the deadlines, they are there for a reason. Prioritize work as you approach those deadlines.

Katie: Thanks, Rob. And, with three months, been over three months past the phase five go live with was on the 1st of September, which is a huge milestone in the industry. So as we look back over the past three months, what advice do you give clients in this post-go live phase?

Sagar: User acceptance testing is important, UAT testing is important. But it's not as good as production testing, right? So production testing, in my opinion, is critical to ensure success. So, what I would suggest is, a lot of these accounts, especially in phase six, they're not gonna see any sort of collateral being posted for a very, very long time. What I suggest is doing periodic tests with your counter parties, low value, to make sure the pipes are still working, or working in general. The last situation you wanna be in, is a year and-a-half down the line you need to post collateral for the reg requirement and there's something missing within the setup, within an operational communication mechanism and, and whatnot.

Rob: Just to add to that. On the threshold monitoring side, I would say, you know, having that process in place to monitor thresholds to really understand the direction that your IM is going in is really important. In particularly volatile markets, you really need to be able to assess the impact of trading decisions and really try and project out when you think you're first gonna cross the threshold. So, I think it combination with that and then having, you know, continued, production testing to just make sure that the pipes were working and that everything's set up helps to, you know, avoid any issues down the track when you do end up going in scope.

Katie: Thanks, both. Any, any final comments to leave on this news with today?

Sagar: Going back to one of my earlier thoughts but to be specific is, focus on what’s important to you for go live right? Don’t get bogged down with some of the details that are, you know, I guess secondary or that can be managed post-Go Live. So, for example, when it comes to legal negotiations, eligibility, when it comes to certain securities markets open with solution and service providers, focus on what’s important, what’s absolute need for day one, and then focus on the rest afterwards, to ensure that you’re gonna meet the, the reg deadline.

Katie: I would agree, keep the scope focused and tight. And Rob, what about you?

Rob: To reaffirm something I said earlier on I think that prioritization is, is really key, prioritize the pairings that you're gonna need first, from a documentation standpoint and then also just getting out there and speaking to providers and really leveraging the wealth of expertise that's been built up in the industry, over the last five phases.

Katie: What we're repeating when we speak to many clients on the topic, is, get ready early. The sheer volume of clients impacted in the next phase is huge. I think the key to success is certainly, work with your providers early, work with your counterparties early, and ensure that, you know, you have your documentation in place and your operating model agreed, in good time. And we have a lot of lessons that we've learned from phase five and so I think as an industry we're very well placed, as we're heading into phase six. Thank you to all our listeners for taking time to join this podcast today. It's been our pleasure. And any further information, of course, can be coordinated by your sales and client service representatives here at J.P. Morgan. And please feel free to, to reach out to them. I would also advise that this communication is provided for information purposes only. It's not intended as an offer or solicitation of the purchase, sale, or tender of any financial instruments. Please visit JPMorgan.com for more information, including important disclosures. 2021 J.P. Morgan Chase & Co., all rights reserved. This episode has been recorded on Thursday the 16th of December, 2021. Thank you very much for listening.

[END OF PODCAST]

Collateral Insights Ep 3: Triparty pledge and the leading drivers

[MUSIC]

Russell Pudney: Welcome to Collateral Insights, a J.P. Morgan collateral services podcast series bringing the latest thought leadership, best practices, and trends impacting the securities financing and collateral ecosystem. In this series, we'll aim to focus on topics such as pledge, asset mobilization, collateral innovation, and efficiency, in addition to other common themes impacting the regulatory and sustainable financing landscape. My name is Russell Pudney, and I work in the UK bank sales team at J.P. Morgan, representing the collateral services business, and have the pleasure to be moderating today. I'm very pleased to be joined by Graham Gooden, head of product management for collateral services, and Adele Burke, APAC head of product management. We'll be speaking today about the very current topic of pledge, including the key drivers, and the exciting and innovative developments coming out of the APAC region. Welcome Graham and Adele. From J.P. Morgan's standpoint the pledge model is now seeing strong adoption in Europe and in APAC, and its success shows how the securities finance industry can successfully adapt to new regulatory challenges while preserving core client protections. Graham, starting with the basics, what is the difference between pledge and title transfer in triparty? 

Graham Gooden: At a high level, in securities financing under transfer of title, collateral is transferred between the collateral provider and a receiver, where the legal title or ownership of the collateral is transferred to the collateral receiver into an account in their name. Under a pledge structure, collateral is transferred into segregated account. But the legal owner of that account is the collateral provider. And the collateral receiver is granted a security interest in the account. Operationally, day to day, there's very little difference between transfer of title or a pledge arrangement from a triparty perspective. The same features and benefits of triparty are fully available for pledge. The account naming convention and the pledge is different to reflect the fact that the collateral is segregated for the benefit of the collateral receiver as a secured party, and that legal title is retained by the collateral provider. But otherwise both parties submit required values, both parties approved eligibility schedules, receive the same reporting as they would do for standard triparty. The significant difference is the legal contract governing the collateral account, which is named as a controlled account agreement or ACA the pledge, versus collateral management service agreement or CMSA for title transfer. 

Russell Pudney: So Graham, how does the pledge structure change the default process then? 

Graham Gooden: In a default scenario, the provider under title transfer arrangement, the collateral receiver already has legal title over the triparty account, and issues a notice of default under the CMSA before instructing the triparty agent to deliver the collateral to the collateral receiver's own custody account for onward liquidation. Under pledge, the secured party issues a notice of exclusive control for the triparty agent to cease accepting instructions from the collateral provider, and similarly instructs the triparty agent to deliver the collateral to the receiver's own custody account. In the event of a collateral receiver default, under pledge the collateral provider can submit a notice of secured party default to the triparty agent, which after a state period and certain conditions being met, transfers control of the collateral account to the collateral provider who in turn will manage through their default protocols pursuant to their underlying principle agreement. 

Russell Pudney: So Graham, is pledge a new concept in triparty? 

Graham Gooden: Pledge has been around for a long time, but was given an increased prominence with uncleared margin rules since 2016. Where pledge in the form of a triparty account control agreement has been widely adopted across the derivatives industry for the posting of initial margin, from a securities lending perspective pledge has been a feature of US activity for some time. But internationally, we partnered with ISLA in 2018 to develop the GMSLA pledge principle agreement and associated triparty ACA from which we have seen a steady uptake since. 

Russell Pudney: And Graham, you mentioned that pledge is growing in popularity. How material has that growth of pledge balances been over the past year versus overall triparty growth? 

