Luxembourg
10 January 2012
Despite the economic clouds hanging over Europe, Luxembourg
is well prepared to grow its securities lending industry
Image: Shutterstock
Despite a deteriorating eurozone outlook eating away at Luxembourg’s financial services industry, bright spots are on the horizon.
As the second-largest investment fund centre in the world and the largest in Europe, Luxembourg’s financial sector continues to adopt European Union regulation early, which is helping to draw in hedge funds, particularly those adapted to operate within the UCITS framework. By mid-2011, over 3,700 hedge funds were registered, a total exceeded only by the UK and France.
The size of Luxembourg’s UCITS sector is now a major attraction for hedge funds moving into Europe to earn credentials for eventual distribution beyond the EU while the country’s low public debt and relatively stable economy present advantages in attracting investment fund flows albeit with fierce competition from Ireland, the Channel Islands and even Malta.
Its success as a financial centre, says agency Luxembourg for Finance, is grounded in the social and political stability of the Grand Duchy and in a modern legal and regulatory framework that is continuously updated, allowing it to offer a wide variety of investment fund vehicles. It is also at the top of the World Economic Forum’s global competitiveness index for the prevalence of foreign ownership of companies.
But an impending recession in Europe, and resulting slowdown in demand from the eurozone will dampen exports, with financial services, which accounts for some 28 per cent of GDP according to some estimates, suffering most.
And the outlook for GDP growth over the next year has weakened further, notes Ernst & Young in its most recent economic report on the country. The firm has heavily revised its forecasts for growth – to 1.9 per cent compared with 3.5 per cent in an earlier report. For 2012, it predicts 0.9 per cent growth, revised down from 1.7 per cent.
The revisions take into account that the economy took a much larger hit from the global crisis than previously calculated while the greater than expected intensity of the eurozone crisis too is affecting future growth prospects.
That has certainly spurred officials, such as the finance minister, trade minister and Grand Duke, to market Luxembourg as Europe’s financial centre to high-growth regions such as China and South East Asia. Relocation of offshore funds and gradual recovery of eurozone financial markets will undoubtedly support financial sector growth but sustaining net inflows in the longer term will require tapping into rising savings flows from East Asian and Middle Eastern emerging markets, notes Ernst & Young.
A more near-term bright spot is the push to derivatives clearing. Alternative investment funds that will now need centralised derivatives trading may be encouraged to relocate to Luxembourg because of its early moves towards an ECB-linked securities repository. In October, Clearstream announced that its joint venture, LuxCSD, with Luxembourg’s central bank became fully operational and will serve as the access point to TARGET2-Securities (T2S).
LuxCSD provides the Luxembourg financial community with central bank money settlement prices as well as issuance and custody services for a wide range of securities, including investment funds.
In the securities lending space, the company has two programmes: ASL supports settlement and is an agency lending programme in which Clearstream acts as guarantor to anonymous trades and ASL+ offers strategic lending to custody clients to earn additional revenue with Clearstream acting as a principal lender.
Currently, only fixed income is available for securities lending activities in Luxembourg until next month, when Clearstream will add equities to the programmes.
Borrowers are the large investment banks in Europe and the US and prime brokers and lenders are Clearstream’s custody clients such as central banks, corporates and custodian banks. Often depository banks will choose Clearstream’s services as opposed to developing their own securities lending business or going to other competitors.
Jean-Robert Wilkin, head of product management for Global Securities Financing at Clearstream, oversees the securities lending business in the ICSD in Luxembourg and CSD in Germany as well as collateral management services across the operations.
“As an ICSD, we are in a very specific and privileged position because we are both acting as a lending agent for the lender, but also as collateral agent for the lender and the borrower out of our triparty programme. So we run a very conservative programme which makes it more secure for ourselves and the lenders,” Wilkin says.
He notes that most securities lending activity for the large pool of assets domiciled in Luxembourg is not generally done in the country, instead traded across major lending desks in London, Paris or Frankfurt. Their own programme, ASL+, is operated out of a trading desk in London.
GSF Summit
In the run-up to the Global Securities Financing Summit, Wilkin expects collateral management to continue to be the hot topic as lenders are increasingly concerned about counterparty risk. Luxembourg’s regulator, the Commission de Surveillance du Secteur Financier (CSSF), has done well to make legislation on liquidation of collateral and protection of the lenders transparent, he says, adding that though many European countries fall under the same EU directives, not all countries have adopted national legislation with the same clarity equally.
