Meet the forerunners
03 April 2018
Regulatory change and its added challenges are the forerunners to opportunity in the securities lending industry. Mark Jones of Northern Trust explains more
Image: Shutterstock
Securities lending is a historically dynamic marketplace. Lenders, their agents, and the borrower community have consistently sought to adapt and improve, using innovative technology, new markets, and strong working relationships to keep the industry moving forward. The industry has also been subject to significant regulatory change that has shaped the way market participants interact.
The current landscape is no different, with regulatory change at the forefront, shifting supply and demand patterns, and evolving distribution mechanisms meaning that the industry will look very different in five years’ time.
Regulatory focus
Regulation has been, and will continue to be, a major influence on how the industry operates. From balance sheet management to transparency, a number of the innovations currently being worked on or contemplated are a direct result of regulatory change.
By the time we reach 2023, the securities lending industry will have undergone a major transformation with respect to transparency. The Securities Financing Transactions Regulation (SFTR) will be live across Europe and we believe it likely that other countries will have adopted and implemented their own reporting regimes, including the US. It is safe to assume that we will see post implementation changes to reporting regimes as regulators come to better understand the data they are receiving and adjust based on patterns they see or areas they wish to investigate further.
Our hope is that we see some level of global consistency from regulators, with a major concern being that the industry is left having to deal with multiple, widely varied reporting requirements. The challenges inherent in SFTR have been widely discussed and we would hope that lessons are learnt as other regulators roll out their own regimes.
An interesting point to consider is what the impact of the increased transparency might be—will we see new regulation based on patterns in the data that regulators will have to review? We think it likely that further changes to regulation could emerge as a result.
Borrowers have been challenged in recent years by regulatory constraints such as regulatory capital rules, liquidity coverage ratio (LCR) and net stable funding ratio (NSFR). As a result, lender type and jurisdiction has become a key determining factor in lending activity. Looking forward, client type will become part of the upfront trade criteria requested by borrowers for certain transactions, and we are already seeing this demand today. Agent lenders will have enhanced their systems and trade filters to account for this new trading attribute. Borrowers will be more discerning in who they trade with to allow them to manage these constraints and it is likely that this enhanced transparency will promote greater pricing differentiation on loans. Client types with a more favourable treatment under certain regulations will benefit from better utilisation and pricing levels, especially for general collateral loans. Similarly, there will be a greater demand for transactions collateralised with non-cash collateral.
We also expect that the industry will have benefited from changes to the capital treatment for securities lending transactions. Regulatory capital requirements will be reduced by approximately half of the levels required prior to the change. We are hopeful that the US will have adopted the Basel standards for the standardised approach as issued in their post crisis reforms in December last year. With other regulation such as single counterparty concentration limits in the US still to be finalised we believe it likely that further impacts will feed through.
Markets and distribution channels
Over the coming years emerging and frontier markets are expected to be an important new source of revenue as the industry looks to both diversify and expand its global footprint. Increased liberalisation of global capital markets, particularly in developing countries, should offer opportunities for the industry to expand into new regions and areas across the globe. The Middle East, Sub-Saharan Africa and pockets of Eastern Europe all remain relatively untapped from a securities finance perspective. However, as these regions develop more sophisticated capital market infrastructure we can expect securities lending opportunities to follow. We have already seen this theme develop in the Middle East, with the Saudi Arabian Capital Markets Authority recently announcing a series of new regulations to help facilitate securities lending and covered short selling. Countries such as Nigeria, Kenya and Romania have all been talked about as longer term opportunities. However, much will ultimately depend on the short selling models these countries introduce, and how effective they are at attracting international investors.
In Asia, emerging market activity already makes up a significant part of the revenue that’s generated from the region. There are already nine active lending markets in Asia, which on a normalised basis generally yield more attractive returns than the US or Europe, although many of these jurisdictions bring operational complexities as a function of the fragmented regulatory landscape across the region.
Asia’s longer term growth prospects are compelling with a number of significant emerging markets expected to be launched over time including India, Indonesia, Philippines and of course China. The latter represents, in our view, one of the most significant opportunities for the industry globally given the sheer size of the economy and expected growth in domestic stock markets. Encouragingly, reform is trending in the right direction as China seeks to liberalise its capital markets to the global community. The Stock Connect platforms have been successful and have paved the way for MSCI inclusion of Chinese shares into their benchmark emerging markets index in mid-2018. This is a positive step towards progressive market changes elsewhere which we hope will extend to development of a feasible offshore securities lending framework.
