US securities finance panel
03 October 2023
Leading participants in US securities lending markets speak to SFT about market performance during 2023 and the impact of monetary tightening, opportunities for cash reinvestment, and the potential implications of accelerated settlement and Basel III Endgame
Image: stock.adobe.com/f11photo
Panellists
Dennis Cahill
Head of trading, North American fixed income and cash collateral re-investment, Securities Finance, BNY Mellon
Saverio Costa
Executive director, head of Securities Optimization Unit, Americas, Natixis
Joseph Gillingwater
Global head of fixed income securities finance trading, Northern Trust
Patricia Hostin
Head of agency lending, State Street
Alexander King
Agency securities lending trader, BNP Paribas' Securities Services
Rob Sackett
Global head of prime finance, Clear Street
Anthony Toscano
Head of global securities lending solutions, North America, Mitsubishi UFJ Trust & Banking Corporation
Phil Zywot
Head of trading, North American equities and US corporates, Securities Finance, BNY Mellon
Market dynamics
Which trends stand out in terms of lending activity and strategy in the US securities lending market over the past 12 months?
Joseph Gillingwater: US Treasury repo markets remain extremely active, with the Fixed Income Clearing Corporation’s (FICC’s) sponsored repo volumes hitting a new all-time high of over US$750 billion in the first half of the year. Rising rates and falling liquidity has prompted a return of the cash-futures bond basis trade, an opportunity for leveraged funds to benefit from very small dislocations in the US Treasury market, while recent rhetoric from the US Securities and Exchange Commission (SEC) around plans for mandatory clearing of treasury repo has only accelerated the need to have as many routes to market as possible.
At the end of July, US banking regulators unveiled changes to the Basel III rule. The updated version of the regulations, known as “Basel III Endgame“, are expected to require banks to hold more regulatory capital to provision against potential risk within trading books and operational processes. A tightening of regulatory standards is creating greater emphasis and acceleration of more regulatory-efficient lending and borrowing trade structures. The emergence of workable centrally cleared securities lending models in the US and international markets is beginning to gain more focus and we expect momentum to gather over time as market participants seek to manage a variety of regulatory binding constraints.
Furthermore, the industry has begun preparing for changes in the standard securities clearing and settlement cycles. In February 2023, the SEC adopted an amendment which brings T+1 into the US market by 28 May 2024 after the Memorial Day long-weekend. Naturally, this will require increased efficiency and automation at every touchpoint in the trade lifecycle. From an agent lender’s perspective, accelerating the timings when we receive sale notifications, and the speed at which we can cover that sale through internal processing or external recall, will be crucial.
Rob Sackett: The push for balance sheet and risk-weighted asset (RWA) optimisation continues. Non-cash flows, upgrade trades, CCP trades and internalisation remain major focuses. We see those trends carrying into the new year. ETF hedging is still very active as investors continue to stay away from single stock hedges.
Patricia Hostin: For equities, borrower strategy has been heavily focused on internal resource management. There has been an acute focus on capital usage by some of the larger borrowers in the US equity market and, for certain participants, this has spread through their global platform. There have been continued conversations across the industry around how borrowers, and lenders, can lessen their RWA footprint. This has perpetuated the conversations around viable CCP solutions and the overall demand for “smart” bucketing of GC loans. Similarly, to the extent borrowers can, there has been a continued push to finance their borrowers with non-cash collateral sets in the form of bilateral US treasuries or equities via triparty relationships.
For fixed income, lending and borrowing trends for US treasuries have followed Federal Open Market Committee (FOMC) hiking actions, with treasury bills and specials activity dominating the overall business. T-Bills have experienced major flows across the curve — with so much cash continually parked in the front-end due to Fed speculation — and have easily seen the most interest for lending and borrowing. Volatile cash markets have kept various current issues in play, with 20-year bonds and 10-year notes experiencing the deepest demand. Fed quantitative tightening has also lowered System Open Market Account (SOMA) supply in some cases, further widening the spread of some issues at times.
Dennis Cahill: Over the past 12 months in US treasuries, volatility in the rates market has resulted in bouts of deep specials and demand for short coupons. More recently, as inflation has become less of a concern and we are nearing an end of this rate cycle, the demand for short coupons has slowed and the market remains a GC market.
With quantitative tightening starting to have an impact, we have seen an uptick in non-cash funding trades owing to a reduction of assets on the Fed’s balance sheet — leading to the removal of liquidity from the market. As borrowers’ US treasury holdings increase as a result, we have seen an increase in non-cash trades due to their preferential balance sheet treatment.
Phil Zywot: Since the regional banking crisis in March, we have seen focus shifting to improved RWA exposure and a change in book structure as counterparties look to manage limited resources. In addition, the return of the bull market has been a headwind for US equity lending volumes, with increased inventory at prime brokers and greater internalisation taking place, which has impacted overall balances. There has also been an overall lack of deal and IPOs, with IPOs down 36 per cent by value and M&A deals down 40 per cent during the first half of the year.
Saverio Costa: Exchange-traded fund (ETF) lending and hard to borrow have been the main revenue drivers and focus for market participants over the past 12 months in the US securities lending business. From a borrower perspective, a key feature has been to follow the corporate actions that are happening in the market. Further, general collateral (GC) utilisation is a significant focal point for lenders but, on the US side, there is a clear limitation due to the Securities and Exchange Commission’s (SEC’s) Rule 15c3-3. In addition, the revenue extracted from portfolios reaches a cap relatively quickly.
Anthony Toscano: Lenders are taking a closer look at their current securities lending agents and starting to inquire what else is available in the marketplace. The pandemic put many searches to the sidelines. Now that things are somewhat back to normal, institutional investors are now kicking the tyres of their current providers, as well as the other providers in the market.
Alexander King: Securities lending activity over the last 12 months has been largely defined by the rising level of interest rates and persistent inflation, which impacted every corner of the economy and drove demand across the board when it comes to interest-rate sensitive sectors, resulting in increased specialness in those areas.
Which trades have been particularly vibrant in terms of loan fees and revenue? What have been the primary drivers of supply and demand?
Toscano: We continue to see strong demand for HQLA and experience very high utilisation based on managing client portfolios on an individual basis. We also see many opportunities in global lending and the ability to move assets to where demand is the strongest — for example lending US treasuries outside of the US against a much more diverse range of collateral than can be found onshore. This achieves wider spreads, diversifying counterparty risk and collateral types while avoiding concentration into the large US counterparties.
Hostin: AMC Entertainment Holdings Inc has clearly been the name that has driven the US equity securities lending market for 2023. The uncertainty around the outcome of court rulings left both long and shorts in this trade anxious for an outcome of the conversion of the AMC Preferred Equity Units (APE) shares and subsequent stock split. Outside of AMC, it is certainly worth mentioning the continued demand in the electric vehicle (EV) space. Lucid Group Inc and Nikola Corp have certainly been at the forefront of demand, while demand for other related names have been in focus at different parts of 2023 (Fisker Inc, ChargePoint Holdings Inc, Quantumscape Corp).
