Where are we now and where to next?
05 September 2017
Lenders that have the ability to adapt their lending programme in line with the industry’s ongoing evolution can expect to be the biggest beneficiaries, says Sunil Daswani of Northern Trust
Image: Shutterstock
The securities lending industry continues to maintain very positive momentum. Data providers show that lendable supply has increased year over year, with total revenues following a similar trend. Although market participants continue to navigate numerous regulatory challenges, they have also been capitalising on a variety of emerging opportunities that look set to help shape the future direction of the industry.
From a beneficial owner perspective, we have observed a number of pertinent trends helping to drive growth and innovation. While a global macroeconomic backdrop of lower interest rates, lacklustre growth and increased scrutiny on cost reduction has been a bane for many investors to navigate, it has been these very factors that have spurred increased beneficial owner interest for securities lending. With a need to offset falling investment returns and address unfunded liabilities, institutional asset owners have seen a behavioural change in their pursuit of alternative alpha generating avenues, particularly where these can be realised with a relatively low level of risk. For this reason, we have observed an increasing appetite for the securities lending product, particularly for investors who have traditionally opted not to engage in a programme. This has been an encouraging theme, which has supported the continued growth of lendable supply within the industry.
The macro and regulatory backdrop has also driven some beneficial owners to leverage the securities lending product in innovative ways to enhance performance, and as a vehicle to address their needs in the management of cash and liquidity through advanced concepts such as agency repo and peer-to-peer lending. It’s clear that while there is a disparity across beneficial owners in respect of the evolution of their programmes, ultimately many of these concepts are helping pave the future direction of the industry.
From a borrower perspective, one of the most dominant themes which comes as no surprise, is the ongoing impact of global regulation. 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. As borrowers continue to seek capital efficient avenues to cover short positions and finance longs, demand from the borrowing community has shifted to more regulatory efficient structures with central counterparty (CCPs) models, collateral pledge solutions and termed transactions positioned as key priorities. While current activity under CCPs and pledge structures remains limited, we expect usage of these conduits to grow through 2018 as beneficial owners and their agents adapt to major demand drivers related to the ongoing development of these frameworks. At Northern Trust, we remain engaged with our clients to ensure ongoing education in this regard, allowing them to make informed decisions on the extent to which these structures represent appropriate opportunities from a risk/reward perspective.
In addition, new transparency regimes, including the second of Markets in Financial Instruments Directive and Securities Financing Transactions Regulation (SFTR), which are designed to provide greater transparency and oversight within the market, remain key priorities for Northern Trust. These complex requirements are expected to drive significant changes in the way providers manage the securities lending product from both a client and borrower perspective.
Positively, the SFTR requirements could allow credit teams and borrowers to obtain transparency of loan activity with beneficial owners much earlier in the lifecycle of the transaction, and therefore be better equipped to actively manage their exposures. This could also pave the way for borrowers to be more selective in the types of transactions executed across beneficial owners—avoiding the most capital intensive trades or those that have greater impact on various balance sheet ratios. This may have an impact on some beneficial owners in certain jurisdictions and could force a change in the way agents structure their lending programmes.
Revenue in 2017 has been buoyant, sustained partially by increased demand for fixed income securities as a function of central bank monetary policy and the ongoing demands of regulatory capital compliance. Towards the end of 2016, pressure mounted in European sovereign markets as the European Central Bank (ECB) maintained its presence as a substantial buyer of government debt through its quantitative easing programme. In addition, regulatory obligations meant banks and end users were compelled to hold large inventories of high-quality liquid assets (HQLA) to meet liquidity ratios, particularly over sensitive reporting periods such as year end. Beneficial owners that hold HQLA have typically benefited from increased utilisation and spreads associated with these themes.
Elsewhere, fees from lending global emerging market bonds have narrowed since the start of the year, as sentiment towards this asset class improved as a result of reduced geopolitical risks. Perhaps the most interesting change has been a widening of spreads observed in the corporate bond space. With increased regulatory burdens and a subsequent reduction in available balance sheet, banks are less able to warehouse risk and hold expensive corporate bond exposures. Correspondingly, assets are more in demand from the agent lender community to satisfy market making responsibilities and cover settlement issues. As such, fees increased throughout the period as agent lenders were able to widen spreads.
From an equity perspective, the broader global macroeconomic environment continues to be the major influence on revenue generation in general. This year has seen a relatively softer start in respect of overall borrowing demand as investors have remained cautious in picking an adequate entry point against a rising market, which has lowered conviction in the deployment of capital on the short side, resulting in a reduction in the volume of traditional ‘specials’ activity.
Notably, however, the industry remains optimistically poised for a better environment in the long run, notwithstanding tail risk considerations relating to geopolitical risk. Sentiments have suggested that a shift from quantitative easing to fiscal spending under US President Donald Trump’s administration would drive markets differently, helping to break down asset price correlation and provide a better environment for traditional long/short fundamental-based strategies, which would bode well for securities lending demand.
