Two stories to tell
25 June 2019
The US is seeing two sides to securities lending, while the supply side enjoys a story of growth, the demand side is telling a disappointing story
Image: Shutterstock
In the US there are two stories in securities lending, one story is that the supply side is seeing growth, while the second story tells a more troubling tale as the demand side is causing a decrease in returns for investors holding US equities.
As well as this, the trade war between the US and China is still ongoing. At this year鈥檚 9th Annual Canadian 网爆吃瓜 Lending Association Conference, Benjamin Tal, managing director and deputy chief economist of CIBC, noted that despite an economic slowdown globally, the US has pushed against this trend. However, this was a 鈥渟hort-term gain鈥�, but could result in 鈥渓ong-term pain鈥� for the US, according to Tal. Usually, governments stimulate their economy when it鈥檚 down鈥攏ot up鈥攂ut Trump provided an extra lift that it did not need when it was high, he explained.
Elaborating on the two stories, Peter Bassler, managing director, business development, eSecLending, explains: 鈥淔irst, the supply side is one of growth where we are seeing new lenders come to the market and the available supply is increasing significantly. That is the good news as a growing number of investors embrace the product.鈥�
鈥淯nfortunately, there is the second story, where the demand side continues to disappoint with few specials in the market leading to lower overall returns for investors holding US equities.鈥�
鈥淚ntrinsic rates on specials remain strong, but there is no breadth and depth of a strong specials market across the board. The current pick up in IPO activity and the recent spike in volatility provide hope as we continue through 2019.鈥�
Lori Paris, head of client management, North America, for Northern Trust securities lending, is seeing a similar story. She observes: 鈥淲e continue to see interest in securities lending by asset owner clients. The lendable base of securities available for loan continues to increase, which is a testament to the continued interest and value proposition of the securities lending product.鈥�
鈥淗owever, demand has not tracked at the same rate as the increase in available supply. While the demand to borrow high-quality liquid assets (HQLA) continues to be significant, regulation and extreme market volatility have contributed to slower demand growth. Hard to borrower securities remain under pressure as a lack of conviction and borrower demand have persisted since the end of 2018.鈥�
鈥淩ecent global economic news has also had an impact on securities lending demand. As investors continued to weigh the impacts of US-China trade negotiations, the potential for softer demand on weaker Chinese and European economies and Brexit related uncertainties, we see consistent borrowing demand in sectors such as autos, financial, technology, healthcare and energy. US borrowing demand has largely been driven by long-term directional sentiment within these sectors.鈥�
Driving the demand
Discussing key market drivers for the US this year, Paris believes that demand will primarily be driven by the overall strength and direction of the financial markets.
She explains: 鈥淩egulation and liquidity management have been a primary focus within the securities financing space for the last several years. Now that many regulations have been implemented or are more clearly understood, market participants can deploy their resources on new product and business initiatives.鈥�
Paris adds: 鈥淔or example, in the past year, several emerging markets have started discussions on workable securities lending models. 网爆吃瓜 lending is a prerequisite for attracting investors to emerging markets by providing the necessary liquidity to the market. In 2019, the securities lending market鈥檚 drivers will rely on a stable broader market.鈥�
Meanwhile, Mike Airey, vice president, strategic solutions, securities finance and collateral management, Broadridge, says: 鈥淩egulation continues to impact the industry and the types of trades undertaken. Another trend is the growth in new sources of supply as brokers look to finance idle assets through fully paid lending.鈥�
Regulators, buy-side and sell-side firms are also seeing a lot of interest and activity around sponsored repo. These moves are generally seen鈥攁mong other benefits鈥� to reduce systemic risk and create market capacity. In addition to broadening the footprint of market participants for sponsored repo, sponsors can also now let their clients trade with counterparties other than themselves. This provides sponsored members with the same execution flexibility as they have in the bi-lateral market today.鈥�
鈥淎 further trend we see is that some beneficial owners are becoming more sophisticated in their business models and evaluating whether to bring some or all of their lending activity in-house. While it is not suitable for everyone, for some participants there can be benefits to lending directly to borrowers.鈥�
鈥淔rom a technology perspective, data is a real theme鈥攁ccess to data, utilising data in trading decisions, cleansing and re-purposing of data across the business stack.鈥�
Regulatory impact
The most immediate regulation that is impacting the US is adherence to the International Swaps and Derivatives Association (ISDA) stay protocol for certain transactions, according to Paris.
