European Securities Lending Panel
24 May 2022
Europe-based securities lending specialists focus on recent market performance, the projected impact of central bank monetary tightening and key opportunities for growth of their lending activities
Image: stock.adobe.com/Taras Rudenko
Panelists
Zoë Balkwell, vice president, trading, EMEA Agency Securities Finance, J.P. Morgan
Julien Berge, head of fixed income and repo trading, CACEIS
Chris Brown, vice president, trading, EMEA Agency Securities Finance Cash Reinvestment, J.P. Morgan
Sunil Daswani, global head of securities lending, Financing & Securities Services, Standard Chartered
Andrew Geggus, global head of agency lending, BNP Paribas Securities Services
Mark Jones, head of securities finance, EMEA, Northern Trust
Matthew Neville, managing director and head of agency lending trading EMEA, State Street Global Markets
Olivier Zemb, head of equity finance and collateral management trading, CACEIS
How do you assess the performance of European securities lending markets over the past 12 months?
Mark Jones: Demand for European sovereign bonds fared well in 2021, with on-loan volumes and fees increasing. This was most prevalent towards the end of the year as further lockdown measures led to subdued economic activity, prompting a flight-to-quality bid for core sovereign bonds. In addition, a collateral crunch became apparent into the year-end as sovereign bonds were in strong demand from market participants, with rates trading deeply into negative territory over the year-end reporting date. This bond scarcity eventually drove a significant specials premium, principally in the German curve, prompting the Deutsche Finance Agency to intervene and increase the outstanding nominal of the cheapest in order to calm market conditions.
Aside from sovereign bonds, demand for loans of corporate bonds increased, as the inflationary environment resulted in higher funding costs. The Central Securities Depositories Regulation (CSDR) Settlement Discipline Regime also came into effect in Q1 2022. This may have meant that some lenders felt less comfortable in lending bonds with liquidity challenges.
Equity lending has been a more challenging environment over the past 12 months. Through 2021, the upward trajectory of European equity markets saw investors maintain a greater net-long bias within their investment portfolios, resulting in softer demand and a weaker specials environment.
However, in the early part of 2022 we have seen a steep reverse in equity market trends, with heightened volatility amid sharp declines in asset valuations. Increased geopolitical tensions, surging inflation and aggressive tightening of monetary policy have all contributed to a risk-off approach. Hedge funds looked to de-gross equity exposures, again translating to weaker borrower demand. Capital raising activity has been one good source of borrower demand. With firms’ balance sheets weakened through the pandemic period and a low interest rate environment, we observed an increased number of companies coming to market to raise cash, creating opportunities for securities lending activity. Short interest across those sectors most exposed to COVID-19 lockdowns increased supply chain disruption and surging commodity prices have also been prominent.
Olivier Zemb: The last 12 months have seen growing balances and revenues across just about every asset class and region. The end of the COVID-19 pandemic has been a big relief for the whole market and corporate action activity increased significantly (including spin-offs, IPOs and M&A activity).
European equities have benefited from strong demand for scrip dividends and directional shorts, mainly around industrials, healthcare and consumer discretionary.
On US equities, a large number of stocks continuously traded at high fee rates and very “GC” names like Visa (for hedging purposes) generated strong returns.
Exchange-traded funds (ETFs) reached new highs nearly every month thanks to a few “top payers” (particularly high yield, investment grade and emerging markets) and activity has been strong on all types of corporate bond, especially French healthcare services and financials.
The conflict in Ukraine has brought back volatility and tension to the markets, which has increased opportunities for sector arbitrage and created additional demand for specific securities. CSDR has laid out requirements for flexibility, responsiveness and efficient settlement processes, with penalties for non-compliance. Demand increased on same-day borrows for liquid names, which are mainly short-duration transactions to reduce potential late settlement and matching issues.
The constant need to optimise collateral posted, to limit the all-in cost of borrowing, pressured lenders to reduce haircuts and maintain a flexible collateral profile — cash and non-cash. Low interest rates made cash the cheapest form of collateral, but this will probably not remain the case for long. Lenders which are able to accept cash and have a suitable balance sheet can capture the majority of GC trades.
Collateral and haircut impact the consumption of risk-weighted assets (RWA), as does the weighting of underlying lenders. Borrowers have therefore put more effort into onboarding or borrowing from “RWA-friendly” beneficial owners.
The “smart bucket” concept has gained traction, becoming increasingly relevant owing to growth in the global lendable base and the arrival of new market players, leading to fiercer competition between lenders.
Finally, we have noted growing appetite for trades over six months (cash vs non-cash) or shorter duration for specific underlying clients, particularly corporates. This may be a consequence of the closer scrutiny from all market participants on the net stable funding ratio (NSFR).
Zoë Balkwell: Over the past 12 months, uncertainty and volatility in the market and the introduction of the CSDR regulations have led to increased volumes across all asset classes in Europe.
Automation and transformation projects have supported these high volumes on both the trading and post-trade sides, especially within the warm space. With the ongoing COVID-19 pandemic and prolonged closures across Europe, sectors impacted by tourism, such as airlines and hospitality, have struggled to recover. Many firms are looking to restructure, raise capital or pivot their business strategy in an effort to recover from a tough two years of depressed revenues.
Sunil Daswani: Equity finance revenues in Europe dropped in the second half of 2021, driven by low equities specials balances in the region. Lendable assets were on the rise — however, the utilisation of these assets failed to match the pace. Two key markets in the region, the UK and Germany, declined in revenues. On the other hand, France’s equity finance revenues increased. A significant contributor to France’s sharp increase was the Vivendi Se spin-off. Broadly speaking, European equity markets have undergone a degree of softening over the past 12 months, with pandemic names in particular (airlines, travel companies) coming off from previous levels. Returns have held up well in Emerging Europe, specifically Greece, Turkey, Israel and pre-invasion Russia. With corporates being long cash, we have also seen improved yield enhancement activity in markets such as Switzerland, France, and Norway.
Capital raising activities have led to some new corporate events, which in turn have led to some additional specials across the board.
Matthew Neville: From a financial resource management (FRM) perspective, we have seen an increase in borrowers taking targeted action to actively manage their capital around quarter-ends by sourcing general collateral (GC) supply from low RWA clients and we expect this trend to continue.
