Europe
10 June 2014
Experts assemble to discuss the machinations of the European markets, the FTT, the need for a CCP, and technology as a solution
Image: Shutterstock
How are European securities lending markets doing at the as we enter the mid-point of the year?
Simon Colvin: Both equity and fixed income securities lending revenues have been relatively flat across Europe over the last couple of years. This is driven by the fact that average fees and loan balances have held relatively steady over this timeframe.
Things are looking healthy on the supply side, as inventories have increased by more than a third over the last 24 months to $4.5 trillion for all European securities. However, this surge in inventory has ensured that utilisation and return to lendable both stand near new lows.
Paul Wilson: From a beneficial owner perspective, the European lending market is very robust, with a strong appetite for lending with new beneficial owners coming to the market and existing lenders keen to grow revenues/maintain existing revenues.
The challenge remains on the demand side, where adjusting to new capital, liquidity and leverage rules are having the effect of impacting capacity and volume of business that borrowers are able to transact. This year’s dividend season has transpired to be very challenging, with some borrowers pulling back on the amount of business they are doing and there being an absence of end users.
There were significant variances in the all-in levels and true differentiation could be achieved by having the right trading strategy. We feel very positive about our overall performance given the trading strategy we utilised.
John Schreyer: Overall, it has been a very solid year so far in both fixed income and equities. On the fixed income side we continue to see considerable demand for high quality collateral in various structured lending trades as well as need for financing against various collateral types and tenors. The market has also been experiencing steady growth in the lending of corporate bonds with an increase in special value. In terms of equities, while there has also been sustained growth, there has been a reduction of leverage in the market as a whole. Two of the main drivers have been greater demand due to a rise in convertible bond issuance and a clear boost in the fees generated on specials.
Jonathan Lombardo: We have seen a steady, albeit small, increase in overall balances year on year since the sharp decline witnessed post-crisis. That trend has continued into this year, although the impact of future regulatory changes may influence this growth as the industry begins to adjust to the increased capital and risk-weighted asset allocations directly to securities lending profit and loss.
Laurence Marshall: European markets have been strong all year across all major markets, according to DataLend data. As for securities finance trading, the EquiLend and BondLend platforms so far in 2014 have seen a 20 percent increase in volumes in Europe, year over year. It has been a busy year so far for the securities finance markets in Europe.
Maurice Leo: European equities lending has been improving over the past year as macro credit concerns have waned and capital has been redeployed into the region. In terms of traditional asset allocation percentages, many investors have been underweight the European region for several years. As this reverses and assets resume trading on fundamentals, the market should continue to produce opportunities to lend shares.
Despite a general long bias in the region, we have seen an increase in the demand to borrow. Many of the most interesting lending opportunities are a result of capital raisings, where we can lend shares against a new offering of securities, and a growing number of corporate distributions with an option to elect scrip, which drives demand for shares over record date.
Jonathan Lacey: The changing regulatory landscape continues to remain an increasing focus for the region, whether it relates to Basel III capital rules, the European Financial Transaction tax, or Basel III large exposure and leverage ratio proposals. As a consequent of these changes, borrowers continue to face increased scrutiny around capital costs and balance sheet usage and as such are changing the way they source their supply needs. Increasingly, when sourcing liquid securities, borrowers are looking to pledge equity collateral on a term basis in order to derive funding benefits. The heightened bank-leverage standards imposed by the regulators will likely increase the capital for some banks causing further shrinkage in the securities lending and repo market. We expect these themes to continue.
European securities lending markets have benefitted from a stabilising macro-economic environment in the region, however, political risk became a key concern as the world focused on protests in the Ukraine, followed by the overthrow of the exiting Ukrainian government and Russia’s annexation of Crimea. Political tensions in Turkey, Thailand and Venezuela were also in the spotlight.
During the heightened tensions in Ukraine, the securities lending and repo markets continued to function normally without any significant disruptions. On the fixed income side, there was increased demand and higher spreads across almost every Ukrainian government bond issue. Targeted Ukrainian issues traded at even higher spread levels as funds executed directional trades.
On the equity lending side, European indices have maintained the positive momentum they had gathered through the second half of 2013. This rise in economic optimism in the region has been a catalyst for hedge funds to rotate capital out of the US and into Europe, which has started to bleed through to growing short balances in the region.
Additionally, Europe’s low interest rate environment, coupled with ongoing regulatory pressure, continued to be a catalyst for capital raising. Rights issues and convertible bond issuance have been a key source of wider lending spread opportunities in 2014 as borrowers look to exploit inherent arbitrage opportunities.
A stabling macro-economic picture has also resulted in an increase in deal making. Global M&A activity totalled an estimated $1.2 trillion for the first five months of 2014, the highest level since 2007 and an estimated 42 percent up on a year ago with an increasing number of deals being financed through a mixture of stock and cash versus previous years. While not all M&A activity will not necessarily translate into increased securities lending loan volume, the higher levels of deal activity in the first half of the year creates optimism for the second half of 2014.
Which assets are attracting the most interest in the major European markets? What about the minor ones?
Marshall: Securities finance trading in major markets has been active this year, particularly in France, where stocks such as Peugeot, Gemalto and Total have been top earners across all of Europe late last year and in 2014. Trading on EquiLend and BondLend has seen strong growth in emerging markets such as Greece and Czech Republic, each recording triple-digit growth over last year, indicating a growing interest in these markets.
Schreyer: Almost all asset classes in the major markets continue to generate substantial opportunities. For fixed income assets in these markets, much of the interest depends on the ability to structure the trades in an efficient manner to meet the requirements of the borrower. This includes adjusting the duration or matching against collateral, and is true for both government and corporate debt.
For the major European markets the demand for equities continues to grow, but the structure of the trade and the type of collateral one accepts has become increasingly important.
