The song remains the same
22 January 2019
While balance sheet efficiency and alternative trade structures remain important to beneficial owners, technology and regulation will also play a big role this year
Image: Shutterstock
PANELLISTS
George Trapp, senior vice president, head of North American client service, securities lending, Northern Trust
Mike Saunders, head of agency lending, Americas, BNP Paribas
George Rennick, head of agency lending, Americas, J.P. Morgan
Peter Bassler, managing director, business development, eSecLending
Glenn Horner, chief regulatory officer, managing director, State Street Global Markets
Matt Wolfe, vice president of product development, OCC
Vikas Nigam, director, head of trading, Americas, Deutsche Bank Agency Íø±¬³Ô¹Ï Lending
What will be the hot topics for beneficial owners in 2019? And what will be the key market drivers?
Vikas Nigam: Not a surprise but just like last year we believe the song remains the same—balance sheet efficiency. Borrowers and repo/reverse repo providers continue to be extremely protective and conscious of their balance sheets and not just at quarter end. Use of offshore entities, the beneficial owner’s risk-weighted asset (RWA) treatment, non-cash collateral eligibility and the provision of documentation to allow netting relief are increasingly factoring into their decisions on which beneficial owners to do business with. We expect this trend to continue, especially as know-your-customer (KYC) procedures become more thorough and frequent.
George Trapp: The topics that beneficial owners will discuss this year are a continuation of the themes from the last several years along with some emerging trends. Regulation has been at the top of everyone’s agenda for the last several years. Recent developments on Íø±¬³Ô¹Ï Financing Transaction Regulation (SFTR) and resolution stay protocols have provided certainty around details and implementation timeframes. As these regulations are finalised and implemented they will allow the industry to position itself for the future.
Alternative distribution channels and alternative trade structures continue to be a focus for the securities lending industry. Central counterparties continue to gain traction and are working closely with the industry to help provide efficiencies both from a trade matching and balance sheet perspective. Along similar lines, borrowers are looking for different trade structures to meet their specific requirements. These include different collateral and term structures. It will be important for beneficial owners to be flexible in terms of the types of collateral they accept and trade structures they will allow in order to keep pace with the changing securities lending marketplace.
Outside of our control, but likely to influence the market in the coming year, will be interest rates and volatility. The recent volatility in the market has shown that beneficial owners should keep a close eye on how the volatility impacts their securities lending programme.
Mike Saunders: Íø±¬³Ô¹Ï financing markets in the year ahead will face similar challenges to those of 2018. Changes to monetary policy throughout the global financial system in the form of higher rates and an end to quantitative easing combined with geopolitical tensions will continue to drive volatility. Historically, elevated levels of volatility benefit participants in a securities lending programme and we believe this trend will continue. As such, beneficial owners should expect a greater demand for specific asset classes and sectors.
The opportunity to monetise holdings of high-quality liquid assets (HQLA) will continue to offer stable and predictable returns. Beneficial owners should be prepared to explore collateral flexibility and longer-dated tenors in their programme as slight enhancements to a lending programme will likely increase utilisation rates on HQLA as well as impact revenue streams.
The parabolic growth of the exchange-traded fund (ETF) product also presents a significant opportunity. Demand from counterparties to borrow ETF’s linked to politically sensitive regions, specific assets classes and operationally sensitive settlement markets will continue to be in high demand. This demand permits borrowers to have an efficient and broad exposure to a region, sector or market which is otherwise difficult to access.
Glenn Horner: Increased market volatility in 2018 magnified dispersion in performance among hedge fund managers. Whether institutional investors react to the 2018 performance with a reallocation among managers, an increased allocation to managers who outperformed, or decide to shift away from hedge funds will impact market demand in 2019.
George Rennick: Regulation will remain a hot topic throughout 2019 with a continued focus on Brexit legal entity strategies and documentation, SFTR reporting preparation and the need to spend significant efforts sourcing non-centralised data elements and respond to continued capital rule implications such as G-SIB requirements. The industry felt the impact of the capital rules and potential G-SIB implications during the year-end turn as liquidity tightened and short term funding rates spiked.
One area where regulation is softening for certain beneficial owners is around collateral. Beneficial owners that can take advantage of flexible collateral schedules, term funding trades and a broad list of US and non-US borrowers will be best positioned to take advantage of opportunities.
How can beneficial owners position themselves for success in 2019?
Peter Bassler: The best way to position yourself is to re-evaluate your programme and assess the flexibility needed to capture the greatest opportunity within your risk/return profile. Many beneficial owners do not rethink and re-evaluate this product enough, and we would suggest this become an annual process.
Some questions to consider include: Are my guidelines suitable for today’s lending and collateral environment? Has the agent landscape changed? Where is pricing, indemnification? Many of these factors are constantly evolving and it is crucial to have a regular cadence to review your programme from a performance, price, partner and structure perspective.
Some firms have outdated cash collateral guidelines that could be revised to capture additional yield in today’s cash markets. Cash yields have improved dramatically and non-cash alternatives can offer a compelling structural alternative to cash and at times for a higher intrinsic lending fee. We suggest a flexible collateral strategy, as not all borrowers have the same preferences.
Matt Wolfe: For lenders, it’s all about utilisation. Years ago, that meant personal relationships, and they still obviously matter. This year, however, lenders are in a technology arms race. Collecting better data and integrating systems across entities to make inventory easily and cheaply accessible is the new table stakes. More data enables better modelling opportunities for machine learning and artificial intelligence (AI); there’s little doubt that such a lucrative business (driving nearly $10 billion in revenues, according to the recent DataLend announcement) is going to attract AI strategies. SFTR is a great catalyst for making technology investments that can drive commercial results as well as regulatory compliance. OCC is also focused on technology that can give our members an advantage at raising their utilisation. We believe that distributed ledger technology has great promise for making inventory easily accessible and cheaply conveyed. We’re convinced that investing in technology to improve client outcomes will prove to be wise decisions.
