Germany
22 November 2011
Fears of a recession have securities lending market participants taking a close look at their involvement
Image: Shutterstock
Germany’s economic outlook has deteriorated noticeably on the back of increasing expectations of a eurozone recession. But the country is still expected to outperform most others in the region albeit at a lower rate of growth than earlier forecast.
At first sight, a strong third quarter showing for German industrial production does not seem to fit with recession concerns, noted Commerzbank in a recent economic summary. But the strong rise is largely due to a special effect: In view of full order books, many companies – particularly in the automotive sector – cancelled their factory shutdowns, thereby boosting production on a seasonally adjusted basis very significantly. This is likely to be corrected in the fourth quarter, say Commerzbank economists, on top of fewer orders being taken both from within and outside of the eurozone countries.
“The poor order figures retrospectively confirm the decline in sentiment indicators, frustrating the hopes of those who believed that this was essentially caused by the turmoil in financial markets. The German economy has become accustomed to success, but its prospects have deteriorated considerably and it is expected to achieve at best low growth in the winter half-year.”
Commerzbank expects GDP to grow three per cent in 2011 and just 0.8 per cent in 2012 adding that Germany should just about manage to avoid a recession, unlike the rest of the eurozone.
Still, the forecast carries unusually high risks. Uncertainty has risen “massively” owing to the further deepening of the sovereign debt crisis. “This is poison not just for the financial markets but also for the economy...The increasingly fraught discussions about the default of a euro country and the massive consequences this could have for the real economy are bound to leave their mark on businesses and private households. The longer the uncertainty goes on, the stronger is the negative effect.”
In addition, as the eurozone slowly slips into a new recession, pressure is sure to mount on politicians across the currency union to maintain government spending. This makes promised reforms from Greece and Italy less likely to lessen the impact of any slowdown in economic growth, according to Robert Smith, manager of the German Growth Trust at Barings Asset Management, who reinforces the view that Germany may yet avoid a recession
He adds that at some point, Germany will have to accept that the UK and US quantitative easing solution to inflate away the debt problem may be the only way out. Meanwhile, the US recovery continues slowly and a soft landing in Asia as a consequence of falling inflation rates in China could be bringing some loosening in monetary policy in the region closer.
“Exporters to the wider world will continue to remain as one of the investments of choice for European equity investors looking for both inflation protection and growth opportunities, and the best representation of this type of company can be found within Germany,” Smith says. “Indeed, this in itself means any slowdown in Germany is likely to be much milder than elsewhere in the eurozone. With German employment at record levels, and consumer confidence holding firmly in positive territory, we believe that Europe’s largest economy may yet avoid a technical recession.”
How any given scenario plays out and how that might translate into an impact on German companies earnings or dividends remains to be seen.
According to Data Explorers, the value of German equities on loan is at $25.2 billion against a lendable supply of $202.2 billion, putting the LongShort ratio at 8.03. This is a sharp fall of some 25 per cent from its five year peak in mid-July this year, when longs outnumbered shorts by almost 11 times.
However, looking further back at pre-Lehman days, value of stock on loan trended at double today’s level while the value of lendable supply had collapsed post-Lehman and been recovering until April this year. Since then, the value of inventory has fallen back to levels seen in May 2010.
So far the equities markets have held up well and, in terms of securities lending, have maintained fairly even balances, notes Andreas Richter, local head of the agency securities lending team at Deutsche Bank in Frankfurt.
“The equities market from a lending point of view has been performing as it did before,” says Richter. “The biggest impact on lending returns we saw was really on the fixed income side and on collateral costs. There may be a consequence with respect to returns from equity lending transactions next year or the year after if, due to the eurozone crisis, earnings potential of German companies start to lower.”
In general, the securities lending market in Germany reflects much of what is going on in the rest of Europe, Richter notes. In the equity markets, the challenges stem from fears over a recession.
“People are looking even closer at the lending market, they are thinking very carefully for how and to whom they want to make securities available for lending. In Germany, investors tend to be more reserved and if anything the discussion on when and how to lend has become longer. ” he adds.
