An energised market
30 May 2017
The Canadian securities lending market remains the second largest in the world after the US, with average lendable balances of more than $842 billion in 2016. Experts discuss the latest trends
Image: Shutterstock
Canadian pension funds easily beat their 2015 returns target last year. How did this affect the country’s securities lending market and how are pension funds fairing in the opening months of 2017?
Don D’Eramo: Canadian pension funds tend to outperform other investor segments such as mutual funds due to the application of different regulatory requirements. For example, the Office of the Superintendent of Financial Institutions (OSFI) governs lending activity for pension plans, while mutual funds are governed by various national instruments, which impose lending limits and provide for narrower collateral criteria. As a result, pension funds have the ability to capture a wider range of lending opportunities, particularly term loans in the high-quality liquid assets (HLQA) space.
Dave Sedman: Canadian defined benefit pension plan sponsors recorded an uptick in returns for Q1 2017, according to the Northern Trust Canadian Defined Benefit Pension Plan universe, a service that tracks the performance of Canadian institutional investment plans.
The median plan gained 3 percent, following a loss of 1.2 percent in Q4 2016. The positive performance was primarily driven by strong equity markets while fixed income also experienced positive performance in a reversal from last quarter. Global equity markets started the year on a strong note with all broad market indices registering positive performance. The median return on Canadian equity at 3.8 percent outperformed the S&P/TSX Composite by 1.6 percent.
Securities lending industry revenues in Q1 2017 were 11 percent lower than Q1 2016, according to DataLend. Low volatility levels and higher equity values muted securities lending demand, especially in the top earning securities. There were pockets of demand in specific sectors of the securities lending market, including the retail, biotechnology and home mortgage industries. There was also an increase in demand for fixed income securities, specifically for HQLA, which would include Canadian sovereign debt. Of course, a beneficial owner’s individual performance will depend upon the allocations they have to the sectors and asset classes that have the highest demand.
Alexa Lemstra: The Canadian market finished 2016 with $492 million in revenue for clients. Securities lending revenue in Canada has shown stable growth, particularly in 2016, when a number of deal names, moving sectors and increased demand for sovereign bonds contributed to revenue.
Q1 2017 revenue continues with steady returns for clients, driven primarily by Canadian common shares at $112.3 million, followed by sovereign debt at $12.5 million. We are seeing a noteworthy increase in revenue from the lending of Canadian sovereigns. HQLA demand is on the rise, leading to an increased appetite for AAA-rated sovereigns, such as Canada’s. The utilisation of Canadian securities averaged 36 percent in Q1 2017 and has been slowly increasing.
Phil Zywot: Many of Canada’s pension funds are sophisticated investors that continue to expand globally and diversify outside of Canada. Pension plans look to securities lending programmes to earn additional incremental revenue for their plans. Most funds have ventured outside of Canada looking at different asset classes to diversify their holdings and to try to maximise returns.
This has resulted in increased global asset holdings, creating a range of different opportunities within the global securities lending space. A majority of Canadian pension funds are fully funded and continue to grow their assets under management, which in turn has resulted in greater growth in lendable positions.
Canadian pension funds have embraced securities lending and look to it as a means to enhance potential returns and to partially offset operational costs, given the low interest rate environment that we’ve seen in Canada. Many economists are predicting that interest rates will remain unchanged in Canada this year.
Chuck Murray: As a result of funds beating their 2015 return targets, assets under custody and the value of securities on loan often increase. While positive, the effects of this on securities lending is nominal, in comparison to the incremental revenue generally generated by securities lending programmes.
In terms of what is being observed in the pension fund space, generally, we are noticing pension funds recalibrating from a risk perspective and broadening collateral, and accepting ‘alternative collateral’ (an expanded range of collateral) to enhance returns. We attribute these expansions in collateral parameters to our ability to monitor and mitigate the increased risk and understand how concentration limits are monitored. Additionally, we analyse how liquidity of the collateral is monitored and how the credit quality of the assets is monitored.
