Adapting to change
11 June 2019
Leading market participants discuss how the European securities finance market is adapting and adjusting to the current changing environment
Image: Shutterstock
Ross Bowman
Senior relationship manager, securities lending
BNP Paribas
Ben Challice
Global head of trading services
J.P. Morgan
Mark Jones
Head of securities lending, EMEA
Northern Trust
Simon Nottage
Head of product development, EMEA
State Street 麻豆传媒 Finance
Simon Tomlinson
Head of trading agency securities finance, EMEA
and Americas
BNY Mellon Markets
How is the European securities finance market currently faring and what trends are you seeing?
Simon Tomlinson: It鈥檚 certainly been a mixed start to the year and follows on from a slower Q4 2018, with revenues down year-on-year.
The European securities finance space is feeling the effects of the political stalemate over Brexit and while there was a hope we might see a second-half jump in demand after a March exit from the EU for the UK, the delay until late October has in all likelihood pushed that back into 2020. This is further compounded by the US and China trade tensions and the potential knock-on effects that will be felt in Europe.
Negative interest rates, general spread compression, lack of specials, a short sale ban in Wirecard, de-leveraging and political tension do not make for good reading and these are all playing their part in the current market conditions.
Mark Jones: It鈥檚 been a challenging start to the year following strong performance from multiple asset classes last year. Continued focus on regulatory capital with borrowers maintaining investigations into methods which encourage efficiencies. Borrowers are seeking access to capital efficient beneficial owners, or those with less challenging netting opinions, so-called 鈥榮egregated lending鈥� or 鈥榮mart buckets鈥�.
The recent addition of pledge, as opposed to the traditional title transfer, also highlights the strong desire of our counterparts to seek capital efficiencies. Specifically, collateral switches continue to be sought in fixed income markets as banks look to satisfy liquidity ratios, though a narrower basis swap has led to a reduction in returns more recently. In equity markets, we have seen a further shift in demand from hedge funds with a quant bias. These strategies typically employee low latency execution and require the highest level of trade automation. Northern Trust has benefitted in this respect given our commitment to automated trading.
Ben Challice: Last year was a watermark year in many respects, but the European securities finance market in 2019 remains robust. On the demand side, trends include a further drive towards efficient borrowing鈥攂orrower defined lending, 鈥榮mart bucketing鈥欌�攁long with greater levels of borrower internalisation. This is translating into demand from borrowers for more tailored trade structures and increasingly automated solutions, resulting in more efficient borrowing. We see little sign of this abating.
While pledge has been an industry hot topic and key ask from borrowers for several years, uptake to date has been somewhat muted. Several factors could be contributing to this, starting with the current business cycle where the absolute binding constraint seems to be revenues rather than balance sheet or capital. Other contributors are greater levels of internalisation, use of synthetic structures and even central counterparties (CCPs). Despite limited use, pledge remains a core part of our offering and we expect to see balances increase steadily through 2019 and into 2020.
Following the inclusion of Saudi Arabia in the MSCI, we鈥檙e seeing an increase in borrowing enquiries. We welcome the work that the International 麻豆传媒 Lending Association (ISLA) cross-industry working group is doing to help open this potential new lending market.
On the supply side, we have seen more assets come into lending programmes across beneficial owner sectors/types and a diverse ange of counterparty types. This increase in supply, against a relatively flat borrower demand, poses a challenge for agent lender on two fronts: seeking the right type of assets to bring into lending pools (along with the right type of collateral flexibility), and developing solutions to ensure their client base remains relevant and attractive to borrowers.
Finally, while environmental, social and governance (ESG)-focused investing has been on beneficial owners鈥� agendas for some time, we are seeing renewed interest especially across recalls for voting and demand for wider ESG-compliant collateral sets. We expect ESG to increase in prominence and are working with our clients and the wider industry to provide ESG-enabled solutions.