The market is different in non-core Europe for both asset classes. There are opportunities to provide financing against these assets but only sporadic demand to borrow these assets.
Leo: Core markets have been the most active, with France, Germany and the UK producing the highest utilisations. The peripherals have produced specific stock trades with high spreads for periods of time, but these markets tend to lack the liquidity to produce substantial portfolio-level performance. Generally, and not unlike the sector interest we’ve seen in other regions, European financial, consumer discretionary and energy names have drawn the greatest interest.
Wilson: In the first part of the year, there has been strong demand for yield enhancement trades on high dividend paying equities. There was a fair amount of capital raising by European banks driven by upcoming European Central Bank (ECB) stress tests, so banks took the opportunity to strengthen their balance sheets.
Balances in international fixed income have risen steadily from the start of the year, reaching levels not seen since September 2012. Spreads were also very steady with demand for German government bonds particularly strong. After the quarter’s end, we saw demand for government bonds drop off as volatility returned to overnight rates, as a result of excess liquidity in the system being paid back to the ECB.
Spain and Italy traded very close to AAA issuers for the first quarter but have widened as excess liquidity declines. Corporate bond demand remained stable throughout the quarter, though lower than the all-time highs seen in Q3 2013. Since dealers are holding less inventory, there is concern that liquidity will be affected, but we are still seeing very few long-term fails.
Lacey: As is typical in the first and second quarters of the year, structured trading activity linked to European company’s dividend distributions has been a key source of demand in Europe’s major markets. However, as referred to above, balance sheet constraints and increased collateral funding costs led to a slight softening of lending spreads versus 2013, with Germany and Italy most affected. In Italy, the financial transaction tax continues to negatively affect demand.
Elsewhere, demand for higher intrinsic value securities remained robust. The highest lending spread opportunities continue to be focused around specific long-term, fundamental lead directional demand across tough sectors that remain negatively affected by lower levels of global growth. These include mining, basic materials, consumer discretionary and information technology.
In terms of more minor markets, Europe’s emerging market sector has continued to attract increased interest.
On the fixed income side, the demand for high-grade sovereign debt versus alternative collateral (ie, equities or corporate debt) remains high as the global regulatory environment continues to put pressure on borrowers to efficiently manage liquidity. This trade is usually done under a term or evergreen structure in order for the borrower to obtain beneficial treatment from a liquidity coverage ratio perspective. Regulators are also requiring market participants to pledge more high-grade sovereign debt as collateral against derivative and other transactions, further fuelling the demand for this asset class.
Colvin: Despite the rather static fee and balance picture, we’ve seen a nice pickup in revenues generated by rights issues, especially financials. Currently, there are 21 financials trading special across Europe, twice the number that was seen at the start of the year. The demand to borrow these names is driven by recent corporate actions led by Banco Espirito Santo, which recently announced a €1.05 billion capital raising effort.
While the current spate of deals revolves around smaller periphery names, the ever growing pressure on bank balance sheets could make rights issues, and the associated securities lending revenue, a bright spot for the industry in the near term.
How many lenders and borrowers exist in Europe today compared to before the financial crisis, and at what level are they doing business?
Lombardo: We have recently seen some consolidation on the broker-dealer side, which we believe is being driven by non-domiciled banks moving business lines back to their domestic hubs as a result of pending regulation and their impact on capital requirements. In terms of balance on loan, we are still below pre-2008 levels, which based on the data we receive is around 10 percent lower.
Overall, Europe remains vitally important for borrowers and lenders while we have seen strong demand for our bespoke post-trade services in newer markets such as Brazil and South Korea, which is indicative of participants looking at revenue streams away from the established European markets.
Guy Knepper: As a custodian acting on a principal basis for many of our clients (UCITS and insurance companies), the picture we have of the securities lending market is not representative of the industry as a whole. Other than the obvious disappearance of Lehman Brothers in the wake of the financial crisis, we do not feel that there has been a significant contraction in the number of lenders and borrowers in the market.
Indeed, from our point of view, the business is growing organically and clients still see the strong business case for joining a securities lending programme when the impact on profit and loss figures is demonstrated. In terms of new securities lending market entrants, we believe that barriers to entry are very high, which will exclude many smaller players, despite the availability of off-the-shelf technology platforms.
In terms of location, CACEIS has its securities lending hub in its Luxembourg-based dealing room, and is capable of acting for clients from any of the group’s entities worldwide.
Schreyer: The number of lenders and borrowers at the wholesale level seems to have remained fairly constant since the financial crisis. The main change has been the size and mix of the business that each is doing. Certainly, the overall volumes are less than they were before the crisis. We have seen firms sharpen their focus to those sectors of the lending market where they see the greatest ability to generate spread or to facilitate other business that is important to them.
Europe is certainly a key region for Deutsche Bank with opportunities across both the equity and fixed income markets. It is also important to point out that the US remains a key focus for us with significant new client wins over the past two years and is a region where we continue to invest. Finally, the Far East also keeps on growing in both the number of lending clients entering the securities lending space, and the development of markets such as India, Taiwan and South Korea.
Wilson: Since the global financial crisis, the number of lenders across Europe has increased. We have seen significant increased demand and appetite since August, when European rates were reduced to zero and beneficial owners sought increased yields. European lenders on the whole do remain more cautious than counterparts in either Asia or the Americas, with a bias towards non-cash programmes focused on yield enhancement and specials activity.
Programsme do remain varied with high degrees of customisations. Beneficial owners are heavily engaged. They have a real desire to be actively involved and informed about lending activities and opportunities to increase returns. We have a highly focused business strategy with key segments across all regions that we have identified as a priority for us and of course this includes many across Europe. However, with demand suppressed and the prospect of overall volumes growing over the next two to three years being quite small, our targeted and focused approach has the right balance of matching supply to demand.
