Stuck in the middle with EU
A review the current state of the European securities lending market, the biggest threats it will face and potential opportunities to be had
What trends are you currently seeing in the European securities lending market?
Simon Heath: I think the best way to encapsulate this is optimisation and efficiency—how lenders and borrowers shape their business to manage to navigate the binding constraints they face. The major trends are the acceleration in the response to these constraints. Thematically, I place these in three broad categories:
Capital:
- Pledge: Full expectation to see various agents have the pledge structures in place and trading on them
- Central counterparties (CCPs): We have seen a number of large borrowers and agents being open with their plans for adopting CCPs. Previously seen as an alternative to pledge and vice versa, we’re seeing the pursuit of both to have in the tool-kit, especially in light of Securities Financing Transaction Regulation (SFTR)
- ‘Plumbing’ has increased: Next Generation Trading (NGT) volumes dramatically increased, greater use of Pirum live
- Greater adoption of analytical platforms to drive price transparency and revenue opportunities
- ‘Smart bucketing’ and broker-defined borrowing criteria: greater use of tools that allows for increased optimisation: types of collateral, risk-weighted assets (RWA), liquidity, net stable funding ratio (NSFR)
Mark Jones: From an equity perspective, the broader global macroeconomic environment continues to be the major influence on revenue generation in general. Increased equity market volatility has certainly played into the hands of some parts of the hedge fund sector. Quantitative strategy hedge funds, that deploy algorithmic-based trading models, are characteristically more active in periods of increased equity volatility, and this has in turn helped support slightly higher loan volumes across 2018. More broadly, a reduction in quantitative easing (QE) is expected to help break down historically high levels of asset price correlation, which should provide a better environment for more traditional, fundamental based investment strategies going forward. Overtime, this ought to provide equity long/short hedge funds with greater conviction to deploy more capital on the short side, which should bode well for securities lending demand.
Similar trends are present in fixed-income markets, where new opportunities continue to present themselves as the regulatory and macro-economic environment evolves. To some extent the fee widening associated with lending European sovereign bonds has been replaced by a strong appetite to source US treasuries from the international borrower community. Market dynamics associated with cross-currency basis swaps have highlighted this opportunity, typically during regulatory-sensitive periods. Often, accepting traditional high-grade assets such as UK gilts or European sovereign bonds has allowed asset owners to extract maximum value from their inventory.
Technology continues to play an increasingly important role in optimising the supply of market liquidity. The growth in quantitative based trading strategies is emphasising this all the more. Borrowers are increasingly focused on executing and pricing securities lending transactions with lenders in a frictionless way as possible, as they seek to reduce execution latency and reduce human touch in the trade lifecycle. EquiLend’s NGT is viewed as an important tool to leverage in this regard, as the industry looks at ways to increase efficiencies across global trading desks. Northern Trust’s significant capital investment in the integration of NGT within its proprietary trading platform is allowing us to continue to be recognised as a market leader in this increasingly important part of an agent lenders product offering.
Harpreet Bains: We are observing a continued increase in interest for securities lending as beneficial owners look for alternative and innovative ways to enhance performance against the backdrop of increasing market and regulatory costs to operate their business, as well as a means of managing their cash and liquidity needs. There is greater engagement to better understand the different strategies and the way in which securities financing across the chain can be of benefit. Demand for high quality liquid assets (HQLA) on a term across European fixed income markets remains robust. It continues to provide a consistent source of revenue and increased utilisation for those lenders that are willing to participate in collateral transformation transactions and longer dated transactions.
European interest for ETFs amongst investors continues to rise, partly driven by the positive effect of the increased transparency delivered by the second Market in Financial Instruments Directive (MiFID II). This flow is making its way into lending programmes both as supply and in the form of collateral. This is one area to watch over the next couple of years. From a borrower perspective, the impact of increased regulations on banks and balance sheet usage means that we continue to see borrowers put greater emphasis on differentiating client types on certain transactions. Borrowers have become increasingly focused on the principals they borrow from in securities lending transactions, with a move towards borrowing from the most capital efficient lender types.
What have European revenue sources shown in the past 12 months?
Bains: Last year, saw equity lending revenue held back by reduced volatility and weakened specials activity; however, financing opportunities such as specific evergreen transactions were prevalent. In Q4, we saw volatility return and directional activity increase in the UK equity market. This continues and is more diverse than that of 2017. During the same period, German equity markets rose due to reduced levels of liquidity in the market. We continue to see good interest in corporate action optimisation with a continued increase in lenders guaranteeing cash on their elections.