Simon Nottage: The landscape is changing as a response to increased regulation and developments in technology. Trends including the adoption of technology, combined with increased levels of transparency, have resulted in higher levels of engagement across market participants looking for integrated financing solutions. Overall, there has been a reduction in yield enhancement trading, which when combined with tightening spreads, has ultimately led to increased volumes and activity. The move to non cash collateral and collateral optimisation has continued to develop and will remain a core component of the securities finance ecosystem.
Ross Bowman: Although often viewed as slow to adopt change, the securities lending industry has demonstrated its resilience to all manner of events over the years and continues to deliver strong returns. Last year was a good revenue year for the market, with double-digit revenue percentage increases over 2017.
Against a backdrop of low capital market volatility, as seen through the CBOE VIX Index, lendable and on loan balance inventories remained stable across Q1 2018/19, seeing only a marginal 4 percent drop in average utilisation across all asset classes.
However, the return to lendable (RTL) over the same period fell by 12 percent as traditional European equity seasonal trading volumes reduced and spreads on high-quality liquid assets (HQLA) government bonds fell, impacted by the reduction in demand to finance bank balance sheet assets and the termination of the ECB PSPP in December 2018.
This picture was echoed in the hedge fund industry as, although alpha generation on the whole has been positive in Q1 2019, long biased fund strategies have been the success story as global equity indices have continued to climb.
With the Brexit and US/China trade negotiations still in play and the potential for broader market volatility and financing costs to increase, it is likely that there will be a positive knock-on impact on securities lending revenues.
Are you seeing increased automation in Europe鈥檚 securities lending market?
Challice: Yes, absolutely. When we talk about automation in securities lending, it鈥檚 important to think how creating and harnessing automation in and across pre-trade and post-trade enables a more seamless end-to-end transaction flow and better client experience.
The use of tools such as next-generation trading (NGT) has allowed far greater connectivity and automation over the last few years. The need for this connectivity is evident: at an industry level, there are ~$2.2 to $2.3 trillion of on loan balances at any one time, of which 80 percent are classified as general collateral (GC), typically below 20 basis points. This volume simply can鈥檛 be processed manually, and NGT offers an elegant solution. We have approximately 70 percent of all agency trade flows already automated with further growth expected, driven by fixed income borrowing (particularly government bonds).
Automation significantly reduces operational costs and risks, and also allows trading teams to focus on more high-value revenue opportunities and the overall client experience, where technology and data are vital enablers. The ability to aggregate and analyse large data sets support better-informed trading decisions, the identification of new revenue opportunities aligned with each beneficial owner鈥檚 investment mandate, and enhanced performance information.
Nottage: The environment is developing along with two key themes; automating pre- and post-trade processing and the adoption of new technologies. Participants are developing and integrating automation. Part of the securities finance strategy is to adopt and leverage platforms to improve the pre- and post-trade efficiencies. The adoption of new technologies, such as artificial intelligence (AI) and distributed ledger technologies (DLT), is happening as part of a wider transformational change at group levels which will feed into securities finance. This combined approach is necessary to maintain market position and deliver innovative client solutions.
Jones: The levels of automated trading deployment continue at a pace but there is still some way to go. Northern Trust has invested heavily to position ourselves as a market leader and benefits greatly from frictionless trading. The aforementioned growth in quantitative-based trading strategies is emphasising this all the more. Borrowers are increasingly focused on executing and pricing securities lending transactions with lenders in as frictionless a way as possible, as they seek to reduce execution latency and reduce human touch in the trade lifecycle.
EquiLend鈥檚 NGT is viewed as an important tool to leverage in this regard, as the industry looks at ways to increase efficiencies across global trading desks. Northern Trust鈥檚 significant capital investment in the integration of NGT within its proprietary trading platform is allowing us to continue to be recognised as a market leader in this increasingly important part of an agent lenders product offering.
The role of new technology such as AI and robotics undoubtedly have a role to play in the future evolution of the industry. At Northern Trust, we are actively working with these new technologies in order to identify ways to enrich everything from trading strategies and data analytics to operational efficiencies.
