Indemnity will survive
13 January 2015
Indemnification comes under the spotlight as securities lending awaits the next challenge. Experts discuss the issues
Image: Shutterstock
What are the main challenges facing beneficial owners in the US?
James Slater: I would say that the main challenges for beneficial owners today are in fact downstream effects from new and emerging regulatory and market pressures on broker-dealers and agent lenders. New requirements around liquidity coverage ratios, a limited supply of strong collateral even as regulatory change drives up requirements, as well as emerging structural changes around central counterparties (CCPs), are all leading to change the character of opportunities and offerings that agent lenders and borrowers are able to undertake.
These changes to the market are putting beneficial owners’ revenue at risk in some areas, but they are also opening up new areas of opportunities. Beneficial owners that are willing to make key changes or adjustments to their programmes—for example, by broadening collateral acceptability or reassessing their needs around indemnification—are poised to tap into new or expanded revenue opportunities.
Evergreen trades are a prime example, as regulatory requirements have moved to create new opportunities for beneficial owners that are ready, willing and able to participate. For dealers, the liquidity coverage ratio changes behaviour. This ratio requires large dealers to maintain a sufficient supply of high quality liquid assets to meet potential net outflows of liquidity over a 30-day stress scenario. As a result, there’s a corresponding increased demand for term financing structures on the cash collateral reinvestment side of our business. It is also creating borrower demand for high quality liquid assets such as treasuries for term against other types of security collateral.
We expect to see this continue, which may contribute to wider spreads and increased lending and reinvestment opportunities for our clients that can engage in these transactions.
Many beneficial owners have or are re-visiting their programme guidelines, expanding their programmes and expanding collateral guidelines, as market pressures continue to drive focus around the optimal use of collateral. Beneficial owners are becoming much more focused on their own liquidity and collateral needs, as rules for central clearing of derivatives leads them to post initial and variable margin to support that activity.
Securities lending plays an important role in helping beneficial owners manage their collateral and liquidity needs. These moves come with corresponding expanded requirements around monitoring and reporting on this activity to beneficial owners’ own stakeholders.
Capital requirements and the leverage ratio are driving interest around the utilisation of CCPs. This isn’t a new topic of conversation in the securities finance space, but it continues to attract more serious attention from market participants. We see most CCPs with committees or groups working on potential solutions for the securities finance market—in particular, to address participants’ concerns around added costs, how to maintain confidence when participants don’t get to choose counterparties, and the measures put in place to mitigate various processing risks.
Doug Brown: Most beneficial owners continue to see low yields on cash, given the low interest rate environment, tight spreads and decreased availability of traditional repo. Borrowers increasingly want to deliver equities and other non-traditional collateral against loans, but some beneficial owners face regulatory or statute limitations against taking that collateral. We’re working with these clients to help change these requirements and allow for more flexibility.
Beneficial owners’ primary challenge over the next couple of years is likely to be understanding, complying with and adapting to regulatory reform, which will affect lending participants in different ways. Money market reform may have a larger impact on asset managers, given the floating rate requirement from prime funds. Increased capital requirements for indemnification offering would likely have a larger impact on those beneficial owners that operate programmes with higher levels of general collateral.
Those clients that have the most collateral and counterparty flexibility will see the best returns in the future. We anticipate securities lending will continue to help our clients achieve their desired returns.
George Trapp: It is important to note that beneficial owners that participate in securities lending are able to earn incremental revenue within established risk parameters and a transparent programme. Although there are uncontrollable challenges in the market environment, beneficial owners do have control over their individual programme, such as acceptable collateral, cash investment guidelines and performance of their securities lending agent.
Northern Trust works directly with beneficial owners to establish a specific programme that provides the best risk adjusted return given the client’s risk tolerance.
The biggest challenges to beneficial owners are ongoing regulatory changes and the impact of regulation on borrower demand. Northern Trust is actively monitoring the potential impact of global regulatory developments. We continue to engage with federal agencies on regulations, both directly and through industry groups. The breadth of regulatory proposals has created uncertainty that has weighed upon the market.
As more of these regulations are finalised, we will have greater clarity and be able to assess the direct and indirect effects of the new rules.
Paul Wilson: At the beginning of 2015, US beneficial owners continue to face myriad issues and challenges. The potential for rising interest rates, pension funding challenges, and the velocity of economic recovery in the US against concern for slowing global economic activity, will demand management and staff resources.
Positioning and overseeing securities lending programmes within this environment, so as to maintain them as a source of valuable incremental investment return, will continue to require resource commitment. Beneficial owners also face the challenge of understanding the impact of new capital rules and the way in which they will affect their agent’s ability and capacity to provide indemnification.
Chris Benedict: Regulatory changes could limit the ability for counterparties to execute certain types of trades. This would be a real challenge for the European markets, where specials are fewer and less pronounced than in North America or Asia.
Lance Wargo: The extensive work being done by regulators globally is affecting our industry with new rules, guidelines, and requirements. Some of these directives have been lacking in clarity or are incomplete, causing speculation and concern among beneficial owners. At BNP Paribas, we have allocated internal and external experts to research each regulatory proposal that will affect our industry and have subsequently built an offering that will thrive within this new framework and leave us equipped to be at the forefront of developments and opportunities.
A lack of full transparency is also a challenge facing beneficial owners. We have seen transparency come on leaps and bounds in the past years, with education increasing for beneficial owners both by providers and the industry. But we believe that it can be further improved by fostering continual communication between clients and their providers.