In fixed income, the trend for term financing in HQLA as part of borrowers’ liquidity coverage ratio (LCR) trading strategies continues, especially in Germany and France. Demand for German specials has held strong, driven by a lack of supply as bonds left the private repo market due to the ECB asset purchasing plan (APP)—although pressure has been easing as more of these bonds found their way back into the market through the central bank’s own lending programme. We closely watch the impact of the reduction in APP, which began in January 2018 and runs through September 2018, although we do not currently anticipate this to significantly alter the demand for repo. Similar to equities, we’ve seen demand increase for corporate bonds following a lack of volatility which affected revenues during most of 2017.
Jones: Revenue sources continue to show that collateral mobilisation and flexibility are key as regulatory requirements compel banks to segregate client and proprietary securities and capital. Elsewhere, the robust global demand for HQLA remains, allowing clients an opportunity to enhance revenue via collateral transformation trades. Meanwhile, in the credit space we have found growing demand and spread widening for corporate bonds. This can be attributed to the increased regulatory burdens and reductions in balance sheets, which means that banks are less able to warehouse risk and hold expensive corporate bond exposures. Correspondingly, assets are more in demand to satisfy market making responsibilities and cover settlement issues.
From an European equity perspective, revenue growth remains positive. The industry recently reported that European equities delivered $438 million of revenue in Q1 2018 (per data supplied by Markit), representing a 15 percent increase compared to Q1 2017 and a similar increase verses Q4 2017. A reduction in equity price correlation, coupled with an uptick in market volatility, has been the catalyst for an increase in investor’s conviction to deploy capital on the short side. Europe’s specials market has also performed better than in previous years. In the UK, Brexit concerns have contributed to stronger returns, while Europe’s low interest rate environment continues to be a catalyst for increased corporate activity.
However, more broadly, demand from the borrower community continues to be focused around trading structures that provide greater efficiencies, whether that is in terms of collateral costs, or reduced balance sheet and regulatory capital consumption. As such, we continue to work closely with our beneficial owners to ensure they are well positioned to maximise revenue growth through opportunities including collateral expansion, term lending, new markets, and collateral pledge structures.
We’ve seen the implementation of MiFID II this year and SFTR is looming. Although they obviously differ, what can members of the European securities lending market learn from MiFID II that they can apply to help them prepare for SFTR?
James Day: Reporting is the key area when it comes to direct comparisons between MiFID II and SFTR. MiFID II greatly increased the number of instruments in scope for transaction reporting and the number of fields required to be reported increased to 65. The same challenges apply to SFTR: to identify the full universe of reportable transactions across the organisation and populate the 143 fields required. Where the two differ is that SFTR has a dual-sided reporting obligation meaning that there is a still a learning curve here. Utilising a contract compare service could improve the matching rates at the trade repository.
Jones: The securities lending market was not impacted across the board by the reporting element of MiFID II but some comparisons can be drawn with the experiences of that implementation, and going back further, that of EMIR.
Firstly, I think it has become very clear that taking a step back and looking at the overall systemic and operational model is going to be of paramount importance under SFTR, given the potential impacts to the way the market operates. This is not just a simple reporting regime where participants will be able to extract data and submit it—working practices will change and technology will play a key role in that.
Secondly, we have the advantage of having developed certain reusable methodologies and have gained experience in implementing key processes and controls that will be important under SFTR. A key lesson learnt is that standardisation of certain data points and processes across the industry will be hugely beneficial—we must learn from the pain experienced under other regimes where single digit matching rates were common. I feel that as an industry we are better prepared due to the significant levels of automation we already have in the post trade environment, and the collaborative approach that the majority of firms take to addressing the challenges we face.
Bains: Plan ahead and avoid the ‘wait and see’ approach. It’s essential that firms start work as soon as possible on the process of understanding their obligations and requirements and begin locating the data that is needed. MiFID II presented challenges around missing legal entity identifiers (LEIs) for both transaction and investor protection reporting where clients hadn’t yet applied for LEIs. With SFTR, LEI is much more than just a reporting field—it’s integral to the post trade reconciliation process, and therefore requires early attention.
Another lesson from MiFID II implementation cited recently by a leading consultant is underestimating the importance of a detailed initial impact assessment before diving into designing solutions. SFTR, like MiFID II, is going to be far reaching, with implications and changes required to more than one area of each firm, making it essential to understand the full scope in the process design.
