Thinking again
21 March 2017
Fresh opportunities are arising and perceptions are changing for securities lending in Australia, as Dane Fannin and Mark Snowdon of Northern Trust explain
Image: Shutterstock
Australia has long positioned itself as one of Asia’s most prominent and mature markets for securities lending.
Yet for several years, the limited appetites of asset owners for the product did not necessarily live up to expectations suggested by this title.
In particular, the financial crisis of 2008 damaged perceptions of securities lending in terms of its risks and rewards for participants. Sensing a mismatch, a number of asset owners chose to opt out of their securities lending programmes as a result.
Today, however, the prevailing economic and regulatory environment is changing this view, as well as presenting lenders with increasing revenue generating opportunities.
The world has moved forward—and given its attractive risk-reward profile versus other investment products—we are seeing a renewed appetite for securities lending.
Domestic drivers
According to data providers, lendable supply in Australia already boasts an impressive one fifth of overall Asian inventory. While a substantial portion of this is derived from offshore asset owners, a larger portion—which is set to continue growing—now originates from domestic funds.
A large slice of these assets are held by Australia’s superannuation funds. This segment is the fourth largest in the world and these superfunds are poised to continue expanding further through increased mandatory contributions from members throughout the next decade.
Asset allocations remain largely domestically focused, particularly in equities, although there is evidence this is changing as the benefits of greater diversification and liquidity in global markets take hold more widely.
By the same measure, this trend will help to diversify and enhance securities lending revenue streams for local beneficial owners, with greater offshore exposure where expected returns can be more attractive.
The Australian market is noted for its close-knit domestic investment community, where local presence remains important for the purposes of relationship building and information flows, particularly for securities lending.
A large portion of lending activity is still transacted onshore with locally domiciled borrowers against Australian collateral—predominantly Australian dollar cash and Australian equities. Northern Trust’s presence in Sydney and Melbourne provides capability and local expertise in the domestic market.
Trends in borrower demand
On a relative basis, demand for Australian inventory has not yet risen to pre-2008 levels, in common with a number of other major securities lending hubs. Regulation, investor redemptions, systemic deleveraging, the increased costs of balance sheet and the drive to internalise inventories have all contributed to this dynamic.
However, demand to borrow Australian assets has been on the rise, and according to data providers, this has been reflected in overall loan balances seeing healthy growth over the last three years.
Available supply in equities remains skewed toward the more liquid and readily available ASX 100 inventory, although with the Australian economy’s inherent exposure to global commodity markets, supply here will continue to thrive as investors look to employ strategies positioned to this theme.
Noticeably, there is a sustained trend in demand for inventory beyond the ASX 100—where typically securities are more of a small- or mid-cap nature and attract higher loan fees.
This is a global trend driven by the growth of quantitative investor strategies, which typically trade within this inventory set. The scarcity of this supply in the market means borrowers are able to pay healthy premiums, presenting attractive opportunities for those beneficial owners holding such inventory within their lending programmes.
Trends in fixed income
One of the most compelling areas of demand growth relates to Australian fixed income securities. While global regulation can often be thought of as a counterforce to growth, in this case it has been the single biggest driver for increased demand within this asset class.
Under Basel III and specifically the liquidity coverage and net stable funding ratios, borrowers have sought to fund themselves on a long-term basis with high-quality liquid assets (HQLA).
This, coupled with reforms compelling HQLA collateral to be posted against centrally cleared over-the-counter derivatives, has helped propel interest in this asset class globally.
Holders of Australian government securities (classified as HQLA by most counterparts) are able to benefit from termed trade opportunities that typically present a premium for the associated duration risk. This is presenting an important revenue stream for those beneficial owners with the appropriate risk appetite for these trades.
Apart from presenting incremental revenue streams for participants, the stability in earnings associated with these opportunities also help to offset any earnings volatility realised within an overnight programme, thus driving increased certainty and stability of securities lending revenue flows overall.
Super funds lead the way?
As the super fund sector has continued to consolidate and grow in Australia, this has encouraged healthy levels of dialogue and benchmarking among asset owners, helping to promote best practices and drive innovation in the market.
It has also been the backdrop for changes in perception among beneficial owners.
This is reshaping the lens through which investors assess the product’s value proposition and has had a knock-on effect to all beneficial owner and intermediary segments.
Despite the fact that securities lending supply has already outstripped pre-2008 levels globally, Australia has been relatively slow to take advantage of what is a low-risk means of enhancing returns and covering costs.
Our view of securities lending continues to be that of a well-regulated practice providing obvious benefits to lenders in terms of its’ risk-return profile. In addition, it carries the wider benefits of supporting the smooth functioning of capital markets through enhanced liquidity and price discovery.