A Deutsche Bank survey from October saw Canada voted as one of the most attractive regions for alternative UCITS allocation. Has this been reflected in securities lending?
Murray: We have not observed any trends from a securities lending perspective that would necessarily support the Deutsche Bank survey that Canada is one of the most attractive regions for alternative UCITS allocation. Though lending rates for UCITS CAD assets have declined, the collateral requirements that UCITS must adhere to likely diminish the benefits of lending these types of assets in Canada.
D’Eramo: Canada continues to be an attractive region for investment, not only for alternative UCITS allocations but also for industry-wide strategic investment. Our high concentration in the commodities sector is particularly important for foreign investment. The prominence of commodities, coupled with a robust financial sector, has provided strong support to the Canadian market.
The S&P/TSX Composite Index return of more than 17 percent over the past 12 months is evidence of the strength of Canada’s economy. Our strong and stable financial system, combined with a stringent and proven regulatory framework, continues to drive foreign investment in Canadian markets.
How are stocks for Canadian companies being used within the country’s lending market? Are there any stand out favourites stocks or industries?
Lemstra: One of the most interesting securities in the lending market so far in 2017 has been Home Capital. The financial services company was the highest-fee stock in the Canadian securities lending market in 2016 and has continued its reign this year, with one-day fees dipping as low as 75 percent in mid-spring. Home Capital remained the top-revenue security in Q1 2017, having brought in $18 million in revenue.
The healthcare sector, the hottest in 2016, continued its ride into 2017 with an average fee of 173 basis points (bps) in 2016 rising to 582 bps in Q1 2017. High fees on marijuana stocks in the pharmaceutical sector are driving the healthcare fees higher as the Canadian government moves toward legalising the industry.
Zywot: Canada experienced a return of specials in the equity market over the past couple of years. This was in conjunction with the correction that we saw in the commodities market that started in the summer of 2015 and continued until February of 2016. With this correction, we saw a corresponding increase in demand for resource-based companies (particularly in the energy sector) and firms that had ties to the resource industry.
We continue to see demand in the resource sector, although it has somewhat levelled off with the rebound and stabilisation of commodity prices. Any return of volatility within this space could spark increased demand in the commodity sector for securities lending. More recently, the booming housing market and the potential overheating of this sector (with the focus being on the Greater Toronto Area) has put the alternative mortgage lending sector in high demand over the past year.
D’Eramo: According to DataLend, the Canadian securities lending market remains the second largest in the world after the US, with average lendable balances of more than $842 billion in 2016, and among the top five markets globally based on fixed income revenue. Canada has seen consistent growth in the general collateral space and capital markets continue to leverage securities lending as a means to optimise their flows. Event-driven strategies and corporate action optimisation remain significant contributors to lending revenues. Throughout 2016 and well into Q1 2017, the hottest sectors for securities lending were healthcare and real estate, both dominated by visible volatility and persistent directional demand.
Murray: As a natural resource-based economy, Canada consistently sees strong demand for mining industry names and the oil and gas sector. This strong demand did not diminish for the oil and gas sector when crude experienced lower prices globally, and the prospect of higher interest rates in the US has had a tangible impact on precious metals, specifically gold.
We have also seen increased demand in financials, including non-bank mortgage lenders and consumer lending firms, as well as healthcare and pharmaceuticals. These noticeable increases are likely the result of overleveraged Canadian consumers, the strong housing market, and the continued interest in biotech.
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. The Canadian specials market benefited from continued demand in financials, specifically mortgage lenders, as their heavy concentration in non-prime residential mortgages implies greater vulnerability versus most Canadian banks.
Directional demand in the healthcare, pharmaceutical and specialty pharmaceutical sector was seen in 2016, over year-end, and throughout Q1 2017. An increase in mergers and acquisitions activity coupled with a negative outlook within department store retailers has fuelled demand for specific companies in those market segments.
A large portion of the revenue generated from Canadian equities is driven by dividend yield enhancement trades, coupled with the dividend reinvestment plan trade. Continued demand from borrowers to pledge various forms of non-cash collateral (equities and corporate debt) has dominated the securities lending market, providing opportunities for beneficial owners who can accommodate this collateral within their risk parameters.