Meanwhile, from a fixed income point of view, the industry in Europe is struggling to adjust to a “two-tier model” for collateral, particularly as new regulations will push derivatives onto exchanges and through clearing houses, requiring high quality collateral.
It is all about realising demand for highly desired sovereign bonds from countries like Germany, Finland, the Netherlands and France, he notes.
Regulatory landscape
Though impacted by such far-reaching global regulations such as Basel III, at the same time, Richter is paying far closer attention to the impacts of a national regulation, the Investmentgesetz (InvG), which provides oversight for so-called KAG funds.
The German lending market can be divided into roughly two categories, the interbank lending and the KAG markets. The KAG market, with some €1.5 trillion in managed assets, is comprised of mutual funds and “Spezialfonds”, which have similar structures except that the latter is backed by a single investor. KAG funds are a unique feature of Germany and as such also an important part of the securities lending market.
Deutsche Bank operates one of the largest agency securities lending programmes with a particular expertise in non-custody lending. The programme interoperates with over 30 custodians worldwide in order to facilitate lending business for clients irrespective of the location of the assets and is able to combine agency with a principal lending structure for clients for both domestic or international markets.
Unlike the Austrian market, which is limited to lending out 30 per cent of any KAG fund portfolio, German law allows asset managers to lend out up to 100 per cent of any portfolio, but mandates a cap at 10 per cent per individual borrower. Austria by contrast can lend the entire portion to any single borrower. Guidelines for Spezialfonds technically have the ability to adjust the 10 per cent limit in Germany but this requires a change in fund guidelines and the uptake has been very limited , says Richter.
Within the InvG, which regulates the asset management activities for German funds, there are specific clauses which address securities lending activities. Recently the InvG was subject to some revisions and changes. “Rather than doing some major changes, there has only been a fine tuning, which will not really pay off for the beneficial owners of the funds from a revenue point of view,” he says, adding that regulators may have understandably been reluctant to amend the rules in the wake of the financial crisis.
As a case in point, due to Basel III compliance, term cash trades have become a hot item that come with an attractive premium. The InvG does not allow term transactions for KAG funds which in turn excludes funds from capturing this revenue opportunity offered by three, six or twelve months term trades.
“The rationale of the law is to ensure there is always liquidity for the funds but this issue could have been resolved by having the right of substitution,” says Richter.
Another example is limits on cash collateral reinvestment. In the wake of AIG as well as the freezing of parts of money markets during the financial crisis, regulators have been closely scrutinising the practice. Most recently, the Financial Stability Board announced that it will be taking a closer look at this particular component of the securities lending market and, in general, there is a global move away from “volume” style of securities lending – when firms extract revenue opportunities from the cash collateral reinvestment over the intrinsic value of the loan itself.
There is no doubt that scrutiny over this practice is warranted, but in Germany, the reverse repo market is largely off limits for reinvestments of KAG funds. Instead, clients can choose between blocked cash accounts earning only a meagre return in the current low interest rate environment and money market instruments in general which potentially offer less protection as they are not collateralised as reverse repo transactions.
“Choosing a reverse repo or triparty repo instead, the transaction is collateralised, is marked-to-market on a daily basis, so the counterpart risk can be considerably lower than other money market instruments.” he says.
Meanwhile, there are new developments on the horizon which are also part of a European trend - the introduction of CCPs to the market. Richter notes that for his own clients there is little to no demand for cleared trades since it would add another layer of cost with little additional security. From the point of view of a new market offering and player, however, he says it remains to be seen what the product will look like and whether it will attract clients but that the competition is welcomed.
CCP – no margin?
Among other offerings in Europe and the US, Eurex Clearing is developing a service to cover bilaterally negotiated OTC securities lending transactions . After a two year consultation with market participants, including traditional agent lenders and borrowers, as well as comprehensive simulation testing, Eurex Clearing is set to start in Germany and Switzerland with a technical launch in November this year offering clients the opportunity for intensive testing of the service and process flows. Pirum Systems will act as a flow provider for the transactions.
