Canada
27 September 2011
While staying on course, the Canadian securities lending market is trying to seize opportunities and improve the legislative landscape for the future
Image: Shutterstock
Slow and steady are the two words that Reeve Serman, head of securities lending trading and market execution at RBC Dexia, uses to describe the Canadian securities lending market.
The Bank of Canada’s prudent fiscal policies and the country’s comparatively functional majority conservative government has sparked investor confidence resulting in strong demand for the country’s debt, and high levels of interest in the equity markets have held up “remarkably well”, says Serman.
“There is huge global demand for purchasing high quality government debt right now from the investment community” says Serman, adding that this same intensifying demand is being translated into multiple opportunities across RBC Dexia’s global lending desks for high quality Canadian and European government debt.
And while a myriad of inconsistent and unpredictable short selling regulations across the world are adding an administrative burden to stock lending and dampening the demand side of the non-Canadian equity book, Canadian equity balances have, in contrast, held strong he notes.
The global custodian bank has four trading desks covering North America, Europe, Spain and Asia-Pacific and is active in 28 markets. The securities lending trading arm headed by Serman has a globally diversified book of business, with high concentrations in North America and Europe and a significant contribution from the Far East.
August was a particularly volatile month from a risk perspective as both the eurozone debt crisis and US political dysfunction in addressing its debt burdens rattled markets causing a global sell-off in equities and, simultaneously, flight-to-safety investing.
“In Canada, from a risk perspective, we are not overly concerned as the major securities lending participants are the major banks, which are some of the best banks globally with solid balance sheets. That brings an element of comfort from a credit risk perspective and allows us to trade up with high balances with less concerns from risk departments, lenders and borrowers,” Serman says.
Though there has been a rebound since the summer, there are still significant market jitters and all eyes have turned to eurozone developments in Greece and to a lesser extent in Spain and Italy, while increasing concerns around French Banks’ exposure to these countries is mounting.
“The eurozone does not seem to have an aligned vision, there are divergent views on how to fix [the sovereign debt crisis] and no real consensus. Italy seems to have a vision of raising taxes, and France is facing an election next year, the expectation on Germany to carry the eurozone is not sustainable and everyone is looking to the US for an economic rebound, there is an election there next year...I think ugly politics are a major hurdle in resolving this global economic downturn,” says Serman.
Moreover, the US’ persistent high unemployment rate, high debt levels, low rates of consumption, among other macroeconomic and internal political dynamics are causing concerns over the potential impact on Canada if the situation continues. Still, the country’s economy is proving to be highly resilient.
In terms of global securities lending, Canada is RBC Dexia’s home market and where it has depth and strength, and while it remains a major focus, in terms of growth, Serman says higher incremental returns are expected from its European desk. “We are seeing opportunity in the eurozone specific to securities lending as we bring more supply into our programme as a result of [the joint venture between RBC and Dexia]. Dexia has lots of clients and has successfully brought in new participants,” Serman adds.
At the same time, risk management functions are taking up more and more of his time. There is a lot of focus on reducing concentration risk on both the loan and collateral side, focusing on liquidity risk for both loans and collateral as well as looking at the correlation risk between the collateral and lending portfolios. For equity loans verse equity collateral, explains Serman, the correlation risk of a portfolio is significantly reduced – if the market moves sharply in either direction, both the loan portfolio and collateral portfolio drop or rise in a more correlated manner.
The same is not true for an equity loan portfolio versus a fixed income collateral portfolio, where one would observe a higher correlation risk between the portfolios as markets move.
“Risk is not something to be afraid of. One needs to understand it and be able to partner with one’s risk group and clients to strategically manage it,” Serman says.
“We would like to see more clients understand how [using equities as collateral] can help them reduce their risk profile in the market. Historically, everyone thought the best kind of collateral is government debt but if one factors in correlation risk during periods of high volatility...equities on equities clearly reduces risk. Many models and research papers published by credible sources demonstrate this dynamic,” Serman says.
Through CASLA, the Canadian Securities Lending Association, an industry representative body where he is a member of the board, Serman would like to engage industry participants, including Canadian regulators, in meaningful discussions to increase awareness and benefits of collateral alternatives, including equities, from a risk reward perspective. In addition, borrowers are receptive to paying higher margin levels for equity collateral at a time when restrictions are many and collateral costs are high for good quality government debt collateral.
