USA
05 October 2010
The world’s largest financial market has suffered more than most as a result of the downturn, and its recovery has not been easy. But while confidence builds, regulation looms large
Image: Shutterstock
At over USD300 billion a year, the US equity lending market dwarfs that of other markets, and represents almost half of the global securities lending industry. But as the biggest market, it was in the eye of the storm when the financial crisis hit, and has taken some time to recover.
2009 was actually not too bad a year in terms of transaction volumes, but in fact this was skewed because of the Citigroup trades. In February 2009, an exchanged was announced converting common stock for publicly held convertible and non-convertible preferred shares in an attempt to build the company’s equity and increase confidence in the company. The market reacted by selling the underlying shares and buying the preferred shares, creating huge volumes in securities lending. Take Citi out of the equation, and 2009 was a year to forget for the country, however.
2010 has been better, however. There have been no large market surges and stability, it feels, is what is needed as the industry gathers itself. While volumes are steadily increasing, fees have fallen, and specials are still scarce.
“The US is predominantly a cash collateral market therefore it is no surprise that the US securities lending market experienced a slower recovery following the credit crisis than most other developed securities lending markets,” says Peter Bassler, managing director at eSecLending.
“In addition, the uncertainty of the implications of global regulations and particularly the Dodd-Frank Act in the US has resulted in lower borrower demand. However, in 2010 supply has returned to the market as many beneficial owners are re-engaging in securities lending and re-starting or expanding their programmes after temporarily suspending activity during the credit crisis. We are also seeing new supply from certain beneficial owners starting lending programmes for the first time.”
As hedge funds retrenched to lick their wounds and beneficial owners withdrew to reduce their risk, many participants really started to struggle. While Lehman was the biggest and most public casualty, many smaller firms bit the dust while others cut costs wherever they could - it’s estimated that there are 40 per cent fewer people working in the securities lending industry now then there were three years ago,
Of course, some of these cuts will end up being good for the market. Even though budgets are tight, new technology has been introduced, which has improved efficiencies and reduced some of the risks. The emergence of providers such as OneChicago and Quadriserv has also created a more welcoming environment for some of the more cautious borrowers and lenders.
These platforms have opened the market, and while they are certainly cannibalising some of the existing securities lending business, they are designed to “increase the size of the pie,” says Greg DePetris, co-founder of Quadriserv. OneChicago has seen huge increases in the number of trades in 2010, and has increased the number of instruments for trading accordingly. It says it has attracted many of the major European organisations to the American securities lending industry, as well as increasing business from the main domestic players. Quadriserv, meanwhile, is accumulating members.
While the hedge fund market is now keen to participate strongly in the market, beneficial owners have been a little slower coming forward. Some, such as Ohio pensions, have returned strongly but others have been less forward. CalPERS, which was hit hard in the downturn, is still a major player, but its activities are muted compared to three years ago.
“The perception of lending continues to shift toward viewing the product as an investment and trading function rather than a back office custodial product,” explains Bassler. “When beneficial owners evaluate lending, particularly in the US, they are realising that it encompasses two separate and distinct skill sets; lending (financing and repo activity) and collateral management (investment management function if cash). Beneficial owners are now more focused on generating returns from the lending component (intrinsic earnings) rather than potential returns from the reinvestment of cash collateral.”
Of course, in terms of participation, everyone who is anyone in global financial services has a stake. The big US banks such as J.P. Morgan, BNY Mellon, State Street and Northern Trust remain major players, but competition from European and Asian providers keeps fees low and ensures constant innovation
Regulation
The elephant in the room however remains regulation. Just as in many other parts of the world, there has been a huge public focus on the financial services industry and widespread anger at the banks’ activities leading up to the financial crisis.
The need for transparency in all markets, including securities lending, has been on the agenda both within the participating organisations and the regulators, and the forthcoming Dodd Frank legislation will push organisations to be more open. This opaqueness has been recognised by most organisations, and irrespective of legislation, available information is greater now than ever before - at a recent conference in London, Data Explorers gave a potted history of the securities lending market over the past couple of decades and showed how the amount of data available now is a magnitude larger than three years ago. But there are still concerns. “The uncertainty of regulatory implications is the key focus at the moment,” says Bassler.
One effect of the new legislation could be a greater move to CCPs and exchange-based trading, something that many in the industry would welcome - although others are not so sure about. There are a number of CCP cheerleaders in the US, who push the benefits of automation, reduced counterparty risk, lower costs, increased liquidity and a level playing field for all participants.
“The main benefit we are seeing of the introduction of services introduced by firms such as OneChicago and Quadriserv is that it is encouraging those who may have been scared away by the banking crisis into securities lending,” says Marco Ancona, a pension fund consultant based in Austin, Texas.