Luxembourg’s most recent legislation on securities lending, Circular 08-356, also leaves the field open for a wide variety of collateral to be posted to secure transactions and, while eligible collateral in the form of AAA government debt continues to diminish, diversification is likely a coming trend for the securities lending space, says Wilkin.
“We are definitely headed towards more diversification now that the funds which are typically beneficial owners are more cautious about investing in government bonds. They are diversifying their portfolio and entering into equities and corporate debt and therefore the move in collateral management follows on from that. As they diversify their investment portfolio, they are also progressively diversifying their collateral portfolio. We already see unsecured cash lending in repo markets disappearing and at some point there will not be enough high quality sovereign debt to go around, so I think we will see this continue into securities lending,” Wilkin says.
This is also evidenced by the increasing demand from lenders for independent collateral management services. The days when lenders gave mandates to a single custodian or agent to be a one-stop shop are coming to end, he adds.
“In the past, someone gave a mandate to a custodian and they were the global custodian, the settlement agent, did the lending, collateralisation, they did it all and lenders just wanted the cheque at the end of the month, that is over, now lenders are cautious and segregate functions and responsibilities to protect themselves,” Wilkin says.
One of the custodians that does operate a desk within Luxembourg is CACEIS, the asset servicing banking group of Crédit Agricole. The bank provides depositary and custodial services, fund administration, middle office services, fund distribution support and issuer services to its institutional and corporate clients.
As a custodian lender, it is a multi-market player focusing on clients in Luxembourg, France and Germany across asset classes such as government or corporate bonds, convertible bonds, equities and exchange-traded funds (ETFs).
Its Luxembourg-based desk operates for any clients throughout the network, a large portion of which are UCITS funds, and its operational set-up concentrates flow as much as possible through the central location.
Leading into the GSF Summit, Guy Knepper, head of securities lending at CACEIS, points to collateral management as an area where he would like to see more information – particularly on the diversification end.
“There is not enough transparency around what the applied collateral metrics in Luxembourg are…the relevant statistics are missing. Since the legislation leaves room for a broad scope of collateral, like shares, equities, corporate bonds for example, it would be very interesting to see how many investment funds have opted for larger metrics moving away from government bonds or cash. There are a lot of grey areas in this respect,” Knepper says.
Luxembourg desk
Luxembourg’s relevant regulation, Circular 08-356, prescribes the conditions by which funds may enter into securities lending transactions. When it was overhauled in 2008, the regulator ended a 30-day limitation for securities lending transactions which put technical burdens on the back office, which is still the case in neighbouring Germany. In addition, Germany also maintained a 10 per cent maximum exposure per counterparty, whereas the Luxembourg regulator mandates that exposure should be kept at a reasonable level, which Knepper interprets as having the ability to reimburse all shareholders when necessary.
One notable peculiarity of Luxembourg’s regulation involves the level of collateralisation required to protect securities lending transactions. The minimum is set at 90 per cent of the global valuation of the securities lent (interests, dividends and other eventual rights included) during the lifetime of the lending agreement. Knepper points out that CACEIS collateralises at 105 per cent, and other market observers note that they are unaware of any agents that take advantage of this regulation, particularly in an environment where lenders are carefully scrutinising counterparty risk.
The Luxembourg securities lending market is driven by international scope while the domestic market is very small, with just three major companies with significant international exposure – steel giant Arcelor Mittal and its spin-off Aperam and satellite operator SES. But the total market valuation of these companies is just some €35 billion.
But it is not so much in equities, rather the physically-backed ETF business that Knepper is seeing the most growth and he notes that ETFs are becoming more widely accepted in the securities lending market, particularly for directional trades.
As of August 2011, French-domiciled investment funds cannot lend ETFs as part of an overall ban on major financial stocks. This is not likely to be repeated in Luxembourg, however, Knepper says.
“As with all investment funds under new rulings such as UCITS IV where you have short prospectuses, the most sensible way to approach the ETF issue, from my perspective, is to also have the same rules for them, so this would seem to be the logical next step for ETFs,” added Knepper.
