Three times a payday
24 January 2017
A new year, president and opportunities promise an interesting next 12 months for securities lending. Experts discuss the issues
Image: Shutterstock
What should be on the top of a beneficial owner’s to-do list for the coming year?
Paul Wilson: The market is more dynamic than ever as demand to borrow and/or finance securities evolves in response to regulatory change, capital/balance sheet constraints, the global economy and other macro events. Beneficial owners generally experienced a decent 2016 in terms of revenue generation, given increased demand for high-quality liquid assets (HQLAs) and a robust equity specials environment, most notably in the US. However, the underlying trend is one of gradually declining revenue on a like-for-like basis, as evidenced by continued erosion of European yield enhancement and lower demand for general collateral.
Therefore, beneficial owners will want to stay abreast of these trends and consider, within their individual risk profile, whether to make changes or think about additional approaches (to markets, collateral, structures or general parameters). For example, some beneficial owners have ‘hold-back’ requirements. If a beneficial owner reduced a 20 percent hold back to 10 percent, revenue on in-demand specials could increase by 12.5 percent.
Being proactive around scrip and corporate action opportunities is another simple, yet effective, option to increase revenues.
There are other, more complex opportunities materialising that won’t be suitable for everyone. Either way, as the industry adjusts, beneficial owners should consider spending time on understanding and evaluating these options versus the overall goals of their securities lending programme.
Finally, the ‘to-do’ list of beneficial owners should include monitoring and adhering to new and evolving requirements regarding transparency (the Securities Financing Transactions Regulation (SFTR) in Europe and the US Securities and Exchange Commission’s Investment Company Reporting Modernization Act, for example) and/or SFT reporting.
Throughout 2017, and in future years, these requirements will become increasingly more commonplace and since failing to adhere is not an option for beneficial owners, this should be near the top of the list.
Lance Wargo: While the US securities lending market is dominated by cash collateral, with interest rates rising, it would be prudent to review cash collateral reinvestment strategies. Particularly, upon the implementation of money market reform in October last year, many investors took a back seat and moved into lower-yielding government money market funds.
As always, there is no one-size-fits-all approach. Beneficial owners need to consider their objectives as well as their unique risk tolerance in formulating a specific and feasible strategy.
Meanwhile, higher interest rates could potentially offer wider spreads. Yet, interest rate risk management would become more significantly important for beneficial owners as the Federal Reserve’s tightening pace accelerates.
That said, beneficial owners should also review their agent bank relationships to ensure that the interest of their securities lending agents are aligned with their own. Beneficial owners rely upon agent banks’ expertise to pursue higher returns and to manage risks, both financially and operationally.
Be it intrinsic lending or general collateral lending, the key is that agent banks need to have the capability and capacity to carry out a unique lending and investment strategy that is best suited for beneficial owners against the backdrop of new economic climates.
Since our programme at BNP Paribas was launched in the US, we have built our platform to offer customised solutions to our clients. We are in frequent dialogue with clients, such that they are fully engaged in the management of their securities lending programmes, and are fully informed of developments in the marketplace.
They are able to quickly implement a new lending and/or investment strategy—at their will—should market conditions evolve.
Joseph Santoro: 2017 should be a year of engagement. With an array of regulatory changes in effect, and more on the way, beneficial owners in the US and overseas would be well served to engage their agent as to how change affects them, their agent and counterparties. The new environment poses real challenges, but it also presents opportunities for those who are willing to invest time in optimising their strategy.
Deutsche Bank always puts the interests of beneficial owners first, and therefore seeks to make the best opportunities available to them by considering the challenges facing counterparties. Trading flexibility, such as collateral types and legal domicile, can provide counterparties with balance sheet relief and reward clients with measurable improvements in returns. Similarly, counterparties incur higher balance sheet costs trading with certain client types, so having flexibility in approving borrowers is increasingly important.
Finally, 2017 might be an ideal time for beneficial owners to re-examine the overall value proposition they receive from their agents. Some agents might be less constrained than others with respect to indemnification and relationship pricing, for example. Moreover, the needs of many beneficial owners are expanding beyond traditional yield enhancement, to include financing and collateral management, which is worth exploring.
George Trapp: Beneficial owners should review their programme parameters in 2017 to ensure they are prepared for a year that will likely experience changes in terms of the securities lending marketplace.
The last several years have provided relatively modest growth in the securities lending market. After a long period of extremely low interest rates globally, the US has increased the overnight fund rate twice in the past 12 months and will likely continue to increase rates during 2017.
Now would be a great time to review the terms of your securities lending programme and ensure they reflect the risk profile of your investment policy. Beneficial owners taking cash collateral would be wise to focus on investment guidelines and how the cash collateral portfolio is positioned relative to the expected increases in the overnight funding rate.
Cesco Squillacioti: Part of what an agent lender does is to review market activity constantly and to translate that activity into actionable suggestions for beneficial owner clients. Some suggestions could be revenue focused, such as engaging in lending in a new or different market; some suggestions could be around risk mitigation; sometimes both.
While we see this as an ongoing activity, the beginning of the year might be an opportune time for beneficial owner clients to take time to review and consider such suggestions in the context of their overall programme parameters and with a view to optimising them.