At last year’s CASLA conference it was suggested that a Canada-based CCP was an unlikely prospect given the size of the country’s securities lending market. Has that changed?
D’Eramo: This view has not changed significantly over the past year. There is currently no dominant central counterparty (CCP) in most of the major financial markets that cater to the functional needs of agency securities lending, and Canada is no different. However, it continues to be a viable model as global markets have already committed the scale and resources to leverage existing CCP solutions that have proven successful within other market products.
Sedman: Northern Trust and other industry participants remain committed to developing a workable CCP model. Our goal is to provide the beneficial owner with the best risk adjusted return for their securities lending programme.
Zywot: CCPs are gathering steam in the US but in the past year we have not seen a noticeable change with respect to a Canadian CCP. Potential implementation of regulations, such as the single counterparty credit limits, could be a driver increasing the importance of a Canadian CCP for securities finance. Risk-weighted assets are another potential motivator that could spur on the CCP in Canada. Currently, the method proposed for how CCPs would function in Canada is not suitable for securities lending—they would need to modify the CPP model to accommodate the clearing of these products.
The size of the Canadian securities lending market is another potential reason why CCPs have not got off the ground in Canada when compared with the much larger US market. Canadian banks are very well capitalised and generally are not as highly-leveraged as their American counterparts, possibly contributing to the lack of desire for utilising a CCP in Canada. Currently, Canadian market participants don’t seem to have the same drive to use CCPs as their American counterparts.
Lemstra: When the Canadian market implements a CCP workflow, EquiLend will be involved to facilitate the trade flow and provide novation. We are currently doing this with EquiLend Clearing Services (ECS) in the US, which interacts with OCC.
We have been working closely with the Canadian marketplace to ensure, as the existing CCP providers move to allow participation by foreign institutions, that ECS likewise will extend its services to Canadian firms.
Murray: Though the industry’s perspective is unlikely to change, the Canadian market could conceivably support its own Canadian-based CCP. The repo market CCP has consistently seen volumes grow over the past few years, with the majority of repo trades going through its facility.
Don D’Eramo: Canadian pension funds tend to outperform other investor segments such as mutual funds due to the application of different regulatory requirements. For example, the Office of the Superintendent of Financial Institutions (OSFI) governs lending activity for pension plans, while mutual funds are governed by various national instruments, which impose lending limits and provide for narrower collateral criteria. As a result, pension funds have the ability to capture a wider range of lending opportunities, particularly term loans in the high-quality liquid assets (HLQA) space.
Dave Sedman: Canadian defined benefit pension plan sponsors recorded an uptick in returns for Q1 2017, according to the Northern Trust Canadian Defined Benefit Pension Plan universe, a service that tracks the performance of Canadian institutional investment plans.
The median plan gained 3 percent, following a loss of 1.2 percent in Q4 2016. The positive performance was primarily driven by strong equity markets while fixed income also experienced positive performance in a reversal from last quarter. Global equity markets started the year on a strong note with all broad market indices registering positive performance. The median return on Canadian equity at 3.8 percent outperformed the S&P/TSX Composite by 1.6 percent.
Securities lending industry revenues in Q1 2017 were 11 percent lower than Q1 2016, according to DataLend. Low volatility levels and higher equity values muted securities lending demand, especially in the top earning securities. There were pockets of demand in specific sectors of the securities lending market, including the retail, biotechnology and home mortgage industries. There was also an increase in demand for fixed income securities, specifically for HQLA, which would include Canadian sovereign debt. Of course, a beneficial owner’s individual performance will depend upon the allocations they have to the sectors and asset classes that have the highest demand.
Alexa Lemstra: The Canadian market finished 2016 with $492 million in revenue for clients. Securities lending revenue in Canada has shown stable growth, particularly in 2016, when a number of deal names, moving sectors and increased demand for sovereign bonds contributed to revenue.