In terms of asset classes, we have seen persistent strong demand in US Treasuries and core European government bonds, particularly bunds and gilts, in the short-end as the demand for High Quality Liquid Assets (HQLA) continues to remain as strong as it did throughout the pandemic.
European equities markets have remained reasonably flat, with minimal corporate activity. Levels achieved for COVID-19-impacted stocks have lessened, along with utilisation. However, increases in company dividend payouts compared to the previous couple of years, combined with sustained seasonal demand, puts us in a stronger position to outperform in this space than last year.
In which European markets (by jurisdiction, asset class) do you identify strongest opportunities for growth of your lending business?
Daswani: In line with the past 12 months, we expect to see continued good performance from the aforementioned European emerging markets.
Neville: In addition to monitoring developments in emerging markets, State Street continues to invest in electronic execution to maximise our existing distribution capabilities. Current initiatives include automating single-fund allocation markets to improve utilisation in countries such as Turkey and Poland.
We are also conducting due diligence on lending in Israel and are closely monitoring developments in Saudi Arabia as the lending model there continues to evolve.
Balkwell: Given our strategic focus on automation and efficiency, we have been able to support the broad increases in volume as well as to deliver post-trade efficiencies for a smoother front-to-back experience. With rising inflation and interest rates, we expect short interest in the international space to continue to increase across asset classes, regions and certain sectors. We are also seeing increased activity among corporate bonds due to disclosure limits on equity short positions, which is creating new opportunities.
Jones: We expect credit markets to be impacted as the growing inflationary environment gives way to recessionary fears. Consequently, demand for corporate bonds is likely to continue to push lending fees higher. This is likely to be mirrored in emerging market issuance as higher funding costs, supply chain disruptions and heightened geopolitical risks pressure asset valuations.
In the equity space, we see Saudi Arabia as a new market with strong growth opportunities. With a regulatory framework now in place, and significant demand materialising, we think this is a really exciting opportunity to be at the forefront of a rapidly developing market and we expect to see an increase in activity in the market before the year end.
Zemb: All things considered, we do not forecast any major change in EMEA Equities. Indeed, we believe the upward trend should continue throughout 2022.
In our search for growth opportunities, focus should be on key European emerging countries where revenues are increasing such as Poland and Turkey and to a lesser extent the Czech Republic and Hungary.
We also expect increased traction for ETFs and a widening of spreads for Core Euro Government Bonds. As mentioned, ETFs hit a new record almost every month. With our clients' loan base, we are confident that this asset class will stand out in 2022.
We believe spreads on Core Euro Govvies should increase due to past and future rate hikes in Europe and the UK. This will also create opportunities for cross-currency arbitrage.
Global financial markets have been subject to major fluctuations in liquidity and market pricing over the past two years, with current geopolitical instability following close on the heels of the Covid pandemic. What pressures and opportunities has this created for your securities lending business?
Chris Brown: The current geopolitical climate in Europe has led to more acute focus across the lending programme on appropriate client liquidity in assets that are now more exposed to risk compared to last year. The market volatility has caused greater and more active rebalancing in portfolios than previous years. Our role as trusted partners is to act seamlessly with our beneficial owners to ensure that lending activity does not impede our clients’ ability to be nimble in these markets. In conjunction with our Quantitative Research team, we can price this added risk on a day-to-day basis, ensuring our ability to provide incremental risk-adjusted returns to our clients.
Jones: Borrowing counterparts are more focused on sourcing High-Quality Liquid Assets (HQLA) in term-maturity tenors. We have seen rising demand to upgrade lower-rated or less-liquid assets for sovereign bonds through COVID-19 and the most recent period of geopolitical instability. In addition, we have continued to see a shift in borrower demand to more targeted lending. Borrowing counterparts are becoming more sensitive to capital usage and, in particular, to RWA — a measure to determine the risk of trading exposures and subsequent capital required.
Julien Berge: The drop in yields, and beneficial owners’ hunt for stronger performance in the current geopolitical environment, have led to an abundance of collateral supply as investors try to maximise yields. Consequently, even though overall revenues are increasing, historical lenders are competing with new lenders and struggle to maintain revenues across all asset classes. We are helping clients to understand the benefits of modifying their collateral matrix to become more attractive in an important step to maintaining market share.
After the pandemic and the return of strong growth, central banks’ efforts to control inflation with rate hikes, while preserving growth, will be decisive for the coming months. This should be positive for our activities since economic distortions, and the responses from central banks, play out at a different pace across each geographical zone. This should contribute to a more favourable environment for our activities, generating opportunities which had disappeared in recent years.
Daswani: We have seen hedge funds de-grossing, reducing long-short exposures and this has dampened demand. The rising interest rate environment in particular is going to be a consistent theme throughout 2022, impacting lenders running cash reinvestment programmes and those lenders holding sizeable positions in government bonds (ie HQLA). Judicious management of cash reinvestment pools will increase returns from lending GC and ‘warm’ securities, given reinvestment opportunities along the yield curve, and for now we continue to see strong demand for US Treasuries throughout the tenor range. Given this unique environment, at least in recent times, stock loan and cash reinvestment desks will need to be closely aligned to optimally manage this asset-liability dynamic.
Neville: The magnitude of central bank quantitative easing (QE) led directly to lower spreads in the fixed income upgrade space compared to previous years, as banks were able to sell paper more cheaply than they would have been able to finance through securities lending. This created a competitive challenge for lenders to generate opportunities for clients while avoiding chasing rates downwards — including ensuring that the pricing achieved from borrower demands to face specific client profiles reflected the value those clients added to a borrower’s capital profile.
As we look beyond the pandemic, and as quantitative tightening (QT) reduces liquidity, we can see opportunities developing should spreads emerge between north and south Europe — depending on the relative growth of the economies in each region. We also see more value in corporate bonds as weaker, less capitalised companies become targets for short-sellers.
What investments and adaptations to working practices have you made to sustain and grow your European securities lending activity in this environment?
Neville: Working from home during the pandemic placed increased pressure on operations and trading teams across all firms. This was particularly in the post-trade space, where offshore models came under significant strain given disparate working restrictions across different countries and regions. We resolved to rapidly advance our post-trade capabilities and connectivity with the vendors, aiming to improve visibility and workflows and, consequently, to increase straight-through-processing (STP) and reduce manual pressures on individuals. These steps are creating greater efficiencies and capacity within our teams, enabling us to work on new initiatives to service our clients more effectively.