“Our model is the first to really incorporate the beneficial owner and agent lender relationship in a CCP service for securities lending,” says Gerard Denham, clearing business development executive at Eurex Clearing. “The agent lender can carry on in their current role as lending agent for the beneficial owner clients. The agent lender does not have to become a clearing member…and we are introducing a special lending license for beneficial owners that will allow them to remain principal in the securities lending transaction.”
This special lending license has important implications for one of the most contentious issues in the CCP securities lending models being developed – margin. Something beneficial owners are not accustomed to posting.
“We don’t think it is necessary from a risk perspective to charge the lending participant any margin on that transaction… in order for Eurex clearing to get comfortable with bringing in those participants and meeting their requests to not to pay margin, we have found a solution that enables the use of non-cash collateral at a triparty agent and construct the pledge basis for this transaction,” Denham says.
The two ICSDs – Clearstream and Euroclear – will be acting as triparty agents in the first phase of the rollout.
The clearing service will not incorporate cash reinvestment services, these services will continue to operate as they are now being carried out by market participants. Simply put, Eurex Clearing intends to complement the existing agent lender and broker dealer relationship by offering a clearing service as market participants show a growing interest in the likelihood that CCPs will be used to mitigate counterparty risks.
“We feel that we have got the product right from a consultation point of view, it is based on the requirements of the major market participants today and they have helped create that service in partnership with us,” Denham says.
“It will evolve over the course of next year with phased releases, also being able to incorporate processing of voluntary corporate actions.
“This is a key feature for a CCP service for securities lending because participants request that the loan is kept open particularly over corporate action events. Mandatory Corporate Action processing is available now and we will have the capability to include Voluntary Corporate Actions next year.”
Denham explains that the different corporate action types can be handled by a single approach whereby even complex combination of choices, for example, sale and exercise of rights due to entitlements or take-over offers, are covered without impacting existing market deadlines.
Over the course of next year, the phased roll-out will target other European markets including France, Belgium, Netherlands and the UK as well as the connection to the SecLend market of Eurex Repo
At first sight, a strong third quarter showing for German industrial production does not seem to fit with recession concerns, noted Commerzbank in a recent economic summary. But the strong rise is largely due to a special effect: In view of full order books, many companies – particularly in the automotive sector – cancelled their factory shutdowns, thereby boosting production on a seasonally adjusted basis very significantly. This is likely to be corrected in the fourth quarter, say Commerzbank economists, on top of fewer orders being taken both from within and outside of the eurozone countries.
“The poor order figures retrospectively confirm the decline in sentiment indicators, frustrating the hopes of those who believed that this was essentially caused by the turmoil in financial markets. The German economy has become accustomed to success, but its prospects have deteriorated considerably and it is expected to achieve at best low growth in the winter half-year.”
Commerzbank expects GDP to grow three per cent in 2011 and just 0.8 per cent in 2012 adding that Germany should just about manage to avoid a recession, unlike the rest of the eurozone.
Still, the forecast carries unusually high risks. Uncertainty has risen “massively” owing to the further deepening of the sovereign debt crisis. “This is poison not just for the financial markets but also for the economy...The increasingly fraught discussions about the default of a euro country and the massive consequences this could have for the real economy are bound to leave their mark on businesses and private households. The longer the uncertainty goes on, the stronger is the negative effect.”
In addition, as the eurozone slowly slips into a new recession, pressure is sure to mount on politicians across the currency union to maintain government spending. This makes promised reforms from Greece and Italy less likely to lessen the impact of any slowdown in economic growth, according to Robert Smith, manager of the German Growth Trust at Barings Asset Management, who reinforces the view that Germany may yet avoid a recession
He adds that at some point, Germany will have to accept that the UK and US quantitative easing solution to inflate away the debt problem may be the only way out. Meanwhile, the US recovery continues slowly and a soft landing in Asia as a consequence of falling inflation rates in China could be bringing some loosening in monetary policy in the region closer.