Chip Dempsey: Stock lending is becoming less profitable for the borrowing banks that facilitate transactions, which has diluted the incentive to provide clients with better service. There are three drivers to the benefits of a central counterparty (CCP):
Clearing affords more favourable capital treatment (with the CCP as counterparty or trade performance guarantor);
CCPs that accept non-cash collateral create opportunities to optimise collateral pledging, using securities that are otherwise un-utilised, further preserving balance sheet; and
CCPs process listed instruments in highly automated ways, which can be leveraged to the cost-efficiency of the stock loan post-trade processing flows.
Our traditional clearing members, many of which are bank-owned broker-dealers, were early adopters of our securities finance clearing. Basel III has had a very direct effect on their need to preserve their balance sheet by switching to lower risk-weighted assets.
The competitive edge is always moving: the conversations we’re having with agent lenders suggest that utilisation will reflect the borrowers’ costs, and the borrowing banks are unequivocal about the relative costs of CCP versus higher risk-weighted counterparties.
Understanding how CCPs affect their competitive position is worthy of being on a beneficial owner’s to-do list.
How will higher interest rates affect your trade choices?
Peter Economou: Higher interest rates add value to beneficial owners that lend securities in a number of ways. Beneficial owners that accept cash collateral and have investment guidelines that allow for a risk-adjusted return that incorporates duration risk can invest in opportunities as an upward sloping yield curve develops. Beneficial owners should carefully assess their liquidity needs to determine a desired liquidity threshold and, likewise, identify the portion of their cash collateral investment that could be extended by maturity to achieve higher returns.
In addition to the benefit for cash collateral, there is also an intrinsic lending benefit. Rising interest rates will continue to increase the securities lending benchmark as represented by the overnight bank funding rate (OBFR). As OBFR increases, there will be more spread between the benchmark and zero, allowing for more earnings to be generated from the opportunity cost of cash. Historical analysis shows that rebate spreads widen as cash opportunity cost spreads widen.
Trapp: Lower bond yields for the last several years have certainly had an impact on the shifting allocation from cash collateral to non-cash collateral. The trend, however, has other drivers as well, including the regulatory environment and the associated costs of utilisation of various types of collateral.
If anything, the recent shift higher in credit yields (ie, prime fund-like returns) versus government funds makes cash collateral more appealing from a pure yield perspective. The regulatory environment remains a driver of collateral decisions, but as spreads widen on cash products, the conversation becomes more compelling to re-engage on the cash side.
Wargo: Prolonged low interest rates have offered limited options for lenders over the years. Higher interest rates, no doubt, open the door for beneficial owners to pursue different trading strategies given their unique objectives. On the other hand, higher interest rates will translate into higher capital costs for broker-dealers. As a result, they will look for alternatives, if any, to lower their funding costs.
We strive to capitalise on market opportunities and maximum client returns in a risk-controlled manner. Our customisable programme structure allows us to achieve these goals throughout business cycles by tailoring to clients’ needs, while addressing borrower demand. In this context, we are designing various cash collateral reinvestment programmes with different asset types and maturity parameters to best capture market opportunities to maximise client returns, while keeping risks contained.
Wilson: By and large, transaction choices are driven by the borrower and the parameters established by the beneficial owner. Generally speaking, a higher interest rate environment will afford a broader range of cash re-investment options, including term. However, this is offset by continued decline in cash collateral provided by borrowers and volatility in cash balances around key reporting points such as quarter ends, which therefore require the need to keep robust levels of liquidity.
With the prospect of further rate rises during 2017, we favour floating rate securities as we feel they provide the best movement ahead of rate changes and we are able to capture the tightening environment. From a fixed rate standpoint, we are mindful of break-evens and interest rate expectations, but continue to be active there as well. Our approach is to try to remain flexible towards transaction choices, collateral, tenure, and so on in order to take advantage of opportunities as they materialise.
Dempsey: It is all about collateral optimisation. The opportunity cost of higher interest-bearing instruments is driving efforts to optimise the use of cash equities as collateral.
Santoro: Higher rates will not have a profound effect as we are focused on lending securities that are in highest demand. Also, we operate on a separate account basis and manage interest rate risk very closely. For us, it is more a matter of staying in close communication with counterparties and managing, or holding the line on, rebate rates as the Fed moves. We have the longest tenured team in the industry, so we’ve been through a number of interest rate cycles.
To what extent will the current low-yield bond environment affect the shift to non-cash collateral?
Squillacioti: We have seen a gradual shift towards non-cash collateral over the past few years, and it is becoming increasingly important. There would seem to be many factors at play to make this the case. The rate environment could certainly be viewed as a contributor to this shift in terms of influencing client preference or acceptance, but another factor has been working to be flexible enough to accept collateral from our counterparties that fosters balance sheet efficiency, under the various regulatory ratio requirements.
I mentioned client preference, but there are also situations where a beneficial owner lender may only accept non-cash collateral. As the number of those clients grows, it would also begin to have an impact on this shift.
