Slam dunk da funk
13 June 2017
Experts discuss the current state of the European securities lending market
Image: Shutterstock
Panel Participants
Donia Rouigueb
Securities lending and financing sales trading
CACEIS
Paul Wilson
Managing director and global head of client management and sales for financing and markets products
J.P. Morgan
Sunil Daswani
Head of international securities lending
Northern Trust
Simon Tomlinson
Head of equity finance for EMEA
BNY Mellon
John Arnesen
Global head of agency lending
BNP Paribas Securities Services
How have European revenue sources changed in the past 12 months?
Paul Wilson: We’ve seen quite a lot of change across the European securities lending landscape over the past 12 months. In equity lending markets, the decline in demand for, and revenue from, yield enhancement activity continues. This has been accompanied by a lack of new specials caused by a decrease in volatility and subdued hedge fund activity, especially in long/short strategies.
The offset to this has been increased scrip opportunities and take up by beneficial owners plus financing and upgrade opportunities. In fixed income markets we see good demand for German and French sovereigns in collateral upgrade trades versus equities in 35 to 185 day evergreen structures. However, the strongest demand is still for US treasuries, which yield a couple of basis points in fees above European government bonds.
There are also alternative revenue opportunities available, such as lending core European sovereigns and taking back peripheral sovereigns, especially Italy and Spain, as collateral. In addition, there is now a strong specials market in Germany with demand especially in the seven to 10-year maturities. This is driven by the removal of supply from the market by the European Central Bank’s (ECB) bond purchase plan—although the ECB does operate a lending programme, availability of specific issues is far more restricted compared to when bonds were freely available in the wider repo market.
Activity in the corporate bond and emerging market sovereign space has remained stable over the past six months, but demand for energy, commodity and financial issuers has significantly reduced year on year.
John Arnesen: When one looks at sources of revenue it is clear that general collateral has always played a significant role in revenue generation, and the past 12 months is no exception. Seasonal spring demand for European equities continues to diminish both in terms of markets and appetite. The most consistent revenue stream year on year has come from lending European government debt on a term basis for longer than 30 days.
Sunil Daswani: Revenue drivers in fixed income markets have been largely dictated by regulatory changes and central bank asset purchase programmes. Pressure mounted in European sovereign markets towards the end of 2016 as the ECB maintained its presence as a substantial buyer of government debt through its quantitative easing programme. Concurrently, regulatory obligations meant banks and end users were compelled to hold large inventories of high-quality liquid assets (HQLA), particularly evident over sensitive reporting periods such as year-end. As such, specific German bonds in particular were in strong demand throughout the period, leading to a widening of spreads amid ongoing concerns related to bond scarcity.
Fees from lending emerging market bonds narrowed during the period as sentiment towards the asset class improved and geopolitical risk subsided. Perhaps the most interesting change has been evident in the widening fees we have observed in lending corporate bonds. With increased regulatory burdens and reductions of balance sheets, banks are less able to warehouse risk and hold expensive corporate bond exposures. Correspondingly, assets are more in demand from the agent lender community to satisfy market making responsibilities and cover settlement issues. As such, fees increased throughout the period as agent lenders were able to widen spreads.
From an equity perspective, Europe’s macroeconomic environment has influenced revenue drivers in the region. Ongoing economic and political instability associated with the UK’s surprise Brexit result, coupled with government leadership elections in many of Europe’s largest economies has created a challenging investment back-drop for investors. Additionally, the new Trump administration’s pro-business policies have typically helped sustain strong equity market growth. As a result, hedge funds typically had less conviction when deploying capital on the short side, resulting in a reduction in the volume of traditional ‘specials’ activity in the region. Revenues have been impacted accordingly, although some one off securities has helped compensation for this trend.
Furthermore, ongoing regulatory scrutiny around balance sheet and regulatory capital constraints continued to represent a headwind in terms of traditional balance growth. Demand from the borrower community is increasingly focused around trading structures that provide greater capital efficiencies. Term activity remains part of the borrower’s demand profile, with collateral pledge structures and central counterparties (CCPs) likely to becoming more prevalent in the short and mid-term. Traditional seasonal sources of revenue remain, with a growth in scrip dividend activity being a positive trend.
Simon Tomlinson: The introduction of the liquidity coverage ratio in 2015 and the upcoming net stable funding ratio are having a dramatic impact on trading by extending the term of trades from what used to be an overnight business. Indeed, three-month evergreen trades and longer are now commonplace as borrowers look to meet Basel III capital requirements.
While equities have traditionally been the largest revenue generator over the past few years—enjoying a buoyant specials market in part because of the drop in commodity prices—there is definitely a change taking place. With the increasing demand for HQLA to meet regulatory requirements and the introduction of margin on non-cleared derivatives, beneficial owners of certain types of European fixed income collateral are seeing an increase in returns. This is not likely to change in the near future, with the ECB’s own asset purchase programme somewhat adding to the problem, causing liquidity to deteriorate and spreads to widen.
Donia Rouigueb: Looking at the four principal revenue sources, general collateral has seen a dip because there are more participants in lending programmes, so much more offer for these liquid assets. Also, borrowers are optimising their internal holdings to avoid borrowing outside so they can control and eventually decrease the balance sheet impact.
A lot of beneficial owners still have a strict collateral matrix, which penalises borrowers. Demand for specials has remained at the same level, and are by definition always requested, but the low volatility of the markets did not improve the demand for these kind of assets so revenues remained steady. We have also seen yield enhancement decrease in 2016 and more or less stabilise in 2017 due to marketplace uncertainty regarding harmonisation and guidelines.