“Exporters to the wider world will continue to remain as one of the investments of choice for European equity investors looking for both inflation protection and growth opportunities, and the best representation of this type of company can be found within Germany,” Smith says. “Indeed, this in itself means any slowdown in Germany is likely to be much milder than elsewhere in the eurozone. With German employment at record levels, and consumer confidence holding firmly in positive territory, we believe that Europe’s largest economy may yet avoid a technical recession.”
How any given scenario plays out and how that might translate into an impact on German companies earnings or dividends remains to be seen.
According to Data Explorers, the value of German equities on loan is at $25.2 billion against a lendable supply of $202.2 billion, putting the LongShort ratio at 8.03. This is a sharp fall of some 25 per cent from its five year peak in mid-July this year, when longs outnumbered shorts by almost 11 times.
However, looking further back at pre-Lehman days, value of stock on loan trended at double today’s level while the value of lendable supply had collapsed post-Lehman and been recovering until April this year. Since then, the value of inventory has fallen back to levels seen in May 2010.
So far the equities markets have held up well and, in terms of securities lending, have maintained fairly even balances, notes Andreas Richter, local head of the agency securities lending team at Deutsche Bank in Frankfurt.
“The equities market from a lending point of view has been performing as it did before,” says Richter. “The biggest impact on lending returns we saw was really on the fixed income side and on collateral costs. There may be a consequence with respect to returns from equity lending transactions next year or the year after if, due to the eurozone crisis, earnings potential of German companies start to lower.”
In general, the securities lending market in Germany reflects much of what is going on in the rest of Europe, Richter notes. In the equity markets, the challenges stem from fears over a recession.
“People are looking even closer at the lending market, they are thinking very carefully for how and to whom they want to make securities available for lending. In Germany, investors tend to be more reserved and if anything the discussion on when and how to lend has become longer. ” he adds.
Meanwhile, from a fixed income point of view, the industry in Europe is struggling to adjust to a “two-tier model” for collateral, particularly as new regulations will push derivatives onto exchanges and through clearing houses, requiring high quality collateral.
It is all about realising demand for highly desired sovereign bonds from countries like Germany, Finland, the Netherlands and France, he notes.
Regulatory landscape
Though impacted by such far-reaching global regulations such as Basel III, at the same time, Richter is paying far closer attention to the impacts of a national regulation, the Investmentgesetz (InvG), which provides oversight for so-called KAG funds.
The German lending market can be divided into roughly two categories, the interbank lending and the KAG markets. The KAG market, with some €1.5 trillion in managed assets, is comprised of mutual funds and “Spezialfonds”, which have similar structures except that the latter is backed by a single investor. KAG funds are a unique feature of Germany and as such also an important part of the securities lending market.
Deutsche Bank operates one of the largest agency securities lending programmes with a particular expertise in non-custody lending. The programme interoperates with over 30 custodians worldwide in order to facilitate lending business for clients irrespective of the location of the assets and is able to combine agency with a principal lending structure for clients for both domestic or international markets.
Unlike the Austrian market, which is limited to lending out 30 per cent of any KAG fund portfolio, German law allows asset managers to lend out up to 100 per cent of any portfolio, but mandates a cap at 10 per cent per individual borrower. Austria by contrast can lend the entire portion to any single borrower. Guidelines for Spezialfonds technically have the ability to adjust the 10 per cent limit in Germany but this requires a change in fund guidelines and the uptake has been very limited , says Richter.
Within the InvG, which regulates the asset management activities for German funds, there are specific clauses which address securities lending activities. Recently the InvG was subject to some revisions and changes. “Rather than doing some major changes, there has only been a fine tuning, which will not really pay off for the beneficial owners of the funds from a revenue point of view,” he says, adding that regulators may have understandably been reluctant to amend the rules in the wake of the financial crisis.
