Warning: Change ahead
04 Febuary 2020
Industry experts offer a run-down of everything to be cognisant of in the US market for 2020, from fixing the repo market and possible collateral rule changes, to revenue predictions and much more
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The US repo market caused waves in September 2019 when a range of issues coalesced to cause a significant rate spike over quarter-end that required a major (and on-going) intervention by the Fed to stabilise things. How did year-end compare?
Joseph Santoro: Compared to the 17 September rate spike, year-end turned out to be a non-event. The combination of the US Federal Reserve’s temporary market operations (overnight and term repos) and outright treasury bill purchases to replenish bank reserves smoothed the repo market to an extent that overnight roll rates were only around 10 to 15 basis points above the overnight bank funding rate.
Joseph Gillingwater: Year-end in the repo market was well managed. The Fed’s actions throughout the quarter, and the eventual year-end market utilisation of $256 billion in Fed repo, along with the Fed’s bill purchases totaling $158 billion, appeared to succeed as the market saw only a small bump in repo rates at year end. However, structural concerns about adequate reserves in the system remain an ongoing issue.
Securities lending markets also did not show meaningful signs of stress at year-end. The concern is that market events put upward pressure on rebates, resulting in downward pressure on the overall spreads. With respect to lending rebates, year-end increases were well contained. In early December, secured financing rates rose sharply, trading at 4 percent for year-end, from normal day-to-day market levels of 1.60 percent. That was short lived, however, as the Fed’s liquidity injections were increased through the month, even leading to undersubscribed repo operations towards the end of the month. In the end, on 31 December, there was only a minimal increase from normal day-to-day market levels, which was a positive to clients versus had there been a larger increase. This sequence of events largely played out how Northern Trust had expected, and our positioning of the portfolio with a focus on normal year-end liquidity needs, in addition to our focus on high quality investments, worked well in conjunction with our structure of securities on loan.
Michael McAuley: The Fed’s operations at year-end produced an orderly funding market to close out 2019. Markets remained calm and traded near the Fed target range. There was some interesting forward market activity but that could have been driven by dealers working client orders or others looking to lock in funding with banks happy to invest at those higher levels.
Michael Saunders: Despite the temporary dislocation in the US treasury financing markets in mid-September, the Fed’s intervention proved impactful. The reaction from the Fed through a combination of open market operations (OMO), term market operations (TMO) and US treasury bill purchases assisted in formulating an orderly financing market over the year-end turn. Of course, financing rates were elevated, which is typical as the market adjusted for the critically important reporting date of year-end, but nothing substantial relative to the period in mid-September. Certainly, the aggregate amount of approximately $400 billion in liquidity offered through both OMO and TMO facilities, combined with the announcement of $60 billion of US treasury bill purchases per month through April, provided the stability market participants desperately needed to engage in financing positions.
While there remains a difference of opinion as to the cause of the repo-spike, it can be confirmed that mid-September was not the first time coupon settlement, quarter-end and coupon refunding settlement coincided. The Fed should be applauded for their swift actions in restoring liquidity and stability. Their efforts removed a substantial amount of trepidation and nervousness heading into year-end. Further assisting the normalisation was the deleveraging of agent lenders – meaning those able to unwind US treasury financing positions were well-served. The challenge will remain for market participants to continue to operate as the Fed removes or scales back the daily operations.
Jarrod Polseno: In comparison to the volatility we experienced in September, year-end was mild and composed despite forward start trades indicating a significant rate premium even into later December. The liquidity injected by the Federal Reserve repo operations and increased treasury bill purchases throughout the fourth quarter, both term and overnight, have helped greatly. As opposed to mid-September where the market was caught off guard, year-end funding was one of the most prepared for and talked about events in recent memory. Market participants on both sides of the trade had ample time to analyse and adjust their books accordingly in order to ensure a smooth transition into the new year.
George Rennick: The Fed’s actions muted the year-end turn, and unlike September 2019, allowed the year to end quietly. Market participants also contributed to the calm, reducing anxieties by diligently managing their balance sheets for the period. That is not to say that the market is fully settled, since the Fed has had ongoing operations since the mid-September spikes, and they injected more than $400 billion of liquidity into the markets ($250 billion in temporary open market operations in addition to over $150 billion through treasury bill purchases) for year-end to avoid cash shortages. Entering 2020, the Fed will now need to gradually decline overnight and term repo operations in an uneventful manner to avoid further liquidity spikes.
A standing repo facility is widely expected to be created this year as one solution to the rate flux, but concerns have been raised that this creates an artificial market dynamic and ignores the issue of over-regulation that also contributed to the spike. What do you think should be done?
Santoro: A repo facility has been discussed during the past meetings of the Federal Open Market Committee. The Federal Reserve is a deliberate institution and a decision is expected this year. A rule change in liquidity requirements would ease some of restrictions faced by large institutions, therefore reducing the need for Fed interventions.
Gillingwater: The Fed is currently operating in an environment where their target rate is achieved via prescribed rates such as interest on excess reserves (IOER), as well as a series of funding facilities (foreign repo facility and the overnight reverse repo facility) that are intended to channel overnight rates. The lower end of this range is managed by the existing programmes theoretically creating a floor for short term rates, but the top end of the range was intended to be contained by market forces. In other words, as rates climbed, banks would be motivated to lend their extra cash into the market, which would have the effect of slowing the rate ascent. The Fed is now focused on expanding its balance sheet broadly to accomplish its goal of ‘ample reserves.’ A standing repo facility could simultaneously be created to theoretically create a ceiling on overnight rates, but the construction is not likely to occur in the immediate future.
The longer-term solution will likely be a combination of efforts to both right-size the excess reserves in the system and address the regulatory need for capital at the banks, as the main intermediaries of the short term funding markets. The intra-day overdraft regulations in particular are being discussed as a possible avenue for regulatory adjustment. We do expect creation of a standing repo facility over time, but don’t see it as an immediate or near term tool. The temporary operations have sufficed for the time being, so the urgency for the facility should remain more muted, especially as the balance sheet is expanded over time.
Saunders: Market participants have been suggesting a permanent, formal validation of a standing repo facility for quite some time. The OMO and TMO facilities are the first steps in this process. These operations have provided the framework for what many participants are seeking in terms of a permanent financing facility. Many in the market are eagerly watching the developments from the Fed, as the OMO and TMO auction schedules are announced, for any insights the Fed may be foreshadowing regarding the deployment of a permanent facility.
The impact of regulation has changed the manner in which market participants operate. This is nothing new and certainly poses new challenges, while adding new dynamics to the financing markets. Regardless, the market has adjusted and will continue to evolve as additional measures are implemented on the regulatory front. As it relates to a standing repo facility, the assistance from the Fed is certainly welcomed by most. The challenge will remain, enticing those with access to the Fed’s facilities to distribute the access to liquidity to other market participants. Expanding the access to liquidity from the Fed will remain a challenge.