He does, however, express the belief that there may not be enough transparency around the products, but with markets shaken investors are likely going to be taking a much closer look at the risks of what they are buying than they previously have.
As the second-largest investment fund centre in the world and the largest in Europe, Luxembourg’s financial sector continues to adopt European Union regulation early, which is helping to draw in hedge funds, particularly those adapted to operate within the UCITS framework. By mid-2011, over 3,700 hedge funds were registered, a total exceeded only by the UK and France.
The size of Luxembourg’s UCITS sector is now a major attraction for hedge funds moving into Europe to earn credentials for eventual distribution beyond the EU while the country’s low public debt and relatively stable economy present advantages in attracting investment fund flows albeit with fierce competition from Ireland, the Channel Islands and even Malta.
Its success as a financial centre, says agency Luxembourg for Finance, is grounded in the social and political stability of the Grand Duchy and in a modern legal and regulatory framework that is continuously updated, allowing it to offer a wide variety of investment fund vehicles. It is also at the top of the World Economic Forum’s global competitiveness index for the prevalence of foreign ownership of companies.
But an impending recession in Europe, and resulting slowdown in demand from the eurozone will dampen exports, with financial services, which accounts for some 28 per cent of GDP according to some estimates, suffering most.
And the outlook for GDP growth over the next year has weakened further, notes Ernst & Young in its most recent economic report on the country. The firm has heavily revised its forecasts for growth – to 1.9 per cent compared with 3.5 per cent in an earlier report. For 2012, it predicts 0.9 per cent growth, revised down from 1.7 per cent.
The revisions take into account that the economy took a much larger hit from the global crisis than previously calculated while the greater than expected intensity of the eurozone crisis too is affecting future growth prospects.
That has certainly spurred officials, such as the finance minister, trade minister and Grand Duke, to market Luxembourg as Europe’s financial centre to high-growth regions such as China and South East Asia. Relocation of offshore funds and gradual recovery of eurozone financial markets will undoubtedly support financial sector growth but sustaining net inflows in the longer term will require tapping into rising savings flows from East Asian and Middle Eastern emerging markets, notes Ernst & Young.
A more near-term bright spot is the push to derivatives clearing. Alternative investment funds that will now need centralised derivatives trading may be encouraged to relocate to Luxembourg because of its early moves towards an ECB-linked securities repository. In October, Clearstream announced that its joint venture, LuxCSD, with Luxembourg’s central bank became fully operational and will serve as the access point to TARGET2-Securities (T2S).
LuxCSD provides the Luxembourg financial community with central bank money settlement prices as well as issuance and custody services for a wide range of securities, including investment funds.
In the securities lending space, the company has two programmes: ASL supports settlement and is an agency lending programme in which Clearstream acts as guarantor to anonymous trades and ASL+ offers strategic lending to custody clients to earn additional revenue with Clearstream acting as a principal lender.
Currently, only fixed income is available for securities lending activities in Luxembourg until next month, when Clearstream will add equities to the programmes.
Borrowers are the large investment banks in Europe and the US and prime brokers and lenders are Clearstream’s custody clients such as central banks, corporates and custodian banks. Often depository banks will choose Clearstream’s services as opposed to developing their own securities lending business or going to other competitors.
Jean-Robert Wilkin, head of product management for Global Securities Financing at Clearstream, oversees the securities lending business in the ICSD in Luxembourg and CSD in Germany as well as collateral management services across the operations.
“As an ICSD, we are in a very specific and privileged position because we are both acting as a lending agent for the lender, but also as collateral agent for the lender and the borrower out of our triparty programme. So we run a very conservative programme which makes it more secure for ourselves and the lenders,” Wilkin says.
He notes that most securities lending activity for the large pool of assets domiciled in Luxembourg is not generally done in the country, instead traded across major lending desks in London, Paris or Frankfurt. Their own programme, ASL+, is operated out of a trading desk in London.
GSF Summit
In the run-up to the Global Securities Financing Summit, Wilkin expects collateral management to continue to be the hot topic as lenders are increasingly concerned about counterparty risk. Luxembourg’s regulator, the Commission de Surveillance du Secteur Financier (CSSF), has done well to make legislation on liquidation of collateral and protection of the lenders transparent, he says, adding that though many European countries fall under the same EU directives, not all countries have adopted national legislation with the same clarity equally.
