Canada
17 April 2012
Canada may never match up to other regions in terms of volume, but the country’s inherent stability will pay off in the long run
Image: Shutterstock
The securities lending market in Canada has been active for nearly three decades, weathering various banking crises, dysfunction from their US neigbour, and an increased focus by both the media and regulators on what used to be a more opaque industry. Throughout the turmoil, what its own citizens deem as characteristic conservatism seems to be a positive, in light of severe downgrading measures other countries are being forced to take.
Canadian High Commissioner to the UK Gordon Cambell describes Canada as having: “generous R&D tax incentives, first rate technology and innovation, a highly skilled workforce, investor protection and a lack of red tape. The OECD and the IMF predict that our economy will continue to be a leader in the industrialised world over the next two years.”
Compared to its American neighbor, however, Canada cannot compete on size. Research from Data Explorers finds that there is USD65 billion of Canadian equities on loan out of a lendable supply of USD418 billion, meaning that longs outnumber shorts by over six times; the LongShort Ratio is 6.42.
By way of comparison, US equities see USD301 billion out on loan against a lending pool of USD3.85 trillion. This gives a LongShort ratio of 12.76.
Yet in terms of financial services, Canada has grown and diversified significantly, generating sales of more than USD82.4 billion in 2010, and with four of the country’s cities in the top 30 of the Global Financial Centres Index, it appears that the oft-described ‘boring’ country wields quiet but considerable power in the market.
Toronto offers a breadth of financial services activity that makes it the third largest financial services centre in North America, whilst Vancouver is Canada’s Pacific gateway, offering unique access to trade financing in the fast growing Asia Pacific markets. Calgary is a global hub for energy and commodity financing, whereas Montreal has strong expertise in pension management, and leads in developing software for the financial services sector.
One step forward, one step back
On 19 September 2008, the US SEC elected to halt short selling in almost 800 financial sector companies in an attempt to stabilise the financial markets. The Ontario Securities Commission (OSC) followed suit by banning short selling in 13 inter-listed TSX-traded equities to prevent regulatory arbitrage. These bans expired on 9 October 2008. Although the SEC applied the ban to “restore equilibrium to the market,” many industry analysts agree that the restrictions on short selling had a negative effect on the marketplace, rather than a positive one as intended.
From a Canadian standpoint, the IIROC released an analysis on 6 October 2008 outlining evidence of further unexpected consequences resulting from the bans. Among other things, surveillance data showed that the bans brought “no appreciable impact on the price of [these] securities” and a “significant increase” in volatility of restricted shares.
However, borrowers continue to track changes to regulations regarding disclosure of short selling activity, with some of the rules possibly impacting hedge funds who borrow. Additionally, many lending agents have begun to anticipate additional requirements from Canadian regulators.
“It’s fair to say that there is a global focus on impending regulations across the financial industry” says Dave Sedman, head of securities lending, Canada Northern Trust. “However, it is important to recognise that the regulatory framework is different in Canada as each province has its own securities regulator. Securities lending participants must comply with applicable lending guidelines (ie, OFSI Guidelines, National Instrument 81-102) that provide guidance for collateral eligibility, controls and records, and the use of an agent. Borrowers typically must comply with IIROC regulations. Additionally, mutual funds must also comply with disclosure requirements regarding securities lending activities.”
“As in other jurisdictions there has been increasing scrutiny on financial market participants from regulators amid the fallout from the 2008 market crisis,” says Rob Ferguson, SVP, capital markets at CIBC Mellon. “Of course, regulation in Canada has always been fairly conservative. Canadians are prudent in general, and we demand the same of our financial services.”
Globally, securities lending has seemed to have adopted a ‘wait and see’ approach to impending regulation. Whilst maintaining cautiousness Canada also has reasons to be cheerful, with regulatory and tax changes in the past few years that have allowed market growth.