Rennick: Beneficial owners should be constantly evaluating their risk/return parameters, working closely with their agent lending partners to evaluate their programme constraints. The business continues to evolve at pace and those lenders who can demonstrate flexibility across the multiple factors, which are considered when lending assets, will be best positioned to take advantage of opportunities.
Saunders: Íø±¬³Ô¹Ï lending is proven to offer incremental income on idle assets in a relatively risk-averse fashion under the proper risk management structure. While it is certainly prudent to examine your programme’s current lending parameters to increase returns, an element of caution is certainly necessary. The impact of higher and anticipated rising interest rates presents an opportunity to implement several strategies to monetise both the interest rate and basis mismatch affiliated with a lending programme. The continued inflow of securities lending cash collateral into prime money market funds is evidence of this opportunity. However, it is necessary to understand the liquidity element associated with these types of strategies.
Non-cash collateral transactions are an alternative to these strategies as they remove interest rate mismatch and liquidity risk while providing equivalent returns. Implementing a non-cash collateral programme will serve beneficial owners well in 2019. The shift towards non-cash collateral continues to accelerate as a percentage of market share and beneficial owners would be well served to explore not only enhancements to their cash collateral guidelines but to their non-cash collateral guidelines throughout 2019.
Trapp: The critical aspects beneficial owners should consider for their securities lending programme are:
Collateral: Review your acceptable collateral and consider whether you can allow alternative types of collateral such as equities
Availability: Maximise the availability of your portfolio by ensuring all of your accounts are approved for lending
Restrictions: Consider whether your programme parameters are appropriate for the current market environment. Review your investment guidelines and any restrictions you have on your programme
Performance: Choose an appropriate industry benchmark and review your performance and ensure it is meeting your expectations
Risk: Review the reporting and set up a framework for regular due diligence on your securities lending programme including a review of borrowers, collateral, cash investment guidelines and the creditworthiness of your lending agent
Nigam: Clients that will see the most success in this year are those that are flexible in terms of the collateral types and counterparts that they can deal in and with. New structures and new documentation are being sought by all lending providers and those that are able to accept some of those will see the benefits.
In terms of indemnification, regulations and the ensuing capital charges associated with providing it is increasingly changing how it is perceived, offered and priced—how can the industry overcome this challenge?
Horner: The implementation of Basel III and soon to be implemented Single Counterparty Credit Limits (SCCL) have impacted the perception of indemnification due to heightened capital costs for agency lenders and the potential for limitations on balances with large borrowers. The Basel III rules have already been implemented and based on the Collins Amendment in the Dodd-Frank Act US agents must use both the advanced and standardised approaches to calculate risk-weighted assets (RWA). The US banks must then manage their risk-based capital ratios against the higher of the two methods at the bank level. For securities finance, the standardised approach results substantially higher RWA than under the advanced approach, sometimes up to 30 times higher. As a result, indemnified transactions that return a very high rate of return on capital under the advanced approach now have an unattractive rate of return based on the use of the standardised approach.
The good news is that industry efforts have resulted in a new standardised approach for securities finance transactions that we approved by the Basel Committee in December 2017. Once implemented in local jurisdictions, this will result in a conservative but much less punitive measurement of RWA, which will make the return on capital more appealing to agent lenders.
SCCL may limit the amount of indemnified transactions that an agent lender can do with a particular borrower. Under the original proposal, the measurement of exposure for securities finance transactions would be based on the current standardised method for capital purposes. However, based on industry feedback the finalised version in the US allows banks to use an approved method for calculating capital requirements. This means that banks with approved advanced approaches methodologies can use their own VaR estimates of exposures. There is some anticipation that once the new Basel standardised method is adopted for capital purposes in the US it will then be the required method for SCCL. However, both the advanced approach and new standardised calculation will significantly reduce the impact of this limit on current balances.
To date, the industry has done a remarkable job of providing feedback to regulators and ensuring that the long term impact on these regulations will have minimal impact on the balances and the future cost of capital related to indemnified transactions. However, the industry is also looking at structural ways that the impact of the regulations can be managed. A couple of potential ways that industry participants have explored are through the use of collateral pledge structures outside the US and the use of central counterparties (CCPs). Both of these efforts are ongoing, but they are examples of how the industry can continue to redefine itself to meet the requirements of the beneficial owner community.
Nigam: It is a provider by provider issue and not necessarily an industry issue. The costs associated with running the business differ from bank to bank and frankly client base to client base. Accurate measurements of resources used and active management of those resources is key to overcoming these challenges.
Trapp: Beneficial owners have resoundingly stated that indemnification is important and in some cases a requirement for their participation in a securities lending programme. Beneficial owners should understand who is offering the indemnification, the financial strength of the issuer and the capital base of the securities lending agent. It is important that the lending agent has a strong capital base given their role in the securities lending transaction. Indemnification should complement a sound risk management framework including careful review of borrowers, collateral, margin requirements and operational practices. A lending agent that has expertise in all aspects of the securities lending and collateral management process, along with a strong balance sheet, is in the best position to act as an agent for your securities lending programme.
Bassler: Indemnification is here to stay. Period. It is incumbent upon every agent to operate within their own firms to navigate costs, limits and the cost/benefit of various transaction types. However, as an industry, we need to accept that the beneficial owners will continue to demand this risk protection. Every agent has a different internal metric and hurdle that will affect how they lend for their client base. The beneficial owner should be proactive in understanding these nuances as it will likely affect the trading the agent does on their behalf.
Some agents will avoid certain transactions due to their capital allocations. Is that in the best interest of beneficial owner’s or just the agent’s? Is your agent committed to lending general collateral for you or pursuing a non-cash strategy that you want to employ? It may come down to their capital hit. Asking the questions here is key.