Entering an environment where rate increases become more of a feature essentially provides additional flexibility to an agent lender, and additional options in trading strategies. Ultimately, the driver has to be what combination of loan and collateral type works best for client guidelines and risk tolerance, and what provides a client a more attractive loan opportunity.
Economou: The current low-yield bond environment has been in place for some time now. Non-cash collateral has continued to increase based upon the borrower’s regulatory requirements and the fact that beneficial owners have seen little opportunity to invest cash in a near-zero interest rate environment.
As interest rates rise, beneficial owners should demand to be paid more for taking non-cash collateral in order to be compensated for forfeiting the reinvestment value of cash collateral with an upward sloping yield curve. This, of course, is only one factor within the intrinsic value of lending securities and should be incorporated into the supply/demand pricing dynamic.
Santoro: In Europe, in keeping with client preferences and convention, the majority of our trades are already booked versus non-cash collateral, accounting for roughly 70 percent of our non-US fixed income book and 90 percent of our equity book.
In the US, until more recently, we did not feel compelled to move an appreciable portion of our book to non-cash, so our clients have been able to enjoy the added pick-up associated with cash collateral. With balance sheet restrictions becoming more of a concern among our counterparties, we would expect these percentages to grow in the US.
Dempsey: The most significant driver towards non-cash collateral is more desirable balance sheet treatment, versus cash collateral, on the part of the borrower. If the lender is sufficiently collateralised and comfortable with that collateral then it may find better pricing on non-cash loans, which can counterbalance shrinking returns under the current low-yield environment.
Wilson: While the low-yield bond environment may affect the buying behaviour of beneficial owners and could also affect the demand to short particular fixed income asset classes, it is not likely to be a material driver in a further shift to non-cash collateral.
We do anticipate the continuation of the shift to non-cash collateral. In the US and for many US beneficial owners, this still has a way to go, but is to some degree dependent upon rule changes that will make it more viable for US dealers to use equities as collateral.
Wargo: Certainly non-cash transactions have increased due to the regulatory and capital advantages. However, the rising rate environment in the US has created a tremendous opportunity for those clients engaging in a cash collateral transaction.
Money market reform, and the subsequent widening of LIBOR, created tremendous opportunities for programmes engaged in cash collateral strategies.
The anticipated interest rate increases in the US will continue to provide an opportunity to monetise rate movements, while current conditions in the credit markets make it an opportune time to engage in cash collateral reinvestment strategies.
Trapp: Lower bond yields for the last several years have certainly had an impact on the shifting allocation from cash collateral to non-cash collateral. The trend, however, has other drivers as well, including the regulatory environment and the associated costs of utilisation of various types of collateral. If anything, the recent shift higher in credit yields (ie, prime fund-like returns) versus government funds makes cash collateral more appealing from a pure yield perspective.
The regulatory environment remains a driver of collateral decisions but as spreads widen on cash products, the conversation becomes more compelling to re-engage on the cash side.
Is President Trump and the economic/regulatory disruption he will likely bring be a good thing for the securities lending market?
Trapp: The outcome of the US presidential election is being felt across the marketplace. Whether it is the anticipation of increased growth or less regulation, the markets have reacted positively.
Although the optimistic sentiment has not necessarily resulted in a consistent improvement across all securities lending asset classes, beneficial owners may see a positive result in terms of portfolio returns, which would benefit performance and funding levels.
US treasuries are also seeing some interest, especially the benchmark and most recently issued securities.
There is increased activity with more general collateral securities and now a spread can be made on lending US treasuries for cash or non-cash collateral. This is a fairly dramatic change from where the US treasury market was a year ago.
At the same time, the current market environment has benefited from returns on the cash collateral for the US dollar. This has helped boost returns for beneficial owners taking cash collateral and will likely continue as rates move higher.
One exception to this has been experienced by Rule 2a-7 government cash-only investment vehicles, which continue to see relatively modest returns due to the demand for US treasury securities.
Economou: We expect more market volatility and better margins, which creates ‘space’ for hedge funds and those that borrow from/lend to them, which means good potential for the securities lending markets. Trump’s appointments to the Treasury and SEC, as well as congressional support, will likely influence various tactical moves that could lighten the regulatory burden on market players.
It is also reasonable to expect that the higher thresholds that have been established by the Fed on global systemically important banks will be scaled back—another potential benefit. As a beneficial owner, this would be positive.
Santoro: Some speculate that the top agenda items for President Donald Trump’s administration will be the ‘repeal’ of Affordable Care Act and tax reform, with the Dodd-Frank Act being addressed at a later date. We’ll have to wait and see with respect to specific growth-oriented economic policies that the new administration will promulgate, and whether post-crisis regulations might be repealed or rolled back in a meaningful way.
Market volatility will always provide opportunities in the securities lending market, so if the tone and content of the election campaign carries over into the next few years, a higher level of market volatility is possible.
Dempsey: OCC supports the idea of efficient and effective regulation that enables a diversity of investment strategies and innovation without increasing systemic risk.
Our focus on developing safe and secure markets through effective risk management aligns with the goals of Dodd-Frank to reduce systemic risk.
It is too early to tell whether there will be any economic or regulatory disruption for the securities lending market until Trump’s policies begin to take shape with his newly formed cabinet.
