Business as beneficial
19 January 2016
With interest rates finally rising in the US, experts discuss what the future has in store for beneficial owners and their agent lenders
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How is the US market faring, particularly after the rise in interest rates?
Chris Benedict: Demand to borrow US securities remained strong in 2015, even after the Federal Reserve raised interest rates by 25 basis points (bps) on 16 December 2015.
There was an average of $954 billion worth of US assets on loan and an average of $7.44 trillion in lendable assets for the US in 2015. The US market averaged fees of 39 bps with an overall utilisation of 12.8 percent for the year. Íø±¬³Ô¹Ï lending revenues for the US grew 21 percent from approximately $3.11 billion in 2014 to about $3.78 in 2015. The US market remained a predominantly general collateral market punctuated with specials in 2015, much as it was in 2014 and 2013.
George Trapp: Since 2016 began, the US market has been reacting to global concerns. There has been an increase in volatility across the global markets. Nominal interest rates still remain at historical lows despite the modest 25 bps increase in the federal funds target range, however, that move was well anticipated and has had little impact on the broader financial markets.
From the securities lending perspective, increased volatility has meant large swings in mark-to-market activity and continued, steady demand in the US market across all asset classes. Short-term rates have settled into their new range and been relatively steady as anticipated. As part of a larger trend, there is less reliance on cash collateral and US beneficial owners are seeing a larger portion of non-cash collateral being pledged by borrowers.
Paul Lynch: The US economic market shows positive signs of moderate growth and stability. The US equity market has experienced volatility due to the price of commodities, global market influences (China), high yield and emerging market credit issues, and the forecasted rising cost of capital. Interest rates are rising, which means the cost of cash is increasing.
There is usually a strong correlation between increased borrowing costs and equity valuation volatility, especially for companies that have levered or have stressed operating profit business models. These are factors that will contribute to a growing securities lending market in 2016. Hedge fund and short activity should continue to grow into 2016 across individual names and sectors as fundamental long and short analysis incorporates the rising cost of cash.
Tim Smollen: In terms of managing interest rate risk, we are very well positioned because we are not relying on the duration of our cash collateral investments to boost revenue. Our model is not intended to capture wider spreads by mismatching assets and liabilities.
Instead, we are focused on getting the rebate rate (fees) right, and maintaining spreads as rates track upwards. Our strategy to refrain from adjusting rebate rates in lock step with the Fed has worked very well for our clients as we avoided spread compression. In fact we increased spreads as the asset side re-priced almost immediately.
Paul Wilson: The US market fared fairly well throughout 2015 and was especially strong in the latter part of the year. Specials activity in US treasuries picked up sharply in Q4 following stronger than expected employment data. The five-year issues, followed by the three- and two-year issues, were the strongest in demand with a trend towards specials in treasury bills over quarter ends.
There was increased usage of the Fed’s overnight repurchase programme, which statistics show rose from $58 billion to $138 billion on 30 November, and highlights a product shortage in the market. In equities, the energy, healthcare, technology and consumer sectors were the most in demand with earnings further boosted by corporate activity led by the GE/Synchrony Financial exchange offer.
We note that the borrowers are increasingly preferring non-cash collateral. With the Fed rate rise taking place as anticipated in December, cash collateral investment activity reflected shorter term investments and mixed with floating rate investments to provide a level of protection against rising overnight rates. While it has been some time since we have been in a rising rate environment, it is something we have been through previously. Our securities lending investment team has been navigating this scenario for most of 2015 in anticipation of the US interest rate rise, but this cycle has been more challenging as high quality issuers are scarcer at the short end of the rate curve.
Michael Saunders: The market responded quickly to the December announcement, as money market yields moved upward reflecting higher benchmarks. General collateral rates took several days to normalise, while top-tier issues as well as trading outside of the general collateral bucket remained steady for the most part.
We believe the likelihood of further rate increases makes this a good time for clients with appropriate reinvestment strategies and risk profiles to consider lending approaches such as overnight/term or interest-rate mismatch portfolio strategies. Going forward, we could see more beneficial owners returning to the US lending space—there has already been an increase in dialogue among some clients, and so we continue to offer solutions to monetise potential opportunities in the making.
Scot Warren: From the central counterparty (CCP) perspective that OCC brings to the marketplace, we see continued growth in our stock loan programme. Month-to-month activity grew throughout 2015, with overall activity up 16 percent from 2014 with nearly 1.4 million new loan transactions in 2015. Average daily open loans were up 12 percent. As OCC continues to see interest from the industry and plans to expand in this area in 2016, we brought on new members to build up our stock loan programme last year.
Owen Nichols: The US securities lending market has been doing very well and demand for US equities in particular has been favourable. Two of the main themes we are seeing now are increasingly strong demand for US equity specials, and widening spreads for US short rates.
With respect to US equity specials, demand for deep specials continues to be robust—Q4 2015 will be one of the strongest on record. In 2015 overall, US equity lending returns in total were the strongest we’ve seen in five years, outpacing 2012’s outstanding performance when demand for a number of social media initial public offerings, alternative energy, and for-profit education positions produced record returns. For 2015, the drop in the price of crude oil has brought a number of energy names to the top of most managers’ short position list. Demand for biotech stocks also contributed to these rich returns.
With respect to US short rates, after seven years of a -0.25 percent Fed target rate, cash reinvestment desks have welcomed the Fed’s December action. Markets have responded to the tightening and anticipated follow-through with a widening of spreads between overnight funding cost indexes and 90-day cash investment indices. These movements should improve reinvestment spreads and create trade opportunities.
How is demand for US beneficial owners’ securities?
Lynch: Overall demand has been good year-over-year. High spread borrows, known as special borrows for a limited amount of securities, continue to generate a healthy percentage of beneficial owner revenue. Moderate spread borrows, known as warm borrows, had been growing in 2015 and we expect them to accelerate growth throughout 2016. Low spread borrows, known as general collateral borrows, began growing in 2015 as prime brokerage long supply decreased, broker-to-broker activity decreased, and some lending agents cut back on general collateral lending due to regulatory costs. We expect the demand for positive low spread business to grow throughout 2016.
It should be noted that collateral and term structure will play important roles in securities lending demand in 2016. Non-cash collateral and term structure will be important factors for structuring trades with optimal risk-adjusted performance for the beneficial owner and optimal regulatory capital costs for the borrower.
James Slater: Demand for borrowing securities continues to evolve in the new landscape. There are many factors that are affecting demand, but the main factors are regulation and its goal to reduce risk and increase transparency, which are causing structural changes to the marketplace.
To better understand the demand for borrowing securities, it’s best to analyse demand by product or asset type. Fundamental demand for borrowing equities continues to be strong, however, accommodative monetary policies have had an impact on the general direction of the financial markets. As a result, some investment strategies would have been challenged as evidenced by their performance in 2015, although in early 2016 the equity market direction has turned, which may provide some hedging/directional-related demand.
Other investment strategies, such as event-driven, could be well positioned as 2015 had the highest mergers and acquisitions activity in the US since 2007. The momentum for event-driven strategies in 2016 seems to remain, but time will tell if this momentum materialises into securities lending opportunities.
Another area that provided some opportunity for demand growth was liquid alternatives. Despite a leveling off from the frothiness in 2014 and early 2015, it will provide some demand for securities finance and borrowing securities.
For fixed income demand, there are a few key influencing factors. Balance sheet efficiency is presenting opportunities for beneficial owners that provide collateral and term flexibility. Regulatory demands around balance sheet ratios and increased collateral demands for central clearing have increased borrowers’ need for high quality liquid assets (HQLAs). This demand is expected to continue. Some would point to the notion that collateral might be viewed as the new cash.