What effect is EU regulation having on the buy- and sell-side behaviour?
Tomlinson: Regulation is having a major effect on both the buy and the sell side. Borrowers are struggling with limited balance sheet and regulatory capital hurdles meaning borrowers need to seek new liquidity solutions not only to service their existing business but also to generate returns in an environment where resources are scarce and costs are mounting. Among the options being reviewed is the traditional method of moving collateral between parties under a title transfer. In its place, the option to receive collateral under pledge is under consideration. This is not without its challenges and the International Securities Lending Association (ISLA) is trying to standardise the documentation for this to work. There is also the consideration of a centrally cleared model for securities financing trades, which could provide a host of post-trade efficiencies for clients if they are eligible and willing to participate.
UCITS are a good example of a fund type that is being excluded from the new trading opportunities being seen in Europe. The UCITS market represents approximately 45 percent of the lendable base but only 15 percent of those assets are on-loan, down from 18 percent three years ago, according to ISLA. There is a dichotomy in the industry right now where term is prevalent and pledge structures are going to play a bigger role going forward. Unfortunately for UCITS, their seven-day maturity limits and requirement for title transfer means a large part of the current assets available will be neglected by the market unless there is some material change to the regulations.
Daswani: The most significant shift in behaviour is still being driven by the multitude of regulations (EU and otherwise) surrounding regulatory capital and the balance sheet. Demand from the borrower community has shifted to more capital efficient structures such as CCP and pledge structures and term activity remains in high demand as a stable funding source. For buy-side firms these demand drivers force them to consider their appetite for ‘non-standard’ lending structures such as pledge and CCP, and while activity under these structures is limited at present, we believe that 2017-18 will no doubt see an increase as lenders and their agents adapt to the major demand drivers.
As an agent lender, we are ensuring that our clients are well educated on these concepts thereby allowing them to make an informed decision on whether or not such structures fit within their risk-reward appetite.
Two other pieces of regulation are grabbing the headlines at present are the second Markets in Financial Instruments Directive (MiFID II) and the Securities Financing Transactions Regulation (SFTR). In terms of direct impact on behaviour in the marketplace the effect is somewhat limited, however, they are complex and wide reaching and will lead to significant changes in the way we manage our products on both sides of the market over the next 18 months and beyond.
One interesting side-effect of SFTR is the fact that by complying with the transaction reporting deadlines, borrowers will have significantly more transparency into their activity with particular beneficial owners much earlier in the lifecycle of a transaction, and will therefore be better able to actively manage their exposures. This means borrowers are likely to be more selective as to what activity they want do with particular beneficial owners—avoiding the most capital-intensive trades or those that have greater impact on the various balance sheet ratios.
This may have an impact on some beneficial owners in certain jurisdictions, and could force a change in the way agents structure their lending programmes. While not specifically linked to SFTR, we do know that there is an underlying regulatory drive towards more transparency in terms of who you are trading with and these developments if not tackled now, may be enforced at a later date. European beneficial owners are beginning to become aware of the revenue opportunities associated with scrip trades.
Wilson: Looking at the buy side, UCITS funds in particular have experienced wide-ranging regulatory change over the last few years across collateral diversification, asset segregation and SFTR Article 13/14, which requires greater disclosure of lending activities in their prospectuses and annual reports. Individually and collectively, the regulations affect the way securities lending can been conducted. These funds have also been affected by declining yield enhancement revenue and are unable to participate in some of the newer term and upgrade opportunities. That said, we find this group of lenders very engaged and keen to add additional funds or make adjustments to lending parameters in order to continue to optimise revenues.
With respect to the sell-side, demand remains strong for borrowing HQLA, particularly US treasuries, versus equity collateral. Borrowers generally require the equity collateral set to include a wide range of main equity indices, but we see occasional demand to borrow against a more limited set, depending on borrower inventory. Demand is generally in an evergreen structure.
The longstanding regulatory driver has been liquidity coverage ratio (LCR), but, for some, the net stable funding ratio (NSFR) is increasingly coming into focus. The fixed income market is slowly becoming more automated–a good percentage of our corporate bond flow now goes through AutoBorrow in BondLend. We are also actively engaged in delivering Next Generation Trading (NGT) to the market—a project that will allow sovereign bonds to also be traded in a more automated way. Financing trades lending equities has been an effective and profitable way in keeping stable balance on for the long term.
Rouigueb: On the sell side, we are seeing a move away from using cash. At the time of the transaction, borrowers’ selection criteria include both availability and increasingly, impacts on ratios and balance sheets. These impacts depend on the type of lender (such as agent lenders, banks, institutions and asset managers) as they are often structured differently there is demand for different securities.
These differences are due to heavy regulatory constraints such as the collateral matrix, and borrowers will often favour a lender with a broad matrix that offers greater flexibility. For example, we do see borrowers having less appetite for securities held by UCITS funds because of all the constraints these lenders face.
On the buy side, regulatory considerations have increased the operational burden, even when outsourcing. The main reason to outsource was that they did not have the resources to run the lending activity in house. The business requires more reports, analyses, declarations, monitoring and brings additional constraints, which take up human and IT resources. There is a vast appetite for securities lending earning potential, but the regulatory complexity scares more risk averse lenders away.