However, based on what we have seen and heard, his platform appears to be more focused on freeing up capital for small business loans.
Some of his potential nominees for the Fed and other relevant policy positions in his administration have been calling for higher liquidity ratios in lieu of tighter regulation. If such actions were to occur, that could portend tighter access to balance sheets, more expensive bilateral credit, and an enhanced need to reduce risk weightings.
This could pose a challenge to OCC’s clearing member firms and could cause us to provide novation for a wider range of the stock loan market in order to afford our member firms our 2 percent risk weighting, as opposed to 20 percent or 100 percent with other counterparties. OCC estimates, supported by industry research, a clearing model reduces a clearing firm’s cost of capital by 71 percent.
What are the possible ramifications of SFTR for your US businesses? And where are US regulators with their own reporting framework?
Wilson: SFTR regulations in Europe impose two obligations: greater disclosure of lending activity by entities and the reporting of SFTs themselves to designated trade repositories.
European Securities and Markets Authority (ESMA) guidelines had already established greater reporting/transparency for UCITS funds and, in October 2016, the US SEC voted to adopt rules, forms and amendments that are intended to modernise and enhance the reporting and disclosure of information by investment companies.
The new rules will enhance data reporting for mutual funds, exchange-traded funds and other registered investment companies.
They also require enhanced and standardised disclosures in financial statements and will add new disclosures in fund registration statements relating to a fund’s securities lending activities.
The reporting of SFTs to trade repositories is still a work in progress with implementation in Europe scheduled for some time in 2018. While the finalised requirements have yet to be published, enough is known to be sure this regime will have a profound impact on entities and beneficial owners.
It is likely to require changes to well established procedures and protocols, especially agent lender disclosure.
For beneficial owners outside of Europe that transact (lend) with entities (borrowers) in Europe, it is believed the reporting requirements will fall on the Europe-based entity, although it is possible that certain information may be required from the non-European entity in order to assist the Europe-based entity in meeting their reporting requirements.
As the approach in Europe is in line with one of the Financial Stability Board’s (FSB) recommendations from 2015, we anticipate that other jurisdictions will follow suit in due course.
Trapp: It’s unlikely that the EU’s SFTR initiative will affect the US business differently to the non-US business. In the near term, US lenders may not be obligated to directly report the loan side of the transaction, but it is anticipated that borrowers will still need confirmation from agent lenders on how their collateral has been allocated among its lending clients.
Generally, challenges are expected during the implementation period, specifically as related to efficient communications between systems for agent lenders and borrowers regarding timing and demands of the available data. Industry-wide discussions on the mechanics of implementation are ongoing.
Northern Trust is actively engaged in those efforts and intends to provide the necessary support to facilitate required reporting under SFTR.
Wargo: The US regulators, from time to time, collect data from the marketplace to help them get a better understanding on how the market functions. While the US securities lending market is the largest in the world, we, along with other market participants, are actively involved in discussions of US regulatory developments.
Economou: Since eSecLending runs a global programme, with EU-member entities as lending clients as well as counterparties, we have already begun complying with SFTR’s requirements.
eSecLending’s programme is managed on a segregated basis rather than a pooled one, which gives us inherent advantages in supporting SFTR, especially regarding upcoming trade reporting requirements.
Trapp: In various jurisdictions, including the US, regulators have been working on the appropriate reporting framework.
The Office of Financial Research (OFR) completed a pilot study to help identify data requirements that would be most well-suited to their transparency goals. We expect regulators to use the results of this study to help guide their input at the FSB level during 2017.
The OFR has also made a recommendation for permanent data collection.
Squillacioti: SFTR could have potential ramifications for any client that is dealing with a European counterpart, as it is a two-way trade repository. However, as the technical standards are expected to be released at the end of Q1, the mechanism for capturing non-European trade data has yet to be determined.
We understand that, from there, implementation would take place over an 18-month timeline.
In terms of the US, the OFR is still finishing work on a proposal for a final permanent data collection method and mechanism. The US will be done on an exposure basis rather than trade-by-trade basis, thereby making the execution considerably simpler.
Santoro: Clearly, there is a technology spend to comply with SFTR regulations. Specific to US regulators, Deutsche Bank participated in the OFR, US Treasury and SEC’s pilot programmes in 2015, which collected lending agent data for three separate dates during the year to provide those regulators parameters in which the market operates.
Further, in October 2016, the SEC adopted reporting modernisation rules that will go into effect on 1 June 2018.
The rules will enhance data reporting for mutual funds, exchange-traded funds and other registered investment companies.
The rules call for new monthly and annual reporting forms, enhanced standardised disclosures and new disclosures in fund registration statements relating to a fund’s securities lending activities.
We do not envision any difficulty meeting the new requirements given we operate on a real-time platform with a dedicated technology team that sits within the business. We’ve already had dialogue with our clients who will be subject to the new rules.
Given Deutsche Bank is a global institution, it is worth mentioning that we service global investors across multiple jurisdictions.
We are very active in the US and overseas in analysing new regulations, including reporting technical standards, in conjunction with our market advocacy, legal and compliance groups.