Andrew Geggus: One major element has been in preparing for CSDR and now actually answering CSDR requirements for our clients. Outside of that, two primary areas of focus have been ESG and technology strategy. At this stage, we already have the capacity to align our programmes to clients’ ESG requirements in multiple ways. Yet, we are still looking at how things could be pushed further, whether it be through our own developments or by working with the market on harmonised practices. Alongside this, continuing the drive for efficiency through technology and automation is another key focal point for our teams. Deploying a combination of proprietary technology developments and vendor-based applications eases the manual elements of the lending process, while offering enhanced analytics to both the lender and agent.
Jones: As a consequence of the capital focus, our borrowing counterparts have sought more bespoke trading routes, including pledge and other capital-efficient lending structures. We have focused on developing this as a key area as we recognise that adapting to changes in demand is crucial to keeping our agency lending programme relevant and competitive.
Brown: Global inflation pressures since 2021 have prompted central banks to become significantly more hawkish on monetary policy so far this year. With implied rates of 3 per cent in the US by the end of the year, coupled with quantitative tightening, and with the European Central Bank (ECB) keen to start raising rates after it ends QE in June, the proliferation of cash in the market will certainly be less than it has been since QE began after 2008. The relative cost of non-cash collateral will also have an impact on the supply of cash collateral in the market. Cash reinvestment programmes already have to keep a close watch on pockets of liquidity and volatility, especially given the medium-term uncertainty with the timing and magnitude of any interest rate moves.
J.P. Morgan’s cash reinvestment team works closely with the lending desk to manage liquidity from loan legs and to capitalise on the greater certainty of liquidity, allowing us to invest cash at more competitive risk-return levels for our clients.
Berge: To enhance our clients’ portfolio performance, we are constantly developing our lending offer through continued innovation and improvement of our processes. The key word is automation, as well as streamlining our processes to better handle volume spikes and the complexity of our clients’ growing constraints.
We are constantly investing in and developing quantitative internal tools to automate essential but lower value-added tasks such trade bookings, recalls and reallocations. The goal is for traders to have more time to focus on finding opportunities in the market and, by doing so, maximising our clients’ revenues. We have also made significant improvements to our communication methods with our clients and counterparties.
What impact will the potential for monetary tightening over the coming 6-12 months have on lending opportunities and collateralisation strategy in Europe?
Berge: Regarding collateralisation strategies, I believe Eurozone monetary policy will tighten, but far slower than in the US. The characteristics and nature of inflation differ on each side of the Atlantic. The withdrawal of excess liquidity in Europe will be gradual and measured. Rate normalisation will mainly impact cash as collateral, which until now has seen very little interest and is handicapping banks in terms of their balance sheet. However, in the coming months this could change when rates return to positive.
Regarding collateral, so-called risky assets were no longer correctly valued and will, henceforth, be traded more on their real fundamentals and no longer according to liquidity and the various stimulus measures.
We can already measure the effects, particularly on "collateral switch" operations, with levels widening again over maturities ranging from one month to six months.
Regarding lending opportunities, the volatility that implies rate hikes should definitely have an impact on the demand for securities and special situations.
Neville: We expect reductions in bond purchases by the central banks through quantitative tightening, leading to an increase in borrower financing requirements. This will result in growing demand for upgrades for HQLA as the breadth of collateral inventory across the asset classes returns to the market. Additionally, the increase in interest rates will create some volatility to generate spreads along the yield curve where there has been little premium in recent months.
Geggus: Volatility linked to the withdrawal of liquidity from a coordinated central bank tightening campaign will provide opportunities across the collateral transformation segment. The demand for cash collateral will be impacted, as other opportunities to invest that cash into high-yield instruments will materialise owing to the tightening. As such, the desire to deploy non-cash collateral will increase and will translate into new securities lending opportunities.
Jones: Collateral scarcity is an area of concern. We have already observed a challenging environment which is likely to persist once the later phases of the Uncleared Margin Rules (UMR) are fully implemented and digested. As such, clients require a full suite of options, allowing them to make quick decisions regarding the best use of their assets. Northern Trust is creating an ecosystem where expanding capabilities within the securities finance space can be harmonised to achieve maximum portfolio optimisation.
What expectations do your clients have from you as a service provider in supporting their commitment to sustainable lending and borrowing? Have recent market conditions and geopolitical stresses had an impact on demand for ESG-compliant lending solutions?
Geggus: For BNP Paribas Securities Services, our clients look to us as their agent to see what is possible and to guide them on the implications — particularly in working through the value chain with borrowers and collateral managers. Proxy voting was the first element discussed and now we are seeing collateral screening as the next natural phase for ESG Securities Lending. Securities lending is not always considered by beneficial owners when they think of ESG. As such, our role as agent is critical to highlight that a fund’s core ESG objectives can be stretched into their securities lending mandates in a complementary way. Recently, we are seeing more and more discussions on that topic.
Daswani: Our role as an agent lender is to support our clients’ requirements in the ESG space, which our business model can deliver effectively given our segregated and highly customisable programmes. An example of this relates to non-cash collateral, which is becoming a bigger topic on the ESG agenda, specifically the ability to screen for non-compliant securities. This is challenging in the traditional pooled environment but relatively straightforward in a truly segregated structure, which is how we have always managed all our client programmes. Tailoring ESG principles into each client’s programme is therefore an extension of what we do for them today.
An argument could be made that some of the more macro aspects of the recent market environment have shone a light further on the topic, particularly around proxy voting. This subject has been front and centre for some years now and this will remain the case as the ESG story evolves in the securities lending context.
Jones: In one word, flexibility. Our client base has a diverse range of views and requirements in respect of their approach to sustainability and ESG matters. Our focus is to ensure we can meet that diversity with optionality. Recent events have brought additional attention and a shift in approach for some firms, but the importance of this topic to our clients was already extremely high in preceding years.