Rennick: A standing repo facility is widely believed to be a key mechanism to controlling interest rates and volatility in money markets, providing overall funding stability. A standing facility would release current bank reserves allowing a reallocation into the market and would provide ongoing liquidity to non-primary dealers especially at times of stress. Although not a certainty, it is very likely the Fed will implement a standing facility during 2020, perhaps as a mechanism to offset their short-term injections, such as those required to calm the markets at year end.
However, as with most policies, there are pros, cons and, often, unintended consequences. While stability may outweigh most concerns, a standing facility should not be viewed as removing all risk from the repo markets. The standing facility is certain to tighten specific spreads which could lead to an acceptance and increase in other risks while searching for yield. It is also unlikely that the standing repo facility would be open for all market participants, so those parties not eligible should not view the Fed as a lender of last resort.
McAuley: If the Fed goes forward with implementing a standing repo facility, commentators have suggested that they price liquidity in a way that moves them back to their traditional role as a backstop rather than being the lender of first resort. Another consideration may be expanding eligible participants to include, for example, securities lending cash collateral accounts.
Polseno: A standing repo facility open to a larger subset of market participants than the current operations could give the Fed a relativity easy-to-operate construct that they could use to increase and decrease the amount of liquidity they inject with less friction than current tools. This could be used to create a ceiling on funding rates (possibly a floor as well when needed) and overall would be welcomed by the market.
There are benefits to this whether it is in conjunction with, or in the absence of, regulatory changes. The financial resource impact of funding government debt securities should be reviewed as well, and this should not distract from that. Domestically, we have been running significantly greater deficits and increasing the overall debt burden, but at the same time making it more expensive and difficult to carry for financial firms over the last decade. We should look at sensible changes to regulation that eases this, whether it is in the repo markets for funding purposes or it is simply the cost to hold them on balance sheet. The notion that we can have an ever-increasing US treasury issuance but diminished capacity to fund and carry that debt seems to oppose one another.
In December last year, the SEC said it was looking into refining its exemption relief for their affiliated securities lending programmes. One suggestion offered was to only allow a mix of affiliated and unaffiliated agents to be used. What impact would this have on the market and what else should the SEC be looking at on this topic?
Polseno: This would force some market participants to use multiple lenders, but to what extent remains to be seen. It would potentially create an interesting prospect for those funds looking to take securities lending in-house, where they would be forced to keep portions with other lenders. The benefits of doing that would need to be weighed against the burden of having to oversee multiple programmes and providers. If the true benefit could not be shown to the underlying investors, then the change may be doubtful.
Santoro: The US Securities and Exchange Commission (SEC) last issued an exemptive order with this relief in 2004, so change is welcome. Requiring affiliated securities lending programmes to adopt a multi-agent strategy may prove very beneficial in terms of relationship pricing, as well as net returns as a result of benchmarking the performance of each provider. More broadly, we think all mutual fund boards would benefit from an SEC requirement that they issue a formal, publicly available request for proposal (RFP) every few years. This is how the US public fund industry operates. RFPs are issued on a predictive schedule. Typically, all qualified agents are welcome to participate, both custodial and non-custodial, and relationship pricing is requested on a bundled and unbundled basis. As a result, US public funds enjoy leading edge pricing and service. Given the sheer number of mutual funds and exchange-traded funds (ETFs), one would expect there to be much more RFP activity than there is currently.
McAuley: In her keynote address at the 2019 ICI Securities law Developments Conference, Dalia Blass, Director of the Division of Investment Management at the SEC, indicated that affiliated securities lending was an area that the regulator “needs to tackle” due to the disparate treatment of market participants. This disparate treatment stems from the fact that the SEC last provided exemptive no action relief in this area back in 2004 so some fund complexes have relief and others do not. This would suggest that the SEC may be looking to codify no-action positions similar to what they have previously done with respect to cash sweep no-action letters.
Blass indicated the SEC would welcome comments on how best to address potential conflicts of interest inherent in those arrangements. Mixing affiliated and unaffiliated lenders was just one suggestion. However, the real focus was on transparency and providing boards with independent information in order to be able to assess the performance of lending agents. The recently implemented investment company modernisation final rule introduced reporting and data collection with respect to securities lending that should go a long way in keeping boards better informed and providing transparency into performance and fees. Mixing lending agents could have some unintended consequences and may not be necessary given increased transparency and the availability of market data.
Rennick: Securities lending continues to play a vital role in the global markets, providing liquidity, efficiency and capital. For investors and other lenders, securities lending offers the opportunity to add an incremental return on idle assets in the form of income that can be used to offset fees and improve performance.
For registered investment companies regulated by the SEC under the Investment Company Act of 1940, the use of an affiliated entity as a securities lending agent is often not viable, absent exemptive relief. Since the early 1990s, many investment companies have filed for and been granted the specific exemptive relief necessary to efficiently enter into a securities lending programme with an affiliated lending agent. The time and resource investment required to gain this exemptive relief is quite significant. In December of 2019 the SEC recognised that the current existence of this relief for some, but not all, investment companies with affiliates capable of serving as their securities lending agent has effectively resulted in a divide of “haves” and “have-nots”.
The SEC should continue to seek ways to ensure that the market is balanced, and that Investment companies and their investors have access to a broad array of potential securities lending agents. Levelling the playing field for all would increase competition and provide opportunities for all investment companies to partner with best securities lending agent for their funds and investors.
Changes to the US 15c3-3 rule for equities as collateral is expected to see progress this summer. How hopeful are you that this change will finally occur and how significant would this be for the US securities lending market?
Rennick: The SEC has started 2020 by soliciting feedback on the most recent interpretation version in early January, a potential sign that the equities as collateral changes are getting closer. However, given past history it is difficult to say this will be the year, but we certainly seem closer to the goal-line. Allowing broker-dealers to pledge equities as collateral will have a significant impact to all parties in the securities lending value chain. More than ever before, lenders with expansive collateral schedules that permit equities and equity repo will benefit over those with more restrictive schedules that exclude equities, either by regulation or internal tolerance. Since the borrowers gain significant benefits by posting equities over cash, we can expect a continual decline of cash collateral posted versus non-cash collateral which would drive ancillary impacts to securities lending returns generated from cash reinvestment.
McAuley: The addition of equity collateral to 15c3-3 for loans of equity securities is expected to eventually become reality. The question is not if, but rather when. When really depends on the process. The change involves two separate actions. The first part is fairly straightforward: the addition of equity collateral to the list of permissible collateral. The second element involves how the equity collateral is treated in the reserve formula. This second part is very complicated and has been the reason the change has been so long in the discussion and drafting phase.