With crypto rebounding to start the year, there was strong demand for companies in this sector, including Coinbase Global and Marathon Digital Holdings. One noticeable outlier for the first half of 2023 has been the presence of capital markets activities, both in the M&A space as well as IPOs. The tides have started to turn in Q3 with the Johnson & Johnson split off from Kenvue Inc providing lucrative trading opportunities. Finally, successful issuances of Arm Holdings, ADR, CAVA Group, and Instacart over the past few weeks should hopefully signal more opportunity ahead.
Zywot: Two trades stand out in the US equity space in 2023. Johnson & Johnson (JNJ) announced it planned to split off at least 80.1 per cent of shares of Kenvue (KVUE) Inc. on 24 July through a discounted exchange offer. Borrowers were interested in take-no-action shares and willing to pay a premium for guaranteed no-sale shares that were not tendered. The other trade of note is the reverse stock split of AMC Entertainment (AMC), a top earner year-to-date, which occurred on 24 August. The highly anticipated conversion of AMC preferred APE shares into AMC common stock completed on 25 August, with the APE shares ceasing trading and subsequently being delisted from the New York Stock Exchange. Following the internal processing of the corporate action, the majority of the AMC shorts and loans were closed out and returned the following week. There has been very little directional demand since completion of this corporate action event.
Another sector that continues to attract demand is the auto sector — in particular, EV securities — but not at the highs we have seen in recent years. Specials continue to pop, but they are not driving the top 10 as they have done in the past, with only one making the current cut, Fisker Inc. (FSR). Meme stocks such as GameStop (GME), Carvana (CVNA) and Tupperware (TUP) have also had sporadic demand.
Cahill: For fixed income, another driver outside of quantitative tightening is the long bias in the equity markets for the first half of this year. This increased the need for equity collateral funding trades. Funding spreads widened after the regional banking stress in March, increasing the need for contingency funding across the Street. Spreads have started to tighten, but they remain wide compared with spreads before Silicon Valley Bank (SVB) collapsed.
Utilisation of US treasuries remains high, despite the inconsistencies of the specials market as lenders look to raise liquidity to meet term reinvestment demand. The wider investment spreads continue to provide opportunities for GC trading.
Sackett: The AMC/APE conversion trade dominated the US market this year and utilisation across the board still appears rather low. Convert hedging was not particularly active and the lack of syndicate activity negatively impacted the market.
Gillingwater: Borrower demand for credit and emerging market (EM) bonds continues to enjoy robust revenue growth. Rising inflation and subsequent global central bank interest rate increases have seen bond valuations decline, prompting significant shorting opportunities which have translated into increased volumes and fees for these asset classes. This is particularly evident for US corporate bonds and dollar-denominated EM debt as issuers are forced to endure higher funding costs.
North American activity has continued to dominate borrowing demand, with USD and CAD-denominated issuance regularly making up the top-10 revenue generating corporate bonds on a global scale in recent quarters. High-yield issuance remains well-sought from a borrow perspective, while we have observed the development of a market more focused on specials, with shorter-dated bonds across investment grade, high-yield and private placements dominating the highest revenue generators list given the sensitivity to interest rate risk.
From an equity perspective, the upward trajectory of markets and the wider macro uncertainty has meant investors have been cautious in picking an appropriate entry point against a rising market. This has created an environment where the demand has been heavily concentrated in a relatively small number of overcrowded specials. These names alone have driven specials revenue close to all-time highs. Demand within this space has been driven by weak fundamentals or unique asset arbitrage prospects.
Elsewhere, less established companies within the electric vehicle sector continue to attract elevated short interest, given the competitive nature of the industry and growing pains to profitability. Corporate activity has cooled against the backdrop of rising borrowing cost, with companies reluctant to come to market at this time. IPO issuance has also suffered.
Directional demand for corporate bond ETFs continues, given policy rate expectations and funding pressures within the corporate debt asset class. Emerging market ETF trackers, especially those replicating an index within countries without a robust SBL model, have also attracted strong short demand. The ETF asset class continues to represent an efficient way of expressing an investment in such markets.
Basel III Endgame
What impact will the Basel III Endgame have on securities lending activities in the US market? How will banks need to adapt to maximise the capital efficiency associated with their borrowing or agent lending activities?
Hostin: Basel III Endgame will have a material impact on bank capital requirements, primarily driven by changes to standards for operational risk and the Basel output floor. RWA increases of 20 per cent are expected on average for US G-SIBs, which will only increase the focus on efficiency where optimisation paths can be pursued. With a number of capital saving solutions in play, securities finance will be an ongoing focus for banks to drive efficiency as Basel reforms begin a multi-year phase in mid-year 2025.
Toscano: On 27 July, the Federal Reserve Board issued its long-awaited proposal on the US implementation of the Basel III regulation. While it is still being analysed, the initial reaction is not favourable and just how punitive it may prove to be depends upon the capital structure and business lines of the particular banking organisation. The new framework may impede the ability of some agents to offer indemnification under the most favourable of terms and pricing.
Capital is always a scarce commodity and the return targets for that capital vary from institution to institution. For organisations in search of higher returns on capital, it may be that they no longer find their current indemnification models fit for purpose to meet those returns.
Cahill: Most large agent lending firms subject to the capital rules will see an increase in their overall capital requirements as a result of the recent US proposal. However, this impact may be felt more in other business lines outside of agency securities lending.
The newly expanded risk-based approach contains some provisions beneficial to securities lending transactions when compared to the current standardised approach, which remains unchanged. These provisions include a new risk-sensitive formula for calculating exposure at default for repo-style transactions and lower risk weights for certain broker-dealer counterparties, which is partially offset by an increase in risk weights for bank counterparties. The impact to any one agent lender’s programme is dependent on a number of factors, including current constraining ratio (advanced or standardised), the size and diversification of their netting sets, and the composition of their portfolios.
Perhaps the most significant change is the elimination of internal models. This will impact those agent lenders that have current approval to utilise a value-at-risk (VAR) model to calculate exposures at default, alongside the ability to use their own internal estimates for counterparty risk weights. If the advanced approach is their controlling measure, then capital requirements in agency lending portfolios are likely to increase. Conversely, if the standardised approach is their constraining measure, they should see a significant decrease.
The elimination of internal models will also impact single counterparty credit limits for firms with approved VAR models. These firms are likely to see an increase in exposures for some counterparties, depending on the composition of the portfolio, the size of the netting set and the amount of diversification. This may require some management of the exposures for those firms, but it is unlikely to result in a significant impact to the overall market.
Nothing in the proposal will change the structures or approaches used to manage capital associated with indemnified agency lending. However, it will continue to foster industry discussion with respect to the cost and benefits of indemnification.
Costa: The increased costs of risk-weighted assets (RWAs) will be challenging for the US securities-based lending industry with regards to the Basel III Endgame. To relieve these costs for dealers, market participants will need to consider clearing, netting and pledging.
Cash reinvestment
What impact is central bank monetary tightening having on the appetite from collateral takers for cash vs. non-cash collateral? How has this impacted the revenue pick-up available through cash reinvestment?
Gillingwater: The rising interest rate environment we have become accustomed to provided opportunities and challenges from an asset-liability construct. The pace and frequency of the Federal Reserve’s rate hikes had to be micro-managed, with lending rebates typically resetting immediately, while cash reinvestment yields took longer to ‘catch-up’ and reset depending on the Weighted Average Maturity (WAM) of investments. In some instances, this led to a pivot to non-cash collateral which provided more revenue security during times of monetary policy uncertainty.