Clients should have the opportunity to call their providers’ desk and ask for market colour, such as what names are trading special or to gain an update on any regulatory requirements that may affect their programmes going forward. Fostering direct communication as well as working on direct client reporting is key to increase education and transparency in the industry.
What about opportunities?
Trapp: Generally speaking, there has been a shift towards higher intrinsic value trading and less appetite for general collateral. Where that manifests itself to the client is that a handful of securities are driving securities lending earnings and have a significant impact during the year. Since it is difficult to predict which stocks will drive revenue, we talk to our clients about the importance of being in a position to benefit from that demand when it occurs.
The key here is ongoing dialogue with clients to understand how they want to customise their programme to take advantage of those opportunities. For some clients, it is to have very few restrictions and try to maximise revenue across their portfolio. For others, it is being very specific about only taking advantage of certain opportunities. So there is no one-size-fits-all approach across our programme.
From a demand perspective, Asian remains buoyant for new opportunities, particularly in India, Indonesia and China. While viable offshore infrastructures are still being developed in these markets, hedge fund demand remains robust and likely to spur significant new revenue streams. Brazil remains a very attractive market, but its lending infrastructure remains challenging. Recent increases in demand due to mergers and acquisitions and initial public offerings are positive. Many market participants expect increasing levels of M&A activity to be a driver of increasing borrower demand.
Brown: We’ve seen increased equity demand as the markets have continued to move higher. It appears investors are being more company-specific about long and short investments, so we’re seeing growing demand to borrow individual stocks. There are opportunities to lend to new counterparties who are either entering the lending space or opening new branches in new locations. There are also opportunities for clients in newer markets, such as Brazil and Malaysia, and hopefully in China as the Hong Kong-Shanghai Connect may help open up that market.
With the anticipated rise in interest rates later in 2015, we expect to see a pick-up in cash collateral investment yields and better demand spreads from US treasuries. The regulations also offer some opportunities, particularly around the liquidity coverage ratio and the need for term funding. For instance, certain client segments, such as pension funds and sovereign investors, may benefit from a migration in borrower demand to term lending.
And we anticipate that the use of non-cash collateral—and particularly non-traditional collateral types—will grow due to more stringent capital and leverage rules and a laser focus on balance sheet management.
Wargo: The macroeconomic environment may lend itself to increased opportunities for beneficial owners in 2015 with increasing interest rates assisting on the reinvestment side of the trade.
There are also opportunities that come from being part of a mature, competitive industry. Beneficial owners are more equipped than ever with a range of options and an arsenal of assets available to them. Beneficial owners can craft a fully customised programme based on their objectives and receive a competitive bid for doing so. The industry has transitioned from being provider-led to being truly focused on beneficial owners in all facets of securities lending.
Wilson: In all stages of the market cycle, opportunities exist for participants willing to explore them. Increased market volatility produces opportunities for beneficial owners as market position takers ramp up strategies that require borrowed securities.
The increasing need for collateralisation in derivatives trading provides opportunities for increased demand for borrowed collateral as well as collateral optimisation to reduce costs and increase portfolio management efficiencies.
Benedict: Beneficial owners will benefit from more competition in the market data space within securities lending. They no longer will have to rely on their own reporting. They will be able to use third-party vendors, such as DataLend, to benchmark their performance on a yearly, quarterly, monthly or ad hoc basis.
Reporting requirements will probably increase as a result of regulation. Beneficial owners will be able to leverage third-party vendors to create reports for regulatory agencies rather than having to invest in infrastructure and resources to do it themselves. Third-party providers offer outsourcing opportunities here too.
Beneficial owners that suspended their programmes after 2008 continue to return to the business despite looming regulations.
Slater: I am optimistic that this will be a good year for securities lending. In 2015, the borrower side will continue to see change. The providers or banks that can optimise from a capital and balance sheet perspective while accommodating borrower demand for collateral will be best positioned for success in the new market environment.
At BNY Mellon, marketplace challenges are identified as opportunities to work consultatively with our clients to deliver the holistic solutions and services that will support their overall investment strategies. We are working hard to bring the right information and the right opportunities to our clients on both the borrower and lender sides.
Knowing our clients and keeping them well informed about upcoming opportunities will be key. This is a remarkable period for the markets. Our clients and counterparties are equally challenged and we are working hard to partner and support their dynamic and evolving needs.
How is indemnification being affected on a day-to-day basis due to new rules? What does the future hold for the practice?
Wargo: Indemnification is under the spotlight in 2015 with updates to the regulatory environment including the Dodd-Frank Act’s Collins Amendment and Basel III’s capital ratio potentially constraining the practice. We believe that indemnification will prove to become a privilege versus an automatic offering in the industry going forward for large US providers. This is due to capital constraints putting pressure on some lending agents. This may lead to some lending agents either not offering indemnification, or if so, increasing costs that may ultimately be funnelled down to beneficial owners.
This is unfortunate, since we believe that indemnification is an important tool to mitigate risk and should not be given up easily. It would be wise for beneficial owners to explore other options and providers before losing indemnification or having their fee splits negatively affected. The largest asset owners and managers will likely be able to retain both their current fee splits and indemnification.
Wilson: The indemnification that securities lending agents offer to beneficial owners have been somewhat undervalued in economic terms as well as in terms of their varying depth and breadth. Regulatory driven changes are demanding that agents interpret and understand the impact of these evolving regulations on their ability to offer, and the cost of providing, these indemnifications. The outcome of these analyses will very likely result in changes to indemnification offerings and price that may differ across agents, and they may also vary by beneficial owner.
