Adaptability in an unpredictable market
23 January 2018
Francesco Squillacioti, global head of agency lending at State Street Securities Finance, explains why ‘adaptability’ should be the watchword of the securities lending industry this year
Image: Shutterstock
Each of us in the securities lending industry has to weigh a number of factors as we look ahead into the next year: what is our best indication of what securities markets will do? What is our house view on interest rates? What regulatory factors are likely to come into play over the next 12 months? What other pressures are being brought to bear on the different participants in the securities lending market, and what could that mean for activity? While these types of considerations can only really be thought about in terms of best estimates rather than certainties, our responsibility is to be ready for ‘it’, whatever it is.
If I had to try to boil down into a single word what will be required to weather potential market challenges this year, it would be ‘adaptability’.
When we think about the market we are really thinking about the combination of a number of different things: activity in underlying securities markets and its impact; regulatory and tax changes in various jurisdictions; and, of course, the actions of various participants in the market – beneficial owners, borrowers, agent lenders, etc. Each component of the market exists as part of a greater ecosystem, a single event in one place will have an impact throughout. Without adaptability, the ecosystem cannot function optimally. New considerations need to be absorbed and new equilibriums need to be reached.
Here are three areas that I think will continue to feature prominently for all of us involved in the industry, and are demonstrative of the need for adaptability.
Non-cash collateral
One of the themes we have seen evolve over the past few years was the growth of trade activity collateralised by non-cash, driven by balance sheet efficiency considerations. While equity collateral in particular has grown significantly, we have also seen the need to take on additional collateral sets. Not only has it been important for lending agents to ensure that risk management and oversight of these types of collateral has been robust, but it has also required that beneficial owner clients broaden their consideration.
More recently, we entered into a period of rising interest rates. While a rising rate environment can present short-term challenges, it is generally a favourable development for clients whose loans are predominantly collateralised by cash. In the years before we entered this rising interest rate regime, equity and other expanded collateral types offered opportunities to enhance securities lending returns by virtue of additional spread, volume or both. From a risk management standpoint, the liquidity characteristics of equities in particular made this type of collateral—properly margined and managed—a good option for both equity and fixed income loans.
As we move forward, despite the rising interest rate environment, equity and other non-cash collateral activity will continue to be both important and prominent. Moreover, the collateral space has been one of relatively constant innovation. Consideration of new types of collateral to be incorporated into securities lending, or looking into more balance sheet efficient ways of transacting with various collateral types, will be a focus.
From an agent lender standpoint, it is obviously important to understand how these types of innovations can impact borrower driven lending activity. It is also important in our role as agent to help work with both borrower and lending principal (beneficial owner) to ensure that the resulting construct is workable and beneficial to both sides. We must continually ensure that we employ rigorous due diligence in the introduction of new collateral types and structures.
Cleared lending
One area where some of these issues come together is that of central counterparties (CCPs). The idea of a CCP—or perhaps a series of CCPs—being in place to handle securities lending transactions has been discussed for the past three or four years, and was estimated for implementation consistently on a (rolling) 12-18 month timescale. Perhaps as a result of how long it has remained a mere ‘discussion’ item, general market skepticism around the timing of an eventual implementation has developed. However, there does appear to be a serious redoubling of efforts by firms looking eventually to offer a CCP solution for securities lending.
Again, adaptability on all fronts will be crucial to support an eventual successful roll-out. The rewards of a capital-efficient way of transacting remain very compelling. However, each party is understandably approaching the idea from quite different vantage points. For example, agent lenders, having to ensure that any new model works for both borrowers and beneficial owners, want a model that fits neatly into the current construct as much as possible. Borrowers and lenders approach the concept with a securities lending mindset. Meanwhile, the clearers approach things from their own mindset. There are points where things are similar in both worlds, but also places where there are different ways of approaching an issue.
Ultimately, for a model to be successful there needs to be alignment around collateralisation, operational and structural ease, and of course, documentation. In all of this, we should recognise that while clearing is not new, and while the application to things such as repo are also not terribly new, from the standpoint of the underlying beneficial owners having transactions go through a CCP will represent a new way of approaching securities lending. Of course, there is much to be finalised with respect to the model, and the needs and requirements of underlying lenders must be kept in mind alongside other participants. Adaptability of the lenders and borrowers, as well as client engagement, will be integral to the success of CCPs.
Regulation
In today’s market, it would be difficult to write an article on securities lending that did not touch on regulation. In fact, relevant regulatory developments could warrant entire articles of their own, given that changes to the regulatory landscape have been pretty much a constant over the past few years. It is also an area that is not confined to any one market, and the effects of change can truly span across borders.
Topics such as the Securities Finance Transactions Regulation (SFTR) and the second Markets in Financial Instruments Directive (MiFID II) bear close consideration in that both impose changes to the way the participants in the lending industry have traditionally approached provision of the service, and this of course means that for all parties, there will be changes. Greater transparency is the eventual outcome, and generally speaking, is important to all parties, but this additional transparency does, however, come with the cost of additional reporting burdens for the various market participants. Significant volumes of additional data will need to be provided to satisfy requirements.