Berge: The central question coming from beneficial owners is: “Can sustainable development and therefore ESG portfolio management be compatible with securities lending?” Academic research and discussions between market participants are ongoing. However, securities lending is already widely recognised as a useful activity, given its contribution to market liquidity and the potential to tailor lending programmes to the specific ESG criteria of lenders and borrowers — for example, relating to collateral selection or General Assembly voting.
Our clients nevertheless expect us to help them navigate the ESG topic. Our clients know we provide full support without impacting their sustainability objectives. Costs incurred by these new investment policies are not negligible and securities lending, while meeting their sustainability criteria, nevertheless constitutes an additional source of alpha at relatively low risk.
ESG policy is a long-term consideration and we have noted little clear impact from recent market conditions, apart from collateral type exclusion (particularly oil and arms) in response to the current geopolitical situation.
Neville: ESG has become a standing agenda item with clients. The lack of homogeneity in approach remains a challenge, given that every client has a unique perspective — whether in terms of the securities in which they are willing to invest or the collateral they are willing to receive. Prior to recent military action in Ukraine, securities in arms manufacturers may have been deemed to be ESG non-compliant. However, in some quarters the view that defence is a requirement to protect citizens has changed that perspective.
Industry solutions will need to be nimble to cater for rapid changes in individual client’s ESG parameters and that continues to be work in progress. That said, we have established our first ESG-aware commingled cash collateral reinvestment vehicle which applies a proprietary ESG scoring system when making investment decisions. This is already available to retirement plan clients and further innovation in this space is underway.
Additionally, we have seen an increase in client enquiries around our proxy voting product, which enables clients to recall and restrict securities ahead of key dates including AGMs, enabling securities lending to remain compatible with clients’ ESG objectives.
How do you assess the outlook for European securities lending markets for the remainder of 2022 and into 2023?
Zemb: For the remainder of 2022 and in 2023, we should be operating in an economic environment characterised by normalisation of monetary policy, but potentially also accompanied by higher asset volatility.
Central banks have given clear indication of what they intend to do and this enables market participants to anticipate and efficiently price future moves. On the other hand, the geopolitical context is still unstable. Pressures may rise on specific sectors and we could witness a high level of specials activity owing to directional shorts. More broadly, the low interest rate environment has prompted more beneficial owners to enter into securities lending programmes in search of additional yields.
The increase in the global lendable asset base could lead to rising pressure on clients with very liquid assets and a defensive collateral profile.
Neville: We anticipate volatility over the coming period, given current levels of inflation and the expected increase in interest rates. As households deal with higher costs, we expect non-essential spending to be curtailed and growth-company equities to suffer in favour of defensive longs. We anticipate an increase in warms and specials as rising interest rates and falling revenues create pressure on companies with large debts, leading to capital increases and debt defaults in those companies that are most directly impacted.
In the fixed income space, we believe there will be continued demand for core HQLA, such as bunds and gilts, versus the lower-grade Spanish and Italian government bonds which will need to be financed. We also believe volatility and a widening of spreads will result as global central banks take measures to adjust their monetary policies at differing cadence, given that the European Central Bank is acting more cautiously compared to the Fed.
Daswani: At this stage, we believe the outlook for the European securities lending markets for the rest of 2022 and into 2023 will not be markedly dissimilar to what we have witnessed over the past 12 months — that is continued borrower demand in certain emerging market countries and robust yield enhancement trading, but offset against a broadly soft landscape at a regional level.
Balkwell: As European economies recover and interest rates rise in the US, confidence in European short interest is expected to return. Corporate action activity will continue to be a theme as those impacted by the pandemic look to restructure amid slower than expected returns to pre-pandemic levels. With the implementation of CSDR and rising volumes, those who have invested in technology and automation will begin to see the rewards. Global inflation will inevitably be a key factor when looking at sector and regional trends. Corporate bonds cannot be overlooked as a core focus for the remainder of 2022 and in 2023, ensuring both trade and post-trade volumes can be supported across the industry.
Jones: With market volatility still very high, and much uncertainty in the macroeconomic and geopolitical environment, it is difficult to see a big change in hedge fund risk appetite. Short interest will continue to be evident in industries most impacted by rising interest rates, supply chain concerns and persistent inflation. With recession risks recently starting to replace interest rate risks, we should see the safe-haven bid maintained for sovereign bonds, providing a fee premium for the most liquid lendable assets. In addition, this is likely to continue to push demand and lending fees higher for credit and emerging market issuance, boding well for fixed income lending revenue.
What is top of your development priorities to capitalise on these market conditions?
Neville: State Street continues to focus on automation, efficient management of financial resources and maximising alpha through effective pricing along the collateral spectrum.
Given our outlook for fixed income, we see opportunities to improve the distribution of corporate bonds and we are working with borrowers to ensure electronic capabilities are active and utilised.
Additionally, we are engaging with borrowers who do not use vendor platforms to source securities and exploring opportunities to interface directly to our proprietary lending platform, WebLend. This connectivity will increase speed of execution and ensure less post-trade intervention through improved STP.
From an FRM perspective, we continue to invest in our pledge capabilities, which we intend to expand across all triparty agents to ensure borrowers can maintain liquidity at their chosen triparty providers. We are also able to support RWA structures at the request of our borrowing clients.
Finally, where it makes commercial sense, we are focused on expanding collateral guidelines in the emerging markets sector, given that the pace of QT will widen spreads versus countries of risk.
Jones: Market and collateral expansion are key to driving a successful lending programme. Opening up new market opportunities to drive revenues and offering flexible collateral schedules will be crucial to capturing new business and generating the best returns for our clients. We continue to invest heavily in our technology, with a focus on automation, flexibility and enabling our clients to make the best possible data-driven decisions for their portfolios.
Berge: We aim to increase investments to streamline our internal trading, enabling us to refine our strategy to support clients’ ESG policies, but also to enhance our reporting services, focusing on technology innovation, digitisation of workflows, and automation of manual processes. As a well-known service provider with a heavily tailor-made approach, we will continue to actively support our clients through innovation by offering solutions around ESG and CSDR topics.
Brown: The impact of increased short activity and volatility across European markets, and the introduction of the CSDR regime at the start of this year, creates a challenging environment for lenders. Ease of doing business has always been a priority and automation will become more important as flows in the region increase. The rise in post-trade automation continues to cut both settlement costs and losses resulting from manual errors. Ultimately, market participants that can provide the best trading efficiency for beneficial owners and borrowers will benefit the most.