However, with the Fed seemingly reaching the terminal interest rate, that is with no more hikes expected, this trend should begin to evolve, eventually seeing a pivot to more loans versus cash. While the medium-term trajectory of rates is still somewhat unclear due to stubborn global inflation and a US economy broadly holding up well to higher rates, the way down will see cash reinvestment funds maximise available WAMs, therefore enjoying higher rates for longer. This will be met with securities lending rebates immediately setting lower, which should be spread positive.
King: Central bank tightening created various opportunities for beneficial owners that accept cash collateral as the Fed’s tightening cycle kicked off — followed by the other major central banks. Lenders that were able to develop a duration-mismatched reinvestment programme have benefited from how clearly the Fed telegraphed their moves. These lenders were able to lend short duration (overnight, etc.), then reinvest the collateral at longer tenors, capturing the spread.
Toscano: It is fantastic. There are demonstrative examples regarding why the fee being paid on a non-cash collateralised loan should be increased. Programmes that default to non-cash will underperform programmes making that same loan taking cash and investing it. In addition, investors only need to look at the returns they receive for reverse repos collateralised by the same securities being pledged in the non-cash loan to see the opportunity lost by not adjusting that fee or doing it versus cash collateral.
Hostin: The higher interest rate environment from the Fed (0-0.25 per cent in March 2022 to current 5.25-5.50 per cent) has increased internal capital costs to a varying degree across the Street. Most houses have passed these costs along to lenders in the form of narrower spreads. Lenders have responded in turn with client guidelines dictating lending activity and determining whether spread “hurdles” mandate activity or whether loans are closed and supply left in the box. Collateral upgrade trades are still prevalent, but continued lower dealer inventories have limited overall opportunities.
Cahill: When the US treasury market believed the Fed was behind the curve, we saw increased short demand in the front end of the yield curve, with ongoing inflationary concerns. We also saw bouts of volatility in the market driven by Fed-speak and policy changes. Short demand increased, but with increased issuance sizes that did not always equate to increased intrinsic value.
In terms of reinvestment strategy, we looked to minimise interest rate risk by staying short of FOMC meetings or investing in SOFR floaters when available. With increased need for contingency funding, floating rate spreads widened more than the cost of GC loans, which stayed somewhat tight to RRP levels and increased overall return for our clients.
Accelerated settlement
How will the move to accelerated T+1 settlement impact the US securities lending market? How are you preparing for this transition?
Sackett: The Street is still on the back foot for T+1. The antiquated technology that dominates the industry today will bring mainframe batch cycle times in the compressed settlement cycle into question. Trades need to be affirmed promptly and outdated batch processing will delay proper communication. Currently, only 68 per cent of trade affirmations occur on trade date, so considerable work is required to increase this number under T+1.
Recall, buy-in, Regulation SHO, and fail liabilities are still the top issues that are making the market feel uneasy. Settlement fails can lead to a buildup of counterparty credit risk and negatively impact market liquidity. The risk is further amplified when replacing legacy solutions, while continuing to operate normally or making changes “in-flight.”
Zywot: The move to T+1 could result in increased fails for securities lending, especially in the less liquid names. The move effectively gives the borrower one day less to locate additional supply to cover a recall and may require some lenders to hold back larger buffers to protect against potential sale fails. This could result in reduced market liquidity.
Automation and streamlining sales information flow are the keys to a successful move to T+1. Beneficial owners need to look at a more efficient way of informing their custodial banks of their transactions (increased batch processing, automation, etc ) to provide enough time for the agent lender to process the sale and recall (if needed) in a timely manner before the deadline. Agent lenders need to automate the process to ensure recalls are sent out in an efficient and timely manner to the borrowers, who must automate the receipt of recalls, allowing the maximum amount of time to react and cover the position.
BNY Mellon is working with industry participants, vendors and industry associations on defining the issues and providing the potential solutions to address the shortened settlement cycle. The organisation continues to invest heavily in technology to ensure an efficient process — from beneficial owner transactions to borrower recalls — to reduce the potential of failed recalls and sales. BNY Mellon is also educating beneficial owners on the importance of timely notifications and on the potential downstream impact of the move to T+1.
Costa: Late recalls associated with the T+1 settlement cycle will lead to an increase in cost, alongside technology and profit and loss (PNL) risks. Market participants will need to work to migrate dealers to a single recall format to avoid the need for connectivity to all platforms, and therefore ease the pass through.
I anticipate a complete repatriation of the US securities-based lending business owing to this greater operational complexity.
Toscano: We are communicating and engaging with our clients, their asset managers, and their custodians to proactively address any necessary changes that will mitigate any negative impact to our securities lending programme because of the shortened settlement cycle.
We are currently reviewing agreements with clients, custodians and borrowers to identify any required changes. We are also reviewing current operating models and workflow to identify the need for changes — for example, use batch processing of client sale notifications versus real time processing. Alongside this, we are working closely with our vendors to ensure that any required system enhancements are tested and delivered in a timely fashion.
We are excited to meet this challenge and expect that this could lead to greater lending opportunities as counterparts will be much quicker to borrow for delivery management purposes than they are today. Obviously, there will also be lending agents that do not handle this change well and this will create opportunities for us to demonstrate to their clients that there is a better way.
King: The move to T+1 will require securities lenders, borrowers and end-users to perform the same core tasks required to settle a trade today, but in half of the time previously allotted. This time compression will likely lead to increased post-trade issues.
BNP Paribas’s Securities Services business is working to develop solutions to mitigate trade fails due to insufficient inventory, including but not limited to the systematic coverage of short positions via solutions such as our principal lending fail coverage programme. Additionally, changes are being instituted for key processes, such as recall timing and margin calculations to ensure support of T+1 on day one. We are actively engaging clients across businesses to assist them with the transition. Separately, BNP Paribas is exploring options to improve current operating models and extend coverage hours in alignment with the T+1 compressed lifecycle, working with counterparts on differing cut offs and what is possible to aid the smooth transition into T+1.
Transaction reporting
What implications will the proposed SEC Rule 10c-1 have for your securities lending business (or the clients you support)? What adaptations will you need to make ahead of 10c-1 enactment?
Cahill: Proposed Rule 10c-1 is yet to be finalised and there is a possibility it could be reproposed. Unlike the European Securities Financing Transaction Reporting (SFTR) regime, the Rule 10c-1 reporting obligation is one-sided and falls on the agent lender rather than the underlying client. To implement, this will require a significant technology build by agent lenders, especially if 15-minute reporting is required. It will also increase ongoing costs by requiring payments to the Financial Industry Regulatory Authority (FINRA). As agent lenders continue to absorb these costs, it will lead to wider client discussions with respect to the level of fee splits and returns.
From a market perspective, much of this transparency already exists and is used by market participants. It is unclear what the impact will be from an increased amount of data and public disclosure, other than to provide regulators with more information and increase the data sets for models used by hedge funds.