Leo: The number of market participants in the region has remained consistent over time, but the depth of demand for some of the traditional players has shifted. With regulatory changes exerting pressure on many borrowers, they have necessarily become more selective in allocating their resources. This has produced greater variability in terms of interest by products and by countries. Europe continues to be a very important and core product offering for both agent lenders and prime brokers. While the product mix and client make-up may continue to evolve, presence in the region is a must for any firms servicing clients on a global basis.
Colvin: This is a bit of a tough question as many securities lending providers do not have the luxury of choosing which markets they operate in. European equities securities lending still represents 55 percent of global revenue recorded this year, which is roughly the same portion as seen last year. With customers increasingly operating internationally and focused on universal offerings, ignoring parts of the European market makes little business sense.
Lacey: In general over the last few years Northern Trust has seen an increase in the number of beneficial owners joining our programme. Most of our client base invests in global assets so the domicile of the lender is not driving the volume of activity we see in the securities lending markets. Northern Trust continues to envisage Europe as an important location to operate business from and we will certainly continue to increase our global footprint in many key counties in the region.
Marshall: Our client base continues to expand. We now have 93 lenders and brokers worldwide using a combination of our trading, post-trade and data services, with all indications suggesting that client participation in the securities finance market remains strong. Europe in particular is and has always been a major hub for all global business due to the time zone and client management from Europe.
The EU 11 are pressing ahead with the Financial Transaction Tax—are European players and those that could be affected indirectly preparing for the worst?
Leo: The main concerns and real damaging effects of the proposed directive are caused by: (i) the establishment principle within Article 4 creating an extraterritorial and global tax charge; and (ii) the fact that both buyer and seller become liable to pay the tax with joint and several liability, thereby creating a tax multiplication or cascading effect on a global basis.
However, the European industry and professional advisors widely speculate that the proposed draft directive to implement an EU Financial Transaction Tax (FTT) between the present 11 participating member states will likely be similar to either the French and Italian iterations or the UK Stamp Duty Reserve Tax (SDRT) regimes. They impose a transfer tax on the purchaser and work on an issuance-based principle only.
Based on this speculation, ongoing jurisdictional political division and lack of agreement among the 11 participating member states, the industry is currently taking little action. Many believe the worst-case scenario—complete implementation of the directive as drafted into EU law—remains highly unlikely.
However, this remains a highly political process. Without an established consultation period, market participants are concerned that the damaging effects of the directive may become a reality for which there is no plan B.
Lacey: There is a level of apprehension around the implementation of the EU FTT and the potential implications for the securities lending market. It is widely hoped that as the exact details of the implementation emerge we will see exemptions adopted for securities lending and repo transactions, although we believe it likely that there will be a reporting requirement for lenders and borrowers.
Should lending transactions become taxable under the final legislation, it will undoubtedly make some of the existing transaction flow economically unviable and would have ramifications for market liquidity and the revenue that beneficial owners are able to generate from lending their assets. The hope is that the implementation will eventually follow the lead of the markets that have already implemented a tax (France and Italy), and after reviewing the impact of capturing securities lending transactions in the scope of the FTT, an exemption will be granted.
In terms of preparation, I believe the market in general is well equipped to deal with any reporting requirement that may emerge, but preparing for a tax liability is more problematic. Lenders and borrowers will need to factor in the additional cost of executing a transaction at point of trade—systemically, this is something that most will be able to manage but as mentioned, there will be a dramatic impact on the volume of transactions actually being executed.
Schreyer: At Deutsche Bank we are constantly tracking the potential outcome of the transaction tax and other regulatory changes and the impact that they may have on various businesses, including the transaction bank. We have been preparing for the likely ramifications of the FTT, such as the potential cost to the agency securities lending business, as well as an evaluation of the trade structures that might emerge once the details of the tax are finalised. The agency securities lending business operates on behalf of lenders and transacts with the borrowing market, so it is critical to continue to facilitate this connection in a profitable manner while addressing the new regulation.
Lombardo: Although the impact to securities lending of the FTT has not yet been realised, there has already been a great deal of analysis of some of the expected effects. At first, this will be seen within the primary markets of the countries that impose the tax, potentially in the shape of a decline in the values of domestic securities and increased expense when fund-raising through capital markets.
Ultimately, these effects will indirectly flow into the securities lending market, which when combined with the direct impact of the tax that currently has securities lending transactions within scope, would lead to at least 65 percent of the current European securities lending market being rendered uneconomic based on analysis by the International Securities Lending Association. Given the scale of the changes, as an industry we must continue to lobby as the EU 11 have yet to finalise how they will implement the new provisions.
Knepper: The impacts of the FTT could well be severe, and may have a major impact on the securities lending business’ ability to generate a profit. Low margin business would likely be killed off by the FTT, which would mean the cost of borrowing securities to hedge positions would rise considerably, and in turn lead to an undesirable reduction in market efficiency.
In terms of the FTT, the negatives clearly outweigh the positives. However, FTT related discussions are in progress, and as yet, no official decision has been made that put securities lending transactions in scope. Furthermore, should securities lending business fall within the FTT’s scope, it is unclear as how the various players in the chain would be taxed. For CACEIS, a custodian acting as principal for its clients, that is a key point to address.
As more central counterparty offerings emerge, are you or your clients taking more of an interest in the CCP model for securities lending?
Wilson: Central counterparties (CCPs) on the face of it do offer a potentially supplementary means to transact. We can definitely see advantages where a robust, fully functioning CPP could be useful and we continue to monitor closely developments in this area.
Ultimately, market dynamics and economics will dictate whether these venues attract any material volume—if borrowers feel they will get reduced capital or more efficiency of capital by utilising a CPP, then there will inevitably be some pick up in volumes. In any event, we don’t foresee a market that is all or nothing. We see a CCP as just another venue or mechanism to extract the best risk adjusted value in certain instances for clients.