We have been adapting to these new rules over the last several years and we feel comfortable with our indemnification offering as evidenced throughout 2014, when we expanded the range of collateral and structures included within our indemnification offering.
Slater: In the past, agent lenders have been able to provide beneficial owners with borrower default indemnification at a relatively low cost. Basel III now requires agent lenders to provide significantly more capital to provide these indemnifications, which ultimately increases the costs for the agent lenders that offer that service to their clients.
Agent lenders have several options in terms of closing this gap. They could try to charge borrowers more for the securities, which would increase revenue. Securities lending margins are often very small relative to the opportunities, so increasing fees even slightly may make trades unworkable.
Lenders could ask for more margin—additional collateral that would help the cost of capital for this service, which may work for some transactions, but it ultimately only increases the cost of capital for the borrower, and again might mean these opportunities are no longer financially viable.
Ultimately, since beneficial owners are the ones reaping the benefits from indemnification, it’s most likely that they will need to bear the costs, either in terms of lower revenue as borrowers and agent lenders expand business with beneficial owners whose requirements do not impose the same indemnification costs, or simply with a lower fee split to cover the difference.
Indemnified securities lending will continue to play a vital role in the market as far as beneficial owners are concerned, and, by extension, agent lenders. But the rulemaking and implementation of regulatory changes will ultimately affect the costs of that indemnification, and the market must change to match.
Brown: I think investor governance and responsibility are reflected in the structuring and monitoring of customised programme guidelines, including eligible counterparties, collateral and the associated margining. The indemnification is a tertiary line of defence. With evolving regulatory influences on the cost of capital, there will be further focus on the equilibrium between client and shareholder value. All products will be considered through that lens, and I think there will be greater diversity in the manner that borrower default indemnification is extended within programmes.
Trapp: Indemnification continues to be an important aspect of the securities lending transaction for beneficial owners. Some industry regulations affect lending agents because of the borrower default indemnification they provide to clients in their securities lending programmes, making it more expensive or limiting. Although there has been progress in the finalisation of various regulations broadly, the treatment of indemnified securities lending transactions is still pending in some cases.
Lending agents continue to evaluate their specific cost and capacity to provide borrower default indemnification. At this time, we do not foresee any wholesale changes to our lending business.
How are fee splits being structured between agents and beneficial owners? Are more incentives required to encourage beneficial owners to the table?
Wargo: Fee splits are also under the spotlight this year as beneficial owners become highly aware of the range of the opportunities afforded to them by the growing number of providers in the industry. The old days of industry-wide standardised fee splits are over. Beneficial owners are looking for competitive, customised offerings that lend fee splits to be considered on a case-by-case basis per the programme proposal at hand.
Brown: Typically, fee splits continue to be a percentage basis, with the client receiving the majority share. The business continues to be very competitive, and this is reflected in the fee splits clients are receiving.
We don’t see a need to offer more financial incentives for beneficial owners to participate in securities lending. Many beneficial owners have altered their programmes since 2008, and we’ve worked with them to create structures so they’re comfortable with the associated risk/return framework.
Trapp: We have seen several beneficial owners entering the securities lending market for the first time, as well as some that have returned to the market after a prolonged absence, encouraged by compelling revenues, competitive fees, and the ability to customise their programmes and establish their risk parameters.
Over the past several years, we have seen new fee arrangements, including a return to bundling services, like custody and securities lending, to provide the optimal fee arrangement.
Slater: While the markets are changing in character and requirements, for beneficial owners holding valuable assets, the markets will find a way for them to continue on in a way that is consistent with their objectives and risk appetite. The fee splits of the past reflected the costs of doing business under the market and regulatory regime of the past.
The current regulatory climate ultimately increases costs on the business, which will affect all participants, but at the same time creating new opportunities for beneficial owners willing to make appropriate adjustments to help bring their requirements into alignment with the market’s demand profile.
Even as regulatory capital costs drive down beneficial owners’ fee share on some trades, new opportunities and growing demand for high quality collateral will no doubt position beneficial owners to find new opportunities that fit their needs.
Wilson: There is a wide range of factors that influence pricing and splits between agents and beneficial owners, including size of assets, type of assets being lent, collateral, cash collateral investment guidelines, reporting requirements, as well as the overall firm-to-firm relationship beyond just securities lending.
We have a sophisticated model that allows us to accurately evaluate the revenue opportunity and costs (including indemnification), and allows us to appropriately price business.
What are beneficial owners considering to encourage more demand from borrowers?
Brown: Some of the options beneficial owners are considering to increase demand are:
New non-cash and repo collateral types, such as equities, corporate bonds and asset-backed securities;
Allowing term loans for either a specific security or for a basket of securities;
Exclusive lending arrangements for certain asset classes, markets or market capitalisation;
Lending in new markets, such as Brazil or Malaysia; and
Expanding their counterparty lists.
Slater: While it’s not really the role of beneficial owners to encourage demand, there are various changes they can make to their programmes to encourage activity and best position themselves to take advantage of borrower demand. For example, there is a lot of growth in terms of broadening collateral acceptability. Borrowers and lenders are both evaluating new opportunities in terms of cash, bonds and other instruments. Collateral choices have a direct impact on both fees and the indemnifications that are asked for or given.
I think that we’ll continue to see change in this area as securities lending participants continue to work through supply and demand issues around collateral. Each organisation has unique requirements, and there is a role for agent lenders to play in terms of presenting clients with information and options to help them make lending programme choices that are right for their own business needs.