Graham Gooden: Certainly. While overall, our triparty balances have been growing healthily around 30% year on year, pledge is growing at over 100% across the program, which we expect to increase as a number of conversations between providers and receivers increases, and pledge becomes more business as usual. 

Russell Pudney: Well, that is certainly impressive growth. It would be interesting to understand what are the main drivers and benefits of pledge. 

Graham Gooden: The main driver for collateral providers is the balance sheet benefit of retaining the principal and margin of the collateral on balance sheet. While we understand pledge structures can cost more from a higher spread perspective for the underlying securities borrowed, but the RWA benefits of collateral posted via pledge often outweighs those premiums. Other benefits of pledge include the comfort around posting collateral over record date for asset servicing, and simplification of disclosures from a shareholder rights perspective. In certain markets where transfer of title is not allowed or is problematic, then pledge offers an effective solution to enable securities financing. 

Russell Pudney: So if I can summarize those key benefits from a borrower's perspective, they are capital release and additional comfort to finance securities of a record date, and for lenders the potential of higher spreads and reporting efficiencies. Graham, is the pledge model better suited to triparty versus bilateral? 

Graham Gooden: Pledge is well suited for the triparty structure, combining the benefits of complex eligibility and optimization functionality with the flexibility to cater for different default scenarios. For the uncleared margin rules, triparty pledge is very well established, accounts for the collateralization over $100 billion of exposures on a daily basis. 

Russell Pudney: Excellent. Thank you, Graham. And switching over to the APAC region, Adele, can you share some insights on the markets in Asia, please? 

Adele Burke: Sure, Russ. We're experiencing similar growth in pledged balances here in APAC. Over the same period Graham referenced earlier, March 2020 to April 2021, in Asia Korean pledged balances are up 48%, Japan onshore pledge is up 65%, and Hong Kong China Stock Connect is up 100%. One of the main drivers for this increase is that markets like Korea and Stock Connect have regulatory restrictions on the free transfer of ownership of local securities. And as you would expect this, of course, is not conducive for traditional triparty financing. However, these markets do allow for the pledging of local securities as collateral. And as such, triparty with the operational benefits and efficiency, have been able to help facilitate the financing of Korea and Stock Connect securities. 

Russell Pudney: Thank you, Adele. So are collateral pledge arrangements new in APAC, and are the requirements and practices similar to other markets say in Europe? 

Adele Burke: Interestingly, pledge arrangements are quite common throughout Asia. In some markets, like China and Japan, pledge financing is more prevalent than title transfer. One of the main drivers is that markets like China, Korea, Taiwan, and India sometimes referred to as investor ID market, as omnibus constructions are not permitted. These markets have regulatory restrictions on the free transfer of assets between different legal entities or beneficial owners. In other words, free transfer across beneficial owners are not allowed. So the typical title transfer financing arrangement just does not work. However, as I mentioned earlier, pledge arrangements are allowed in these markets, and therefore collateral receivers can obtain a security interest over local securities. In other markets, like Japan, this is not an issue as it relates to ID market. Free transfer across beneficial owners and different legal entities are permitted. That said, Japan has its own nuance when it comes to the pledging of Japanese securities. In Japan, to create a valid and perfected security interest over Japanese securities, the pledge must be administered in compliance with the Japanese Book Entry Act, which is a local regulation. Under the Japanese Book Entry Act, there are two key requirements. The first, the pledge of Japanese securities must be governed on the Japanese law. And the second, the pledge securities must be transferred into a pledge account open in the name of the collateral receiver by the custodian. Just another point to note is that the custodian administrating the pledge must be registered with the Bank of Japan as it relates to JGBs, and adjusted for Japanese equities, corporate bonds, or any securities cleared through [INAUDIBLE]. 

Russell Pudney: That's very interesting. There are certainly some unique complexities and opportunities to pledge in APAC. Adele, focusing on pledging Japanese securities, did I get it right that they would need to be transferred to an account opened in the collateral receiver's name? And so does the collateral receiver then become the legal owner of those securities? 

Adele Burke: So Russ, the Japanese securities would need to be transferred to a pledge account opened in the collateral receiver's name. However, and this is critically important your question, the collateral provider or the pledger will retain ownership over the pledged securities in the account. Now, this is the case because under the Japanese Book Entry Act there are several security transfer types available. Two of the most commonly used are [JAPANESE], which is a transfer of securities without any change in ownership, and the other one is [JAPANESE], which is the transfer of securities that would result in the change of legal ownership. Now, [JAPANESE], which is also referred to in English as the simplified pledge, is a type of transfer that is commonly used for the pledging of Japanese securities where the securities are transferred into an account in the collateral receiver's name, without any change in terms of legal ownership. In short, the legal title remains with the collateral provider. This nuance is covered in the bilateral security agreement which addresses the perfection of the pledge, as well as the triparty account control agreement. 

Russell Pudney: Thank you for that detailed explanation. Given the nuances you've highlighted, particularly with respect to Japanese pledge, is it possible to have a mixed pool of Japanese and non-Japanese collateral? 

Adele Burke: No. This is a great question, which is of critical importance to our global clients who usually post a mixed basket of collateral in triparty. So the answer is yes. Clients can pledge a mix of Japanese and non-Japanese collateral for a given trade in triparty. Now, this is possible because unlike in the case in Japan where the Japanese Book Entry Act is very prescriptive with respect to the account structure and the naming convention of the pledge account, the European and US requirement for a valid and perfected pledge are much more relaxed and therefore, able to conform to the Japanese pledge requirements particularly around the account naming convention. This means that with updated provisions to the security agreement, which is the bilateral trade agreement, along with the triparty ACA, Japanese securities as well as non-Japanese securities, like US Treasury or UK equities, can all be held in a single pledge account open in the collateral receiver's name. A final point in Japan, with respect to the event of a pledge's default involving Japanese collateral, the enforcement process is exactly the same as you are familiar with for standard triparty arrangements. Meaning that the collateral receiver would send a notice of default to the triparty agent along with instructions on SSI detail for the delivery of the Japanese securities to their account at their custodian, at which time the title or the ownership of the collateral will be transferred to the collateral receiver who will become the legal and beneficial owner of the securities. 

Russell Pudney: Thank you, Adele. It's certainly great to hear there is a triparty solution to co-mingle international and Japanese assets under a Japanese pledge. So we've really come to the end of the podcast. And a good question to finish on, what does a future of pledge look like? Graham, would you like to go first? 

Graham Gooden: Thanks, Russ. Other applications of pledge we've seen are controller count agreements to collateralize margin lending. Another area of development is the use of pledge for repo arrangements, which is under discussion. 

