Welcome to the new normal
10 December 2019
Technology and regulation have helped push open the doors to the securities lending market where new entrants were once viewed with suspicion
Image: Shutterstock
Securities lending was once thought of as a murky world that played host to several scandals that were finally brought to light when the financial crash hit between 2007, revealing the dark underbelly of an otherwise legitimate industry.
In 2007, the US Securities and Exchange Commission (SEC) charged 38 people, including Wall Street traders, in a series of fraudulent schemes involving phoney finder fees and illegal kickbacks in the securities lending industry.
According to the SEC, these traders conspired in various schemes with 21 purported securities finders – intermediaries who help locate shares and arrange the loans of hard-to-borrow stocks – to skim profits on transactions. The defendants pocketed more than $12 million over a period of nearly a decade.
In the wake of events like this, regulation has come in stricter and more complex forms than ever before to help combat some of these shadowy areas of the industry. However, disruption also brings opportunity and as the securities lending market has opened up to new entrants seeking to capitalise new opportunities to provide services to the market or offer their assets for loans.
Where in the past the market was dominated by a close-knit community of large entities, today’s landscape is populated with a wide variety of new market players from new, smaller lenders and borrowers to fintech service providers, platform hosts and other intermediaries.
However, the way ahead for new-comers is still far from clear with start-up costs, regulatory burdens and industry stalwarts resistant to change all standing in their way.
Letting in the light
Transparency is becoming a more welcome feature in the industry but before the financial crisis, market players operated in an opaque environment – and some liked it that way.
Market visibility is advantageous for new market entrants because, as Yannick Lucas, senior consultant, securities financing at Margin Reform, points out, it allows for competition, which is good as it will aid price discovery. According to Lucas, the industry now welcomes new entrants and new supply.
Hazeltree’s managing director, business development, Tim Smith, also sees that these cultural barriers are coming down. “They [the barriers] were high but they are now becoming lower as all stakeholders recognise that the doors can’t be pulled shut anymore,” he says.
Smith outlines that even as recently as a few years ago, some market participants thought of transparency as a dirty word.
“Adjusting to this, the concept of transparency has transitioned from being unwelcome through being tolerated to most recently being embraced,” Smith continues.
Indeed, according to Smith, cultural barriers meant that participants used to say that they didn’t want more counterparties and they were happy with their own intermediary group, but that attitude has dissipated significantly now. In fact, he says that intermediaries have now turned into facilitators and their clients are appreciative of the assistance they obtain.
Reinforcing this point, IHS Markit’s global head of securities finance, Paul Wilson, emphasises that competition is a positive force that drives innovation and choice and delivers a much better outcome for everyone, especially beneficial owners considering entering the market. “That competition exists in virtually all aspects and across all segments of market participants and providers,” he explains.
Further to this, Boaz Yaari, CEO and founder of Sharegain, a fintech newcomer aiming to open up securities lending and to relatively small investors, including high-net-worth individuals, notes that today most banks and custodians enable their clients freedom of choice with regards to the routes to market, for example joining their custodians’ lending programme, lending directly or appointing an agent.
While transparency, and with that, the healthy appetite for competition, is one of the opportunities that have come from regulation, Hazeltree’s Smith says: “The twin-pronged attack of regulatory and transparency initiatives has now meant that the pressure to do one’s own lending and the pressure to allow different participants in the value chain to talk to each other and negotiate with each other has led to further opportunities for direct lending.”
According to Smith, institutions are now able to see around certain intermediaries to the direct borrower and are recognising that they are able to undertake their own lending programme.
And, undertaking your own programme can provide opportunities in terms of having more direct control over risk, compliance, reporting and revenue generation.
Meanwhile, location can also play a role in the ease of entering the securities lending market. Smith identifies that in North America, for example, it is the norm to undertake securities lending via your custodial lending programme, and in Europe, it is easier to initiate your own securities lending programme with the custodian bank facilitating it.
Meanwhile, in Asia, for local participants, it has been more challenging due to historical local regulations.
The double-edged sword
While cultural aspects and regulation have placed new-market players wanting to start their own lending programme or offer a service to those lenders in good stead, technology is somewhat of a double-edged sword.
On one hand, new players have the advantage of starting from scratch without having to rely on old legacy systems. This can give them a competitive advantage against their peers to create something new and innovative.
Sakti Narayan, senior consultant, securities financing at Margin Reform, argues that new entrants have more choice as they can benefit from the advances in trading platform technology brought forward by new vendors or opt for the established platforms.
“With new technology, I would expect the onboarding time-frame to be shorter and the post-implementation support/maintenance less expensive and less painful compared to using legacy technology,” Narayan says. “New entrants will benefit from the post-trade automation services - these are efficient, easy to onboard and to use.”