Arnesen: Buy-side clients are in the thick of regulatory changes if they are European asset managers, UCITS funds or insurance companies, as there are a number of regulations that apply to their own activities and to us as agents, such as MiFID II. Clients outside of the EU are somewhat immune from it but are interested in how regulation is changing the demand dynamics and whether this is leading to increased, decreased or stable revenue stream.
A change to the risk profile requirements in Germany, for example, has led to an all but elimination of demand at certain times of the year. IHS Markit published a very interesting report recently comparing Q1 2016 to 2017 and it’s a sobering read. All equity markets are producing less revenue than over the same period last year. However, when the markets are in a bull run, perhaps this is not of great concern.
The LCR is one regulation that has increased demand for HQLA and this continues to be a stable source of consistent revenue. The need to accept equity collateral is resonating with the buy side, but it’s not a slam dunk. Internal policy, governance and risk and liquidity metrics have to be satisfied if clients are to introduce the obvious collateral swap nature of these transactions. Those that have are reaping the rewards.
One of the more interesting developments to watch over the next 12 to 18 months will be how regulation will start to shape the traditional lending models that the industry has come to know so well, the implications of which could increase market focus on the use of CCPs and pledge collateral structures. Over supply relative to borrower demand and the increasing balance sheet costs of this demand may result in lenders that are looking to maintain revenue streams with little choice than to consider these market developments more seriously than in previous years.
Beneficial owners are beginning to wake up to the revenue opportunities associated with scrip trades. What role should agent lenders be playing in making sure their clients maximise these options?
Rouigueb: The most important thing of all is to make the risk/reward ratio clear. Agent lenders take an advisory role, aiming to demonstrate a trade’s full potential, from the various methods for processing transactions to the associated revenues. We aim to keep today’s decision-makers informed about this type of transaction, which means we work directly with the client to discuss market opportunities in an efficient manner and optimise revenues. We must be responsive, know the market and be transparent.
Arnesen: Proceed with caution. It is an agent’s fiduciary responsibility to act in the best interests of clients and for the best possible outcome. It is not, however, an agent’s role to offer investment advice, and in this current regulatory and conduct environment, one does not want an interpretation of an agent playing a role that is considered as offering advice. Investment managers make decisions and agent lenders work with the parameters given to them. Clearly, there is an environment where both parties are made aware of mutual objectives that are simply a reflection of good relationship management. These transactions have definitely taken a greater role in all of the strategies employed by agents and those clients that automatically elect for cash are rewarded accordingly.
Wilson: Our beneficial owner clients have been aware of scrip opportunities for some time and have consistently engaged in them. As a result of the rise in passive funds and an increased number of companies offering a scrip option, the prevalence of scrip activity has naturally increased. We have seen some change with beneficial owners, such as pension funds, which use external fund managers. The owners are increasingly putting pressure on those managers to provide the necessary information earlier to maximise securities lending revenue since there are material differences in committed and not committed scrip elections.
Tomlinson: At BNY Mellon, we’ve been working with clients and offering optimisation opportunities around scrip trades for many years. While we largely agree with a recent Finadium discussion around the amount of so-called sub-optimal elections that still take place, one could argue that sub-optimal is a subjective term. In many cases, beneficial owners defer the decision around what election to take to the portfolio managers, who may have differing opinions or mandates that indicate a certain election for them is the right one at that time. It’s here that the role of the agent lender is important and they need to be continuously assessing the performance of these trades for clients, providing feedback and offering revenue enhancement opportunities.
To be clear, despite the fact that elections can often be called sub-optimal, most trades that do not have specific pre-agreed elections will have been structured on a profit share basis so any alpha generated post-election is shared between the borrower and the client. Also, with the regulatory landscape placing more constraints on borrowers, such as increased collateral costs and limited balance sheet availability, the industry has had to innovate and find alternative ways to optimise and enhance client revenues outside the traditional models.
Daswani: Scrip trades provide shareholders with the option to receive their dividend entitlement in cash or new shares—with companies incentivising shareholders to elect for stock by offering it at a discount to the prevailing market price. The price differential between the value of the cash and stock dividend options creates arbitrage opportunities. This means borrowers are able to monetise sub-optimal elections (typically the cash option) by electing stock for themselves. The new entitlement shares, issued at a discounted price, are subsequently sold at the higher prevailing market price, with profits creating higher lending fees. Securities lending programmes allow these sub-optimal elections to be optimised, capturing a greater value for investors.
Revenue associated with the lending of scrip dividends is becoming an increasingly important part of the industry’s revenue mix. Over recent years there has been a consistent trend for companies to distribute scrip dividends as a way of conserving cash reserves. This has resulted in a significant increase in both the number and value of scrip dividend distributions across the region.
In terms of the role of securities lending agents, we need to have the right level of communication with clients so they have the transparency and knowledge to allow them to optimise their election strategies based on their risk and reward appetite. Industry analysis continues to show that asset owners’ election decisions could be more efficient, with a significant portion of the potential outperformance still being left on the table. Often it can simply be a case of beneficial owners providing a more prompt election decision (or pre-election guarantees).
In Europe’s current low interest rate environment, optimising these returns can represent an important, and often relatively simple, source of additional yield, especially for index tracking mandates seeking to generate all important out performance. As such, it’s critical that asset owners understand how securities lending programs can add efficiencies, reduce risk and help optimise returns around these opportunities.
At Northern Trust, we continue to work in close partnership with our clients to ensure they understand the execution opportunities that our securities lending programme can offer with regards scrip dividends. Through these discussions we can tailor the most appropriate trading approach to help optimise their election strategies.