In addition, the recent movement in US interest rates has provided some scarcity value in select treasury securities, and the general flight to HQLA in response to geopolitical circumstances continues to fuel demand. New margin rules for non-cleared derivatives activity and looming money market reform is anticipated to result in further increased demand for government securities/HQLAs.
While the Fed, through its reverse repo facility provides access to HQLAs for some borrowers, it remains to be seen whether it satisfies the demand created by the ever increasing need for HQLAs. Offsetting some of the growing sources of demand for HQLAs is that there is less intermediation on the part of dealers to hold and support this activity due to its capital intensity and relatively low profit margins.
Benedict: Energy, IT and healthcare sectors were all in focus in 2015. Energy commanded average fees of approximately 155 bps in 2015, well above other sectors this year, mostly due to the selloff in oil. The oil and gas drilling and coal and consumable fuels industries were especially hot within the energy sector, with average fees to borrow coming in at 339 bps and 213 bps for the year, respectively. Utilisation for these industries was also higher than average at 49 percent for the drillers and 44 percent for coal and consumable fuels.
IT was the second-hottest sector globally with average fees to borrow at 87 bps and 11 percent utilisation for the year. The healthcare sector was just behind IT in terms of its borrowing fees for 2015, coming in just 1 bps shy at 86 bps with an average 8.5 percent utilisation.
Smollen: We think demand is good, but that depends somewhat on one’s business model and the client’s holdings. Deutsche Bank markets selectively to beneficial owners with attractive, diversified portfolios. Keep in mind that even desirable mandates include securities with low demand characteristics, so we see our role as determining the liquidity and rebate rate for every holding.
Our clients tend to be long?time lenders with defined expectations as to what a ‘right?sized’ programme should be. That means not lending securities where the risk?adjusted returns would fall short of client expectations. We call it optimising within a risk?constrained set of objectives. More than that, it is a sustainable business model.
Wilson: From a supply perspective across US beneficial owners, this has been one of our strongest years, coupled with an even greater level of engagement and participation by beneficial owners. Existing clients have been quite open minded towards expanding, reviewing cash reinvestment guidelines (and options given money market reform), diversifying collateral, reviewing restrictions/parameters and being more active about complex markets, such as Taiwan and Malaysia.
We have seen new beneficial owners clients come to market and others re-entering the market since the global financial crisis. Our third-party business has grown substantially as beneficial owners become increasingly focused on matching their risk/reward profile to an agent. Without doubt, indemnification remains the number one topic of discussion across beneficial owners. The increased focus and debate about indemnification has undoubtedly led to a better appreciation of the relative quality and differences of agents in the indemnification offerings.
Trapp: Demand continues to be strong for US beneficial owner’s securities, however, the market has moved to more of a specials market with general collateral making up a smaller portion of earnings, especially for portfolios concentrated in US government fixed income securities. It is anticipated that diversified portfolios will continue to be in demand because they will likely include specials across a variety of markets.
Saunders: While new regulatory mandates have weighed on liquidity to some extent, we are still seeing consistent borrower demand for all of our clients’ asset classes, particularly around issues that trade special such as Amercian depository receipts, common equities, corporates and US treasuries. Intrinsic lending continues to be the strategy of choice for domestic owners, and we believe that bodes well for such programmes in the year ahead.
The ongoing sell-off in commodities has been keenly felt within the high yield and emerging markets, compelling borrowers to secure supplies linked to these segments as well as commodity sensitive firms. Meanwhile, the imposition of more stringent capital-adequacy/liquidity coverage requirements under Basel III and the US Dodd-Frank Act has raised the appeal of HQLAs, compelling HQLA owners to consider capitalising on the increased demand among large institutional borrowers.
How are they and their agent lenders innovating to boost returns while keeping risk to a minimum?
Wilson: While we see increased beneficial owner engagement and a willingness to review parameters, we have not seen significant changes in programmes and programme structures. Risk management, indemnification and operational efficiency rightly remain the cornerstones of lending programmes for US beneficial owners. Any changes that may boost returns need to be evaluated against those parameters.
Macro issues affecting the industry on borrowers and agents include regulatory change and the pace it is implemented by jurisdictions. This may create challenges for program development for some beneficial owners. We continue to liaise with beneficial owners on alternative (non-traditional) structures and transaction types, which could create some additional value to beneficial owners.
Trapp: The metrics, analytics, and trading tools being used to price demand and distribute inventory are the most significant innovations over the past several years. New markets continue to offer opportunities for innovation and increased income for beneficial owners. However, we have observed that innovations in trading have led to the largest gains in and revenue for beneficial owners.
Collateral diversification is also an important aspect to maintaining and increasing returns for lenders. The trend to non-cash collateral continues and those lenders willing to accept a broader range of collateral are likely to be well-positioned to maximise revenue within their acceptable risk parameters.
Lynch: Innovation is occurring on multiple fronts. Flexibility regarding forms of collateral has been a high growth area. Various forms of non-cash collateral from US and non-US counterparties that have appropriate haircuts that are marked-to-market daily, have a daily value-at-risk (VaR) calculation, and are appropriately stressed for VaR and liquidity needs are contributing to risk-adjusted returns.
Matching the method of distribution with borrower demand is also contributing to risk adjusted returns both from a technological perspective and a structural perspective. We see increased demand for structured exclusives versus discretionary lending in certain markets and certain asset classes. Auctionable exclusives for 2016 have had significant growth in demand and performance.
Nichols: We continue to evaluate new equity lending markets and collateral types to add incremental return for lenders while managing the various risks associated with each trade type. In regards to collateral reinvestment, agent lenders are working closely with beneficial owners to adapt reinvestment guidelines to reflect a new reality in which credit ratings are less relevant within the industry and increasingly liquidity is found from non-traditional sources. We’ve also been working to develop innovative approaches to utilise agency lending as a source of leverage and liquidity for our client base.
Smollen: We innovate through collaboration with our clients given that any solution we develop has to comport with client risk tolerances and return expectations. We are a third?party agent, so our clients expect us to be in regular contact and proactive in dealing with change and offering up ideas, solutions and options. This involves continuously evaluating programs and client initiatives to boost returns that might involve areas such as enhanced trading structures, non?traditional counterparties, non?traditional collateral and cash reinvestment solutions. The thing about our programme is that it never sits still—we are constantly evolving.
In terms of how we manage risk, we employ an enterprise?wide approach to risk management that entails oversight and consultative input from numerous independent risk units. We have teams, for example, that advise on market reforms and regulatory risk across both agent lending and principal borrowing activities of Deutsche Bank.
This positions us extremely well to advise clients on the stress factors affecting both agents and borrowers, and possible solutions, such as incorporating non?traditional counterparties into a clients’ strategy, while still retaining the ability to indemnify certain risks. Additionally, we measure balance sheet and indemnification cost and use this to help guide the business when contemplating trade opportunities, such as lending in one jurisdiction and accepting collateral elsewhere.
Saunders: Innovation and customisation continue to fuel our securities lending practice. Portfolio maximisation, for instance, allows us to create customised lending and reinvestment solutions on a client-by client basis, whether it be intrinsic only or conservative overnight reinvestment options using repo/money market mutual funds, or more sophisticated programmes that centre on term lending or similar structures. We also prioritise operational efficiency and risk-mitigation strategies, which we believe are just as important to clients as enhanced returns, perhaps even more so in some instances.
Additionally, we strive to be at the forefront of new global opportunities—our business currently extends to 48 different markets, with solutions that encompass emerging as well as other international strategies. Our team of network experts helps us stay informed about lending in new markets and regulatory initiatives in the making. They also help us in implementing funding structures that can benefit owners and borrowers alike. Closer to home, we continue to monitor discussions aimed at amending Íø±¬³Ô¹Ï and Exchange Commission (SEC) Rule 15c3-3, with an eye toward utilising equities as collateral should such changes occur.