Sackett: Borrows and loan activity must be communicated regularly to a central depository. Our trades are always booked in a timely manner, so we will need to solve for the communication mechanism. There are still many open questions as to how to provide the most accurate and actionable data to investors and other market participants to enable them to make informed decisions.
At firms with out-of-date technology, this data is often siloed and sometimes compiled manually. Firms with more modern technology are better equipped to offer access to accurate, real-time information and the rich portfolio analytics that investors and regulators need.
King: SEC Rule 10c-1 is similar to the Securities Financing Transactions Regulation in the EU in many ways. However, the data requested and the timelines involved are significantly different to those of SFTR.
Specifically, the need for participants to report transactions within 15 minutes of execution has two clear implications for lenders, with the potential to separate those that already have advanced technological capabilities from those that do not. Lenders will need to work with their clients to enable the efficient passing of required data from lender to agent for each trade.
Additionally, lenders need to ensure they have the technology in place to enable the capture of all required data elements at trade execution and the transmission of that data to the correct entity. At present, BNP Paribas is dedicating significant resources and working with industry trade groups to formulate an efficient response to SEC Rule 10c-1.
Toscano: Ultimately, it will depend on what the final rule looks like. Much deviation from SFTR will create the largest burden. Nevertheless, the lift for all of these regulatory requirements makes the barrier for entry for any new securities lending agent extremely high.
Peer-to-peer
Are you noting a rise in peer-to-peer lending and financing in the US market? How are beneficial owners exploiting this channel alongside, or instead of, agent bank intermediated lending activity?
Toscano: We are not. Our observation is peer-to-peer activity is limited to a small number of large institutions with the resources to vet the risks involved to their own satisfaction. They are not representative of the vast majority of those who participate in securities lending.
I suppose the concept will continue to evolve and will not be fortified until there is an actual test. The ability of non-financial institutions to liquidate collateral as promptly as financial institutions could be a challenge. The role that regulators (i.e., a state insurance commission) may play during times of stress — and how one measures any cross-jurisdictional or sovereign risk in these transactions — needs to be understood. These scenarios have already been tested by banks as intermediaries.
Zywot: BNY Mellon has had beneficial owners participating as borrowers in our securities lending programme for more than 10 years. During that time, we have found peer-to-peer lending to be a complementary source of distribution to the traditional bank and broker-dealer borrowers. We find that our clients are interested in trading with their peers when it helps them to meet their goals — generally, revenue or liquidity management — without adding operational complexity. Because approving peers does not change the operational process for clients of our lending programme, engagement has not been an issue — outside of regulatory (or similar) restrictions to approving these clients.
In terms of setting up a self-lending programme without the support of their agent, we do not see substantial client interest. Self-lending is typically an inefficient source of investment for beneficial owners, taking into account the need to purchase or develop systems, to conform to the necessary regulations, to negotiate legal documents and to manage the daily operational burden. However, we do see interest from beneficial owners in utilising BNY Mellon’s technology to act in the role of borrower to implement leverage (long and short) and liquidity strategies.
Costa: We have noticed an increase in participation in peer-to-peer groups, but this is clearly a technological change and is likely to benefit the more technologically advanced entities — which would prosper from the demand and inventory of others in that same group. There is still a need to reduce exposure risk, but it is the role of the dealers to diversify the risk that the end users could face.
Development priorities
How are you investing in new product solutions and services through H2 2023 and into 2024? And what updates are you making to your technology and business processes to support this?
King: At BNP Paribas, we have recognised the added-value securities lending can bring to clients. We are making sure we deliver a service that helps our clients to optimise revenue while closely managing risk and staying on top of regulatory and market trends.
Our solution has always been subject to continuous investments. These were amped up recently with the ambition to invest further into our technology and systems. Our focus is currently on efficiency and improving client experience. We are looking at our client portal, optimisation of collateral processes, settlement times and more. Under our dedicated enhancement project, we believe we will further improve clients’ experience with their securities lending programme, as well as making it even more efficient for our borrowers to access securities they can borrow.
Sackett: Clear Street is a technology-first prime broker and almost 40 per cent of our staff is dedicated to building a best-in-class technology stack. We have built a proprietary, API-first prime brokerage platform starting with clearing, settlement, and custody. Over the past few years, we have scaled to other parts of the market, including securities finance, execution and risk management. Our platform adds significant efficiency to prime brokerage and focuses on minimising client risk and cost.
In June, we began to expand our asset class capabilities to include certain types of fixed income and, in July, we announced intentions to expand into the futures clearing market. These developments are possible because of our integrated horizontally-scalable platform that has a single source of truth for any given piece of information. Many platforms struggle to add capabilities for new asset classes, but our technology allows us to do so in months instead of years.
In addition to rolling out new products, we recognise how the client stays connected as we increase these roll-outs. Our dedication to in-house products and services and our mandate to connect them via our front-end and back-end systems is where we truly differentiate.
Cahill: There is no one particular update or new product, but rather a continuous evolution of the business. Automation remains a key driver — maybe even more so as we head into a world of shortened settlement cycles — and we expect much more focus on trade matching and post trade to remove the chance of fails. This area has possibly lacked the investment it deserved.
Beyond this, we are working with HQLAX and expect, in the not-too-distant future, to be trading fully tokenised transactions. There is a lot of interest here and we can see the benefits of the delivery-versus-delivery (DvD) model from an efficiency perspective and, perhaps more importantly, for its ability to unlock trapped pools of liquidity.
Costa: A driving factor for Natixis is to focus on cash execution and on connecting to securities-based lending vendors to improve inventory and lifecycle management. The US markets remain specific and distinct from international markets, with its own limitations, rules and habits. Consequently, it is difficult to support the market effectively simply by leveraging a global set of tools.
Where do you identify the strongest opportunities for the growth of your US securities lending activities in the 12 months ahead?
Hostin: A strong IPO pipeline, coupled with an uptick in gross leverage, offers promise for specials in what has been a tame end to Q3. Meme stocks are not the theme at the moment, so we turn towards a more fundamental assessment of winners and losers and are hopeful for less concentrated outcomes for lenders.
Toscano: There is no shortage of opportunities for us over the next 12 months. Firstly, we anticipate a number of extremely large and important clients coming to market to seek new providers. We are also engaged in interesting discussions with firms seeking to outsource their programme or partner up with us in some capacity.
In terms of the client searches, we are optimistic that these searches will be “decoupled” from custody, allowing third-party bidders so that institutional investors can obtain “best in class” service and increased net earnings.
Sackett: We see a strong opportunity to differentiate ourselves in the hard-to-borrow space and through quick, transparent client connectivity. The Automated Trading Locates Allocation System (ATLAS) is our proprietary trading system that allocates stock loan inventory to incoming customer requests. Since launching ATLAS in Q4 2022, our trading desk is much more efficient in serving our clients than it was previously. The team no longer spends precious time sifting through pages of information manually and they can react to market events in real time. We have started to roll this out to some customers, who are happy with the modern user experience.
Intraday during peak market activity, Clear Street sees a throughput of 10,000 locate requests per minute. On the busiest trading days, processing is close to 100,000 locate requests per day, which is significant for a trading system launched less than a year ago. Most automated locate requests are fulfilled in less than 50 milliseconds.