How has the transition to Target2-Securities affected securities lending so far?
Tomlinson: At this time we’re not convinced the securities finance industry has really seen any material change as a result of the transition to Target2-Securities (T2S). There is no doubt that harmonisation is a good thing from a settlement perspective and costs will be reduced as a result of the improved efficiency. You could also argue that collateral mobility has improved because of it, but has it increased the flow of business to date? We would say not.
Arnesen: The shortening of the settlement cycle across Europe following the implementation of T2S has led many investment managers and equity brokers to put in place securities lending and borrowing programmes to assist with any settlement fail coverage they may need. Historically, utilising securities lending programmes to cover potential trade settlement fails was a key service offered to sell-side institutions by the large prime brokers, however, the cost of carrying large equity inventories on balance sheet by the prime brokers to service their clients in this way has dramatically increased under Basel III.
As a result, many of these managers and brokers have turned to their custodian for solutions. As a provider of both agency and principal lending and borrowing programmes, BNP Paribas has been well positioned through its extensive custodial network to provide these services to its clients.
Daswani: The securities lending industry appears to have managed the transition to the T2S environment very well so far. The main impacts have been operational in nature and through a series of system enhancements and slight structural changes we have absorbed the change without any particular impact to our business, and been able to take advantage of some the operational enhancements that the framework provides.
Some of the expected benefits such as collateral mobility and efficiency have not really crystallised in our market yet, but inevitably it will take time for market participants to adjust their own models to make best use of the harmonised infrastructure. From our perspective the impact has been neutral to our business, which for a change of this scale can only be described as a positive outcome.
What should beneficial owners be doing going forward to adapt their lending programmes to perform best in the next 12 months?
Arnesen: Engage, engage, and engage. No beneficial owner should be surprised by a sudden change in the revenue of its programmes if agents are doing their jobs. The market is shedding its reactionary past, partly as a result of regulatory initiatives which is increasing the cost of business and partly out of necessity as it moves closer to accepting pledge collateral, preparing for SFTR and the higher likelihood of far greater CCP usage. All of these developments have a direct effect on beneficial owners, particularly in the case of SFTR which has costs associated with it. A clear understanding of how each or all of these could affect performance of a programme and more importantly how adjustments to parameters could potentially enhance revenue will be very important in the coming 12 months.
Wilson: The key for beneficial owners is to remain engaged with and informed on the changing landscape and evolving opportunities. This shouldn’t be limited to specific transactions, but includes changing structures such as pledge, central counterparty and lending to non-traditional borrowers/repo counterparties. This won’t work for every beneficial owner as securities lending does need to complement a beneficial owner’s overall investment objectives. Agents have a significant role to play in working through legal, regulatory, risk, operational and documentation aspects and, in turn, providing beneficial owners with digestible information that allows them to appraise all opportunities and make informed decisions. The market is moving rapidly, so speed is often important–this can be a challenge given a beneficial owner’s overall set of priorities. Article 4 of SFTR remains a key watch item as it will require beneficial owners in the EU to provide transaction reporting to designated trade repositories. This is a complicated requirement which is being worked through currently—the estimated implementation is during the latter part of 2018.
Daswani: The ability for a lending agent to customise their lending programme to suit their clients’ needs is key to adapting to the ever evolving investment and regulatory environment. Supporting and adapting to clients’ needs is a cornerstone of Northern Trust’s philosophy.
Therefore, there is not a single solution for each beneficial owner to perform best over the next 12 months. Performance continues to be relative based on each beneficial owner’s objectives and risk tolerances. We continue to believe it is important that beneficial owners adapt their programmes, but they should ensure their programmes risk profile continues to fit within their overall investment policy of their own internal committees. With that said, our conversations with beneficial owners have shifted. Previously, we may have worked with our beneficial owners on opportunities to generate revenue. However, as some of the traditional revenue streams decline, we are now working with our beneficial owners on revenue protection as well as revenue growth through collateral expansion, CCPs, term lending, new markets, collateral pledges and approved counterparties.
Rouigueb: Working closely with the agent lender is key, as is increasing flexibility in the collateral matrix and accepting transactions with a longer maturity, although that is not always possible for certain types of client. Working closely with a lending agent enables lenders to gain support for regulatory issues and to rapidly capture market opportunities as they arise. Furthermore, having a well-defined internal risk strategy and a clear picture of how securities lending fits into that is central to an efficient relationship and to realistic expectations of revenues for the risk taken. Securities lending used to be more ‘hands-off’ for lenders, maybe a board decision, very low risk, HQLA collateral only, and very generous rewards. However today, that is no longer the case, the tighter regulatory environment, additional compliance complexity, and the need to take on some risk for a return, requires a real analysis and close involvement of the beneficial owner. Performance competition is increasing, and securities lending can be a core strategy to maintain competitiveness in the market.
Tomlinson: Adaptability, agility and communication are key. The big winners will be beneficial owners that have their lending programmes set up to offer a wide choice of collateral options and also different routes to market. In the past, opportunities to expand collateral guidelines were more linear and longer-serving; however, in this new world of collateral optimisation and mobility, you have to be nimble to grab opportunities when they are presented.
Scrip optional dividends and other corporate actions will also continue to be a good source of revenue for clients, and there are some material changes taking shape in the way that business is conducted in the securities finance space. The ability to lend your securities via a CCP or by utilising a pledge collateral structure under a the global master securities lending agreement are going to be the next big thing for the market. Clients that are able and willing to consider these options are very likely to see some fantastic growth opportunities over the next 12 months if they can react quickly.