Having been in the industry for some time, it seems that the market presents both challenges and opportunities daily. Whatever one’s overall position on the year ahead—and from my perspective it looks like it will be a busy one—there are likely to be a number of areas where lenders, borrowers and agents will need to be more closely coordinated—and more adaptable—than ever before.
If I had to try to boil down into a single word what will be required to weather potential market challenges this year, it would be ‘adaptability’.
When we think about the market we are really thinking about the combination of a number of different things: activity in underlying securities markets and its impact; regulatory and tax changes in various jurisdictions; and, of course, the actions of various participants in the market – beneficial owners, borrowers, agent lenders, etc. Each component of the market exists as part of a greater ecosystem, a single event in one place will have an impact throughout. Without adaptability, the ecosystem cannot function optimally. New considerations need to be absorbed and new equilibriums need to be reached.
Here are three areas that I think will continue to feature prominently for all of us involved in the industry, and are demonstrative of the need for adaptability.
Non-cash collateral
One of the themes we have seen evolve over the past few years was the growth of trade activity collateralised by non-cash, driven by balance sheet efficiency considerations. While equity collateral in particular has grown significantly, we have also seen the need to take on additional collateral sets. Not only has it been important for lending agents to ensure that risk management and oversight of these types of collateral has been robust, but it has also required that beneficial owner clients broaden their consideration.
More recently, we entered into a period of rising interest rates. While a rising rate environment can present short-term challenges, it is generally a favourable development for clients whose loans are predominantly collateralised by cash. In the years before we entered this rising interest rate regime, equity and other expanded collateral types offered opportunities to enhance securities lending returns by virtue of additional spread, volume or both. From a risk management standpoint, the liquidity characteristics of equities in particular made this type of collateral—properly margined and managed—a good option for both equity and fixed income loans.
As we move forward, despite the rising interest rate environment, equity and other non-cash collateral activity will continue to be both important and prominent. Moreover, the collateral space has been one of relatively constant innovation. Consideration of new types of collateral to be incorporated into securities lending, or looking into more balance sheet efficient ways of transacting with various collateral types, will be a focus.
From an agent lender standpoint, it is obviously important to understand how these types of innovations can impact borrower driven lending activity. It is also important in our role as agent to help work with both borrower and lending principal (beneficial owner) to ensure that the resulting construct is workable and beneficial to both sides. We must continually ensure that we employ rigorous due diligence in the introduction of new collateral types and structures.
Cleared lending
One area where some of these issues come together is that of central counterparties (CCPs). The idea of a CCP—or perhaps a series of CCPs—being in place to handle securities lending transactions has been discussed for the past three or four years, and was estimated for implementation consistently on a (rolling) 12-18 month timescale. Perhaps as a result of how long it has remained a mere ‘discussion’ item, general market skepticism around the timing of an eventual implementation has developed. However, there does appear to be a serious redoubling of efforts by firms looking eventually to offer a CCP solution for securities lending.
Again, adaptability on all fronts will be crucial to support an eventual successful roll-out. The rewards of a capital-efficient way of transacting remain very compelling. However, each party is understandably approaching the idea from quite different vantage points. For example, agent lenders, having to ensure that any new model works for both borrowers and beneficial owners, want a model that fits neatly into the current construct as much as possible. Borrowers and lenders approach the concept with a securities lending mindset. Meanwhile, the clearers approach things from their own mindset. There are points where things are similar in both worlds, but also places where there are different ways of approaching an issue.
Ultimately, for a model to be successful there needs to be alignment around collateralisation, operational and structural ease, and of course, documentation. In all of this, we should recognise that while clearing is not new, and while the application to things such as repo are also not terribly new, from the standpoint of the underlying beneficial owners having transactions go through a CCP will represent a new way of approaching securities lending. Of course, there is much to be finalised with respect to the model, and the needs and requirements of underlying lenders must be kept in mind alongside other participants. Adaptability of the lenders and borrowers, as well as client engagement, will be integral to the success of CCPs.
Regulation
In today’s market, it would be difficult to write an article on securities lending that did not touch on regulation. In fact, relevant regulatory developments could warrant entire articles of their own, given that changes to the regulatory landscape have been pretty much a constant over the past few years. It is also an area that is not confined to any one market, and the effects of change can truly span across borders.
Topics such as the Securities Finance Transactions Regulation (SFTR) and the second Markets in Financial Instruments Directive (MiFID II) bear close consideration in that both impose changes to the way the participants in the lending industry have traditionally approached provision of the service, and this of course means that for all parties, there will be changes. Greater transparency is the eventual outcome, and generally speaking, is important to all parties, but this additional transparency does, however, come with the cost of additional reporting burdens for the various market participants. Significant volumes of additional data will need to be provided to satisfy requirements.
Having been in the industry for some time, it seems that the market presents both challenges and opportunities daily. Whatever one’s overall position on the year ahead—and from my perspective it looks like it will be a busy one—there are likely to be a number of areas where lenders, borrowers and agents will need to be more closely coordinated—and more adaptable—than ever before.
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