Good times forecast
09 April 2019
Although levels of borrower demand are lower than before the crisis, Mark Snowdon of Northern Trust explains that Australia is now seeing a new growth impetus in line with its Asian counterparts
Image: Shutterstock
Australia is big business for the securities lending industry, and securities lending has become big business for Australia. According to the major data providers, Australian assets account for around one-fifth of the total lendable supply in the Asia Pacific region. Along with global markets, supply declined dramatically in the wake of the global financial crisis but has now rebounded to surpass pre-2008 levels. Although levels of borrower demand are lower than before the crisis, Australia remains a well-established and mature securities lending market that is now seeing a new growth impetus in line with its Asian counterparts.
The Australian market’s domestic orientation and close-knit investment community set it apart from other markets. Word of mouth is important in helping the industry grow, and reputations are hard-won and keenly protected. This makes a local presence essential for relationships and information flows.
With a presence in Sydney and Melbourne, organisations like Northern Trust can provide local expertise to domestic lending clients. As the asset owner and asset manager sectors continue to consolidate and grow, the bar has been raised across the industry and has driven innovation in Australia and beyond.
Against this backdrop of progress, and with a need to seek additional alpha wherever possible, the perception of securities lending has shifted. For participants who opted out of securities lending following the crisis, appetite to re-engage their programmes has generally been weaker for onshore local lenders than it has for those of other jurisdictions. However, the industry has been able to demonstrate how securities lending has evolved into a more robust, transparent and flexible offering, with new tools available for customising parameters and managing risk.
Organisations that used to lend have now returned; those that never left are expanding their programmes. There is also a growing segment of the market that has never previously engaged in securities lending but is now launching programmes to meet their bespoke needs and specific requirements. As funds have struggled to fight the headwinds and impacts of a low interest-rate and low growth environment, the need to reduce costs and enhance performance has come to the fore, particularly for products that deliver revenue streams with relatively low levels of risk.
Growth over time
Australian lending has been viewed as heavily general collateral in nature, due in part to the dominance of companies with large and liquid market capitalisations. While this dynamic occurs across the Asia Pacific and even globally, it does appear more pronounced in Australia. The decline in index arbitrage strategies is a global phenomenon but accounted for significant loan volumes in Australia before the negative impact of increased regulation and balance sheet management. However, in a cyclical market where change is a constant and volatility is always around the corner, the landscape is changing for lenders and borrowers alike. This is creating alternative opportunities for market players and reshaping participant behaviour. For instance, the capital raising mandated by the Australian Prudential Regulation Authority saw strong securities lending revenues on the back of dividend reinvestment plan trades in 2017. While these opportunities fell away, collateral-flexible lenders and those who engaged in term trades continued to benefit from elevated spreads even for general collateral stocks in 2018.
In the fixed income space, there remains a robust trend to borrow high-quality liquid assets (HQLA) on a termed basis. Basel III required borrowers to meet liquidity ratios and funding thresholds—liquid coverage ratio and net stable funding ratio—and the migration of over-the-counter derivatives to a centrally cleared model has created further demand for HQLA as collateral. Historically, borrowers would have accessed HQLA supply instead of cash collateral, but the repo rate dynamic has made this trade economically difficult and made non-cash collateral the optimal choice.
Borrowers need to reduce capital drag on their balance sheets, and we have seen continued and growing demand to borrow HQLAs in the form of Australian government bonds instead of lower-rated or less liquid collateral. With the additional benefit to borrowers of accessing these HQLAs on a term basis, lenders have received premiums for the term element of the trade as well as the collateral transformation aspect.
A large proportion of assets are held by Australia’s superannuation funds. As the fourth-largest segment in the world, the superfunds continue expanding through increased mandatory contributions from members throughout the next decade. While asset allocation, particularly in equities, remains largely domestically focused, there is evidence that the benefits of greater diversification and liquidity in global markets are driving a more globally balanced approach.
With domestic lending revenues being more focused and therefore generally more volatile in nature, a trend towards globalisation will help to diversify and enhance securities lending revenue streams for local beneficial owners. Recent industry data showed an increase to almost USD $20 trillion of lendable assets globally in 2018, with over USD $2.1 trillion on loan. Over time, increased allocations to offshore exposure are expected to give access to attractive and more consistent returns.
The benefits of a growing securities lending industry are felt not just by lenders and borrowers. As a well-regulated practice that aids the smooth functioning of capital markets through enhanced liquidity and price discovery, securities lending delivers benefits to a range of domestic and global stakeholders.
Technology leading the way
Advances in technological capabilities continue to transform the securities lending industry. Robotics is a key enabler for operational improvement, artificial intelligence (AI) is allowing improvements to the sourcing and enrichment of trading data and detailed reporting is a key benefit to lenders and to trading optimisation.