“There was the broadening of the ‘qualified security’ definition in the Tax Act, which allowed for securities lending in markets where previously Canadian participants were not allowed,” states Sedman. “Significant industry lobbying efforts contributed to the eventual broadening of the ‘qualified security’ definition to include any security traded on any exchange globally. Until then, Canadian market participants were at a distinct disadvantage by not being able to lend in certain markets. Another change positively impacting the Canadian market was elimination of the withholding tax on fees and interest on cross-border transactions.”
The Canadian marketplace in general is somewhat more straightforward,” says Don D’Eramo, MD of securities finance at State Street. “We’re very securities based, so there is a lot of issues like reinvestment of cash collateral. Overall, though, the macroeconomic landscape is tough. Dodd Frank and Volcker are very much a moving target. Some of the general points that we have our eye on are increased capital and potential liquidity. Certain rules become very onerous for beneficial owners. There are concerns around liquidity, but at this point it’s still flexible.”
“While the full effects of Basel III remain to be seen, the changes in capital and liquidity requirements will likely impact both lenders and borrowers in the industry,” agrees Sedman. “The new capital requirements may create stronger counterparties, and firms with collateral flexibility will likely benefit the most. Many firms have begun to implement some of these changes and anticipate additional requirements from local regulatory agencies.”
Enhancing returns
In view of enhancing returns, insiders agree that underperformance is a necessary evil in some cases, but the conservative nature of major Canadian banks means expectations of both lenders and borrowers have not been significantly reduced.
“The main obstacle is capital markets; the activity is not at a level that it was” said Ferguson. “Another challenge would be the credit side. There have been significant downgrades on cash reinvestment side. Issues we might have purchased have been downgraded to a point where they’re not worth it any more. Coming into 2008, you ask yourselves, do we need to be more restrictive? Prior to the crisis, we would go out to clients with cash reinvestment guidelines knowing that there could be a slight underperformance compared to our peers. Sometimes it could be a difficult conversation; but in hindsight our conservatism has been a very good thing.”
Cash reinvestment has also proved a pertinent issue to State Street, with D’Eramo commenting: “Securities services have optimised programmes within a client’s risk parameters. Risk appetite has changed, whether it’s more conservative guidelines or whether it’s moving towards ensuring we capture the intrinsic values of securities. There is a movement towards minimum spreads. But it is an ongoing discussion with beneficial owners, it’s a collaboration. We’ve always been very transparent about our reinvestment of cash. Sometimes our benchmarks are underperforming but that’s perfectly acceptable in our eyes, considering their low risk. “
Sedman stated that there are several variables impacting enhancement of returns that are worth watching in the near future, most particularly M&A activity. “Historically, there is a strong correlation between M&A activity and borrower demand, as investors look to capitalise on arbitrage opportunities. Recently, the M&A space has shown signs of increased activity, which may lead to growth in borrower demand and loan volumes.
“A second key variable worth watching is the amount of liquidity held by the hedge funds, which is currently high relative to historic levels. As the cash on hand at some hedge funds eventually gets put to work the market, we would expect to see an uptick in borrower demand and potentially an increase in spreads.”
Changing collateral type
Cash collateral was an unspoken phrase in Canada just 10 years ago, but the market is beginning to see a slight shift in its importance.
“The types of collateral that a lender may accept will vary as it is dependent on the terms of each client’s collateral guidelines, said Sedman. “In recent years, we have seen some Canadian collateral parameters expand to include cash, equities and a broader range of debt assets. Clients with broader [collateral guidelines] tend to experience an increase in lending revenues and utilisation. Flexibility in acceptance of collateral types is a key driver of revenue and will probably remain so in the future. An agent lender should be able to offer its clients a wide variety of collateral options, such as cash, tri-party arrangements, cross–currency arrangements, equities and corporate debt.
Northern Trust incorporates such flexibility when it comes to tailoring our clients’ programmes to their specific needs. As available collateral types continue to expand, we expect that our collateral profile will continue to develop through conversations with clients and market developments.”
“If you were to look at the non-cash world, Canada has been heavily weighted towards securities as collateral,” said D’Eramo. “Clients are not only looking at collateral but also putting in buffers and a minimum spread approach. We continue to see equities as collateral. On the cash reinvestment side, we’ve seen clients addressing duration, etc. There are rules in the US that prohibit broker/dealers from possessing certain collateral, which naturally drove cash reinvestment over there.”