Russell Pudney: OK, excellent. And Adele, from your perspective? 

Adele Burke: Like most discussions around Asia, they usually start and end with China. So currently, we support in our triparty program Chinese equities traded through the Hong Kong China Stock Connect scheme. Now with respect to Chinese fixed income securities, we are in consultation with local market experts on a triparty solution. 
Russell Pudney: So Adele, what's the driver for looking at China onshore? 

Adele Burke: So for a bit of context, the China onshore bond market is the second largest bond market globally with a total outstanding issuance of around $13 trillion. As of August this year, the total foreign investors' holdings was around $600 billion, which increased 86% over the last two years. Including in this 600 billion are Chinese government bonds, commonly referred to as CGB. These account for almost 60% of the foreign investor holdings or $340 billion which grew by 85% over the last two years. Given this growth in foreign investor CGB holdings and the fact that pledged security financing is well established in China and is more popular and widely accepted locally, CGB is now our immediate focus. 

Russell Pudney: Graham, Adele, thank you very much for your time and insights. I think you've provided a comprehensive view of the key considerations with regards to pledge for the securities financing participant. And thank you to all of our listeners for taking the time to join this podcast. Any further information required can of course be coordinated by your sales and client service representatives. Please feel free to reach out to them. I would also advise that this communication is provided for information purposes only. It is not intended as an offer or solicitation for the purchase, sale, or tender of any financial instruments. Please visit jpmorgan.com for more information, including important disclosures. 2021, JPMorgan Chase and Co, all rights reserved. This episode was recorded on Wednesday, the 10th of November, 2021. Thank you for listening.  

[END OF PODCAST]

Collateral Insights Episode 2: CSDR and its impacts on securities financing and collateral lending

[MUSIC]

Julie-Anne Atkins: Welcome to Collateral Insights, a J.P. Morgan collateral services podcast series bringing the latest thought leadership, best practices and trends impacting the securities financing and collateral ecosystem. In this series, we will aim to focus on topics such as asset mobilization, collateral innovation and efficiency, in addition to other common themes impacting the regulatory and sustainable financing landscape. My name is Julie- Anne Atkins, sales executive, representing the collateral services business at JPMorgan. And I'm very pleased to be joined by Rickie Smith, Vice President Tri-Party Product Management, who will be speaking today about the very current topic of central securities depositories regulation, or CSDR. Welcome, Rickie.

Rickie Smith: Hi Julie-Anne. Ah, thank you very much for having me on the podcast today. Um, I'm sure it won't be news to many to learn that CSDR is going to impact industry participants with the third phase of the regulation scheduled to go live in February 2022.

Julie-Anne Atkins: Indeed. And we intend to spend time discussing the background and the overall objectives more broadly, as well as updates on industry advocacy efforts to ensure that timings and readiness are in sync. Rickie, for background purposes, we should recap on what CSDR is, who it impacts and what it aims to achieve.

Rickie Smith: Absolutely. It's important to remember the overall aim of CSDR is to facilitate the post-trade harmonization efforts in Europe and increase the safety and security settlement and the settlement infrastructures in the European Union. Now the CSDR actually entered into force on the 17th of September 2014, and implementation has been phased in over several years, with implementation already completed for account segregation, whereby CSDs are required to offer participants the choice of having a segregated market account. And also internalized settlement, which introduced the quarterly reporting obligation for settlement internalizers to report both value and volume and activity that has been settled outside of CSDs to their local competent authorities. Now the next phase of CSDR which we are faced with is arguably the most impactful. This is the settlement discipline regime, which is scheduled to go live 1st of February 2022. The particular aims of the settlement discipline regime is to ensure the timely settlement of transactions which impact throughout the trade life cycle. This is going from pre-settlement, in terms of trade allocation and confirmation, settlement, from a trade settlement matching, settlement fail monitoring, but also measures to address settlement fails including cash penalties and mandatory buy-ins. 

Julie-Anne Atkins: And in terms of who it impacts you mentioned settlement infrastructures in the European Union.

Rickie Smith: Yes exactly and- and it's important to highlight that given the CSDR, applies to all European C-S-T's and to all market operators in the context of security settlement this scape of impacts from both the client trading and settlement perspective is global and does not only apply to EU domicile legal entities. Additionally it is worth mentioning that the UK treasure has confirmed earlier this year that it will not implement a settlement disciple regime. Meaning that any UK trades settling in the Crest Settlement System are not in scope of the European Union settlement, and the existing framework will continue to apply.

Julie-Anne Atkins: Okay so we've covered what the regulation is looking to achieve. Uh, let's discuss the impact, the industry, and the main challenges that firms are faced with in complying with the requirements.

Rickie Smith: Sure. the impact of CSDR, specifically settlement discipline regime can be categorized into two main areas. So firstly, there is the loss prevention aspect. Covering life cycles, then such as pre settlement, and settlement monitoring. This is where the regulation mandates adherence to existing best practices for completing trade allocation and conformation on t zero, in addition to a harmonized settlement matching criteria across Europe. Where by clients will need to ensure the correct transaction type is included on their settlement instruction. The second area of focus is on the punitive measures, the dealing with late settlements. Firstly with the introduction of settlement penalties, which will be applied to fouled settlements from the contractual settlement date onwards. The penalty system itself is administered by the CSD's and results in a debit from the failing participant and a credit to the failed upon or the receiving participant. The charges levied will be one basis point per business day for liquid equities. And zero point one basis point for government bonds. If the settle continues to fail for an extended period of time, for example four business days for a liquid equity, the regulation mandates that the buyer of the security is legally required to initiate a by in, for the appointment of an independent by in agent. This is for a process referred to as the mandatory buy in framework.

Julie-Anne Atkins: And expanding on those punitive measures, specifically the mandatory buy-ins, could you, um, expand on what exactly those consequences are?