The eventual impact of the change on the US lending market will to some degree be determined by how the trades are priced. Equity-for-equity general collateral trades outside of the US do not command premium pricing. This is in large part due to the fact that those markets evolved dependent on securities collateral as a result of a lack of – or fragmentation in – money markets. If equity collateral is expected to displace cash, then the transaction pricing will need to reflect the balance sheet benefit to the borrower and the loss of investment return by the lender. One potential benefit to lenders is that the change may incent borrowers to transition some of their broker-to-broker activity to agent lending programmes, which would represent new demand.
Santoro: Regulatory reforms are having a meaningful impact on agents, counterparties and beneficial owners. Trade flexibility in particular has come to the forefront in response to counterparties seeking less balance sheet intensive loan structures. Counterparties want to pledge equities and seek to transact with beneficial owners willing to accept them. We think it will happen soon and it will be significant in the public fund space where we have a number of large funds who are less constrained and can benefit fairly quickly.
Polseno: This change has been debated for years now with little change, although it feels as if it is gaining some traction, it is hard to say it will actually come to pass. There are also other changes such as the Department of Labor’s rules for 1940’s Act funds that would need to happen along with the SEC change to truly have a market impact. Over the years, changes in borrowing locations have allowed beneficial owners that accept equities as collateral to accept it from a robust set of counterparties. This change may in some ways serve to move the borrow from one entity, most likely a non-domestic one, back onshore. To say that overall demand or loan balance increases is a difficult one, global borrowers may already be using entities that can give equities as collateral and would not have significant upside. There could be an argument made that smaller domestic-only borrowers would be able to use this change to their advantage though. It also remains to be seen how robust the approved equities set is, if it is quite narrow, say SP500 only, it could be less interesting to the market and hence lower demand.
Gillingwater: There is no doubt this would be a significant change to the US securities lending market. Given the balance sheet benefits, it is expected US broker dealers would leverage their long equities to finance their borrows, which could potentially reduce loan volumes versus cash or sovereign debt loan volume.
For agent lenders, equity collateral for loans with broker dealers would be more punitive from a capital perspective than when pledged by EMEA bank entities. The related softening in cash collateral volumes could have an impact on cash reinvestment returns.
Additionally, clients with equity collateral in their guidelines could see a strengthening in their portfolio utilisation compared to clients who only accept cash and government debt collateral.
Saunders: The market has been closely monitoring developments to any changes related to US 15c3-3. The benefits are rather clear and the market is certainly optimistic that the initiative progresses in the near term. However, the expansion of permissible collateral would still require amendments to many lenders throughout the beneficial owner community. So while beneficial, the proposed changes are not the magic solution. Regardless of the timing of the proposed changes to 15c3-3, lenders, agents and borrowers willing to engage in capital-friendly transactions through Central Counterparties, noncash loans and pledge structures are well-positioned to increase utilisation.
Last year saw a major beneficial owner partially withdraw from the market on the grounds that lending facilitated short selling, which was counter to its ESG goals. Has this had any impact on the market in practical terms of global liquidity? Are you aware of, or do you foresee, other lenders having similar concerns?
Saunders: The subject of environmental, social and governance (ESG) is first and foremost among the beneficial owner community. It is on the agenda of every board meeting, client review and part of every RFP as of late. ESG is only going to grow in importance and cannot be ignored.
It is imperative that the market implement ESG mandates into the management of a securities lending programme. Agent lenders will be required to facilitate the ESG mandates of the beneficial owner community into the management of lending programmes. While several of the largest, most sophisticated lenders have recently implemented changes to their lending policies to reflect the heightened focus on ESG, many agent-lending programmes are more than capable to support the requests of lenders. For example, the subject of proxy voting is often cited as the rationale for supporting an ESG-compliant lending programme. Our experience with beneficial owners around ESG has been positive as it relates to proxy voting. Here at BNP Paribas it is a priority to implement and apply our client’s ESG mandates into our lending programme. As a bank, BNP Paribas is committed to implementing our own ESG policies, while supporting clients pursuing their own ESG mandates.
Santoro: It may be that some beneficial owners are conflating abusive short selling or perhaps empty voting with securities lending, which would be a mistake, in our view. We have not seen any impact on the market in practical terms and we’ve not encountered beneficial owners with similar concerns. Securities lending and ESG are fully compatible, in our case. We can accommodate ESG across the key facets of the service from approved counterparties, restrictions, collateral filtering, reinvestment, reporting, and recalling for proxy voting.
At Deutsche Bank, we’re partnered with DWS, our affiliated professional asset manager who is a recognised leader in ESG, which adds another dimension. DWS offers an ESG themed money fund, as well as separately managed accounts with an ESG overlay. We think these capabilities will grow in importance as US-based investors embrace ESG.
McAuley: Securities lending is in general an oversupplied market so the cessation of lending by a few large entities should not have a material impact. In spite of the reviews underway by those large plans, a broad community of market participants agree that short selling provides a range of benefits to the market, not least is acting as a countervailing force against overvalued securities. Regulatory bodies are generally in agreement. In December 2019, the European Securities and Markets Authority (ESMA) issued a report analyzing short-term pressures facing corporations. The body considered arguments concerning the impact of short-selling and securities lending practices and their potential link with short-termism. ESMA pointed out that short-selling and securities lending are key for price discovery and market liquidity. ESMA also indicated that it is not aware of concrete evidence pointing to a cause-effect connection between these practices and the existence of undue short-term market pressures and that securities lending, if done in a controlled way, is an opportunity to add value for fund investors and is compatible with long-term investment strategies.
ISLA announced the formation of a new Council for Sustainable Finance, which will introduce a series of principles for sustainable securities lending in the first quarter of this year aimed to promote and embed ESG values into securities lending.
These are just the latest developments in a long sequence of industry improvements to enhance market transparency and provide reassurance that strong corporate governance frameworks support responsible securities lending programmes.
Polseno: There has been no discernable impact on liquidity in the market based on some beneficial owners withdrawing from the market. The trend has been for those not lending to come back into the market for some time now (and continues to be), which has muted any impacts of those exiting.
Gillingwater: To put it in perspective, 2018 was a record-breaking year for securities lending revenue, and 2019 was the second highest revenue generating year in the past decade, according to IHS Markit. Looking ahead in fixed income lending markets, the first phase of a US/China trade agreement and greater certainty around Brexit have taken risk off the table and led to improved sentiment amongst our counterparts. With stock markets rallying to fresh highs, banks may have more risk appetite and capital to deploy into 2020. In this respect, we expect to see continued strong demand to collateralise with equities, particularly benefiting buy-to-hold clients who are able to utilise high-quality sovereign bond inventory in term maturity tenor exposures. With the cross-currency basis swap market more opaque in nature, it is challenging to predict how cross-currency collateral swap trades will perform. However, it is unlikely we will see a material shift in demand to source US dollars, thus the appetite to borrow US treasuries should be maintained, albeit with a threat of narrower lending fees.