Most developed markets have seen increases in the number of lenders and the value of lendable assets over the last few years, and signs are emerging that Australia is catching up fast. Recent data showed an increase to USD 16 trillion of lendable assets globally in 2016, with more than USD 2 trillion on loan.
With global investment strategies and regular mandatory funding injections, Australia’s super funds are well-placed to benefit from the resurgence in securities lending activity.
Education and lender agent partnerships have been instrumental in driving this trend, with beneficial owners now feeling more comfortable about the increased levels of control and governance they can exert on their lending programmes.
Taking control: Technology and client education
This enhancement is in part due to the innovation and technical developments brought to the market by agent lenders, including Northern Trust.
Such enhancements are facilitating high levels of automation, and flexibility in securities lending, as well as bespoke programme structures, allowing solutions to be built to suit all types of beneficial owner, from the more conservative to the highly sophisticated.
While many lenders are returning to the industry and either growing or launching their programmes in Australia, challenges nonetheless remain. The decision to start a lending programme can be made more complicated by the need to convince a range of often diverse stakeholders.
In particular, the potential opportunity loss of delaying or not engaging in securities lending should be considered by board and investment committee members alongside risk management considerations.
Industry professionals have a role to play in ensuring that these stakeholders are well educated in the realities of lending, and are able to take fact-based decisions by looking at the revenues and risk management of various lending options.
Northern Trust recognises the need for stakeholders to ensure their use of securities lending is structured in ways that are appropriate for their members.
Here, technology is helping to enhance the levels of control and governance that agent-providers can bring to the table.
Emerging opportunities
Beyond the momentum of new beneficial owner interest, many Australian asset owners remained committed to their securities lending programmes through the crisis, and have continued to evolve the ways in which they derive value from the product.
We are seeing greater sophistication here, particularly in terms of the extent to which securities lending can assist treasury functions in terms of cash management and liquidity by utilising concepts such as peer-to-peer lending, agency repo and collateral optimisation.
It is clear that while differences exist across beneficial owners in respect of the evolution of their programmes, ultimately many of these concepts are helping pave the future direction of the industry.
It is crucial that lending agents continue to provide the ongoing partnership, flexibility and customisation that will afford clients the means of fulfilling their long-term investment objectives.
Australia remains an important securities lending destination, with compelling growth prospects for industry participants.
As local asset owners have struggled to fight the headwinds and impacts of the low return and low interest rate environment, the need to reduce costs and enhance performance has come to the fore.
This is driving a resurgence in securities lending—and its use as a tool by lenders to achieve their overall risk-return objectives.
Yet for several years, the limited appetites of asset owners for the product did not necessarily live up to expectations suggested by this title.
In particular, the financial crisis of 2008 damaged perceptions of securities lending in terms of its risks and rewards for participants. Sensing a mismatch, a number of asset owners chose to opt out of their securities lending programmes as a result.
Today, however, the prevailing economic and regulatory environment is changing this view, as well as presenting lenders with increasing revenue generating opportunities.
The world has moved forward—and given its attractive risk-reward profile versus other investment products—we are seeing a renewed appetite for securities lending.
Domestic drivers
According to data providers, lendable supply in Australia already boasts an impressive one fifth of overall Asian inventory. While a substantial portion of this is derived from offshore asset owners, a larger portion—which is set to continue growing—now originates from domestic funds.
A large slice of these assets are held by Australia’s superannuation funds. This segment is the fourth largest in the world and these superfunds are poised to continue expanding further through increased mandatory contributions from members throughout the next decade.
Asset allocations remain largely domestically focused, particularly in equities, although there is evidence this is changing as the benefits of greater diversification and liquidity in global markets take hold more widely.
By the same measure, this trend will help to diversify and enhance securities lending revenue streams for local beneficial owners, with greater offshore exposure where expected returns can be more attractive.
The Australian market is noted for its close-knit domestic investment community, where local presence remains important for the purposes of relationship building and information flows, particularly for securities lending.
A large portion of lending activity is still transacted onshore with locally domiciled borrowers against Australian collateral—predominantly Australian dollar cash and Australian equities. Northern Trust’s presence in Sydney and Melbourne provides capability and local expertise in the domestic market.
Trends in borrower demand
On a relative basis, demand for Australian inventory has not yet risen to pre-2008 levels, in common with a number of other major securities lending hubs. Regulation, investor redemptions, systemic deleveraging, the increased costs of balance sheet and the drive to internalise inventories have all contributed to this dynamic.
However, demand to borrow Australian assets has been on the rise, and according to data providers, this has been reflected in overall loan balances seeing healthy growth over the last three years.
Available supply in equities remains skewed toward the more liquid and readily available ASX 100 inventory, although with the Australian economy’s inherent exposure to global commodity markets, supply here will continue to thrive as investors look to employ strategies positioned to this theme.