Wilson: Beneficial owners looking for opportunities to grow their participation and securities lending returns need to consider broadening the types of collateral that they are willing to accept from borrowers facing changing financing needs and costs. Beneficial owners willing, and able, to accept broad market index equities and other non-traditional, non-cash collateral will increase their value to borrowers and thereby increase their potential for increased returns.
When taking cash collateral, beneficial owners willing to expand on the types, maturities, and term structures of collateral investments will see increased lending opportunities and the potential for increased returns. The impact of money market reforms and the transition to floating NAV (net asset value) institutional money market funds will create additional challenges, and opportunities, for beneficial owners that have traditionally utilised these vehicles for cash collateral investments.
The ability to utilise alternatives to these long-time market standards will offer opportunities to those beneficial owners who expand their cash collateral investment regimes.
Benedict: Broker-dealers have more impetus to engage in ‘balance-sheet friendly’ transactions with leverage ratio and the liquidity coverage ratios coming down the pike. Beneficial owners willing to engage in structured cash collateral term trades with broker-dealers may see increased demand from broker-dealers. This also acts as a potential opportunity for beneficial owners (and agent lenders) on the cash reinvestment side.
Collateral flexibility will also help drive utilisation. High-quality collateral is in demand, and the willingness to accept different grades of collateral from broker-dealers will help spur demand.
Trapp: Over the last several years we have seen beneficial owners returning to the market and increasing participation. Without wanting to increase risk, beneficial owners are considering alternative forms of collateral and term funding opportunities to participate in a wider variety of trade opportunities. These topics are high on borrowers’ lists as they seek to reduce their use of balance sheet.
Wargo: We are seeing an increased interest in beneficial owners exploring how to maximise their portfolios in this low rate environment, whether that be by considering new markets, reviewing a subset of a portfolio that they are not lending, or by extracting revenue through an intrinsic value-based approach.
At BNP Paribas, we explore all of these opportunities with clients directly through providing client access to our specialists on our trading desk as well as our risk and compliance departments in order to maximise revenue within client-directed parameters.
What sorts of collateral are beneficial owners accepting, and how has demand for high quality liquid assets affected what they accept?
Wilson: There has been some increased demand for high quality liquid assets but this in itself has not driven beneficial owners to systematically change their collateral eligibility. Beneficial owners are becoming more open minded and considerate of broadening eligible collateral and considering term structures. Collateral they are accepting includes a broad range of Organisation for Economic Co-operation and Development government bonds and a range of international equity indices.
Benedict: Beneficial owners are still pretty conservative after 2008, with most readily accepting cash and treasuries or sovereigns. However, we are seeing an increase in those accepting high-grade equities and corporate bonds as collateral.
Brown: The volume of non-cash collateralised loans and types pledged—including equities, corporate bonds, sovereign debt and other forms—have grown substantially in the last six years or so. Within our own lending programme, for instance, we’ve seen an increase from 13 percent at the end of 2009 to 40 percent at the end of 2014, and equity non-cash collateral as a percentage of all non-cash collateral received has more than quadrupled in that same time frame.
A focus on liquidity coverage has certainly played a substantial role, with borrowers optimising their balance sheets in part by maximising their use of pledged securities. Improved information systems within prime brokerage houses and improvements within triparty custodians have also allowed brokers to better access and optimise their collateral usage.
Trapp: Collateral acceptance is specific to each client. Historically, the US has been dominated by cash collateral, but beneficial owners are seeing more opportunities for non-cash trades. With our global business platform, Northern Trust is able to provide flexibility to our clients across regions and collateral types.
Each client has its own view on acceptable collateral based its own risk and return tolerance. When it comes to cash collateral, clients need to decide if they are interested in a separately managed account with customised guidelines, or a pooled fund for diversification. Other considerations include how to invest cash collateral, such as whether to follow guidelines similar to Securities and Exchange Commission Rule 2a-7 or to expand beyond that scope.
Over the past several years, we have also seen a wider use and acceptance of non-cash collateral, such as equities, in an effort to take advantage of broader trade opportunities with borrowers.
Wargo: Every beneficial owner is different in their needs and requirements for their programmes. This belief extends itself to the types of collateral that they are willing to accept. Safety of assets and customisation is central to the US BNP Paribas agency lending offering and we therefore tailor programmes in partnership with beneficial owners in order to achieve their objectives within their directed risk tolerance, whether that be straightforward overnight government repo collateral reinvestment or taking on alternative forms of collateral for longer durations.
No beneficial owner has ever suffered losses in a BNP Paribas-directed agency lending programme, which is the result of working closely in partnership with clients to craft strict collateral guidelines.
Slater: While Europe has always been more open to non-cash collateral in general, now US beneficial owners are moving toward accepting a wider variety of non-cash, including equities.
Regulations are changing the markets and, in some cases, creating new opportunities. The rewards are growing in particular for beneficial owners and agent lenders that take a more flexible approach to collateral. BNY Mellon is working closely with its beneficial owner clients, broadening collateral acceptability across different asset classes, moving away from a focus on sovereign debt and cash.
Many beneficial owners are also becoming much more focused on their own liquidity and collateral needs as the new rules for central clearing of derivatives are creating the need to post initial and variable margin to support this activity with high quality liquid assets.
We are also working closely with our clients to structure and assess various trades with close consideration to the potential returns on specific, underlying trades—not just around diversified collateral types. Beneficial owners are becoming more sophisticated and interested in understanding the return drivers behind the choices they make around accepting alternative forms of collateral.
This is a key growth area for the industry, as some beneficial owners may make their first forays into participation in securities lending based on a handful of trading opportunities that fit very closely with their specific needs. Starting small can help beneficial owners build comfort and understanding around the types of lending programmes that make sense for them.