Benedict: Agent lenders are using more benchmark performance reporting tools to ensure an optimal return for their beneficial owner clients. For many beneficial owners, securities lending is an integral part of their investment strategy as lending revenue can have a positive impact on their portfolio’s overall return.
To optimise the return to their portfolios, and to better understand market trends and opportunities, both agent lenders and beneficial owners are engaging directly with tools like DataLend’s Client Performance Reporting suite. This allows them to achieve a true ‘like-to-like’ view of their performance benchmarking tool, where they can select the most accurate peer group possible for their clients based on similar fiscal locations, legal structures, securities on loan and dividend rates.
Slater: Risk management is a cornerstone to any securities lending programme. With that in mind, there are several avenues for clients to derive returns from securities finance. These can range from the well-known intrinsically valued lending programme to the new collateral paradigm that is evolving, ie, the HQLA supply shortfall mentioned above. This can mean lending into the increasing demand for HQLAs, to capturing opportunities related to term financing, and/or engaging in collateral transformation trades. These strategies require establishing a rigorous and comprehensive risk management oversight programme. Counterparties, margin, market and trading activities must be carefully considered before engaging in a transaction followed by continuing oversight over the programme to ensure the goals of the programme remain in place. As the pace of change is ever increasing, it is important that there is active oversight and governance for these programmes.
Another area to keep a close eye on is money market reform. Depending on how money market mutual funds adapt, and should they follow the path of some early movers in transitioning from prime funds to government funds, one would expect a widening of spreads for corporate issuances as demand for government securities increases. This in turn will increase demand for lenders willing to extend term and provide flexibility around collateral.
Participants are continuing to push for mutual fund rule changes in a bid to optimise collateral usage—how would these changes affect the US business for either side of the trade?
Lynch: The industry has been advocating for changes in the form of alternative non-cash collateral, namely, equities as collateral. Alternative collateral will require mutual fund rule changes as well as broker-dealer SEC Rule 15c3-3 changes. There is a strong argument that an equity fund should be able to accept equities as collateral assuming that it is appropriately diversified, liquid, has a daily VaR, has periodic stress tests, and has a sufficient haircut. Equities as collateral could be beneficial to both sides of the trades if structured appropriately.
Also, some members of the fund industry are looking to more efficiently use their cash collateral as a treasurer function within the fund. As mutual funds become more efficient, the question is why pay for outside lines of credit for subscription/redemption activity and over-the-counter (OTC) collateral needs when a fund can create cash collateral from lending activity? Why not minimise expenses of the fund for shareholders? Innovation in this area continues to be explored with the need for rule interpretations.
Benedict: Should collateral guidelines for mutual funds be amended, the use of non-cash collateral will likely increase in the US market as regulatory requirements such as the leverage ratio and liquidity coverage ratio make pledging non-cash collateral more capital efficient for borrowers. Currently, non-cash collateral is pledged against only 36 percent of all securities lending transactions in the US, whereas that same collateral type accounts for a much higher percentage in the European, 80 percent, and 73 percent in Asian markets.
Smollen: We are of the mindset that we should explain to beneficial owners market place events, how it might affect them, and their options. We have worked with industry groups to do the same for the broader constituencies. As far as US mutual funds, the ultimate decision makers are the independent fund boards. We work consultatively with them and their advisors as they decide what is best for fund shareholders after their regulators approve any changes.
Nichols: Collateral optimisation will be a key driver of the securities finance business going forward in light of the regulatory challenges faced by both agent lenders and borrowers. Current discussions are on enhancing the ability of borrowers to optimise their collateral usage in a manner that is most efficient from a balance sheet perspective. Given the changes to leverage limits globally, and particularly for US global systemically important banks, the ability to enter into less punitive balance sheet trades, such as trades that can be netted or non-cash trades, will continue to be a priority for borrowers. These trades have limited direct benefit to the agent lenders, but similar to central counterparties (CCPs), they provide an opportunity to maintain demand and protect trade flow.
How are lenders adapting to regulatory change?
Wilson: US beneficial owners are engaged and thoughtful about understanding regulatory change, the impact on the industry and the impact on their lending programmes. On the whole, we have seen them adapting to regulatory changes by becoming more flexible in their approach to lending and their overall lending parameters. Regulations and rules such as the liquidity coverage ratio (LCR), supplementary leverage ratio (SLR) and net-stable funding ratio (NSFR) mean that borrowers are now looking to lock up loans for term, rather than on open. Additionally, the SLR and NSFR have also meant that borrowers are more likely to post non-cash collateral, a big change in the US markets. Lenders have had to get comfortable with taking additional types of collateral for longer durations than they have in the past.
Lastly, the increased cost of capital means that clients are now re-assessing the breadth and depth of the indemnity and discussing this with their agent lenders. Since the crisis, lenders who continue to value lending as a revenue source have become more actively involved in their lending programmes, which is a positive step. The lenders that are interested in staying abreast of regulatory change should continue to receive value from lending.
Slater: While regulation continues to reshape the lending market, beneficial owners are making the changes necessary to take advantage of the opportunities created by new regulatory requirements. For example, liquidity ratios and mandated clearing have created new sources of demand.
This, coupled with the impact of increased leverage ratio requirements on borrowers, has resulted in a significant increase in the number of transactions collateralised by securities collateral. This makes collateral flexibility key to maintaining utilisation and taking advantage of these new opportunities.
Many lenders have already expanded or are in the process of expanding their collateral guidelines. Europe has always been more open to securities collateral in general, but now US lenders appear to be accepting of a wider variety of securities collateral including equities.
New regulations are also creating collateral and liquidity challenges for some beneficial owners. Traditional sources of liquidity have become limited and expensive at the same time that collateral requirements for beneficial owners are increasing. As a result, many beneficial owners may become interested in the role that securities lending can play in helping them meet their liquidity and collateral needs while seeking to reduce costs and improve fund returns.
Nichols: Regulatory change is a continuous process that is impacting both agent lenders and borrowers. The agent lenders are becoming increasingly focused on the amount of risk-weighted assets (RWAs) being consumed by indemnified transactions and the return on capital associated with such transactions. In the US, some banks are being constrained by the standardised approach for calculating RWAs based on the Collins Amendment and even those who are not constrained under this approach from a regulatory capital perspective are beginning to feel the effects due to the standardised approach being the only option for comprehensive capital analysis purposes. Additionally, agent lenders are awaiting the finalsation of the Basel large exposure/Dodd-Frank Act 165(e) rules.
These regulations as currently proposed would utilise the standardised approach and would likely require a reduction in lending to some of the largest borrowers. At the same time that the agent lenders are facing this regulatory landscape, the borrower community is either being impacted or will be impacted by the new leverage rules, RWA constraints, the NSFR and the LCR. As a result of these regulatory changes, the use of non-cash collateral and term trades have increased, certain asset classes have been re-priced, and the re-pricing of certain client relationships, or explicitly pricing indemnification, has occurred. Additionally, lenders are exploring other routes to market that have lower regulatory hurdles, such as central counterparties or utilising third party support in lieu of indemnifications. These efforts are ongoing and full implementation may be longer term in nature.
Trapp: Beneficial owners are experiencing the indirect impacts of regulation through the modified lending behaviour of other market participants, such as borrowers and agent lenders. This could in turn cause beneficial owners to make changes to their own lending programmes. For example, the demand for borrowers to pledge more non-cash collateral and utilise term lending has increased across the market. Similarly, beneficial owners are adopting expanded collateral guidelines in order to maintain levels of lending activity that are consistent with their historical trends.