SFTR in many respects is closer in design to EMIR than MiFID II so, in addition, we should leverage the learnings from EMIR.
Heath: Do not underestimate how large the SFTR lift is and that whilst timelines may be pushed out, as an industry we can’t afford any stragglers and late adopters.
Last year, was a big year for Target2-Securities (T2S). How has the transition to Target2-Securities affected securities lending so far?
Bains: The T2S initiative has been about European post-trade harmonisation, efficiency and enhanced settlement processing. Fully supported by J.P. Morgan, the transition was well prepared and settlement and asset servicing models were adapted to the new model with minimum disruption to clients. We haven’t yet seen any significant impact to securities lending since implementation; however, we view the T2S project as a catalyst for further harmonisation of post-trade practices and regulations across Europe. This will continue to drive down the costs of securities settlement in Europe, as well as improve liquidity and collateral optimisation for market participants.
What should beneficial owners be doing going forward to adapt their lending programmes as we look towards the future?
Jones: We encourage our beneficial owners to be leaders in the industry by implementing flexible programme parameters, by lending in new markets and by adopting new routes to market as long as those new strategies fit into their internal risk framework. For example, we are working with our beneficial owners to support capital efficient transactions such as collateral pledge as well as implementing new markets such as Saudi Arabia. The definition of a successful lending programme varies widely across different beneficial owners. For some, a low risk programme with modest returns that offset other asset servicing costs is sufficient, whereas others will be seeking to maximise revenue with a more aggressive attitude to risk. With the diversification of potential routes to market increasing, beneficial owners must decide which strategies fit their objectives and then challenge their providers to implement a programme that fits those objectives. At Northern Trust, we are proud of the flexibility our programme offers and our ability to meet the whole spectrum of beneficial owner requirements.
Bains: As an agent lender, we continue to react to changes in counterparty demand as a result of borrowers’ need to comply with regulations, and it’s key that the market dynamics as it relates to borrower demand preferences are understood by beneficial owners. Those that are willing to work with their agents to adjust programme structures, take a fresh look at non-traditional structures, and be open to re-evaluating their risk appetite to take advantage of non-cash and cash collateral reinvestment strategies can position themselves to monetise market opportunities and optimise revenue.
Specifically, borrowers are looking for greater collateral flexibility; therefore, it’s important that beneficial owners consider both kinds of collateral and adjust their parameters and guidelines accordingly. This is especially true given the continued demand from borrowers for less balance sheet-intensive loans against non-US—non-cash collateral, as well as increased yields which create new opportunities for lenders to reinvest cash using different strategies to earn better returns in a risk controlled manner.
Further, we expect to continue to see borrowers allocate business based in a number of variables, including client types, as they seek out balance sheet relief. A consequence of this is that beneficial owners in certain jurisdictions are no longer lender of choice for a borrower and counterparty diversification becomes a necessary consideration for beneficial owners.
Day: The first thing that beneficial owners should understand, are the major binding constraints that borrowers and agent lenders are operating under: namely capital requirements, leverage ratios and balance sheet considerations. Understanding these dynamics and tailoring a lending programme that enhances the returns for beneficial owners should be the focus.
Secondly, broad collateral acceptance and eligibility will enable clients to maintain high utilisation levels as the makeup of available collateral on the street changes over time.
Capital efficient solutions are also coming to market. For example, accepting collateral under a pledge structure rather than a title transfer can enable clients to increase utilisation rates and revenue.
Finally, centrally cleared securities lending transactions are another capital efficient way to access the market. Clients signed up to a CCP via an agent lender are able to benefit and extract additional revenue from their eligible assets.
Heath: There is no ‘one size fits all’ with respect to a beneficial owners lending programme. Whether a beneficial owner adopts a principal, agency, exclusive or under an indemnity, will depend entirely on their own bespoke parameters, mandate and risk profiles. How they adapt these, like agents and borrowers themselves, will depend on their own binding constraints and their motivations for lending. Collateral flexibility, openness to pledge structures and CCPs will ensure beneficial owners assets remain competitive and relevant in a changing market landscape.
How does the European securities lending market compare to the US and Canada?
Jones: From a trading perspective, the level of granularity is greater in European markets. For example, lenders typically have to contend with a number of different lending markets, collateral types and asset inventory depots. This results in a more diversified trading book, though also brings a number of operational challenges. In addition, while the balance has started to change in recent years, we continue to see a heavier weighting to non-cash trades in international markets.