“I am finding a new dynamic in the securities lending world, where there is a disjoint between the demand and supply side of the market,” says Serman. “Borrowers want lenders to be more flexible on not just collateral, but also term structures, which provide certain financial institutions balance sheet advantages as a result of certain term structures specific to high quality government debt. If lenders were open to [this], there is a huge opportunity which is not really being capitalised on as lenders struggle to get these opportunities approved internally,” he adds. “While securities lending may not be a core product of lenders, these opportunities can result in significant incremental revenue streams in a risk adjusted manner.”
It might be too much to ask for flexibility at a time when playing it safe is on most agendas. One area that Serman has seen a significant shift towards this attitude is in the specials market. Although the slowing of this activity is indicative of less mergers and acquisitions activity, it is also a reflection of a diversified risk adjusted return approach, meaning less capital being allocated to highly concentrated one-off trading opportunities as caution is being applied to decisions on how to best allocate that capital.
But just as lenders are cautious in flexibility and big risks, they are not shying away from new “rules of engagement” in terms of demanding transparency, benchmarking, reporting and analytics.
“It is a bitter sweet dynamic, we are encouraged that [lenders] are getting more sophisticated, however, with that comes a lot of extra management with the clients,” Serman notes.
For now, participants in the Canadian securities lending market are focused on operational efficiency, risk management automation and managing the underlying client. While an initiative to start a CCP for Canada, though getting some attention in the market, is not a priority for the immediate future, he adds.
Paving the way
Still, CCPs are an expected requirement for certain transactions under the US Dodd-Frank Act and participants in Canada are moving in this direction, as are many other markets. In general, CCPs offer benefits around efficiency, transparency and risk-reduction, but CCPs only make sense if they can achieve these goals without unduly driving up costs, says Rob Ferguson, head of global securities lending at CIBC Mellon.
“Conceptually, CCPs are an interesting idea and certainly worth discussing – so long as benefits outweigh costs. To date, however, it has been difficult to identify the benefits for our underlying securities lending and borrowing clients,” he says.
That is, in part, because borrowers and lenders can create a bespoke model and make choices on collateral, counterparties and design a risk profile. Ferguson notes that CCP models could take away some of that flexibility, while also not making it clear who the counterparties are.
“I am not saying that a CCP model is more risky, it just might not result in the particular risk profile that clients would have chosen under a non-CCP model,” he says. “[CCPs] could take away the clients’ ability to control the composition of their risk balance.”
He also thinks that a CCP for Canada’s securities lending market is far from being a done deal.
“I am not sure that we could just be an island. If other jurisdictions move to CCP models and become comfortable with their operation, I could see participants becoming more comfortable with the various risk profile, cost and revenue implications of a CCP model. So if the rest of world moves in this direction, maybe we would see it happen here in Canada, but I certainly don’t see this as a slam dunk,” he notes.
This is particularly true as any increased costs are anathema in an environment of global economic challenges. Though 2011 has been stronger than 2010 for CIBC Mellon’s securities lending business, uncertainty and negativity as a result of macroeconomic concerns may impact business volumes, says Ferguson, adding that low interest rates and a flat yield curve are also making cash reinvestment more challenging.
One of the areas gaining traction is the use of equity collateral in the post-credit crisis landscape. Though non-cash collateral tends to be predominantly government sovereign debt – accounting for some 90 per cent – participants are showing increased interest in broadening what is acceptable as collateral in securities lending transactions.
More than three-quarters of Canadian agent lending is done versus non-cash collateral - that has dropped off somewhat from just over a decade ago, when the figure was above 90 per cent. At the same time, barriers to using non-cash collateral are relatively small if a security is deemed qualified under Canada’s Income Tax Act, Ferguson says.
Mutual funds, a relatively new player in Canadian securities lending, are prohibited from accepting equity collateral.
“These rules do disadvantage mutual funds, putting them on unequal footing with pension funds, for example,” Ferguson says.
He is supportive of the efforts to broaden collateral being undertaken by CASLA and its president Rob Chiuch.
“A smaller part of broadening collateral is about improving a client’s risk profile. We would never tell a client to take 100 per cent equity collateral, but we would say a small percentage of equities would improve your risk profile. If regulations were amended to broaden collateral acceptability, mutual funds might then be able to accept equity collateral, which in turn could mean new revenue opportunities,” Ferguson says.