Donia Rouigueb
Securities lending and financing sales trading
CACEIS
Paul Wilson
Managing director and global head of client management and sales for financing and markets products
J.P. Morgan
Sunil Daswani
Head of international securities lending
Northern Trust
Simon Tomlinson
Head of equity finance for EMEA
BNY Mellon
John Arnesen
Global head of agency lending
BNP Paribas Securities Services
How have European revenue sources changed in the past 12 months?
Paul Wilson: We’ve seen quite a lot of change across the European securities lending landscape over the past 12 months. In equity lending markets, the decline in demand for, and revenue from, yield enhancement activity continues. This has been accompanied by a lack of new specials caused by a decrease in volatility and subdued hedge fund activity, especially in long/short strategies.
The offset to this has been increased scrip opportunities and take up by beneficial owners plus financing and upgrade opportunities. In fixed income markets we see good demand for German and French sovereigns in collateral upgrade trades versus equities in 35 to 185 day evergreen structures. However, the strongest demand is still for US treasuries, which yield a couple of basis points in fees above European government bonds.
There are also alternative revenue opportunities available, such as lending core European sovereigns and taking back peripheral sovereigns, especially Italy and Spain, as collateral. In addition, there is now a strong specials market in Germany with demand especially in the seven to 10-year maturities. This is driven by the removal of supply from the market by the European Central Bank’s (ECB) bond purchase plan—although the ECB does operate a lending programme, availability of specific issues is far more restricted compared to when bonds were freely available in the wider repo market.
Activity in the corporate bond and emerging market sovereign space has remained stable over the past six months, but demand for energy, commodity and financial issuers has significantly reduced year on year.
John Arnesen: When one looks at sources of revenue it is clear that general collateral has always played a significant role in revenue generation, and the past 12 months is no exception. Seasonal spring demand for European equities continues to diminish both in terms of markets and appetite. The most consistent revenue stream year on year has come from lending European government debt on a term basis for longer than 30 days.
Sunil Daswani: Revenue drivers in fixed income markets have been largely dictated by regulatory changes and central bank asset purchase programmes. Pressure mounted in European sovereign markets towards the end of 2016 as the ECB maintained its presence as a substantial buyer of government debt through its quantitative easing programme. Concurrently, regulatory obligations meant banks and end users were compelled to hold large inventories of high-quality liquid assets (HQLA), particularly evident over sensitive reporting periods such as year-end. As such, specific German bonds in particular were in strong demand throughout the period, leading to a widening of spreads amid ongoing concerns related to bond scarcity.
Fees from lending emerging market bonds narrowed during the period as sentiment towards the asset class improved and geopolitical risk subsided. Perhaps the most interesting change has been evident in the widening fees we have observed in lending corporate bonds. With increased regulatory burdens and reductions of balance sheets, banks are less able to warehouse risk and hold expensive corporate bond exposures. Correspondingly, assets are more in demand from the agent lender community to satisfy market making responsibilities and cover settlement issues. As such, fees increased throughout the period as agent lenders were able to widen spreads.
From an equity perspective, Europe’s macroeconomic environment has influenced revenue drivers in the region. Ongoing economic and political instability associated with the UK’s surprise Brexit result, coupled with government leadership elections in many of Europe’s largest economies has created a challenging investment back-drop for investors. Additionally, the new Trump administration’s pro-business policies have typically helped sustain strong equity market growth. As a result, hedge funds typically had less conviction when deploying capital on the short side, resulting in a reduction in the volume of traditional ‘specials’ activity in the region. Revenues have been impacted accordingly, although some one off securities has helped compensation for this trend.
Furthermore, ongoing regulatory scrutiny around balance sheet and regulatory capital constraints continued to represent a headwind in terms of traditional balance growth. Demand from the borrower community is increasingly focused around trading structures that provide greater capital efficiencies. Term activity remains part of the borrower’s demand profile, with collateral pledge structures and central counterparties (CCPs) likely to becoming more prevalent in the short and mid-term. Traditional seasonal sources of revenue remain, with a growth in scrip dividend activity being a positive trend.
Simon Tomlinson: The introduction of the liquidity coverage ratio in 2015 and the upcoming net stable funding ratio are having a dramatic impact on trading by extending the term of trades from what used to be an overnight business. Indeed, three-month evergreen trades and longer are now commonplace as borrowers look to meet Basel III capital requirements.
While equities have traditionally been the largest revenue generator over the past few years—enjoying a buoyant specials market in part because of the drop in commodity prices—there is definitely a change taking place. With the increasing demand for HQLA to meet regulatory requirements and the introduction of margin on non-cleared derivatives, beneficial owners of certain types of European fixed income collateral are seeing an increase in returns. This is not likely to change in the near future, with the ECB’s own asset purchase programme somewhat adding to the problem, causing liquidity to deteriorate and spreads to widen.
Donia Rouigueb: Looking at the four principal revenue sources, general collateral has seen a dip because there are more participants in lending programmes, so much more offer for these liquid assets. Also, borrowers are optimising their internal holdings to avoid borrowing outside so they can control and eventually decrease the balance sheet impact.
A lot of beneficial owners still have a strict collateral matrix, which penalises borrowers. Demand for specials has remained at the same level, and are by definition always requested, but the low volatility of the markets did not improve the demand for these kind of assets so revenues remained steady. We have also seen yield enhancement decrease in 2016 and more or less stabilise in 2017 due to marketplace uncertainty regarding harmonisation and guidelines.