Ferguson comments that whilst Canada and CIBC Mellon has seen an increase in the amount of cash collateral, collateral type has not changed significantly.
“We haven’t seen major changes in collateral acceptability over the last few years, so we aren’t taking anything particularly exotic. Generally the collateral we are taking is very mundane, traditional, prudent - you might even say boring. One of the changes we have seen is that there are fewer European countries whose bonds are acceptable as collateral. Another change is the growing demand from both borrowers and beneficial owners for loans against cash collateral. We will continue to respond to borrower and lender needs, but I don’t expect any sudden shifts in collateral choices.”
The creation of CASLA
Created in 2009, the Canadian Securities Lending Association hoped to follow in the footsteps of organisations such as the European ISLA and American RMA and provide a unifying voice for securities lenders across Canada. Sedman, one of its founding executives, comments: “CASLA works directly with Canadian regulators and stakeholders on issues that are relevant to its members. In short order, CASLA has been successful in lobbying for the change in prescribed market rules in Canada, as well as for changes in the treatment of withholding tax on cross border rebates. These changes have led to increased opportunities to generate revenue and on-loan balances.
“The major market participants in Canada wanted to enhance the public’s understanding of securities lending and the role it plays in Canada’s financial markets. CASLA works with Canadian regulators, self-regulatory organisations and other market participants to ensure the long-term viability of the Canadian securities lending industry and the adoption of best practices. CASLA allows us to respond with a unified voice specific to the Canadian legal and regulatory environment.”
“CASLA was long overdue,” agrees D’Eramo. “We were one of the founding members, and I think it’s a great forum for different players in the industry to work together. You have ISLA in Europe, the RMA in the US…it’s a sign that the Canadian market is maturing.”
Rob Ferguson emphasises the unifying aspect of the organisation, saying: “CASLA has been extremely positive for our market. Prior to this, securities lending participants had worked together on a number of regulatory fronts, but formalizing the process through CASLA bought more structure, more vigour. We’ve been able to provide an opportunity to speak on behalf of the entire industry, to raise our profile in a positive way. Last year CASLA hosted a very successful securities lending conference and we’re building on that success in next month’s second annual conference.”
Private eye
Securities lending and its risk/reward profile have been in the headlines since 2007/8, with some in the industry claiming that the sector suffers from both negative and misinformed press. Indeed, most press picked up by the mainstream financial media in recent years has tended to focus on the extent that the sector contributed to the 2008 crisis, or lawsuits filed against securities lending programmes of major banks.
Institutional investors filed a lawsuit against Wells Fargo in late March, claiming that the bank miss-sold the safeness of its securities lending programme, and J.P. Morgan will pay USD150 million to settle a recent lawsuit by three American union pension funds and other investors accusing the bank of securities lending losses.
However, Ferguson argues that whilst the sector is not always understood by the press, “any time a light is shone on an activity it is good. Scrutiny is not inherently a bad thing.” D’Eramo agrees, stating that: “In the past three or four years there has been more press around securities lending. Whether it has been negative or positive is open to interpretation. I think that the more discussion, the better, as it encourages engagement with regulators. However, are there certain articles that contain misinformation? Yes.”
Sedman views the scrutiny as a chance for Northern Trust to develop its offerings, stating: “There has been an increased focus on risk-adjusted returns in the past several years. In a few cases, we have seen clients move to more customised and conservative collateral guidelines. Clients participating in Northern Trust’s securities lending programme may actively control their programme through establishing limits and restrictions.”
When asked to describe the Canadian securities lending market, answers from industry experts overwhelmingly described it as conservative, stable, fiscally responsible, and at times, boring.
But after Lehman Brothers, the stereotype of Canada as uninteresting started to look a lot more attractive. Major Canadian banks built liquidity to meet fluctuations in balance, made sure that they understood what their collateral positions were, and quickly executed on the liquidation of the collateral and the purchasing of the securities back to get them back into the client accounts.