“They are used to buying and selling stocks on exchanges, and often have experience with exchange-traded derivatives. They understand how these trades are settled. The idea of entering securities lending in an OTC market may have proved a bit daunting, but seeing a recognisable process for a new market helps them to get their heads around it. It’s not for everyone, but it certainly will build the market - as we have seen in Europe.”
This won’t mean everything moves in this direction - even one of the market’s biggest proponents, Quadriserv’s Greg DePetris believes there is room for all types of trading in the market - but new entrants are certainly looking at market-based systems more closely.
“We only dipped our toes in securities lending [until 2010] says a representative from one mid-size pension plan based in the MidWest. “And we’re staying cautious. But we prefer the mitigation of risk that you see with CCPs and while we’re in business to make money, it’s more important that we don’t lose it.”
There are also proposed new rules on cost basis reporting for securities lending transactions. The rules, which were proposed almost a year ago and are still being discussed, aim to ensure that gross sale proceeds from covered securities transactions are accurate and complete.
They would require everyone undertaking a transfer of covered securities to a broker to provide the broker with a written statement to the broker. The new section will also require brokers, upon disposing of the transferred securities, to divulge various pieces of information to help taxpayers work out their profits or losses.
The problem has arisen because the wording has been changed to include non-covered securities, which according to the Risk Management Association (RMA) “appears to include transfers resulting from securities lending transactions”.
The RMA has asked for securities lending to be made exempt from these rules. In a letter to the US tax authorities, the association said the required information is not relevant as securities lending agreements are not classed as taxable. The lender’s position within the transaction is preserved throughout the life of the loan and rights are not necessarily transferred to the borrower.
If securities lending transactions are included in the new rules, says the RMA, the regulation could also affect participants when they are exchanging collateral or returning borrowed shares. A further reason for the exemption is that many of the securities lending participants affected - pension and mutual funds for example - have a different tax status to conventional investors.
The future
Securities lending appears to be becoming an increasingly specialised activity and while the major players will always be able to win mandates based on their suite of middle and back office offerings, the focus on how securities lending fits into an overall strategy means the teams responsible for this side of the market are become more and more important. There is also the possibility that more specialised providers build up their market share.
“The securities lending landscape continues to evolve,” says Bassler. “The industry is showing a renewed focus on intrinsic returns and developing customised solutions for clients.
“The increased focus on counterparty risk management and view of securities lending as an investment management product rather than an operational function tied to custody has encouraged beneficial owners to more explore alternative routes to market. As evidenced by some of the new mandates we have won thus far in 2010, beneficial owners are seeking differentiated solutions and a proven process. As a result of these trends, we expect to see continued unbundling of securities lending, custody, and cash management. These trends have already been underway for several years but we expect they will only accelerate as a result the increased focus on securities lending.”
2009 was actually not too bad a year in terms of transaction volumes, but in fact this was skewed because of the Citigroup trades. In February 2009, an exchanged was announced converting common stock for publicly held convertible and non-convertible preferred shares in an attempt to build the company’s equity and increase confidence in the company. The market reacted by selling the underlying shares and buying the preferred shares, creating huge volumes in securities lending. Take Citi out of the equation, and 2009 was a year to forget for the country, however.
2010 has been better, however. There have been no large market surges and stability, it feels, is what is needed as the industry gathers itself. While volumes are steadily increasing, fees have fallen, and specials are still scarce.
“The US is predominantly a cash collateral market therefore it is no surprise that the US securities lending market experienced a slower recovery following the credit crisis than most other developed securities lending markets,” says Peter Bassler, managing director at eSecLending.
“In addition, the uncertainty of the implications of global regulations and particularly the Dodd-Frank Act in the US has resulted in lower borrower demand. However, in 2010 supply has returned to the market as many beneficial owners are re-engaging in securities lending and re-starting or expanding their programmes after temporarily suspending activity during the credit crisis. We are also seeing new supply from certain beneficial owners starting lending programmes for the first time.”
As hedge funds retrenched to lick their wounds and beneficial owners withdrew to reduce their risk, many participants really started to struggle. While Lehman was the biggest and most public casualty, many smaller firms bit the dust while others cut costs wherever they could - it’s estimated that there are 40 per cent fewer people working in the securities lending industry now then there were three years ago,
Of course, some of these cuts will end up being good for the market. Even though budgets are tight, new technology has been introduced, which has improved efficiencies and reduced some of the risks. The emergence of providers such as OneChicago and Quadriserv has also created a more welcoming environment for some of the more cautious borrowers and lenders.
These platforms have opened the market, and while they are certainly cannibalising some of the existing securities lending business, they are designed to “increase the size of the pie,” says Greg DePetris, co-founder of Quadriserv. OneChicago has seen huge increases in the number of trades in 2010, and has increased the number of instruments for trading accordingly. It says it has attracted many of the major European organisations to the American securities lending industry, as well as increasing business from the main domestic players. Quadriserv, meanwhile, is accumulating members.
