UK
06 December 2011
It’s going to be a long slog to recover from the financial crisis, which means the attitudes of many are changing
Image: Shutterstock
The UK is facing the longest recovery since the end of the First World War. Domestic demand is expected to shrink throughout 2012 and the labour market remains slack.
A large part of the slowdown is due to weak domestic demand, which in turn is a result of developments in international financial markets, writes the National Institute of Economic and Social Research (NIESR) in a recent economic review.
As of October, UK equity prices have fallen by over 10 per cent in July, with bank stocks in particular down some 20 per cent. Meanwhile, the spread of corporate bonds over 10-year gilts in the UK has widened significantly over the past few months to levels last seen in 2009.
Meanwhile, the recent Autumn Statement from Chancellor of the Exchequer, George Osborne, resulted in the think tank revising economic growth forecasts downwards.
NIESR now expects the UK to experience a short recession followed by growth in the second half of 2012 and forecasts GDP growth at 0.1 per cent for the year, and growth in 2013 at 2.2 per cent.
“The Chancellor can do little to resolve the eurozone crisis. It remains our view that in the short term fiscal policy is too tight, and a temporary loosening would improve prospects for output and employment with little or no negative effect on fiscal credibility,” it wrote in a statement.
The forecasts are affected by an assumption that European leadership will continue to struggle through current difficulties as opposed to taking decisive action. The Office for Budget Responsibility (OBR) too revised its outlook for the economy and public finances under this scenario. However, there is some upside risk to these forecasts should decisive action among European leadership materialise.
Simon Kirby, senior researcher at NIESR, does note some welcome initiatives announced in the UK’s Autumn Statement targeting youth unemployment as well as credit easing for small and medium sized enterprises, but points out that there are not enough details at the moment with which to evaluate what impact these initiatives might have on the UK economy.
At the time of writing, markets were rallying across the board to recently announced coordinated action among five central banks – Bank of Canada, Bank of England, Bank of Japan, European Central Bank (ECB) and Swiss National Bank - to ease USD tightness by making it cheaper for the ECB to lend USD into European banks. The move is seen as beneficial for eurozone banks, those with junk credits and with liabilities in USD and earnings stream in another currency.
But economists have pointed out that this action is no panacea for the eurozone crisis.
“The fundamental point is that the biggest boost to the UK economy at the moment would be a resolution of the euro area crisis,” Kirby says.
Economic fallout
John Arnesen, head of agency lending product at BNP Paribas Securities Services, agrees that the outlook is somewhat bleak both for the pan-European and UK economy, affecting the level to which clients are interested in value-added products such as securities lending. It is a bit of a paradox he notes, since asset managers are fixated on risk and securities lending is coming under that scrutiny, while at the same time, those that engage in lending incorporated as part of their risk strategy produce additional incremental returns.
However, the European situation is presenting an opportunity as well, because government debt in Europe is no longer created equal, a trend noted in many parts of the continent. The resulting collateral upgrade trade presents a compelling revenue generating opportunity.
“Germany has become the defacto benchmark for the pan-European market place and when you step outside of those handful of triple-A rated countries into the other European members of the union, the spreads are enormous…taking those securities as collateral [presents] a large opportunity to generate revenue…particularly because of the shift for investment banks which will need to manage their capital requirements more closely…fixed income markets are not being driven by shorts, but by the wholesale need for highly liquid triple-A rated government securities that you can fund on an overnight basis,” Arnesen says.
BNP Paribas has both an agency and principal securities lending capability and, as a major global custodian, provides services for the world’s most authorative clients, including central banks, sovereign wealth funds, pension funds and asset managers. He notes that the business is becoming more about collateral management, automation and speed of execution while IT staff and the solutions they develop are increasingly gaining prominence as part of the industry.
In terms of equities, he notes that the UK market never really disappoints as it has an abundant supply and relatively predictable demand drivers. The overall spread from UK equities is increasing, but utilisation is quite low and it remains a mostly non-special market.
UK equities out on loan are at some $30 billion against a lendable supply of around $550 billion - putting the LongShort ratio at just over 21, meaning there are over 20 times more longs than shorts, according to Data Explorers’ research.