What effect is EU regulation having on the buy- and sell-side behaviour?
Tomlinson: Regulation is having a major effect on both the buy and the sell side. Borrowers are struggling with limited balance sheet and regulatory capital hurdles meaning borrowers need to seek new liquidity solutions not only to service their existing business but also to generate returns in an environment where resources are scarce and costs are mounting. Among the options being reviewed is the traditional method of moving collateral between parties under a title transfer. In its place, the option to receive collateral under pledge is under consideration. This is not without its challenges and the International Securities Lending Association (ISLA) is trying to standardise the documentation for this to work. There is also the consideration of a centrally cleared model for securities financing trades, which could provide a host of post-trade efficiencies for clients if they are eligible and willing to participate.
UCITS are a good example of a fund type that is being excluded from the new trading opportunities being seen in Europe. The UCITS market represents approximately 45 percent of the lendable base but only 15 percent of those assets are on-loan, down from 18 percent three years ago, according to ISLA. There is a dichotomy in the industry right now where term is prevalent and pledge structures are going to play a bigger role going forward. Unfortunately for UCITS, their seven-day maturity limits and requirement for title transfer means a large part of the current assets available will be neglected by the market unless there is some material change to the regulations.
Daswani: The most significant shift in behaviour is still being driven by the multitude of regulations (EU and otherwise) surrounding regulatory capital and the balance sheet. Demand from the borrower community has shifted to more capital efficient structures such as CCP and pledge structures and term activity remains in high demand as a stable funding source. For buy-side firms these demand drivers force them to consider their appetite for ‘non-standard’ lending structures such as pledge and CCP, and while activity under these structures is limited at present, we believe that 2017-18 will no doubt see an increase as lenders and their agents adapt to the major demand drivers.
As an agent lender, we are ensuring that our clients are well educated on these concepts thereby allowing them to make an informed decision on whether or not such structures fit within their risk-reward appetite.
Two other pieces of regulation are grabbing the headlines at present are the second Markets in Financial Instruments Directive (MiFID II) and the Securities Financing Transactions Regulation (SFTR). In terms of direct impact on behaviour in the marketplace the effect is somewhat limited, however, they are complex and wide reaching and will lead to significant changes in the way we manage our products on both sides of the market over the next 18 months and beyond.
One interesting side-effect of SFTR is the fact that by complying with the transaction reporting deadlines, borrowers will have significantly more transparency into their activity with particular beneficial owners much earlier in the lifecycle of a transaction, and will therefore be better able to actively manage their exposures. This means borrowers are likely to be more selective as to what activity they want do with particular beneficial owners—avoiding the most capital-intensive trades or those that have greater impact on the various balance sheet ratios.
This may have an impact on some beneficial owners in certain jurisdictions, and could force a change in the way agents structure their lending programmes. While not specifically linked to SFTR, we do know that there is an underlying regulatory drive towards more transparency in terms of who you are trading with and these developments if not tackled now, may be enforced at a later date. European beneficial owners are beginning to become aware of the revenue opportunities associated with scrip trades.
Wilson: Looking at the buy side, UCITS funds in particular have experienced wide-ranging regulatory change over the last few years across collateral diversification, asset segregation and SFTR Article 13/14, which requires greater disclosure of lending activities in their prospectuses and annual reports. Individually and collectively, the regulations affect the way securities lending can been conducted. These funds have also been affected by declining yield enhancement revenue and are unable to participate in some of the newer term and upgrade opportunities. That said, we find this group of lenders very engaged and keen to add additional funds or make adjustments to lending parameters in order to continue to optimise revenues.
With respect to the sell-side, demand remains strong for borrowing HQLA, particularly US treasuries, versus equity collateral. Borrowers generally require the equity collateral set to include a wide range of main equity indices, but we see occasional demand to borrow against a more limited set, depending on borrower inventory. Demand is generally in an evergreen structure.
The longstanding regulatory driver has been liquidity coverage ratio (LCR), but, for some, the net stable funding ratio (NSFR) is increasingly coming into focus. The fixed income market is slowly becoming more automated–a good percentage of our corporate bond flow now goes through AutoBorrow in BondLend. We are also actively engaged in delivering Next Generation Trading (NGT) to the market—a project that will allow sovereign bonds to also be traded in a more automated way. Financing trades lending equities has been an effective and profitable way in keeping stable balance on for the long term.
Rouigueb: On the sell side, we are seeing a move away from using cash. At the time of the transaction, borrowers’ selection criteria include both availability and increasingly, impacts on ratios and balance sheets. These impacts depend on the type of lender (such as agent lenders, banks, institutions and asset managers) as they are often structured differently there is demand for different securities.
These differences are due to heavy regulatory constraints such as the collateral matrix, and borrowers will often favour a lender with a broad matrix that offers greater flexibility. For example, we do see borrowers having less appetite for securities held by UCITS funds because of all the constraints these lenders face.
On the buy side, regulatory considerations have increased the operational burden, even when outsourcing. The main reason to outsource was that they did not have the resources to run the lending activity in house. The business requires more reports, analyses, declarations, monitoring and brings additional constraints, which take up human and IT resources. There is a vast appetite for securities lending earning potential, but the regulatory complexity scares more risk averse lenders away.
Arnesen: Buy-side clients are in the thick of regulatory changes if they are European asset managers, UCITS funds or insurance companies, as there are a number of regulations that apply to their own activities and to us as agents, such as MiFID II. Clients outside of the EU are somewhat immune from it but are interested in how regulation is changing the demand dynamics and whether this is leading to increased, decreased or stable revenue stream.
