Industry participants provide an update on the Canadian securities lending market, discussing market performance, regulatory initiatives and more
How has the Canadian securities lending market performed in the opening months of 2018?
Donato D’Eramo: The Canadian securities lending market maintained healthy growth during the first quarter of 2018, driven by increased market volatility, as well as a continuation of significant demand for Canadian equities and fixed income. Persistence in several high value sectors continued well into the new year and the appetite for high quality liquid assets (HQLA) remained strong, benefiting lenders of Canadian sovereign and provincial assets.
It is evident that incremental opportunities in the lending market are no longer limited to directional demand but also extend to more structured lending paradigms, such as term lending. Beneficial owners within the RBC Investor & Treasury Services Securities Finance programme generally saw approximately 20 percent growth in Canadian asset average loan balances year-over-year (source: IHS Markit).
Phil Zywot: Canadian equities have continued to perform well in the opening months of 2018. We have seen strong performances in this asset class over the last three years, which has been driven mainly by cyclical market activity. There is continued interest from borrowers looking for high quality liquid assets (HQLAs) and there is especially strong demand for Canadian government bonds, given their liquidity and Canada’s standing as one of the few AAA-rated countries remaining.
Looking at pension funds specifically, Canadian pension plan providers are among the most sophisticated and successful institutional investors in the world. Most are fully funded and they continue to look to securities lending programmes as an avenue to earn additional revenue for their beneficiaries. Flexibility, collateral management and liquidity solutions remain a priority for pension funds here in Canada.
Stephen Novo: The securities lending market in Canada continued to see strong flows in the first few months of 2018, with demand across most asset classes remaining largely steady. Equity flows were buoyed by increased overall demand for general collateral, as well as revenue growth in a few key sectors. Energy, financials, mining and other traditionally strong sectors were accompanied by increased interest in the marijuana and blockchain industries.
Fixed income also performed well in the first few months of the year, with regulatory pressures driving demand for Canada governments higher and more specifically for those beneficial owners with wider collateral profiles. Lower supply of the highest quality collateral has had positive ancillary effects on demand for other fixed income instruments. Real return issues, Canada Housing Trust bonds and provincial issues have benefited through higher spreads and higher utilisation rates than historically seen. Increased demand for term structures has also helped boost fixed income returns.
Alexa Lemstra: According to DataLend, revenue from lending Canadian assets in Q1 2018 reached more than $128 million across equities and fixed income. That represents a drop of 6 percent compared to Q1 2017. Equities revenue in Q1 2018 was $95 million, a moderate drop year over year, while fixed income revenue increased a staggering 40 percent to $33 million. The decline in equity revenue and increase in fixed income revenue is a trend we are seeing in many markets around the globe.
Revenue for Canadian beneficial owners is a good story, with 20 percent year-over-year growth to $107 million in Q1 2018.
Dave Sedman: If market volatility is any indication, then the start to this year has been very exciting. Overall, while fees tended to increase, Canadian loan volumes decreased slightly over the quarter, when compared to Q4 2017. This is a seasonal shift that is mostly attributed to a decrease in supply as the Canadian markets begin to move through the proxy season. In demand names experienced higher than average fees as borrowers struggled to maintain their positions due to the temporary constraint in supply. It is important for beneficial owners to consider their options around the proxy voting time because additional fees can be earned from lending during the proxy season.
Throughout the quarter, demand weakened somewhat in some sectors such as specialty pharmaceutical and alternative mortgage finance. On the positive side, borrower demand remains stable within the retail and oil and mining sectors and dividend reinvestment plan (DRIP) trade opportunities remained constant throughout the quarter.
There was also an increase in demand for fixed income securities, specifically for HQLA assets, which would include Canadian sovereign debt. This has been a theme over the last several years as borrowers have adapted to the new regulatory requirements. On the flipside of this, borrowers want to pledge a variety of collateral including equities and corporate debt. Beneficial owners can accommodate this collateral set within their risk parameters.
Is investor education (beneficial owners knowledge of securities lending) a problem in Canada like other countries?