James Slater: I would say that the main challenges for beneficial owners today are in fact downstream effects from new and emerging regulatory and market pressures on broker-dealers and agent lenders. New requirements around liquidity coverage ratios, a limited supply of strong collateral even as regulatory change drives up requirements, as well as emerging structural changes around central counterparties (CCPs), are all leading to change the character of opportunities and offerings that agent lenders and borrowers are able to undertake.
These changes to the market are putting beneficial owners’ revenue at risk in some areas, but they are also opening up new areas of opportunities. Beneficial owners that are willing to make key changes or adjustments to their programmes—for example, by broadening collateral acceptability or reassessing their needs around indemnification—are poised to tap into new or expanded revenue opportunities.
Evergreen trades are a prime example, as regulatory requirements have moved to create new opportunities for beneficial owners that are ready, willing and able to participate. For dealers, the liquidity coverage ratio changes behaviour. This ratio requires large dealers to maintain a sufficient supply of high quality liquid assets to meet potential net outflows of liquidity over a 30-day stress scenario. As a result, there’s a corresponding increased demand for term financing structures on the cash collateral reinvestment side of our business. It is also creating borrower demand for high quality liquid assets such as treasuries for term against other types of security collateral.
We expect to see this continue, which may contribute to wider spreads and increased lending and reinvestment opportunities for our clients that can engage in these transactions.
Many beneficial owners have or are re-visiting their programme guidelines, expanding their programmes and expanding collateral guidelines, as market pressures continue to drive focus around the optimal use of collateral. Beneficial owners are becoming much more focused on their own liquidity and collateral needs, as rules for central clearing of derivatives leads them to post initial and variable margin to support that activity.
Securities lending plays an important role in helping beneficial owners manage their collateral and liquidity needs. These moves come with corresponding expanded requirements around monitoring and reporting on this activity to beneficial owners’ own stakeholders.
Capital requirements and the leverage ratio are driving interest around the utilisation of CCPs. This isn’t a new topic of conversation in the securities finance space, but it continues to attract more serious attention from market participants. We see most CCPs with committees or groups working on potential solutions for the securities finance market—in particular, to address participants’ concerns around added costs, how to maintain confidence when participants don’t get to choose counterparties, and the measures put in place to mitigate various processing risks.
Doug Brown: Most beneficial owners continue to see low yields on cash, given the low interest rate environment, tight spreads and decreased availability of traditional repo. Borrowers increasingly want to deliver equities and other non-traditional collateral against loans, but some beneficial owners face regulatory or statute limitations against taking that collateral. We’re working with these clients to help change these requirements and allow for more flexibility.
Beneficial owners’ primary challenge over the next couple of years is likely to be understanding, complying with and adapting to regulatory reform, which will affect lending participants in different ways. Money market reform may have a larger impact on asset managers, given the floating rate requirement from prime funds. Increased capital requirements for indemnification offering would likely have a larger impact on those beneficial owners that operate programmes with higher levels of general collateral.
Those clients that have the most collateral and counterparty flexibility will see the best returns in the future. We anticipate securities lending will continue to help our clients achieve their desired returns.
George Trapp: It is important to note that beneficial owners that participate in securities lending are able to earn incremental revenue within established risk parameters and a transparent programme. Although there are uncontrollable challenges in the market environment, beneficial owners do have control over their individual programme, such as acceptable collateral, cash investment guidelines and performance of their securities lending agent.
Northern Trust works directly with beneficial owners to establish a specific programme that provides the best risk adjusted return given the client’s risk tolerance.
The biggest challenges to beneficial owners are ongoing regulatory changes and the impact of regulation on borrower demand. Northern Trust is actively monitoring the potential impact of global regulatory developments. We continue to engage with federal agencies on regulations, both directly and through industry groups. The breadth of regulatory proposals has created uncertainty that has weighed upon the market.
As more of these regulations are finalised, we will have greater clarity and be able to assess the direct and indirect effects of the new rules.
Paul Wilson: At the beginning of 2015, US beneficial owners continue to face myriad issues and challenges. The potential for rising interest rates, pension funding challenges, and the velocity of economic recovery in the US against concern for slowing global economic activity, will demand management and staff resources.
Positioning and overseeing securities lending programmes within this environment, so as to maintain them as a source of valuable incremental investment return, will continue to require resource commitment. Beneficial owners also face the challenge of understanding the impact of new capital rules and the way in which they will affect their agent’s ability and capacity to provide indemnification.
Chris Benedict: Regulatory changes could limit the ability for counterparties to execute certain types of trades. This would be a real challenge for the European markets, where specials are fewer and less pronounced than in North America or Asia.
Lance Wargo: The extensive work being done by regulators globally is affecting our industry with new rules, guidelines, and requirements. Some of these directives have been lacking in clarity or are incomplete, causing speculation and concern among beneficial owners. At BNP Paribas, we have allocated internal and external experts to research each regulatory proposal that will affect our industry and have subsequently built an offering that will thrive within this new framework and leave us equipped to be at the forefront of developments and opportunities.
A lack of full transparency is also a challenge facing beneficial owners. We have seen transparency come on leaps and bounds in the past years, with education increasing for beneficial owners both by providers and the industry. But we believe that it can be further improved by fostering continual communication between clients and their providers.
Clients should have the opportunity to call their providers’ desk and ask for market colour, such as what names are trading special or to gain an update on any regulatory requirements that may affect their programmes going forward. Fostering direct communication as well as working on direct client reporting is key to increase education and transparency in the industry.