A change to the risk profile requirements in Germany, for example, has led to an all but elimination of demand at certain times of the year. IHS Markit published a very interesting report recently comparing Q1 2016 to 2017 and it’s a sobering read. All equity markets are producing less revenue than over the same period last year. However, when the markets are in a bull run, perhaps this is not of great concern.
The LCR is one regulation that has increased demand for HQLA and this continues to be a stable source of consistent revenue. The need to accept equity collateral is resonating with the buy side, but it’s not a slam dunk. Internal policy, governance and risk and liquidity metrics have to be satisfied if clients are to introduce the obvious collateral swap nature of these transactions. Those that have are reaping the rewards.
One of the more interesting developments to watch over the next 12 to 18 months will be how regulation will start to shape the traditional lending models that the industry has come to know so well, the implications of which could increase market focus on the use of CCPs and pledge collateral structures. Over supply relative to borrower demand and the increasing balance sheet costs of this demand may result in lenders that are looking to maintain revenue streams with little choice than to consider these market developments more seriously than in previous years.
Beneficial owners are beginning to wake up to the revenue opportunities associated with scrip trades. What role should agent lenders be playing in making sure their clients maximise these options?
Rouigueb: The most important thing of all is to make the risk/reward ratio clear. Agent lenders take an advisory role, aiming to demonstrate a trade’s full potential, from the various methods for processing transactions to the associated revenues. We aim to keep today’s decision-makers informed about this type of transaction, which means we work directly with the client to discuss market opportunities in an efficient manner and optimise revenues. We must be responsive, know the market and be transparent.
Arnesen: Proceed with caution. It is an agent’s fiduciary responsibility to act in the best interests of clients and for the best possible outcome. It is not, however, an agent’s role to offer investment advice, and in this current regulatory and conduct environment, one does not want an interpretation of an agent playing a role that is considered as offering advice. Investment managers make decisions and agent lenders work with the parameters given to them. Clearly, there is an environment where both parties are made aware of mutual objectives that are simply a reflection of good relationship management. These transactions have definitely taken a greater role in all of the strategies employed by agents and those clients that automatically elect for cash are rewarded accordingly.
Wilson: Our beneficial owner clients have been aware of scrip opportunities for some time and have consistently engaged in them. As a result of the rise in passive funds and an increased number of companies offering a scrip option, the prevalence of scrip activity has naturally increased. We have seen some change with beneficial owners, such as pension funds, which use external fund managers. The owners are increasingly putting pressure on those managers to provide the necessary information earlier to maximise securities lending revenue since there are material differences in committed and not committed scrip elections.
Tomlinson: At BNY Mellon, we’ve been working with clients and offering optimisation opportunities around scrip trades for many years. While we largely agree with a recent Finadium discussion around the amount of so-called sub-optimal elections that still take place, one could argue that sub-optimal is a subjective term. In many cases, beneficial owners defer the decision around what election to take to the portfolio managers, who may have differing opinions or mandates that indicate a certain election for them is the right one at that time. It’s here that the role of the agent lender is important and they need to be continuously assessing the performance of these trades for clients, providing feedback and offering revenue enhancement opportunities.
To be clear, despite the fact that elections can often be called sub-optimal, most trades that do not have specific pre-agreed elections will have been structured on a profit share basis so any alpha generated post-election is shared between the borrower and the client. Also, with the regulatory landscape placing more constraints on borrowers, such as increased collateral costs and limited balance sheet availability, the industry has had to innovate and find alternative ways to optimise and enhance client revenues outside the traditional models.
Daswani: Scrip trades provide shareholders with the option to receive their dividend entitlement in cash or new shares—with companies incentivising shareholders to elect for stock by offering it at a discount to the prevailing market price. The price differential between the value of the cash and stock dividend options creates arbitrage opportunities. This means borrowers are able to monetise sub-optimal elections (typically the cash option) by electing stock for themselves. The new entitlement shares, issued at a discounted price, are subsequently sold at the higher prevailing market price, with profits creating higher lending fees. Securities lending programmes allow these sub-optimal elections to be optimised, capturing a greater value for investors.
Revenue associated with the lending of scrip dividends is becoming an increasingly important part of the industry’s revenue mix. Over recent years there has been a consistent trend for companies to distribute scrip dividends as a way of conserving cash reserves. This has resulted in a significant increase in both the number and value of scrip dividend distributions across the region.
In terms of the role of securities lending agents, we need to have the right level of communication with clients so they have the transparency and knowledge to allow them to optimise their election strategies based on their risk and reward appetite. Industry analysis continues to show that asset owners’ election decisions could be more efficient, with a significant portion of the potential outperformance still being left on the table. Often it can simply be a case of beneficial owners providing a more prompt election decision (or pre-election guarantees).
In Europe’s current low interest rate environment, optimising these returns can represent an important, and often relatively simple, source of additional yield, especially for index tracking mandates seeking to generate all important out performance. As such, it’s critical that asset owners understand how securities lending programs can add efficiencies, reduce risk and help optimise returns around these opportunities.
At Northern Trust, we continue to work in close partnership with our clients to ensure they understand the execution opportunities that our securities lending programme can offer with regards scrip dividends. Through these discussions we can tailor the most appropriate trading approach to help optimise their election strategies.
How has the transition to Target2-Securities affected securities lending so far?
