We’ve heard a lot about the subdued demand environment—are beneficial owners still interested in lending given the protracted nature of the recovery?
In short, the answer is yes—absolutely. Like any industry, securities lending has cyclical lows. Nevertheless, lending returns over the last six months have been stronger and ultimately, beneficial owners understand that the product has a long-term horizon. While we would acknowledge that demand is currently at a relative low, our clients and those we talk to in the industry recognise lending as an important part of their investment philosophy. Beneficial owners remain engaged because they appreciate the benefits lending can bring in a competitive environment and view it as an important revenue stream.
Having said that, beneficial owners are certainly evaluating lending in a different way today than they were five years ago. They are more aware of the risks and rewards associated with the product and are viewing it as they would any other investment activity. Programme oversight is the most robust it’s ever been and beneficial owners are carefully aligning their programme structures and earnings composition with their overall objectives and risk/reward profile.
Importantly, we do see the light at the end of the tunnel with factors pointing to a smoother road ahead—monetary policies have started to normalise, hedge fund assets under management continue to grow and corporate confidence seems to be returning—leading to improved securities lending returns.
How are borrowing strategies and demand drivers changing and what’s been the impact on beneficial owners?
The fundamental drivers of demand have not really changed to a great degree from an intrinsic value perspective. Directional and event driven strategies remain in play. Borrowers are, however, becoming more selective in the deployment of their balance sheet as a result of Basel lll, and are taking a more strategic approach to the assets they borrow (ie, consideration of collateral options, trade structures and loan durations). The general collateral trade has been most negatively affected as the cumulative effect of tax and regulatory change has driven down profitability. The end result is that industry participants are focusing on prioritising resources towards higher margin activity.
Given the current environment, our clients are assessing special lending opportunities and are more willing to review new revenue opportunities at the individual security level rather than the more traditional method of overall portfolio returns. At the same time, this willingness to engage in new strategies has also meant that our clients are demanding greater degrees of transparency so that they are fluent when discussing with their boards and other stakeholders.
You mention transparency and increased demands from boards. Does transparency mean something different today than it did five years ago, and what are boards looking for?
Even for beneficial owners that have historically been fully engaged in lending, boards of directors and other stakeholders are rightly examining the approach, relative performance, income attribution, and risk management on an ongoing basis. Indeed, this trend is something we have witnessed for other products across the capital markets spectrum and has not just been isolated to lending.
More than ever, boards want transparency into demand drivers, an understanding of the role securities lending plays in the broader capital markets, and sometimes whether it’s even a worthwhile activity given the cyclical low we’ve experienced in the demand environment. Even for the experienced lender, these arguments can be difficult to address if you are not fully informed or unable to access the appropriate information.
At Brown Brothers Harriman, we work very closely with our clients, providing them with timely information that enables them to answer any questions that may arise, and make informed decisions about how they engage in lending. Beneficial owners that understand the nuances of different strategies and some of the more challenging objections will not only be able to address the concerns of others, but will ultimately be more comfortable with their own position and approach to lending.
The focus on transparency in the past few years has been all about post-trade reporting. What happens pre-trade and how much does this matter?
The industry has taken great strides in the last few years to improve transparency, but the over-the-counter nature of the market means that it is still an area that presents opportunities for improvement. Agent lenders have developed or enhanced in-house reporting systems and competition among benchmarking providers has increased, all of which have contributed to significant improvements in the post-trade environment.
Looking ahead, we think it is just as important to pay the same level of attention to the pre-trade environment and that greater transparency and pre-trade analytics will play an increasingly important role in the future. For beneficial owners as well as those on the side lines evaluating whether lending is for them, having access to pre-trade information will provide lenders with the necessary tools to effectively assess revenue opportunities and make informed decisions regarding their lending programme.
While the industry has certainly made significant advancements, the increased focus on efficiency, transparency, and income attribution will continue to create exciting opportunities for development over the next few years.
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