But in the here and now in the securities lending industry, despite challenges, the uncertainty cloud hanging over markets does have a silver lining; uncertainty often lends itself to some securities lending optimism.
Ferguson points to solar energy company stocks as an example, where a combination of short-term downward price pressure, but good longer term prospects is creating revenue opportunities for both borrowers and lenders.
“From CIBC Mellon’s perspective, our lending program continues to grow as we add new clients and earn additional business from our existing partners. I remain cautiously optimistic about the market in 2012,” says Ferguson.
Simply tax
From a tax perspective, Canada is mired in layers of draft legislation as part of the Income Tax Act, impacting the efficiency of the market, says Reya Ali-Dabydeen, tax partner in the Financial Services Group at Ernst & Young.
“We need to have more clarity. Today, we rely on the draft legislation to perform transactions on the assumption that the Department of Finance would provide us certainty,” Ali-Dabydeen says.
Currently, analysis of trade requires that tax advisers look at draft legislation from 2002 and 2006, which often shows a variance between the two, making the process inefficient, he adds.
But withholding taxes are the biggest issue for Ernst & Young clients, he notes, as Canadians borrowing, for example, European equities are charged withholding tax on the compensation payments.
“Canada needs to start thinking about how it applies withholding taxes on non-Canadian source dividends…at the moment the process is market inefficient,” Ali-Dabydeen says.
Clients are using derivatives instruments to deal with this inefficiency in order to synthesise desired returns, but this is also an area without a clear set of rules.
“Canadian rules lack a cohesive scheme, different bits and pieces of [the Income Tax Act] need to be tied together. This is not a bad thing as some of those rules are intended to prevent tax avoidance but where other jurisdictions have comprehensive securities lending rules, Canada does not. [The government] should at the very least be passing current legislation but at the same time begin thinking about rules in a comprehensive fashion,” he says. “Right now, there are always bigger legislative issues and the size of Canada’s market may not attract Finance’s attention, and so it is one of those areas that is not a priority of the Department of Finance as one might hope.”
In general, Ali-Dabydeen positions Canada somewhere between the US and UK in terms of development. Canada could do more to follow the example set by the City of London, which lobbies aggressively for clear guidance on capital markets, but without going as far as the US in terms of the complexity of burdensome rules.
“The risk [of not having a clear framework] is that transactions are more expensive partly because of the lack of clarity, but also it may impede the development of the Canadian securities lending market,” he says. SLT
The Bank of Canada’s prudent fiscal policies and the country’s comparatively functional majority conservative government has sparked investor confidence resulting in strong demand for the country’s debt, and high levels of interest in the equity markets have held up “remarkably well”, says Serman.
“There is huge global demand for purchasing high quality government debt right now from the investment community” says Serman, adding that this same intensifying demand is being translated into multiple opportunities across RBC Dexia’s global lending desks for high quality Canadian and European government debt.
And while a myriad of inconsistent and unpredictable short selling regulations across the world are adding an administrative burden to stock lending and dampening the demand side of the non-Canadian equity book, Canadian equity balances have, in contrast, held strong he notes.
The global custodian bank has four trading desks covering North America, Europe, Spain and Asia-Pacific and is active in 28 markets. The securities lending trading arm headed by Serman has a globally diversified book of business, with high concentrations in North America and Europe and a significant contribution from the Far East.
August was a particularly volatile month from a risk perspective as both the eurozone debt crisis and US political dysfunction in addressing its debt burdens rattled markets causing a global sell-off in equities and, simultaneously, flight-to-safety investing.
“In Canada, from a risk perspective, we are not overly concerned as the major securities lending participants are the major banks, which are some of the best banks globally with solid balance sheets. That brings an element of comfort from a credit risk perspective and allows us to trade up with high balances with less concerns from risk departments, lenders and borrowers,” Serman says.
Though there has been a rebound since the summer, there are still significant market jitters and all eyes have turned to eurozone developments in Greece and to a lesser extent in Spain and Italy, while increasing concerns around French Banks’ exposure to these countries is mounting.
“The eurozone does not seem to have an aligned vision, there are divergent views on how to fix [the sovereign debt crisis] and no real consensus. Italy seems to have a vision of raising taxes, and France is facing an election next year, the expectation on Germany to carry the eurozone is not sustainable and everyone is looking to the US for an economic rebound, there is an election there next year...I think ugly politics are a major hurdle in resolving this global economic downturn,” says Serman.