Wolfe: Prudent risk management is crucial to the success of any lending programme. The risk to lenders stemming from a counterparty’s default has been mitigated primarily through three components: credit evaluation, excess collateral, and indemnification. Credit evaluation is an important step to ensure that any new counterparties are creditworthy, and this assessment should be reaffirmed on a frequent basis. Excess collateral, (for example, 102 percent for cash collateral) is the primary tool that helps avoid losses should the lender need to buy-in the loaned securities in the event of a borrower’s default. Indemnification is a back-stop if the collateral is insufficient. OCC has a similar three-tier approach for mitigating risk. The first tier is through careful assessment of new members and ongoing monitoring. The second tier is margin collateral, which is based upon econometric models of future stock prices and the amount of collateral is recalculated daily to cover losses at a 99 percent confidence interval. The third tier is a guarantee fund which is only drawn upon if the margin collateral was insufficient to cover the obligations of a defaulted member.
Essentially indemnification is an insurance policy and like insurance, the premium is related to the likelihood of drawing upon the insurance policy. The securities lending industry could consider counterparty credit evaluation and setting of collateral rates as ways to lower the probability of drawing upon indemnification. If the counterparty risk evaluation is effective and the collateralisation rate is more certain to cover the replacement cost of lent securities, then the conversation about indemnification may change. The guarantee provided by central clearing is another alternative that would help reduce the likelihood of drawing upon indemnification.
Saunders: Regulation and the ensuing cost of indemnification will continue to be a pain point for agent lenders and clients. The industry, for the most part, has been repriced to reflect the capital cost associated with indemnification through tiered splits, third-party providers of indemnification, minimum spreads or various other commercial elements. The crux of the conversation remains the same—the attractiveness of the pool of lendable assets for each client. Clients with optimal assets for lending or specific risk profiles will benefit throughout this process and each lending agent views these relationships differently. Therefore, it is the notion of client selectivity which becomes the main issue when discussing indemnification with lending agents determining how the capital will be deployed across their lending programme clients.
Rennick: Indemnification has become somewhat standard and expected as part of the core offering. At the same time, capital is a finite resource and as capital charges continue to increase, certain securities lending activity may become prohibitive for an agent lender and a borrower. Similar to conversations in other parts of the financial industry, for example, between prime brokers and hedge funds, we are starting to have discussions with our lending clients about what is additive or detractive to a bank or broker dealer’s balance sheet. That education is critical as capital is a binding constraint for both the agent lender and borrower. One outcome may be one price for indemnified business and a different price for the non-indemnified business. Solutions to reduce capital footprints remain a priority and alternatives such as central clearing or accepting collateral via pledge will gather momentum as they benefit asset owners, lenders and borrowers.
After two years of Donald Trump’s presidency in the US, how have beneficial owners adapted to the new landscape?
Nigam: Beneficial owners adapt to market conditions, which are obviously influenced by political administrations. It behoves them to watch the trends in the market when making decisions, rather than reacting to the issue of the day in Washington.
Trapp: Beneficial owners have felt the impact of the market volatility in Q4, 2018 on their investment portfolios and on their securities lending earnings. It’s hard to attribute what happened in the securities lending market back to the Donald Trump presidency, but certainly, the volatility has been felt across the markets. In terms of the regulatory landscape, there has been progress over the last several years as the industry looks to implement several new regulations. The current administration’s stance towards reducing regulation is favourable, however, and will likely slow the pace of new regulations over the coming year.
Saunders: Regardless of political views, the landscape has proven beneficial owners and lending agents who maintain an active dialogue to discuss, implement and monetise opportunities are well positioned. Market volatility will remain and likely increase throughout 2019 and those nimble enough to have the framework in place to handle the volatility will likely outperform.
Bassler: The new landscape during most of the last two years had been one of low volatility and upward stock markets. That changed in Q4 2018 with market dislocation and higher volatility. This market climate may be here to stay given global political and macro factors, and it could lead to more short conviction and a better demand environment for beneficial owners. We anticipated higher volatility with the Trump presidency, but only recently have we seen it come to fruition. Staying engaged with your agent and other peers and market participants is critical to remaining relevant as a lender, and then reacting to an evolving market in order to capture opportunity that the financing markets offer.
How are beneficial owners approaching SFTR? What are the main challenges they are facing?
Saunders: The implementation of SFTR has consumed tremendous resources within the firms participating in securities lending as well as those providing securities financing services. The general sentiment from a servicing perspective continues to focus on the successful implementation of the solution. These challenges have been eased with the assistance of third party vendors. However, challenges remain on automating the data submission component and the sharing of costs to comply with SFTR. It remains an open question as to how agent lenders will handle the commercial elements of SFTR. Several agent lenders have absorbed this cost as a matter of sound business practice. As SFTR progresses, certainly beneficial owners will require bespoke reporting solutions which will add additional levels of complexity both in terms of costs and data sharing.
Despite these challenges, there is an opportunity as a lender to synthesise the data to increase lending performance. The compilation of market data is simply another data point which can be utilised to benchmark the performance of a programme.
Nigam: It has been our experience that beneficial owners are relying heavily on their providers for guidance and solutions with SFTR.
Rennick: SFTR remains at the forefront of discussions with some beneficial owners more prepared than others, but all share concerns around the need to supply an approximate 150 data elements, particularly since many of those elements lack consistency and a centralised source. Market participants will remain active in meeting the specific transaction reporting requirements, but asset owners that delay focus may risk being left behind. We continue to articulate the extra-territorial impact this EU regulation is going to have to the US and the Asia Pacific clients.
Trapp: We are working closely with the industry to ensure that the requirements for the SFTR are understood for our clients by the 2020 deadline.
In terms of technology, what developments do you expect to see in 2019? And how are they benefitting beneficial owners?
