How low can you go?
21 January 2014
Paul Wilson, the global head of agent lending product for J.P. Morgan, gives his 2014 predictions—which do not include a one-size-fits-all approach to pricing
Image: Shutterstock
It would be fair to say that 2013 was a challenging year for the securities lending business, and this was mostly driven by constraints on the demand side. The macroeconomic environment was tough, given central bank intervention and quantitative easing, coupled with very strong equity markets that resulted in somewhat subdued hedge fund activity. Last year was a year of generally lower volumes, lower spreads, and the consequence was lower returns.
All of these headwinds have come with the undercurrent of regulation, which—for the most part—has been impacting the demand-side of the business.
On the supply-side of the market, we continue to see that being positive. We still see new lenders coming to market, as well as existing lenders seeking ways to optimise their revenue from their portfolio by considering new and different things. That is very encouraging. With the demand side of the business being subdued, we have been careful as to how we have grown our inventory. If the demand simply isn’t there, growing supply for supply’s sake will likely exacerbate the problem, and spreads will decline further because on this imbalance.
Pricing
It is difficult to predict with any degree of certainty what is going to happen to pricing, as there are numerous factors that go into determining the fee split. You also have to understand the starting point for the agent or client, as well as the size, scope and breadth of services. Given these factors, pricing will not be one-size-fits-all, and I don’t see fees going one way or another. I would point out that post the financial crisis, the market environment has become one where volumes are lower, demand is reduced, and spreads have narrowed. However, the market is also far more transparent: there is better reporting and technology, and indemnification is probably broader than it has ever been.
The result of this is that is that the securities lending market continues to be highly competitive, with a wide array of choice for the beneficial owners. I think that has been a very positive consequence for the industry, and I actually don’t see those dynamics changing. I think that the winners will adapt, innovate and find new and different ways to enhance the returns for their clients.
Our pricing is incredibly unbundled and incredibly transparent. We talk to our clients constantly about returns, how they are generated, how that compares to benchmarks and how returns can be enhanced. I would suggest that there is a tipping point on fees. There is a level below that we won’t go if we don’t feel we are being paid appropriately.
Supply
We are seeing clients becoming more comfortable with emerging markets such as Taiwan, South Korea, Brazil and Malaysia—and emerging markets are something that we are widely recognised as being the market leader in (for example, we are still the only international lender that is active in Brazil). We do see some improved opportunities with collateral upgrades trades particularly in term, say three months.
There is also some opportunity in more developed markets, particularly for beneficial owners which are holders of high quality liquid assets. There is good opportunity to do decent profitable upgrades there. We are also actively expanding the range of collateral within the programme.
Advances in risk management
Risk management can mean different things to different people. It doesn’t mean the broadest array of indemnified collateral, which is something I have heard many times. Because one agent might indemnify something another agent doesn’t, this doesn’t imply they can manage risk better—it could be the opposite.
Risk management practices have definitely evolved, and the way we look and manage risk has evolved. We spend a lot of time, for example, analysing event risk that was born out of the global financial crisis, Lehman Brothers, the euro crisis, etc. We spend as much time on this as we do managing risks associated with collateral, counterparties, liquidity, markets, etc. Our business resides within the corporate and investment bank at J.P. Morgan, and so we are able to leverage the tremendous strength, expertise and resources that J.P. Morgan has as a firm as part of the risk management of the business.
2014 predictions
For 2014, the key industry will be heavily focused on regulation, specifically Basel III, the European Financial Transaction Tax, and the Financial Stability Board’s (FSB) shadow banking work that includes securities lending and repo. Basel III (and the Collins Amendment under the US Dodd-Frank Act) may mean that large US banks will be required to calculate regulatory capital ratios using both an advanced and standardised approach and to apply the more conservative of the two.
We are monitoring how all this regulation is going to affect our clients, the industry and us. The most notable aspects of the FSB recommendations are the potential advent of trade repositories, and the distinction between lending and financing transactions that could have different (minimum) haircut requirements.