Noticeably, there is a sustained trend in demand for inventory beyond the ASX 100—where typically securities are more of a small- or mid-cap nature and attract higher loan fees.
This is a global trend driven by the growth of quantitative investor strategies, which typically trade within this inventory set. The scarcity of this supply in the market means borrowers are able to pay healthy premiums, presenting attractive opportunities for those beneficial owners holding such inventory within their lending programmes.
Trends in fixed income
One of the most compelling areas of demand growth relates to Australian fixed income securities. While global regulation can often be thought of as a counterforce to growth, in this case it has been the single biggest driver for increased demand within this asset class.
Under Basel III and specifically the liquidity coverage and net stable funding ratios, borrowers have sought to fund themselves on a long-term basis with high-quality liquid assets (HQLA).
This, coupled with reforms compelling HQLA collateral to be posted against centrally cleared over-the-counter derivatives, has helped propel interest in this asset class globally.
Holders of Australian government securities (classified as HQLA by most counterparts) are able to benefit from termed trade opportunities that typically present a premium for the associated duration risk. This is presenting an important revenue stream for those beneficial owners with the appropriate risk appetite for these trades.
Apart from presenting incremental revenue streams for participants, the stability in earnings associated with these opportunities also help to offset any earnings volatility realised within an overnight programme, thus driving increased certainty and stability of securities lending revenue flows overall.
Super funds lead the way?
As the super fund sector has continued to consolidate and grow in Australia, this has encouraged healthy levels of dialogue and benchmarking among asset owners, helping to promote best practices and drive innovation in the market.
It has also been the backdrop for changes in perception among beneficial owners.
This is reshaping the lens through which investors assess the product’s value proposition and has had a knock-on effect to all beneficial owner and intermediary segments.
Despite the fact that securities lending supply has already outstripped pre-2008 levels globally, Australia has been relatively slow to take advantage of what is a low-risk means of enhancing returns and covering costs.
Our view of securities lending continues to be that of a well-regulated practice providing obvious benefits to lenders in terms of its’ risk-return profile. In addition, it carries the wider benefits of supporting the smooth functioning of capital markets through enhanced liquidity and price discovery.
Most developed markets have seen increases in the number of lenders and the value of lendable assets over the last few years, and signs are emerging that Australia is catching up fast. Recent data showed an increase to USD 16 trillion of lendable assets globally in 2016, with more than USD 2 trillion on loan.
With global investment strategies and regular mandatory funding injections, Australia’s super funds are well-placed to benefit from the resurgence in securities lending activity.
Education and lender agent partnerships have been instrumental in driving this trend, with beneficial owners now feeling more comfortable about the increased levels of control and governance they can exert on their lending programmes.
Taking control: Technology and client education
This enhancement is in part due to the innovation and technical developments brought to the market by agent lenders, including Northern Trust.
Such enhancements are facilitating high levels of automation, and flexibility in securities lending, as well as bespoke programme structures, allowing solutions to be built to suit all types of beneficial owner, from the more conservative to the highly sophisticated.
While many lenders are returning to the industry and either growing or launching their programmes in Australia, challenges nonetheless remain. The decision to start a lending programme can be made more complicated by the need to convince a range of often diverse stakeholders.
In particular, the potential opportunity loss of delaying or not engaging in securities lending should be considered by board and investment committee members alongside risk management considerations.
Industry professionals have a role to play in ensuring that these stakeholders are well educated in the realities of lending, and are able to take fact-based decisions by looking at the revenues and risk management of various lending options.
Northern Trust recognises the need for stakeholders to ensure their use of securities lending is structured in ways that are appropriate for their members.
Here, technology is helping to enhance the levels of control and governance that agent-providers can bring to the table.
Emerging opportunities
Beyond the momentum of new beneficial owner interest, many Australian asset owners remained committed to their securities lending programmes through the crisis, and have continued to evolve the ways in which they derive value from the product.
We are seeing greater sophistication here, particularly in terms of the extent to which securities lending can assist treasury functions in terms of cash management and liquidity by utilising concepts such as peer-to-peer lending, agency repo and collateral optimisation.
It is clear that while differences exist across beneficial owners in respect of the evolution of their programmes, ultimately many of these concepts are helping pave the future direction of the industry.
It is crucial that lending agents continue to provide the ongoing partnership, flexibility and customisation that will afford clients the means of fulfilling their long-term investment objectives.
Australia remains an important securities lending destination, with compelling growth prospects for industry participants.
As local asset owners have struggled to fight the headwinds and impacts of the low return and low interest rate environment, the need to reduce costs and enhance performance has come to the fore.
This is driving a resurgence in securities lending—and its use as a tool by lenders to achieve their overall risk-return objectives.
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