Saunders: Using thought leadership tools such as webinars, newsletters and roundtables to keep clients apprised of specific regulatory rulings remains highly important as is a consistent direct line of communication on such topics. The key challenge is finding common ground so that all parties are able to benefit. We believe that maintaining this kind of dialogue between clients, industry groups and dealers is key to achieving a fully transparent lending programme. Accordingly, we anticipate and plan on holding further discussions throughout the year as the regulatory environment continues to evolve. The experts at BNP Paribas are keenly watching and participating in all relevant discussions on a global basis.
Smollen: Our clients are interested in understanding the impact of change on the business, including stresses on agents and counterparties. While many are constrained by policy or statute, others enjoy the flexibility to rethink long?standing ways of doing business. In some cases, the movement is small and measured, but we are seeing receptivity, which is essential. Ultimately, dealing with market reforms may yield rewards, including alternate sources of liquidity and new reinvestment opportunities in a less intermediated future. We think that we are well situated as change unfolds.
How are collective investment schemes such as ETFs changing securities lending? What about synthetic products such as single stock futures and swaps?
Trapp: Exchange-traded funds (ETFs) are a great example of a product that has benefitted from securities lending. Íø±¬³Ô¹Ï lending has brought liquidity and incremental returns to ETFs, which in turn have benefited the end users, investors, of the ETFs.
Lynch: ETFs provide two forms of lending: (i) the ‘registered fund’ that lends the underlying assets of the ETF, similar to a mutual fund; and (ii) the beneficial owner/investor in the ETF lending the ETF holding. Demand for lending the ETF holding has risen over the past few years. Specific index ETFs such as the Russell 2000, High Yield, Emerging Markets and Junk Bonds have traded at valuable spreads. Similarly, certain sector ETFs and country ETFs have also traded at great value. Demand for these securities is due to the ease of shorting an index, sector or country. Swaps continue to be a tradable alternative to owning a physical security and lending it. They add complexity with investment guidelines, investment disclosure, and tax consequences, but are a viable solution for lending in emerging markets or for any market. It is important that the beneficial owner understands the swap, understands all of the returns, flows and netted expenses, and makes a suitable investment decision versus owning the security and lending it.
Smollen: ETFs have exploded in popularity with investors, as well as with short sellers seeking exposure to markets or asset classes that can be difficult or impossible to short otherwise. This has driven record securities lending revenues on these products based on resilient demand. It is no surprise that many prime brokers have now created and staffed desks to exclusively trade this product. We’ve reacted to that and trade the ETF book separate from the US equity book.
Conversely, many counterparts have looked to use ETFs as collateral as more and more are being held within inventory for future sale. We are extremely careful in accepting ETFs as collateral as there have been well publicised tracking errors to the constituent parts in down markets, and many ETFs increase correlated risks within stressed markets. Our acceptance of ETFs is dynamic in that approvals are based on current market conditions.
Nichols: Obviously, ETFs have been loaned for some time and are used as a hedging tool as well as an access point to markets that may be difficult to enter. We have noted increased demand spreads over the last year as borrowers’ balance sheet constraints have limited their ability to create ETF baskets within their business. Regarding single stock futures, they certainly do compete with our business but on a very limited number of positions. However, this trade is obviously attractive to prime brokers, as they are generally off-balance sheet transactions.
Saunders: During the past year, ETFs became more visible than ever before, and with good reason. ETFs can offer the potential for greater utilisation and liquidity within the marketplace, particularly portfolios tied to specific sectors or regions—for instance, metal, mining, energy and other commodity-based ETFs have been unusually strong of late.
Accordingly, we are seeing a greater number of ETF investors actively interested in securities lending due to the revenue generating opportunities within.
Appetite for vehicles such as swaps, derivatives or single stock futures is very client-specific, and, when applicable, BNP Paribas can offer appropriate services and solutions. For the most part, programme participants have remained focused on generating incremental income through basic lending transactions. However, we regularly provide guidance on all other opportunities within the marketplace.
This year could well be the year of the CCP—what are US beneficial owners saying about central clearing that they haven’t before?
Warren: In 2015, OCC saw an increased interest in central clearing for stock loan, and a need for more education from the agent lenders on behalf of their beneficial owners in terms of what benefits they can derive from a CCP such as OCC. We believe market participants are no longer debating whether central clearing is beneficial for the stock loan industry. Instead, they are looking at how a CCP solution can in fact enhance securities lending activity for lenders as well as the broker-dealer borrowing community.
Slater: Central clearing models for the agency securities lending market are still nascent. BNY Mellon has been working with industry participants to develop a clearing model that meets the needs of beneficial owners. It is expected that a workable model will emerge in the near future. This year may be the year that we begin to see some initial transactions. However, certain regulatory changes will be needed to allow for most US beneficial owners to participate broadly.
The move to central clearing is being driven in large part from the pressure on dealers’ balance sheets as a result of increased leverage ratio requirements. Central clearing will allow the dealers to maintain their existing volumes, but in a more balance sheet efficient manner due to increased netting benefits. As a result, CCPs will become an important distribution channel for our clients’ assets that will allow them to maintain balances and in some cases, obtain better pricing.
It is expected that the decision to utilise central clearing will develop as a point of trade discussion just like any other loan term. The negotiation with respect to how the trade will be cleared (centrally or in the traditional bilateral manner) will likely be based upon the benefits that the borrower may derive from central clearing. Accordingly, it is expected that a pricing differential would develop between centrally cleared loans and traditional bilateral loans.
Trapp: The questions still remain from the beneficial owners about what benefits they will see and how the CCP model compares relative to a typical lending transaction.
Nichols: At this point in time both agent lenders and borrowers are working closely with a number of CCPs to develop viable options for agency securities lending transactions. A number of issues remain to be resolved before CCPs experience significant flows from agency securities lending business. Current offerings are limited in the markets available, and operational efficiencies, especially around corporate actions, must be developed before there is a wholesale adoption.
We are currently working with CCPs to ensure that these issues are resolved in such a manner as to protect the interests of the beneficial owners that we service. As such, conversations with clients remain in the infancy stage with the ability to add or protect trade flow being the primary discussion point.
Lynch: US beneficial owners are watching and educating themselves as the CCP model evolves. The securities lending CCP model has evolved faster in Europe but current regulatory registrations do not allow US beneficial owners to participate. A US CCP model is still in the concept stage. I believe most beneficial owners are curious and are willing to review models as they come to market, but are waiting to see what they are and what value it brings to them.
Benedict: As CCPs offer both borrowers and lenders a more capital-efficient route to market, there has been increased interest not only from these two market participants, but also from beneficial owners. CCPs will allow borrowers to capture netting benefits and will reduce the risk weighting applied to agent lenders’ indemnified transactions. As the securities finance industry recognises the benefits of a CCP model, EquiLend has partnered with Eurex Clearing to facilitate CCP access for our client base. Our clients will be able to make use of their existing infrastructure to route transactions to Eurex Clearing’s Lending CCP. As this new route to market emerges, DataLend is poised to capture transactions executed on CCP platforms in addition to traditional bilateral trades.
Wilson: Beneficial owners are expressing an interest in the benefits and how they will impact on them. The benefits are more obvious for borrowers and agents but are less clear for beneficial owners. Beneficial owners would want to understand whether this will result in higher revenue or lower risk. Given the current product, market, and collateral coverage from CCPs, there is only a relatively small amount of business that could be transacted, but further increase would be reliant on other factors all being aligned. That being said, given the regulations and rules that are upon the industry, CCPs can play a part of the changing landscape. Going on that journey as they expand and build out capability is a positive development.
Saunders: We continue to hold client discussions that primarily focus on the role of CCPs as counterparty, as well as on the protection of client assets in the event of a default. Though such conversations have become more frequent, at this time we still do not see CCPs occupying a central role within the US marketplace anytime soon.
That said, we intend to closely monitor new developments on behalf of our clients, with the belief that ongoing discussions will be beneficial to the markets as a whole. The bottom line is that many clients will be required to conduct a complete review of their lending programmes, including what is permitted under their existing charters, guidelines or mandates, before any such changes can occur.