Additionally, the general outlook for credit market performance is expected to remain robust with expectations of moderate global growth replacing fears of recession. Moreover, with central banks seemingly in no rush to raise interest rates, corporate bonds should remain in demand as the hunt for yield continues. If the global economic outlook improves significantly ahead of expectations, government bond yields could rise in anticipation of an interest rate increase. This may motivate investors to switch out of credit, thus adding some upward pressure on lending fees.
Rennick: The subject of stewardship and ESG is attracting increased industry focus, with growing discussion about how lenders can meet their individual governance objectives whilst successfully participating in securities lending.
As lenders’ ESG principles can vary across different portfolios, jurisdictions and client types, it is important for the agent lender to engage in ongoing dialogue with lending clients to understand their specific ESG goals. Once a lenders’ specific goals have been understood, we believe that through adherence to existing industry best practices, development of operating protocols and inclusion of ESG criteria, solutions can be developed affording lenders the ability to continue to participate in a securities lending programme which enhances fund performance and contributes to improved liquidity in the market, whilst achieving their ESG principles.
Securities lending is incorrectly associated with facilitating short selling. Various industry studies, including one conducted by the U.S. Federal Reserve, have concluded that short selling does not systematically drive down asset prices. In fact, by facilitating corrections in overvalued securities, short selling can help identify poor behavior by companies, and this knowledge benefits all investors in the long run. Therefore, by participating in securities lending in a responsible way, one is able to contribute to better governance and oversight across the financial system.
We expect ESG to remain a key topic across all client segments at the highest levels. We welcome opportunities to partner with and educate clients, about the ability for ESG principles and securities lending not only to co-exist, but to remain aligned in delivering the same goals.
Last year failed to live up to highs of 2018’s global revenue intake. Are there any indicators of how 2020 will fare?
Rennick: Looking forward to 2020 we may see a similar pattern to 2019, with a slow start followed by pockets of opportunity as volatility increases from factors such as an economic slowdown and the official start of the US presidential election cycle. While the US economy remains strong, it is not immune to the constant geopolitical tensions, global growth slowdowns or other type of shock events such as a global health scare. The new coronavirus emerging in China is already expected to impact growth and is bringing back memories of the deadly SARS virus, which was not only a public health problem but also impacted economies and drove a mass exodus of ex-patriots from places like Hong Kong, contributing to an immediate recession. While most analysts see the impact of the virus as short-lived, it remains to be seen if the recent market sell off was an opportunity to sell long or if short interest begins to increase. Hedge funds are cautious as the stellar returns in the US equity market in 2019 made short exposure a dangerous proposition. Overall, 2020 may be an eventful year starting with events in China, progressing with merger activity in Europe, the Middle East and Africa and ending with the outcome of a US presidential election and the ancillary policies.
Saunders: Performance in 2019 was certainly driven by a combination of factors led by the attribution of specials from initial public offerings. Market data supports this concept. However, returns for lenders holding general collateral and high-quality liquid assets (HQLA) fared well throughout the year. Demand remains insatiable for HQLA and clients permitted to engage in non-cash collateral transactions with a broadened collateral set experienced solid performance. Despite the increased participation from historically idle lenders and thus increase in supply, opportunities continued to be present in the market. Lenders willing to be patient and engage in capital-friendly transactions, and transact via alternate trade structures and various market infrastructures, will be at the forefront of revenue opportunities regardless of the portfolio composition.
Polseno: It is early days but this should be an interesting year. There are a lot of factors at play that can affect broader market performance, political, trade, central bank actions, etc., that could curb the steady and robust equity appreciation that we have seen in the last few years. If we transition into a market that is friendlier to active management strategies, then it could prove to increase lending performance and become more interesting. The demand side of securities finance has been challenged as relative performance of hedge funds and long/short equity funds in many cases has lagged and fee structures questioned as investors compare to passive mandates. This has decreased overall demand as well as put pressure on borrowing fees as prime brokers offer concessions to their clients to retain or grow their market share. To the extent that these themes continue in 2020, the overall performance of 2019 could carry forward again.
Santoro: It’s hard to predict 2020 revenues, but thus far January has proved to be a good month for us and we expect to report increases month-over-month for nearly all of our US-based clients.
McAuley: The lending market in 2019 was characterised by low volatility and very few specials. Much of the revenue was concentrated in a few initial public offerings and a couple of corporate events. While it is very early in 2020, we are expecting to see some renewed demand for HQLA. In addition, there is some expectation that corporate activity will trend in a positive direction.
What other trends and developments should the market be aware of in the US for this year?
McAuley: As the securities lending market moves forward the focus is on innovation designed to preserve indemnification, while also creating capacity to meet demand. Another focus of innovation is on creating new distribution channels that provide capital efficiency to borrowers, thereby stimulating new demand. One of the newest distribution channels is clearing. Last year, BNY Mellon became the first agent lender to clear a lending transaction through Eurex Clearing’s securities lending structure. While BNY Mellon remains the only agent lender currently providing this distribution channel to lenders, we have seen demand for clearing continue to grow. Lenders that embrace clearing may see increased distribution opportunities as well as premium pricing. As with anything new, the onboarding process can be tedious. However, we have been working together to streamline this process and to make clearing more accessible for all lenders.
Santoro: We expect investor interest in ESG will continue to grow in the US, which will lead to increasing engagement relative to incorporating ESG into programme guidelines and service delivery. As a general matter, we expect to maintain a high level of client engagement on programme optimisation, including collateral expansion, trade ideas, and providing client PMs with useful information and analysis to assist with their long investing. In addition, the Securities Financing Transactions Regulation (SFTR) is on the near horizon for US beneficial owners. In terms of the market, continued US treasury supply will keep spreads in current ranges. Fed fund futures are pricing in one rate cut in Q4 2020.
Saunders: Efficiency and capital-friendly transactions remain at the forefront for many agent lenders in 2020. The implementation of automation to distribute increased supply, along with the leveraging of technology to discover pockets of liquidity, remain a priority for most participants. As BNP Paribas continues to evolve our lending programme, we are cognisant that a combination of technology and alternative trade structure be utilised to expand our distribution, while adequately pricing risk.
Polseno: In terms of aspects of the business that can be controlled by agent lenders, the themes of this year are not so different than past years – collateral and trade structure flexibility will be important for continued growth. We are seeing more interest in ETFs and convertible bonds – emerging market sovereign and corporate bonds. With regards to structures this could mean a few things, examples would be term trades, pledge collateral arrangements, central counterparty clearings (CCPs) and shift to triparty collateral from bilateral.
The overall theme of differentiation in the lending market from one beneficial owner versus another based upon the choices they make for their programme will continue. As some aspects of stock loan flow becomes further commoditised and technology enhancements are leveling the playing field, alpha tends to be generated through uniqueness.
Rennick: We spoke about potential changes to 15c3-3 and the SEC’s review of affiliated lending programmes, but the two critical regulatory changes expected to significantly impact securities lending in 2020 are SFTR and the Central Securities Depositories Regulation (CSDR). Both of these topics have been discussed and addressed numerous times before; however, 2020 is the year each of these regulations come into effect. So expect further discussion and even more questions, especially around CSDR, general operating principles and how mandatory buy-ins will be treated.