However, on the other hand, technology comes with costs and for many new entrants, these can still be too high.
Sharegain’s CEO has expressed that there are lots of hurdles to cross if you’re a newcomer trying to set up a new programme and cost is a major factor. “Setting up an internal securities lending programme is an operationally intensive process, requiring both expertise and IT resources,” he adds.
As well as this, establishing relationships with counterparties and collateral managers is also a high hurdle for many financial institutions. And, on top of the set-up costs, one should take into consideration the additional resources needed for keeping up-to-date with the evolution of the securities lending industry and regulatory changes.
“Even for large financial institutions with significant resources, this could be quite a challenge,” Yaari says. “That is why we see more and more financial institutions looking for a different offering that can give them the best of both worlds – benefitting from the additional revenue without operational and IT constraints.”
However, despite its cost, technology is not something that can be overlooked by new entrants. For example, when institutions set up a new programme, Smith highlights that the first discussions will look at how it will be monitored and booked.
Emphasising this, Smith adds: “Technology is critical – and I’ll go a step further to say that cutting-edge technology and continued investment in technology are essential. When you consider the volumes traded and the risk involved, to establish any potential competitive advantage, new entrants absolutely need cutting-edge technology to grow their market share.”
Meanwhile, at Sharegain, Yaari sees technology as the catalyst for the democratisation of the securities lending ecosystem and explains that in many cases, financial institutions are constrained by their own legacy technology and have decided not to develop securities lending solution in-house given the lack of adequate IT budgets.
He continues: “Instead, many of them are looking for a solution that can integrate with their systems without the need to overhaul them and is based on a software-as-a-service commercial model.”
Still more to do
Entering the securities lending industry and starting up your own programme has become easier over the years and as Margin Reform’s Lucas remarks: “Given the new regulatory landscape, with the emphasis on trade matching, timely settlement, and good bookkeeping - it’s a great time for new entrants to start a business from scratch since the bespoke operational model will have to be regulatory compliant.”
Additionally, according to IHS Markit’s Wilson, it is relatively easy for beneficial owners who are looking to start their own programme.
Wilson explains: “At IHS Markit, we work extensively with new entrants to help them understand the revenue opportunity and associated risk from a number of different programme styles – from high-value intrinsic lending to a voluminous general collateral programme. We also help new entrants create the right framework, guidelines and internal governance structure to support the type of programme they wish to operate.”
While regulation has made the path smoother for starting your own programme, there are still hurdles to overcome, and the industry is not out of the woods just yet. Further education, guidance and lower costs could be a start in further opening the door and ensuring it stays open in the years to come.
In 2007, the US Securities and Exchange Commission (SEC) charged 38 people, including Wall Street traders, in a series of fraudulent schemes involving phoney finder fees and illegal kickbacks in the securities lending industry.
According to the SEC, these traders conspired in various schemes with 21 purported securities finders – intermediaries who help locate shares and arrange the loans of hard-to-borrow stocks – to skim profits on transactions. The defendants pocketed more than $12 million over a period of nearly a decade.
In the wake of events like this, regulation has come in stricter and more complex forms than ever before to help combat some of these shadowy areas of the industry. However, disruption also brings opportunity and as the securities lending market has opened up to new entrants seeking to capitalise new opportunities to provide services to the market or offer their assets for loans.
Where in the past the market was dominated by a close-knit community of large entities, today’s landscape is populated with a wide variety of new market players from new, smaller lenders and borrowers to fintech service providers, platform hosts and other intermediaries.
However, the way ahead for new-comers is still far from clear with start-up costs, regulatory burdens and industry stalwarts resistant to change all standing in their way.
Letting in the light
Transparency is becoming a more welcome feature in the industry but before the financial crisis, market players operated in an opaque environment – and some liked it that way.
Market visibility is advantageous for new market entrants because, as Yannick Lucas, senior consultant, securities financing at Margin Reform, points out, it allows for competition, which is good as it will aid price discovery. According to Lucas, the industry now welcomes new entrants and new supply.
Hazeltree’s managing director, business development, Tim Smith, also sees that these cultural barriers are coming down. “They [the barriers] were high but they are now becoming lower as all stakeholders recognise that the doors can’t be pulled shut anymore,” he says.
Smith outlines that even as recently as a few years ago, some market participants thought of transparency as a dirty word.
“Adjusting to this, the concept of transparency has transitioned from being unwelcome through being tolerated to most recently being embraced,” Smith continues.
Indeed, according to Smith, cultural barriers meant that participants used to say that they didn’t want more counterparties and they were happy with their own intermediary group, but that attitude has dissipated significantly now. In fact, he says that intermediaries have now turned into facilitators and their clients are appreciative of the assistance they obtain.