Novo: The Canadian securities lending market is one of the largest and most mature markets. As a result, participants in the market are generally some of the most sophisticated and knowledgeable in the industry. Despite the relatively strong history of securities lending in Canada, there remains a need to continually engage beneficial owners in industry developments and to educate less experienced investors on the securities lending market, including benefits and risks. For example, while Canadian mutual funds have been participants in the lending market for years with the adoption of National Instrument (NI) 81-102, there are many mutual funds that, for various reasons, have not participated in the market.
Continued education and dialogue with those who are not currently capturing value by participating in the industry will be key to expanding the supply of the Canadian securities lending market.
D’Eramo: We are constantly looking for opportunities to engage with our beneficial owners in order to increase their knowledge of securities lending. As an agent lender, one of our primary responsibilities is to provide lenders with insights into their portfolio opportunities and how the market is developing. This engagement has proven invaluable in helping beneficial owners realise the benefits of a securities lending programme and providing RBC Investor & Treasury Services, as agent lender, with a complete view of our clients’ goals.
Directional trades and shorting continue to be a frequent topic of conversation, especially with portfolio managers. The broad range of market data available today is key to our goal of increasing awareness of the drivers and dynamics of the securities lending market among beneficial owners. Industry data and metrics are essential to providing lenders with the transparency and information necessary for them to understand this investment space.
Sedman: Globally, beneficial owners are taking a much more active role in their securities lending programmes, which means that transparency and education remain a key component of the client relationship. Canadian clients have always taken a keen interest in understanding the risk/reward trade off from implementing a securities lending programme. Beneficial owners are interested in more closely monitoring their programmes to ensure they remain within their specified risk tolerance and that income is tracking their expectations.
Client service is a hallmark of Northern Trust and we work closely with our Canadian clients to ensure they have the information they need to manage their programmes effectively. In addition to monitoring borrowing and collateral exposure, beneficial owners are interested in the demand and revenue paid for their securities. Benchmark reporting and detailed revenue information is an important aspect of the relationship review process with clients. Online access to reporting augments the client experience to assist clients in their oversight of the programme.
Zywot: Generally speaking, Canadian beneficial owners are engaged and well versed in securities lending. Most participants, view securities lending as both an opportunity to generate incremental revenue for their unitholders, as well as an additional investment vehicle for diversification purposes. In an ever-changing environment, it’s important to keep up-to-date on industry trends and to share that knowledge with beneficial owners in order to help them stay current with market changes, from key regulatory updates to market-specific demands.
How has the recent 2018 Federal Budget been received by the securities finance industry and what do we need to take note of?
Novo: The recently released Federal budget did contain some language around the “specified securities lending arrangement”, which was largely seen as tightening up the rules that had already taken effect in April last year, but will not be impactful on the agency lending market.
What regulatory initiatives are being discussed and how will they affect Canada?
Zywot: We are awaiting the final amendments to the Alternative Fund Proposals by the Canadian Securities Administrators (CSA), which affects NI 81-102, a core regulatory framework for mutual funds in Canada. This change looks promising for the alternative investment funds industry in Canada, as it would allow alternate fund strategies to be offered to retail investors in the same manner as mutual funds. Once implemented, this regulatory change could be a major growth area for liquid alternatives in Canada, and it could add additional demand for securities financing solutions.
CASLA is currently in the process of lobbying for changes to NI 81-102, specifically to permit Canadian mutual fund managers to expand their acceptable collateral profiles to include equities for securities lending transactions. This flexibility would provide additional diversity to their collateral profiles, generate opportunities for additional income, and position fund managers to compete with similar European funds (UCITS) and pension plans on a more level playing field in security loan transactions.
Ed Hellaby: The ongoing implementation of BCBS IOSCO uncleared margin rules continue to impact the Canadian market. The requirement to exchange initial margin bilaterally has been phased into effect since 2016, culminating in 2020 for all firms with over $8 billion aggregate average notional amount (AANA). For many Canadian buy-side institutions who fall into the final phase of the regulation there is much work still to be done, with just over two years until the regulation takes effect. FIS is seeing the process of readiness for these rules taking market participants anywhere up to 24 months depending upon their current infrastructure and capability.
There are many steps involved, including the determination of net trade open notional; negotiation of initial margin legal agreements; selection and implementation of a technology solution to perform the ISDA standard initial margin methodology (SIMM) IM calculation; enhancement of the current margin call processing workflow; and negotiation of triparty account structures for IM segregation.