As much as the business has changed over the years, quick responses through ATLAS, competitive rates, stability, market colour, and maximising return on loans through fully paid lending, continue to generate alpha for our clients.
Dennis Cahill
Head of trading, North American fixed income and cash collateral re-investment, Securities Finance, BNY Mellon
Saverio Costa
Executive director, head of Securities Optimization Unit, Americas, Natixis
Joseph Gillingwater
Global head of fixed income securities finance trading, Northern Trust
Patricia Hostin
Head of agency lending, State Street
Alexander King
Agency securities lending trader, BNP Paribas' Securities Services
Rob Sackett
Global head of prime finance, Clear Street
Anthony Toscano
Head of global securities lending solutions, North America, Mitsubishi UFJ Trust & Banking Corporation
Phil Zywot
Head of trading, North American equities and US corporates, Securities Finance, BNY Mellon
Market dynamics
Which trends stand out in terms of lending activity and strategy in the US securities lending market over the past 12 months?
Joseph Gillingwater: US Treasury repo markets remain extremely active, with the Fixed Income Clearing Corporation’s (FICC’s) sponsored repo volumes hitting a new all-time high of over US$750 billion in the first half of the year. Rising rates and falling liquidity has prompted a return of the cash-futures bond basis trade, an opportunity for leveraged funds to benefit from very small dislocations in the US Treasury market, while recent rhetoric from the US Securities and Exchange Commission (SEC) around plans for mandatory clearing of treasury repo has only accelerated the need to have as many routes to market as possible.
At the end of July, US banking regulators unveiled changes to the Basel III rule. The updated version of the regulations, known as “Basel III Endgame“, are expected to require banks to hold more regulatory capital to provision against potential risk within trading books and operational processes. A tightening of regulatory standards is creating greater emphasis and acceleration of more regulatory-efficient lending and borrowing trade structures. The emergence of workable centrally cleared securities lending models in the US and international markets is beginning to gain more focus and we expect momentum to gather over time as market participants seek to manage a variety of regulatory binding constraints.
Furthermore, the industry has begun preparing for changes in the standard securities clearing and settlement cycles. In February 2023, the SEC adopted an amendment which brings T+1 into the US market by 28 May 2024 after the Memorial Day long-weekend. Naturally, this will require increased efficiency and automation at every touchpoint in the trade lifecycle. From an agent lender’s perspective, accelerating the timings when we receive sale notifications, and the speed at which we can cover that sale through internal processing or external recall, will be crucial.
Rob Sackett: The push for balance sheet and risk-weighted asset (RWA) optimisation continues. Non-cash flows, upgrade trades, CCP trades and internalisation remain major focuses. We see those trends carrying into the new year. ETF hedging is still very active as investors continue to stay away from single stock hedges.
Patricia Hostin: For equities, borrower strategy has been heavily focused on internal resource management. There has been an acute focus on capital usage by some of the larger borrowers in the US equity market and, for certain participants, this has spread through their global platform. There have been continued conversations across the industry around how borrowers, and lenders, can lessen their RWA footprint. This has perpetuated the conversations around viable CCP solutions and the overall demand for “smart” bucketing of GC loans. Similarly, to the extent borrowers can, there has been a continued push to finance their borrowers with non-cash collateral sets in the form of bilateral US treasuries or equities via triparty relationships.
For fixed income, lending and borrowing trends for US treasuries have followed Federal Open Market Committee (FOMC) hiking actions, with treasury bills and specials activity dominating the overall business. T-Bills have experienced major flows across the curve — with so much cash continually parked in the front-end due to Fed speculation — and have easily seen the most interest for lending and borrowing. Volatile cash markets have kept various current issues in play, with 20-year bonds and 10-year notes experiencing the deepest demand. Fed quantitative tightening has also lowered System Open Market Account (SOMA) supply in some cases, further widening the spread of some issues at times.
Dennis Cahill: Over the past 12 months in US treasuries, volatility in the rates market has resulted in bouts of deep specials and demand for short coupons. More recently, as inflation has become less of a concern and we are nearing an end of this rate cycle, the demand for short coupons has slowed and the market remains a GC market.
With quantitative tightening starting to have an impact, we have seen an uptick in non-cash funding trades owing to a reduction of assets on the Fed’s balance sheet — leading to the removal of liquidity from the market. As borrowers’ US treasury holdings increase as a result, we have seen an increase in non-cash trades due to their preferential balance sheet treatment.
Phil Zywot: Since the regional banking crisis in March, we have seen focus shifting to improved RWA exposure and a change in book structure as counterparties look to manage limited resources. In addition, the return of the bull market has been a headwind for US equity lending volumes, with increased inventory at prime brokers and greater internalisation taking place, which has impacted overall balances. There has also been an overall lack of deal and IPOs, with IPOs down 36 per cent by value and M&A deals down 40 per cent during the first half of the year.
Saverio Costa: Exchange-traded fund (ETF) lending and hard to borrow have been the main revenue drivers and focus for market participants over the past 12 months in the US securities lending business. From a borrower perspective, a key feature has been to follow the corporate actions that are happening in the market. Further, general collateral (GC) utilisation is a significant focal point for lenders but, on the US side, there is a clear limitation due to the Securities and Exchange Commission’s (SEC’s) Rule 15c3-3. In addition, the revenue extracted from portfolios reaches a cap relatively quickly.
Anthony Toscano: Lenders are taking a closer look at their current securities lending agents and starting to inquire what else is available in the marketplace. The pandemic put many searches to the sidelines. Now that things are somewhat back to normal, institutional investors are now kicking the tyres of their current providers, as well as the other providers in the market.
Alexander King: Securities lending activity over the last 12 months has been largely defined by the rising level of interest rates and persistent inflation, which impacted every corner of the economy and drove demand across the board when it comes to interest-rate sensitive sectors, resulting in increased specialness in those areas.
Which trades have been particularly vibrant in terms of loan fees and revenue? What have been the primary drivers of supply and demand?
Toscano: We continue to see strong demand for HQLA and experience very high utilisation based on managing client portfolios on an individual basis. We also see many opportunities in global lending and the ability to move assets to where demand is the strongest — for example lending US treasuries outside of the US against a much more diverse range of collateral than can be found onshore. This achieves wider spreads, diversifying counterparty risk and collateral types while avoiding concentration into the large US counterparties.
Hostin: AMC Entertainment Holdings Inc has clearly been the name that has driven the US equity securities lending market for 2023. The uncertainty around the outcome of court rulings left both long and shorts in this trade anxious for an outcome of the conversion of the AMC Preferred Equity Units (APE) shares and subsequent stock split. Outside of AMC, it is certainly worth mentioning the continued demand in the electric vehicle (EV) space. Lucid Group Inc and Nikola Corp have certainly been at the forefront of demand, while demand for other related names have been in focus at different parts of 2023 (Fisker Inc, ChargePoint Holdings Inc, Quantumscape Corp).
With crypto rebounding to start the year, there was strong demand for companies in this sector, including Coinbase Global and Marathon Digital Holdings. One noticeable outlier for the first half of 2023 has been the presence of capital markets activities, both in the M&A space as well as IPOs. The tides have started to turn in Q3 with the Johnson & Johnson split off from Kenvue Inc providing lucrative trading opportunities. Finally, successful issuances of Arm Holdings, ADR, CAVA Group, and Instacart over the past few weeks should hopefully signal more opportunity ahead.