Emerging markets have continued to deliver strong performance for beneficial owners, and we expect the emergence of new markets to present compelling new streams of revenue for the industry. Demand for untapped jurisdictions, including China, Saudi Arabia, India and Indonesia, remains robust, although regulatory development has been slow to progress for securities lending. Market consensus is that China continues to present one of the most significant potential opportunities for the securities lending industry in the long term. Although the launch of both the Shanghai-Hong Kong and Shenzhen-Hong Kong stock connect schemes has opened the door to lending of Chinese shares, the framework offered is not conducive in its current form. However, the industry is optimistic for progressive change as China continues to liberalise its capital markets, and the recent inclusion of A-shares by the MSCI into its emerging market trackers is seen as a positive step in this regard. Saudi Arabia also looks like another market that, over time, could represent a significant opportunity for the industry.
The Saudi Arabian Capital Markets Authority has recently implemented a series of new regulations to help facilitate securities lending and covered short selling, the first for a Gulf state. More work is required before the platform is fit for purpose, however, this represents an exciting development in a region that potentially offers significant long-term promise.
As in almost all financial sectors, technology is emerging as an important tool in optimising the delivery of the product. The increasing growth in quantitative-based trading strategies is transforming the way in which borrowers are consuming, pricing and executing securities lending transactions with lenders as they pursue reduced execution latency and a higher degree of automation. EquiLend’s Next Generation Trading (NGT) is seen as an important tool to leverage in this regard, and the industry continues to expand efforts in deploying this technology to maximise the efficiencies it can bring to trading desks. Northern Trust has made a significant capital investment in the integration of NGT within its proprietary trading platform. As borrowers look to allocate business to lending agents that can offer the lowest friction trading solution possible, this is helping us to become a recognised market leader in this increasingly important part of an agent lenders product offering.
So, in summary, while challenges associated with the regulatory landscape remain an ever-present headwind, initiatives such as collateral pledge structures, more transparent beneficial ownership disclosure and CCPs should all be viewed as evidence of the industry’s ability to evolve and adapt to change. Additionally, as further capital market liberalisation takes place, particularly in developing countries, we can expect the industry to continue to expand its global footprint as it looks to tap into new revenue streams. New technology clearly has a big role to play in the industry’s future, both in terms of providing greater pricing transparency and better trade-flow efficiencies. NGT, blockchain and the growth of the financial technology industry will all be key to its ongoing success. Collateral flexibility will undoubtedly remain an ever-present theme. In a world of greater collateral mobility and optimisation, collateral flexibility will be instrumental in helping achieve out-performance.
Fundamentally, those lenders that have the ability to adapt their lending programme in line with the industry’s ongoing evolution can expect to be the biggest beneficiaries. At Northern Trust, we remain committed to working in close partnership with our clients to ensure they can make appropriate risk-reward decisions so that securities lending can remain a core component of their global portfolio returns.
From a beneficial owner perspective, we have observed a number of pertinent trends helping to drive growth and innovation. While a global macroeconomic backdrop of lower interest rates, lacklustre growth and increased scrutiny on cost reduction has been a bane for many investors to navigate, it has been these very factors that have spurred increased beneficial owner interest for securities lending. With a need to offset falling investment returns and address unfunded liabilities, institutional asset owners have seen a behavioural change in their pursuit of alternative alpha generating avenues, particularly where these can be realised with a relatively low level of risk. For this reason, we have observed an increasing appetite for the securities lending product, particularly for investors who have traditionally opted not to engage in a programme. This has been an encouraging theme, which has supported the continued growth of lendable supply within the industry.
The macro and regulatory backdrop has also driven some beneficial owners to leverage the securities lending product in innovative ways to enhance performance, and as a vehicle to address their needs in the management of cash and liquidity through advanced concepts such as agency repo and peer-to-peer lending. It’s clear that while there is a disparity across beneficial owners in respect of the evolution of their programmes, ultimately many of these concepts are helping pave the future direction of the industry.
From a borrower perspective, one of the most dominant themes which comes as no surprise, is the ongoing impact of global regulation. 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. As borrowers continue to seek capital efficient avenues to cover short positions and finance longs, demand from the borrowing community has shifted to more regulatory efficient structures with central counterparty (CCPs) models, collateral pledge solutions and termed transactions positioned as key priorities. While current activity under CCPs and pledge structures remains limited, we expect usage of these conduits to grow through 2018 as beneficial owners and their agents adapt to major demand drivers related to the ongoing development of these frameworks. At Northern Trust, we remain engaged with our clients to ensure ongoing education in this regard, allowing them to make informed decisions on the extent to which these structures represent appropriate opportunities from a risk/reward perspective.
In addition, new transparency regimes, including the second of Markets in Financial Instruments Directive and Securities Financing Transactions Regulation (SFTR), which are designed to provide greater transparency and oversight within the market, remain key priorities for Northern Trust. These complex requirements are expected to drive significant changes in the way providers manage the securities lending product from both a client and borrower perspective.