Where appropriate, we are working together with industry groups towards a consistent and efficient industry-level approach.
Paul Wilson: The market is more dynamic than ever as demand to borrow and/or finance securities evolves in response to regulatory change, capital/balance sheet constraints, the global economy and other macro events. Beneficial owners generally experienced a decent 2016 in terms of revenue generation, given increased demand for high-quality liquid assets (HQLAs) and a robust equity specials environment, most notably in the US. However, the underlying trend is one of gradually declining revenue on a like-for-like basis, as evidenced by continued erosion of European yield enhancement and lower demand for general collateral.
Therefore, beneficial owners will want to stay abreast of these trends and consider, within their individual risk profile, whether to make changes or think about additional approaches (to markets, collateral, structures or general parameters). For example, some beneficial owners have ‘hold-back’ requirements. If a beneficial owner reduced a 20 percent hold back to 10 percent, revenue on in-demand specials could increase by 12.5 percent.
Being proactive around scrip and corporate action opportunities is another simple, yet effective, option to increase revenues.
There are other, more complex opportunities materialising that won’t be suitable for everyone. Either way, as the industry adjusts, beneficial owners should consider spending time on understanding and evaluating these options versus the overall goals of their securities lending programme.
Finally, the ‘to-do’ list of beneficial owners should include monitoring and adhering to new and evolving requirements regarding transparency (the Securities Financing Transactions Regulation (SFTR) in Europe and the US Securities and Exchange Commission’s Investment Company Reporting Modernization Act, for example) and/or SFT reporting.
Throughout 2017, and in future years, these requirements will become increasingly more commonplace and since failing to adhere is not an option for beneficial owners, this should be near the top of the list.
Lance Wargo: While the US securities lending market is dominated by cash collateral, with interest rates rising, it would be prudent to review cash collateral reinvestment strategies. Particularly, upon the implementation of money market reform in October last year, many investors took a back seat and moved into lower-yielding government money market funds.
As always, there is no one-size-fits-all approach. Beneficial owners need to consider their objectives as well as their unique risk tolerance in formulating a specific and feasible strategy.
Meanwhile, higher interest rates could potentially offer wider spreads. Yet, interest rate risk management would become more significantly important for beneficial owners as the Federal Reserve’s tightening pace accelerates.
That said, beneficial owners should also review their agent bank relationships to ensure that the interest of their securities lending agents are aligned with their own. Beneficial owners rely upon agent banks’ expertise to pursue higher returns and to manage risks, both financially and operationally.
Be it intrinsic lending or general collateral lending, the key is that agent banks need to have the capability and capacity to carry out a unique lending and investment strategy that is best suited for beneficial owners against the backdrop of new economic climates.
Since our programme at BNP Paribas was launched in the US, we have built our platform to offer customised solutions to our clients. We are in frequent dialogue with clients, such that they are fully engaged in the management of their securities lending programmes, and are fully informed of developments in the marketplace.
They are able to quickly implement a new lending and/or investment strategy—at their will—should market conditions evolve.
Joseph Santoro: 2017 should be a year of engagement. With an array of regulatory changes in effect, and more on the way, beneficial owners in the US and overseas would be well served to engage their agent as to how change affects them, their agent and counterparties. The new environment poses real challenges, but it also presents opportunities for those who are willing to invest time in optimising their strategy.
Deutsche Bank always puts the interests of beneficial owners first, and therefore seeks to make the best opportunities available to them by considering the challenges facing counterparties. Trading flexibility, such as collateral types and legal domicile, can provide counterparties with balance sheet relief and reward clients with measurable improvements in returns. Similarly, counterparties incur higher balance sheet costs trading with certain client types, so having flexibility in approving borrowers is increasingly important.
Finally, 2017 might be an ideal time for beneficial owners to re-examine the overall value proposition they receive from their agents. Some agents might be less constrained than others with respect to indemnification and relationship pricing, for example. Moreover, the needs of many beneficial owners are expanding beyond traditional yield enhancement, to include financing and collateral management, which is worth exploring.
George Trapp: Beneficial owners should review their programme parameters in 2017 to ensure they are prepared for a year that will likely experience changes in terms of the securities lending marketplace.
The last several years have provided relatively modest growth in the securities lending market. After a long period of extremely low interest rates globally, the US has increased the overnight fund rate twice in the past 12 months and will likely continue to increase rates during 2017.
Now would be a great time to review the terms of your securities lending programme and ensure they reflect the risk profile of your investment policy. Beneficial owners taking cash collateral would be wise to focus on investment guidelines and how the cash collateral portfolio is positioned relative to the expected increases in the overnight funding rate.
Cesco Squillacioti: Part of what an agent lender does is to review market activity constantly and to translate that activity into actionable suggestions for beneficial owner clients. Some suggestions could be revenue focused, such as engaging in lending in a new or different market; some suggestions could be around risk mitigation; sometimes both.
While we see this as an ongoing activity, the beginning of the year might be an opportune time for beneficial owner clients to take time to review and consider such suggestions in the context of their overall programme parameters and with a view to optimising them.