Mark Jones: CCPs for securities lending is still a hot topic and one that generates a lot of discussion, particularly with the upcoming implementation of the European Market Infrastructure Regulation and mandatory central clearing for derivative transactions, which has led to beneficial owners becoming more familiar with the CCP model in general and therefore better equipped to question if and how it could be used more broadly in the securities lending market.
There are still obstacles for the CCPs to overcome in terms of providing a workable and scalable model to support securities lending, not least cost and post-trade activities, and we feel that these issues are likely to limit the volume of activity that will trade through CCPs in the very near future.
We do feel that the regulatory focus on mitigating systemic risk through the use of CCPs and the increasing familiarity that certain beneficial owners have with the CCP model will keep this topic high on the agenda moving forward, and that there may be an inevitable increase in the number of securities lending transactions that are centrally cleared. The scale will be determined by how hard regulators push the market and the CCP provider’s ability to address the concerns of market participants.
Leo: With the market evolving and adjusting to changes brought about by regulation and other events, I think lending market participants must continually evaluate options to optimally manage the product. The emergence of alternative models may provide certain benefits, and CCPs are likely to be one tool used in the future by many market participants.
Marshall: The securities finance industry currently operates almost entirely on a bilateral trading model, with much of that activity taking place via our global trading platform. The CCP discussion has been ongoing for years, but it hasn’t changed the status quo much, although there has been some renewed interest in CCPs more recently given certain regulatory pressures on firms. We have been discussing this with our clients regularly and have committed to implementing CCP connectivity if client demand for it exists. Currently, we have not seen that demand yet.
Schreyer: We have been looking at the CCP model for quite a while. The model offers some real benefits in terms of risk and capital treatment. However, there are still some potential issues with combining the CCP model with the agency trade structure. Provided these issues can be resolved, some business will move into the CCPs but it is too early to determine how much.
Lombardo: We have been experiencing a surge in interest and take up of our CCP Gateway offering, which links into Eurex Clearing’s Lending CCP. With several clients already live, in excess of €125 million of trades already being executed during May and an incredibly strong pipeline of clients in integration. we feel that the ‘ocean liner’ has finally turned. Increased risk-weighted asset and capital requirements have become a reality and the industry has embraced the benefits of a CCP in dealing with these issues. This is evident through the creation of ISLA’s CCP working group.
We believe that the majority of organisations will, over the next few years, allocate a percentage of their business to be traded via a CCP. We believe this percentage allocation will range from between 5 to 20 percent of their total business and will be comprised of strategic but capital intensive trades that better suit novation to a CCP with its reduced capital requirements, as opposed to the higher capital requirement when trading bilaterally.
Finally, how are technology offerings streamlining business in Europe and making it more efficient? What more do vendors need to do in the next few years?
Marshall: Market participants want to be as efficient as possible with both their time and their budgets. We have responded to those calls by building Next Generation Trading (NGT), a consolidated, screen-based platform that combines trading of general collateral, warm and hot securities integrated with market data. Ultimately, NGT will eliminate the need for schedules, enabling real-time communication and trading of securities from general collateral through specials. This will truly change the way the securities finance industry trades.
The input from the industry on the ongoing build and rollout of NGT is truly unprecedented in the securities finance market. We have worked alongside dozens of traders, developers and relationship managers from lenders and brokers across North America, Europe and Asia-Pacific to ensure this platform encapsulates everything that they need in their daily trading activity, in the most intuitive and efficient way possible.
Wilson: Technology and operational efficiency are more important than ever. We are investing heavily in our core technology and particularly in our client facing technology, providing more fingertip information and analytics to our clients. We prefer to undertake technology developments in-house, but connect to industry applications such as EquiLend where possible.
Knepper: One of the principal benefits of technology is trading systems’ ability to provide front- to back-office integration, which greatly increases the efficiency and data transfers for reporting purposes for custody clients on in securities lending programme. Today, there is no need to book tickets for transactions. Trading platforms and IT systems automatically import and book the transactions with no manual input. Furthermore, the STP nature enables us to absorb transaction volume spikes with ease.
Lombardo: Strategic alignments are critical for future growth and for the evolution of the market. Aversion to any infrastructural change and limited technology resources prohibit participants from building to match the ever changing dynamic of the fluid marketplace in a timely fashion. By utilising Pirum’s central hub structure, participants technically outsource a portion of their development work, reducing overall cost, technology risk and implementation timelines. Customers further benefit from the ‘network’ effect where one connection, via a single portal, enables connectivity into all partnership structures developed by Pirum.
Flexibility, nimbleness, and ‘light touch’ implementation are key differentials that will separate successful models from those that require individual pipes or highly customised development. The latter models will ultimately struggle in today’s present environment of cost reductions and technology resource restraints.
Jones: Technology is a key focus for Northern Trust and the continuing development of trading platforms such as Equilend and Bondlend are key factors in maximising trading efficiency for market participants. In addition, post-trade activities such as contract compare and collateral requirement matching continue to offer operational efficiencies and risk mitigation to the participants.
The demand and trend of increasing automation is unlikely to abate and vendors will need to adapt to the changing market infrastructure and regulation across Europe to ensure their offerings remain up-to-date. Transparency and reporting requirements across the securities lending market will undoubtedly increase as a result of increased regulatory focus and the need to have immediate access to data will be key.
There is also an opportunity for vendors to help the market respond to this requirement from regulators by being able to provide such regulatory reporting ‘off the shelf’ and minimising the impact on in-house technology teams. Vendors that store vast quantities of data on lending activity will clearly be well placed to help the market respond to this push for market transparency.
