Why do you talk about the ‘evolution’ of securities lending? What does that mean?
Adaptation is critical for growth. The securities lending market is no exception. In its roughly 40-year existence, this business has changed dramatically. The changes have come from multiple dimensions: externally, in the form of regulation, and internally, in the expanding complexity of needs represented by the main stakeholders in a securities lending transaction.
There is a vast difference in the business value proposition. The business is now multifaceted and supports a number of trading strategies, emphasising evolution beyond what was once simply back-office activity.
Why is that important?
The market is an ecosystem and there have been numerous influences upon it. Making State Street the most efficient source from which to borrow is ultimately a key to growth and expansion. In this sense, responding to the needs of our borrower base and understanding the various collateral types and trade structures that allow them to do more business with our clients is paramount. Changing regulation has made this efficiency an absolute necessity. As such, evolution in collateral and the growth of the various trade structures has been a key focus. And, of course, one of the most important of those is the needs of our clients. Over time, we have expanded the kinds of clients we service. In a traditional agency lending context, this has meant providing greater flexibility and breadth of service with respect to collateral and structure type under which to lend. Traditional long-only clients then moved into the leveraged space, and it became important to offer solutions which catered to lending out long positions, as well as lending to these clients for shorts. Facilitating client demands for financing through a securities lending arrangement is becoming a consistent request as well. And importantly, these services are not mutually exclusive: clients are demanding that these services be offered in tandem. The number of clients who use multiple services in combination has grown dramatically, and shows no sign of abating.
What key regulations have changed the securities lending ecosystem?
Following the financial crisis in 2008 to 2009, regulators have overhauled the financial regulatory rules with the introduction of Basel III. Prior to Basel III, the primary regulatory tool for bank regulators was the risk-weighted assets (RWA) and risk-based capital (RBC) ratios. While this continues to be a key tool for regulators, Basel III has introduced the supplementary leverage ratio (SLR), liquidity coverage ratio (LCR), net stable funding ratio (NSFR) and large exposure rules.
To date, the SLR and LCR have been implemented within the US, and the RWA measurements have been revamped to increase conservatism. In the US, the SLR complements the already existing leverage ratio and prevents banks from becoming excessively levered even if the assets are low risk. The LCR requires banks to maintain sufficient liquidity to fund operations under a 30-day stress environment. Additionally, the Dodd-Frank Act requires large banks to measure their RWA under both the advanced and standardised approaches. For securities finance transactions, this results in substantially higher RWA on the magnitude of 20 to 30 times.
Additionally, the US Comprehensive Capital Analysis and Review (CCAR) requires large banks to test their leverage and RBC ratios under a period of significant stress over nine quarters. There are three stress scenarios each year: an adverse, severally adverse and bank scenario. Under the Dodd Frank Stress Test (DFAST), banks are required to run the bank scenario twice a year.
These regulations have impacted lending agents from a return on risk based capital perspective, as the increased RWA has led to significantly more capital required to support the business. This has resulted in a significant increase in the cost of indemnifying clients. Borrowers have also seen an increase in RWA and associated capital required for the business. However, they have also seen an increase in capital costs associated with the SLR and greater funding requirements for short term cash transactions.
How has the market reacted to these regulatory changes?
Key changes to the market include a greater use of non-cash collateral, which may reduce the leverage, and liquidity impacts of the regulatory changes for borrowers. However, non-cash collateral can result in an increase in RWA for both lenders and borrowers. Additionally, the use of the term transactions both on the lending and reinvestment portions of the business have increased. This is being primarily driven by the LCR and the NSFR (when implemented) requirements.
The industry has also explored new transaction structures such as using collateral pledging rather than transfer of title, which could reduce RWA impacts for some participants. The use of central counterparties (CCPs) continues to be explored, but some hurdles remain before wholesale utilisation of a CCP model is enacted.
Are there any other changes coming down the road?