Alongside global expansion, we will see the development of new routes to distributing lendable supply, some of which are already taking shape. Perhaps the most significant could be an increase in centrally cleared lending transactions. A number of providers are either live with offerings or in the process of developing them, and we would expect that in the five year time period a significant proportion of transactions will be routed through central counterparty (CCP) solutions. The potential game changer here is if regulators move to mandate clearing as they have in other markets. Should this occur the proportion of cleared loans would rise significantly.
Beneficial owners
Beneficial owners providing supply are the key to a successful securities lending market. We think it likely that regulatory change such as SFTR will cause some beneficial owners to consider their ongoing participation in lending activity. For some the overhead created by compliance may be seen as burdensome. From our own perspective we will be ensuring that we can support our clients in their reporting obligations, and that in five years’ time facilitating transaction reporting will be a core component of the product offering, allowing our clients to base their choice to lend on the key benefits rather than concerns over the operational burden.
Over the next five years, we expect to see growth in the participation of two key industry sectors, namely asset managers and beneficial owners from jurisdictions where lending has not previously been widespread. Regarding asset managers, the on-going competition to lower costs for their investors coupled with increasing market and regulatory costs to operate their business we believe could promote a more pro-lending philosophy. The ability for their lending agent to customise a programme that does not interfere in their day to day core business will be an important differentiator. Similar to our comments above about new lending jurisdictions, a logical conclusion will be that these new jurisdictions will bring new lenders from that jurisdiction. Whether this growth comes from China, Indonesia, Saudi Arabia or Romania, the most apparent source of the supply in those markets will be from lenders domiciled in those markets.
Finally, the growth of environmental, social and governance investing cannot be ignored. With the industry’s current structure today where the ability to vote proxies passing from lender to borrower, we believe there will need to be a shift in operational processes (for example, easier automatic recall to vote process), a shift in technology (for example, distributed ledger/blockchain) or a combination of both. There is no reason why securities lending cannot sit side by side with an environmental, social and governance mandate where voting is important to a manager and investor.
Technology
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 distributed ledger technology (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 the technology, it could also open up future opportunities around account structures, regulatory reporting and digital issuance.
For Northern Trust, our priority is to ensure that we remain well positioned to bring our clients together with the borrower community in a way that maximises returns for our client base while not compromising the principles they apply to their lending programme. At the same time we need to ensure we are providing borrowers with the flexibility they require. This is no small challenge in times of significant change, so over the next five years our approach will be to continue to ensure we engage with our clients on the new types of activity available in the market, the impact of regulation, and advances in technology, thereby allowing them to make well informed decisions on how they structure their programme based on full transparency of the risk/reward equation. By investing time in client education and by taking advantage of the new technologies and distribution channels available, we will ensure our lending programme continues to deliver excellent risk-adjusted returns to our client base.
The current landscape is no different, with regulatory change at the forefront, shifting supply and demand patterns, and evolving distribution mechanisms meaning that the industry will look very different in five years’ time.
Regulatory focus
Regulation has been, and will continue to be, a major influence on how the industry operates. From balance sheet management to transparency, a number of the innovations currently being worked on or contemplated are a direct result of regulatory change.
By the time we reach 2023, the securities lending industry will have undergone a major transformation with respect to transparency. The Securities Financing Transactions Regulation (SFTR) will be live across Europe and we believe it likely that other countries will have adopted and implemented their own reporting regimes, including the US. It is safe to assume that we will see post implementation changes to reporting regimes as regulators come to better understand the data they are receiving and adjust based on patterns they see or areas they wish to investigate further.
Our hope is that we see some level of global consistency from regulators, with a major concern being that the industry is left having to deal with multiple, widely varied reporting requirements. The challenges inherent in SFTR have been widely discussed and we would hope that lessons are learnt as other regulators roll out their own regimes.
An interesting point to consider is what the impact of the increased transparency might be—will we see new regulation based on patterns in the data that regulators will have to review? We think it likely that further changes to regulation could emerge as a result.
Borrowers have been challenged in recent years by regulatory constraints such as regulatory capital rules, liquidity coverage ratio (LCR) and net stable funding ratio (NSFR). As a result, lender type and jurisdiction has become a key determining factor in lending activity. Looking forward, client type will become part of the upfront trade criteria requested by borrowers for certain transactions, and we are already seeing this demand today. Agent lenders will have enhanced their systems and trade filters to account for this new trading attribute. Borrowers will be more discerning in who they trade with to allow them to manage these constraints and it is likely that this enhanced transparency will promote greater pricing differentiation on loans. Client types with a more favourable treatment under certain regulations will benefit from better utilisation and pricing levels, especially for general collateral loans. Similarly, there will be a greater demand for transactions collateralised with non-cash collateral.