Q1 2017 revenue continues with steady returns for clients, driven primarily by Canadian common shares at $112.3 million, followed by sovereign debt at $12.5 million. We are seeing a noteworthy increase in revenue from the lending of Canadian sovereigns. HQLA demand is on the rise, leading to an increased appetite for AAA-rated sovereigns, such as Canada’s. The utilisation of Canadian securities averaged 36 percent in Q1 2017 and has been slowly increasing.
Phil Zywot: Many of Canada’s pension funds are sophisticated investors that continue to expand globally and diversify outside of Canada. Pension plans look to securities lending programmes to earn additional incremental revenue for their plans. Most funds have ventured outside of Canada looking at different asset classes to diversify their holdings and to try to maximise returns.
This has resulted in increased global asset holdings, creating a range of different opportunities within the global securities lending space. A majority of Canadian pension funds are fully funded and continue to grow their assets under management, which in turn has resulted in greater growth in lendable positions.
Canadian pension funds have embraced securities lending and look to it as a means to enhance potential returns and to partially offset operational costs, given the low interest rate environment that we’ve seen in Canada. Many economists are predicting that interest rates will remain unchanged in Canada this year.
Chuck Murray: As a result of funds beating their 2015 return targets, assets under custody and the value of securities on loan often increase. While positive, the effects of this on securities lending is nominal, in comparison to the incremental revenue generally generated by securities lending programmes.
In terms of what is being observed in the pension fund space, generally, we are noticing pension funds recalibrating from a risk perspective and broadening collateral, and accepting ‘alternative collateral’ (an expanded range of collateral) to enhance returns. We attribute these expansions in collateral parameters to our ability to monitor and mitigate the increased risk and understand how concentration limits are monitored. Additionally, we analyse how liquidity of the collateral is monitored and how the credit quality of the assets is monitored.
A Deutsche Bank survey from October saw Canada voted as one of the most attractive regions for alternative UCITS allocation. Has this been reflected in securities lending?
Murray: We have not observed any trends from a securities lending perspective that would necessarily support the Deutsche Bank survey that Canada is one of the most attractive regions for alternative UCITS allocation. Though lending rates for UCITS CAD assets have declined, the collateral requirements that UCITS must adhere to likely diminish the benefits of lending these types of assets in Canada.
D’Eramo: Canada continues to be an attractive region for investment, not only for alternative UCITS allocations but also for industry-wide strategic investment. Our high concentration in the commodities sector is particularly important for foreign investment. The prominence of commodities, coupled with a robust financial sector, has provided strong support to the Canadian market.
The S&P/TSX Composite Index return of more than 17 percent over the past 12 months is evidence of the strength of Canada’s economy. Our strong and stable financial system, combined with a stringent and proven regulatory framework, continues to drive foreign investment in Canadian markets.
How are stocks for Canadian companies being used within the country’s lending market? Are there any stand out favourites stocks or industries?
Lemstra: One of the most interesting securities in the lending market so far in 2017 has been Home Capital. The financial services company was the highest-fee stock in the Canadian securities lending market in 2016 and has continued its reign this year, with one-day fees dipping as low as 75 percent in mid-spring. Home Capital remained the top-revenue security in Q1 2017, having brought in $18 million in revenue.
The healthcare sector, the hottest in 2016, continued its ride into 2017 with an average fee of 173 basis points (bps) in 2016 rising to 582 bps in Q1 2017. High fees on marijuana stocks in the pharmaceutical sector are driving the healthcare fees higher as the Canadian government moves toward legalising the industry.
Zywot: Canada experienced a return of specials in the equity market over the past couple of years. This was in conjunction with the correction that we saw in the commodities market that started in the summer of 2015 and continued until February of 2016. With this correction, we saw a corresponding increase in demand for resource-based companies (particularly in the energy sector) and firms that had ties to the resource industry.
We continue to see demand in the resource sector, although it has somewhat levelled off with the rebound and stabilisation of commodity prices. Any return of volatility within this space could spark increased demand in the commodity sector for securities lending. More recently, the booming housing market and the potential overheating of this sector (with the focus being on the Greater Toronto Area) has put the alternative mortgage lending sector in high demand over the past year.