We also believe that blockchain (or DLT) can have a transformative impact on the industry, as has been discussed over recent years. We believe this technology has multiple applications and can help deliver significant benefits, including increased transparency, enhanced risk management, and operating efficiency. What is interesting is the increase in the practical application of the technology in various markets that are now occurring, there鈥檚 a new story on this almost every day. Northern Trust already has a track record of integrating this technology into other areas of its business, and we remain focused on exploring opportunities to deploy it across our capital markets business.
Bowman: Yes. However, due to the over-the-counter (OTC) and un-commoditised nature of the securities lending market, automation has largely been confined to back-office reconciliation processes through the application of technologies offered by companies such as Pirum and DataLend to drive operational efficiency. Triggered, at least initially, by the broad-based adoption of trading technologies such as DataLend, NGT, and more recently spurred on by the enhanced connectivity that will be required under the 麻豆传媒 Financing Transactions Regulation (SFTR), there is a palpable sense that true innovation within the industry lies just around the corner. More than at any other time in the history of the industry, we have seen an explosion in technology start-ups right across banking and capital markets businesses, all looking for opportunities to disintermediate the historic chains that have been synonymous within the securities lending industry, particularly: beneficial owner鈥攁gent鈥� borrower鈥攈edge fund. With the overwhelming drive by banks to efficiently manage collateral inventory across their businesses, technologies that help firms reduce the significant capital costs of doing business and generate enhanced automation across all aspects of the product life-cycle will help drive down fixed costs. Businesses that are service providers within these participant chains will need to be more nimble than ever, adopting change through a combination of in-house and externally-sourced solutions.
Tomlinson: Yes, automation is key to any successful participant in this business. This ranges from the basic straight-through processing (STP) trading of the low margin, high volume business via a platform like Equilend or directly via our own trading platform up to the use of AI and machine learning to improve pricing and the way we look to distribute our client鈥檚 assets.
At BNY Mellon, we have made a major commitment to our securities finance business in terms of technology and infrastructure. For example, in December we purchased the securities lending intellectual property from Trading Apps. After a successful multi-year relationship and the accelerated pace of change taking place in the industry, we felt it advantageous to firmly take control of the direction of the product positioning us to lead change, quickly being able to adapt the programme and position us to deliver increased opportunities to our clients.
We are excited by the potential ahead of us.
Ultimately, we are all being asked to do more with less and there is only one real way you can do that which is by automating manual processes, improving connectivity and creating smart solutions for both clients and counterparties.
How can technology be leveraged in the collateral space?
Nottage: Technology is a key driver in providing collateral management and optimisation solutions. The new transparency regimes will make data more readily available and force increased automation to improve settlement levels. The application of prudential regulations (Basel III) has led to an increase in the use of non-cash collateral and structures to manage the risk-weighted asset (RWA) usage, such as English law pledge. It is anticipated that the improved market-wide data and digitisation of the operating environments will allow further developments in collateral management with portfolios to be actively managed across different limits. This will also allow increased correlation and new structures to be added.
Tomlinson: Technology already plays a huge part in the collateral space, as lenders and borrowers would not be able to manage the complexity of their collateral requirements without it.
In the near term, the digitisation of collateral schedules and the workflow around their agreements will reduce the time to market. With the mobilisation and optimisation of collateral a key factor for any borrower, the ability to do that easily across multiple collateral boxes becomes a huge differentiator for any tri-party service provider.
BNY Mellon鈥檚 tri-party offering has these capabilities either live or due imminently, and during the course of this year we will see wider use of our online collateral schedule platform, RULE, which simplifies the schedule set up and maintenance, and ECPO, which provides continuous portfolio optimisation across borrowers; various collateral holdings.
Beyond these important developments, the discussion around tokenisation continues and it will be interesting to see how that progresses.
Bowman: Technology will continue to play an increasing role in supporting securities lending players鈥� crucial needs for efficient management of their collateral pool. The integration between Tri-party collateral agents and trading or matching platforms is now offering a full STP post-trade chain for collateral management and a solution to meet SFTR requirements.