Wolfe: I expect we will see two technology changes in the future that will benefit beneficial owners: machine learning and distributed ledger technology. SFTR is requiring that many more data points be captured and made available in electronic form for European regulators. Firms and vendors have been investing in new technologies to support these requirements. Improved access to this more robust dataset could enable participants to apply machine learning in order to discover surprising and valuable insights. Similarly, distributed ledger technology has the potential to not only improve the transparency for beneficial owners but also to potentially enable beneficial owners to take a more active role in their lending programmes. I’m not confident either of these will come to fruition this year, but I do believe we will see experimentation and innovation over the coming year in both of these emerging technologies.
Rennick: At J.P. Morgan, we continue to make significant investments in our securities lending platform as technology remains a differentiator and true value add to the beneficial owner community. Clients have access to vital lending data and consolidated reporting, while our advanced proprietary trading platform consolidates data repositories, trading parameters and the trade lifecycle with advanced risk management and analytics as we draw from the firm’s quantitative research capabilities. Data consumption and comparison will most likely be a key theme for beneficial owners over the next few years as big data and AI will help drive decisions and opportunities.
Trapp: The increasing use of technology and automation continues to bring benefits to beneficial owners. There is continued focus on pre-trade, trade and post-trade automation to increase efficiencies for the securities lending industry. In 2018, the expanded use of the NGT platform added significant straight-through processing capabilities, bringing increased levels of transparency and efficiency to the industry. Northern Trust has built out our capability to take full advantage of the improved distribution and pricing offered by the platform. This year, our focus will be on the use of emerging technologies such as AI, robotics and machine learning to further optimise pricing and distribution of client portfolios.
Saunders: Participants in securities financing transactions are at various stages of harnessing technology to offer a more compelling product. Each participant has a different focus as to how they are spending their technology budgets. At BNP Paribas, we have opted to focus on efficiency and transparency. We are utilising AI and simplistic forms of robotics to remove many of the daily, manual processes associated with a lending transaction. These developments automate many of the low margin, high volume transactions and enable more of a focus on bespoke trading strategies to extract value from a clients’ lending portfolio.
The common denominator remains to generate more revenue for beneficial owners while offering higher levels of transparency. In a relatively low margin, high volume type of business, efficiency is a critical component and leveraging the tools of technology are assisting the industry in their efforts to monetise opportunities in a cost-effective and risk-controlled manner.
Nigam: With SFTR and the unparalleled level of data that will come as a result, we expect to see vendors pitching new views on the industry and how it pertains to the beneficial owners. Additionally, we also expect to see a more concerted push for central counterparties to take on and counteract some of the balance sheet inefficiencies that currently plague the industry.
Over the next 12 months, how do you expect to see the securities lending landscape develop/change?
Bassler: We expect to see greater beneficial owner engagement and focus as securities lending continues to see more attention across the investor segment. Beneficial owners are under pressure to show value to their underlying shareholders and beneficiaries, and securities lending is a pure shareholder value product. This means existing lenders will be looking for new opportunities in new markets, new collateral structures and potentially new peer to peer transaction opportunities. Agents and providers will continue to have to keep up with the demands of the beneficial owners from education, technology and overall innovation perspective. The market will remain competitive as clients demand more, and focus on transparency, best execution and a partner that is truly looking around every corner for opportunities or risks that are not necessarily obvious.
Nigam: We expect to see a continued shift away from cash as collateral. The spike in treasury repo rates over year-end illustrated the need to be prepared and have an alternative plan, be it shifting more balances to non-cash or signing up new counterparties that are not a balance sheet driven.
Saunders: At BNP Paribas, we expect this year to be a pivotal year as we realise the significant investment in several initiatives, which will substantially benefit our clients. There will remain a continued focus on extracting value, implementing technology and looking for cost-effective strategies to grow business. We will continue to leverage the multitude of technology offerings which exist as well as continue with the development of propriety systems all with the focus on delivering value to our clients and shareholders. Ultimately, client selectivity and higher levels of engagement will become the forefront of our programme as we seek to deliver the benefits of securities lending to our clients.
Trapp: Technology and automation are the primary focus of the industry. Continuing to improve the distribution channels through the use of CCP’s and fintech tools will have a large impact on the future of the lending business. Beneficial owners can put themselves in a position to benefit from these developments by reviewing their collateral guidelines and ensuring they are aligned with the trend toward non-cash collateral.
Emerging markets will also provide opportunities for clients given the need for borrowers to source supply in less liquid markets or securities. As a custodian and fund manager, Northern Trust has experience working in both developed and emerging markets to provide access for our securities lending clients.
Despite the trend towards non-cash collateral, cash collateral investment can generate incremental returns for beneficial owners. A favourable investment spread can have a significant impact on earnings. Beneficial owners should review their cash investment guidelines to make sure they are aligned for changes in short term interest rates.
Rennick: The biggest changes will continue to be driven by regulation, especially SFTR and potentially Brexit, G-SIB charges, the Central Íø±¬³Ô¹Ï Depositories Regulation and changes to collateral rules. SFTR will offer unprecedented transparency, but will also challenge firms to first comply and then data mine for trends and opportunities. Outside of regulation, you are seeing beneficial owners return to lending after a long pause post the financial crisis. You also see new entrants, with lending portfolios seeking to increase challenged returns or possibly to offset fee pressures in the asset management client segment, for example. Evolution is constant and the firms that can adapt quickly and remain flexible are the ones that will maximise opportunities.
Horner: We expect beneficial owners to adopt peer-to-peer solutions that will allow them to potentially increase utilisation/returns while maintaining indemnification and operational/trade support from their agent lender.
Wolfe: I expect the use of non-cash collateral will continue to grow, and hopefully there will be continued dialogue with the US Íø±¬³Ô¹Ï and Exchange Commission regarding the use of equities as collateral. OCC is working closely with the custody banks and industry participants to develop a cleared programme for non-cash lending. CCPs and peer-to-peer are exciting initiatives that have the potential to increase utilisation, improve revenues, and lower costs. Finally, I believe that the decreasing cost and increasing access to big data and advanced data analytics and potentially new network paradigms will introduce exciting developments.