Zoë Balkwell, vice president, trading, EMEA Agency Securities Finance, J.P. Morgan
Julien Berge, head of fixed income and repo trading, CACEIS
Chris Brown, vice president, trading, EMEA Agency Securities Finance Cash Reinvestment, J.P. Morgan
Sunil Daswani, global head of securities lending, Financing & Securities Services, Standard Chartered
Andrew Geggus, global head of agency lending, BNP Paribas Securities Services
Mark Jones, head of securities finance, EMEA, Northern Trust
Matthew Neville, managing director and head of agency lending trading EMEA, State Street Global Markets
Olivier Zemb, head of equity finance and collateral management trading, CACEIS
How do you assess the performance of European securities lending markets over the past 12 months?
Mark Jones: Demand for European sovereign bonds fared well in 2021, with on-loan volumes and fees increasing. This was most prevalent towards the end of the year as further lockdown measures led to subdued economic activity, prompting a flight-to-quality bid for core sovereign bonds. In addition, a collateral crunch became apparent into the year-end as sovereign bonds were in strong demand from market participants, with rates trading deeply into negative territory over the year-end reporting date. This bond scarcity eventually drove a significant specials premium, principally in the German curve, prompting the Deutsche Finance Agency to intervene and increase the outstanding nominal of the cheapest in order to calm market conditions.
Aside from sovereign bonds, demand for loans of corporate bonds increased, as the inflationary environment resulted in higher funding costs. The Central Securities Depositories Regulation (CSDR) Settlement Discipline Regime also came into effect in Q1 2022. This may have meant that some lenders felt less comfortable in lending bonds with liquidity challenges.
Equity lending has been a more challenging environment over the past 12 months. Through 2021, the upward trajectory of European equity markets saw investors maintain a greater net-long bias within their investment portfolios, resulting in softer demand and a weaker specials environment.
However, in the early part of 2022 we have seen a steep reverse in equity market trends, with heightened volatility amid sharp declines in asset valuations. Increased geopolitical tensions, surging inflation and aggressive tightening of monetary policy have all contributed to a risk-off approach. Hedge funds looked to de-gross equity exposures, again translating to weaker borrower demand. Capital raising activity has been one good source of borrower demand. With firms’ balance sheets weakened through the pandemic period and a low interest rate environment, we observed an increased number of companies coming to market to raise cash, creating opportunities for securities lending activity. Short interest across those sectors most exposed to COVID-19 lockdowns increased supply chain disruption and surging commodity prices have also been prominent.
Olivier Zemb: The last 12 months have seen growing balances and revenues across just about every asset class and region. The end of the COVID-19 pandemic has been a big relief for the whole market and corporate action activity increased significantly (including spin-offs, IPOs and M&A activity).
European equities have benefited from strong demand for scrip dividends and directional shorts, mainly around industrials, healthcare and consumer discretionary.
On US equities, a large number of stocks continuously traded at high fee rates and very “GC” names like Visa (for hedging purposes) generated strong returns.
Exchange-traded funds (ETFs) reached new highs nearly every month thanks to a few “top payers” (particularly high yield, investment grade and emerging markets) and activity has been strong on all types of corporate bond, especially French healthcare services and financials.
The conflict in Ukraine has brought back volatility and tension to the markets, which has increased opportunities for sector arbitrage and created additional demand for specific securities. CSDR has laid out requirements for flexibility, responsiveness and efficient settlement processes, with penalties for non-compliance. Demand increased on same-day borrows for liquid names, which are mainly short-duration transactions to reduce potential late settlement and matching issues.
The constant need to optimise collateral posted, to limit the all-in cost of borrowing, pressured lenders to reduce haircuts and maintain a flexible collateral profile — cash and non-cash. Low interest rates made cash the cheapest form of collateral, but this will probably not remain the case for long. Lenders which are able to accept cash and have a suitable balance sheet can capture the majority of GC trades.
Collateral and haircut impact the consumption of risk-weighted assets (RWA), as does the weighting of underlying lenders. Borrowers have therefore put more effort into onboarding or borrowing from “RWA-friendly” beneficial owners.
The “smart bucket” concept has gained traction, becoming increasingly relevant owing to growth in the global lendable base and the arrival of new market players, leading to fiercer competition between lenders.
Finally, we have noted growing appetite for trades over six months (cash vs non-cash) or shorter duration for specific underlying clients, particularly corporates. This may be a consequence of the closer scrutiny from all market participants on the net stable funding ratio (NSFR).
Zoë Balkwell: Over the past 12 months, uncertainty and volatility in the market and the introduction of the CSDR regulations have led to increased volumes across all asset classes in Europe.
Automation and transformation projects have supported these high volumes on both the trading and post-trade sides, especially within the warm space. With the ongoing COVID-19 pandemic and prolonged closures across Europe, sectors impacted by tourism, such as airlines and hospitality, have struggled to recover. Many firms are looking to restructure, raise capital or pivot their business strategy in an effort to recover from a tough two years of depressed revenues.
Sunil Daswani: Equity finance revenues in Europe dropped in the second half of 2021, driven by low equities specials balances in the region. Lendable assets were on the rise — however, the utilisation of these assets failed to match the pace. Two key markets in the region, the UK and Germany, declined in revenues. On the other hand, France’s equity finance revenues increased. A significant contributor to France’s sharp increase was the Vivendi Se spin-off. Broadly speaking, European equity markets have undergone a degree of softening over the past 12 months, with pandemic names in particular (airlines, travel companies) coming off from previous levels. Returns have held up well in Emerging Europe, specifically Greece, Turkey, Israel and pre-invasion Russia. With corporates being long cash, we have also seen improved yield enhancement activity in markets such as Switzerland, France, and Norway.
Capital raising activities have led to some new corporate events, which in turn have led to some additional specials across the board.
Matthew Neville: From a financial resource management (FRM) perspective, we have seen an increase in borrowers taking targeted action to actively manage their capital around quarter-ends by sourcing general collateral (GC) supply from low RWA clients and we expect this trend to continue.