As the global markets limp to recovery, Canada are capitalising on their conservatism, but also looking at ways to develop their current services. With agent lenders starting to deal with cash, and the market opening up to a global arena, the country looks poised for some well-deserved success.
Canadian High Commissioner to the UK Gordon Cambell describes Canada as having: “generous R&D tax incentives, first rate technology and innovation, a highly skilled workforce, investor protection and a lack of red tape. The OECD and the IMF predict that our economy will continue to be a leader in the industrialised world over the next two years.”
Compared to its American neighbor, however, Canada cannot compete on size. Research from Data Explorers finds that there is USD65 billion of Canadian equities on loan out of a lendable supply of USD418 billion, meaning that longs outnumber shorts by over six times; the LongShort Ratio is 6.42.
By way of comparison, US equities see USD301 billion out on loan against a lending pool of USD3.85 trillion. This gives a LongShort ratio of 12.76.
Yet in terms of financial services, Canada has grown and diversified significantly, generating sales of more than USD82.4 billion in 2010, and with four of the country’s cities in the top 30 of the Global Financial Centres Index, it appears that the oft-described ‘boring’ country wields quiet but considerable power in the market.
Toronto offers a breadth of financial services activity that makes it the third largest financial services centre in North America, whilst Vancouver is Canada’s Pacific gateway, offering unique access to trade financing in the fast growing Asia Pacific markets. Calgary is a global hub for energy and commodity financing, whereas Montreal has strong expertise in pension management, and leads in developing software for the financial services sector.
One step forward, one step back
On 19 September 2008, the US SEC elected to halt short selling in almost 800 financial sector companies in an attempt to stabilise the financial markets. The Ontario Securities Commission (OSC) followed suit by banning short selling in 13 inter-listed TSX-traded equities to prevent regulatory arbitrage. These bans expired on 9 October 2008. Although the SEC applied the ban to “restore equilibrium to the market,” many industry analysts agree that the restrictions on short selling had a negative effect on the marketplace, rather than a positive one as intended.
From a Canadian standpoint, the IIROC released an analysis on 6 October 2008 outlining evidence of further unexpected consequences resulting from the bans. Among other things, surveillance data showed that the bans brought “no appreciable impact on the price of [these] securities” and a “significant increase” in volatility of restricted shares.
However, borrowers continue to track changes to regulations regarding disclosure of short selling activity, with some of the rules possibly impacting hedge funds who borrow. Additionally, many lending agents have begun to anticipate additional requirements from Canadian regulators.
“It’s fair to say that there is a global focus on impending regulations across the financial industry” says Dave Sedman, head of securities lending, Canada Northern Trust. “However, it is important to recognise that the regulatory framework is different in Canada as each province has its own securities regulator. Securities lending participants must comply with applicable lending guidelines (ie, OFSI Guidelines, National Instrument 81-102) that provide guidance for collateral eligibility, controls and records, and the use of an agent. Borrowers typically must comply with IIROC regulations. Additionally, mutual funds must also comply with disclosure requirements regarding securities lending activities.”
“As in other jurisdictions there has been increasing scrutiny on financial market participants from regulators amid the fallout from the 2008 market crisis,” says Rob Ferguson, SVP, capital markets at CIBC Mellon. “Of course, regulation in Canada has always been fairly conservative. Canadians are prudent in general, and we demand the same of our financial services.”
Globally, securities lending has seemed to have adopted a ‘wait and see’ approach to impending regulation. Whilst maintaining cautiousness Canada also has reasons to be cheerful, with regulatory and tax changes in the past few years that have allowed market growth.
“There was the broadening of the ‘qualified security’ definition in the Tax Act, which allowed for securities lending in markets where previously Canadian participants were not allowed,” states Sedman. “Significant industry lobbying efforts contributed to the eventual broadening of the ‘qualified security’ definition to include any security traded on any exchange globally. Until then, Canadian market participants were at a distinct disadvantage by not being able to lend in certain markets. Another change positively impacting the Canadian market was elimination of the withholding tax on fees and interest on cross-border transactions.”