D’Eramo: According to DataLend, the Canadian securities lending market remains the second largest in the world after the US, with average lendable balances of more than $842 billion in 2016, and among the top five markets globally based on fixed income revenue. Canada has seen consistent growth in the general collateral space and capital markets continue to leverage securities lending as a means to optimise their flows. Event-driven strategies and corporate action optimisation remain significant contributors to lending revenues. Throughout 2016 and well into Q1 2017, the hottest sectors for securities lending were healthcare and real estate, both dominated by visible volatility and persistent directional demand.
Murray: As a natural resource-based economy, Canada consistently sees strong demand for mining industry names and the oil and gas sector. This strong demand did not diminish for the oil and gas sector when crude experienced lower prices globally, and the prospect of higher interest rates in the US has had a tangible impact on precious metals, specifically gold.
We have also seen increased demand in financials, including non-bank mortgage lenders and consumer lending firms, as well as healthcare and pharmaceuticals. These noticeable increases are likely the result of overleveraged Canadian consumers, the strong housing market, and the continued interest in biotech.
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. The Canadian specials market benefited from continued demand in financials, specifically mortgage lenders, as their heavy concentration in non-prime residential mortgages implies greater vulnerability versus most Canadian banks.
Directional demand in the healthcare, pharmaceutical and specialty pharmaceutical sector was seen in 2016, over year-end, and throughout Q1 2017. An increase in mergers and acquisitions activity coupled with a negative outlook within department store retailers has fuelled demand for specific companies in those market segments.
A large portion of the revenue generated from Canadian equities is driven by dividend yield enhancement trades, coupled with the dividend reinvestment plan trade. Continued demand from borrowers to pledge various forms of non-cash collateral (equities and corporate debt) has dominated the securities lending market, providing opportunities for beneficial owners who can accommodate this collateral within their risk parameters.
At last year’s CASLA conference it was suggested that a Canada-based CCP was an unlikely prospect given the size of the country’s securities lending market. Has that changed?
D’Eramo: This view has not changed significantly over the past year. There is currently no dominant central counterparty (CCP) in most of the major financial markets that cater to the functional needs of agency securities lending, and Canada is no different. However, it continues to be a viable model as global markets have already committed the scale and resources to leverage existing CCP solutions that have proven successful within other market products.
Sedman: Northern Trust and other industry participants remain committed to developing a workable CCP model. Our goal is to provide the beneficial owner with the best risk adjusted return for their securities lending programme.
Zywot: CCPs are gathering steam in the US but in the past year we have not seen a noticeable change with respect to a Canadian CCP. Potential implementation of regulations, such as the single counterparty credit limits, could be a driver increasing the importance of a Canadian CCP for securities finance. Risk-weighted assets are another potential motivator that could spur on the CCP in Canada. Currently, the method proposed for how CCPs would function in Canada is not suitable for securities lending—they would need to modify the CPP model to accommodate the clearing of these products.
The size of the Canadian securities lending market is another potential reason why CCPs have not got off the ground in Canada when compared with the much larger US market. Canadian banks are very well capitalised and generally are not as highly-leveraged as their American counterparts, possibly contributing to the lack of desire for utilising a CCP in Canada. Currently, Canadian market participants don’t seem to have the same drive to use CCPs as their American counterparts.
Lemstra: When the Canadian market implements a CCP workflow, EquiLend will be involved to facilitate the trade flow and provide novation. We are currently doing this with EquiLend Clearing Services (ECS) in the US, which interacts with OCC.
We have been working closely with the Canadian marketplace to ensure, as the existing CCP providers move to allow participation by foreign institutions, that ECS likewise will extend its services to Canadian firms.
Murray: Though the industry’s perspective is unlikely to change, the Canadian market could conceivably support its own Canadian-based CCP. The repo market CCP has consistently seen volumes grow over the past few years, with the majority of repo trades going through its facility.
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