Moreover, the US’ persistent high unemployment rate, high debt levels, low rates of consumption, among other macroeconomic and internal political dynamics are causing concerns over the potential impact on Canada if the situation continues. Still, the country’s economy is proving to be highly resilient.
In terms of global securities lending, Canada is RBC Dexia’s home market and where it has depth and strength, and while it remains a major focus, in terms of growth, Serman says higher incremental returns are expected from its European desk. “We are seeing opportunity in the eurozone specific to securities lending as we bring more supply into our programme as a result of [the joint venture between RBC and Dexia]. Dexia has lots of clients and has successfully brought in new participants,” Serman adds.
At the same time, risk management functions are taking up more and more of his time. There is a lot of focus on reducing concentration risk on both the loan and collateral side, focusing on liquidity risk for both loans and collateral as well as looking at the correlation risk between the collateral and lending portfolios. For equity loans verse equity collateral, explains Serman, the correlation risk of a portfolio is significantly reduced – if the market moves sharply in either direction, both the loan portfolio and collateral portfolio drop or rise in a more correlated manner.
The same is not true for an equity loan portfolio versus a fixed income collateral portfolio, where one would observe a higher correlation risk between the portfolios as markets move.
“Risk is not something to be afraid of. One needs to understand it and be able to partner with one’s risk group and clients to strategically manage it,” Serman says.
“We would like to see more clients understand how [using equities as collateral] can help them reduce their risk profile in the market. Historically, everyone thought the best kind of collateral is government debt but if one factors in correlation risk during periods of high volatility...equities on equities clearly reduces risk. Many models and research papers published by credible sources demonstrate this dynamic,” Serman says.
Through CASLA, the Canadian Securities Lending Association, an industry representative body where he is a member of the board, Serman would like to engage industry participants, including Canadian regulators, in meaningful discussions to increase awareness and benefits of collateral alternatives, including equities, from a risk reward perspective. In addition, borrowers are receptive to paying higher margin levels for equity collateral at a time when restrictions are many and collateral costs are high for good quality government debt collateral.
“I am finding a new dynamic in the securities lending world, where there is a disjoint between the demand and supply side of the market,” says Serman. “Borrowers want lenders to be more flexible on not just collateral, but also term structures, which provide certain financial institutions balance sheet advantages as a result of certain term structures specific to high quality government debt. If lenders were open to [this], there is a huge opportunity which is not really being capitalised on as lenders struggle to get these opportunities approved internally,” he adds. “While securities lending may not be a core product of lenders, these opportunities can result in significant incremental revenue streams in a risk adjusted manner.”
It might be too much to ask for flexibility at a time when playing it safe is on most agendas. One area that Serman has seen a significant shift towards this attitude is in the specials market. Although the slowing of this activity is indicative of less mergers and acquisitions activity, it is also a reflection of a diversified risk adjusted return approach, meaning less capital being allocated to highly concentrated one-off trading opportunities as caution is being applied to decisions on how to best allocate that capital.
But just as lenders are cautious in flexibility and big risks, they are not shying away from new “rules of engagement” in terms of demanding transparency, benchmarking, reporting and analytics.
“It is a bitter sweet dynamic, we are encouraged that [lenders] are getting more sophisticated, however, with that comes a lot of extra management with the clients,” Serman notes.
For now, participants in the Canadian securities lending market are focused on operational efficiency, risk management automation and managing the underlying client. While an initiative to start a CCP for Canada, though getting some attention in the market, is not a priority for the immediate future, he adds.
Paving the way
Still, CCPs are an expected requirement for certain transactions under the US Dodd-Frank Act and participants in Canada are moving in this direction, as are many other markets. In general, CCPs offer benefits around efficiency, transparency and risk-reduction, but CCPs only make sense if they can achieve these goals without unduly driving up costs, says Rob Ferguson, head of global securities lending at CIBC Mellon.
“Conceptually, CCPs are an interesting idea and certainly worth discussing – so long as benefits outweigh costs. To date, however, it has been difficult to identify the benefits for our underlying securities lending and borrowing clients,” he says.
That is, in part, because borrowers and lenders can create a bespoke model and make choices on collateral, counterparties and design a risk profile. Ferguson notes that CCP models could take away some of that flexibility, while also not making it clear who the counterparties are.
“I am not saying that a CCP model is more risky, it just might not result in the particular risk profile that clients would have chosen under a non-CCP model,” he says. “[CCPs] could take away the clients’ ability to control the composition of their risk balance.”