Technology provides opportunities for improvements across the value chain, from trading strategies and operational efficiencies to enhanced revenue generation and deeper counterparty relationships. At Northern Trust, we are working with a number of new technologies including machine learning, AI, robotics and data analysis. In addition to increased transparency, we are likely to see the use of automated pricing mechanisms, which enable lenders to more accurately predict and determine appropriate pricing levels for specials. A focus on investing in areas we believe will unlock value for our clients, such as automation of the trading function, frees resources to seek maximum trading value for our clients. Our expectation is that the practical application of new technology will help drive competitive advantage through greater efficiency, optimised performance and enhanced client experience.
The use of blockchain technology will be more widespread in five years’ time, with its potential to drive both small-scale benefits for lenders and borrowers, and major industry-wide improvements and opportunities. Through our experience and expertise in deploying blockchain technology for private equity markets, Northern Trust believes distributed ledger technology will improve the transparency and efficiency of the market and provide potential opportunities to achieve industry cost efficiencies across the value chain. As confidence continues to grow in the technology, future opportunities could develop around account structures, regulatory reporting and digital issuance.
Strategic opportunities
At a time when some asset owners and asset managers are working closely with their boards to approve first-time engagement in securities lending, some lenders in Australia are leading the way in using securities lending as a vehicle to meet the needs of other functions with their businesses.
Many Australian asset owners remained committed to their securities lending programmes during and beyond the crisis, and have continuously evolved ways to derive additional value from the service and infrastructure. One interesting theme being explored is the extent to which securities lending can help the needs of the treasury function, with respect to cash management and liquidity, through concepts such as cash collateral self-investment, agency repo, collateral optimisation and peer-to-peer lending. With regulation never far away, the advent of a widely used securities lending central counterparty clearing platform is also a possibility.
While differences exist across beneficial owners with respect to the evolution of their programmes, many of these concepts are ultimately helping pave the future direction of the industry. Lending agents must continue to provide the ongoing partnership support, flexibility and customisation that afford their clients the means of fulfilling their long-term investment and risk management objectives.
Looking ahead
Australia, like its Asian counterparts, remains an important securities lending market. It has strong growth prospects and provides industry participants with a wide range of compelling opportunities. As Australian asset owners and managers continue to fight the headwinds of a low-return and low interest-rate environment, the need to cover costs and enhance performance has never been more important. This has encouraged the resurgence in securities lending that is now in full swing.
We expect continued efforts from the industry to develop lending programmes against a backdrop of robust, global demand. The forecast is bright and the outlook is positive.
The Australian market’s domestic orientation and close-knit investment community set it apart from other markets. Word of mouth is important in helping the industry grow, and reputations are hard-won and keenly protected. This makes a local presence essential for relationships and information flows.
With a presence in Sydney and Melbourne, organisations like Northern Trust can provide local expertise to domestic lending clients. As the asset owner and asset manager sectors continue to consolidate and grow, the bar has been raised across the industry and has driven innovation in Australia and beyond.
Against this backdrop of progress, and with a need to seek additional alpha wherever possible, the perception of securities lending has shifted. For participants who opted out of securities lending following the crisis, appetite to re-engage their programmes has generally been weaker for onshore local lenders than it has for those of other jurisdictions. However, the industry has been able to demonstrate how securities lending has evolved into a more robust, transparent and flexible offering, with new tools available for customising parameters and managing risk.
Organisations that used to lend have now returned; those that never left are expanding their programmes. There is also a growing segment of the market that has never previously engaged in securities lending but is now launching programmes to meet their bespoke needs and specific requirements. As funds have struggled to fight the headwinds and impacts of a low interest-rate and low growth environment, the need to reduce costs and enhance performance has come to the fore, particularly for products that deliver revenue streams with relatively low levels of risk.
Growth over time
Australian lending has been viewed as heavily general collateral in nature, due in part to the dominance of companies with large and liquid market capitalisations. While this dynamic occurs across the Asia Pacific and even globally, it does appear more pronounced in Australia. The decline in index arbitrage strategies is a global phenomenon but accounted for significant loan volumes in Australia before the negative impact of increased regulation and balance sheet management. However, in a cyclical market where change is a constant and volatility is always around the corner, the landscape is changing for lenders and borrowers alike. This is creating alternative opportunities for market players and reshaping participant behaviour. For instance, the capital raising mandated by the Australian Prudential Regulation Authority saw strong securities lending revenues on the back of dividend reinvestment plan trades in 2017. While these opportunities fell away, collateral-flexible lenders and those who engaged in term trades continued to benefit from elevated spreads even for general collateral stocks in 2018.