Luxembourg’s most recent legislation on securities lending, Circular 08-356, also leaves the field open for a wide variety of collateral to be posted to secure transactions and, while eligible collateral in the form of AAA government debt continues to diminish, diversification is likely a coming trend for the securities lending space, says Wilkin.
“We are definitely headed towards more diversification now that the funds which are typically beneficial owners are more cautious about investing in government bonds. They are diversifying their portfolio and entering into equities and corporate debt and therefore the move in collateral management follows on from that. As they diversify their investment portfolio, they are also progressively diversifying their collateral portfolio. We already see unsecured cash lending in repo markets disappearing and at some point there will not be enough high quality sovereign debt to go around, so I think we will see this continue into securities lending,” Wilkin says.
This is also evidenced by the increasing demand from lenders for independent collateral management services. The days when lenders gave mandates to a single custodian or agent to be a one-stop shop are coming to end, he adds.
“In the past, someone gave a mandate to a custodian and they were the global custodian, the settlement agent, did the lending, collateralisation, they did it all and lenders just wanted the cheque at the end of the month, that is over, now lenders are cautious and segregate functions and responsibilities to protect themselves,” Wilkin says.
One of the custodians that does operate a desk within Luxembourg is CACEIS, the asset servicing banking group of Crédit Agricole. The bank provides depositary and custodial services, fund administration, middle office services, fund distribution support and issuer services to its institutional and corporate clients.
As a custodian lender, it is a multi-market player focusing on clients in Luxembourg, France and Germany across asset classes such as government or corporate bonds, convertible bonds, equities and exchange-traded funds (ETFs).
Its Luxembourg-based desk operates for any clients throughout the network, a large portion of which are UCITS funds, and its operational set-up concentrates flow as much as possible through the central location.
Leading into the GSF Summit, Guy Knepper, head of securities lending at CACEIS, points to collateral management as an area where he would like to see more information – particularly on the diversification end.
“There is not enough transparency around what the applied collateral metrics in Luxembourg are…the relevant statistics are missing. Since the legislation leaves room for a broad scope of collateral, like shares, equities, corporate bonds for example, it would be very interesting to see how many investment funds have opted for larger metrics moving away from government bonds or cash. There are a lot of grey areas in this respect,” Knepper says.
Luxembourg desk
Luxembourg’s relevant regulation, Circular 08-356, prescribes the conditions by which funds may enter into securities lending transactions. When it was overhauled in 2008, the regulator ended a 30-day limitation for securities lending transactions which put technical burdens on the back office, which is still the case in neighbouring Germany. In addition, Germany also maintained a 10 per cent maximum exposure per counterparty, whereas the Luxembourg regulator mandates that exposure should be kept at a reasonable level, which Knepper interprets as having the ability to reimburse all shareholders when necessary.
One notable peculiarity of Luxembourg’s regulation involves the level of collateralisation required to protect securities lending transactions. The minimum is set at 90 per cent of the global valuation of the securities lent (interests, dividends and other eventual rights included) during the lifetime of the lending agreement. Knepper points out that CACEIS collateralises at 105 per cent, and other market observers note that they are unaware of any agents that take advantage of this regulation, particularly in an environment where lenders are carefully scrutinising counterparty risk.
The Luxembourg securities lending market is driven by international scope while the domestic market is very small, with just three major companies with significant international exposure – steel giant Arcelor Mittal and its spin-off Aperam and satellite operator SES. But the total market valuation of these companies is just some €35 billion.
But it is not so much in equities, rather the physically-backed ETF business that Knepper is seeing the most growth and he notes that ETFs are becoming more widely accepted in the securities lending market, particularly for directional trades.
As of August 2011, French-domiciled investment funds cannot lend ETFs as part of an overall ban on major financial stocks. This is not likely to be repeated in Luxembourg, however, Knepper says.
“As with all investment funds under new rulings such as UCITS IV where you have short prospectuses, the most sensible way to approach the ETF issue, from my perspective, is to also have the same rules for them, so this would seem to be the logical next step for ETFs,” added Knepper.
He does, however, express the belief that there may not be enough transparency around the products, but with markets shaken investors are likely going to be taking a much closer look at the risks of what they are buying than they previously have.
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