Zywot: Two trades stand out in the US equity space in 2023. Johnson & Johnson (JNJ) announced it planned to split off at least 80.1 per cent of shares of Kenvue (KVUE) Inc. on 24 July through a discounted exchange offer. Borrowers were interested in take-no-action shares and willing to pay a premium for guaranteed no-sale shares that were not tendered. The other trade of note is the reverse stock split of AMC Entertainment (AMC), a top earner year-to-date, which occurred on 24 August. The highly anticipated conversion of AMC preferred APE shares into AMC common stock completed on 25 August, with the APE shares ceasing trading and subsequently being delisted from the New York Stock Exchange. Following the internal processing of the corporate action, the majority of the AMC shorts and loans were closed out and returned the following week. There has been very little directional demand since completion of this corporate action event.
Another sector that continues to attract demand is the auto sector — in particular, EV securities — but not at the highs we have seen in recent years. Specials continue to pop, but they are not driving the top 10 as they have done in the past, with only one making the current cut, Fisker Inc. (FSR). Meme stocks such as GameStop (GME), Carvana (CVNA) and Tupperware (TUP) have also had sporadic demand.
Cahill: For fixed income, another driver outside of quantitative tightening is the long bias in the equity markets for the first half of this year. This increased the need for equity collateral funding trades. Funding spreads widened after the regional banking stress in March, increasing the need for contingency funding across the Street. Spreads have started to tighten, but they remain wide compared with spreads before Silicon Valley Bank (SVB) collapsed.
Utilisation of US treasuries remains high, despite the inconsistencies of the specials market as lenders look to raise liquidity to meet term reinvestment demand. The wider investment spreads continue to provide opportunities for GC trading.
Sackett: The AMC/APE conversion trade dominated the US market this year and utilisation across the board still appears rather low. Convert hedging was not particularly active and the lack of syndicate activity negatively impacted the market.
Gillingwater: Borrower demand for credit and emerging market (EM) bonds continues to enjoy robust revenue growth. Rising inflation and subsequent global central bank interest rate increases have seen bond valuations decline, prompting significant shorting opportunities which have translated into increased volumes and fees for these asset classes. This is particularly evident for US corporate bonds and dollar-denominated EM debt as issuers are forced to endure higher funding costs.
North American activity has continued to dominate borrowing demand, with USD and CAD-denominated issuance regularly making up the top-10 revenue generating corporate bonds on a global scale in recent quarters. High-yield issuance remains well-sought from a borrow perspective, while we have observed the development of a market more focused on specials, with shorter-dated bonds across investment grade, high-yield and private placements dominating the highest revenue generators list given the sensitivity to interest rate risk.
From an equity perspective, the upward trajectory of markets and the wider macro uncertainty has meant investors have been cautious in picking an appropriate entry point against a rising market. This has created an environment where the demand has been heavily concentrated in a relatively small number of overcrowded specials. These names alone have driven specials revenue close to all-time highs. Demand within this space has been driven by weak fundamentals or unique asset arbitrage prospects.
Elsewhere, less established companies within the electric vehicle sector continue to attract elevated short interest, given the competitive nature of the industry and growing pains to profitability. Corporate activity has cooled against the backdrop of rising borrowing cost, with companies reluctant to come to market at this time. IPO issuance has also suffered.
Directional demand for corporate bond ETFs continues, given policy rate expectations and funding pressures within the corporate debt asset class. Emerging market ETF trackers, especially those replicating an index within countries without a robust SBL model, have also attracted strong short demand. The ETF asset class continues to represent an efficient way of expressing an investment in such markets.
Basel III Endgame
What impact will the Basel III Endgame have on securities lending activities in the US market? How will banks need to adapt to maximise the capital efficiency associated with their borrowing or agent lending activities?
Hostin: Basel III Endgame will have a material impact on bank capital requirements, primarily driven by changes to standards for operational risk and the Basel output floor. RWA increases of 20 per cent are expected on average for US G-SIBs, which will only increase the focus on efficiency where optimisation paths can be pursued. With a number of capital saving solutions in play, securities finance will be an ongoing focus for banks to drive efficiency as Basel reforms begin a multi-year phase in mid-year 2025.
Toscano: On 27 July, the Federal Reserve Board issued its long-awaited proposal on the US implementation of the Basel III regulation. While it is still being analysed, the initial reaction is not favourable and just how punitive it may prove to be depends upon the capital structure and business lines of the particular banking organisation. The new framework may impede the ability of some agents to offer indemnification under the most favourable of terms and pricing.
Capital is always a scarce commodity and the return targets for that capital vary from institution to institution. For organisations in search of higher returns on capital, it may be that they no longer find their current indemnification models fit for purpose to meet those returns.
Cahill: Most large agent lending firms subject to the capital rules will see an increase in their overall capital requirements as a result of the recent US proposal. However, this impact may be felt more in other business lines outside of agency securities lending.
The newly expanded risk-based approach contains some provisions beneficial to securities lending transactions when compared to the current standardised approach, which remains unchanged. These provisions include a new risk-sensitive formula for calculating exposure at default for repo-style transactions and lower risk weights for certain broker-dealer counterparties, which is partially offset by an increase in risk weights for bank counterparties. The impact to any one agent lender’s programme is dependent on a number of factors, including current constraining ratio (advanced or standardised), the size and diversification of their netting sets, and the composition of their portfolios.
Perhaps the most significant change is the elimination of internal models. This will impact those agent lenders that have current approval to utilise a value-at-risk (VAR) model to calculate exposures at default, alongside the ability to use their own internal estimates for counterparty risk weights. If the advanced approach is their controlling measure, then capital requirements in agency lending portfolios are likely to increase. Conversely, if the standardised approach is their constraining measure, they should see a significant decrease.
The elimination of internal models will also impact single counterparty credit limits for firms with approved VAR models. These firms are likely to see an increase in exposures for some counterparties, depending on the composition of the portfolio, the size of the netting set and the amount of diversification. This may require some management of the exposures for those firms, but it is unlikely to result in a significant impact to the overall market.
Nothing in the proposal will change the structures or approaches used to manage capital associated with indemnified agency lending. However, it will continue to foster industry discussion with respect to the cost and benefits of indemnification.
Costa: The increased costs of risk-weighted assets (RWAs) will be challenging for the US securities-based lending industry with regards to the Basel III Endgame. To relieve these costs for dealers, market participants will need to consider clearing, netting and pledging.
Cash reinvestment
What impact is central bank monetary tightening having on the appetite from collateral takers for cash vs. non-cash collateral? How has this impacted the revenue pick-up available through cash reinvestment?
Gillingwater: The rising interest rate environment we have become accustomed to provided opportunities and challenges from an asset-liability construct. The pace and frequency of the Federal Reserve’s rate hikes had to be micro-managed, with lending rebates typically resetting immediately, while cash reinvestment yields took longer to ‘catch-up’ and reset depending on the Weighted Average Maturity (WAM) of investments. In some instances, this led to a pivot to non-cash collateral which provided more revenue security during times of monetary policy uncertainty.