Chris Benedict: Demand to borrow US securities remained strong in 2015, even after the Federal Reserve raised interest rates by 25 basis points (bps) on 16 December 2015.
There was an average of $954 billion worth of US assets on loan and an average of $7.44 trillion in lendable assets for the US in 2015. The US market averaged fees of 39 bps with an overall utilisation of 12.8 percent for the year. Íø±¬³Ô¹Ï lending revenues for the US grew 21 percent from approximately $3.11 billion in 2014 to about $3.78 in 2015. The US market remained a predominantly general collateral market punctuated with specials in 2015, much as it was in 2014 and 2013.
George Trapp: Since 2016 began, the US market has been reacting to global concerns. There has been an increase in volatility across the global markets. Nominal interest rates still remain at historical lows despite the modest 25 bps increase in the federal funds target range, however, that move was well anticipated and has had little impact on the broader financial markets.
From the securities lending perspective, increased volatility has meant large swings in mark-to-market activity and continued, steady demand in the US market across all asset classes. Short-term rates have settled into their new range and been relatively steady as anticipated. As part of a larger trend, there is less reliance on cash collateral and US beneficial owners are seeing a larger portion of non-cash collateral being pledged by borrowers.
Paul Lynch: The US economic market shows positive signs of moderate growth and stability. The US equity market has experienced volatility due to the price of commodities, global market influences (China), high yield and emerging market credit issues, and the forecasted rising cost of capital. Interest rates are rising, which means the cost of cash is increasing.
There is usually a strong correlation between increased borrowing costs and equity valuation volatility, especially for companies that have levered or have stressed operating profit business models. These are factors that will contribute to a growing securities lending market in 2016. Hedge fund and short activity should continue to grow into 2016 across individual names and sectors as fundamental long and short analysis incorporates the rising cost of cash.
Tim Smollen: In terms of managing interest rate risk, we are very well positioned because we are not relying on the duration of our cash collateral investments to boost revenue. Our model is not intended to capture wider spreads by mismatching assets and liabilities.
Instead, we are focused on getting the rebate rate (fees) right, and maintaining spreads as rates track upwards. Our strategy to refrain from adjusting rebate rates in lock step with the Fed has worked very well for our clients as we avoided spread compression. In fact we increased spreads as the asset side re-priced almost immediately.
Paul Wilson: The US market fared fairly well throughout 2015 and was especially strong in the latter part of the year. Specials activity in US treasuries picked up sharply in Q4 following stronger than expected employment data. The five-year issues, followed by the three- and two-year issues, were the strongest in demand with a trend towards specials in treasury bills over quarter ends.
There was increased usage of the Fed’s overnight repurchase programme, which statistics show rose from $58 billion to $138 billion on 30 November, and highlights a product shortage in the market. In equities, the energy, healthcare, technology and consumer sectors were the most in demand with earnings further boosted by corporate activity led by the GE/Synchrony Financial exchange offer.
We note that the borrowers are increasingly preferring non-cash collateral. With the Fed rate rise taking place as anticipated in December, cash collateral investment activity reflected shorter term investments and mixed with floating rate investments to provide a level of protection against rising overnight rates. While it has been some time since we have been in a rising rate environment, it is something we have been through previously. Our securities lending investment team has been navigating this scenario for most of 2015 in anticipation of the US interest rate rise, but this cycle has been more challenging as high quality issuers are scarcer at the short end of the rate curve.
Michael Saunders: The market responded quickly to the December announcement, as money market yields moved upward reflecting higher benchmarks. General collateral rates took several days to normalise, while top-tier issues as well as trading outside of the general collateral bucket remained steady for the most part.
We believe the likelihood of further rate increases makes this a good time for clients with appropriate reinvestment strategies and risk profiles to consider lending approaches such as overnight/term or interest-rate mismatch portfolio strategies. Going forward, we could see more beneficial owners returning to the US lending space—there has already been an increase in dialogue among some clients, and so we continue to offer solutions to monetise potential opportunities in the making.
Scot Warren: From the central counterparty (CCP) perspective that OCC brings to the marketplace, we see continued growth in our stock loan programme. Month-to-month activity grew throughout 2015, with overall activity up 16 percent from 2014 with nearly 1.4 million new loan transactions in 2015. Average daily open loans were up 12 percent. As OCC continues to see interest from the industry and plans to expand in this area in 2016, we brought on new members to build up our stock loan programme last year.
Owen Nichols: The US securities lending market has been doing very well and demand for US equities in particular has been favourable. Two of the main themes we are seeing now are increasingly strong demand for US equity specials, and widening spreads for US short rates.
With respect to US equity specials, demand for deep specials continues to be robust—Q4 2015 will be one of the strongest on record. In 2015 overall, US equity lending returns in total were the strongest we’ve seen in five years, outpacing 2012’s outstanding performance when demand for a number of social media initial public offerings, alternative energy, and for-profit education positions produced record returns. For 2015, the drop in the price of crude oil has brought a number of energy names to the top of most managers’ short position list. Demand for biotech stocks also contributed to these rich returns.
With respect to US short rates, after seven years of a -0.25 percent Fed target rate, cash reinvestment desks have welcomed the Fed’s December action. Markets have responded to the tightening and anticipated follow-through with a widening of spreads between overnight funding cost indexes and 90-day cash investment indices. These movements should improve reinvestment spreads and create trade opportunities.
How is demand for US beneficial owners’ securities?
Lynch: Overall demand has been good year-over-year. High spread borrows, known as special borrows for a limited amount of securities, continue to generate a healthy percentage of beneficial owner revenue. Moderate spread borrows, known as warm borrows, had been growing in 2015 and we expect them to accelerate growth throughout 2016. Low spread borrows, known as general collateral borrows, began growing in 2015 as prime brokerage long supply decreased, broker-to-broker activity decreased, and some lending agents cut back on general collateral lending due to regulatory costs. We expect the demand for positive low spread business to grow throughout 2016.
It should be noted that collateral and term structure will play important roles in securities lending demand in 2016. Non-cash collateral and term structure will be important factors for structuring trades with optimal risk-adjusted performance for the beneficial owner and optimal regulatory capital costs for the borrower.
James Slater: Demand for borrowing securities continues to evolve in the new landscape. There are many factors that are affecting demand, but the main factors are regulation and its goal to reduce risk and increase transparency, which are causing structural changes to the marketplace.
To better understand the demand for borrowing securities, it’s best to analyse demand by product or asset type. Fundamental demand for borrowing equities continues to be strong, however, accommodative monetary policies have had an impact on the general direction of the financial markets. As a result, some investment strategies would have been challenged as evidenced by their performance in 2015, although in early 2016 the equity market direction has turned, which may provide some hedging/directional-related demand.
Other investment strategies, such as event-driven, could be well positioned as 2015 had the highest mergers and acquisitions activity in the US since 2007. The momentum for event-driven strategies in 2016 seems to remain, but time will tell if this momentum materialises into securities lending opportunities.
Another area that provided some opportunity for demand growth was liquid alternatives. Despite a leveling off from the frothiness in 2014 and early 2015, it will provide some demand for securities finance and borrowing securities.
For fixed income demand, there are a few key influencing factors. Balance sheet efficiency is presenting opportunities for beneficial owners that provide collateral and term flexibility. Regulatory demands around balance sheet ratios and increased collateral demands for central clearing have increased borrowers’ need for high quality liquid assets (HQLAs). This demand is expected to continue. Some would point to the notion that collateral might be viewed as the new cash.
In addition, the recent movement in US interest rates has provided some scarcity value in select treasury securities, and the general flight to HQLA in response to geopolitical circumstances continues to fuel demand. New margin rules for non-cleared derivatives activity and looming money market reform is anticipated to result in further increased demand for government securities/HQLAs.