Joseph Santoro: Compared to the 17 September rate spike, year-end turned out to be a non-event. The combination of the US Federal Reserve’s temporary market operations (overnight and term repos) and outright treasury bill purchases to replenish bank reserves smoothed the repo market to an extent that overnight roll rates were only around 10 to 15 basis points above the overnight bank funding rate.
Joseph Gillingwater: Year-end in the repo market was well managed. The Fed’s actions throughout the quarter, and the eventual year-end market utilisation of $256 billion in Fed repo, along with the Fed’s bill purchases totaling $158 billion, appeared to succeed as the market saw only a small bump in repo rates at year end. However, structural concerns about adequate reserves in the system remain an ongoing issue.
Securities lending markets also did not show meaningful signs of stress at year-end. The concern is that market events put upward pressure on rebates, resulting in downward pressure on the overall spreads. With respect to lending rebates, year-end increases were well contained. In early December, secured financing rates rose sharply, trading at 4 percent for year-end, from normal day-to-day market levels of 1.60 percent. That was short lived, however, as the Fed’s liquidity injections were increased through the month, even leading to undersubscribed repo operations towards the end of the month. In the end, on 31 December, there was only a minimal increase from normal day-to-day market levels, which was a positive to clients versus had there been a larger increase. This sequence of events largely played out how Northern Trust had expected, and our positioning of the portfolio with a focus on normal year-end liquidity needs, in addition to our focus on high quality investments, worked well in conjunction with our structure of securities on loan.
Michael McAuley: The Fed’s operations at year-end produced an orderly funding market to close out 2019. Markets remained calm and traded near the Fed target range. There was some interesting forward market activity but that could have been driven by dealers working client orders or others looking to lock in funding with banks happy to invest at those higher levels.
Michael Saunders: Despite the temporary dislocation in the US treasury financing markets in mid-September, the Fed’s intervention proved impactful. The reaction from the Fed through a combination of open market operations (OMO), term market operations (TMO) and US treasury bill purchases assisted in formulating an orderly financing market over the year-end turn. Of course, financing rates were elevated, which is typical as the market adjusted for the critically important reporting date of year-end, but nothing substantial relative to the period in mid-September. Certainly, the aggregate amount of approximately $400 billion in liquidity offered through both OMO and TMO facilities, combined with the announcement of $60 billion of US treasury bill purchases per month through April, provided the stability market participants desperately needed to engage in financing positions.
While there remains a difference of opinion as to the cause of the repo-spike, it can be confirmed that mid-September was not the first time coupon settlement, quarter-end and coupon refunding settlement coincided. The Fed should be applauded for their swift actions in restoring liquidity and stability. Their efforts removed a substantial amount of trepidation and nervousness heading into year-end. Further assisting the normalisation was the deleveraging of agent lenders – meaning those able to unwind US treasury financing positions were well-served. The challenge will remain for market participants to continue to operate as the Fed removes or scales back the daily operations.
Jarrod Polseno: In comparison to the volatility we experienced in September, year-end was mild and composed despite forward start trades indicating a significant rate premium even into later December. The liquidity injected by the Federal Reserve repo operations and increased treasury bill purchases throughout the fourth quarter, both term and overnight, have helped greatly. As opposed to mid-September where the market was caught off guard, year-end funding was one of the most prepared for and talked about events in recent memory. Market participants on both sides of the trade had ample time to analyse and adjust their books accordingly in order to ensure a smooth transition into the new year.
George Rennick: The Fed’s actions muted the year-end turn, and unlike September 2019, allowed the year to end quietly. Market participants also contributed to the calm, reducing anxieties by diligently managing their balance sheets for the period. That is not to say that the market is fully settled, since the Fed has had ongoing operations since the mid-September spikes, and they injected more than $400 billion of liquidity into the markets ($250 billion in temporary open market operations in addition to over $150 billion through treasury bill purchases) for year-end to avoid cash shortages. Entering 2020, the Fed will now need to gradually decline overnight and term repo operations in an uneventful manner to avoid further liquidity spikes.
A standing repo facility is widely expected to be created this year as one solution to the rate flux, but concerns have been raised that this creates an artificial market dynamic and ignores the issue of over-regulation that also contributed to the spike. What do you think should be done?
Santoro: A repo facility has been discussed during the past meetings of the Federal Open Market Committee. The Federal Reserve is a deliberate institution and a decision is expected this year. A rule change in liquidity requirements would ease some of restrictions faced by large institutions, therefore reducing the need for Fed interventions.
Gillingwater: The Fed is currently operating in an environment where their target rate is achieved via prescribed rates such as interest on excess reserves (IOER), as well as a series of funding facilities (foreign repo facility and the overnight reverse repo facility) that are intended to channel overnight rates. The lower end of this range is managed by the existing programmes theoretically creating a floor for short term rates, but the top end of the range was intended to be contained by market forces. In other words, as rates climbed, banks would be motivated to lend their extra cash into the market, which would have the effect of slowing the rate ascent. The Fed is now focused on expanding its balance sheet broadly to accomplish its goal of ‘ample reserves.’ A standing repo facility could simultaneously be created to theoretically create a ceiling on overnight rates, but the construction is not likely to occur in the immediate future.
The longer-term solution will likely be a combination of efforts to both right-size the excess reserves in the system and address the regulatory need for capital at the banks, as the main intermediaries of the short term funding markets. The intra-day overdraft regulations in particular are being discussed as a possible avenue for regulatory adjustment. We do expect creation of a standing repo facility over time, but don’t see it as an immediate or near term tool. The temporary operations have sufficed for the time being, so the urgency for the facility should remain more muted, especially as the balance sheet is expanded over time.
Saunders: Market participants have been suggesting a permanent, formal validation of a standing repo facility for quite some time. The OMO and TMO facilities are the first steps in this process. These operations have provided the framework for what many participants are seeking in terms of a permanent financing facility. Many in the market are eagerly watching the developments from the Fed, as the OMO and TMO auction schedules are announced, for any insights the Fed may be foreshadowing regarding the deployment of a permanent facility.
The impact of regulation has changed the manner in which market participants operate. This is nothing new and certainly poses new challenges, while adding new dynamics to the financing markets. Regardless, the market has adjusted and will continue to evolve as additional measures are implemented on the regulatory front. As it relates to a standing repo facility, the assistance from the Fed is certainly welcomed by most. The challenge will remain, enticing those with access to the Fed’s facilities to distribute the access to liquidity to other market participants. Expanding the access to liquidity from the Fed will remain a challenge.