In the fixed income space, there remains a robust trend to borrow high-quality liquid assets (HQLA) on a termed basis. Basel III required borrowers to meet liquidity ratios and funding thresholds—liquid coverage ratio and net stable funding ratio—and the migration of over-the-counter derivatives to a centrally cleared model has created further demand for HQLA as collateral. Historically, borrowers would have accessed HQLA supply instead of cash collateral, but the repo rate dynamic has made this trade economically difficult and made non-cash collateral the optimal choice.
Borrowers need to reduce capital drag on their balance sheets, and we have seen continued and growing demand to borrow HQLAs in the form of Australian government bonds instead of lower-rated or less liquid collateral. With the additional benefit to borrowers of accessing these HQLAs on a term basis, lenders have received premiums for the term element of the trade as well as the collateral transformation aspect.
A large proportion of assets are held by Australia’s superannuation funds. As the fourth-largest segment in the world, the superfunds continue expanding through increased mandatory contributions from members throughout the next decade. While asset allocation, particularly in equities, remains largely domestically focused, there is evidence that the benefits of greater diversification and liquidity in global markets are driving a more globally balanced approach.
With domestic lending revenues being more focused and therefore generally more volatile in nature, a trend towards globalisation will help to diversify and enhance securities lending revenue streams for local beneficial owners. Recent industry data showed an increase to almost USD $20 trillion of lendable assets globally in 2018, with over USD $2.1 trillion on loan. Over time, increased allocations to offshore exposure are expected to give access to attractive and more consistent returns.
The benefits of a growing securities lending industry are felt not just by lenders and borrowers. As a well-regulated practice that aids the smooth functioning of capital markets through enhanced liquidity and price discovery, securities lending delivers benefits to a range of domestic and global stakeholders.
Technology leading the way
Advances in technological capabilities continue to transform the securities lending industry. Robotics is a key enabler for operational improvement, artificial intelligence (AI) is allowing improvements to the sourcing and enrichment of trading data and detailed reporting is a key benefit to lenders and to trading optimisation.
Technology provides opportunities for improvements across the value chain, from trading strategies and operational efficiencies to enhanced revenue generation and deeper counterparty relationships. At Northern Trust, we are working with a number of new technologies including machine learning, AI, robotics and data analysis. In addition to increased transparency, we are likely to see the use of automated pricing mechanisms, which enable lenders to more accurately predict and determine appropriate pricing levels for specials. A focus on investing in areas we believe will unlock value for our clients, such as automation of the trading function, frees resources to seek maximum trading value for our clients. Our expectation is that the practical application of new technology will help drive competitive advantage through greater efficiency, optimised performance and enhanced client experience.
The use of blockchain technology will be more widespread in five years’ time, with its potential to drive both small-scale benefits for lenders and borrowers, and major industry-wide improvements and opportunities. Through our experience and expertise in deploying blockchain technology for private equity markets, Northern Trust believes distributed ledger technology will improve the transparency and efficiency of the market and provide potential opportunities to achieve industry cost efficiencies across the value chain. As confidence continues to grow in the technology, future opportunities could develop around account structures, regulatory reporting and digital issuance.
Strategic opportunities
At a time when some asset owners and asset managers are working closely with their boards to approve first-time engagement in securities lending, some lenders in Australia are leading the way in using securities lending as a vehicle to meet the needs of other functions with their businesses.
Many Australian asset owners remained committed to their securities lending programmes during and beyond the crisis, and have continuously evolved ways to derive additional value from the service and infrastructure. One interesting theme being explored is the extent to which securities lending can help the needs of the treasury function, with respect to cash management and liquidity, through concepts such as cash collateral self-investment, agency repo, collateral optimisation and peer-to-peer lending. With regulation never far away, the advent of a widely used securities lending central counterparty clearing platform is also a possibility.
While differences exist across beneficial owners with respect to the evolution of their programmes, many of these concepts are ultimately helping pave the future direction of the industry. Lending agents must continue to provide the ongoing partnership support, flexibility and customisation that afford their clients the means of fulfilling their long-term investment and risk management objectives.
Looking ahead
Australia, like its Asian counterparts, remains an important securities lending market. It has strong growth prospects and provides industry participants with a wide range of compelling opportunities. As Australian asset owners and managers continue to fight the headwinds of a low-return and low interest-rate environment, the need to cover costs and enhance performance has never been more important. This has encouraged the resurgence in securities lending that is now in full swing.
We expect continued efforts from the industry to develop lending programmes against a backdrop of robust, global demand. The forecast is bright and the outlook is positive.
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