The Canadian marketplace in general is somewhat more straightforward,” says Don D’Eramo, MD of securities finance at State Street. “We’re very securities based, so there is a lot of issues like reinvestment of cash collateral. Overall, though, the macroeconomic landscape is tough. Dodd Frank and Volcker are very much a moving target. Some of the general points that we have our eye on are increased capital and potential liquidity. Certain rules become very onerous for beneficial owners. There are concerns around liquidity, but at this point it’s still flexible.”
“While the full effects of Basel III remain to be seen, the changes in capital and liquidity requirements will likely impact both lenders and borrowers in the industry,” agrees Sedman. “The new capital requirements may create stronger counterparties, and firms with collateral flexibility will likely benefit the most. Many firms have begun to implement some of these changes and anticipate additional requirements from local regulatory agencies.”
Enhancing returns
In view of enhancing returns, insiders agree that underperformance is a necessary evil in some cases, but the conservative nature of major Canadian banks means expectations of both lenders and borrowers have not been significantly reduced.
“The main obstacle is capital markets; the activity is not at a level that it was” said Ferguson. “Another challenge would be the credit side. There have been significant downgrades on cash reinvestment side. Issues we might have purchased have been downgraded to a point where they’re not worth it any more. Coming into 2008, you ask yourselves, do we need to be more restrictive? Prior to the crisis, we would go out to clients with cash reinvestment guidelines knowing that there could be a slight underperformance compared to our peers. Sometimes it could be a difficult conversation; but in hindsight our conservatism has been a very good thing.”
Cash reinvestment has also proved a pertinent issue to State Street, with D’Eramo commenting: “Securities services have optimised programmes within a client’s risk parameters. Risk appetite has changed, whether it’s more conservative guidelines or whether it’s moving towards ensuring we capture the intrinsic values of securities. There is a movement towards minimum spreads. But it is an ongoing discussion with beneficial owners, it’s a collaboration. We’ve always been very transparent about our reinvestment of cash. Sometimes our benchmarks are underperforming but that’s perfectly acceptable in our eyes, considering their low risk. “
Sedman stated that there are several variables impacting enhancement of returns that are worth watching in the near future, most particularly M&A activity. “Historically, there is a strong correlation between M&A activity and borrower demand, as investors look to capitalise on arbitrage opportunities. Recently, the M&A space has shown signs of increased activity, which may lead to growth in borrower demand and loan volumes.
“A second key variable worth watching is the amount of liquidity held by the hedge funds, which is currently high relative to historic levels. As the cash on hand at some hedge funds eventually gets put to work the market, we would expect to see an uptick in borrower demand and potentially an increase in spreads.”
Changing collateral type
Cash collateral was an unspoken phrase in Canada just 10 years ago, but the market is beginning to see a slight shift in its importance.
“The types of collateral that a lender may accept will vary as it is dependent on the terms of each client’s collateral guidelines, said Sedman. “In recent years, we have seen some Canadian collateral parameters expand to include cash, equities and a broader range of debt assets. Clients with broader [collateral guidelines] tend to experience an increase in lending revenues and utilisation. Flexibility in acceptance of collateral types is a key driver of revenue and will probably remain so in the future. An agent lender should be able to offer its clients a wide variety of collateral options, such as cash, tri-party arrangements, cross–currency arrangements, equities and corporate debt.
Northern Trust incorporates such flexibility when it comes to tailoring our clients’ programmes to their specific needs. As available collateral types continue to expand, we expect that our collateral profile will continue to develop through conversations with clients and market developments.”
“If you were to look at the non-cash world, Canada has been heavily weighted towards securities as collateral,” said D’Eramo. “Clients are not only looking at collateral but also putting in buffers and a minimum spread approach. We continue to see equities as collateral. On the cash reinvestment side, we’ve seen clients addressing duration, etc. There are rules in the US that prohibit broker/dealers from possessing certain collateral, which naturally drove cash reinvestment over there.”
Ferguson comments that whilst Canada and CIBC Mellon has seen an increase in the amount of cash collateral, collateral type has not changed significantly.