In addition to managing the workflow and calculations, market participants will need to be able to mobilise liquidity to cover these additional obligations, often in the form of HQLA. We have seen many Canadian firms approach us to help develop a centralised real time view of their assets to better understand their funding capacity.
This is being coupled with the ability to be able to estimate initial and variation margin requirements to ensure sufficient liquidity can be made available to cover obligations without the need for maintaining cash buffers. As we get closer to the deadlines we expect there to be a scramble to put infrastructure and processes in place, so we encourage firms to engage with trusted industry partners such as FIS as early as possible, to help guide them through the available solutions in the market.
D’Eramo: On the regulatory front, the Canadian mutual fund market continues to evolve in tandem with the increasing sophistication of investors seeking leverage and exposure in their investment portfolios. The inability of Canadian mutual funds to accept equities as collateral significantly limits their lending opportunities. It is essential that conversations on the need for regulatory change highlight the importance of securities lending from an alpha perspective and its ability to mitigate market risk.
Additionally, the liquid alternative space continues to develop including potential regulatory relief to expand the leverage capabilities of Canadian mutual funds. This is an important development for the securities lending industry, potentially leading to increased borrower demand as mutual funds seek to gain further exposure to alternative investment structures and implement leverage strategies across these structures.
Novo: The regulatory front in Canada has been largely quiet over the past few months. The industry has been in the early stages of working on initiatives that would expand the ability of specific types of beneficial owners to take a wider array of collateral, improving flexibility and supply, as the industry continues to move to more non?traditional collateral.
Lemstra: Among the number of regulatory changes impacting our industry, we hear the most about Securities Financing Transactions Regulation (SFTR). While SFTR is a European regulation, Canadian market participants have an ear tuned to SFTR where it impacts their global book and counterparty relationships.
Whether the exposure to SFTR comes through reporting obligations themselves in a jurisdiction where they trade, or whether they trade with a client that has an obligation to report, firms must prepare their systems and workflows to provide the required information. For firms in scope, SFTR has a significant impact, including technology spend, regulatory resources and industry working group engagement. SFTR is front and centre in the global securities lending industry and on the radar of all Canadian participants.
How are stocks for Canadian companies being used within the country’s lending market? Are there any stand out favourites stocks or industries?
Sedman: The market continues to define itself with a mix of high demand ‘specials’ securities and lower demand general collateral. The specials tend to be very name specific and associated with industries where there has been volatility in underlying share prices. Specials can represent a large portion of a lender’s earnings so it is important to monitor and understand the dynamics that are driving the demand. This year the Canadian specials market benefited from continued directional demand in the specialty pharmaceutical, energy and department store retail sectors.
Another pocket of demand relates to the lack of liquidity in certain securities around proxy voting periods. In Canada, we tend to experience some cyclical demand based on the proxy voting. Lenders should understand whether it makes sense to lend your securities over the proxy period and try to gain some additional income.
A large portion of the revenue generated from certain large cap Canadian equities is driven by the dividend reinvestment plan (DRIP) trade. Similar to the proxy demand, DRIPs typically have season demand, so it is important for lender’s to understand the timing and demand for these opportunities.
Lemstra: The healthcare sector remains one of the most active ones for lenders in Canada, especially the Pharmaceuticals industry, where medical marijuana stocks have been very hot for some time. Three of the five top-earning securities in Q1 2018 are part of the medical marijuana class; this area has contributed significantly to securities lending revenue in this market as the Canadian government continues its push to legalise marijuana in
summer 2018.
Novo: Though general collateral trades continue to drive most of the volume in the Canadian market, directional activity continues to be the source of earnings growth. While Q1 2017 was characterised by a focus on the alternative financials, most predominant of which was Home Capital Group, the first quarter of 2018 saw borrowers focused on a few other sectors.
Mining firms, and in particular ones focused on gold mining, continued to see a bid especially in light of the US Federal reserve’s expected rate path and its impact on prices of the yellow metal.