However, with the Fed seemingly reaching the terminal interest rate, that is with no more hikes expected, this trend should begin to evolve, eventually seeing a pivot to more loans versus cash. While the medium-term trajectory of rates is still somewhat unclear due to stubborn global inflation and a US economy broadly holding up well to higher rates, the way down will see cash reinvestment funds maximise available WAMs, therefore enjoying higher rates for longer. This will be met with securities lending rebates immediately setting lower, which should be spread positive.
King: Central bank tightening created various opportunities for beneficial owners that accept cash collateral as the Fed’s tightening cycle kicked off — followed by the other major central banks. Lenders that were able to develop a duration-mismatched reinvestment programme have benefited from how clearly the Fed telegraphed their moves. These lenders were able to lend short duration (overnight, etc.), then reinvest the collateral at longer tenors, capturing the spread.
Toscano: It is fantastic. There are demonstrative examples regarding why the fee being paid on a non-cash collateralised loan should be increased. Programmes that default to non-cash will underperform programmes making that same loan taking cash and investing it. In addition, investors only need to look at the returns they receive for reverse repos collateralised by the same securities being pledged in the non-cash loan to see the opportunity lost by not adjusting that fee or doing it versus cash collateral.
Hostin: The higher interest rate environment from the Fed (0-0.25 per cent in March 2022 to current 5.25-5.50 per cent) has increased internal capital costs to a varying degree across the Street. Most houses have passed these costs along to lenders in the form of narrower spreads. Lenders have responded in turn with client guidelines dictating lending activity and determining whether spread “hurdles” mandate activity or whether loans are closed and supply left in the box. Collateral upgrade trades are still prevalent, but continued lower dealer inventories have limited overall opportunities.
Cahill: When the US treasury market believed the Fed was behind the curve, we saw increased short demand in the front end of the yield curve, with ongoing inflationary concerns. We also saw bouts of volatility in the market driven by Fed-speak and policy changes. Short demand increased, but with increased issuance sizes that did not always equate to increased intrinsic value.
In terms of reinvestment strategy, we looked to minimise interest rate risk by staying short of FOMC meetings or investing in SOFR floaters when available. With increased need for contingency funding, floating rate spreads widened more than the cost of GC loans, which stayed somewhat tight to RRP levels and increased overall return for our clients.
Accelerated settlement
How will the move to accelerated T+1 settlement impact the US securities lending market? How are you preparing for this transition?
Sackett: The Street is still on the back foot for T+1. The antiquated technology that dominates the industry today will bring mainframe batch cycle times in the compressed settlement cycle into question. Trades need to be affirmed promptly and outdated batch processing will delay proper communication. Currently, only 68 per cent of trade affirmations occur on trade date, so considerable work is required to increase this number under T+1.
Recall, buy-in, Regulation SHO, and fail liabilities are still the top issues that are making the market feel uneasy. Settlement fails can lead to a buildup of counterparty credit risk and negatively impact market liquidity. The risk is further amplified when replacing legacy solutions, while continuing to operate normally or making changes “in-flight.”
Zywot: The move to T+1 could result in increased fails for securities lending, especially in the less liquid names. The move effectively gives the borrower one day less to locate additional supply to cover a recall and may require some lenders to hold back larger buffers to protect against potential sale fails. This could result in reduced market liquidity.
Automation and streamlining sales information flow are the keys to a successful move to T+1. Beneficial owners need to look at a more efficient way of informing their custodial banks of their transactions (increased batch processing, automation, etc ) to provide enough time for the agent lender to process the sale and recall (if needed) in a timely manner before the deadline. Agent lenders need to automate the process to ensure recalls are sent out in an efficient and timely manner to the borrowers, who must automate the receipt of recalls, allowing the maximum amount of time to react and cover the position.
BNY Mellon is working with industry participants, vendors and industry associations on defining the issues and providing the potential solutions to address the shortened settlement cycle. The organisation continues to invest heavily in technology to ensure an efficient process — from beneficial owner transactions to borrower recalls — to reduce the potential of failed recalls and sales. BNY Mellon is also educating beneficial owners on the importance of timely notifications and on the potential downstream impact of the move to T+1.
Costa: Late recalls associated with the T+1 settlement cycle will lead to an increase in cost, alongside technology and profit and loss (PNL) risks. Market participants will need to work to migrate dealers to a single recall format to avoid the need for connectivity to all platforms, and therefore ease the pass through.
I anticipate a complete repatriation of the US securities-based lending business owing to this greater operational complexity.
Toscano: We are communicating and engaging with our clients, their asset managers, and their custodians to proactively address any necessary changes that will mitigate any negative impact to our securities lending programme because of the shortened settlement cycle.
We are currently reviewing agreements with clients, custodians and borrowers to identify any required changes. We are also reviewing current operating models and workflow to identify the need for changes — for example, use batch processing of client sale notifications versus real time processing. Alongside this, we are working closely with our vendors to ensure that any required system enhancements are tested and delivered in a timely fashion.
We are excited to meet this challenge and expect that this could lead to greater lending opportunities as counterparts will be much quicker to borrow for delivery management purposes than they are today. Obviously, there will also be lending agents that do not handle this change well and this will create opportunities for us to demonstrate to their clients that there is a better way.
King: The move to T+1 will require securities lenders, borrowers and end-users to perform the same core tasks required to settle a trade today, but in half of the time previously allotted. This time compression will likely lead to increased post-trade issues.
BNP Paribas’s Securities Services business is working to develop solutions to mitigate trade fails due to insufficient inventory, including but not limited to the systematic coverage of short positions via solutions such as our principal lending fail coverage programme. Additionally, changes are being instituted for key processes, such as recall timing and margin calculations to ensure support of T+1 on day one. We are actively engaging clients across businesses to assist them with the transition. Separately, BNP Paribas is exploring options to improve current operating models and extend coverage hours in alignment with the T+1 compressed lifecycle, working with counterparts on differing cut offs and what is possible to aid the smooth transition into T+1.
Transaction reporting
What implications will the proposed SEC Rule 10c-1 have for your securities lending business (or the clients you support)? What adaptations will you need to make ahead of 10c-1 enactment?
Cahill: Proposed Rule 10c-1 is yet to be finalised and there is a possibility it could be reproposed. Unlike the European Securities Financing Transaction Reporting (SFTR) regime, the Rule 10c-1 reporting obligation is one-sided and falls on the agent lender rather than the underlying client. To implement, this will require a significant technology build by agent lenders, especially if 15-minute reporting is required. It will also increase ongoing costs by requiring payments to the Financial Industry Regulatory Authority (FINRA). As agent lenders continue to absorb these costs, it will lead to wider client discussions with respect to the level of fee splits and returns.
From a market perspective, much of this transparency already exists and is used by market participants. It is unclear what the impact will be from an increased amount of data and public disclosure, other than to provide regulators with more information and increase the data sets for models used by hedge funds.
Sackett: Borrows and loan activity must be communicated regularly to a central depository. Our trades are always booked in a timely manner, so we will need to solve for the communication mechanism. There are still many open questions as to how to provide the most accurate and actionable data to investors and other market participants to enable them to make informed decisions.