In terms of asset classes, we have seen persistent strong demand in US Treasuries and core European government bonds, particularly bunds and gilts, in the short-end as the demand for High Quality Liquid Assets (HQLA) continues to remain as strong as it did throughout the pandemic.
European equities markets have remained reasonably flat, with minimal corporate activity. Levels achieved for COVID-19-impacted stocks have lessened, along with utilisation. However, increases in company dividend payouts compared to the previous couple of years, combined with sustained seasonal demand, puts us in a stronger position to outperform in this space than last year.
In which European markets (by jurisdiction, asset class) do you identify strongest opportunities for growth of your lending business?
Daswani: In line with the past 12 months, we expect to see continued good performance from the aforementioned European emerging markets.
Neville: In addition to monitoring developments in emerging markets, State Street continues to invest in electronic execution to maximise our existing distribution capabilities. Current initiatives include automating single-fund allocation markets to improve utilisation in countries such as Turkey and Poland.
We are also conducting due diligence on lending in Israel and are closely monitoring developments in Saudi Arabia as the lending model there continues to evolve.
Balkwell: Given our strategic focus on automation and efficiency, we have been able to support the broad increases in volume as well as to deliver post-trade efficiencies for a smoother front-to-back experience. With rising inflation and interest rates, we expect short interest in the international space to continue to increase across asset classes, regions and certain sectors. We are also seeing increased activity among corporate bonds due to disclosure limits on equity short positions, which is creating new opportunities.
Jones: We expect credit markets to be impacted as the growing inflationary environment gives way to recessionary fears. Consequently, demand for corporate bonds is likely to continue to push lending fees higher. This is likely to be mirrored in emerging market issuance as higher funding costs, supply chain disruptions and heightened geopolitical risks pressure asset valuations.
In the equity space, we see Saudi Arabia as a new market with strong growth opportunities. With a regulatory framework now in place, and significant demand materialising, we think this is a really exciting opportunity to be at the forefront of a rapidly developing market and we expect to see an increase in activity in the market before the year end.
Zemb: All things considered, we do not forecast any major change in EMEA Equities. Indeed, we believe the upward trend should continue throughout 2022.
In our search for growth opportunities, focus should be on key European emerging countries where revenues are increasing such as Poland and Turkey and to a lesser extent the Czech Republic and Hungary.
We also expect increased traction for ETFs and a widening of spreads for Core Euro Government Bonds. As mentioned, ETFs hit a new record almost every month. With our clients' loan base, we are confident that this asset class will stand out in 2022.
We believe spreads on Core Euro Govvies should increase due to past and future rate hikes in Europe and the UK. This will also create opportunities for cross-currency arbitrage.
Global financial markets have been subject to major fluctuations in liquidity and market pricing over the past two years, with current geopolitical instability following close on the heels of the Covid pandemic. What pressures and opportunities has this created for your securities lending business?
Chris Brown: The current geopolitical climate in Europe has led to more acute focus across the lending programme on appropriate client liquidity in assets that are now more exposed to risk compared to last year. The market volatility has caused greater and more active rebalancing in portfolios than previous years. Our role as trusted partners is to act seamlessly with our beneficial owners to ensure that lending activity does not impede our clients’ ability to be nimble in these markets. In conjunction with our Quantitative Research team, we can price this added risk on a day-to-day basis, ensuring our ability to provide incremental risk-adjusted returns to our clients.
Jones: Borrowing counterparts are more focused on sourcing High-Quality Liquid Assets (HQLA) in term-maturity tenors. We have seen rising demand to upgrade lower-rated or less-liquid assets for sovereign bonds through COVID-19 and the most recent period of geopolitical instability. In addition, we have continued to see a shift in borrower demand to more targeted lending. Borrowing counterparts are becoming more sensitive to capital usage and, in particular, to RWA — a measure to determine the risk of trading exposures and subsequent capital required.
Julien Berge: The drop in yields, and beneficial owners’ hunt for stronger performance in the current geopolitical environment, have led to an abundance of collateral supply as investors try to maximise yields. Consequently, even though overall revenues are increasing, historical lenders are competing with new lenders and struggle to maintain revenues across all asset classes. We are helping clients to understand the benefits of modifying their collateral matrix to become more attractive in an important step to maintaining market share.
After the pandemic and the return of strong growth, central banks’ efforts to control inflation with rate hikes, while preserving growth, will be decisive for the coming months. This should be positive for our activities since economic distortions, and the responses from central banks, play out at a different pace across each geographical zone. This should contribute to a more favourable environment for our activities, generating opportunities which had disappeared in recent years.
Daswani: We have seen hedge funds de-grossing, reducing long-short exposures and this has dampened demand. The rising interest rate environment in particular is going to be a consistent theme throughout 2022, impacting lenders running cash reinvestment programmes and those lenders holding sizeable positions in government bonds (ie HQLA). Judicious management of cash reinvestment pools will increase returns from lending GC and ‘warm’ securities, given reinvestment opportunities along the yield curve, and for now we continue to see strong demand for US Treasuries throughout the tenor range. Given this unique environment, at least in recent times, stock loan and cash reinvestment desks will need to be closely aligned to optimally manage this asset-liability dynamic.
Neville: The magnitude of central bank quantitative easing (QE) led directly to lower spreads in the fixed income upgrade space compared to previous years, as banks were able to sell paper more cheaply than they would have been able to finance through securities lending. This created a competitive challenge for lenders to generate opportunities for clients while avoiding chasing rates downwards — including ensuring that the pricing achieved from borrower demands to face specific client profiles reflected the value those clients added to a borrower’s capital profile.
As we look beyond the pandemic, and as quantitative tightening (QT) reduces liquidity, we can see opportunities developing should spreads emerge between north and south Europe — depending on the relative growth of the economies in each region. We also see more value in corporate bonds as weaker, less capitalised companies become targets for short-sellers.
What investments and adaptations to working practices have you made to sustain and grow your European securities lending activity in this environment?
Neville: Working from home during the pandemic placed increased pressure on operations and trading teams across all firms. This was particularly in the post-trade space, where offshore models came under significant strain given disparate working restrictions across different countries and regions. We resolved to rapidly advance our post-trade capabilities and connectivity with the vendors, aiming to improve visibility and workflows and, consequently, to increase straight-through-processing (STP) and reduce manual pressures on individuals. These steps are creating greater efficiencies and capacity within our teams, enabling us to work on new initiatives to service our clients more effectively.