Tomlinson: At this time we’re not convinced the securities finance industry has really seen any material change as a result of the transition to Target2-Securities (T2S). There is no doubt that harmonisation is a good thing from a settlement perspective and costs will be reduced as a result of the improved efficiency. You could also argue that collateral mobility has improved because of it, but has it increased the flow of business to date? We would say not.
Arnesen: The shortening of the settlement cycle across Europe following the implementation of T2S has led many investment managers and equity brokers to put in place securities lending and borrowing programmes to assist with any settlement fail coverage they may need. Historically, utilising securities lending programmes to cover potential trade settlement fails was a key service offered to sell-side institutions by the large prime brokers, however, the cost of carrying large equity inventories on balance sheet by the prime brokers to service their clients in this way has dramatically increased under Basel III.
As a result, many of these managers and brokers have turned to their custodian for solutions. As a provider of both agency and principal lending and borrowing programmes, BNP Paribas has been well positioned through its extensive custodial network to provide these services to its clients.
Daswani: The securities lending industry appears to have managed the transition to the T2S environment very well so far. The main impacts have been operational in nature and through a series of system enhancements and slight structural changes we have absorbed the change without any particular impact to our business, and been able to take advantage of some the operational enhancements that the framework provides.
Some of the expected benefits such as collateral mobility and efficiency have not really crystallised in our market yet, but inevitably it will take time for market participants to adjust their own models to make best use of the harmonised infrastructure. From our perspective the impact has been neutral to our business, which for a change of this scale can only be described as a positive outcome.
What should beneficial owners be doing going forward to adapt their lending programmes to perform best in the next 12 months?
Arnesen: Engage, engage, and engage. No beneficial owner should be surprised by a sudden change in the revenue of its programmes if agents are doing their jobs. The market is shedding its reactionary past, partly as a result of regulatory initiatives which is increasing the cost of business and partly out of necessity as it moves closer to accepting pledge collateral, preparing for SFTR and the higher likelihood of far greater CCP usage. All of these developments have a direct effect on beneficial owners, particularly in the case of SFTR which has costs associated with it. A clear understanding of how each or all of these could affect performance of a programme and more importantly how adjustments to parameters could potentially enhance revenue will be very important in the coming 12 months.
Wilson: The key for beneficial owners is to remain engaged with and informed on the changing landscape and evolving opportunities. This shouldn’t be limited to specific transactions, but includes changing structures such as pledge, central counterparty and lending to non-traditional borrowers/repo counterparties. This won’t work for every beneficial owner as securities lending does need to complement a beneficial owner’s overall investment objectives. Agents have a significant role to play in working through legal, regulatory, risk, operational and documentation aspects and, in turn, providing beneficial owners with digestible information that allows them to appraise all opportunities and make informed decisions. The market is moving rapidly, so speed is often important–this can be a challenge given a beneficial owner’s overall set of priorities. Article 4 of SFTR remains a key watch item as it will require beneficial owners in the EU to provide transaction reporting to designated trade repositories. This is a complicated requirement which is being worked through currently—the estimated implementation is during the latter part of 2018.
Daswani: The ability for a lending agent to customise their lending programme to suit their clients’ needs is key to adapting to the ever evolving investment and regulatory environment. Supporting and adapting to clients’ needs is a cornerstone of Northern Trust’s philosophy.
Therefore, there is not a single solution for each beneficial owner to perform best over the next 12 months. Performance continues to be relative based on each beneficial owner’s objectives and risk tolerances. We continue to believe it is important that beneficial owners adapt their programmes, but they should ensure their programmes risk profile continues to fit within their overall investment policy of their own internal committees. With that said, our conversations with beneficial owners have shifted. Previously, we may have worked with our beneficial owners on opportunities to generate revenue. However, as some of the traditional revenue streams decline, we are now working with our beneficial owners on revenue protection as well as revenue growth through collateral expansion, CCPs, term lending, new markets, collateral pledges and approved counterparties.
Rouigueb: Working closely with the agent lender is key, as is increasing flexibility in the collateral matrix and accepting transactions with a longer maturity, although that is not always possible for certain types of client. Working closely with a lending agent enables lenders to gain support for regulatory issues and to rapidly capture market opportunities as they arise. Furthermore, having a well-defined internal risk strategy and a clear picture of how securities lending fits into that is central to an efficient relationship and to realistic expectations of revenues for the risk taken. Securities lending used to be more ‘hands-off’ for lenders, maybe a board decision, very low risk, HQLA collateral only, and very generous rewards. However today, that is no longer the case, the tighter regulatory environment, additional compliance complexity, and the need to take on some risk for a return, requires a real analysis and close involvement of the beneficial owner. Performance competition is increasing, and securities lending can be a core strategy to maintain competitiveness in the market.
Tomlinson: Adaptability, agility and communication are key. The big winners will be beneficial owners that have their lending programmes set up to offer a wide choice of collateral options and also different routes to market. In the past, opportunities to expand collateral guidelines were more linear and longer-serving; however, in this new world of collateral optimisation and mobility, you have to be nimble to grab opportunities when they are presented.
Scrip optional dividends and other corporate actions will also continue to be a good source of revenue for clients, and there are some material changes taking shape in the way that business is conducted in the securities finance space. The ability to lend your securities via a CCP or by utilising a pledge collateral structure under a the global master securities lending agreement are going to be the next big thing for the market. Clients that are able and willing to consider these options are very likely to see some fantastic growth opportunities over the next 12 months if they can react quickly.
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