RBC
Don D’Eramo
27 October 2020
RBC’s Don D’Eramo appraises how the major revenue trends of 2020 so far, including COVID-19 and the rise of SPAC IPOs, are being offset against hyperactive central banks dishing out alternative sources of liquidity
Image: Don D’Eramo
Despite ongoing challenges presented by COVID-19 in 2020, the securities lending industry continues to demonstrate resilience. As a result of robust risk management practices, the industry experienced little to no financial impact during the recent period of significant market stress. This was managed alongside the implementation of two significant and complex regulatory initiatives. Throughout these months, it was imperative that we maintained open lines of communication with our beneficial owners and counterparties to address volatility concerns and provide clarity around the regulatory changes. Meanwhile, the market continues to evolve as intrinsic value opportunities re-emerge and macro-economic policy changes affect demand drivers for high-quality liquid assets (HQLA).
How has the securities lending industry managed regulatory change during COVID-19 and what impact has this change had on stakeholders?
The initial phase of the Securities Financing Transactions Regulation (SFTR) was implemented in July, followed by the EU’s revised Shareholder Rights Directive (SRD II) in September. While SFTR reporting obligations initially apply to counterparties, the next phase of implementation in October extended the requirements to beneficial owners. SFTR is a complex undertaking and, so far, implementation has been successful. Industry associations have provided tremendous support to participants in clarifying the new regulatory requirements. Looking ahead, the SFTR agenda remains a key focus across the industry. Agent lenders, buy/sell side firms, vendors and trade repositories will continue to deploy system enhancements to facilitate the new regulatory requirements. Best practices will evolve and ongoing advocacy efforts by industry associations will help ensure that the technical requirements are implemented in a practical manner.
SRD II went live shortly after the July implementation of SFTR. As of 3 September, intermediaries such as agent lenders are responsible for disclosing shareholder information if requested by issuers within applicable EU member states. SRD II is an important evolution of the marketplace and can be viewed in lockstep with sustainable finance principles and environmental, social and governance (ESG) investment practices. It should be noted that, similar to ESG, SRD II does not impede securities lending. While agent lenders now have a reporting obligation, beneficial owners retain their right to exercise proxy voting on any security held within their invested portfolio. As such, clients must continue to request a temporary recall of the security from the borrower or mandate their agent lender to proactively recall securities based on publicly available information. The latter action is typically taken only by a small group of beneficial owners who frequently exercise their voting entitlements and have taken into account the relevant revenue considerations. This process remains well defined across the industry globally.
Given current market conditions, where do you see opportunities for incremental value?
Global demand for specials has been declining since its peak in 2018 and 2019 when the frequency of ‘hot’ and ‘white hot’ securities was high. Although we see fewer specials in today’s market environment, opportunities to gain incremental returns on intrinsic value opportunities continue to arise, albeit from slightly different avenues. Corporate events, for example, have historically presented value opportunities in the securities lending market through initial public offerings (IPOs) or mergers and acquisitions activity, resulting in exchange offers and other corporate events. So far in 2020, we have seen fewer IPOs but they have not disappeared entirely including a series of announcements since August (for example, Airbnb, Palantir and Snowflake).
The pandemic and resultant market volatility have also created alternative opportunities through Special Purpose Acquisition Company (SPAC) offerings. SPACs have accounted for almost half of all IPOs so far in 2020. Demand for these non-traditional ‘reverse offerings’ is generated by two factors: implicit spreads between event options and directional investor sentiment.
While such events may look different, the inherent incremental returns are similar and perhaps even greater than traditional IPO events. In addition, traditional corporate events such as exchange offers, dividend reinvestment plans and scrip issues continue to provide pockets of intrinsic value. In order to capitalise on such events, the experience of the agent lender and the relationships on both sides of the trade — with beneficial owners and counterparties — are vital given the time-sensitive nature of these opportunities.
How have the actions of central banks impacted the securities lending market?
Recent fluctuations in the demand for fixed income securities highlight the effects of macroeconomic factors on lending. In past years, fixed income loan balances have exceeded equities, primarily driven by demand for HQLA to support liquidity requirements and attributable to key financial resilience reforms stemming from the 2008 credit crisis. This resulted in larger open balances and significant demand for term loan structures. However, we continue to see this trend reversing in 2020, given the substantial liquidity that currently exists across global financial markets.
Volatility experienced earlier this year has necessitated significant central bank intervention to control inflation and ease liquidity concerns. The Bank of Canada and US Federal Reserve quantitative easing (QE) programmes, in addition to all-time-low interest rates, are providing alternatives to the liquidity once sought in the securities lending market. As a result, demand for additional term lending has softened and a number of financial institutions have reduced existing structures taken on prior to the COVID-induced market decline. In Canada, such demand has been concentrated around level one and level two assets, Canadian government bonds and provincial debt. While demand for Canadian government bonds persists, albeit at lower levels, demand for provincial debt has tapered due to alternative sources of liquidity and collateral optimization. In comparison, significant appetite continues to exist for the borrowing of US treasuries. As we approach 2021 a key focus across the industry will be on further central bank actions, which have the potential for additional impacts on demand for term lending.
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