Blockchain related issues were another source of demand that helped drive revenues in the first quarter, as a spate of firms ‘rebranded’ themselves with blockchain technology as being a focus of their business strategy. Despite the focus on these sectors, financials and in particular consumer finance companies, continued to be steady favourites as concerns about overleveraged Canadian consumers continued into the current year.
Zywot: Over the last three years, Canada has experienced cyclical demand in the equity market. We have seen a shift from Canada being a mostly general collateral market to specials-driven, mainly due to cyclical market activity.
For example, we saw specials in the resource sector, which coincided with the resource correction that began mid-2014. This was followed by the housing sector surge, which drove demand specifically for the alternative mortgage financing segment, and now we are enjoying increased demand in the healthcare sector, driven by the popularity of the emerging medical marijuana industry.
Are industry participants still interested in developing a workable central counterparty (CCP) model or are we looking past CCP’s at other solutions?
Novo: Canadian industry participants continue to work with a number of CCPs to develop a working model. The Canadian securities finance market has already seen some degree of success with CCPs, with the introduction of clearing of Canadian fixed income repo by the Canadian Derivatives Clearing Corporation (CDCC) in 2012.
CCPs continue to offer potentially significant advantages for borrowers and agent lenders from a regulatory perspective. Borrowers would benefit from leverage and liquidity coverage ratio perspectives, while both agent lenders and borrowers would attain some degree of RWA benefit. Agent lenders would benefit from a single counterpart credit limit perspective, which will also help to mitigate large counterparty exposures and in turn related regulatory impacts. Industry participants view CCPs as one potential solution that will complement other solutions being pursued.
Zywot: The proposed method for how CCPs would function in Canada is not currently suitable for securities lending. Overall, we are not experiencing the increased interest in this model that has been seen in other countries. However, there have been some recent developments with the addition of some buy-side participants to the Canadian CCP model run by the Canadian Derivatives Clearing Corporation (CDCC).
Globally speaking, as part of a wider range of solutions for the securities finance industry to utilise, there is a broader push for CCPs, which are becoming an alternative tool for
market participants.
Lemstra: The global industry is making progress with CCPs in different jurisdictions. In the US, volumes and balances in the OCC hedge programme have been steadily growing, while FICC fixed income offerings continue to have steady growth.
Meanwhile, in Europe, there are indications that Eurex is gaining traction. Through EquiLend Clearing Services (ECS), we continue to see interest and investment in the CCP model, especially in the US and Europe. In Canada, the CCP model is in place for fixed income through the CDCC. The CDCC says it is considering adding a model for equities, but nothing is scheduled for release in the short term.
What is the level of automation in Canadian securities lending and is there a desire for blockchain, AI and all the many talked about fixes for problems that do not exist?
D’Eramo: Automation is playing an increasingly important role in the securities lending business. Technology is key to ensuring that beneficial owners continue to realise the benefits of an agent lender’s ability to efficiently optimise portfolios. The focus in Canada has generally been around automated trading.
RBC Investor & Treasury Services’ technology development efforts are centred on how we connect with counterparts, as well as the way we seek opportunities for non-lending clients and the process for pricing trades.
As an early adopter of Next Generation Trading (NGT), we have automated more than 75 percent of our connectivity with counterparts, freeing up our global lending desk to focus on optimising high-value lending and exploring new trading strategies. Pricing algorithms are another way that technology is shaping the industry. This goes hand-in-hand with the increasing sophistication of beneficial owners, who expect agent lenders to be price-makers as opposed to simply being price-takers.
The development of automated pricing strategies has enabled RBC to utilise the full spectrum of data available in the market, proactively generating well informed pricing rather than reactively bidding up the price offered by the broker.
Novo: Given the maturity of the Canadian market, adding efficiencies through technology remains a key focus for industry participants. While the industry has made great strides in automating trade flow through better connectivity between lenders and borrower, it continues to look for other ways to optimise through emerging technologies. Generally speaking these emerging technologies will be helpful for the transparency and efficiency of the securities lending market.
With respect to blockchain/distributed ledger technology (DLT), benefits include reduction in transaction costs around settlements, reconciliation times throughout the transaction lifecycle and a shared common data source between counterparties.
These mechanics of the technology will help reduce intraday risk and associated capital requirements banks deal with in the current settlement structure.