Positively, the SFTR requirements could allow credit teams and borrowers to obtain transparency of loan activity with beneficial owners much earlier in the lifecycle of the transaction, and therefore be better equipped to actively manage their exposures. This could also pave the way for borrowers to be more selective in the types of transactions executed across beneficial owners—avoiding the most capital intensive trades or those that have greater impact on various balance sheet ratios. This may have an impact on some beneficial owners in certain jurisdictions and could force a change in the way agents structure their lending programmes.
Revenue in 2017 has been buoyant, sustained partially by increased demand for fixed income securities as a function of central bank monetary policy and the ongoing demands of regulatory capital compliance. Towards the end of 2016, pressure mounted in European sovereign markets as the European Central Bank (ECB) maintained its presence as a substantial buyer of government debt through its quantitative easing programme. In addition, regulatory obligations meant banks and end users were compelled to hold large inventories of high-quality liquid assets (HQLA) to meet liquidity ratios, particularly over sensitive reporting periods such as year end. Beneficial owners that hold HQLA have typically benefited from increased utilisation and spreads associated with these themes.
Elsewhere, fees from lending global emerging market bonds have narrowed since the start of the year, as sentiment towards this asset class improved as a result of reduced geopolitical risks. Perhaps the most interesting change has been a widening of spreads observed in the corporate bond space. With increased regulatory burdens and a subsequent reduction in available balance sheet, banks are less able to warehouse risk and hold expensive corporate bond exposures. Correspondingly, assets are more in demand from the agent lender community to satisfy market making responsibilities and cover settlement issues. As such, fees increased throughout the period as agent lenders were able to widen spreads.
From an equity perspective, the broader global macroeconomic environment continues to be the major influence on revenue generation in general. This year has seen a relatively softer start in respect of overall borrowing demand as investors have remained cautious in picking an adequate entry point against a rising market, which has lowered conviction in the deployment of capital on the short side, resulting in a reduction in the volume of traditional ‘specials’ activity.
Notably, however, the industry remains optimistically poised for a better environment in the long run, notwithstanding tail risk considerations relating to geopolitical risk. Sentiments have suggested that a shift from quantitative easing to fiscal spending under US President Donald Trump’s administration would drive markets differently, helping to break down asset price correlation and provide a better environment for traditional long/short fundamental-based strategies, which would bode well for securities lending demand.
Emerging markets have continued to deliver strong performance for beneficial owners, and we expect the emergence of new markets to present compelling new streams of revenue for the industry. Demand for untapped jurisdictions, including China, Saudi Arabia, India and Indonesia, remains robust, although regulatory development has been slow to progress for securities lending. Market consensus is that China continues to present one of the most significant potential opportunities for the securities lending industry in the long term. Although the launch of both the Shanghai-Hong Kong and Shenzhen-Hong Kong stock connect schemes has opened the door to lending of Chinese shares, the framework offered is not conducive in its current form. However, the industry is optimistic for progressive change as China continues to liberalise its capital markets, and the recent inclusion of A-shares by the MSCI into its emerging market trackers is seen as a positive step in this regard. Saudi Arabia also looks like another market that, over time, could represent a significant opportunity for the industry.
The Saudi Arabian Capital Markets Authority has recently implemented a series of new regulations to help facilitate securities lending and covered short selling, the first for a Gulf state. More work is required before the platform is fit for purpose, however, this represents an exciting development in a region that potentially offers significant long-term promise.
As in almost all financial sectors, technology is emerging as an important tool in optimising the delivery of the product. The increasing growth in quantitative-based trading strategies is transforming the way in which borrowers are consuming, pricing and executing securities lending transactions with lenders as they pursue reduced execution latency and a higher degree of automation. EquiLend’s Next Generation Trading (NGT) is seen as an important tool to leverage in this regard, and the industry continues to expand efforts in deploying this technology to maximise the efficiencies it can bring to trading desks. Northern Trust has made a significant capital investment in the integration of NGT within its proprietary trading platform. As borrowers look to allocate business to lending agents that can offer the lowest friction trading solution possible, this is helping us to become a recognised market leader in this increasingly important part of an agent lenders product offering.
So, in summary, while challenges associated with the regulatory landscape remain an ever-present headwind, initiatives such as collateral pledge structures, more transparent beneficial ownership disclosure and CCPs should all be viewed as evidence of the industry’s ability to evolve and adapt to change. Additionally, as further capital market liberalisation takes place, particularly in developing countries, we can expect the industry to continue to expand its global footprint as it looks to tap into new revenue streams. New technology clearly has a big role to play in the industry’s future, both in terms of providing greater pricing transparency and better trade-flow efficiencies. NGT, blockchain and the growth of the financial technology industry will all be key to its ongoing success. Collateral flexibility will undoubtedly remain an ever-present theme. In a world of greater collateral mobility and optimisation, collateral flexibility will be instrumental in helping achieve out-performance.
Fundamentally, those lenders that have the ability to adapt their lending programme in line with the industry’s ongoing evolution can expect to be the biggest beneficiaries. At Northern Trust, we remain committed to working in close partnership with our clients to ensure they can make appropriate risk-reward decisions so that securities lending can remain a core component of their global portfolio returns.
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