Chip Dempsey: Stock lending is becoming less profitable for the borrowing banks that facilitate transactions, which has diluted the incentive to provide clients with better service. There are three drivers to the benefits of a central counterparty (CCP):
Clearing affords more favourable capital treatment (with the CCP as counterparty or trade performance guarantor);
CCPs that accept non-cash collateral create opportunities to optimise collateral pledging, using securities that are otherwise un-utilised, further preserving balance sheet; and
CCPs process listed instruments in highly automated ways, which can be leveraged to the cost-efficiency of the stock loan post-trade processing flows.
Our traditional clearing members, many of which are bank-owned broker-dealers, were early adopters of our securities finance clearing. Basel III has had a very direct effect on their need to preserve their balance sheet by switching to lower risk-weighted assets.
The competitive edge is always moving: the conversations we’re having with agent lenders suggest that utilisation will reflect the borrowers’ costs, and the borrowing banks are unequivocal about the relative costs of CCP versus higher risk-weighted counterparties.
Understanding how CCPs affect their competitive position is worthy of being on a beneficial owner’s to-do list.
How will higher interest rates affect your trade choices?
Peter Economou: Higher interest rates add value to beneficial owners that lend securities in a number of ways. Beneficial owners that accept cash collateral and have investment guidelines that allow for a risk-adjusted return that incorporates duration risk can invest in opportunities as an upward sloping yield curve develops. Beneficial owners should carefully assess their liquidity needs to determine a desired liquidity threshold and, likewise, identify the portion of their cash collateral investment that could be extended by maturity to achieve higher returns.
In addition to the benefit for cash collateral, there is also an intrinsic lending benefit. Rising interest rates will continue to increase the securities lending benchmark as represented by the overnight bank funding rate (OBFR). As OBFR increases, there will be more spread between the benchmark and zero, allowing for more earnings to be generated from the opportunity cost of cash. Historical analysis shows that rebate spreads widen as cash opportunity cost spreads widen.
Trapp: Lower bond yields for the last several years have certainly had an impact on the shifting allocation from cash collateral to non-cash collateral. The trend, however, has other drivers as well, including the regulatory environment and the associated costs of utilisation of various types of collateral.
If anything, the recent shift higher in credit yields (ie, prime fund-like returns) versus government funds makes cash collateral more appealing from a pure yield perspective. The regulatory environment remains a driver of collateral decisions, but as spreads widen on cash products, the conversation becomes more compelling to re-engage on the cash side.
Wargo: Prolonged low interest rates have offered limited options for lenders over the years. Higher interest rates, no doubt, open the door for beneficial owners to pursue different trading strategies given their unique objectives. On the other hand, higher interest rates will translate into higher capital costs for broker-dealers. As a result, they will look for alternatives, if any, to lower their funding costs.
We strive to capitalise on market opportunities and maximum client returns in a risk-controlled manner. Our customisable programme structure allows us to achieve these goals throughout business cycles by tailoring to clients’ needs, while addressing borrower demand. In this context, we are designing various cash collateral reinvestment programmes with different asset types and maturity parameters to best capture market opportunities to maximise client returns, while keeping risks contained.
Wilson: By and large, transaction choices are driven by the borrower and the parameters established by the beneficial owner. Generally speaking, a higher interest rate environment will afford a broader range of cash re-investment options, including term. However, this is offset by continued decline in cash collateral provided by borrowers and volatility in cash balances around key reporting points such as quarter ends, which therefore require the need to keep robust levels of liquidity.
With the prospect of further rate rises during 2017, we favour floating rate securities as we feel they provide the best movement ahead of rate changes and we are able to capture the tightening environment. From a fixed rate standpoint, we are mindful of break-evens and interest rate expectations, but continue to be active there as well. Our approach is to try to remain flexible towards transaction choices, collateral, tenure, and so on in order to take advantage of opportunities as they materialise.
Dempsey: It is all about collateral optimisation. The opportunity cost of higher interest-bearing instruments is driving efforts to optimise the use of cash equities as collateral.
Santoro: Higher rates will not have a profound effect as we are focused on lending securities that are in highest demand. Also, we operate on a separate account basis and manage interest rate risk very closely. For us, it is more a matter of staying in close communication with counterparties and managing, or holding the line on, rebate rates as the Fed moves. We have the longest tenured team in the industry, so we’ve been through a number of interest rate cycles.
To what extent will the current low-yield bond environment affect the shift to non-cash collateral?
Squillacioti: We have seen a gradual shift towards non-cash collateral over the past few years, and it is becoming increasingly important. There would seem to be many factors at play to make this the case. The rate environment could certainly be viewed as a contributor to this shift in terms of influencing client preference or acceptance, but another factor has been working to be flexible enough to accept collateral from our counterparties that fosters balance sheet efficiency, under the various regulatory ratio requirements.
I mentioned client preference, but there are also situations where a beneficial owner lender may only accept non-cash collateral. As the number of those clients grows, it would also begin to have an impact on this shift.
Entering an environment where rate increases become more of a feature essentially provides additional flexibility to an agent lender, and additional options in trading strategies. Ultimately, the driver has to be what combination of loan and collateral type works best for client guidelines and risk tolerance, and what provides a client a more attractive loan opportunity.