Additional opportunities will be near?real time attribution of securities and client exposures, Smart Contracts to automate existing manual touch points and more efficient ways of tracking trade lifecycles and trade attribution.
Artificial intelligence (AI) and machine learning allows for better decision making, which allows firms to automate processes that they weren’t able to do before. Some applications of this include better predictions of borrow rates, which help in pricing and the ability to match transactions quicker, which improves reconciliation times.
Hellaby: The collateral management industry is an example of one that has continued to innovate to strive towards high levels of automation and straight-through processing (STP). Over 30 FIS clients are leveraging the Apex Collateral solution to allow them to manage increased margin call volumes by leveraging a broad community of industry utilities; implementing exception margin based workflows; and automating the collateralisation process through collateral optimisation.
As the uptake of repo margin call processing through Acadiasoft continues to increase, organisations are looking to ensure their repo collateral management solutions are fully integrated with the industry utility.
This level of integration allows an institution to automatically issue and agree all margin calls with their brokers based on exception rules before they have even stepped foot into the office. If this process is combined with collateral optimisation an organisation can take the level of automation one step further, by having their collateral platform automatically select the most efficient piece of collateral to cover the obligation and communicate this to the counterparty.
At FIS, we have seen clients report the average time to process a margin call fall by over 300 percent by leveraging Apex Collateral’s out of the box connectivity with Acadiasoft and cost based optimisation routines.
It is clear that disruptive technologies such as blockchain and artificial intelligence will continue to drive efficiency in the securities finance industry, and across markets more broadly. In addition to the drives for efficiency outlined above, FIS has been leveraging artificial intelligence within our Intellimatch solution to better aid its matching and reconciliation process.
Zywot: We are experiencing rapid technology change in the financial services industry overall, and it is not a time to stand still.
However, when it comes to technological change, Canada has traditionally been a late adaptor or more of a “strategic follower” of proven technologies.
At BNY Mellon, we are embracing opportunities for innovation and efficiency. By automating certain repetitive tasks, employee capital can be re-allocated to more value-added functions and opportunities.
There is a strong industry desire for blockchain-type solutions.
The technology behind blockchain has the potential to help with trade settlements and other back-office efficiencies, as well as increase transparency and potentially reduce operational human error.
Lemstra: The Canadian securities lending industry has an impressive history of innovating and investing in technology. That is evidenced by the widespread adoption of EquiLend, specifically NGT and our post-trade suite, throughout the market.
At EquiLend, we continue to see investment into automating trading and post-trade activities with the goal of improving straight-through processing (STP) and efficiency in the Canadian lending industry.
Technology investment is very important to participants here, and it is certainly front of mind and a key item on annual budgets.
The Canadian market was early to adopt NGT, and Canadian participants have pushed innovation of that product globally.
The move into blockchain and AI by Canadian banks will not likely be implemented first in the securities lending segment of the market, but if the technology evolves and becomes more prevalent, the securities lending market will no doubt will to meet the challenge alongside their global colleagues.
Sedman: We cannot look forward to the future of our industry without considering the impact of technology. Advances in technological capabilities have the potential to completely transform our industry, and the broader financial markets to a degree unthinkable 10 years ago.
At Northern Trust, we are working with a number of new technologies such as machine learning and robotics as well as developing our data analysis capabilities.
We believe these technologies can and will be employed to enhance everything from trading strategies through to operational efficiencies, and we only see them becoming commonplace in the coming years.
Combined with increased transparency, we are likely to see the use of automated pricing mechanisms with lenders being more able to predict and determine appropriate pricing levels for specials.
It is highly likely that the use of blockchain technology will be much more widespread in five years’ time.
Northern Trust believes blockchain technology and DLT have the potential to drive major industry-wide improvements and opportunities.
This is supported by a wide industry view that blockchain technology can significantly change the manner in which market participants interact and conduct financial transactions.
Through our experience and expertise in deploying blockchain technology for private equity markets, Northern Trust believes DLT will improve the transparency and efficiency of the market, as well as provide potential opportunities to achieve industry cost efficiencies across the value chain.
As confidence continues to grow in technology, it could also open up future opportunities around account structures, regulatory reporting and digital issuance.