Technology should now be leveraged to facilitate the negotiation and the day-to-day management of eligibility schedules. But where technology will also need to play a key role is around anticipation and optimisation of collateral allocation across activities. Simulation engines should enable a consolidated view of collateral activity with associated eligibility terms and selection criteria to be built. This should serve to better anticipate needs and make the best use of the collateral to be allocated across all trading relationships.
New ways to exchange collateral and improve settlement using technology such as blockchain will definitely drive us towards new capacities, more flexibility and opportunities.
Challice: While technology has been an increasing differentiator for collateral management for many years, the speed and demand for change is increasing and is multi-faceted. As the collateral ecosystem looks to build increasingly automated and sophisticated tools, all actors within the end-to-end collateral flow have different challenges to solve for. This demands a collaborative approach as one participant cannot create a solution in isolation, and there鈥檚 an opportunity for a solution that targets one problem to have much broader application.
As one example, the drive for increasingly sophisticated optimisation by collateral providers cannot be tackled by developing a best-in-class optimiser as a standalone solution: you need to approach the problem holistically. Without up-to-date eligibility schedules, exposure calculations and available inventory, even the best optimiser will be ineffective. To be effective, optimisation needs eligibility schedules to be digitised in order that they can be automatically consumed. When schedules are digitised, the end-to-end workflow to update them can then be industrialised through user interfaces and application interfaces.
Another example would be asset mobilisation. Industry players and technology need to combine to reduce friction in the movement of assets in order to increase efficiency in liquidity and optimisation. As an enabler, a unified global collateral management platform can help to quickly mobilise and optimise collateral across regions and legal entities. More broadly, tokenisation is widely discussed as a possible technological solution that would foster liquidity, asset mobility and velocity along with other, as-yet-unknown, benefits.
How is regulation impacting the industry in Europe?
Bowman: In recent years, conversation in the industry has been dominated by regulation and its impacts. Regulation focused on investor protection such as the second Markets in Financial Instruments Directive (MiFID II) and the European 麻豆传媒 and Markets Authority (ESMA) has driven changes in market practices and financial conduct, while Basel III regulation has placed additional requirements on banks to maintain higher levels of capital and liquidity.
SFTR and the Central 麻豆传媒 Depositories Regulation (CSDR) are challenging market infrastructure and practices. The real test for the industry will be how the market copes with the reporting obligations under SFTR next year.
Nottage: The new regulatory regimes, such as CSDR and SFTR, are a central focus for market participants and require a significant amount of allocation of both personnel and budget resources. All indications from local regulators seem to suggest that the implementation of a firm鈥檚 regulatory solution will be closely scrutinised and penalties will be applied for insufficient adherence. The increasing cost of providing securities lending may lead to possible market consolidation where smaller participants may exit due to the cost of compliance, while the new market level transparency is encouraging new asset owners to look at participating in a securities finance programme.
Jones: SFTR and CSDR dominate the regulatory agenda at present. We鈥檝e talked about SFTR for a number of years now, and with the deadline now set, efforts across the industry is intensifying.
CSDR presents a different set of challenges but could be potentially just as impactful. The settlement discipline regime that comes into force later in 2020 will demand that the industry becomes as efficient as possible in terms of trade matching and settlement if we are to avoid the fines and mandatory buy-ins that are being introduced.
As a lender, we will need to consider the things we can do to ensure our instructions are timely and that any issues are resolved quickly.
Frequent buy-ins as a result of failing returns would be detrimental to the beneficial owner client base and risk of reduced supply exists if we get this wrong as an industry. The work ISLA are doing around the best practice is going to be helpful, and it鈥檚 interesting that the end goal of efficient trade booking and settlement practices will also have overlapping benefits for SFTR.
Tomlinson: Regulation is not new and has been an ongoing theme since 2008. However, it does feel as though 2020 will finally see the end of the larger development initiatives such as SFTR and CSDR.