However, as asset managers’ attentions shift to Asia, so too does the securities lending industry, particularly in light of the additional returns on equities from such countries as Korea, Taiwan and Hong Kong. As an example, if UK equities are making somewhere in the neighbourhood of 35 basis points annualised return, Taiwanese equities are in the hundreds of basis points. Even given that there are regulatory hurdles unique to each location, this level of return is compelling.
“The UK is a great market to be in, there is lots of supply here, particularly where the supply is not necessarily UK-based…the UK is a massive buying centre in general... [there are] very large pension funds based here but also a multinational approach, so the assets may not be UK but the domicile of the fund is here. That has always been an extremely important revenue stream of any agent lender,” Arnesen says.
Still, with 2012 largely predicted to be a lost year for investment on the back of pan-European economic woes and an anticipated slowdown in global growth, the industry might take a hit, especially in light of numerous regulations that are coming down the pipeline which may increase costs of doing business.
“At the end of the day, if [regulation] moves the market in a different direction slightly or if we have more expense to deal with compliance, that has to get paid for somehow, now whether that is covered by the institutions or whether that causes some pricing changes, it is either going to get passed on or absorbed somehow,” Arnesen says, adding that short selling bans have been proven to be misguided by both academic research and regulator remorse after the fact.
The risks, he adds, are that the returns become more subdued and that there is too much supply chasing continued dampened demand, especially if an agent lender’s business model has not embraced the full use of technology to keep costs down. At the moment, market pressures have led to disproportionate fee splits in a bid to win business at any cost, a kind of race to the bottom, which Arnesen points out is an industry heading in the wrong direction.
“I don’t believe that securities lending should have ever been anything more than a low risk, low utilisation addition in terms of a handful of basis points of return to a portfolio …the minute it becomes something else, we should call it something else and that should be with the full understanding of the client involved or the beneficial owner as well,” Arnesen says.
Beneficial owner POV
Joyce Martindale wears several hats - she works for RPMI Railpen, which looks after the £18 billion UK Industry wide Railways Pension Scheme, is a member of the National Association of Pension Funds (NAPF) Investment Council and also represents NAPF on the Bank of England’s Securities Lending and Repo Committee (SLRC). She reinforces the view that though investments which can deliver extra returns or offset fees are welcome and recognised, beneficial owners in the UK are hesitant to interfere with investment portfolios.
“Securities lending is an activity that shouldn’t impact on the main purpose of the portfolio, which is to generate income or to generate return, and you will have selected a particular portfolio with particular assets because it meets your investment criteria...As soon as a securities lending activity impacts on that, then that is not good news,” Martindale says.
Attitudes towards wider European trends, which favour term trades are a case in point. With an active investment manager, booking term trades may interfere with overall strategy depending on how active in voting a pension fund may be. Meanwhile, other options, such as accepting equities as collateral are heavily dependent on the beneficial owner’s risk profile.
Though RPMI Railpen has accepted UK equities as collateral to a limited extent in the past, Martindale lined up collateral and loan currencies to mitigate risk. Other collateral risk mitigation strategies are to take equities in the same market or a basket of equities.
It is much the same issue with the introduction of CCPs into the securities lending market, which she is watching with “some trepidation”. Even if a CCP provides for a bilateral offering without expecting the lender to post collateral, if there is a lien or claim on the assets resulting in a disruption to the primary purpose of an investment portfolio, it is sure to make beneficial owners think twice about the value proposition, Martindale notes.
Still, the main barrier to entry is a lack of education about the securities lending industry and, to some degree, a mismatched conversation between lenders and borrowers. As part of her work on the BoE SLRC, Martindale served on the Education sub-committee, which produced an introductory guide and question checklist for lenders as well as information about the kinds of disclosures agent lenders should be providing.
What some securities lending industry practitioners don’t understand, she explains, is that just because consumers don’t know how to rebuild a car engine does not mean they can’t pick out a suitable car.