Finally, infrastructure developments such as TARGET-2 Securities will have a major impact on how market participants interact with the settlement mechanisms in Europe and vendors will need to be mindful of the evolving needs of their clients in respect of these changes.
Simon Colvin: Both equity and fixed income securities lending revenues have been relatively flat across Europe over the last couple of years. This is driven by the fact that average fees and loan balances have held relatively steady over this timeframe.
Things are looking healthy on the supply side, as inventories have increased by more than a third over the last 24 months to $4.5 trillion for all European securities. However, this surge in inventory has ensured that utilisation and return to lendable both stand near new lows.
Paul Wilson: From a beneficial owner perspective, the European lending market is very robust, with a strong appetite for lending with new beneficial owners coming to the market and existing lenders keen to grow revenues/maintain existing revenues.
The challenge remains on the demand side, where adjusting to new capital, liquidity and leverage rules are having the effect of impacting capacity and volume of business that borrowers are able to transact. This year’s dividend season has transpired to be very challenging, with some borrowers pulling back on the amount of business they are doing and there being an absence of end users.
There were significant variances in the all-in levels and true differentiation could be achieved by having the right trading strategy. We feel very positive about our overall performance given the trading strategy we utilised.
John Schreyer: Overall, it has been a very solid year so far in both fixed income and equities. On the fixed income side we continue to see considerable demand for high quality collateral in various structured lending trades as well as need for financing against various collateral types and tenors. The market has also been experiencing steady growth in the lending of corporate bonds with an increase in special value. In terms of equities, while there has also been sustained growth, there has been a reduction of leverage in the market as a whole. Two of the main drivers have been greater demand due to a rise in convertible bond issuance and a clear boost in the fees generated on specials.
Jonathan Lombardo: We have seen a steady, albeit small, increase in overall balances year on year since the sharp decline witnessed post-crisis. That trend has continued into this year, although the impact of future regulatory changes may influence this growth as the industry begins to adjust to the increased capital and risk-weighted asset allocations directly to securities lending profit and loss.
Laurence Marshall: European markets have been strong all year across all major markets, according to DataLend data. As for securities finance trading, the EquiLend and BondLend platforms so far in 2014 have seen a 20 percent increase in volumes in Europe, year over year. It has been a busy year so far for the securities finance markets in Europe.
Maurice Leo: European equities lending has been improving over the past year as macro credit concerns have waned and capital has been redeployed into the region. In terms of traditional asset allocation percentages, many investors have been underweight the European region for several years. As this reverses and assets resume trading on fundamentals, the market should continue to produce opportunities to lend shares.
Despite a general long bias in the region, we have seen an increase in the demand to borrow. Many of the most interesting lending opportunities are a result of capital raisings, where we can lend shares against a new offering of securities, and a growing number of corporate distributions with an option to elect scrip, which drives demand for shares over record date.
Jonathan Lacey: The changing regulatory landscape continues to remain an increasing focus for the region, whether it relates to Basel III capital rules, the European Financial Transaction tax, or Basel III large exposure and leverage ratio proposals. As a consequent of these changes, borrowers continue to face increased scrutiny around capital costs and balance sheet usage and as such are changing the way they source their supply needs. Increasingly, when sourcing liquid securities, borrowers are looking to pledge equity collateral on a term basis in order to derive funding benefits. The heightened bank-leverage standards imposed by the regulators will likely increase the capital for some banks causing further shrinkage in the securities lending and repo market. We expect these themes to continue.
European securities lending markets have benefitted from a stabilising macro-economic environment in the region, however, political risk became a key concern as the world focused on protests in the Ukraine, followed by the overthrow of the exiting Ukrainian government and Russia’s annexation of Crimea. Political tensions in Turkey, Thailand and Venezuela were also in the spotlight.
During the heightened tensions in Ukraine, the securities lending and repo markets continued to function normally without any significant disruptions. On the fixed income side, there was increased demand and higher spreads across almost every Ukrainian government bond issue. Targeted Ukrainian issues traded at even higher spread levels as funds executed directional trades.
On the equity lending side, European indices have maintained the positive momentum they had gathered through the second half of 2013. This rise in economic optimism in the region has been a catalyst for hedge funds to rotate capital out of the US and into Europe, which has started to bleed through to growing short balances in the region.
Additionally, Europe’s low interest rate environment, coupled with ongoing regulatory pressure, continued to be a catalyst for capital raising. Rights issues and convertible bond issuance have been a key source of wider lending spread opportunities in 2014 as borrowers look to exploit inherent arbitrage opportunities.
A stabling macro-economic picture has also resulted in an increase in deal making. Global M&A activity totalled an estimated $1.2 trillion for the first five months of 2014, the highest level since 2007 and an estimated 42 percent up on a year ago with an increasing number of deals being financed through a mixture of stock and cash versus previous years. While not all M&A activity will not necessarily translate into increased securities lending loan volume, the higher levels of deal activity in the first half of the year creates optimism for the second half of 2014.
Which assets are attracting the most interest in the major European markets? What about the minor ones?
Marshall: Securities finance trading in major markets has been active this year, particularly in France, where stocks such as Peugeot, Gemalto and Total have been top earners across all of Europe late last year and in 2014. Trading on EquiLend and BondLend has seen strong growth in emerging markets such as Greece and Czech Republic, each recording triple-digit growth over last year, indicating a growing interest in these markets.
Schreyer: Almost all asset classes in the major markets continue to generate substantial opportunities. For fixed income assets in these markets, much of the interest depends on the ability to structure the trades in an efficient manner to meet the requirements of the borrower. This includes adjusting the duration or matching against collateral, and is true for both government and corporate debt.
For the major European markets the demand for equities continues to grow, but the structure of the trade and the type of collateral one accepts has become increasingly important.
The market is different in non-core Europe for both asset classes. There are opportunities to provide financing against these assets but only sporadic demand to borrow these assets.