The big changes still to come include the implementation of Single Counterparty Credit Limits (SCCL) in the US. The SCCL regulation has been finalised and will go into effect on 1 January 2020. Fortunately, the final rule is not as draconian as the prior proposal and the disruption to securities finance markets should be minimal.
The NSFR is yet to be implemented in the US. This is a complement to the LCR and focuses on liquidity requirements over the course of 12 months. The NSFR will impact borrowers; however, it appears that most market participants have already adjusted their business models in anticipation of the NSFR.
Finally, Basel III has finalised a new method of calculating the standardised method for securities finance RWA. The new method will account for correlations of loans and collateral, as well as diversification across the portfolio. Once adopted in the US, this should reduce the cost of capital impact for agent lenders and borrowers.
Can you tell us more about what you’re doing on the quant side in securities finance?
We are changing the operating model in securities finance by leveraging new methods, cutting edge technology and increased automation to rethink how the core functions of the business work. The algorithmic trading team integrates business and technical knowledge to drive novel, efficient solutions in the business. This mixture of expertise—business insight, technical knowledge (computing and hard sciences), and the right talent to facilitate—is increasingly important in the industry given the trends both in securities lending and the broader financial services landscape.
On the research side, we take a similarly integrated approach, leveraging academic partnerships, use of alternative data and sophisticated quant methods, and close collaboration with the business to ensure a high-value, differentiated product. With the combination of academic and business considerations, we find research angles—such as one of our current projects, modeling stocks going special using some alternative factors—that are both meaningful and impactful.
With the ‘ecosystem’ idea that the industry is composed of interdependent parts, how do these quant methods and research fit into the securities finance ecosystem?
The algorithmic trading team has partnerships at various levels of the firm as well as external counterparties. These relationships allow us to see a more holistic view, tap into talent pools and integrate with bigger initiatives more freely. Given the speed of transformation at State Street and the industry at large, it is impossible for business units to work in silos. The value this operating model creates and the implicit knowledge and familiarity it brings is what ultimately drives innovation and speeds up the delivery of new products.
On the research side, the ‘ecosystem approach’ is one of our major differentiators. The State Street Associates office, our academic arm, is located in Harvard Square, allowing us to frequently interface with our academic partners from Harvard, MIT, and other area universities. That said, the research team also sits with the business several days a week, understanding what we’re seeing internally, what clients need, and fostering shared ideas and collaboration. In that sense, we’re able to integrate into the ecosystem seamlessly.
It sounds like there are some great initiatives in securities finance broadly at State Street. How do you ensure you have seamless integration? What are the key components to the strategy?
For us, talent management is critical to ensuring success. One way we’ve formalised our efforts in this space is by launching the Numerates Network. This is a firm-wide initiative where we bring together talent and encourage the further development of quantitative skills through workshops, training programmes, mentorships and other initiatives. The direct implication for securities finance is that we are constantly sharing ideas throughout State Street, leveraging best practices, fostering creativity and collaborating on quantitative initiatives to deliver cutting-edge products.
Another great example of integrating new ideas into the financing landscape is our Direct Access product, which provides enhanced custody (demand) clients the ability to borrower directly from agency lending (supply) clients in a managed peer to peer structure. This not only provides economic benefits to borrowers, but also allows State Street’s agency lending clients greater utilisation of their lendable securities.
Any closing thoughts?
Regulatory constraints on both agent lenders and prime brokers has led to an evolution of the securities finance ecosystem. New solutions that meet clients’ needs from both a lending and borrowing perspective are being developed. Work is being done on a number of fronts and in a number of areas with the goal of providing a unified, holistic solution to our clients. Having great individual products is not enough anymore. Many clients no longer need simple securities lending—they need a securities finance solution. Each client’s solution must be tailored to their specific needs, and the ability to seamlessly integrate multiple products together optimally to meet those needs will be the key to success in the new securities finance ecosystem.
Francesco Squillacioti, global head of client management for securities finance
Glenn Horner, chief regulatory officer for State Street Global Markets
Nick Delikaris, global head of algorithmic trading for securities finance
Stephanie Lo, head of securities finance research
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