Right now you may argue that a significant amount of tech spend and resource has been focused on meeting these regulatory demands, and this has limited the discretionary level of spending on developing solutions to enhance productivity and revenues.
However, you only have to look at how the market has evolved and continues to develop to know that is not the case. Regulation, while in most cases costly to implement, has also brought about a significant opportunity for those able to quickly adapt.
For example, in June 2018 we printed our first pledge transaction and saw steady growth in balances which will continue as more lenders sign up. In H1 2019 we will be looking to clear our first European SFT via Eurex and this again will be something that will gain traction as regulators are keen for this to become more widely utilised. These developments have come about because of the challenges new regulation has placed on businesses and the need to become efficient in the use of financial resources.
So while regulation has, without doubt, had a significant impact on the industry, it has also brought opportunity in the form of new trade structures and routes to market, with more focus on the efficient use of limited resources.
Challice: SFTR is the single biggest shift in the industry on the horizon and, given its scale, could drive consolidation in the securities financing industry. If that consolidation is combined with effective solutions and offers, it could present a significant opportunity to create a more efficient market. SFTR, along with CSDR, will also affect the collateral space. As significant undertakings for the industry as a whole, the hope and expectation is that implementing these regulations might drive further industry collaboration, data standardisation and technology solutions. Uncleared margin rules segregated initial margin rules are quickly coming into scope for the buy side in September 2020. Although primarily a derivatives conversation, providing an end-to-end solution brings together a number of core competencies offered by securities services providers: custodians providing control accounts, collateral managers agreeing and exchanging initial margin and securities financing transforming available securities into eligible collateral. While none of these services is new, served collectively they create a solution that is greater than the sum of the parts for institutions adapting to regulatory driven change.
Across the board, regulation continues to dominate in terms of how both borrowers and lenders manage to binding constraints鈥攄riving the need to find solutions that optimise collateral structures, such as pledge, CCP, collateral allocation methodologies and inter-entity structures.
How is your firm preparing for SFTR?
Challice: We are working closely with all affected parties to prepare for SFTR. On the industry side, we鈥檝e engaged with both ISLA and ICMA to ensure that we are in line with industry best practices for reporting under SFTR as we work through the roadmap, and are working with ISLA to respond to the consultation on guidelines for reporting under articles 4 and 12 of SFTR released by ESMA on 27 May 2019.
We are partnering with our clients to make sure they are aware of SFTR and the service we will provide to them for reporting, and working with borrower counterparties to ensure they are aware of how we aim to share data with them to support their SFTR reporting obligations. The key technology components are in an advanced development phase and we expect to begin testing with vendor partners and counterparties later this year in order to have sufficient time to identify and address any issues. We are also beginning to formulate the target operating model that will support the SFTR reporting service.
Tomlinson: BNY Mellon began its SFTR project around two years ago, and over that time we have been an important contributor in the refining of the regulation, both with the regulator directly and via the excellent work of the industry associations.
As one of the first agent lenders to sign to a vendor solution in the third quarter of 2017, BNY Mellon is leveraging existing post-trade data feeds to provide near real-time, legal entity identifier-level transaction and collateral data, as well as UTI allocation.
As a result, we are already in the early stages of data provision and have the ability to reconcile with similarly connected counterparties. Despite having no direct obligation under SFTR, we fully understand the importance of the role that agent lenders will have to play in the provision of assisted/delegated reporting solutions for their clients and, as importantly, the provision of data to in-scope counterparties. This is also why a partnership with a vendor solution was chosen since the connectivity for both reconciliation and the dispersal of data would have been difficult to achieve in isolation.
In preparation for the April 2020 鈥榞o live鈥�, we intend to continue to dedicate resource to the industry associations in the defining of reporting 鈥榖est practice鈥�, the ongoing collation and refining of loan and collateral data, and look to begin testing as soon as possible as the best way to ensure the accuracy of our data and that of our in-scope borrowers.
Jones: We are in the midst of our preparation for SFTR with multiple workstreams active. We are working closely with our vendor and technology teams on the core system build we need to produce the data in the right way, and at the same time analysing our processes across front office and operations to ensure that the data we are producing is as accurate and complete as possible before it leaves our organisation.