Leo: Core markets have been the most active, with France, Germany and the UK producing the highest utilisations. The peripherals have produced specific stock trades with high spreads for periods of time, but these markets tend to lack the liquidity to produce substantial portfolio-level performance. Generally, and not unlike the sector interest we’ve seen in other regions, European financial, consumer discretionary and energy names have drawn the greatest interest.
Wilson: In the first part of the year, there has been strong demand for yield enhancement trades on high dividend paying equities. There was a fair amount of capital raising by European banks driven by upcoming European Central Bank (ECB) stress tests, so banks took the opportunity to strengthen their balance sheets.
Balances in international fixed income have risen steadily from the start of the year, reaching levels not seen since September 2012. Spreads were also very steady with demand for German government bonds particularly strong. After the quarter’s end, we saw demand for government bonds drop off as volatility returned to overnight rates, as a result of excess liquidity in the system being paid back to the ECB.
Spain and Italy traded very close to AAA issuers for the first quarter but have widened as excess liquidity declines. Corporate bond demand remained stable throughout the quarter, though lower than the all-time highs seen in Q3 2013. Since dealers are holding less inventory, there is concern that liquidity will be affected, but we are still seeing very few long-term fails.
Lacey: As is typical in the first and second quarters of the year, structured trading activity linked to European company’s dividend distributions has been a key source of demand in Europe’s major markets. However, as referred to above, balance sheet constraints and increased collateral funding costs led to a slight softening of lending spreads versus 2013, with Germany and Italy most affected. In Italy, the financial transaction tax continues to negatively affect demand.
Elsewhere, demand for higher intrinsic value securities remained robust. The highest lending spread opportunities continue to be focused around specific long-term, fundamental lead directional demand across tough sectors that remain negatively affected by lower levels of global growth. These include mining, basic materials, consumer discretionary and information technology.
In terms of more minor markets, Europe’s emerging market sector has continued to attract increased interest.
On the fixed income side, the demand for high-grade sovereign debt versus alternative collateral (ie, equities or corporate debt) remains high as the global regulatory environment continues to put pressure on borrowers to efficiently manage liquidity. This trade is usually done under a term or evergreen structure in order for the borrower to obtain beneficial treatment from a liquidity coverage ratio perspective. Regulators are also requiring market participants to pledge more high-grade sovereign debt as collateral against derivative and other transactions, further fuelling the demand for this asset class.
Colvin: Despite the rather static fee and balance picture, we’ve seen a nice pickup in revenues generated by rights issues, especially financials. Currently, there are 21 financials trading special across Europe, twice the number that was seen at the start of the year. The demand to borrow these names is driven by recent corporate actions led by Banco Espirito Santo, which recently announced a €1.05 billion capital raising effort.
While the current spate of deals revolves around smaller periphery names, the ever growing pressure on bank balance sheets could make rights issues, and the associated securities lending revenue, a bright spot for the industry in the near term.
How many lenders and borrowers exist in Europe today compared to before the financial crisis, and at what level are they doing business?
Lombardo: We have recently seen some consolidation on the broker-dealer side, which we believe is being driven by non-domiciled banks moving business lines back to their domestic hubs as a result of pending regulation and their impact on capital requirements. In terms of balance on loan, we are still below pre-2008 levels, which based on the data we receive is around 10 percent lower.
Overall, Europe remains vitally important for borrowers and lenders while we have seen strong demand for our bespoke post-trade services in newer markets such as Brazil and South Korea, which is indicative of participants looking at revenue streams away from the established European markets.
Guy Knepper: As a custodian acting on a principal basis for many of our clients (UCITS and insurance companies), the picture we have of the securities lending market is not representative of the industry as a whole. Other than the obvious disappearance of Lehman Brothers in the wake of the financial crisis, we do not feel that there has been a significant contraction in the number of lenders and borrowers in the market.
Indeed, from our point of view, the business is growing organically and clients still see the strong business case for joining a securities lending programme when the impact on profit and loss figures is demonstrated. In terms of new securities lending market entrants, we believe that barriers to entry are very high, which will exclude many smaller players, despite the availability of off-the-shelf technology platforms.
In terms of location, CACEIS has its securities lending hub in its Luxembourg-based dealing room, and is capable of acting for clients from any of the group’s entities worldwide.
Schreyer: The number of lenders and borrowers at the wholesale level seems to have remained fairly constant since the financial crisis. The main change has been the size and mix of the business that each is doing. Certainly, the overall volumes are less than they were before the crisis. We have seen firms sharpen their focus to those sectors of the lending market where they see the greatest ability to generate spread or to facilitate other business that is important to them.
Europe is certainly a key region for Deutsche Bank with opportunities across both the equity and fixed income markets. It is also important to point out that the US remains a key focus for us with significant new client wins over the past two years and is a region where we continue to invest. Finally, the Far East also keeps on growing in both the number of lending clients entering the securities lending space, and the development of markets such as India, Taiwan and South Korea.
Wilson: Since the global financial crisis, the number of lenders across Europe has increased. We have seen significant increased demand and appetite since August, when European rates were reduced to zero and beneficial owners sought increased yields. European lenders on the whole do remain more cautious than counterparts in either Asia or the Americas, with a bias towards non-cash programmes focused on yield enhancement and specials activity.
Programsme do remain varied with high degrees of customisations. Beneficial owners are heavily engaged. They have a real desire to be actively involved and informed about lending activities and opportunities to increase returns. We have a highly focused business strategy with key segments across all regions that we have identified as a priority for us and of course this includes many across Europe. However, with demand suppressed and the prospect of overall volumes growing over the next two to three years being quite small, our targeted and focused approach has the right balance of matching supply to demand.