At firms with out-of-date technology, this data is often siloed and sometimes compiled manually. Firms with more modern technology are better equipped to offer access to accurate, real-time information and the rich portfolio analytics that investors and regulators need.
King: SEC Rule 10c-1 is similar to the Securities Financing Transactions Regulation in the EU in many ways. However, the data requested and the timelines involved are significantly different to those of SFTR.
Specifically, the need for participants to report transactions within 15 minutes of execution has two clear implications for lenders, with the potential to separate those that already have advanced technological capabilities from those that do not. Lenders will need to work with their clients to enable the efficient passing of required data from lender to agent for each trade.
Additionally, lenders need to ensure they have the technology in place to enable the capture of all required data elements at trade execution and the transmission of that data to the correct entity. At present, BNP Paribas is dedicating significant resources and working with industry trade groups to formulate an efficient response to SEC Rule 10c-1.
Toscano: Ultimately, it will depend on what the final rule looks like. Much deviation from SFTR will create the largest burden. Nevertheless, the lift for all of these regulatory requirements makes the barrier for entry for any new securities lending agent extremely high.
Peer-to-peer
Are you noting a rise in peer-to-peer lending and financing in the US market? How are beneficial owners exploiting this channel alongside, or instead of, agent bank intermediated lending activity?
Toscano: We are not. Our observation is peer-to-peer activity is limited to a small number of large institutions with the resources to vet the risks involved to their own satisfaction. They are not representative of the vast majority of those who participate in securities lending.
I suppose the concept will continue to evolve and will not be fortified until there is an actual test. The ability of non-financial institutions to liquidate collateral as promptly as financial institutions could be a challenge. The role that regulators (i.e., a state insurance commission) may play during times of stress — and how one measures any cross-jurisdictional or sovereign risk in these transactions — needs to be understood. These scenarios have already been tested by banks as intermediaries.
Zywot: BNY Mellon has had beneficial owners participating as borrowers in our securities lending programme for more than 10 years. During that time, we have found peer-to-peer lending to be a complementary source of distribution to the traditional bank and broker-dealer borrowers. We find that our clients are interested in trading with their peers when it helps them to meet their goals — generally, revenue or liquidity management — without adding operational complexity. Because approving peers does not change the operational process for clients of our lending programme, engagement has not been an issue — outside of regulatory (or similar) restrictions to approving these clients.
In terms of setting up a self-lending programme without the support of their agent, we do not see substantial client interest. Self-lending is typically an inefficient source of investment for beneficial owners, taking into account the need to purchase or develop systems, to conform to the necessary regulations, to negotiate legal documents and to manage the daily operational burden. However, we do see interest from beneficial owners in utilising BNY Mellon’s technology to act in the role of borrower to implement leverage (long and short) and liquidity strategies.
Costa: We have noticed an increase in participation in peer-to-peer groups, but this is clearly a technological change and is likely to benefit the more technologically advanced entities — which would prosper from the demand and inventory of others in that same group. There is still a need to reduce exposure risk, but it is the role of the dealers to diversify the risk that the end users could face.
Development priorities
How are you investing in new product solutions and services through H2 2023 and into 2024? And what updates are you making to your technology and business processes to support this?
King: At BNP Paribas, we have recognised the added-value securities lending can bring to clients. We are making sure we deliver a service that helps our clients to optimise revenue while closely managing risk and staying on top of regulatory and market trends.
Our solution has always been subject to continuous investments. These were amped up recently with the ambition to invest further into our technology and systems. Our focus is currently on efficiency and improving client experience. We are looking at our client portal, optimisation of collateral processes, settlement times and more. Under our dedicated enhancement project, we believe we will further improve clients’ experience with their securities lending programme, as well as making it even more efficient for our borrowers to access securities they can borrow.
Sackett: Clear Street is a technology-first prime broker and almost 40 per cent of our staff is dedicated to building a best-in-class technology stack. We have built a proprietary, API-first prime brokerage platform starting with clearing, settlement, and custody. Over the past few years, we have scaled to other parts of the market, including securities finance, execution and risk management. Our platform adds significant efficiency to prime brokerage and focuses on minimising client risk and cost.
In June, we began to expand our asset class capabilities to include certain types of fixed income and, in July, we announced intentions to expand into the futures clearing market. These developments are possible because of our integrated horizontally-scalable platform that has a single source of truth for any given piece of information. Many platforms struggle to add capabilities for new asset classes, but our technology allows us to do so in months instead of years.
In addition to rolling out new products, we recognise how the client stays connected as we increase these roll-outs. Our dedication to in-house products and services and our mandate to connect them via our front-end and back-end systems is where we truly differentiate.
Cahill: There is no one particular update or new product, but rather a continuous evolution of the business. Automation remains a key driver — maybe even more so as we head into a world of shortened settlement cycles — and we expect much more focus on trade matching and post trade to remove the chance of fails. This area has possibly lacked the investment it deserved.
Beyond this, we are working with HQLAX and expect, in the not-too-distant future, to be trading fully tokenised transactions. There is a lot of interest here and we can see the benefits of the delivery-versus-delivery (DvD) model from an efficiency perspective and, perhaps more importantly, for its ability to unlock trapped pools of liquidity.
Costa: A driving factor for Natixis is to focus on cash execution and on connecting to securities-based lending vendors to improve inventory and lifecycle management. The US markets remain specific and distinct from international markets, with its own limitations, rules and habits. Consequently, it is difficult to support the market effectively simply by leveraging a global set of tools.
Where do you identify the strongest opportunities for the growth of your US securities lending activities in the 12 months ahead?
Hostin: A strong IPO pipeline, coupled with an uptick in gross leverage, offers promise for specials in what has been a tame end to Q3. Meme stocks are not the theme at the moment, so we turn towards a more fundamental assessment of winners and losers and are hopeful for less concentrated outcomes for lenders.
Toscano: There is no shortage of opportunities for us over the next 12 months. Firstly, we anticipate a number of extremely large and important clients coming to market to seek new providers. We are also engaged in interesting discussions with firms seeking to outsource their programme or partner up with us in some capacity.
In terms of the client searches, we are optimistic that these searches will be “decoupled” from custody, allowing third-party bidders so that institutional investors can obtain “best in class” service and increased net earnings.
Sackett: We see a strong opportunity to differentiate ourselves in the hard-to-borrow space and through quick, transparent client connectivity. The Automated Trading Locates Allocation System (ATLAS) is our proprietary trading system that allocates stock loan inventory to incoming customer requests. Since launching ATLAS in Q4 2022, our trading desk is much more efficient in serving our clients than it was previously. The team no longer spends precious time sifting through pages of information manually and they can react to market events in real time. We have started to roll this out to some customers, who are happy with the modern user experience.
Intraday during peak market activity, Clear Street sees a throughput of 10,000 locate requests per minute. On the busiest trading days, processing is close to 100,000 locate requests per day, which is significant for a trading system launched less than a year ago. Most automated locate requests are fulfilled in less than 50 milliseconds.
As much as the business has changed over the years, quick responses through ATLAS, competitive rates, stability, market colour, and maximising return on loans through fully paid lending, continue to generate alpha for our clients.
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