We also expect that the industry will have benefited from changes to the capital treatment for securities lending transactions. Regulatory capital requirements will be reduced by approximately half of the levels required prior to the change. We are hopeful that the US will have adopted the Basel standards for the standardised approach as issued in their post crisis reforms in December last year. With other regulation such as single counterparty concentration limits in the US still to be finalised we believe it likely that further impacts will feed through.
Markets and distribution channels
Over the coming years emerging and frontier markets are expected to be an important new source of revenue as the industry looks to both diversify and expand its global footprint. Increased liberalisation of global capital markets, particularly in developing countries, should offer opportunities for the industry to expand into new regions and areas across the globe. The Middle East, Sub-Saharan Africa and pockets of Eastern Europe all remain relatively untapped from a securities finance perspective. However, as these regions develop more sophisticated capital market infrastructure we can expect securities lending opportunities to follow. We have already seen this theme develop in the Middle East, with the Saudi Arabian Capital Markets Authority recently announcing a series of new regulations to help facilitate securities lending and covered short selling. Countries such as Nigeria, Kenya and Romania have all been talked about as longer term opportunities. However, much will ultimately depend on the short selling models these countries introduce, and how effective they are at attracting international investors.
In Asia, emerging market activity already makes up a significant part of the revenue that’s generated from the region. There are already nine active lending markets in Asia, which on a normalised basis generally yield more attractive returns than the US or Europe, although many of these jurisdictions bring operational complexities as a function of the fragmented regulatory landscape across the region.
Asia’s longer term growth prospects are compelling with a number of significant emerging markets expected to be launched over time including India, Indonesia, Philippines and of course China. The latter represents, in our view, one of the most significant opportunities for the industry globally given the sheer size of the economy and expected growth in domestic stock markets. Encouragingly, reform is trending in the right direction as China seeks to liberalise its capital markets to the global community. The Stock Connect platforms have been successful and have paved the way for MSCI inclusion of Chinese shares into their benchmark emerging markets index in mid-2018. This is a positive step towards progressive market changes elsewhere which we hope will extend to development of a feasible offshore securities lending framework.
Alongside global expansion, we will see the development of new routes to distributing lendable supply, some of which are already taking shape. Perhaps the most significant could be an increase in centrally cleared lending transactions. A number of providers are either live with offerings or in the process of developing them, and we would expect that in the five year time period a significant proportion of transactions will be routed through central counterparty (CCP) solutions. The potential game changer here is if regulators move to mandate clearing as they have in other markets. Should this occur the proportion of cleared loans would rise significantly.
Beneficial owners
Beneficial owners providing supply are the key to a successful securities lending market. We think it likely that regulatory change such as SFTR will cause some beneficial owners to consider their ongoing participation in lending activity. For some the overhead created by compliance may be seen as burdensome. From our own perspective we will be ensuring that we can support our clients in their reporting obligations, and that in five years’ time facilitating transaction reporting will be a core component of the product offering, allowing our clients to base their choice to lend on the key benefits rather than concerns over the operational burden.
Over the next five years, we expect to see growth in the participation of two key industry sectors, namely asset managers and beneficial owners from jurisdictions where lending has not previously been widespread. Regarding asset managers, the on-going competition to lower costs for their investors coupled with increasing market and regulatory costs to operate their business we believe could promote a more pro-lending philosophy. The ability for their lending agent to customise a programme that does not interfere in their day to day core business will be an important differentiator. Similar to our comments above about new lending jurisdictions, a logical conclusion will be that these new jurisdictions will bring new lenders from that jurisdiction. Whether this growth comes from China, Indonesia, Saudi Arabia or Romania, the most apparent source of the supply in those markets will be from lenders domiciled in those markets.
Finally, the growth of environmental, social and governance investing cannot be ignored. With the industry’s current structure today where the ability to vote proxies passing from lender to borrower, we believe there will need to be a shift in operational processes (for example, easier automatic recall to vote process), a shift in technology (for example, distributed ledger/blockchain) or a combination of both. There is no reason why securities lending cannot sit side by side with an environmental, social and governance mandate where voting is important to a manager and investor.
Technology
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 distributed ledger technology (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 the technology, it could also open up future opportunities around account structures, regulatory reporting and digital issuance.
For Northern Trust, our priority is to ensure that we remain well positioned to bring our clients together with the borrower community in a way that maximises returns for our client base while not compromising the principles they apply to their lending programme. At the same time we need to ensure we are providing borrowers with the flexibility they require. This is no small challenge in times of significant change, so over the next five years our approach will be to continue to ensure we engage with our clients on the new types of activity available in the market, the impact of regulation, and advances in technology, thereby allowing them to make well informed decisions on how they structure their programme based on full transparency of the risk/reward equation. By investing time in client education and by taking advantage of the new technologies and distribution channels available, we will ensure our lending programme continues to deliver excellent risk-adjusted returns to our client base.
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