George Trapp, senior vice president, head of North American client service, securities lending, Northern Trust
Mike Saunders, head of agency lending, Americas, BNP Paribas
George Rennick, head of agency lending, Americas, J.P. Morgan
Peter Bassler, managing director, business development, eSecLending
Glenn Horner, chief regulatory officer, managing director, State Street Global Markets
Matt Wolfe, vice president of product development, OCC
Vikas Nigam, director, head of trading, Americas, Deutsche Bank Agency Íø±¬³Ô¹Ï Lending
What will be the hot topics for beneficial owners in 2019? And what will be the key market drivers?
Vikas Nigam: Not a surprise but just like last year we believe the song remains the same—balance sheet efficiency. Borrowers and repo/reverse repo providers continue to be extremely protective and conscious of their balance sheets and not just at quarter end. Use of offshore entities, the beneficial owner’s risk-weighted asset (RWA) treatment, non-cash collateral eligibility and the provision of documentation to allow netting relief are increasingly factoring into their decisions on which beneficial owners to do business with. We expect this trend to continue, especially as know-your-customer (KYC) procedures become more thorough and frequent.
George Trapp: The topics that beneficial owners will discuss this year are a continuation of the themes from the last several years along with some emerging trends. Regulation has been at the top of everyone’s agenda for the last several years. Recent developments on Íø±¬³Ô¹Ï Financing Transaction Regulation (SFTR) and resolution stay protocols have provided certainty around details and implementation timeframes. As these regulations are finalised and implemented they will allow the industry to position itself for the future.
Alternative distribution channels and alternative trade structures continue to be a focus for the securities lending industry. Central counterparties continue to gain traction and are working closely with the industry to help provide efficiencies both from a trade matching and balance sheet perspective. Along similar lines, borrowers are looking for different trade structures to meet their specific requirements. These include different collateral and term structures. It will be important for beneficial owners to be flexible in terms of the types of collateral they accept and trade structures they will allow in order to keep pace with the changing securities lending marketplace.
Outside of our control, but likely to influence the market in the coming year, will be interest rates and volatility. The recent volatility in the market has shown that beneficial owners should keep a close eye on how the volatility impacts their securities lending programme.
Mike Saunders: Íø±¬³Ô¹Ï financing markets in the year ahead will face similar challenges to those of 2018. Changes to monetary policy throughout the global financial system in the form of higher rates and an end to quantitative easing combined with geopolitical tensions will continue to drive volatility. Historically, elevated levels of volatility benefit participants in a securities lending programme and we believe this trend will continue. As such, beneficial owners should expect a greater demand for specific asset classes and sectors.
The opportunity to monetise holdings of high-quality liquid assets (HQLA) will continue to offer stable and predictable returns. Beneficial owners should be prepared to explore collateral flexibility and longer-dated tenors in their programme as slight enhancements to a lending programme will likely increase utilisation rates on HQLA as well as impact revenue streams.
The parabolic growth of the exchange-traded fund (ETF) product also presents a significant opportunity. Demand from counterparties to borrow ETF’s linked to politically sensitive regions, specific assets classes and operationally sensitive settlement markets will continue to be in high demand. This demand permits borrowers to have an efficient and broad exposure to a region, sector or market which is otherwise difficult to access.
Glenn Horner: Increased market volatility in 2018 magnified dispersion in performance among hedge fund managers. Whether institutional investors react to the 2018 performance with a reallocation among managers, an increased allocation to managers who outperformed, or decide to shift away from hedge funds will impact market demand in 2019.
George Rennick: Regulation will remain a hot topic throughout 2019 with a continued focus on Brexit legal entity strategies and documentation, SFTR reporting preparation and the need to spend significant efforts sourcing non-centralised data elements and respond to continued capital rule implications such as G-SIB requirements. The industry felt the impact of the capital rules and potential G-SIB implications during the year-end turn as liquidity tightened and short term funding rates spiked.
One area where regulation is softening for certain beneficial owners is around collateral. Beneficial owners that can take advantage of flexible collateral schedules, term funding trades and a broad list of US and non-US borrowers will be best positioned to take advantage of opportunities.
How can beneficial owners position themselves for success in 2019?
Peter Bassler: The best way to position yourself is to re-evaluate your programme and assess the flexibility needed to capture the greatest opportunity within your risk/return profile. Many beneficial owners do not rethink and re-evaluate this product enough, and we would suggest this become an annual process.
Some questions to consider include: Are my guidelines suitable for today’s lending and collateral environment? Has the agent landscape changed? Where is pricing, indemnification? Many of these factors are constantly evolving and it is crucial to have a regular cadence to review your programme from a performance, price, partner and structure perspective.
Some firms have outdated cash collateral guidelines that could be revised to capture additional yield in today’s cash markets. Cash yields have improved dramatically and non-cash alternatives can offer a compelling structural alternative to cash and at times for a higher intrinsic lending fee. We suggest a flexible collateral strategy, as not all borrowers have the same preferences.
Matt Wolfe: For lenders, it’s all about utilisation. Years ago, that meant personal relationships, and they still obviously matter. This year, however, lenders are in a technology arms race. Collecting better data and integrating systems across entities to make inventory easily and cheaply accessible is the new table stakes. More data enables better modelling opportunities for machine learning and artificial intelligence (AI); there’s little doubt that such a lucrative business (driving nearly $10 billion in revenues, according to the recent DataLend announcement) is going to attract AI strategies. SFTR is a great catalyst for making technology investments that can drive commercial results as well as regulatory compliance. OCC is also focused on technology that can give our members an advantage at raising their utilisation. We believe that distributed ledger technology has great promise for making inventory easily accessible and cheaply conveyed. We’re convinced that investing in technology to improve client outcomes will prove to be wise decisions.