Rennick: A standing repo facility is widely believed to be a key mechanism to controlling interest rates and volatility in money markets, providing overall funding stability. A standing facility would release current bank reserves allowing a reallocation into the market and would provide ongoing liquidity to non-primary dealers especially at times of stress. Although not a certainty, it is very likely the Fed will implement a standing facility during 2020, perhaps as a mechanism to offset their short-term injections, such as those required to calm the markets at year end.
However, as with most policies, there are pros, cons and, often, unintended consequences. While stability may outweigh most concerns, a standing facility should not be viewed as removing all risk from the repo markets. The standing facility is certain to tighten specific spreads which could lead to an acceptance and increase in other risks while searching for yield. It is also unlikely that the standing repo facility would be open for all market participants, so those parties not eligible should not view the Fed as a lender of last resort.
McAuley: If the Fed goes forward with implementing a standing repo facility, commentators have suggested that they price liquidity in a way that moves them back to their traditional role as a backstop rather than being the lender of first resort. Another consideration may be expanding eligible participants to include, for example, securities lending cash collateral accounts.
Polseno: A standing repo facility open to a larger subset of market participants than the current operations could give the Fed a relativity easy-to-operate construct that they could use to increase and decrease the amount of liquidity they inject with less friction than current tools. This could be used to create a ceiling on funding rates (possibly a floor as well when needed) and overall would be welcomed by the market.
There are benefits to this whether it is in conjunction with, or in the absence of, regulatory changes. The financial resource impact of funding government debt securities should be reviewed as well, and this should not distract from that. Domestically, we have been running significantly greater deficits and increasing the overall debt burden, but at the same time making it more expensive and difficult to carry for financial firms over the last decade. We should look at sensible changes to regulation that eases this, whether it is in the repo markets for funding purposes or it is simply the cost to hold them on balance sheet. The notion that we can have an ever-increasing US treasury issuance but diminished capacity to fund and carry that debt seems to oppose one another.
In December last year, the SEC said it was looking into refining its exemption relief for their affiliated securities lending programmes. One suggestion offered was to only allow a mix of affiliated and unaffiliated agents to be used. What impact would this have on the market and what else should the SEC be looking at on this topic?
Polseno: This would force some market participants to use multiple lenders, but to what extent remains to be seen. It would potentially create an interesting prospect for those funds looking to take securities lending in-house, where they would be forced to keep portions with other lenders. The benefits of doing that would need to be weighed against the burden of having to oversee multiple programmes and providers. If the true benefit could not be shown to the underlying investors, then the change may be doubtful.
Santoro: The US Securities and Exchange Commission (SEC) last issued an exemptive order with this relief in 2004, so change is welcome. Requiring affiliated securities lending programmes to adopt a multi-agent strategy may prove very beneficial in terms of relationship pricing, as well as net returns as a result of benchmarking the performance of each provider. More broadly, we think all mutual fund boards would benefit from an SEC requirement that they issue a formal, publicly available request for proposal (RFP) every few years. This is how the US public fund industry operates. RFPs are issued on a predictive schedule. Typically, all qualified agents are welcome to participate, both custodial and non-custodial, and relationship pricing is requested on a bundled and unbundled basis. As a result, US public funds enjoy leading edge pricing and service. Given the sheer number of mutual funds and exchange-traded funds (ETFs), one would expect there to be much more RFP activity than there is currently.
McAuley: In her keynote address at the 2019 ICI Securities law Developments Conference, Dalia Blass, Director of the Division of Investment Management at the SEC, indicated that affiliated securities lending was an area that the regulator “needs to tackle” due to the disparate treatment of market participants. This disparate treatment stems from the fact that the SEC last provided exemptive no action relief in this area back in 2004 so some fund complexes have relief and others do not. This would suggest that the SEC may be looking to codify no-action positions similar to what they have previously done with respect to cash sweep no-action letters.
Blass indicated the SEC would welcome comments on how best to address potential conflicts of interest inherent in those arrangements. Mixing affiliated and unaffiliated lenders was just one suggestion. However, the real focus was on transparency and providing boards with independent information in order to be able to assess the performance of lending agents. The recently implemented investment company modernisation final rule introduced reporting and data collection with respect to securities lending that should go a long way in keeping boards better informed and providing transparency into performance and fees. Mixing lending agents could have some unintended consequences and may not be necessary given increased transparency and the availability of market data.
Rennick: Securities lending continues to play a vital role in the global markets, providing liquidity, efficiency and capital. For investors and other lenders, securities lending offers the opportunity to add an incremental return on idle assets in the form of income that can be used to offset fees and improve performance.
For registered investment companies regulated by the SEC under the Investment Company Act of 1940, the use of an affiliated entity as a securities lending agent is often not viable, absent exemptive relief. Since the early 1990s, many investment companies have filed for and been granted the specific exemptive relief necessary to efficiently enter into a securities lending programme with an affiliated lending agent. The time and resource investment required to gain this exemptive relief is quite significant. In December of 2019 the SEC recognised that the current existence of this relief for some, but not all, investment companies with affiliates capable of serving as their securities lending agent has effectively resulted in a divide of “haves” and “have-nots”.
The SEC should continue to seek ways to ensure that the market is balanced, and that Investment companies and their investors have access to a broad array of potential securities lending agents. Levelling the playing field for all would increase competition and provide opportunities for all investment companies to partner with best securities lending agent for their funds and investors.
Changes to the US 15c3-3 rule for equities as collateral is expected to see progress this summer. How hopeful are you that this change will finally occur and how significant would this be for the US securities lending market?
Rennick: The SEC has started 2020 by soliciting feedback on the most recent interpretation version in early January, a potential sign that the equities as collateral changes are getting closer. However, given past history it is difficult to say this will be the year, but we certainly seem closer to the goal-line. Allowing broker-dealers to pledge equities as collateral will have a significant impact to all parties in the securities lending value chain. More than ever before, lenders with expansive collateral schedules that permit equities and equity repo will benefit over those with more restrictive schedules that exclude equities, either by regulation or internal tolerance. Since the borrowers gain significant benefits by posting equities over cash, we can expect a continual decline of cash collateral posted versus non-cash collateral which would drive ancillary impacts to securities lending returns generated from cash reinvestment.
McAuley: The addition of equity collateral to 15c3-3 for loans of equity securities is expected to eventually become reality. The question is not if, but rather when. When really depends on the process. The change involves two separate actions. The first part is fairly straightforward: the addition of equity collateral to the list of permissible collateral. The second element involves how the equity collateral is treated in the reserve formula. This second part is very complicated and has been the reason the change has been so long in the discussion and drafting phase.
The eventual impact of the change on the US lending market will to some degree be determined by how the trades are priced. Equity-for-equity general collateral trades outside of the US do not command premium pricing. This is in large part due to the fact that those markets evolved dependent on securities collateral as a result of a lack of – or fragmentation in – money markets. If equity collateral is expected to displace cash, then the transaction pricing will need to reflect the balance sheet benefit to the borrower and the loss of investment return by the lender. One potential benefit to lenders is that the change may incent borrowers to transition some of their broker-to-broker activity to agent lending programmes, which would represent new demand.