While the Fed, through its reverse repo facility provides access to HQLAs for some borrowers, it remains to be seen whether it satisfies the demand created by the ever increasing need for HQLAs. Offsetting some of the growing sources of demand for HQLAs is that there is less intermediation on the part of dealers to hold and support this activity due to its capital intensity and relatively low profit margins.
Benedict: Energy, IT and healthcare sectors were all in focus in 2015. Energy commanded average fees of approximately 155 bps in 2015, well above other sectors this year, mostly due to the selloff in oil. The oil and gas drilling and coal and consumable fuels industries were especially hot within the energy sector, with average fees to borrow coming in at 339 bps and 213 bps for the year, respectively. Utilisation for these industries was also higher than average at 49 percent for the drillers and 44 percent for coal and consumable fuels.
IT was the second-hottest sector globally with average fees to borrow at 87 bps and 11 percent utilisation for the year. The healthcare sector was just behind IT in terms of its borrowing fees for 2015, coming in just 1 bps shy at 86 bps with an average 8.5 percent utilisation.
Smollen: We think demand is good, but that depends somewhat on one’s business model and the client’s holdings. Deutsche Bank markets selectively to beneficial owners with attractive, diversified portfolios. Keep in mind that even desirable mandates include securities with low demand characteristics, so we see our role as determining the liquidity and rebate rate for every holding.
Our clients tend to be long?time lenders with defined expectations as to what a ‘right?sized’ programme should be. That means not lending securities where the risk?adjusted returns would fall short of client expectations. We call it optimising within a risk?constrained set of objectives. More than that, it is a sustainable business model.
Wilson: From a supply perspective across US beneficial owners, this has been one of our strongest years, coupled with an even greater level of engagement and participation by beneficial owners. Existing clients have been quite open minded towards expanding, reviewing cash reinvestment guidelines (and options given money market reform), diversifying collateral, reviewing restrictions/parameters and being more active about complex markets, such as Taiwan and Malaysia.
We have seen new beneficial owners clients come to market and others re-entering the market since the global financial crisis. Our third-party business has grown substantially as beneficial owners become increasingly focused on matching their risk/reward profile to an agent. Without doubt, indemnification remains the number one topic of discussion across beneficial owners. The increased focus and debate about indemnification has undoubtedly led to a better appreciation of the relative quality and differences of agents in the indemnification offerings.
Trapp: Demand continues to be strong for US beneficial owner’s securities, however, the market has moved to more of a specials market with general collateral making up a smaller portion of earnings, especially for portfolios concentrated in US government fixed income securities. It is anticipated that diversified portfolios will continue to be in demand because they will likely include specials across a variety of markets.
Saunders: While new regulatory mandates have weighed on liquidity to some extent, we are still seeing consistent borrower demand for all of our clients’ asset classes, particularly around issues that trade special such as Amercian depository receipts, common equities, corporates and US treasuries. Intrinsic lending continues to be the strategy of choice for domestic owners, and we believe that bodes well for such programmes in the year ahead.
The ongoing sell-off in commodities has been keenly felt within the high yield and emerging markets, compelling borrowers to secure supplies linked to these segments as well as commodity sensitive firms. Meanwhile, the imposition of more stringent capital-adequacy/liquidity coverage requirements under Basel III and the US Dodd-Frank Act has raised the appeal of HQLAs, compelling HQLA owners to consider capitalising on the increased demand among large institutional borrowers.
How are they and their agent lenders innovating to boost returns while keeping risk to a minimum?
Wilson: While we see increased beneficial owner engagement and a willingness to review parameters, we have not seen significant changes in programmes and programme structures. Risk management, indemnification and operational efficiency rightly remain the cornerstones of lending programmes for US beneficial owners. Any changes that may boost returns need to be evaluated against those parameters.
Macro issues affecting the industry on borrowers and agents include regulatory change and the pace it is implemented by jurisdictions. This may create challenges for program development for some beneficial owners. We continue to liaise with beneficial owners on alternative (non-traditional) structures and transaction types, which could create some additional value to beneficial owners.
Trapp: The metrics, analytics, and trading tools being used to price demand and distribute inventory are the most significant innovations over the past several years. New markets continue to offer opportunities for innovation and increased income for beneficial owners. However, we have observed that innovations in trading have led to the largest gains in and revenue for beneficial owners.
Collateral diversification is also an important aspect to maintaining and increasing returns for lenders. The trend to non-cash collateral continues and those lenders willing to accept a broader range of collateral are likely to be well-positioned to maximise revenue within their acceptable risk parameters.
Lynch: Innovation is occurring on multiple fronts. Flexibility regarding forms of collateral has been a high growth area. Various forms of non-cash collateral from US and non-US counterparties that have appropriate haircuts that are marked-to-market daily, have a daily value-at-risk (VaR) calculation, and are appropriately stressed for VaR and liquidity needs are contributing to risk-adjusted returns.
Matching the method of distribution with borrower demand is also contributing to risk adjusted returns both from a technological perspective and a structural perspective. We see increased demand for structured exclusives versus discretionary lending in certain markets and certain asset classes. Auctionable exclusives for 2016 have had significant growth in demand and performance.
Nichols: We continue to evaluate new equity lending markets and collateral types to add incremental return for lenders while managing the various risks associated with each trade type. In regards to collateral reinvestment, agent lenders are working closely with beneficial owners to adapt reinvestment guidelines to reflect a new reality in which credit ratings are less relevant within the industry and increasingly liquidity is found from non-traditional sources. We’ve also been working to develop innovative approaches to utilise agency lending as a source of leverage and liquidity for our client base.
Smollen: We innovate through collaboration with our clients given that any solution we develop has to comport with client risk tolerances and return expectations. We are a third?party agent, so our clients expect us to be in regular contact and proactive in dealing with change and offering up ideas, solutions and options. This involves continuously evaluating programs and client initiatives to boost returns that might involve areas such as enhanced trading structures, non?traditional counterparties, non?traditional collateral and cash reinvestment solutions. The thing about our programme is that it never sits still—we are constantly evolving.
In terms of how we manage risk, we employ an enterprise?wide approach to risk management that entails oversight and consultative input from numerous independent risk units. We have teams, for example, that advise on market reforms and regulatory risk across both agent lending and principal borrowing activities of Deutsche Bank.
This positions us extremely well to advise clients on the stress factors affecting both agents and borrowers, and possible solutions, such as incorporating non?traditional counterparties into a clients’ strategy, while still retaining the ability to indemnify certain risks. Additionally, we measure balance sheet and indemnification cost and use this to help guide the business when contemplating trade opportunities, such as lending in one jurisdiction and accepting collateral elsewhere.
Saunders: Innovation and customisation continue to fuel our securities lending practice. Portfolio maximisation, for instance, allows us to create customised lending and reinvestment solutions on a client-by client basis, whether it be intrinsic only or conservative overnight reinvestment options using repo/money market mutual funds, or more sophisticated programmes that centre on term lending or similar structures. We also prioritise operational efficiency and risk-mitigation strategies, which we believe are just as important to clients as enhanced returns, perhaps even more so in some instances.
Additionally, we strive to be at the forefront of new global opportunities—our business currently extends to 48 different markets, with solutions that encompass emerging as well as other international strategies. Our team of network experts helps us stay informed about lending in new markets and regulatory initiatives in the making. They also help us in implementing funding structures that can benefit owners and borrowers alike. Closer to home, we continue to monitor discussions aimed at amending Íø±¬³Ô¹Ï and Exchange Commission (SEC) Rule 15c3-3, with an eye toward utilising equities as collateral should such changes occur.