She notes that, as a requirement for certain borrowers, on 1 July 2019 participating lenders need to confirm their adherence to stay protocol resolution or risk having an impact on their securities lending programme.
Paris continues: 鈥淟ooking ahead, there has been progress with SFTR (网爆吃瓜 Finance Transaction Reporting) to prepare for the 2020 regulatory deadlines. The necessary infrastructure is being offered by several providers and lenders, who will have to decide how to comply with this massive industry regulatory reporting initiative.鈥�
Airey points out that Basel III and Dodd-Frank continue to influence the types of transactions undertaken, such as term trades, and the behaviour of various market participants.
He adds: 鈥淭here鈥檚 more of a focus on the capital impact of certain trades and counterparties, along with rising indemnification costs. The BCBS IOSCO Uncleared Margin Reform rules will continue to increase demand for collateral as more participants meet the thresholds for compliance in September. Single-counterparty exposure limits will also start to impact some market participants soon.鈥�
鈥淭hese regulations are driving the continuing consolidation of securities lending, repo and derivatives collateral management. This is coupled with a need for technology solutions that can provide clear views of inventory and exposures across business lines, mobilise and process collateral efficiently and connect to market infrastructure.鈥�
Talking technology
Discussing technology, Paris sees the opportunities that technology can bring and notes that the increasing use of technology and automation continues to bring benefits to asset owner clients that participate in securities lending.
Paris asserts: 鈥淲e see 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 Next Generation Trading (NGT) platform added significant straight-through processing capabilities, bringing increased levels of transparency and efficiency to the industry.鈥�
鈥淣orthern Trust has built out our capability to take advantage of the improved distribution and pricing offered by the platform. In 2019, our focus will be on the use of emerging technologies such as artificial intelligence (AI), robotics and machine learning to further optimise pricing and distribution of client portfolios.鈥�
Bassler explains that technology can help improve efficiency, he cites: 鈥淎ll agents and borrowers today are looking for efficiencies in their respective businesses and technology is the catalyst to accomplish this. Whether this is through ALD for on-boarding new lenders or Equilend鈥檚 NGT platform for auto-borrow, the desire for efficiencies for lower cost is a top priority for all businesses across the securities finance landscape.鈥�
鈥淎utomating administrative functions and low spread trading is important to allow your talent to focus on generating revenue from the high spread opportunities and focusing efforts on creative and new ways to identify new revenue opportunities through new markets, structured trades, peer to peer
transactions etc.鈥�
Airey doesn鈥檛 necessarily see technology as a disruptor, as it is a highly regulated environment with a highly connected ecosystem. He says: 鈥淭here is also significant potential for operational and systemic risk. Many market participants, particularly beneficial owners, are conservative by nature.鈥�
He states: 鈥淔or real innovation or business model change to work in securities finance it needs to be adopted simultaneously, en-masse among a range of market participants. This makes it difficult to achieve widespread disruption to business models, is not helped by ageing legacy technology solutions and a lack of standardisation.鈥�
On the topic of AI, Airey believes that AI offers great potential and notes that there has been a lot of conjecture recently on the extent that AI will replace people in securities finance.