Santoro: Regulatory reforms are having a meaningful impact on agents, counterparties and beneficial owners. Trade flexibility in particular has come to the forefront in response to counterparties seeking less balance sheet intensive loan structures. Counterparties want to pledge equities and seek to transact with beneficial owners willing to accept them. We think it will happen soon and it will be significant in the public fund space where we have a number of large funds who are less constrained and can benefit fairly quickly.
Polseno: This change has been debated for years now with little change, although it feels as if it is gaining some traction, it is hard to say it will actually come to pass. There are also other changes such as the Department of Labor’s rules for 1940’s Act funds that would need to happen along with the SEC change to truly have a market impact. Over the years, changes in borrowing locations have allowed beneficial owners that accept equities as collateral to accept it from a robust set of counterparties. This change may in some ways serve to move the borrow from one entity, most likely a non-domestic one, back onshore. To say that overall demand or loan balance increases is a difficult one, global borrowers may already be using entities that can give equities as collateral and would not have significant upside. There could be an argument made that smaller domestic-only borrowers would be able to use this change to their advantage though. It also remains to be seen how robust the approved equities set is, if it is quite narrow, say SP500 only, it could be less interesting to the market and hence lower demand.
Gillingwater: There is no doubt this would be a significant change to the US securities lending market. Given the balance sheet benefits, it is expected US broker dealers would leverage their long equities to finance their borrows, which could potentially reduce loan volumes versus cash or sovereign debt loan volume.
For agent lenders, equity collateral for loans with broker dealers would be more punitive from a capital perspective than when pledged by EMEA bank entities. The related softening in cash collateral volumes could have an impact on cash reinvestment returns.
Additionally, clients with equity collateral in their guidelines could see a strengthening in their portfolio utilisation compared to clients who only accept cash and government debt collateral.
Saunders: The market has been closely monitoring developments to any changes related to US 15c3-3. The benefits are rather clear and the market is certainly optimistic that the initiative progresses in the near term. However, the expansion of permissible collateral would still require amendments to many lenders throughout the beneficial owner community. So while beneficial, the proposed changes are not the magic solution. Regardless of the timing of the proposed changes to 15c3-3, lenders, agents and borrowers willing to engage in capital-friendly transactions through Central Counterparties, noncash loans and pledge structures are well-positioned to increase utilisation.
Last year saw a major beneficial owner partially withdraw from the market on the grounds that lending facilitated short selling, which was counter to its ESG goals. Has this had any impact on the market in practical terms of global liquidity? Are you aware of, or do you foresee, other lenders having similar concerns?
Saunders: The subject of environmental, social and governance (ESG) is first and foremost among the beneficial owner community. It is on the agenda of every board meeting, client review and part of every RFP as of late. ESG is only going to grow in importance and cannot be ignored.
It is imperative that the market implement ESG mandates into the management of a securities lending programme. Agent lenders will be required to facilitate the ESG mandates of the beneficial owner community into the management of lending programmes. While several of the largest, most sophisticated lenders have recently implemented changes to their lending policies to reflect the heightened focus on ESG, many agent-lending programmes are more than capable to support the requests of lenders. For example, the subject of proxy voting is often cited as the rationale for supporting an ESG-compliant lending programme. Our experience with beneficial owners around ESG has been positive as it relates to proxy voting. Here at BNP Paribas it is a priority to implement and apply our client’s ESG mandates into our lending programme. As a bank, BNP Paribas is committed to implementing our own ESG policies, while supporting clients pursuing their own ESG mandates.
Santoro: It may be that some beneficial owners are conflating abusive short selling or perhaps empty voting with securities lending, which would be a mistake, in our view. We have not seen any impact on the market in practical terms and we’ve not encountered beneficial owners with similar concerns. Securities lending and ESG are fully compatible, in our case. We can accommodate ESG across the key facets of the service from approved counterparties, restrictions, collateral filtering, reinvestment, reporting, and recalling for proxy voting.
At Deutsche Bank, we’re partnered with DWS, our affiliated professional asset manager who is a recognised leader in ESG, which adds another dimension. DWS offers an ESG themed money fund, as well as separately managed accounts with an ESG overlay. We think these capabilities will grow in importance as US-based investors embrace ESG.
McAuley: Securities lending is in general an oversupplied market so the cessation of lending by a few large entities should not have a material impact. In spite of the reviews underway by those large plans, a broad community of market participants agree that short selling provides a range of benefits to the market, not least is acting as a countervailing force against overvalued securities. Regulatory bodies are generally in agreement. In December 2019, the European Securities and Markets Authority (ESMA) issued a report analyzing short-term pressures facing corporations. The body considered arguments concerning the impact of short-selling and securities lending practices and their potential link with short-termism. ESMA pointed out that short-selling and securities lending are key for price discovery and market liquidity. ESMA also indicated that it is not aware of concrete evidence pointing to a cause-effect connection between these practices and the existence of undue short-term market pressures and that securities lending, if done in a controlled way, is an opportunity to add value for fund investors and is compatible with long-term investment strategies.
ISLA announced the formation of a new Council for Sustainable Finance, which will introduce a series of principles for sustainable securities lending in the first quarter of this year aimed to promote and embed ESG values into securities lending.
These are just the latest developments in a long sequence of industry improvements to enhance market transparency and provide reassurance that strong corporate governance frameworks support responsible securities lending programmes.
Polseno: There has been no discernable impact on liquidity in the market based on some beneficial owners withdrawing from the market. The trend has been for those not lending to come back into the market for some time now (and continues to be), which has muted any impacts of those exiting.
Gillingwater: To put it in perspective, 2018 was a record-breaking year for securities lending revenue, and 2019 was the second highest revenue generating year in the past decade, according to IHS Markit. Looking ahead in fixed income lending markets, the first phase of a US/China trade agreement and greater certainty around Brexit have taken risk off the table and led to improved sentiment amongst our counterparts. With stock markets rallying to fresh highs, banks may have more risk appetite and capital to deploy into 2020. In this respect, we expect to see continued strong demand to collateralise with equities, particularly benefiting buy-to-hold clients who are able to utilise high-quality sovereign bond inventory in term maturity tenor exposures. With the cross-currency basis swap market more opaque in nature, it is challenging to predict how cross-currency collateral swap trades will perform. However, it is unlikely we will see a material shift in demand to source US dollars, thus the appetite to borrow US treasuries should be maintained, albeit with a threat of narrower lending fees.
Additionally, the general outlook for credit market performance is expected to remain robust with expectations of moderate global growth replacing fears of recession. Moreover, with central banks seemingly in no rush to raise interest rates, corporate bonds should remain in demand as the hunt for yield continues. If the global economic outlook improves significantly ahead of expectations, government bond yields could rise in anticipation of an interest rate increase. This may motivate investors to switch out of credit, thus adding some upward pressure on lending fees.