Benedict: Agent lenders are using more benchmark performance reporting tools to ensure an optimal return for their beneficial owner clients. For many beneficial owners, securities lending is an integral part of their investment strategy as lending revenue can have a positive impact on their portfolio’s overall return.
To optimise the return to their portfolios, and to better understand market trends and opportunities, both agent lenders and beneficial owners are engaging directly with tools like DataLend’s Client Performance Reporting suite. This allows them to achieve a true ‘like-to-like’ view of their performance benchmarking tool, where they can select the most accurate peer group possible for their clients based on similar fiscal locations, legal structures, securities on loan and dividend rates.
Slater: Risk management is a cornerstone to any securities lending programme. With that in mind, there are several avenues for clients to derive returns from securities finance. These can range from the well-known intrinsically valued lending programme to the new collateral paradigm that is evolving, ie, the HQLA supply shortfall mentioned above. This can mean lending into the increasing demand for HQLAs, to capturing opportunities related to term financing, and/or engaging in collateral transformation trades. These strategies require establishing a rigorous and comprehensive risk management oversight programme. Counterparties, margin, market and trading activities must be carefully considered before engaging in a transaction followed by continuing oversight over the programme to ensure the goals of the programme remain in place. As the pace of change is ever increasing, it is important that there is active oversight and governance for these programmes.
Another area to keep a close eye on is money market reform. Depending on how money market mutual funds adapt, and should they follow the path of some early movers in transitioning from prime funds to government funds, one would expect a widening of spreads for corporate issuances as demand for government securities increases. This in turn will increase demand for lenders willing to extend term and provide flexibility around collateral.
Participants are continuing to push for mutual fund rule changes in a bid to optimise collateral usage—how would these changes affect the US business for either side of the trade?
Lynch: The industry has been advocating for changes in the form of alternative non-cash collateral, namely, equities as collateral. Alternative collateral will require mutual fund rule changes as well as broker-dealer SEC Rule 15c3-3 changes. There is a strong argument that an equity fund should be able to accept equities as collateral assuming that it is appropriately diversified, liquid, has a daily VaR, has periodic stress tests, and has a sufficient haircut. Equities as collateral could be beneficial to both sides of the trades if structured appropriately.
Also, some members of the fund industry are looking to more efficiently use their cash collateral as a treasurer function within the fund. As mutual funds become more efficient, the question is why pay for outside lines of credit for subscription/redemption activity and over-the-counter (OTC) collateral needs when a fund can create cash collateral from lending activity? Why not minimise expenses of the fund for shareholders? Innovation in this area continues to be explored with the need for rule interpretations.
Benedict: Should collateral guidelines for mutual funds be amended, the use of non-cash collateral will likely increase in the US market as regulatory requirements such as the leverage ratio and liquidity coverage ratio make pledging non-cash collateral more capital efficient for borrowers. Currently, non-cash collateral is pledged against only 36 percent of all securities lending transactions in the US, whereas that same collateral type accounts for a much higher percentage in the European, 80 percent, and 73 percent in Asian markets.
Smollen: We are of the mindset that we should explain to beneficial owners market place events, how it might affect them, and their options. We have worked with industry groups to do the same for the broader constituencies. As far as US mutual funds, the ultimate decision makers are the independent fund boards. We work consultatively with them and their advisors as they decide what is best for fund shareholders after their regulators approve any changes.
Nichols: Collateral optimisation will be a key driver of the securities finance business going forward in light of the regulatory challenges faced by both agent lenders and borrowers. Current discussions are on enhancing the ability of borrowers to optimise their collateral usage in a manner that is most efficient from a balance sheet perspective. Given the changes to leverage limits globally, and particularly for US global systemically important banks, the ability to enter into less punitive balance sheet trades, such as trades that can be netted or non-cash trades, will continue to be a priority for borrowers. These trades have limited direct benefit to the agent lenders, but similar to central counterparties (CCPs), they provide an opportunity to maintain demand and protect trade flow.
How are lenders adapting to regulatory change?
Wilson: US beneficial owners are engaged and thoughtful about understanding regulatory change, the impact on the industry and the impact on their lending programmes. On the whole, we have seen them adapting to regulatory changes by becoming more flexible in their approach to lending and their overall lending parameters. Regulations and rules such as the liquidity coverage ratio (LCR), supplementary leverage ratio (SLR) and net-stable funding ratio (NSFR) mean that borrowers are now looking to lock up loans for term, rather than on open. Additionally, the SLR and NSFR have also meant that borrowers are more likely to post non-cash collateral, a big change in the US markets. Lenders have had to get comfortable with taking additional types of collateral for longer durations than they have in the past.
Lastly, the increased cost of capital means that clients are now re-assessing the breadth and depth of the indemnity and discussing this with their agent lenders. Since the crisis, lenders who continue to value lending as a revenue source have become more actively involved in their lending programmes, which is a positive step. The lenders that are interested in staying abreast of regulatory change should continue to receive value from lending.
Slater: While regulation continues to reshape the lending market, beneficial owners are making the changes necessary to take advantage of the opportunities created by new regulatory requirements. For example, liquidity ratios and mandated clearing have created new sources of demand.
This, coupled with the impact of increased leverage ratio requirements on borrowers, has resulted in a significant increase in the number of transactions collateralised by securities collateral. This makes collateral flexibility key to maintaining utilisation and taking advantage of these new opportunities.
Many lenders have already expanded or are in the process of expanding their collateral guidelines. Europe has always been more open to securities collateral in general, but now US lenders appear to be accepting of a wider variety of securities collateral including equities.
New regulations are also creating collateral and liquidity challenges for some beneficial owners. Traditional sources of liquidity have become limited and expensive at the same time that collateral requirements for beneficial owners are increasing. As a result, many beneficial owners may become interested in the role that securities lending can play in helping them meet their liquidity and collateral needs while seeking to reduce costs and improve fund returns.
Nichols: Regulatory change is a continuous process that is impacting both agent lenders and borrowers. The agent lenders are becoming increasingly focused on the amount of risk-weighted assets (RWAs) being consumed by indemnified transactions and the return on capital associated with such transactions. In the US, some banks are being constrained by the standardised approach for calculating RWAs based on the Collins Amendment and even those who are not constrained under this approach from a regulatory capital perspective are beginning to feel the effects due to the standardised approach being the only option for comprehensive capital analysis purposes. Additionally, agent lenders are awaiting the finalsation of the Basel large exposure/Dodd-Frank Act 165(e) rules.
These regulations as currently proposed would utilise the standardised approach and would likely require a reduction in lending to some of the largest borrowers. At the same time that the agent lenders are facing this regulatory landscape, the borrower community is either being impacted or will be impacted by the new leverage rules, RWA constraints, the NSFR and the LCR. As a result of these regulatory changes, the use of non-cash collateral and term trades have increased, certain asset classes have been re-priced, and the re-pricing of certain client relationships, or explicitly pricing indemnification, has occurred. Additionally, lenders are exploring other routes to market that have lower regulatory hurdles, such as central counterparties or utilising third party support in lieu of indemnifications. These efforts are ongoing and full implementation may be longer term in nature.
Trapp: Beneficial owners are experiencing the indirect impacts of regulation through the modified lending behaviour of other market participants, such as borrowers and agent lenders. This could in turn cause beneficial owners to make changes to their own lending programmes. For example, the demand for borrowers to pledge more non-cash collateral and utilise term lending has increased across the market. Similarly, beneficial owners are adopting expanded collateral guidelines in order to maintain levels of lending activity that are consistent with their historical trends.
Saunders: Using thought leadership tools such as webinars, newsletters and roundtables to keep clients apprised of specific regulatory rulings remains highly important as is a consistent direct line of communication on such topics. The key challenge is finding common ground so that all parties are able to benefit. We believe that maintaining this kind of dialogue between clients, industry groups and dealers is key to achieving a fully transparent lending programme. Accordingly, we anticipate and plan on holding further discussions throughout the year as the regulatory environment continues to evolve. The experts at BNP Paribas are keenly watching and participating in all relevant discussions on a global basis.