Rickie Smith: Sure. So probably best to take us a little step back. So for those not familiar, a buy-in mechanism is available to the purchasing counterparty of trade in the event that the selling counterparty fails to deliver the purchased securities as contractually agreed. Now, under a conventional buy-in, which is executed at the discretion of the failed-to entity, the original trade is canceled and any differences rising from the net costs of the original transaction and the buy-in are settled between both parties, as both negative and positive. Through the CSDR, the initiation of a buy-in will become mandatory and the purchasing counterparty will be required to initiate the buy-in at the end of the extension period, which is four business days post intended settlement for liquid shares, and seven business days for fixed income securities. Now, there a- there are a number of open questions which remain outstanding, particularly around the practical applicability of the mandatory buy-in regime and ongoing discussions with an industry working groups to agree on a standardized approach. I'll touch upon a few of these issues now and concerns to get a feel for what the industry's dealing with. First of all, we have the impact on liquidity and pricing, whereby it's foreseen that mandatory buy-ins would have a substantial negative impact on market liquidity and pricing, especially in stressed market conditions. Then there's the definition of scope and the type of settlements and categories of financial instruments, actually subject to the mandatory buy-ins, which remains unclear, as I mentioned, the mandatory obligation of the failed-to party to actually appoint a buy-in agent, and the execution of those buy-ins. This includes the outstanding mechanism of buy-in price limits and a need to identify the responsible party for putting the original settlement instruction on hold. There is also a requirement for reporting of the buy-ins to regulators by trading parties and settlement agents into CSDs. And finally, probably the biggest challenges around the price is assymetry. Now this is whereby, if buy-in price is higher than the initial trade price, the failing party must pay the difference to the buyer. However, if the buy-in price is lower, there is no payment and the differential is deemed paid. Therefore, the industry is looking at contractual remedies which would need to be put in place to address this.

Julie-Anne Atkins: So with this implementation date fast approaching, what are JPMorgan and the industry doing to overcome some of these challenges?

Rickie Smith: So J.P. Morgan has and continues to, to actively engage with European Commission, ESMA and national regulators on the challenges surrounding the Settlement Discipline Regime. Advocacy is ongoing bilaterally and together with other industry stakeholders and trade bodies, such as ISLA, ICMA, and AFME to request clarity on service scope, scope a- aspects, and this is via a Q&A submission, um, into ESMA. But also, there's a re- in, in relations to the lobbying effort, which, to request the decoupling and deferral of the mandatory buy-in regime altogether from the 1st of February '22 deadline.

Julie-Anne Atkins: And how likely is it that the current implementation date is set in stone, or put another way, what's the likelihood of any potential delay

Rickie Smith: So although the, the European Commission has provided strong indication of the intentions to postpone or remove the mandatory buy-in regime from the 1st of February '22 Go-Live dates, the legal vehicle in which to achieve the decoupling of the mandatory buy-in implementation, um, is not yet clear, and the industry runs a real risk in not be operationally and contractually ready should this be unsuccessful. On September the 23rd, ESMA sent a promising letter to the chair of the European Commission calling for urgent action to provide a signal that a modification of the current implementation deadline is considered. I postpone in the mandatory buy-in framework, as soon as possible. And, ideally, at the latest, by the end of October, 2021.

Julie-Anne Atkins: The- More specifically for the securities financing industry, how are these transactions impacted? And, where are the highest risk areas? How will behaviors and operating models need to adapt to comply with this third phase of CSDR?

Rickie Smith: Within the securities financing space, the- the Settlement Discipline Regime has an impact stock lending activity throughout the life cycle of the trade. If we look at the- the response to the- to an insular survey in 2019, it was reported that settlement rates were between 80 and 90 percent. With the majority of fouls coming from loan returns. Now, reasons for the trade's failing cited for the survey ranged from complex account structures, through to life cycle adjustments, with swops and reallocations impacting the return in SSIs on the trade. And, through to earlier than scheduled recalls. Um, but whatever the underlying cause, these findings did highlight that certain process improvements are required. It should be a focal point of all firms in order to drive down foul rates and to improve settlement efficiency. Not just to- in order to mitigate additional reporting and cash penalties. But, also the potential, um, of the mandatory buy-ins. Now, both new loans and returns are concerned covered transactions, and are in scope of the Settlement Discipline Regime requirements. This does mean that any- any new loan or return that fouls to settle on the contractually agreed intended settlement day, the at-fault party will receive a penalty debit and the foul two party will receive a penalty credit. As previously mentioned, this is calculated and facilitated by the CSD. However, within the regulation, the mandatory buy-in regime specifically exempts securities financing transactions with a term of less than 30 days. Thus, recognizing the importance of securities lending to trade-in liquidity. However, as an industry, we are still awaiting clarity on Open date SFTs. Whereby, these trades are treated from a risk in accounting perspective in a similar way to less than 30 day term trades. And, therefore, from an industry perspective, we believe should also be included within this exemption. This is one of the questions that are outstanding, currently, with ESMA on this specific point. Another are of impact from securities lending perspective, is around the process of recall in loans. In the instance whereby the underlying lender is reliant upon the recall to fulfill a settlement of a cash market sell. Therefore, it's critical time, the timely receipt of sell notifications, to initiate a timely recall. This is paramount in a line in the intended settlement dates to mitigate any settlement foul risk and associated penalties. Given the punitive rates of foul settlement which, as mentioned, for liquid equities is one basis point per calendar day, effectively 250 basis points per annum, what we could see is an increased borrower demand for fouls coverage in order to fulfill failing deliveries, whilst negating the cost of the penalties. Internally, at JP Morgan across lines of business, we have explored ways in which to enhance the existing operating model flows of fouls coverage. Starting with AI tools that will predict the end of day settlement fouls, through to automated borrower requests. Including, the use of tri-party structures to increase the efficiency of the pre-collaterization requirements.

Julie-Anne Atkins: Now, you've mentioned, uh, the use of tri-party structures. Um, let's discuss impact to tri-party borrowers and lenders. Um, is it fair to say that because tri-party settlements are processed away from CSDs, are e- on the books and records of the tri-party agent, then this means that there's no impact for borrowers and lenders?

Rickie Smith: Yes. A certain aspect of this correct, uh, um, especially with regards to settlement activity that is processed through Tri-Party. So, there are two aspects, really. First, if we look at the allocation of collateral between borrower and lender, whether that be via transfer of title or pledge. This settlement activity is indeed only reflected on the books and records of the tri-party agent. And, this is classified as internalized settlement or captured within article nine of CSDR. Whereby, JP Morgan, as tri-party agent, has an obligation to provide reporting to the local competent authority on a quarterly basis. The second aspect is the market settlement activity with regards to the borrower long box management, i.e. the delivery of securities into and recalls out of tri-party. This type of settlement is in scope of the Settlement Discipline Regime. And, even though the transaction is classified as no change in beneficial owner, or NCBO. The regulation does not provide any exemption- exception for these trades. Within J.P. Morgan tri-party, approximately 90% of the fouls we witness are on broker deliveries into the tri-party long box from an external custody account. This is predominantly due to the traditional broker funding models, whereby movements are instructed based upon a contractual settlement perspective. And, the broker is awaiting the delivery from their counterparty on the other side. Even though these types of transactions are said to represent the no change in beneficial ownership, as the regulation makes no exception, brokers will be faced with the operational burden of booking, reconciling and accounting for a credit penalty on one side and a debit penalty on the other side, which reflects the foul trade between two custodian accounts. Additionally, due to the lack of clarity within the scope of the mandatory buy-in framework, we again are still awaiting response from the regulator as to whether NCBO settlement fouls will be excluded from the requirements of the mandatory buy-ins. Intuitively, the party who's simply moving securities between two custodians, would never actually invoke a buy-in on themselves. However, the regulation does not specifically exempt this type of settlement activity. And, therefore, certain contractual provisions are therefore required to be included within the master services collatorate agreements. As article 25 of the regulation stipulates that all participants shall establish the necessary contracted arrangements with their clients to ensure that the buy-in requirements set out within the regulation, are enforceable in all jurisdictions to which the parties in the settlement chain belong.