Rennick: Beneficial owners should be constantly evaluating their risk/return parameters, working closely with their agent lending partners to evaluate their programme constraints. The business continues to evolve at pace and those lenders who can demonstrate flexibility across the multiple factors, which are considered when lending assets, will be best positioned to take advantage of opportunities.
Saunders: Íø±¬³Ô¹Ï lending is proven to offer incremental income on idle assets in a relatively risk-averse fashion under the proper risk management structure. While it is certainly prudent to examine your programme’s current lending parameters to increase returns, an element of caution is certainly necessary. The impact of higher and anticipated rising interest rates presents an opportunity to implement several strategies to monetise both the interest rate and basis mismatch affiliated with a lending programme. The continued inflow of securities lending cash collateral into prime money market funds is evidence of this opportunity. However, it is necessary to understand the liquidity element associated with these types of strategies.
Non-cash collateral transactions are an alternative to these strategies as they remove interest rate mismatch and liquidity risk while providing equivalent returns. Implementing a non-cash collateral programme will serve beneficial owners well in 2019. The shift towards non-cash collateral continues to accelerate as a percentage of market share and beneficial owners would be well served to explore not only enhancements to their cash collateral guidelines but to their non-cash collateral guidelines throughout 2019.
Trapp: The critical aspects beneficial owners should consider for their securities lending programme are:
Collateral: Review your acceptable collateral and consider whether you can allow alternative types of collateral such as equities
Availability: Maximise the availability of your portfolio by ensuring all of your accounts are approved for lending
Restrictions: Consider whether your programme parameters are appropriate for the current market environment. Review your investment guidelines and any restrictions you have on your programme
Performance: Choose an appropriate industry benchmark and review your performance and ensure it is meeting your expectations
Risk: Review the reporting and set up a framework for regular due diligence on your securities lending programme including a review of borrowers, collateral, cash investment guidelines and the creditworthiness of your lending agent
Nigam: Clients that will see the most success in this year are those that are flexible in terms of the collateral types and counterparts that they can deal in and with. New structures and new documentation are being sought by all lending providers and those that are able to accept some of those will see the benefits.
In terms of indemnification, regulations and the ensuing capital charges associated with providing it is increasingly changing how it is perceived, offered and priced—how can the industry overcome this challenge?
Horner: The implementation of Basel III and soon to be implemented Single Counterparty Credit Limits (SCCL) have impacted the perception of indemnification due to heightened capital costs for agency lenders and the potential for limitations on balances with large borrowers. The Basel III rules have already been implemented and based on the Collins Amendment in the Dodd-Frank Act US agents must use both the advanced and standardised approaches to calculate risk-weighted assets (RWA). The US banks must then manage their risk-based capital ratios against the higher of the two methods at the bank level. For securities finance, the standardised approach results substantially higher RWA than under the advanced approach, sometimes up to 30 times higher. As a result, indemnified transactions that return a very high rate of return on capital under the advanced approach now have an unattractive rate of return based on the use of the standardised approach.
The good news is that industry efforts have resulted in a new standardised approach for securities finance transactions that we approved by the Basel Committee in December 2017. Once implemented in local jurisdictions, this will result in a conservative but much less punitive measurement of RWA, which will make the return on capital more appealing to agent lenders.
SCCL may limit the amount of indemnified transactions that an agent lender can do with a particular borrower. Under the original proposal, the measurement of exposure for securities finance transactions would be based on the current standardised method for capital purposes. However, based on industry feedback the finalised version in the US allows banks to use an approved method for calculating capital requirements. This means that banks with approved advanced approaches methodologies can use their own VaR estimates of exposures. There is some anticipation that once the new Basel standardised method is adopted for capital purposes in the US it will then be the required method for SCCL. However, both the advanced approach and new standardised calculation will significantly reduce the impact of this limit on current balances.
To date, the industry has done a remarkable job of providing feedback to regulators and ensuring that the long term impact on these regulations will have minimal impact on the balances and the future cost of capital related to indemnified transactions. However, the industry is also looking at structural ways that the impact of the regulations can be managed. A couple of potential ways that industry participants have explored are through the use of collateral pledge structures outside the US and the use of central counterparties (CCPs). Both of these efforts are ongoing, but they are examples of how the industry can continue to redefine itself to meet the requirements of the beneficial owner community.
Nigam: It is a provider by provider issue and not necessarily an industry issue. The costs associated with running the business differ from bank to bank and frankly client base to client base. Accurate measurements of resources used and active management of those resources is key to overcoming these challenges.
Trapp: Beneficial owners have resoundingly stated that indemnification is important and in some cases a requirement for their participation in a securities lending programme. Beneficial owners should understand who is offering the indemnification, the financial strength of the issuer and the capital base of the securities lending agent. It is important that the lending agent has a strong capital base given their role in the securities lending transaction. Indemnification should complement a sound risk management framework including careful review of borrowers, collateral, margin requirements and operational practices. A lending agent that has expertise in all aspects of the securities lending and collateral management process, along with a strong balance sheet, is in the best position to act as an agent for your securities lending programme.
Bassler: Indemnification is here to stay. Period. It is incumbent upon every agent to operate within their own firms to navigate costs, limits and the cost/benefit of various transaction types. However, as an industry, we need to accept that the beneficial owners will continue to demand this risk protection. Every agent has a different internal metric and hurdle that will affect how they lend for their client base. The beneficial owner should be proactive in understanding these nuances as it will likely affect the trading the agent does on their behalf.
Some agents will avoid certain transactions due to their capital allocations. Is that in the best interest of beneficial owner’s or just the agent’s? Is your agent committed to lending general collateral for you or pursuing a non-cash strategy that you want to employ? It may come down to their capital hit. Asking the questions here is key.