Airey continued: 鈥淗owever, we don鈥檛 expect the entire trade lifecycle to be completely automated. There is a reason that parts of the business are still relationship based. Human interaction will also still be a requirement due to a need to continually govern AI solutions.鈥�
鈥淪omeone needs to identify sources of bad data, manage the impact of new data as it enters the system and recalibrates the solution to ensure the correct outcomes. It is unlikely that many market participants are ready to trust their trading or operations activity to a completely automated machine learning algorithm.鈥�
The collateral question
Non-cash collateral has been trending in the US recently, and Bassler observes: 鈥淎lthough many in the US are not accustomed to non-cash collateral, we are having many risk discussions around the nuances with this structure. We are comfortable with the tri-party arrangements and work closely with our clients to discuss how various forms of non-cash collateral will perform in market stress scenarios.鈥�
Bassler highlights that education in this area could be heightened: 鈥淭here is a lot of education that is needed on this topic in the US. Europe, Canada and Asia view non-cash as a standard practice, however, it is still early in the life cycle in the US, so education is necessary.鈥�
Paris sees the non-cash trend as a result of regulations impacting the borrowers. She asserts: 鈥淎s borrowers look to more efficiently utilise their balance sheets, and deploy cash and HQLA assets in more effective ways, non-cash balances have risen to new heights in the securities lending market. With that being said, it is absolutely imperative to have a non-cash strategy and work with our clients to understand collateral flexibility and diversification to take advantage of this important trend.鈥�
Airey adds: 鈥淔rom a systems perspective, it creates a need for solutions that can handle the added complexity of non-cash (corporate actions and substitutions for example) in an automated way without a corresponding increase in operational workload.鈥�
On the 2019 horizon
In March this year, the Federal Reserve indicated that there will be no more hikes ahead this year and said that they would be 鈥榩atient鈥� and take a 鈥榳ait-and-see approach鈥� to changes.
Paris affirms that anticipating interest rate changes has an impact on securities lending because it signals the direction of the economy.
She comments: 鈥淎t the end of 2018 and in the first quarter of 2019, we saw extreme volatility in the market mainly due to uncertainty around the strength of the economy which in turn stifled securities lending demand.鈥�
鈥淭here were other factors at play such as year-end funding, profit-taking and balance sheet considerations that also contributed to lower-demand. So as we look ahead to 2019, a key factor for securities lending demand is the ability to keep volatility at moderate levels.鈥�
As well as this, the trade war between the US and China is still ongoing. At this year鈥檚 9th Annual Canadian 网爆吃瓜 Lending Association Conference, Benjamin Tal, managing director and deputy chief economist of CIBC, noted that despite an economic slowdown globally, the US has pushed against this trend. However, this was a 鈥渟hort-term gain鈥�, but could result in 鈥渓ong-term pain鈥� for the US, according to Tal. Usually, governments stimulate their economy when it鈥檚 down鈥攏ot up鈥攂ut Trump provided an extra lift that it did not need when it was high, he explained.
Elaborating on the two stories, Peter Bassler, managing director, business development, eSecLending, explains: 鈥淔irst, the supply side is one of growth where we are seeing new lenders come to the market and the available supply is increasing significantly. That is the good news as a growing number of investors embrace the product.鈥�
鈥淯nfortunately, there is the second story, where the demand side continues to disappoint with few specials in the market leading to lower overall returns for investors holding US equities.鈥�
鈥淚ntrinsic rates on specials remain strong, but there is no breadth and depth of a strong specials market across the board. The current pick up in IPO activity and the recent spike in volatility provide hope as we continue through 2019.鈥�
Lori Paris, head of client management, North America, for Northern Trust securities lending, is seeing a similar story. She observes: 鈥淲e continue to see interest in securities lending by asset owner clients. The lendable base of securities available for loan continues to increase, which is a testament to the continued interest and value proposition of the securities lending product.鈥�
鈥淗owever, demand has not tracked at the same rate as the increase in available supply. While the demand to borrow high-quality liquid assets (HQLA) continues to be significant, regulation and extreme market volatility have contributed to slower demand growth. Hard to borrower securities remain under pressure as a lack of conviction and borrower demand have persisted since the end of 2018.鈥�
鈥淩ecent global economic news has also had an impact on securities lending demand. As investors continued to weigh the impacts of US-China trade negotiations, the potential for softer demand on weaker Chinese and European economies and Brexit related uncertainties, we see consistent borrowing demand in sectors such as autos, financial, technology, healthcare and energy. US borrowing demand has largely been driven by long-term directional sentiment within these sectors.鈥�
Driving the demand
Discussing key market drivers for the US this year, Paris believes that demand will primarily be driven by the overall strength and direction of the financial markets.