As a case in point, due to Basel III compliance, term cash trades have become a hot item that come with an attractive premium. The InvG does not allow term transactions for KAG funds which in turn excludes funds from capturing this revenue opportunity offered by three, six or twelve months term trades.
“The rationale of the law is to ensure there is always liquidity for the funds but this issue could have been resolved by having the right of substitution,” says Richter.
Another example is limits on cash collateral reinvestment. In the wake of AIG as well as the freezing of parts of money markets during the financial crisis, regulators have been closely scrutinising the practice. Most recently, the Financial Stability Board announced that it will be taking a closer look at this particular component of the securities lending market and, in general, there is a global move away from “volume” style of securities lending – when firms extract revenue opportunities from the cash collateral reinvestment over the intrinsic value of the loan itself.
There is no doubt that scrutiny over this practice is warranted, but in Germany, the reverse repo market is largely off limits for reinvestments of KAG funds. Instead, clients can choose between blocked cash accounts earning only a meagre return in the current low interest rate environment and money market instruments in general which potentially offer less protection as they are not collateralised as reverse repo transactions.
“Choosing a reverse repo or triparty repo instead, the transaction is collateralised, is marked-to-market on a daily basis, so the counterpart risk can be considerably lower than other money market instruments.” he says.
Meanwhile, there are new developments on the horizon which are also part of a European trend - the introduction of CCPs to the market. Richter notes that for his own clients there is little to no demand for cleared trades since it would add another layer of cost with little additional security. From the point of view of a new market offering and player, however, he says it remains to be seen what the product will look like and whether it will attract clients but that the competition is welcomed.
CCP – no margin?
Among other offerings in Europe and the US, Eurex Clearing is developing a service to cover bilaterally negotiated OTC securities lending transactions . After a two year consultation with market participants, including traditional agent lenders and borrowers, as well as comprehensive simulation testing, Eurex Clearing is set to start in Germany and Switzerland with a technical launch in November this year offering clients the opportunity for intensive testing of the service and process flows. Pirum Systems will act as a flow provider for the transactions.
“Our model is the first to really incorporate the beneficial owner and agent lender relationship in a CCP service for securities lending,” says Gerard Denham, clearing business development executive at Eurex Clearing. “The agent lender can carry on in their current role as lending agent for the beneficial owner clients. The agent lender does not have to become a clearing member…and we are introducing a special lending license for beneficial owners that will allow them to remain principal in the securities lending transaction.”
This special lending license has important implications for one of the most contentious issues in the CCP securities lending models being developed – margin. Something beneficial owners are not accustomed to posting.
“We don’t think it is necessary from a risk perspective to charge the lending participant any margin on that transaction… in order for Eurex clearing to get comfortable with bringing in those participants and meeting their requests to not to pay margin, we have found a solution that enables the use of non-cash collateral at a triparty agent and construct the pledge basis for this transaction,” Denham says.
The two ICSDs – Clearstream and Euroclear – will be acting as triparty agents in the first phase of the rollout.
The clearing service will not incorporate cash reinvestment services, these services will continue to operate as they are now being carried out by market participants. Simply put, Eurex Clearing intends to complement the existing agent lender and broker dealer relationship by offering a clearing service as market participants show a growing interest in the likelihood that CCPs will be used to mitigate counterparty risks.
“We feel that we have got the product right from a consultation point of view, it is based on the requirements of the major market participants today and they have helped create that service in partnership with us,” Denham says.
“It will evolve over the course of next year with phased releases, also being able to incorporate processing of voluntary corporate actions.
“This is a key feature for a CCP service for securities lending because participants request that the loan is kept open particularly over corporate action events. Mandatory Corporate Action processing is available now and we will have the capability to include Voluntary Corporate Actions next year.”
Denham explains that the different corporate action types can be handled by a single approach whereby even complex combination of choices, for example, sale and exercise of rights due to entitlements or take-over offers, are covered without impacting existing market deadlines.
Over the course of next year, the phased roll-out will target other European markets including France, Belgium, Netherlands and the UK as well as the connection to the SecLend market of Eurex Repo
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