Wolfe: Prudent risk management is crucial to the success of any lending programme. The risk to lenders stemming from a counterparty’s default has been mitigated primarily through three components: credit evaluation, excess collateral, and indemnification. Credit evaluation is an important step to ensure that any new counterparties are creditworthy, and this assessment should be reaffirmed on a frequent basis. Excess collateral, (for example, 102 percent for cash collateral) is the primary tool that helps avoid losses should the lender need to buy-in the loaned securities in the event of a borrower’s default. Indemnification is a back-stop if the collateral is insufficient. OCC has a similar three-tier approach for mitigating risk. The first tier is through careful assessment of new members and ongoing monitoring. The second tier is margin collateral, which is based upon econometric models of future stock prices and the amount of collateral is recalculated daily to cover losses at a 99 percent confidence interval. The third tier is a guarantee fund which is only drawn upon if the margin collateral was insufficient to cover the obligations of a defaulted member.
Essentially indemnification is an insurance policy and like insurance, the premium is related to the likelihood of drawing upon the insurance policy. The securities lending industry could consider counterparty credit evaluation and setting of collateral rates as ways to lower the probability of drawing upon indemnification. If the counterparty risk evaluation is effective and the collateralisation rate is more certain to cover the replacement cost of lent securities, then the conversation about indemnification may change. The guarantee provided by central clearing is another alternative that would help reduce the likelihood of drawing upon indemnification.
Saunders: Regulation and the ensuing cost of indemnification will continue to be a pain point for agent lenders and clients. The industry, for the most part, has been repriced to reflect the capital cost associated with indemnification through tiered splits, third-party providers of indemnification, minimum spreads or various other commercial elements. The crux of the conversation remains the same—the attractiveness of the pool of lendable assets for each client. Clients with optimal assets for lending or specific risk profiles will benefit throughout this process and each lending agent views these relationships differently. Therefore, it is the notion of client selectivity which becomes the main issue when discussing indemnification with lending agents determining how the capital will be deployed across their lending programme clients.
Rennick: Indemnification has become somewhat standard and expected as part of the core offering. At the same time, capital is a finite resource and as capital charges continue to increase, certain securities lending activity may become prohibitive for an agent lender and a borrower. Similar to conversations in other parts of the financial industry, for example, between prime brokers and hedge funds, we are starting to have discussions with our lending clients about what is additive or detractive to a bank or broker dealer’s balance sheet. That education is critical as capital is a binding constraint for both the agent lender and borrower. One outcome may be one price for indemnified business and a different price for the non-indemnified business. Solutions to reduce capital footprints remain a priority and alternatives such as central clearing or accepting collateral via pledge will gather momentum as they benefit asset owners, lenders and borrowers.
After two years of Donald Trump’s presidency in the US, how have beneficial owners adapted to the new landscape?
Nigam: Beneficial owners adapt to market conditions, which are obviously influenced by political administrations. It behoves them to watch the trends in the market when making decisions, rather than reacting to the issue of the day in Washington.
Trapp: Beneficial owners have felt the impact of the market volatility in Q4, 2018 on their investment portfolios and on their securities lending earnings. It’s hard to attribute what happened in the securities lending market back to the Donald Trump presidency, but certainly, the volatility has been felt across the markets. In terms of the regulatory landscape, there has been progress over the last several years as the industry looks to implement several new regulations. The current administration’s stance towards reducing regulation is favourable, however, and will likely slow the pace of new regulations over the coming year.
Saunders: Regardless of political views, the landscape has proven beneficial owners and lending agents who maintain an active dialogue to discuss, implement and monetise opportunities are well positioned. Market volatility will remain and likely increase throughout 2019 and those nimble enough to have the framework in place to handle the volatility will likely outperform.
Bassler: The new landscape during most of the last two years had been one of low volatility and upward stock markets. That changed in Q4 2018 with market dislocation and higher volatility. This market climate may be here to stay given global political and macro factors, and it could lead to more short conviction and a better demand environment for beneficial owners. We anticipated higher volatility with the Trump presidency, but only recently have we seen it come to fruition. Staying engaged with your agent and other peers and market participants is critical to remaining relevant as a lender, and then reacting to an evolving market in order to capture opportunity that the financing markets offer.
How are beneficial owners approaching SFTR? What are the main challenges they are facing?
Saunders: The implementation of SFTR has consumed tremendous resources within the firms participating in securities lending as well as those providing securities financing services. The general sentiment from a servicing perspective continues to focus on the successful implementation of the solution. These challenges have been eased with the assistance of third party vendors. However, challenges remain on automating the data submission component and the sharing of costs to comply with SFTR. It remains an open question as to how agent lenders will handle the commercial elements of SFTR. Several agent lenders have absorbed this cost as a matter of sound business practice. As SFTR progresses, certainly beneficial owners will require bespoke reporting solutions which will add additional levels of complexity both in terms of costs and data sharing.
Despite these challenges, there is an opportunity as a lender to synthesise the data to increase lending performance. The compilation of market data is simply another data point which can be utilised to benchmark the performance of a programme.
Nigam: It has been our experience that beneficial owners are relying heavily on their providers for guidance and solutions with SFTR.
Rennick: SFTR remains at the forefront of discussions with some beneficial owners more prepared than others, but all share concerns around the need to supply an approximate 150 data elements, particularly since many of those elements lack consistency and a centralised source. Market participants will remain active in meeting the specific transaction reporting requirements, but asset owners that delay focus may risk being left behind. We continue to articulate the extra-territorial impact this EU regulation is going to have to the US and the Asia Pacific clients.
Trapp: We are working closely with the industry to ensure that the requirements for the SFTR are understood for our clients by the 2020 deadline.
In terms of technology, what developments do you expect to see in 2019? And how are they benefitting beneficial owners?