Leo: The number of market participants in the region has remained consistent over time, but the depth of demand for some of the traditional players has shifted. With regulatory changes exerting pressure on many borrowers, they have necessarily become more selective in allocating their resources. This has produced greater variability in terms of interest by products and by countries. Europe continues to be a very important and core product offering for both agent lenders and prime brokers. While the product mix and client make-up may continue to evolve, presence in the region is a must for any firms servicing clients on a global basis.
Colvin: This is a bit of a tough question as many securities lending providers do not have the luxury of choosing which markets they operate in. European equities securities lending still represents 55 percent of global revenue recorded this year, which is roughly the same portion as seen last year. With customers increasingly operating internationally and focused on universal offerings, ignoring parts of the European market makes little business sense.
Lacey: In general over the last few years Northern Trust has seen an increase in the number of beneficial owners joining our programme. Most of our client base invests in global assets so the domicile of the lender is not driving the volume of activity we see in the securities lending markets. Northern Trust continues to envisage Europe as an important location to operate business from and we will certainly continue to increase our global footprint in many key counties in the region.
Marshall: Our client base continues to expand. We now have 93 lenders and brokers worldwide using a combination of our trading, post-trade and data services, with all indications suggesting that client participation in the securities finance market remains strong. Europe in particular is and has always been a major hub for all global business due to the time zone and client management from Europe.
The EU 11 are pressing ahead with the Financial Transaction Tax—are European players and those that could be affected indirectly preparing for the worst?
Leo: The main concerns and real damaging effects of the proposed directive are caused by: (i) the establishment principle within Article 4 creating an extraterritorial and global tax charge; and (ii) the fact that both buyer and seller become liable to pay the tax with joint and several liability, thereby creating a tax multiplication or cascading effect on a global basis.
However, the European industry and professional advisors widely speculate that the proposed draft directive to implement an EU Financial Transaction Tax (FTT) between the present 11 participating member states will likely be similar to either the French and Italian iterations or the UK Stamp Duty Reserve Tax (SDRT) regimes. They impose a transfer tax on the purchaser and work on an issuance-based principle only.
Based on this speculation, ongoing jurisdictional political division and lack of agreement among the 11 participating member states, the industry is currently taking little action. Many believe the worst-case scenario—complete implementation of the directive as drafted into EU law—remains highly unlikely.
However, this remains a highly political process. Without an established consultation period, market participants are concerned that the damaging effects of the directive may become a reality for which there is no plan B.
Lacey: There is a level of apprehension around the implementation of the EU FTT and the potential implications for the securities lending market. It is widely hoped that as the exact details of the implementation emerge we will see exemptions adopted for securities lending and repo transactions, although we believe it likely that there will be a reporting requirement for lenders and borrowers.
Should lending transactions become taxable under the final legislation, it will undoubtedly make some of the existing transaction flow economically unviable and would have ramifications for market liquidity and the revenue that beneficial owners are able to generate from lending their assets. The hope is that the implementation will eventually follow the lead of the markets that have already implemented a tax (France and Italy), and after reviewing the impact of capturing securities lending transactions in the scope of the FTT, an exemption will be granted.
In terms of preparation, I believe the market in general is well equipped to deal with any reporting requirement that may emerge, but preparing for a tax liability is more problematic. Lenders and borrowers will need to factor in the additional cost of executing a transaction at point of trade—systemically, this is something that most will be able to manage but as mentioned, there will be a dramatic impact on the volume of transactions actually being executed.
Schreyer: At Deutsche Bank we are constantly tracking the potential outcome of the transaction tax and other regulatory changes and the impact that they may have on various businesses, including the transaction bank. We have been preparing for the likely ramifications of the FTT, such as the potential cost to the agency securities lending business, as well as an evaluation of the trade structures that might emerge once the details of the tax are finalised. The agency securities lending business operates on behalf of lenders and transacts with the borrowing market, so it is critical to continue to facilitate this connection in a profitable manner while addressing the new regulation.
Lombardo: Although the impact to securities lending of the FTT has not yet been realised, there has already been a great deal of analysis of some of the expected effects. At first, this will be seen within the primary markets of the countries that impose the tax, potentially in the shape of a decline in the values of domestic securities and increased expense when fund-raising through capital markets.
Ultimately, these effects will indirectly flow into the securities lending market, which when combined with the direct impact of the tax that currently has securities lending transactions within scope, would lead to at least 65 percent of the current European securities lending market being rendered uneconomic based on analysis by the International Securities Lending Association. Given the scale of the changes, as an industry we must continue to lobby as the EU 11 have yet to finalise how they will implement the new provisions.
Knepper: The impacts of the FTT could well be severe, and may have a major impact on the securities lending business’ ability to generate a profit. Low margin business would likely be killed off by the FTT, which would mean the cost of borrowing securities to hedge positions would rise considerably, and in turn lead to an undesirable reduction in market efficiency.
In terms of the FTT, the negatives clearly outweigh the positives. However, FTT related discussions are in progress, and as yet, no official decision has been made that put securities lending transactions in scope. Furthermore, should securities lending business fall within the FTT’s scope, it is unclear as how the various players in the chain would be taxed. For CACEIS, a custodian acting as principal for its clients, that is a key point to address.
As more central counterparty offerings emerge, are you or your clients taking more of an interest in the CCP model for securities lending?
Wilson: Central counterparties (CCPs) on the face of it do offer a potentially supplementary means to transact. We can definitely see advantages where a robust, fully functioning CPP could be useful and we continue to monitor closely developments in this area.
Ultimately, market dynamics and economics will dictate whether these venues attract any material volume—if borrowers feel they will get reduced capital or more efficiency of capital by utilising a CPP, then there will inevitably be some pick up in volumes. In any event, we don’t foresee a market that is all or nothing. We see a CCP as just another venue or mechanism to extract the best risk adjusted value in certain instances for clients.