Julie-Anne Atkins: And, practically speaking, what does this mean from a borrower perspective and are JP Morgan tri-party making any product enhancements to assist our clients?

Rickie Smith: Yes. So, in July of 2021, uh, JP Morgan produced a CSDR client toolkit for all of our tri-party clients, to highlight the summary of changes being implemented in preparation of the February 1st Go live. Now, starting with pre-settlement, JP Morgan and it's role and function as tri-party agent is review certain functionalities in order to support our clients and to facilitate accurate and timely trade instructions down to the market. Now, the Settlement Discipline Regime defines specific mandatory matching fields on all trade settlement instructions which have validated against our existing messaging and confirmed no changes required on this part, from clients nor on the JP Morgan side. However, for one particular mandatory field transaction type, it is suggested that clients consider whether they are sending the most appropriate value to represent the actual transaction. Historically, clients have used the trade identifier, or TRAD as some may know it within the SWIFT messaging. However, this would indicate that the underlying instruction represents a trade. Whereby, it may be a NCBO movement or a collateral movement, both of which have their own distinct transaction types. Then moving on to settlement penalties, and from this aspect, JP Morgan will allocate and pass on penalty debits and credits to the underlying brokers. Reporting will be made available both daily and monthly, identifying the effective trades with the actual debit or credit on a net basis, occurring monthly. However, in order to process the debits and credits, JP Morgan will be required to open client dedicated cash accounts in the respective currencies for their in-scope markets. And, again, should- should the advocacy efforts to de-couple the mandatory buy-in regime be unsuccessful, and no further clarity is required from the regulators of the scope of transactions, we have built new auto-cancellation functionality that allows borrowers to set a predetermined date in which they wish to cancel an outstanding market settlements. This is live already. And, clients wishing to discuss in more detail should reach out to their respective client service representatives. And, finally, whilst we await full clarity on all outstanding Q and A responses from the regulators, we continue towards working together to achieve operational readiness across all aspects of the Settlement Discipline Regime.

Julie-Anne Atkins: And so Rickie, final question. If you were to summarize the risks that would need to be considered on one the loan leg and two the collateral leg, would it be a fair statement to describe that as being three buckets of securities, finance, transactions in terms of CSDR risks?

Rickie Smith: It's a good question Julie-Anne and, and a good way to conclude the session so, yes in a way if- if we take the collateral leg, there are three stages or models of, of evolution and reducing settlement risks. First the biggest risks is where no cash collateral is exchanged bi laterally between provider and receiver, given every deliver recoil and substitution, depends on physical settlement in the market. This risk is then somewhat reduces for the utilization of tri party structures. Where only the delivery legs into an ounce of the tri party agent result in market settlement. As previously mentioned the actual exchange of collateral is internally settled. So off market. However users of tri party must insure that the pre collateralization flow doesn't impact the timely release of the underlying loan. And this will increase the settlement risk on the loan side. And then finally the third bucket, a key consideration for the future, is around tokenized structures, or the transition to digital collateral. Which would not rely on physical market settlement at all, in both the loan leg and the collateral leg can settle digitally on the block chain. Thus eliminating settlement risk all together.

Julie-Anne Atkins: Rickie, thank you very much for your time and insights. I think you've provided a comprehensive view of key considerations with regard to CSDR, for the securities finance industry participants. Both from a loan and from a collateral perspective. Any further information required from J.P. Morgan tri party clients can of course be coordinated by their dedicated client service representatives. I would also advice that this communication is provided for information purposes only. It is not intended as an offer or solicitation for the purchase, sell, or tender of any financial instruments. Please visit J.P. Morgan dot com for more information including important disclosures. 2021, J.P. Morgan Chase and Co. All rights reserved. This episode was recorded on September the 28th, 2021. Thank you for listening.

[END OF PODCAST]

Collateral Insights Episode 1: ESG: Exploring the intersections from a lender perspective

[MUSIC]

Rickie Smith: Hello and welcome to “Collateral Insights” a new JPM Collateral Services podcast series, bringing to you the latest thought leadership, best practices and trends impacting the collateral financing eco system. Including focus areas such as asset mobilization, collateral innovation, efficiency, in addition to other common themes impacting the regulatory and sustainable financing landscape. My name is Rickie Smith, product manager within the collateral services business at J.P. Morgan, and I'm both pleased and honored to be joined by our Global Head of Product Management of Agencies Securities Lending, Harpreet Bains, who will be speaking from the perspective of an agent lender. The topic of discussion will be on sustainable financing. Also known as ESG and we'll be focusing on topics within the agent lending space such as transparency, sustainable fund labels, stewardship, EU regulation and recent developments within the U.S. under the Biden regime. Before diving into the discussion today, I would like to provide our listeners with a few updates with regards to Collateral whereby the growing focus on sustainable finance is leading funds to restrict their assets to those weighted with companies adhering to specific ESG criteria – which includes the collateral that they receive. In addition to the traditional eligibility exclusion and concentration limit tests, within our tri-party program we have incorporated multiple ESG indices that clients can build schedules against to test the eligibility of the collateral that they receive. Thus facilitating a lenders requirements to integrate the collateral process into their wider ESG policies / sustainability framework. We also continue Working with the ISLA ESG through active participation with both ESG and Collateral Management Steering focused on the direction of ESG data integration, including adoption of best practice, vendor utilisation, and where possible, standardisation- inclusive of indices. I'd now like to move on by welcoming Harpreet, and we’ll jump into the first topic which follows on from the J.P. Morgan financing and collateral conference, where back in February we heard the common topics of the “ESG in securities lending” discussion tend to be focused on collateral and proxy voting. However, it does appear that focus may now be shifting towards transparency and the debate into whether the activity of securities lending itself lacks transparency. So without further ado, welcome Harpreet to the episode, and interesting to get your opening thoughts here.