Reinforcing this point, IHS Markit’s global head of securities finance, Paul Wilson, emphasises that competition is a positive force that drives innovation and choice and delivers a much better outcome for everyone, especially beneficial owners considering entering the market. “That competition exists in virtually all aspects and across all segments of market participants and providers,” he explains.
Further to this, Boaz Yaari, CEO and founder of Sharegain, a fintech newcomer aiming to open up securities lending and to relatively small investors, including high-net-worth individuals, notes that today most banks and custodians enable their clients freedom of choice with regards to the routes to market, for example joining their custodians’ lending programme, lending directly or appointing an agent.
While transparency, and with that, the healthy appetite for competition, is one of the opportunities that have come from regulation, Hazeltree’s Smith says: “The twin-pronged attack of regulatory and transparency initiatives has now meant that the pressure to do one’s own lending and the pressure to allow different participants in the value chain to talk to each other and negotiate with each other has led to further opportunities for direct lending.”
According to Smith, institutions are now able to see around certain intermediaries to the direct borrower and are recognising that they are able to undertake their own lending programme.
And, undertaking your own programme can provide opportunities in terms of having more direct control over risk, compliance, reporting and revenue generation.
Meanwhile, location can also play a role in the ease of entering the securities lending market. Smith identifies that in North America, for example, it is the norm to undertake securities lending via your custodial lending programme, and in Europe, it is easier to initiate your own securities lending programme with the custodian bank facilitating it.
Meanwhile, in Asia, for local participants, it has been more challenging due to historical local regulations.
The double-edged sword
While cultural aspects and regulation have placed new-market players wanting to start their own lending programme or offer a service to those lenders in good stead, technology is somewhat of a double-edged sword.
On one hand, new players have the advantage of starting from scratch without having to rely on old legacy systems. This can give them a competitive advantage against their peers to create something new and innovative.
Sakti Narayan, senior consultant, securities financing at Margin Reform, argues that new entrants have more choice as they can benefit from the advances in trading platform technology brought forward by new vendors or opt for the established platforms.
“With new technology, I would expect the onboarding time-frame to be shorter and the post-implementation support/maintenance less expensive and less painful compared to using legacy technology,” Narayan says. “New entrants will benefit from the post-trade automation services - these are efficient, easy to onboard and to use.”
However, on the other hand, technology comes with costs and for many new entrants, these can still be too high.
Sharegain’s CEO has expressed that there are lots of hurdles to cross if you’re a newcomer trying to set up a new programme and cost is a major factor. “Setting up an internal securities lending programme is an operationally intensive process, requiring both expertise and IT resources,” he adds.
As well as this, establishing relationships with counterparties and collateral managers is also a high hurdle for many financial institutions. And, on top of the set-up costs, one should take into consideration the additional resources needed for keeping up-to-date with the evolution of the securities lending industry and regulatory changes.
“Even for large financial institutions with significant resources, this could be quite a challenge,” Yaari says. “That is why we see more and more financial institutions looking for a different offering that can give them the best of both worlds – benefitting from the additional revenue without operational and IT constraints.”
However, despite its cost, technology is not something that can be overlooked by new entrants. For example, when institutions set up a new programme, Smith highlights that the first discussions will look at how it will be monitored and booked.
Emphasising this, Smith adds: “Technology is critical – and I’ll go a step further to say that cutting-edge technology and continued investment in technology are essential. When you consider the volumes traded and the risk involved, to establish any potential competitive advantage, new entrants absolutely need cutting-edge technology to grow their market share.”
Meanwhile, at Sharegain, Yaari sees technology as the catalyst for the democratisation of the securities lending ecosystem and explains that in many cases, financial institutions are constrained by their own legacy technology and have decided not to develop securities lending solution in-house given the lack of adequate IT budgets.
He continues: “Instead, many of them are looking for a solution that can integrate with their systems without the need to overhaul them and is based on a software-as-a-service commercial model.”
Still more to do
Entering the securities lending industry and starting up your own programme has become easier over the years and as Margin Reform’s Lucas remarks: “Given the new regulatory landscape, with the emphasis on trade matching, timely settlement, and good bookkeeping - it’s a great time for new entrants to start a business from scratch since the bespoke operational model will have to be regulatory compliant.”
Additionally, according to IHS Markit’s Wilson, it is relatively easy for beneficial owners who are looking to start their own programme.
Wilson explains: “At IHS Markit, we work extensively with new entrants to help them understand the revenue opportunity and associated risk from a number of different programme styles – from high-value intrinsic lending to a voluminous general collateral programme. We also help new entrants create the right framework, guidelines and internal governance structure to support the type of programme they wish to operate.”
While regulation has made the path smoother for starting your own programme, there are still hurdles to overcome, and the industry is not out of the woods just yet. Further education, guidance and lower costs could be a start in further opening the door and ensuring it stays open in the years to come.
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