Mark Jones: CCPs for securities lending is still a hot topic and one that generates a lot of discussion, particularly with the upcoming implementation of the European Market Infrastructure Regulation and mandatory central clearing for derivative transactions, which has led to beneficial owners becoming more familiar with the CCP model in general and therefore better equipped to question if and how it could be used more broadly in the securities lending market.
There are still obstacles for the CCPs to overcome in terms of providing a workable and scalable model to support securities lending, not least cost and post-trade activities, and we feel that these issues are likely to limit the volume of activity that will trade through CCPs in the very near future.
We do feel that the regulatory focus on mitigating systemic risk through the use of CCPs and the increasing familiarity that certain beneficial owners have with the CCP model will keep this topic high on the agenda moving forward, and that there may be an inevitable increase in the number of securities lending transactions that are centrally cleared. The scale will be determined by how hard regulators push the market and the CCP provider’s ability to address the concerns of market participants.
Leo: With the market evolving and adjusting to changes brought about by regulation and other events, I think lending market participants must continually evaluate options to optimally manage the product. The emergence of alternative models may provide certain benefits, and CCPs are likely to be one tool used in the future by many market participants.
Marshall: The securities finance industry currently operates almost entirely on a bilateral trading model, with much of that activity taking place via our global trading platform. The CCP discussion has been ongoing for years, but it hasn’t changed the status quo much, although there has been some renewed interest in CCPs more recently given certain regulatory pressures on firms. We have been discussing this with our clients regularly and have committed to implementing CCP connectivity if client demand for it exists. Currently, we have not seen that demand yet.
Schreyer: We have been looking at the CCP model for quite a while. The model offers some real benefits in terms of risk and capital treatment. However, there are still some potential issues with combining the CCP model with the agency trade structure. Provided these issues can be resolved, some business will move into the CCPs but it is too early to determine how much.
Lombardo: We have been experiencing a surge in interest and take up of our CCP Gateway offering, which links into Eurex Clearing’s Lending CCP. With several clients already live, in excess of €125 million of trades already being executed during May and an incredibly strong pipeline of clients in integration. we feel that the ‘ocean liner’ has finally turned. Increased risk-weighted asset and capital requirements have become a reality and the industry has embraced the benefits of a CCP in dealing with these issues. This is evident through the creation of ISLA’s CCP working group.
We believe that the majority of organisations will, over the next few years, allocate a percentage of their business to be traded via a CCP. We believe this percentage allocation will range from between 5 to 20 percent of their total business and will be comprised of strategic but capital intensive trades that better suit novation to a CCP with its reduced capital requirements, as opposed to the higher capital requirement when trading bilaterally.
Finally, how are technology offerings streamlining business in Europe and making it more efficient? What more do vendors need to do in the next few years?
Marshall: Market participants want to be as efficient as possible with both their time and their budgets. We have responded to those calls by building Next Generation Trading (NGT), a consolidated, screen-based platform that combines trading of general collateral, warm and hot securities integrated with market data. Ultimately, NGT will eliminate the need for schedules, enabling real-time communication and trading of securities from general collateral through specials. This will truly change the way the securities finance industry trades.
The input from the industry on the ongoing build and rollout of NGT is truly unprecedented in the securities finance market. We have worked alongside dozens of traders, developers and relationship managers from lenders and brokers across North America, Europe and Asia-Pacific to ensure this platform encapsulates everything that they need in their daily trading activity, in the most intuitive and efficient way possible.
Wilson: Technology and operational efficiency are more important than ever. We are investing heavily in our core technology and particularly in our client facing technology, providing more fingertip information and analytics to our clients. We prefer to undertake technology developments in-house, but connect to industry applications such as EquiLend where possible.
Knepper: One of the principal benefits of technology is trading systems’ ability to provide front- to back-office integration, which greatly increases the efficiency and data transfers for reporting purposes for custody clients on in securities lending programme. Today, there is no need to book tickets for transactions. Trading platforms and IT systems automatically import and book the transactions with no manual input. Furthermore, the STP nature enables us to absorb transaction volume spikes with ease.
Lombardo: Strategic alignments are critical for future growth and for the evolution of the market. Aversion to any infrastructural change and limited technology resources prohibit participants from building to match the ever changing dynamic of the fluid marketplace in a timely fashion. By utilising Pirum’s central hub structure, participants technically outsource a portion of their development work, reducing overall cost, technology risk and implementation timelines. Customers further benefit from the ‘network’ effect where one connection, via a single portal, enables connectivity into all partnership structures developed by Pirum.
Flexibility, nimbleness, and ‘light touch’ implementation are key differentials that will separate successful models from those that require individual pipes or highly customised development. The latter models will ultimately struggle in today’s present environment of cost reductions and technology resource restraints.
Jones: Technology is a key focus for Northern Trust and the continuing development of trading platforms such as Equilend and Bondlend are key factors in maximising trading efficiency for market participants. In addition, post-trade activities such as contract compare and collateral requirement matching continue to offer operational efficiencies and risk mitigation to the participants.
The demand and trend of increasing automation is unlikely to abate and vendors will need to adapt to the changing market infrastructure and regulation across Europe to ensure their offerings remain up-to-date. Transparency and reporting requirements across the securities lending market will undoubtedly increase as a result of increased regulatory focus and the need to have immediate access to data will be key.
There is also an opportunity for vendors to help the market respond to this requirement from regulators by being able to provide such regulatory reporting ‘off the shelf’ and minimising the impact on in-house technology teams. Vendors that store vast quantities of data on lending activity will clearly be well placed to help the market respond to this push for market transparency.
Finally, infrastructure developments such as TARGET-2 Securities will have a major impact on how market participants interact with the settlement mechanisms in Europe and vendors will need to be mindful of the evolving needs of their clients in respect of these changes.
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