There are concerns in the industry that Brexit poses a threat to the harmonisation effect of the CMU. How is your firm prepared for what this could mean for securities lending and how are you prepared for this eventuality?
Day: It is important that the securities lending industry is able to continue to serve its function of providing liquidity and collateral into the market and enable it to function efficiently for all beneficial owners. BNY Mellon is working very closely with outside legal counsel and the regulators to find a solution post-Brexit that enables the business to continue to provide liquidity into the market efficiently and protect client revenues, while meeting local regulatory oversight and control requirements.
What is the biggest threat the industry faces right now?
Bains: Regulatory implementation remains a major influence on the industry, in particular, the unchartered landscape of SFTR. It’s receiving a significant amount of the industry’s attention given the breadth of the requirements and the challenging scope. The industry challenges that come with the implementation of one of the most detailed and complex reporting regimes seen in Europe are real, and will have impact to beneficial owners both within and outside of Europe due to the nature of the dual sided reporting.
Alongside those challenges, SFTR presents exciting opportunities for the industry to collaborate, embrace advances in technology and open doors to automation and standardisation. It could be the catalyst needed to force new operating models as we believe the likelihood of seeing both borrowers and lender alter their trading behaviour post go-live is high.
Jones: The ongoing impact of global regulation will continue to shape the market. Challenges associated with increased capital consumption, higher funding costs and ongoing limitations in balance sheet capacity continue to be key influencing factors for industry participants to navigate. We have also observed that regulations continue to prompt a greater focus on the type and jurisdiction of the underlying beneficial owner as country risk classifications drive borrower demand appetite and RWA usage. This has the potential to negatively impact client performance and revenue if remedial measures are not established.
When you add in SFTR, the forthcoming settlement discipline regime under Central Securities Depositories Regulation (CSDR), and other legislative changes such as the recent German Investment Tax Act updates, there is the potential that some supply could leave the market due to a perceived increase in risk or operational overhead. Our challenge is to meet these changes with solutions that address beneficial owner concerns and allow us to maintain the efficiencies that have made the industry so successful in the past.
Heath: There are always threats, but SFTR has the potential to be very destabilising if all market participants do not solution for it in the correct manner.
Day: The biggest challenge for the industry will be preparing for the reporting requirements under SFTR. Businesses will need to understand all the activity caught under the regulation and where to source the information required for transaction reporting. Being a dual-sided reporting regime, reconciliation of the data ahead of submission to the trade repository is essential.
Finally, where do you see the biggest opportunity?
Day: Without doubt, the biggest opportunity will be transacting under a pledge arrangement. As balances have increased across the industry and borrowers continue to focus on managing their resources, clients that are able to transact under a pledge agreement will be attractive counterparties for borrowers, which in turn will create improved utilisation and rates.
Heath: Paradoxically, the same threats presented by regulation and binding constraints have the biggest opportunity if lenders can solve for them. I would see pledge as the biggest opportunity in the short to medium term.
Bains: As banks have pulled back from certain transactions due to higher capital charges and balance sheet scarcity in recent years, new transactions are being developed. Consequently, alternative structures and supplementary routes to market are evolving into an important area of focus for the industry. We see this coming through with the development of pledge structures, slow but steady interest in CCP activity, the rise of peer-to peer and direct lending, and agency repo. There is opportunity for the trades to be structured in a number of different ways depending on the motivators—whether driven by cash, securities or risk management and for the participants to select the services most important to them. Agent lenders will need to adapt their offering to meet those needs, whether that be credit intermediation, valuation, operations, collateral management or a combination of all. We expect alternative routes to market to remain a hot topic for this year and beyond.
Jones: For Northern Trust, emerging technology is an area where we see massive opportunity for the development of our programme, and for the industry as a whole. The way we use data is critical, and leveraging technology such as machine learning and artificial intelligence to enhance our approach to loan pricing and market analytics is a key focus for us, with our aim to be able to break the cycle of demand driven pricing that has been dominant in our industry for many years, allowing us to predict and determine appropriate pricing levels for specials activity.
We are also of the view that distributed ledger technology has the potential to transform the way that market participants interact and conduct financial transactions. We are already seeing movement in this direction with a number of exchanges and regulators initiating projects to adopt this structure and allow more flexible access to markets. The potential for a wider range of counterparts to come together on this type of platform is potentially transformational. At Northern Trust, we believe that this technology will improve the transparency and efficiency of the market, as well as provide potential opportunities to achieve industry cost efficiencies across the value chain