Harpreet Bains: Firstly, thank you for the introduction Rickie. You know the issue space is for sure one that continues to occupy a significant amount of headline space and it can be difficult at times right, to digest all the information that hits our desks on this topic almost every day. So hopefully this brief session will help draw out for our listeners some of the prominent threads and discussion points, at least with respect to securities lending and ESG at this point in time. So now you know turning back to your first question. Transparency, it's an interesting one, right, and a theme I think for sure needs to be unpacked more as it's been part of the debates but in rather broad terms, whereas I think what may assist the discussion is more precision around the actual risk. You know in my view generalized statements that there isn't transparency are hard to support. In fact, you know ISLA recently commented on this topic and highlighted that there are a number of regulatory and legislative safeguards that exist today to support transparency. Some of which actually came about as we know as part of the post financial crisis reform and accumulatively have helped shine the light on securities financing more so than ever before, really taking it out of the shadow. And in most part, been a key success factor in driving up investor confidence, hence the unprecedented levels of increasing supply that we see today. By that I mean you know what are those key examples of protections that I'm referring to? So, firstly the recent implementation of SFTR, which has introduced granular transparency on transactions including all life cycle events in collateral. You then have the DAC6 transparency requirements that require market participants to report arrangements so the main benefit is, or could be assumed to be a tax advantage. And then, very important to the fact pattern is that mostly all securities are linked to prudentially regulated entities, with a transactional rating within a framework subject to a wide set of rules such as MiFID, the market abuse regime, the Bank of England money market code, all of which are there to protect against the build up on risk, malpractice, market abuse as well as empty voting. And should help give lenders some reasonable comfort that there are measures to protect against wrong doing by actors in the value chain. And you know further to this debate Rickie, you could also argue that the very act of securities lending is indeed a mechanism for increasing transparency across capital market through the crucial role that you know, lending plays with price discovery and supporting short selling, which is a market tool that can help tackle green washing and help identify other significant issues and misrepresentations such as we saw in the case of Wirecard.

Rickie Smith: Thanks and that's interesting Harpreet. I think if we can draw attention to a sort of recent industry paper where we actually, we saw the mention of the idea, of tracking, tracking through the train in a like GPS way. Do you have any sort of thoughts around this?

Harpreet Bains: I do. So look, you know one question we have seen raised is in relation to the identity of counterparts in back to back arrangements not because it impacts necessarily the long term ESG performance of the investment, but on the basis that a lender may not want to support certain business that wasn't aligned with their own sustainability standards or reigns.  Here, I think it's important to remember that as it stands today, a lender does have full right to restrict any counter parties that don't meet the ESG criteria. However, at the same time you do have to remain mindful of the current legal structure. The transaction relies on transfer of title, where legal ownership passes to the borrower and the lender thereafter has no legal association beyond the party to whom they've lent the securities, and therefore admittedly existing market infrastructures doesn't today identify for the lender, who their borrower counter part might might have onward dealt with in the chain. But the question that this opens up in mind my at least is, is this any different to regular cash market trading where once a sale is complete, assets will inevitably regularly exchange ownership in the secondary market without any further look through afforded to the original seller? And so you know going back to your question, whilst I am open minded to thinking about future tracking solutions, I do think we have to remain mindful that it will have limited value unless it comes hand in hand with reform of the legal structure, which isn't a small undertaking, right? So hence why it's really important to ensure that we don't get disproportionate in our response to the perceived risk. And similarly if there are concerns around the reasons why counter parties are borrowing securities, agent lenders can keep lenders informed about the demand drivers for specific stocks supported by in-depth market insights from data providers to better understand market footprints. And therefore, whilst it may not be possible for lenders to know who the end users of their on loan stocks are, this information offers a reasonable idea of activity around particular stocks and reasons behind individual borrows more than ever before, in turn, allowing for that more informed decision making around recourse restrictions should a lender feel uncomfortable with any particular transaction.

Rickie Smith: Absolutely, absolutely. If we could now maybe turn our attention to the topic of labels. Now there has been some ambiguity around whether obtaining a European sustainable fund label, i.e. any ESG label, actually prevents participation in an agency securities lending program. Now, can you give a view with regards to this?

Harpreet Bains: Yes. So you're right, we are seeing that labels for sustainable finance are gaining popularity in Europe. To put into context, nearly 1,500 labeled funds holding just under 700 billion of assets under management at the end of 2020. And this isn't too much of a surprise right, given the increasing investor sentiment for ESG products, and labels can be an effective means to give investors reassurance that the products that they are buying have been independently validated against agreed market best practices. And they can certainly help increase the profile of ESG funds. However, what we also begun to hear from clients which was a tad concerning, was that there appeared to be some ambiguity amongst a few around whether obtaining a label precludes active participation in securities lending. So to try and address, we undertook our own independent review of the criteria published by four of the most prevalent labels. Specifically we looked at France, Belgium, Luxembourg, Germany. And in our view we found that whilst the criteria varies across labels, all seem to have provided little specific guidance or explicit references to a funds participation in lending. Albeit that said, recently you know in May this year Rickie, we did see the Febelfin agency update its standard with a specific sec lending section. However, what we did note through our review as you'd expect, is a reoccurring reference to principles, namely corporate engagement, transparency of information to investors, adoption of portfolio exclusions, which in our view can effectively co-exist alongside participation in lending. In fact, you know going back to that recent action by the Febelfin to include a new dedicated section for securities lending, where it clarifies expectations on voting and oversight, you could argue it removes the ambiguity as to whether lending is permitted. And on the contrary, the emphasis in the text for lenders to explore sustainability considerations with their providers, can be implied to be an acknowledgment that solutions are possible. My point being, if they wanted to add explicit restrictions, then they could have done so within this amendment. So I take this as a positive. I know timing's short today, so I won't go through each of the principles, but we have prepared a short paper, which summarizes the criteria, our thoughts, and we'd be very pleased to share that with interested clients and discuss in more detail the ways in which programs can be structured to prevent there to have to be a choice between registering for a label versus generating additional income for investors. And just before I finish on this one actually just one further point Rickie, I should also reiterate that this specific dialogue has also been raised with ISLA as we'd like the opportunity to also table directly with agencies and hopefully lobby for wider messaging that may help with removing any doubt around this subject. So, more to come on this one.