What about opportunities?
Trapp: Generally speaking, there has been a shift towards higher intrinsic value trading and less appetite for general collateral. Where that manifests itself to the client is that a handful of securities are driving securities lending earnings and have a significant impact during the year. Since it is difficult to predict which stocks will drive revenue, we talk to our clients about the importance of being in a position to benefit from that demand when it occurs.
The key here is ongoing dialogue with clients to understand how they want to customise their programme to take advantage of those opportunities. For some clients, it is to have very few restrictions and try to maximise revenue across their portfolio. For others, it is being very specific about only taking advantage of certain opportunities. So there is no one-size-fits-all approach across our programme.
From a demand perspective, Asian remains buoyant for new opportunities, particularly in India, Indonesia and China. While viable offshore infrastructures are still being developed in these markets, hedge fund demand remains robust and likely to spur significant new revenue streams. Brazil remains a very attractive market, but its lending infrastructure remains challenging. Recent increases in demand due to mergers and acquisitions and initial public offerings are positive. Many market participants expect increasing levels of M&A activity to be a driver of increasing borrower demand.
Brown: We’ve seen increased equity demand as the markets have continued to move higher. It appears investors are being more company-specific about long and short investments, so we’re seeing growing demand to borrow individual stocks. There are opportunities to lend to new counterparties who are either entering the lending space or opening new branches in new locations. There are also opportunities for clients in newer markets, such as Brazil and Malaysia, and hopefully in China as the Hong Kong-Shanghai Connect may help open up that market.
With the anticipated rise in interest rates later in 2015, we expect to see a pick-up in cash collateral investment yields and better demand spreads from US treasuries. The regulations also offer some opportunities, particularly around the liquidity coverage ratio and the need for term funding. For instance, certain client segments, such as pension funds and sovereign investors, may benefit from a migration in borrower demand to term lending.
And we anticipate that the use of non-cash collateral—and particularly non-traditional collateral types—will grow due to more stringent capital and leverage rules and a laser focus on balance sheet management.
Wargo: The macroeconomic environment may lend itself to increased opportunities for beneficial owners in 2015 with increasing interest rates assisting on the reinvestment side of the trade.
There are also opportunities that come from being part of a mature, competitive industry. Beneficial owners are more equipped than ever with a range of options and an arsenal of assets available to them. Beneficial owners can craft a fully customised programme based on their objectives and receive a competitive bid for doing so. The industry has transitioned from being provider-led to being truly focused on beneficial owners in all facets of securities lending.
Wilson: In all stages of the market cycle, opportunities exist for participants willing to explore them. Increased market volatility produces opportunities for beneficial owners as market position takers ramp up strategies that require borrowed securities.
The increasing need for collateralisation in derivatives trading provides opportunities for increased demand for borrowed collateral as well as collateral optimisation to reduce costs and increase portfolio management efficiencies.
Benedict: Beneficial owners will benefit from more competition in the market data space within securities lending. They no longer will have to rely on their own reporting. They will be able to use third-party vendors, such as DataLend, to benchmark their performance on a yearly, quarterly, monthly or ad hoc basis.
Reporting requirements will probably increase as a result of regulation. Beneficial owners will be able to leverage third-party vendors to create reports for regulatory agencies rather than having to invest in infrastructure and resources to do it themselves. Third-party providers offer outsourcing opportunities here too.
Beneficial owners that suspended their programmes after 2008 continue to return to the business despite looming regulations.
Slater: I am optimistic that this will be a good year for securities lending. In 2015, the borrower side will continue to see change. The providers or banks that can optimise from a capital and balance sheet perspective while accommodating borrower demand for collateral will be best positioned for success in the new market environment.
At BNY Mellon, marketplace challenges are identified as opportunities to work consultatively with our clients to deliver the holistic solutions and services that will support their overall investment strategies. We are working hard to bring the right information and the right opportunities to our clients on both the borrower and lender sides.
Knowing our clients and keeping them well informed about upcoming opportunities will be key. This is a remarkable period for the markets. Our clients and counterparties are equally challenged and we are working hard to partner and support their dynamic and evolving needs.
How is indemnification being affected on a day-to-day basis due to new rules? What does the future hold for the practice?
Wargo: Indemnification is under the spotlight in 2015 with updates to the regulatory environment including the Dodd-Frank Act’s Collins Amendment and Basel III’s capital ratio potentially constraining the practice. We believe that indemnification will prove to become a privilege versus an automatic offering in the industry going forward for large US providers. This is due to capital constraints putting pressure on some lending agents. This may lead to some lending agents either not offering indemnification, or if so, increasing costs that may ultimately be funnelled down to beneficial owners.
This is unfortunate, since we believe that indemnification is an important tool to mitigate risk and should not be given up easily. It would be wise for beneficial owners to explore other options and providers before losing indemnification or having their fee splits negatively affected. The largest asset owners and managers will likely be able to retain both their current fee splits and indemnification.
Wilson: The indemnification that securities lending agents offer to beneficial owners have been somewhat undervalued in economic terms as well as in terms of their varying depth and breadth. Regulatory driven changes are demanding that agents interpret and understand the impact of these evolving regulations on their ability to offer, and the cost of providing, these indemnifications. The outcome of these analyses will very likely result in changes to indemnification offerings and price that may differ across agents, and they may also vary by beneficial owner.
We have been adapting to these new rules over the last several years and we feel comfortable with our indemnification offering as evidenced throughout 2014, when we expanded the range of collateral and structures included within our indemnification offering.