“We haven’t seen major changes in collateral acceptability over the last few years, so we aren’t taking anything particularly exotic. Generally the collateral we are taking is very mundane, traditional, prudent - you might even say boring. One of the changes we have seen is that there are fewer European countries whose bonds are acceptable as collateral. Another change is the growing demand from both borrowers and beneficial owners for loans against cash collateral. We will continue to respond to borrower and lender needs, but I don’t expect any sudden shifts in collateral choices.”
The creation of CASLA
Created in 2009, the Canadian Securities Lending Association hoped to follow in the footsteps of organisations such as the European ISLA and American RMA and provide a unifying voice for securities lenders across Canada. Sedman, one of its founding executives, comments: “CASLA works directly with Canadian regulators and stakeholders on issues that are relevant to its members. In short order, CASLA has been successful in lobbying for the change in prescribed market rules in Canada, as well as for changes in the treatment of withholding tax on cross border rebates. These changes have led to increased opportunities to generate revenue and on-loan balances.
“The major market participants in Canada wanted to enhance the public’s understanding of securities lending and the role it plays in Canada’s financial markets. CASLA works with Canadian regulators, self-regulatory organisations and other market participants to ensure the long-term viability of the Canadian securities lending industry and the adoption of best practices. CASLA allows us to respond with a unified voice specific to the Canadian legal and regulatory environment.”
“CASLA was long overdue,” agrees D’Eramo. “We were one of the founding members, and I think it’s a great forum for different players in the industry to work together. You have ISLA in Europe, the RMA in the US…it’s a sign that the Canadian market is maturing.”
Rob Ferguson emphasises the unifying aspect of the organisation, saying: “CASLA has been extremely positive for our market. Prior to this, securities lending participants had worked together on a number of regulatory fronts, but formalizing the process through CASLA bought more structure, more vigour. We’ve been able to provide an opportunity to speak on behalf of the entire industry, to raise our profile in a positive way. Last year CASLA hosted a very successful securities lending conference and we’re building on that success in next month’s second annual conference.”
Private eye
Securities lending and its risk/reward profile have been in the headlines since 2007/8, with some in the industry claiming that the sector suffers from both negative and misinformed press. Indeed, most press picked up by the mainstream financial media in recent years has tended to focus on the extent that the sector contributed to the 2008 crisis, or lawsuits filed against securities lending programmes of major banks.
Institutional investors filed a lawsuit against Wells Fargo in late March, claiming that the bank miss-sold the safeness of its securities lending programme, and J.P. Morgan will pay USD150 million to settle a recent lawsuit by three American union pension funds and other investors accusing the bank of securities lending losses.
However, Ferguson argues that whilst the sector is not always understood by the press, “any time a light is shone on an activity it is good. Scrutiny is not inherently a bad thing.” D’Eramo agrees, stating that: “In the past three or four years there has been more press around securities lending. Whether it has been negative or positive is open to interpretation. I think that the more discussion, the better, as it encourages engagement with regulators. However, are there certain articles that contain misinformation? Yes.”
Sedman views the scrutiny as a chance for Northern Trust to develop its offerings, stating: “There has been an increased focus on risk-adjusted returns in the past several years. In a few cases, we have seen clients move to more customised and conservative collateral guidelines. Clients participating in Northern Trust’s securities lending programme may actively control their programme through establishing limits and restrictions.”
When asked to describe the Canadian securities lending market, answers from industry experts overwhelmingly described it as conservative, stable, fiscally responsible, and at times, boring.
But after Lehman Brothers, the stereotype of Canada as uninteresting started to look a lot more attractive. Major Canadian banks built liquidity to meet fluctuations in balance, made sure that they understood what their collateral positions were, and quickly executed on the liquidation of the collateral and the purchasing of the securities back to get them back into the client accounts.
As the global markets limp to recovery, Canada are capitalising on their conservatism, but also looking at ways to develop their current services. With agent lenders starting to deal with cash, and the market opening up to a global arena, the country looks poised for some well-deserved success.
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