He also thinks that a CCP for Canada’s securities lending market is far from being a done deal.
“I am not sure that we could just be an island. If other jurisdictions move to CCP models and become comfortable with their operation, I could see participants becoming more comfortable with the various risk profile, cost and revenue implications of a CCP model. So if the rest of world moves in this direction, maybe we would see it happen here in Canada, but I certainly don’t see this as a slam dunk,” he notes.
This is particularly true as any increased costs are anathema in an environment of global economic challenges. Though 2011 has been stronger than 2010 for CIBC Mellon’s securities lending business, uncertainty and negativity as a result of macroeconomic concerns may impact business volumes, says Ferguson, adding that low interest rates and a flat yield curve are also making cash reinvestment more challenging.
One of the areas gaining traction is the use of equity collateral in the post-credit crisis landscape. Though non-cash collateral tends to be predominantly government sovereign debt – accounting for some 90 per cent – participants are showing increased interest in broadening what is acceptable as collateral in securities lending transactions.
More than three-quarters of Canadian agent lending is done versus non-cash collateral - that has dropped off somewhat from just over a decade ago, when the figure was above 90 per cent. At the same time, barriers to using non-cash collateral are relatively small if a security is deemed qualified under Canada’s Income Tax Act, Ferguson says.
Mutual funds, a relatively new player in Canadian securities lending, are prohibited from accepting equity collateral.
“These rules do disadvantage mutual funds, putting them on unequal footing with pension funds, for example,” Ferguson says.
He is supportive of the efforts to broaden collateral being undertaken by CASLA and its president Rob Chiuch.
“A smaller part of broadening collateral is about improving a client’s risk profile. We would never tell a client to take 100 per cent equity collateral, but we would say a small percentage of equities would improve your risk profile. If regulations were amended to broaden collateral acceptability, mutual funds might then be able to accept equity collateral, which in turn could mean new revenue opportunities,” Ferguson says.
But in the here and now in the securities lending industry, despite challenges, the uncertainty cloud hanging over markets does have a silver lining; uncertainty often lends itself to some securities lending optimism.
Ferguson points to solar energy company stocks as an example, where a combination of short-term downward price pressure, but good longer term prospects is creating revenue opportunities for both borrowers and lenders.
“From CIBC Mellon’s perspective, our lending program continues to grow as we add new clients and earn additional business from our existing partners. I remain cautiously optimistic about the market in 2012,” says Ferguson.
Simply tax
From a tax perspective, Canada is mired in layers of draft legislation as part of the Income Tax Act, impacting the efficiency of the market, says Reya Ali-Dabydeen, tax partner in the Financial Services Group at Ernst & Young.
“We need to have more clarity. Today, we rely on the draft legislation to perform transactions on the assumption that the Department of Finance would provide us certainty,” Ali-Dabydeen says.
Currently, analysis of trade requires that tax advisers look at draft legislation from 2002 and 2006, which often shows a variance between the two, making the process inefficient, he adds.
But withholding taxes are the biggest issue for Ernst & Young clients, he notes, as Canadians borrowing, for example, European equities are charged withholding tax on the compensation payments.
“Canada needs to start thinking about how it applies withholding taxes on non-Canadian source dividends…at the moment the process is market inefficient,” Ali-Dabydeen says.
Clients are using derivatives instruments to deal with this inefficiency in order to synthesise desired returns, but this is also an area without a clear set of rules.
“Canadian rules lack a cohesive scheme, different bits and pieces of [the Income Tax Act] need to be tied together. This is not a bad thing as some of those rules are intended to prevent tax avoidance but where other jurisdictions have comprehensive securities lending rules, Canada does not. [The government] should at the very least be passing current legislation but at the same time begin thinking about rules in a comprehensive fashion,” he says. “Right now, there are always bigger legislative issues and the size of Canada’s market may not attract Finance’s attention, and so it is one of those areas that is not a priority of the Department of Finance as one might hope.”
In general, Ali-Dabydeen positions Canada somewhere between the US and UK in terms of development. Canada could do more to follow the example set by the City of London, which lobbies aggressively for clear guidance on capital markets, but without going as far as the US in terms of the complexity of burdensome rules.
“The risk [of not having a clear framework] is that transactions are more expensive partly because of the lack of clarity, but also it may impede the development of the Canadian securities lending market,” he says. SLT
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