Rennick: The subject of stewardship and ESG is attracting increased industry focus, with growing discussion about how lenders can meet their individual governance objectives whilst successfully participating in securities lending.
As lenders’ ESG principles can vary across different portfolios, jurisdictions and client types, it is important for the agent lender to engage in ongoing dialogue with lending clients to understand their specific ESG goals. Once a lenders’ specific goals have been understood, we believe that through adherence to existing industry best practices, development of operating protocols and inclusion of ESG criteria, solutions can be developed affording lenders the ability to continue to participate in a securities lending programme which enhances fund performance and contributes to improved liquidity in the market, whilst achieving their ESG principles.
Securities lending is incorrectly associated with facilitating short selling. Various industry studies, including one conducted by the U.S. Federal Reserve, have concluded that short selling does not systematically drive down asset prices. In fact, by facilitating corrections in overvalued securities, short selling can help identify poor behavior by companies, and this knowledge benefits all investors in the long run. Therefore, by participating in securities lending in a responsible way, one is able to contribute to better governance and oversight across the financial system.
We expect ESG to remain a key topic across all client segments at the highest levels. We welcome opportunities to partner with and educate clients, about the ability for ESG principles and securities lending not only to co-exist, but to remain aligned in delivering the same goals.
Last year failed to live up to highs of 2018’s global revenue intake. Are there any indicators of how 2020 will fare?
Rennick: Looking forward to 2020 we may see a similar pattern to 2019, with a slow start followed by pockets of opportunity as volatility increases from factors such as an economic slowdown and the official start of the US presidential election cycle. While the US economy remains strong, it is not immune to the constant geopolitical tensions, global growth slowdowns or other type of shock events such as a global health scare. The new coronavirus emerging in China is already expected to impact growth and is bringing back memories of the deadly SARS virus, which was not only a public health problem but also impacted economies and drove a mass exodus of ex-patriots from places like Hong Kong, contributing to an immediate recession. While most analysts see the impact of the virus as short-lived, it remains to be seen if the recent market sell off was an opportunity to sell long or if short interest begins to increase. Hedge funds are cautious as the stellar returns in the US equity market in 2019 made short exposure a dangerous proposition. Overall, 2020 may be an eventful year starting with events in China, progressing with merger activity in Europe, the Middle East and Africa and ending with the outcome of a US presidential election and the ancillary policies.
Saunders: Performance in 2019 was certainly driven by a combination of factors led by the attribution of specials from initial public offerings. Market data supports this concept. However, returns for lenders holding general collateral and high-quality liquid assets (HQLA) fared well throughout the year. Demand remains insatiable for HQLA and clients permitted to engage in non-cash collateral transactions with a broadened collateral set experienced solid performance. Despite the increased participation from historically idle lenders and thus increase in supply, opportunities continued to be present in the market. Lenders willing to be patient and engage in capital-friendly transactions, and transact via alternate trade structures and various market infrastructures, will be at the forefront of revenue opportunities regardless of the portfolio composition.
Polseno: It is early days but this should be an interesting year. There are a lot of factors at play that can affect broader market performance, political, trade, central bank actions, etc., that could curb the steady and robust equity appreciation that we have seen in the last few years. If we transition into a market that is friendlier to active management strategies, then it could prove to increase lending performance and become more interesting. The demand side of securities finance has been challenged as relative performance of hedge funds and long/short equity funds in many cases has lagged and fee structures questioned as investors compare to passive mandates. This has decreased overall demand as well as put pressure on borrowing fees as prime brokers offer concessions to their clients to retain or grow their market share. To the extent that these themes continue in 2020, the overall performance of 2019 could carry forward again.
Santoro: It’s hard to predict 2020 revenues, but thus far January has proved to be a good month for us and we expect to report increases month-over-month for nearly all of our US-based clients.
McAuley: The lending market in 2019 was characterised by low volatility and very few specials. Much of the revenue was concentrated in a few initial public offerings and a couple of corporate events. While it is very early in 2020, we are expecting to see some renewed demand for HQLA. In addition, there is some expectation that corporate activity will trend in a positive direction.
What other trends and developments should the market be aware of in the US for this year?
McAuley: As the securities lending market moves forward the focus is on innovation designed to preserve indemnification, while also creating capacity to meet demand. Another focus of innovation is on creating new distribution channels that provide capital efficiency to borrowers, thereby stimulating new demand. One of the newest distribution channels is clearing. Last year, BNY Mellon became the first agent lender to clear a lending transaction through Eurex Clearing’s securities lending structure. While BNY Mellon remains the only agent lender currently providing this distribution channel to lenders, we have seen demand for clearing continue to grow. Lenders that embrace clearing may see increased distribution opportunities as well as premium pricing. As with anything new, the onboarding process can be tedious. However, we have been working together to streamline this process and to make clearing more accessible for all lenders.
Santoro: We expect investor interest in ESG will continue to grow in the US, which will lead to increasing engagement relative to incorporating ESG into programme guidelines and service delivery. As a general matter, we expect to maintain a high level of client engagement on programme optimisation, including collateral expansion, trade ideas, and providing client PMs with useful information and analysis to assist with their long investing. In addition, the Securities Financing Transactions Regulation (SFTR) is on the near horizon for US beneficial owners. In terms of the market, continued US treasury supply will keep spreads in current ranges. Fed fund futures are pricing in one rate cut in Q4 2020.
Saunders: Efficiency and capital-friendly transactions remain at the forefront for many agent lenders in 2020. The implementation of automation to distribute increased supply, along with the leveraging of technology to discover pockets of liquidity, remain a priority for most participants. As BNP Paribas continues to evolve our lending programme, we are cognisant that a combination of technology and alternative trade structure be utilised to expand our distribution, while adequately pricing risk.
Polseno: In terms of aspects of the business that can be controlled by agent lenders, the themes of this year are not so different than past years – collateral and trade structure flexibility will be important for continued growth. We are seeing more interest in ETFs and convertible bonds – emerging market sovereign and corporate bonds. With regards to structures this could mean a few things, examples would be term trades, pledge collateral arrangements, central counterparty clearings (CCPs) and shift to triparty collateral from bilateral.
The overall theme of differentiation in the lending market from one beneficial owner versus another based upon the choices they make for their programme will continue. As some aspects of stock loan flow becomes further commoditised and technology enhancements are leveling the playing field, alpha tends to be generated through uniqueness.
Rennick: We spoke about potential changes to 15c3-3 and the SEC’s review of affiliated lending programmes, but the two critical regulatory changes expected to significantly impact securities lending in 2020 are SFTR and the Central Securities Depositories Regulation (CSDR). Both of these topics have been discussed and addressed numerous times before; however, 2020 is the year each of these regulations come into effect. So expect further discussion and even more questions, especially around CSDR, general operating principles and how mandatory buy-ins will be treated.
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