In summarising some of the advice contained within the BoE SLRC document, Martindale says, “Make sure you know what you are getting into, make sure you understand your risk versus reward criteria very carefully, understand what you want to do in terms of voting, what kind of collateral you are happy to accept and communicate clearly about [those things].”
A large part of the slowdown is due to weak domestic demand, which in turn is a result of developments in international financial markets, writes the National Institute of Economic and Social Research (NIESR) in a recent economic review.
As of October, UK equity prices have fallen by over 10 per cent in July, with bank stocks in particular down some 20 per cent. Meanwhile, the spread of corporate bonds over 10-year gilts in the UK has widened significantly over the past few months to levels last seen in 2009.
Meanwhile, the recent Autumn Statement from Chancellor of the Exchequer, George Osborne, resulted in the think tank revising economic growth forecasts downwards.
NIESR now expects the UK to experience a short recession followed by growth in the second half of 2012 and forecasts GDP growth at 0.1 per cent for the year, and growth in 2013 at 2.2 per cent.
“The Chancellor can do little to resolve the eurozone crisis. It remains our view that in the short term fiscal policy is too tight, and a temporary loosening would improve prospects for output and employment with little or no negative effect on fiscal credibility,” it wrote in a statement.
The forecasts are affected by an assumption that European leadership will continue to struggle through current difficulties as opposed to taking decisive action. The Office for Budget Responsibility (OBR) too revised its outlook for the economy and public finances under this scenario. However, there is some upside risk to these forecasts should decisive action among European leadership materialise.
Simon Kirby, senior researcher at NIESR, does note some welcome initiatives announced in the UK’s Autumn Statement targeting youth unemployment as well as credit easing for small and medium sized enterprises, but points out that there are not enough details at the moment with which to evaluate what impact these initiatives might have on the UK economy.
At the time of writing, markets were rallying across the board to recently announced coordinated action among five central banks – Bank of Canada, Bank of England, Bank of Japan, European Central Bank (ECB) and Swiss National Bank - to ease USD tightness by making it cheaper for the ECB to lend USD into European banks. The move is seen as beneficial for eurozone banks, those with junk credits and with liabilities in USD and earnings stream in another currency.
But economists have pointed out that this action is no panacea for the eurozone crisis.
“The fundamental point is that the biggest boost to the UK economy at the moment would be a resolution of the euro area crisis,” Kirby says.
Economic fallout
John Arnesen, head of agency lending product at BNP Paribas Securities Services, agrees that the outlook is somewhat bleak both for the pan-European and UK economy, affecting the level to which clients are interested in value-added products such as securities lending. It is a bit of a paradox he notes, since asset managers are fixated on risk and securities lending is coming under that scrutiny, while at the same time, those that engage in lending incorporated as part of their risk strategy produce additional incremental returns.
However, the European situation is presenting an opportunity as well, because government debt in Europe is no longer created equal, a trend noted in many parts of the continent. The resulting collateral upgrade trade presents a compelling revenue generating opportunity.
“Germany has become the defacto benchmark for the pan-European market place and when you step outside of those handful of triple-A rated countries into the other European members of the union, the spreads are enormous…taking those securities as collateral [presents] a large opportunity to generate revenue…particularly because of the shift for investment banks which will need to manage their capital requirements more closely…fixed income markets are not being driven by shorts, but by the wholesale need for highly liquid triple-A rated government securities that you can fund on an overnight basis,” Arnesen says.
BNP Paribas has both an agency and principal securities lending capability and, as a major global custodian, provides services for the world’s most authorative clients, including central banks, sovereign wealth funds, pension funds and asset managers. He notes that the business is becoming more about collateral management, automation and speed of execution while IT staff and the solutions they develop are increasingly gaining prominence as part of the industry.
In terms of equities, he notes that the UK market never really disappoints as it has an abundant supply and relatively predictable demand drivers. The overall spread from UK equities is increasing, but utilisation is quite low and it remains a mostly non-special market.
UK equities out on loan are at some $30 billion against a lendable supply of around $550 billion - putting the LongShort ratio at just over 21, meaning there are over 20 times more longs than shorts, according to Data Explorers’ research.