Slater: In the past, agent lenders have been able to provide beneficial owners with borrower default indemnification at a relatively low cost. Basel III now requires agent lenders to provide significantly more capital to provide these indemnifications, which ultimately increases the costs for the agent lenders that offer that service to their clients.
Agent lenders have several options in terms of closing this gap. They could try to charge borrowers more for the securities, which would increase revenue. Securities lending margins are often very small relative to the opportunities, so increasing fees even slightly may make trades unworkable.
Lenders could ask for more margin—additional collateral that would help the cost of capital for this service, which may work for some transactions, but it ultimately only increases the cost of capital for the borrower, and again might mean these opportunities are no longer financially viable.
Ultimately, since beneficial owners are the ones reaping the benefits from indemnification, it’s most likely that they will need to bear the costs, either in terms of lower revenue as borrowers and agent lenders expand business with beneficial owners whose requirements do not impose the same indemnification costs, or simply with a lower fee split to cover the difference.
Indemnified securities lending will continue to play a vital role in the market as far as beneficial owners are concerned, and, by extension, agent lenders. But the rulemaking and implementation of regulatory changes will ultimately affect the costs of that indemnification, and the market must change to match.
Brown: I think investor governance and responsibility are reflected in the structuring and monitoring of customised programme guidelines, including eligible counterparties, collateral and the associated margining. The indemnification is a tertiary line of defence. With evolving regulatory influences on the cost of capital, there will be further focus on the equilibrium between client and shareholder value. All products will be considered through that lens, and I think there will be greater diversity in the manner that borrower default indemnification is extended within programmes.
Trapp: Indemnification continues to be an important aspect of the securities lending transaction for beneficial owners. Some industry regulations affect lending agents because of the borrower default indemnification they provide to clients in their securities lending programmes, making it more expensive or limiting. Although there has been progress in the finalisation of various regulations broadly, the treatment of indemnified securities lending transactions is still pending in some cases.
Lending agents continue to evaluate their specific cost and capacity to provide borrower default indemnification. At this time, we do not foresee any wholesale changes to our lending business.
How are fee splits being structured between agents and beneficial owners? Are more incentives required to encourage beneficial owners to the table?
Wargo: Fee splits are also under the spotlight this year as beneficial owners become highly aware of the range of the opportunities afforded to them by the growing number of providers in the industry. The old days of industry-wide standardised fee splits are over. Beneficial owners are looking for competitive, customised offerings that lend fee splits to be considered on a case-by-case basis per the programme proposal at hand.
Brown: Typically, fee splits continue to be a percentage basis, with the client receiving the majority share. The business continues to be very competitive, and this is reflected in the fee splits clients are receiving.
We don’t see a need to offer more financial incentives for beneficial owners to participate in securities lending. Many beneficial owners have altered their programmes since 2008, and we’ve worked with them to create structures so they’re comfortable with the associated risk/return framework.
Trapp: We have seen several beneficial owners entering the securities lending market for the first time, as well as some that have returned to the market after a prolonged absence, encouraged by compelling revenues, competitive fees, and the ability to customise their programmes and establish their risk parameters.
Over the past several years, we have seen new fee arrangements, including a return to bundling services, like custody and securities lending, to provide the optimal fee arrangement.
Slater: While the markets are changing in character and requirements, for beneficial owners holding valuable assets, the markets will find a way for them to continue on in a way that is consistent with their objectives and risk appetite. The fee splits of the past reflected the costs of doing business under the market and regulatory regime of the past.
The current regulatory climate ultimately increases costs on the business, which will affect all participants, but at the same time creating new opportunities for beneficial owners willing to make appropriate adjustments to help bring their requirements into alignment with the market’s demand profile.
Even as regulatory capital costs drive down beneficial owners’ fee share on some trades, new opportunities and growing demand for high quality collateral will no doubt position beneficial owners to find new opportunities that fit their needs.
Wilson: There is a wide range of factors that influence pricing and splits between agents and beneficial owners, including size of assets, type of assets being lent, collateral, cash collateral investment guidelines, reporting requirements, as well as the overall firm-to-firm relationship beyond just securities lending.
We have a sophisticated model that allows us to accurately evaluate the revenue opportunity and costs (including indemnification), and allows us to appropriately price business.
What are beneficial owners considering to encourage more demand from borrowers?
Brown: Some of the options beneficial owners are considering to increase demand are:
New non-cash and repo collateral types, such as equities, corporate bonds and asset-backed securities;
Allowing term loans for either a specific security or for a basket of securities;
Exclusive lending arrangements for certain asset classes, markets or market capitalisation;
Lending in new markets, such as Brazil or Malaysia; and
Expanding their counterparty lists.
Slater: While it’s not really the role of beneficial owners to encourage demand, there are various changes they can make to their programmes to encourage activity and best position themselves to take advantage of borrower demand. For example, there is a lot of growth in terms of broadening collateral acceptability. Borrowers and lenders are both evaluating new opportunities in terms of cash, bonds and other instruments. Collateral choices have a direct impact on both fees and the indemnifications that are asked for or given.
I think that we’ll continue to see change in this area as securities lending participants continue to work through supply and demand issues around collateral. Each organisation has unique requirements, and there is a role for agent lenders to play in terms of presenting clients with information and options to help them make lending programme choices that are right for their own business needs.
Wilson: Beneficial owners looking for opportunities to grow their participation and securities lending returns need to consider broadening the types of collateral that they are willing to accept from borrowers facing changing financing needs and costs. Beneficial owners willing, and able, to accept broad market index equities and other non-traditional, non-cash collateral will increase their value to borrowers and thereby increase their potential for increased returns.