Andrew Geggus: One major element has been in preparing for CSDR and now actually answering CSDR requirements for our clients. Outside of that, two primary areas of focus have been ESG and technology strategy. At this stage, we already have the capacity to align our programmes to clients’ ESG requirements in multiple ways. Yet, we are still looking at how things could be pushed further, whether it be through our own developments or by working with the market on harmonised practices. Alongside this, continuing the drive for efficiency through technology and automation is another key focal point for our teams. Deploying a combination of proprietary technology developments and vendor-based applications eases the manual elements of the lending process, while offering enhanced analytics to both the lender and agent.
Jones: As a consequence of the capital focus, our borrowing counterparts have sought more bespoke trading routes, including pledge and other capital-efficient lending structures. We have focused on developing this as a key area as we recognise that adapting to changes in demand is crucial to keeping our agency lending programme relevant and competitive.
Brown: Global inflation pressures since 2021 have prompted central banks to become significantly more hawkish on monetary policy so far this year. With implied rates of 3 per cent in the US by the end of the year, coupled with quantitative tightening, and with the European Central Bank (ECB) keen to start raising rates after it ends QE in June, the proliferation of cash in the market will certainly be less than it has been since QE began after 2008. The relative cost of non-cash collateral will also have an impact on the supply of cash collateral in the market. Cash reinvestment programmes already have to keep a close watch on pockets of liquidity and volatility, especially given the medium-term uncertainty with the timing and magnitude of any interest rate moves.
J.P. Morgan’s cash reinvestment team works closely with the lending desk to manage liquidity from loan legs and to capitalise on the greater certainty of liquidity, allowing us to invest cash at more competitive risk-return levels for our clients.
Berge: To enhance our clients’ portfolio performance, we are constantly developing our lending offer through continued innovation and improvement of our processes. The key word is automation, as well as streamlining our processes to better handle volume spikes and the complexity of our clients’ growing constraints.
We are constantly investing in and developing quantitative internal tools to automate essential but lower value-added tasks such trade bookings, recalls and reallocations. The goal is for traders to have more time to focus on finding opportunities in the market and, by doing so, maximising our clients’ revenues. We have also made significant improvements to our communication methods with our clients and counterparties.
What impact will the potential for monetary tightening over the coming 6-12 months have on lending opportunities and collateralisation strategy in Europe?
Berge: Regarding collateralisation strategies, I believe Eurozone monetary policy will tighten, but far slower than in the US. The characteristics and nature of inflation differ on each side of the Atlantic. The withdrawal of excess liquidity in Europe will be gradual and measured. Rate normalisation will mainly impact cash as collateral, which until now has seen very little interest and is handicapping banks in terms of their balance sheet. However, in the coming months this could change when rates return to positive.
Regarding collateral, so-called risky assets were no longer correctly valued and will, henceforth, be traded more on their real fundamentals and no longer according to liquidity and the various stimulus measures.
We can already measure the effects, particularly on "collateral switch" operations, with levels widening again over maturities ranging from one month to six months.
Regarding lending opportunities, the volatility that implies rate hikes should definitely have an impact on the demand for securities and special situations.
Neville: We expect reductions in bond purchases by the central banks through quantitative tightening, leading to an increase in borrower financing requirements. This will result in growing demand for upgrades for HQLA as the breadth of collateral inventory across the asset classes returns to the market. Additionally, the increase in interest rates will create some volatility to generate spreads along the yield curve where there has been little premium in recent months.
Geggus: Volatility linked to the withdrawal of liquidity from a coordinated central bank tightening campaign will provide opportunities across the collateral transformation segment. The demand for cash collateral will be impacted, as other opportunities to invest that cash into high-yield instruments will materialise owing to the tightening. As such, the desire to deploy non-cash collateral will increase and will translate into new securities lending opportunities.
Jones: Collateral scarcity is an area of concern. We have already observed a challenging environment which is likely to persist once the later phases of the Uncleared Margin Rules (UMR) are fully implemented and digested. As such, clients require a full suite of options, allowing them to make quick decisions regarding the best use of their assets. Northern Trust is creating an ecosystem where expanding capabilities within the securities finance space can be harmonised to achieve maximum portfolio optimisation.
What expectations do your clients have from you as a service provider in supporting their commitment to sustainable lending and borrowing? Have recent market conditions and geopolitical stresses had an impact on demand for ESG-compliant lending solutions?
Geggus: For BNP Paribas Securities Services, our clients look to us as their agent to see what is possible and to guide them on the implications — particularly in working through the value chain with borrowers and collateral managers. Proxy voting was the first element discussed and now we are seeing collateral screening as the next natural phase for ESG Securities Lending. Securities lending is not always considered by beneficial owners when they think of ESG. As such, our role as agent is critical to highlight that a fund’s core ESG objectives can be stretched into their securities lending mandates in a complementary way. Recently, we are seeing more and more discussions on that topic.
Daswani: Our role as an agent lender is to support our clients’ requirements in the ESG space, which our business model can deliver effectively given our segregated and highly customisable programmes. An example of this relates to non-cash collateral, which is becoming a bigger topic on the ESG agenda, specifically the ability to screen for non-compliant securities. This is challenging in the traditional pooled environment but relatively straightforward in a truly segregated structure, which is how we have always managed all our client programmes. Tailoring ESG principles into each client’s programme is therefore an extension of what we do for them today.
An argument could be made that some of the more macro aspects of the recent market environment have shone a light further on the topic, particularly around proxy voting. This subject has been front and centre for some years now and this will remain the case as the ESG story evolves in the securities lending context.
Jones: In one word, flexibility. Our client base has a diverse range of views and requirements in respect of their approach to sustainability and ESG matters. Our focus is to ensure we can meet that diversity with optionality. Recent events have brought additional attention and a shift in approach for some firms, but the importance of this topic to our clients was already extremely high in preceding years.
Berge: The central question coming from beneficial owners is: “Can sustainable development and therefore ESG portfolio management be compatible with securities lending?” Academic research and discussions between market participants are ongoing. However, securities lending is already widely recognised as a useful activity, given its contribution to market liquidity and the potential to tailor lending programmes to the specific ESG criteria of lenders and borrowers — for example, relating to collateral selection or General Assembly voting.