She explains: 鈥淩egulation and liquidity management have been a primary focus within the securities financing space for the last several years. Now that many regulations have been implemented or are more clearly understood, market participants can deploy their resources on new product and business initiatives.鈥�
Paris adds: 鈥淔or example, in the past year, several emerging markets have started discussions on workable securities lending models. 网爆吃瓜 lending is a prerequisite for attracting investors to emerging markets by providing the necessary liquidity to the market. In 2019, the securities lending market鈥檚 drivers will rely on a stable broader market.鈥�
Meanwhile, Mike Airey, vice president, strategic solutions, securities finance and collateral management, Broadridge, says: 鈥淩egulation continues to impact the industry and the types of trades undertaken. Another trend is the growth in new sources of supply as brokers look to finance idle assets through fully paid lending.鈥�
Regulators, buy-side and sell-side firms are also seeing a lot of interest and activity around sponsored repo. These moves are generally seen鈥攁mong other benefits鈥� to reduce systemic risk and create market capacity. In addition to broadening the footprint of market participants for sponsored repo, sponsors can also now let their clients trade with counterparties other than themselves. This provides sponsored members with the same execution flexibility as they have in the bi-lateral market today.鈥�
鈥淎 further trend we see is that some beneficial owners are becoming more sophisticated in their business models and evaluating whether to bring some or all of their lending activity in-house. While it is not suitable for everyone, for some participants there can be benefits to lending directly to borrowers.鈥�
鈥淔rom a technology perspective, data is a real theme鈥攁ccess to data, utilising data in trading decisions, cleansing and re-purposing of data across the business stack.鈥�
Regulatory impact
The most immediate regulation that is impacting the US is adherence to the International Swaps and Derivatives Association (ISDA) stay protocol for certain transactions, according to Paris.
She notes that, as a requirement for certain borrowers, on 1 July 2019 participating lenders need to confirm their adherence to stay protocol resolution or risk having an impact on their securities lending programme.
Paris continues: 鈥淟ooking ahead, there has been progress with SFTR (网爆吃瓜 Finance Transaction Reporting) to prepare for the 2020 regulatory deadlines. The necessary infrastructure is being offered by several providers and lenders, who will have to decide how to comply with this massive industry regulatory reporting initiative.鈥�
Airey points out that Basel III and Dodd-Frank continue to influence the types of transactions undertaken, such as term trades, and the behaviour of various market participants.
He adds: 鈥淭here鈥檚 more of a focus on the capital impact of certain trades and counterparties, along with rising indemnification costs. The BCBS IOSCO Uncleared Margin Reform rules will continue to increase demand for collateral as more participants meet the thresholds for compliance in September. Single-counterparty exposure limits will also start to impact some market participants soon.鈥�
鈥淭hese regulations are driving the continuing consolidation of securities lending, repo and derivatives collateral management. This is coupled with a need for technology solutions that can provide clear views of inventory and exposures across business lines, mobilise and process collateral efficiently and connect to market infrastructure.鈥�
Talking technology
Discussing technology, Paris sees the opportunities that technology can bring and notes that the increasing use of technology and automation continues to bring benefits to asset owner clients that participate in securities lending.