When taking cash collateral, beneficial owners willing to expand on the types, maturities, and term structures of collateral investments will see increased lending opportunities and the potential for increased returns. The impact of money market reforms and the transition to floating NAV (net asset value) institutional money market funds will create additional challenges, and opportunities, for beneficial owners that have traditionally utilised these vehicles for cash collateral investments.
The ability to utilise alternatives to these long-time market standards will offer opportunities to those beneficial owners who expand their cash collateral investment regimes.
Benedict: Broker-dealers have more impetus to engage in ‘balance-sheet friendly’ transactions with leverage ratio and the liquidity coverage ratios coming down the pike. Beneficial owners willing to engage in structured cash collateral term trades with broker-dealers may see increased demand from broker-dealers. This also acts as a potential opportunity for beneficial owners (and agent lenders) on the cash reinvestment side.
Collateral flexibility will also help drive utilisation. High-quality collateral is in demand, and the willingness to accept different grades of collateral from broker-dealers will help spur demand.
Trapp: Over the last several years we have seen beneficial owners returning to the market and increasing participation. Without wanting to increase risk, beneficial owners are considering alternative forms of collateral and term funding opportunities to participate in a wider variety of trade opportunities. These topics are high on borrowers’ lists as they seek to reduce their use of balance sheet.
Wargo: We are seeing an increased interest in beneficial owners exploring how to maximise their portfolios in this low rate environment, whether that be by considering new markets, reviewing a subset of a portfolio that they are not lending, or by extracting revenue through an intrinsic value-based approach.
At BNP Paribas, we explore all of these opportunities with clients directly through providing client access to our specialists on our trading desk as well as our risk and compliance departments in order to maximise revenue within client-directed parameters.
What sorts of collateral are beneficial owners accepting, and how has demand for high quality liquid assets affected what they accept?
Wilson: There has been some increased demand for high quality liquid assets but this in itself has not driven beneficial owners to systematically change their collateral eligibility. Beneficial owners are becoming more open minded and considerate of broadening eligible collateral and considering term structures. Collateral they are accepting includes a broad range of Organisation for Economic Co-operation and Development government bonds and a range of international equity indices.
Benedict: Beneficial owners are still pretty conservative after 2008, with most readily accepting cash and treasuries or sovereigns. However, we are seeing an increase in those accepting high-grade equities and corporate bonds as collateral.
Brown: The volume of non-cash collateralised loans and types pledged—including equities, corporate bonds, sovereign debt and other forms—have grown substantially in the last six years or so. Within our own lending programme, for instance, we’ve seen an increase from 13 percent at the end of 2009 to 40 percent at the end of 2014, and equity non-cash collateral as a percentage of all non-cash collateral received has more than quadrupled in that same time frame.
A focus on liquidity coverage has certainly played a substantial role, with borrowers optimising their balance sheets in part by maximising their use of pledged securities. Improved information systems within prime brokerage houses and improvements within triparty custodians have also allowed brokers to better access and optimise their collateral usage.
Trapp: Collateral acceptance is specific to each client. Historically, the US has been dominated by cash collateral, but beneficial owners are seeing more opportunities for non-cash trades. With our global business platform, Northern Trust is able to provide flexibility to our clients across regions and collateral types.
Each client has its own view on acceptable collateral based its own risk and return tolerance. When it comes to cash collateral, clients need to decide if they are interested in a separately managed account with customised guidelines, or a pooled fund for diversification. Other considerations include how to invest cash collateral, such as whether to follow guidelines similar to Securities and Exchange Commission Rule 2a-7 or to expand beyond that scope.
Over the past several years, we have also seen a wider use and acceptance of non-cash collateral, such as equities, in an effort to take advantage of broader trade opportunities with borrowers.
Wargo: Every beneficial owner is different in their needs and requirements for their programmes. This belief extends itself to the types of collateral that they are willing to accept. Safety of assets and customisation is central to the US BNP Paribas agency lending offering and we therefore tailor programmes in partnership with beneficial owners in order to achieve their objectives within their directed risk tolerance, whether that be straightforward overnight government repo collateral reinvestment or taking on alternative forms of collateral for longer durations.
No beneficial owner has ever suffered losses in a BNP Paribas-directed agency lending programme, which is the result of working closely in partnership with clients to craft strict collateral guidelines.
Slater: While Europe has always been more open to non-cash collateral in general, now US beneficial owners are moving toward accepting a wider variety of non-cash, including equities.
Regulations are changing the markets and, in some cases, creating new opportunities. The rewards are growing in particular for beneficial owners and agent lenders that take a more flexible approach to collateral. BNY Mellon is working closely with its beneficial owner clients, broadening collateral acceptability across different asset classes, moving away from a focus on sovereign debt and cash.
Many beneficial owners are also becoming much more focused on their own liquidity and collateral needs as the new rules for central clearing of derivatives are creating the need to post initial and variable margin to support this activity with high quality liquid assets.
We are also working closely with our clients to structure and assess various trades with close consideration to the potential returns on specific, underlying trades—not just around diversified collateral types. Beneficial owners are becoming more sophisticated and interested in understanding the return drivers behind the choices they make around accepting alternative forms of collateral.
This is a key growth area for the industry, as some beneficial owners may make their first forays into participation in securities lending based on a handful of trading opportunities that fit very closely with their specific needs. Starting small can help beneficial owners build comfort and understanding around the types of lending programmes that make sense for them.
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