Wolfe: I expect we will see two technology changes in the future that will benefit beneficial owners: machine learning and distributed ledger technology. SFTR is requiring that many more data points be captured and made available in electronic form for European regulators. Firms and vendors have been investing in new technologies to support these requirements. Improved access to this more robust dataset could enable participants to apply machine learning in order to discover surprising and valuable insights. Similarly, distributed ledger technology has the potential to not only improve the transparency for beneficial owners but also to potentially enable beneficial owners to take a more active role in their lending programmes. I’m not confident either of these will come to fruition this year, but I do believe we will see experimentation and innovation over the coming year in both of these emerging technologies.
Rennick: At J.P. Morgan, we continue to make significant investments in our securities lending platform as technology remains a differentiator and true value add to the beneficial owner community. Clients have access to vital lending data and consolidated reporting, while our advanced proprietary trading platform consolidates data repositories, trading parameters and the trade lifecycle with advanced risk management and analytics as we draw from the firm’s quantitative research capabilities. Data consumption and comparison will most likely be a key theme for beneficial owners over the next few years as big data and AI will help drive decisions and opportunities.
Trapp: The increasing use of technology and automation continues to bring benefits to beneficial owners. There is continued focus on pre-trade, trade and post-trade automation to increase efficiencies for the securities lending industry. In 2018, the expanded use of the NGT platform added significant straight-through processing capabilities, bringing increased levels of transparency and efficiency to the industry. Northern Trust has built out our capability to take full advantage of the improved distribution and pricing offered by the platform. This year, our focus will be on the use of emerging technologies such as AI, robotics and machine learning to further optimise pricing and distribution of client portfolios.
Saunders: Participants in securities financing transactions are at various stages of harnessing technology to offer a more compelling product. Each participant has a different focus as to how they are spending their technology budgets. At BNP Paribas, we have opted to focus on efficiency and transparency. We are utilising AI and simplistic forms of robotics to remove many of the daily, manual processes associated with a lending transaction. These developments automate many of the low margin, high volume transactions and enable more of a focus on bespoke trading strategies to extract value from a clients’ lending portfolio.
The common denominator remains to generate more revenue for beneficial owners while offering higher levels of transparency. In a relatively low margin, high volume type of business, efficiency is a critical component and leveraging the tools of technology are assisting the industry in their efforts to monetise opportunities in a cost-effective and risk-controlled manner.
Nigam: With SFTR and the unparalleled level of data that will come as a result, we expect to see vendors pitching new views on the industry and how it pertains to the beneficial owners. Additionally, we also expect to see a more concerted push for central counterparties to take on and counteract some of the balance sheet inefficiencies that currently plague the industry.
Over the next 12 months, how do you expect to see the securities lending landscape develop/change?
Bassler: We expect to see greater beneficial owner engagement and focus as securities lending continues to see more attention across the investor segment. Beneficial owners are under pressure to show value to their underlying shareholders and beneficiaries, and securities lending is a pure shareholder value product. This means existing lenders will be looking for new opportunities in new markets, new collateral structures and potentially new peer to peer transaction opportunities. Agents and providers will continue to have to keep up with the demands of the beneficial owners from education, technology and overall innovation perspective. The market will remain competitive as clients demand more, and focus on transparency, best execution and a partner that is truly looking around every corner for opportunities or risks that are not necessarily obvious.
Nigam: We expect to see a continued shift away from cash as collateral. The spike in treasury repo rates over year-end illustrated the need to be prepared and have an alternative plan, be it shifting more balances to non-cash or signing up new counterparties that are not a balance sheet driven.
Saunders: At BNP Paribas, we expect this year to be a pivotal year as we realise the significant investment in several initiatives, which will substantially benefit our clients. There will remain a continued focus on extracting value, implementing technology and looking for cost-effective strategies to grow business. We will continue to leverage the multitude of technology offerings which exist as well as continue with the development of propriety systems all with the focus on delivering value to our clients and shareholders. Ultimately, client selectivity and higher levels of engagement will become the forefront of our programme as we seek to deliver the benefits of securities lending to our clients.
Trapp: Technology and automation are the primary focus of the industry. Continuing to improve the distribution channels through the use of CCP’s and fintech tools will have a large impact on the future of the lending business. Beneficial owners can put themselves in a position to benefit from these developments by reviewing their collateral guidelines and ensuring they are aligned with the trend toward non-cash collateral.
Emerging markets will also provide opportunities for clients given the need for borrowers to source supply in less liquid markets or securities. As a custodian and fund manager, Northern Trust has experience working in both developed and emerging markets to provide access for our securities lending clients.
Despite the trend towards non-cash collateral, cash collateral investment can generate incremental returns for beneficial owners. A favourable investment spread can have a significant impact on earnings. Beneficial owners should review their cash investment guidelines to make sure they are aligned for changes in short term interest rates.
Rennick: The biggest changes will continue to be driven by regulation, especially SFTR and potentially Brexit, G-SIB charges, the Central Íø±¬³Ô¹Ï Depositories Regulation and changes to collateral rules. SFTR will offer unprecedented transparency, but will also challenge firms to first comply and then data mine for trends and opportunities. Outside of regulation, you are seeing beneficial owners return to lending after a long pause post the financial crisis. You also see new entrants, with lending portfolios seeking to increase challenged returns or possibly to offset fee pressures in the asset management client segment, for example. Evolution is constant and the firms that can adapt quickly and remain flexible are the ones that will maximise opportunities.
Horner: We expect beneficial owners to adopt peer-to-peer solutions that will allow them to potentially increase utilisation/returns while maintaining indemnification and operational/trade support from their agent lender.
Wolfe: I expect the use of non-cash collateral will continue to grow, and hopefully there will be continued dialogue with the US Íø±¬³Ô¹Ï and Exchange Commission regarding the use of equities as collateral. OCC is working closely with the custody banks and industry participants to develop a cleared programme for non-cash lending. CCPs and peer-to-peer are exciting initiatives that have the potential to increase utilisation, improve revenues, and lower costs. Finally, I believe that the decreasing cost and increasing access to big data and advanced data analytics and potentially new network paradigms will introduce exciting developments.
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