Rickie Smith: Thank you. And then really sort of switching through the gears, we know what's happening in the EU. But how is the rest of the world fairing? I suppose more specifically Harpreet, the U.S. So we’re under the new Biden administration and the changes of France of the SEC, will we know we see renewed focus on the ESG within the political agenda? And probably second part to that question is, if so, where can we expect that focus to be placed

Harpreet Bains: Yeah, look, I think it's fair to say that you know, the previous high degree of divergence within Europe, and the little that was happening in the U.S. particularly at the Fed reg level has now turned a different direction for sure. We are seeing a paradigm shift with developments almost on a daily basis. Whilst Europe has to date been the epicenter of the ESG regulatory debate with SFDR and other regulations, the Biden administration represents a significant shift in view points from the previous with respect to climate change, DEI matters and specifically the current leadership of the SEC has moved quickly and decisively to demonstrate the agency's intention to focus on ESG investing and climate related issues. For example, you know within weeks of her appointment, we saw Allison Lee create a new ESG focus position within the office of the acting chair. Satyam Khanna, the first senior policy advisor for climate and ESG to advise on ESG matters and advance related initiatives. And this trend is also reflecting itself in market data. For example, if you look at some of the numbers from Bloomberg, it indicates that the U.S. has taken over Europe's long held dominance in ESG ETF funds, and whilst Europe remains the largest for ESG ETF listings, the largest share of ESG ETF investments are now directed into the U.S. You know a trend likely to continue Rickie, fueled by the U.S. climate push broadening of funds strategies and overall increasing investor awareness.

Rickie Smith: And on that point, are there any notable observations from your perspective which gives us a preview as to how the fund industry may be impacted, or specifically alter the way they think about securities lending

Harpreet Bains: Yeah look, if I look back over the year so far I think there are certainly some interesting preludes that could shape the ways in which funds have to think and consider for ESG into the future. If I had to point to the ones that stood out for me, I'd say firstly the focus on disclosures. On, you know, on March, the 4th, we saw Lee launch a new climate in ESG task force within the SEC's division of enforcement which we understood would initially focus on identifying material gaps or misstatements in climate risk disclosures under existing rules whilst also analyzing both disclosure and compliance issues relating to funds ESG strategies. Still in March, we then heard Lee call for changes to shareholder proxy voting disclosures and reiterated the need to ensure that retail investors have more insights into how their money is voted. Most notably from this speech, you know, we also heard her scrutinize that balancing act the index funds must perform in exercising their voting capabilities in support of ESG matters which can add value for investors versus maximizing returns through an active securities lending program. Secondly, I would probably call out the emphasis on green washing. You know specifically in April we saw the SEC issue a risk alert on ESG investing. Now, when the SEC puts out a risk alert it's in all our interests to pay attention to it. And in ISLA the SEC introduced its observations from recent exams, emphasized the importance of consistency between stated and actual practices. And specifically expressed their concerns with green washing. Essentially funds need to do what they are saying they are doing. And in recent weeks we have seen more come out from Gensler on how we can expect the agency to address this concern going forward. And then finally, the announcements from the Department of labor. So just to remind our listeners, last year, the DOL put out some very controversial rules precluding ERISA plans from considering ESG factors when investing, impacting the ability of fund managers to promote sustainability through their investments. However, in March, the DOL announced that it wouldn't be enforcing this rule, that it would be revisited. But it was unclear Rickie, at the time what timeline to expect albeit it was welcome news to providers of ESG products. Now, fast forward three months, and at the end of May we saw the introduction of a bill which if enacted, the proposed law would effectively clarify that retirement plans may consider ESG factors in investment decisions in a prudent manner, consistent with other fiduciary obligations, i.e, the same legal standard applied to other non-ESG factors. Now, I think it's reasonable to assume that opposition to the bill is likely, however what is clear at this point is that if it is passed, it would make ESG consideration much easier for ERISA fiduciaries and therefore promote ESG investing more generally. And and just to finish this point you know, the focus on ESG isn't entirely new. Some will remember Lee's comments from last year where she pointed out that reg involvement is needed around standard and comparable disclosures. Overlay that now, like you said with Biden administration's border commitment to advancing climate change, the current SEC focus on ESG is not therefore surprising. But the actions so far do leave you wondering what outcomes the enhanced in focus will lead to. You know, will Gensler be fully lock set with the issue views of Lee, or will he align somewhere between those views and some of the other commissioners, who in fact indicate that more caution is needed? So I think it's one to watch closely for sure. And maybe we should revisit this question in six to 12 months time, in a future session to see where this focus actually leads us.

Rickie Smith: Yeah, definitely await and see there to what direction that takes. And Harpreet, maybe picking up on the earlier mention of SFDR and which for those less familiar is an EU disclosure and transparency regulation and sets out a number of entity and product that will disclosure your requirements of in scope firms as regards to both sustainable investments and sustainability risks. Now, in your opinion is agency lending considered an in scope product, i.e. is it sustainable in its own right? And then if so, what does this mean in how firm's products need to adapt to adhere to those requirements?

Harpreet Bains: Okay, just to remind listeners right, and you sort of touched on it, the aim of the new regulation SFDR, is to provide transparency on sustainability within the financial markets in a standardized way in order to reduce green washing and facilitate that comparability, thus supporting increased sustainable investment. Now, if you're conducting portfolio management under MiFID definitions from an entity based in Europe, which can be the case for cash reinvestments, then current interpretation suggests that agent lenders could be within scope in relation to those portfolio management activities. For those in scope, you then have to consider how you would categorize for disclosure purposes vanilla, light green, dark green, which by the way just filtering into only three boxes is the challenge in itself, right, with the growing view that more differentiation is needed. But Rickie, what's made it even more confusing is the scrutiny applied by some as to whether securities lending in its own right as a product, not just in relation to cash reinvestment should be considered as promoting sustainable characteristics. On the basis that it's role in the promotion of market liquidity ultimately leads to better capital raising conditions which is good for ESG focused companies. Now, my view is that this is quite a broad application and more work needed to verify that correlation between liquidity and the long term ESG performance of a security to really test this one out. But the other side of the coin is acknowledging that lending for certain plays an important role in supporting the capital market eco system, but it's not a sustainable product in its own right as the act of lending is not making a direct contribution to the UN sustainable development goals. Now, unfortunately this debate isn't helped by the fact that the meaning of promotion within the regulation generally remains unclear and it's actually one of the points where further clarification has been sought, therefore as of now as ISLA pointed out at the time of go-live, the most sensible thing is to wait until further clarity from the regulation is made available. And actually saying that Rickie, you know I've heard that the European commission response to those clarity questions was actually published earlier this week, so that's my bedtime reading sorted. But you know, also probably worth highlighting before I finish at this stage, that the EU commission has announced in this last month, a delay to the implementation of the second phase, right, until July, '22. Allowing for additional technical guidance to be made available to those impacted.