While the hedge fund market is now keen to participate strongly in the market, beneficial owners have been a little slower coming forward. Some, such as Ohio pensions, have returned strongly but others have been less forward. CalPERS, which was hit hard in the downturn, is still a major player, but its activities are muted compared to three years ago.
“The perception of lending continues to shift toward viewing the product as an investment and trading function rather than a back office custodial product,” explains Bassler. “When beneficial owners evaluate lending, particularly in the US, they are realising that it encompasses two separate and distinct skill sets; lending (financing and repo activity) and collateral management (investment management function if cash). Beneficial owners are now more focused on generating returns from the lending component (intrinsic earnings) rather than potential returns from the reinvestment of cash collateral.”
Of course, in terms of participation, everyone who is anyone in global financial services has a stake. The big US banks such as J.P. Morgan, BNY Mellon, State Street and Northern Trust remain major players, but competition from European and Asian providers keeps fees low and ensures constant innovation
Regulation
The elephant in the room however remains regulation. Just as in many other parts of the world, there has been a huge public focus on the financial services industry and widespread anger at the banks’ activities leading up to the financial crisis.
The need for transparency in all markets, including securities lending, has been on the agenda both within the participating organisations and the regulators, and the forthcoming Dodd Frank legislation will push organisations to be more open. This opaqueness has been recognised by most organisations, and irrespective of legislation, available information is greater now than ever before - at a recent conference in London, Data Explorers gave a potted history of the securities lending market over the past couple of decades and showed how the amount of data available now is a magnitude larger than three years ago. But there are still concerns. “The uncertainty of regulatory implications is the key focus at the moment,” says Bassler.
One effect of the new legislation could be a greater move to CCPs and exchange-based trading, something that many in the industry would welcome - although others are not so sure about. There are a number of CCP cheerleaders in the US, who push the benefits of automation, reduced counterparty risk, lower costs, increased liquidity and a level playing field for all participants.
“The main benefit we are seeing of the introduction of services introduced by firms such as OneChicago and Quadriserv is that it is encouraging those who may have been scared away by the banking crisis into securities lending,” says Marco Ancona, a pension fund consultant based in Austin, Texas.
“They are used to buying and selling stocks on exchanges, and often have experience with exchange-traded derivatives. They understand how these trades are settled. The idea of entering securities lending in an OTC market may have proved a bit daunting, but seeing a recognisable process for a new market helps them to get their heads around it. It’s not for everyone, but it certainly will build the market - as we have seen in Europe.”
This won’t mean everything moves in this direction - even one of the market’s biggest proponents, Quadriserv’s Greg DePetris believes there is room for all types of trading in the market - but new entrants are certainly looking at market-based systems more closely.
“We only dipped our toes in securities lending [until 2010] says a representative from one mid-size pension plan based in the MidWest. “And we’re staying cautious. But we prefer the mitigation of risk that you see with CCPs and while we’re in business to make money, it’s more important that we don’t lose it.”
There are also proposed new rules on cost basis reporting for securities lending transactions. The rules, which were proposed almost a year ago and are still being discussed, aim to ensure that gross sale proceeds from covered securities transactions are accurate and complete.
They would require everyone undertaking a transfer of covered securities to a broker to provide the broker with a written statement to the broker. The new section will also require brokers, upon disposing of the transferred securities, to divulge various pieces of information to help taxpayers work out their profits or losses.
The problem has arisen because the wording has been changed to include non-covered securities, which according to the Risk Management Association (RMA) “appears to include transfers resulting from securities lending transactions”.
The RMA has asked for securities lending to be made exempt from these rules. In a letter to the US tax authorities, the association said the required information is not relevant as securities lending agreements are not classed as taxable. The lender’s position within the transaction is preserved throughout the life of the loan and rights are not necessarily transferred to the borrower.
If securities lending transactions are included in the new rules, says the RMA, the regulation could also affect participants when they are exchanging collateral or returning borrowed shares. A further reason for the exemption is that many of the securities lending participants affected - pension and mutual funds for example - have a different tax status to conventional investors.
The future
Securities lending appears to be becoming an increasingly specialised activity and while the major players will always be able to win mandates based on their suite of middle and back office offerings, the focus on how securities lending fits into an overall strategy means the teams responsible for this side of the market are become more and more important. There is also the possibility that more specialised providers build up their market share.
“The securities lending landscape continues to evolve,” says Bassler. “The industry is showing a renewed focus on intrinsic returns and developing customised solutions for clients.
“The increased focus on counterparty risk management and view of securities lending as an investment management product rather than an operational function tied to custody has encouraged beneficial owners to more explore alternative routes to market. As evidenced by some of the new mandates we have won thus far in 2010, beneficial owners are seeking differentiated solutions and a proven process. As a result of these trends, we expect to see continued unbundling of securities lending, custody, and cash management. These trends have already been underway for several years but we expect they will only accelerate as a result the increased focus on securities lending.”
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