Paris asserts: 鈥淲e see 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 Next Generation Trading (NGT) platform added significant straight-through processing capabilities, bringing increased levels of transparency and efficiency to the industry.鈥�
鈥淣orthern Trust has built out our capability to take advantage of the improved distribution and pricing offered by the platform. In 2019, our focus will be on the use of emerging technologies such as artificial intelligence (AI), robotics and machine learning to further optimise pricing and distribution of client portfolios.鈥�
Bassler explains that technology can help improve efficiency, he cites: 鈥淎ll agents and borrowers today are looking for efficiencies in their respective businesses and technology is the catalyst to accomplish this. Whether this is through ALD for on-boarding new lenders or Equilend鈥檚 NGT platform for auto-borrow, the desire for efficiencies for lower cost is a top priority for all businesses across the securities finance landscape.鈥�
鈥淎utomating administrative functions and low spread trading is important to allow your talent to focus on generating revenue from the high spread opportunities and focusing efforts on creative and new ways to identify new revenue opportunities through new markets, structured trades, peer to peer
transactions etc.鈥�
Airey doesn鈥檛 necessarily see technology as a disruptor, as it is a highly regulated environment with a highly connected ecosystem. He says: 鈥淭here is also significant potential for operational and systemic risk. Many market participants, particularly beneficial owners, are conservative by nature.鈥�
He states: 鈥淔or real innovation or business model change to work in securities finance it needs to be adopted simultaneously, en-masse among a range of market participants. This makes it difficult to achieve widespread disruption to business models, is not helped by ageing legacy technology solutions and a lack of standardisation.鈥�
On the topic of AI, Airey believes that AI offers great potential and notes that there has been a lot of conjecture recently on the extent that AI will replace people in securities finance.
Airey continued: 鈥淗owever, we don鈥檛 expect the entire trade lifecycle to be completely automated. There is a reason that parts of the business are still relationship based. Human interaction will also still be a requirement due to a need to continually govern AI solutions.鈥�
鈥淪omeone needs to identify sources of bad data, manage the impact of new data as it enters the system and recalibrates the solution to ensure the correct outcomes. It is unlikely that many market participants are ready to trust their trading or operations activity to a completely automated machine learning algorithm.鈥�
The collateral question
Non-cash collateral has been trending in the US recently, and Bassler observes: 鈥淎lthough many in the US are not accustomed to non-cash collateral, we are having many risk discussions around the nuances with this structure. We are comfortable with the tri-party arrangements and work closely with our clients to discuss how various forms of non-cash collateral will perform in market stress scenarios.鈥�
Bassler highlights that education in this area could be heightened: 鈥淭here is a lot of education that is needed on this topic in the US. Europe, Canada and Asia view non-cash as a standard practice, however, it is still early in the life cycle in the US, so education is necessary.鈥�
Paris sees the non-cash trend as a result of regulations impacting the borrowers. She asserts: 鈥淎s borrowers look to more efficiently utilise their balance sheets, and deploy cash and HQLA assets in more effective ways, non-cash balances have risen to new heights in the securities lending market. With that being said, it is absolutely imperative to have a non-cash strategy and work with our clients to understand collateral flexibility and diversification to take advantage of this important trend.鈥�
Airey adds: 鈥淔rom a systems perspective, it creates a need for solutions that can handle the added complexity of non-cash (corporate actions and substitutions for example) in an automated way without a corresponding increase in operational workload.鈥�
On the 2019 horizon
In March this year, the Federal Reserve indicated that there will be no more hikes ahead this year and said that they would be 鈥榩atient鈥� and take a 鈥榳ait-and-see approach鈥� to changes.
Paris affirms that anticipating interest rate changes has an impact on securities lending because it signals the direction of the economy.
She comments: 鈥淎t the end of 2018 and in the first quarter of 2019, we saw extreme volatility in the market mainly due to uncertainty around the strength of the economy which in turn stifled securities lending demand.鈥�
鈥淭here were other factors at play such as year-end funding, profit-taking and balance sheet considerations that also contributed to lower-demand. So as we look ahead to 2019, a key factor for securities lending demand is the ability to keep volatility at moderate levels.鈥�
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