Our clients nevertheless expect us to help them navigate the ESG topic. Our clients know we provide full support without impacting their sustainability objectives. Costs incurred by these new investment policies are not negligible and securities lending, while meeting their sustainability criteria, nevertheless constitutes an additional source of alpha at relatively low risk.
ESG policy is a long-term consideration and we have noted little clear impact from recent market conditions, apart from collateral type exclusion (particularly oil and arms) in response to the current geopolitical situation.
Neville: ESG has become a standing agenda item with clients. The lack of homogeneity in approach remains a challenge, given that every client has a unique perspective — whether in terms of the securities in which they are willing to invest or the collateral they are willing to receive. Prior to recent military action in Ukraine, securities in arms manufacturers may have been deemed to be ESG non-compliant. However, in some quarters the view that defence is a requirement to protect citizens has changed that perspective.
Industry solutions will need to be nimble to cater for rapid changes in individual client’s ESG parameters and that continues to be work in progress. That said, we have established our first ESG-aware commingled cash collateral reinvestment vehicle which applies a proprietary ESG scoring system when making investment decisions. This is already available to retirement plan clients and further innovation in this space is underway.
Additionally, we have seen an increase in client enquiries around our proxy voting product, which enables clients to recall and restrict securities ahead of key dates including AGMs, enabling securities lending to remain compatible with clients’ ESG objectives.
How do you assess the outlook for European securities lending markets for the remainder of 2022 and into 2023?
Zemb: For the remainder of 2022 and in 2023, we should be operating in an economic environment characterised by normalisation of monetary policy, but potentially also accompanied by higher asset volatility.
Central banks have given clear indication of what they intend to do and this enables market participants to anticipate and efficiently price future moves. On the other hand, the geopolitical context is still unstable. Pressures may rise on specific sectors and we could witness a high level of specials activity owing to directional shorts. More broadly, the low interest rate environment has prompted more beneficial owners to enter into securities lending programmes in search of additional yields.
The increase in the global lendable asset base could lead to rising pressure on clients with very liquid assets and a defensive collateral profile.
Neville: We anticipate volatility over the coming period, given current levels of inflation and the expected increase in interest rates. As households deal with higher costs, we expect non-essential spending to be curtailed and growth-company equities to suffer in favour of defensive longs. We anticipate an increase in warms and specials as rising interest rates and falling revenues create pressure on companies with large debts, leading to capital increases and debt defaults in those companies that are most directly impacted.
In the fixed income space, we believe there will be continued demand for core HQLA, such as bunds and gilts, versus the lower-grade Spanish and Italian government bonds which will need to be financed. We also believe volatility and a widening of spreads will result as global central banks take measures to adjust their monetary policies at differing cadence, given that the European Central Bank is acting more cautiously compared to the Fed.
Daswani: At this stage, we believe the outlook for the European securities lending markets for the rest of 2022 and into 2023 will not be markedly dissimilar to what we have witnessed over the past 12 months — that is continued borrower demand in certain emerging market countries and robust yield enhancement trading, but offset against a broadly soft landscape at a regional level.
Balkwell: As European economies recover and interest rates rise in the US, confidence in European short interest is expected to return. Corporate action activity will continue to be a theme as those impacted by the pandemic look to restructure amid slower than expected returns to pre-pandemic levels. With the implementation of CSDR and rising volumes, those who have invested in technology and automation will begin to see the rewards. Global inflation will inevitably be a key factor when looking at sector and regional trends. Corporate bonds cannot be overlooked as a core focus for the remainder of 2022 and in 2023, ensuring both trade and post-trade volumes can be supported across the industry.
Jones: With market volatility still very high, and much uncertainty in the macroeconomic and geopolitical environment, it is difficult to see a big change in hedge fund risk appetite. Short interest will continue to be evident in industries most impacted by rising interest rates, supply chain concerns and persistent inflation. With recession risks recently starting to replace interest rate risks, we should see the safe-haven bid maintained for sovereign bonds, providing a fee premium for the most liquid lendable assets. In addition, this is likely to continue to push demand and lending fees higher for credit and emerging market issuance, boding well for fixed income lending revenue.
What is top of your development priorities to capitalise on these market conditions?
Neville: State Street continues to focus on automation, efficient management of financial resources and maximising alpha through effective pricing along the collateral spectrum.
Given our outlook for fixed income, we see opportunities to improve the distribution of corporate bonds and we are working with borrowers to ensure electronic capabilities are active and utilised.
Additionally, we are engaging with borrowers who do not use vendor platforms to source securities and exploring opportunities to interface directly to our proprietary lending platform, WebLend. This connectivity will increase speed of execution and ensure less post-trade intervention through improved STP.
From an FRM perspective, we continue to invest in our pledge capabilities, which we intend to expand across all triparty agents to ensure borrowers can maintain liquidity at their chosen triparty providers. We are also able to support RWA structures at the request of our borrowing clients.
Finally, where it makes commercial sense, we are focused on expanding collateral guidelines in the emerging markets sector, given that the pace of QT will widen spreads versus countries of risk.
Jones: Market and collateral expansion are key to driving a successful lending programme. Opening up new market opportunities to drive revenues and offering flexible collateral schedules will be crucial to capturing new business and generating the best returns for our clients. We continue to invest heavily in our technology, with a focus on automation, flexibility and enabling our clients to make the best possible data-driven decisions for their portfolios.
Berge: We aim to increase investments to streamline our internal trading, enabling us to refine our strategy to support clients’ ESG policies, but also to enhance our reporting services, focusing on technology innovation, digitisation of workflows, and automation of manual processes. As a well-known service provider with a heavily tailor-made approach, we will continue to actively support our clients through innovation by offering solutions around ESG and CSDR topics.
Brown: The impact of increased short activity and volatility across European markets, and the introduction of the CSDR regime at the start of this year, creates a challenging environment for lenders. Ease of doing business has always been a priority and automation will become more important as flows in the region increase. The rise in post-trade automation continues to cut both settlement costs and losses resulting from manual errors. Ultimately, market participants that can provide the best trading efficiency for beneficial owners and borrowers will benefit the most.
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