Economou: The current low-yield bond environment has been in place for some time now. Non-cash collateral has continued to increase based upon the borrower’s regulatory requirements and the fact that beneficial owners have seen little opportunity to invest cash in a near-zero interest rate environment.
As interest rates rise, beneficial owners should demand to be paid more for taking non-cash collateral in order to be compensated for forfeiting the reinvestment value of cash collateral with an upward sloping yield curve. This, of course, is only one factor within the intrinsic value of lending securities and should be incorporated into the supply/demand pricing dynamic.
Santoro: In Europe, in keeping with client preferences and convention, the majority of our trades are already booked versus non-cash collateral, accounting for roughly 70 percent of our non-US fixed income book and 90 percent of our equity book.
In the US, until more recently, we did not feel compelled to move an appreciable portion of our book to non-cash, so our clients have been able to enjoy the added pick-up associated with cash collateral. With balance sheet restrictions becoming more of a concern among our counterparties, we would expect these percentages to grow in the US.
Dempsey: The most significant driver towards non-cash collateral is more desirable balance sheet treatment, versus cash collateral, on the part of the borrower. If the lender is sufficiently collateralised and comfortable with that collateral then it may find better pricing on non-cash loans, which can counterbalance shrinking returns under the current low-yield environment.
Wilson: While the low-yield bond environment may affect the buying behaviour of beneficial owners and could also affect the demand to short particular fixed income asset classes, it is not likely to be a material driver in a further shift to non-cash collateral.
We do anticipate the continuation of the shift to non-cash collateral. In the US and for many US beneficial owners, this still has a way to go, but is to some degree dependent upon rule changes that will make it more viable for US dealers to use equities as collateral.
Wargo: Certainly non-cash transactions have increased due to the regulatory and capital advantages. However, the rising rate environment in the US has created a tremendous opportunity for those clients engaging in a cash collateral transaction.
Money market reform, and the subsequent widening of LIBOR, created tremendous opportunities for programmes engaged in cash collateral strategies.
The anticipated interest rate increases in the US will continue to provide an opportunity to monetise rate movements, while current conditions in the credit markets make it an opportune time to engage in cash collateral reinvestment strategies.
Trapp: Lower bond yields for the last several years have certainly had an impact on the shifting allocation from cash collateral to non-cash collateral. The trend, however, has other drivers as well, including the regulatory environment and the associated costs of utilisation of various types of collateral. If anything, the recent shift higher in credit yields (ie, prime fund-like returns) versus government funds makes cash collateral more appealing from a pure yield perspective.
The regulatory environment remains a driver of collateral decisions but as spreads widen on cash products, the conversation becomes more compelling to re-engage on the cash side.
Is President Trump and the economic/regulatory disruption he will likely bring be a good thing for the securities lending market?
Trapp: The outcome of the US presidential election is being felt across the marketplace. Whether it is the anticipation of increased growth or less regulation, the markets have reacted positively.
Although the optimistic sentiment has not necessarily resulted in a consistent improvement across all securities lending asset classes, beneficial owners may see a positive result in terms of portfolio returns, which would benefit performance and funding levels.
US treasuries are also seeing some interest, especially the benchmark and most recently issued securities.
There is increased activity with more general collateral securities and now a spread can be made on lending US treasuries for cash or non-cash collateral. This is a fairly dramatic change from where the US treasury market was a year ago.
At the same time, the current market environment has benefited from returns on the cash collateral for the US dollar. This has helped boost returns for beneficial owners taking cash collateral and will likely continue as rates move higher.
One exception to this has been experienced by Rule 2a-7 government cash-only investment vehicles, which continue to see relatively modest returns due to the demand for US treasury securities.
Economou: We expect more market volatility and better margins, which creates ‘space’ for hedge funds and those that borrow from/lend to them, which means good potential for the securities lending markets. Trump’s appointments to the Treasury and SEC, as well as congressional support, will likely influence various tactical moves that could lighten the regulatory burden on market players.
It is also reasonable to expect that the higher thresholds that have been established by the Fed on global systemically important banks will be scaled back—another potential benefit. As a beneficial owner, this would be positive.
Santoro: Some speculate that the top agenda items for President Donald Trump’s administration will be the ‘repeal’ of Affordable Care Act and tax reform, with the Dodd-Frank Act being addressed at a later date. We’ll have to wait and see with respect to specific growth-oriented economic policies that the new administration will promulgate, and whether post-crisis regulations might be repealed or rolled back in a meaningful way.
Market volatility will always provide opportunities in the securities lending market, so if the tone and content of the election campaign carries over into the next few years, a higher level of market volatility is possible.
Dempsey: OCC supports the idea of efficient and effective regulation that enables a diversity of investment strategies and innovation without increasing systemic risk.
Our focus on developing safe and secure markets through effective risk management aligns with the goals of Dodd-Frank to reduce systemic risk.
It is too early to tell whether there will be any economic or regulatory disruption for the securities lending market until Trump’s policies begin to take shape with his newly formed cabinet.
However, based on what we have seen and heard, his platform appears to be more focused on freeing up capital for small business loans.