Smollen: Our clients are interested in understanding the impact of change on the business, including stresses on agents and counterparties. While many are constrained by policy or statute, others enjoy the flexibility to rethink long?standing ways of doing business. In some cases, the movement is small and measured, but we are seeing receptivity, which is essential. Ultimately, dealing with market reforms may yield rewards, including alternate sources of liquidity and new reinvestment opportunities in a less intermediated future. We think that we are well situated as change unfolds.
How are collective investment schemes such as ETFs changing securities lending? What about synthetic products such as single stock futures and swaps?
Trapp: Exchange-traded funds (ETFs) are a great example of a product that has benefitted from securities lending. Íø±¬³Ô¹Ï lending has brought liquidity and incremental returns to ETFs, which in turn have benefited the end users, investors, of the ETFs.
Lynch: ETFs provide two forms of lending: (i) the ‘registered fund’ that lends the underlying assets of the ETF, similar to a mutual fund; and (ii) the beneficial owner/investor in the ETF lending the ETF holding. Demand for lending the ETF holding has risen over the past few years. Specific index ETFs such as the Russell 2000, High Yield, Emerging Markets and Junk Bonds have traded at valuable spreads. Similarly, certain sector ETFs and country ETFs have also traded at great value. Demand for these securities is due to the ease of shorting an index, sector or country. Swaps continue to be a tradable alternative to owning a physical security and lending it. They add complexity with investment guidelines, investment disclosure, and tax consequences, but are a viable solution for lending in emerging markets or for any market. It is important that the beneficial owner understands the swap, understands all of the returns, flows and netted expenses, and makes a suitable investment decision versus owning the security and lending it.
Smollen: ETFs have exploded in popularity with investors, as well as with short sellers seeking exposure to markets or asset classes that can be difficult or impossible to short otherwise. This has driven record securities lending revenues on these products based on resilient demand. It is no surprise that many prime brokers have now created and staffed desks to exclusively trade this product. We’ve reacted to that and trade the ETF book separate from the US equity book.
Conversely, many counterparts have looked to use ETFs as collateral as more and more are being held within inventory for future sale. We are extremely careful in accepting ETFs as collateral as there have been well publicised tracking errors to the constituent parts in down markets, and many ETFs increase correlated risks within stressed markets. Our acceptance of ETFs is dynamic in that approvals are based on current market conditions.
Nichols: Obviously, ETFs have been loaned for some time and are used as a hedging tool as well as an access point to markets that may be difficult to enter. We have noted increased demand spreads over the last year as borrowers’ balance sheet constraints have limited their ability to create ETF baskets within their business. Regarding single stock futures, they certainly do compete with our business but on a very limited number of positions. However, this trade is obviously attractive to prime brokers, as they are generally off-balance sheet transactions.
Saunders: During the past year, ETFs became more visible than ever before, and with good reason. ETFs can offer the potential for greater utilisation and liquidity within the marketplace, particularly portfolios tied to specific sectors or regions—for instance, metal, mining, energy and other commodity-based ETFs have been unusually strong of late.
Accordingly, we are seeing a greater number of ETF investors actively interested in securities lending due to the revenue generating opportunities within.
Appetite for vehicles such as swaps, derivatives or single stock futures is very client-specific, and, when applicable, BNP Paribas can offer appropriate services and solutions. For the most part, programme participants have remained focused on generating incremental income through basic lending transactions. However, we regularly provide guidance on all other opportunities within the marketplace.
This year could well be the year of the CCP—what are US beneficial owners saying about central clearing that they haven’t before?
Warren: In 2015, OCC saw an increased interest in central clearing for stock loan, and a need for more education from the agent lenders on behalf of their beneficial owners in terms of what benefits they can derive from a CCP such as OCC. We believe market participants are no longer debating whether central clearing is beneficial for the stock loan industry. Instead, they are looking at how a CCP solution can in fact enhance securities lending activity for lenders as well as the broker-dealer borrowing community.
Slater: Central clearing models for the agency securities lending market are still nascent. BNY Mellon has been working with industry participants to develop a clearing model that meets the needs of beneficial owners. It is expected that a workable model will emerge in the near future. This year may be the year that we begin to see some initial transactions. However, certain regulatory changes will be needed to allow for most US beneficial owners to participate broadly.
The move to central clearing is being driven in large part from the pressure on dealers’ balance sheets as a result of increased leverage ratio requirements. Central clearing will allow the dealers to maintain their existing volumes, but in a more balance sheet efficient manner due to increased netting benefits. As a result, CCPs will become an important distribution channel for our clients’ assets that will allow them to maintain balances and in some cases, obtain better pricing.
It is expected that the decision to utilise central clearing will develop as a point of trade discussion just like any other loan term. The negotiation with respect to how the trade will be cleared (centrally or in the traditional bilateral manner) will likely be based upon the benefits that the borrower may derive from central clearing. Accordingly, it is expected that a pricing differential would develop between centrally cleared loans and traditional bilateral loans.
Trapp: The questions still remain from the beneficial owners about what benefits they will see and how the CCP model compares relative to a typical lending transaction.
Nichols: At this point in time both agent lenders and borrowers are working closely with a number of CCPs to develop viable options for agency securities lending transactions. A number of issues remain to be resolved before CCPs experience significant flows from agency securities lending business. Current offerings are limited in the markets available, and operational efficiencies, especially around corporate actions, must be developed before there is a wholesale adoption.
We are currently working with CCPs to ensure that these issues are resolved in such a manner as to protect the interests of the beneficial owners that we service. As such, conversations with clients remain in the infancy stage with the ability to add or protect trade flow being the primary discussion point.
Lynch: US beneficial owners are watching and educating themselves as the CCP model evolves. The securities lending CCP model has evolved faster in Europe but current regulatory registrations do not allow US beneficial owners to participate. A US CCP model is still in the concept stage. I believe most beneficial owners are curious and are willing to review models as they come to market, but are waiting to see what they are and what value it brings to them.
Benedict: As CCPs offer both borrowers and lenders a more capital-efficient route to market, there has been increased interest not only from these two market participants, but also from beneficial owners. CCPs will allow borrowers to capture netting benefits and will reduce the risk weighting applied to agent lenders’ indemnified transactions. As the securities finance industry recognises the benefits of a CCP model, EquiLend has partnered with Eurex Clearing to facilitate CCP access for our client base. Our clients will be able to make use of their existing infrastructure to route transactions to Eurex Clearing’s Lending CCP. As this new route to market emerges, DataLend is poised to capture transactions executed on CCP platforms in addition to traditional bilateral trades.
Wilson: Beneficial owners are expressing an interest in the benefits and how they will impact on them. The benefits are more obvious for borrowers and agents but are less clear for beneficial owners. Beneficial owners would want to understand whether this will result in higher revenue or lower risk. Given the current product, market, and collateral coverage from CCPs, there is only a relatively small amount of business that could be transacted, but further increase would be reliant on other factors all being aligned. That being said, given the regulations and rules that are upon the industry, CCPs can play a part of the changing landscape. Going on that journey as they expand and build out capability is a positive development.
Saunders: We continue to hold client discussions that primarily focus on the role of CCPs as counterparty, as well as on the protection of client assets in the event of a default. Though such conversations have become more frequent, at this time we still do not see CCPs occupying a central role within the US marketplace anytime soon.
That said, we intend to closely monitor new developments on behalf of our clients, with the belief that ongoing discussions will be beneficial to the markets as a whole. The bottom line is that many clients will be required to conduct a complete review of their lending programmes, including what is permitted under their existing charters, guidelines or mandates, before any such changes can occur.
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