Regarding equity markets, we feel they will again be positive—not to the same extent as 2013— but there may be a bit more volatility (which as a result, may increase hedge fund activity). Equity markets have been strong, corporate profits have been improving and we are starting to see more M&A activity, which should be positive for some of the yield enhancement and specials activity.
All of these headwinds have come with the undercurrent of regulation, which—for the most part—has been impacting the demand-side of the business.
On the supply-side of the market, we continue to see that being positive. We still see new lenders coming to market, as well as existing lenders seeking ways to optimise their revenue from their portfolio by considering new and different things. That is very encouraging. With the demand side of the business being subdued, we have been careful as to how we have grown our inventory. If the demand simply isn’t there, growing supply for supply’s sake will likely exacerbate the problem, and spreads will decline further because on this imbalance.
Pricing
It is difficult to predict with any degree of certainty what is going to happen to pricing, as there are numerous factors that go into determining the fee split. You also have to understand the starting point for the agent or client, as well as the size, scope and breadth of services. Given these factors, pricing will not be one-size-fits-all, and I don’t see fees going one way or another. I would point out that post the financial crisis, the market environment has become one where volumes are lower, demand is reduced, and spreads have narrowed. However, the market is also far more transparent: there is better reporting and technology, and indemnification is probably broader than it has ever been.
The result of this is that is that the securities lending market continues to be highly competitive, with a wide array of choice for the beneficial owners. I think that has been a very positive consequence for the industry, and I actually don’t see those dynamics changing. I think that the winners will adapt, innovate and find new and different ways to enhance the returns for their clients.
Our pricing is incredibly unbundled and incredibly transparent. We talk to our clients constantly about returns, how they are generated, how that compares to benchmarks and how returns can be enhanced. I would suggest that there is a tipping point on fees. There is a level below that we won’t go if we don’t feel we are being paid appropriately.
Supply
We are seeing clients becoming more comfortable with emerging markets such as Taiwan, South Korea, Brazil and Malaysia—and emerging markets are something that we are widely recognised as being the market leader in (for example, we are still the only international lender that is active in Brazil). We do see some improved opportunities with collateral upgrades trades particularly in term, say three months.
There is also some opportunity in more developed markets, particularly for beneficial owners which are holders of high quality liquid assets. There is good opportunity to do decent profitable upgrades there. We are also actively expanding the range of collateral within the programme.
Advances in risk management
Risk management can mean different things to different people. It doesn’t mean the broadest array of indemnified collateral, which is something I have heard many times. Because one agent might indemnify something another agent doesn’t, this doesn’t imply they can manage risk better—it could be the opposite.
Risk management practices have definitely evolved, and the way we look and manage risk has evolved. We spend a lot of time, for example, analysing event risk that was born out of the global financial crisis, Lehman Brothers, the euro crisis, etc. We spend as much time on this as we do managing risks associated with collateral, counterparties, liquidity, markets, etc. Our business resides within the corporate and investment bank at J.P. Morgan, and so we are able to leverage the tremendous strength, expertise and resources that J.P. Morgan has as a firm as part of the risk management of the business.
2014 predictions
For 2014, the key industry will be heavily focused on regulation, specifically Basel III, the European Financial Transaction Tax, and the Financial Stability Board’s (FSB) shadow banking work that includes securities lending and repo. Basel III (and the Collins Amendment under the US Dodd-Frank Act) may mean that large US banks will be required to calculate regulatory capital ratios using both an advanced and standardised approach and to apply the more conservative of the two.
We are monitoring how all this regulation is going to affect our clients, the industry and us. The most notable aspects of the FSB recommendations are the potential advent of trade repositories, and the distinction between lending and financing transactions that could have different (minimum) haircut requirements.
Regarding equity markets, we feel they will again be positive—not to the same extent as 2013— but there may be a bit more volatility (which as a result, may increase hedge fund activity). Equity markets have been strong, corporate profits have been improving and we are starting to see more M&A activity, which should be positive for some of the yield enhancement and specials activity.
NO FEE, NO RISK
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100% ON RETURNS If you invest in only one securities finance news source this year, make sure it is your free subscription to Securities Finance Times