Some of his potential nominees for the Fed and other relevant policy positions in his administration have been calling for higher liquidity ratios in lieu of tighter regulation. If such actions were to occur, that could portend tighter access to balance sheets, more expensive bilateral credit, and an enhanced need to reduce risk weightings.
This could pose a challenge to OCC’s clearing member firms and could cause us to provide novation for a wider range of the stock loan market in order to afford our member firms our 2 percent risk weighting, as opposed to 20 percent or 100 percent with other counterparties. OCC estimates, supported by industry research, a clearing model reduces a clearing firm’s cost of capital by 71 percent.
What are the possible ramifications of SFTR for your US businesses? And where are US regulators with their own reporting framework?
Wilson: SFTR regulations in Europe impose two obligations: greater disclosure of lending activity by entities and the reporting of SFTs themselves to designated trade repositories.
European Securities and Markets Authority (ESMA) guidelines had already established greater reporting/transparency for UCITS funds and, in October 2016, the US SEC voted to adopt rules, forms and amendments that are intended to modernise and enhance the reporting and disclosure of information by investment companies.
The new rules will enhance data reporting for mutual funds, exchange-traded funds and other registered investment companies.
They also require enhanced and standardised disclosures in financial statements and will add new disclosures in fund registration statements relating to a fund’s securities lending activities.
The reporting of SFTs to trade repositories is still a work in progress with implementation in Europe scheduled for some time in 2018. While the finalised requirements have yet to be published, enough is known to be sure this regime will have a profound impact on entities and beneficial owners.
It is likely to require changes to well established procedures and protocols, especially agent lender disclosure.
For beneficial owners outside of Europe that transact (lend) with entities (borrowers) in Europe, it is believed the reporting requirements will fall on the Europe-based entity, although it is possible that certain information may be required from the non-European entity in order to assist the Europe-based entity in meeting their reporting requirements.
As the approach in Europe is in line with one of the Financial Stability Board’s (FSB) recommendations from 2015, we anticipate that other jurisdictions will follow suit in due course.
Trapp: It’s unlikely that the EU’s SFTR initiative will affect the US business differently to the non-US business. In the near term, US lenders may not be obligated to directly report the loan side of the transaction, but it is anticipated that borrowers will still need confirmation from agent lenders on how their collateral has been allocated among its lending clients.
Generally, challenges are expected during the implementation period, specifically as related to efficient communications between systems for agent lenders and borrowers regarding timing and demands of the available data. Industry-wide discussions on the mechanics of implementation are ongoing.
Northern Trust is actively engaged in those efforts and intends to provide the necessary support to facilitate required reporting under SFTR.
Wargo: The US regulators, from time to time, collect data from the marketplace to help them get a better understanding on how the market functions. While the US securities lending market is the largest in the world, we, along with other market participants, are actively involved in discussions of US regulatory developments.
Economou: Since eSecLending runs a global programme, with EU-member entities as lending clients as well as counterparties, we have already begun complying with SFTR’s requirements.
eSecLending’s programme is managed on a segregated basis rather than a pooled one, which gives us inherent advantages in supporting SFTR, especially regarding upcoming trade reporting requirements.
Trapp: In various jurisdictions, including the US, regulators have been working on the appropriate reporting framework.
The Office of Financial Research (OFR) completed a pilot study to help identify data requirements that would be most well-suited to their transparency goals. We expect regulators to use the results of this study to help guide their input at the FSB level during 2017.
The OFR has also made a recommendation for permanent data collection.
Squillacioti: SFTR could have potential ramifications for any client that is dealing with a European counterpart, as it is a two-way trade repository. However, as the technical standards are expected to be released at the end of Q1, the mechanism for capturing non-European trade data has yet to be determined.
We understand that, from there, implementation would take place over an 18-month timeline.
In terms of the US, the OFR is still finishing work on a proposal for a final permanent data collection method and mechanism. The US will be done on an exposure basis rather than trade-by-trade basis, thereby making the execution considerably simpler.
Santoro: Clearly, there is a technology spend to comply with SFTR regulations. Specific to US regulators, Deutsche Bank participated in the OFR, US Treasury and SEC’s pilot programmes in 2015, which collected lending agent data for three separate dates during the year to provide those regulators parameters in which the market operates.
Further, in October 2016, the SEC adopted reporting modernisation rules that will go into effect on 1 June 2018.
The rules will enhance data reporting for mutual funds, exchange-traded funds and other registered investment companies.
The rules call for new monthly and annual reporting forms, enhanced standardised disclosures and new disclosures in fund registration statements relating to a fund’s securities lending activities.
We do not envision any difficulty meeting the new requirements given we operate on a real-time platform with a dedicated technology team that sits within the business. We’ve already had dialogue with our clients who will be subject to the new rules.
Given Deutsche Bank is a global institution, it is worth mentioning that we service global investors across multiple jurisdictions.
We are very active in the US and overseas in analysing new regulations, including reporting technical standards, in conjunction with our market advocacy, legal and compliance groups.
Where appropriate, we are working together with industry groups towards a consistent and efficient industry-level approach.
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