Rickie Smith: Yeah. And how do you think this impacts the demand for ESG products and fund managers more broadly?

Harpreet Bains: So what I think we can say more confidently, right, as of now, is that the increased transparency of which products are ESG and which are not, could indeed provide additional support right, to the development of ESG investing and push more capital towards sustainable activities. There has been, in fact still is right, a high degree of opaqueness, which makes selection of sustainable funds quite difficult. But the new categorization and the requirement to now provide detailed sustainability risk information, will inevitably lead to more informed investor decision making, allowing them to compare and differentiate between funds and increase their ability to assess on the true sustainability of products. In fact going further, you could argue that the disclosures will potentially expose laggards, highlight non ESG products as archaic, therefore in order to remain competitive, the market may see these now being converted, leading to a potential surge in sustainable fund launches as asset managers look to reposition products triggered by that comply or explain the SFDR is introducing. Finally, I think it'd be fair to say that in the future, we will see other regulators in other regions, also inevitably responding with the introduction of similar rules. In fact this month alone, we expect the FCA to announce a set of principles for ESG and sustainability fund design and disclosures. And in parallel, many other existing regulations are also planned to be upgraded. For example, distribution rules under MiFID are expected to be amended to reflect some ESG components. What this means as an agent lender? Well, we're watching these trends closely as this combination of expected growth and heightened focus you know may trigger a rise in scrutiny from impacted clients as they assess how the ESG strategies are integrated across all of their investment activities including their lending programs. You know, there's little doubt in my mind that SFDR is placing sustainability right at the center of the investment process and you know as an industry we've already seen signs of such scrutiny and much has been said already the ability for lending to co exist alongside client's ESG objectives. However the spotlight only gets stronger with SFDR in my view, and it becomes ever more crucial that we move this conversation from the why to the how with respect to aligning programs to client-specific strategies.

Rickie Smith: Very interesting there Harpreet, thank you. Given the discussion today is focused on the view of an agent lender it does seem reasonable to address the topic of stewardship and how a beneficial owner is able to continue to deliver healthy returns to investors, whilst balancing their responsibilities with regards to demonstrating active stewardship over their investments. This I feel would also be of interest to our Tri-Party client base. So Harpreet, can I get your thoughts on this last subject for today please?
Harpreet Bains: So, I'd begin by saying look, firstly I do think there is a need to dispel some of the reservation that exists amongst some by side community that securities lending undermines an asset managers stewardship responsibility around exercising voting rights and as a result maybe viewing lending as a barrier to effective shareholder engagement. Before I delve into any of the detail, it's important to place into context and recognize that the you know, proportion of a company's market count that is routinely on loan, is only at negligible levels, right? If you took them data from 2020 it suggests that in 2019, you know on average, less than one percent of the market cap of the FTSE 100 was on loan at any one time during the year, and therefore too simplistic in the wider debate on lost votes to only point to stock on loan as the sole contributing factor.

Harpreet Bains: That said, as an agent lender we fully acknowledge that clients will increasingly be looking to drive long term sustainable value through proxy voting, hence you know why once a lender has established a full engagement voting strategy, it should be discussed with the lending agent, who should be able to calibrate the program to ensure that the lending client has relevant securities back in their custody accounts ahead of important company meetings should clients be wishing to vote. Therefore, negating that risk of lending becoming an impediment to responsible voting. This is largely what happens today where active stewardship has become an important part of our markets. And best practice already reflects essential elements of shareholder engagement. In fact data shows that there is clearly a reduction in lending supply over proxy record date proving that the recall process is in play today. But all of that said Rickie, we also clearly recognize that there will be differing views on what to recall and when since sustainability objectives differ across asset owners. And thus you know, we continue to invest in our program with this being at the fore front of our minds.

Rickie Smith: And could you potentially share a little bit more about what that investment entails?

Harpreet Bains: Sure. So what is meant by this is that we are placing a great deal of focus on enhancing our program with a data-lead approach that will enable clients to exercise greater flexibility when setting their preferences, whether it's a blanket recall defined by market, size of holdings or even determined by vote materiality. In fact, you know, building on this last point, we're also seeing that while some asset owners have data already feeding down from their enterprise that is driving their position on voting and lending, others are still in nascent stages, therefore to support further, we can now provide vote materiality scoring for global assets sourced from a leading third party proxy specialist as an additional data point to facilitate the process. And then finally for all lenders, we provide our what if scenario tool, which enables clients to model the lost revenue that could have been earned if the securities had stayed on loan. You know it's a recent investment we've made as we get that it's a complex process, and essentially a juggling act between trying to balance stewardships goals and fiduciary duty to generate revenue. Therefore, being able to model the potential revenue impacts can be an enabler for more informed decision making. Look, just to summarize right, we have to remember that for some time now, data and insights in securities lending have become increasingly more integral to investment decision making, pushing the role of the agent lender more up stream. And the same is playing itself out with ESG, right, as more and more of these objectives become integrated into portfolio construction. And we're keeping this point clearly at the fore front of our data development strategy. So just going back to the top you, we're confident that we can partner with clients to help incorporate their ESG considerations, help strike the right balance, and there are some you know, strong industry case studies both from a global asset owner and asset manager perspective to demonstrate this. And you know, we would very welcome the opportunity to discuss these proxy options in more detail with our clients.
Rickie Smith: And with that we come to the end of the session. I'd like to firstly thank Harpreet very much for joining me to discuss this pertinent focus area. We have touched upon a wide range of topics and from the discussion it's evident that ESG principles are increasingly being integrated into the whole investment process and growing in importance globally. I would like to invite both our Tri-Party Borrowers and Lenders to reach out to their respective Sales and client service representatives should they wish to learn more around the aforementioned developments with regards to collateral solutions, in the context of ESG. I hope all listeners have enjoyed today's discussion, and we very much look forward to bringing to you the second episode in the near term. This communication is provided for information purposes only. It is not intended as an offer or solicitation for the purchase, sale or tender of any financial instruments. Please visit jpmorgan.com for more information including important disclosures. ©2021, J.P. Morgan Chase & Co. All rights reserved. This episode was recorded on July, 27th, 2021.

[END OF PODCAST]