However, as asset managers’ attentions shift to Asia, so too does the securities lending industry, particularly in light of the additional returns on equities from such countries as Korea, Taiwan and Hong Kong. As an example, if UK equities are making somewhere in the neighbourhood of 35 basis points annualised return, Taiwanese equities are in the hundreds of basis points. Even given that there are regulatory hurdles unique to each location, this level of return is compelling.
“The UK is a great market to be in, there is lots of supply here, particularly where the supply is not necessarily UK-based…the UK is a massive buying centre in general... [there are] very large pension funds based here but also a multinational approach, so the assets may not be UK but the domicile of the fund is here. That has always been an extremely important revenue stream of any agent lender,” Arnesen says.
Still, with 2012 largely predicted to be a lost year for investment on the back of pan-European economic woes and an anticipated slowdown in global growth, the industry might take a hit, especially in light of numerous regulations that are coming down the pipeline which may increase costs of doing business.
“At the end of the day, if [regulation] moves the market in a different direction slightly or if we have more expense to deal with compliance, that has to get paid for somehow, now whether that is covered by the institutions or whether that causes some pricing changes, it is either going to get passed on or absorbed somehow,” Arnesen says, adding that short selling bans have been proven to be misguided by both academic research and regulator remorse after the fact.
The risks, he adds, are that the returns become more subdued and that there is too much supply chasing continued dampened demand, especially if an agent lender’s business model has not embraced the full use of technology to keep costs down. At the moment, market pressures have led to disproportionate fee splits in a bid to win business at any cost, a kind of race to the bottom, which Arnesen points out is an industry heading in the wrong direction.
“I don’t believe that securities lending should have ever been anything more than a low risk, low utilisation addition in terms of a handful of basis points of return to a portfolio …the minute it becomes something else, we should call it something else and that should be with the full understanding of the client involved or the beneficial owner as well,” Arnesen says.
Beneficial owner POV
Joyce Martindale wears several hats - she works for RPMI Railpen, which looks after the £18 billion UK Industry wide Railways Pension Scheme, is a member of the National Association of Pension Funds (NAPF) Investment Council and also represents NAPF on the Bank of England’s Securities Lending and Repo Committee (SLRC). She reinforces the view that though investments which can deliver extra returns or offset fees are welcome and recognised, beneficial owners in the UK are hesitant to interfere with investment portfolios.
“Securities lending is an activity that shouldn’t impact on the main purpose of the portfolio, which is to generate income or to generate return, and you will have selected a particular portfolio with particular assets because it meets your investment criteria...As soon as a securities lending activity impacts on that, then that is not good news,” Martindale says.
Attitudes towards wider European trends, which favour term trades are a case in point. With an active investment manager, booking term trades may interfere with overall strategy depending on how active in voting a pension fund may be. Meanwhile, other options, such as accepting equities as collateral are heavily dependent on the beneficial owner’s risk profile.
Though RPMI Railpen has accepted UK equities as collateral to a limited extent in the past, Martindale lined up collateral and loan currencies to mitigate risk. Other collateral risk mitigation strategies are to take equities in the same market or a basket of equities.
It is much the same issue with the introduction of CCPs into the securities lending market, which she is watching with “some trepidation”. Even if a CCP provides for a bilateral offering without expecting the lender to post collateral, if there is a lien or claim on the assets resulting in a disruption to the primary purpose of an investment portfolio, it is sure to make beneficial owners think twice about the value proposition, Martindale notes.
Still, the main barrier to entry is a lack of education about the securities lending industry and, to some degree, a mismatched conversation between lenders and borrowers. As part of her work on the BoE SLRC, Martindale served on the Education sub-committee, which produced an introductory guide and question checklist for lenders as well as information about the kinds of disclosures agent lenders should be providing.
What some securities lending industry practitioners don’t understand, she explains, is that just because consumers don’t know how to rebuild a car engine does not mean they can’t pick out a suitable car.
In summarising some of the advice contained within the BoE SLRC document, Martindale says, “Make sure you know what you are getting into, make sure you understand your risk versus reward criteria very carefully, understand what you want to do in terms of voting, what kind of collateral you are happy to accept and communicate clearly about [those things].”
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