Through this process, we are definitely seeing that a lot of firms we speak to are more comfortable with the mechanics of the requirement, and are switching focus to less obvious impacts such as how their own long-established practices fit in with the regulation and what they might need to change to get their reporting right. Overall, the industry will benefit from this exercise and we鈥檒l come out of it understanding the way our counterparts manage their processes better than ever before. This can only be a good thing for market efficiency, standardisation, and automation.
We鈥檝e also stepped up our client communication programme to ensure the lenders on whose behalf we will be reporting are well informed and have the information they need to be comfortable with the progress and end result of the implementation.
Bowman: SFTR and MiFID II have driven the shift in demand across the securities lending market, where financial regulation has materially impacted the level of balance sheet capital banks and broker-dealers can allocate to borrowing securities. Such regulation has reduced demand as the cost to borrow through a securities lending transaction has increased and alternative financial instruments including the use of synthetics and swaps have emerged to provide banks with a similar level of desired market exposure but at a reduced balance sheet cost.
At BNP Paribas, we are addressing the needs of our clients who are required to report under SFTR. Under a dedicated bank-wide transversal project, we have partnered with IHS Markit and Pirum, collating all the requirements now known under the final operating model. We are fully committed to providing our clients with the necessary reporting to fulfil their requirements under the regulation, whether this is through providing reporting to our clients or reporting directly on their behalf.
Nottage: State Street is fully engaged and working collaboratively with different parties across the securities finance ecosystem in building a scalable operating model that will support current and future business volumes to provide the data, governance and reporting to meet the regulatory requirements. State Street has engaged with vendor platforms to support the operational matching and reconciliation of trading and the management of collateral to develop the required reporting solutions for the trade repositories. There is an open dialogue with both borrowers and lenders to socialise the State Street solution and our response to these regulations.
What are the biggest challenges that the industry faces?
Bowman: Aside from macro-economic and market factors that impact our industry, enhanced regulation in the form of SFTR and CSDR remain a primary focus of attention for market participants. Although an incredible amount of time and resource is being consumed across the market in readiness for these regulations, they are not the only challenge on the horizon.
Borrower demand and behaviour should also be a key area of focus as the increasing cost of balance sheet capital for a securities lending transaction has reduced borrower demand and pushed banks and broker-dealers towards synthetics and swaps as alternative instruments for financing. The consideration of pledge collateral over title transfer has gained much traction in the last 12 months and it is widely expected that the adoption of Pledge will become increasingly important for the industry鈥檚 longevity going forward.
Nottage: Regulations, and how they are implemented globally, are a central challenge. The new regulatory regimes will disrupt current operating and technology models and necessitate a change in the workforce to be able to respond to these changes. The ability of participants to react and adapt quickly to these changes will be a key challenge.
Tomlinson: In the short term, the regulation still remains the biggest challenge for the industry. A number of the post-crisis rules have come into force already and some of them are due to go live in 2020 and onwards, all bringing with them significant change.
The industry will be focusing on SFTR and CSDR, as they are on the horizon now, the former brings about a reporting regime like nothing we have ever seen before, and the scale and cost of development to meet this requirement is as significant as the amount of information that will be flowing to the regulator.
CSDR will change the way we lend, the buffers that are held, and may reduce liquidity as lenders ensure they do not create unwanted fail activity. This will require significant attention and effort, necessitating both technology and process change.
Jones: Borrowers are increasingly discerning around the clients they wish to transact with. The type and jurisdiction of the underlying beneficial owner have increasingly become a deciding trading factor as country risk classifications drive appetite and RWA usage. This may negatively impact client performance and revenue if remedial measures are not established. This will likely be in the form of pledge, CCPs, collateral expansion, and stability guarantees, for example.
In addition, regulation continues to prompt a greater focus on technology. Firms who have not taken a good look at their systems architecture and made efforts to move with the evolution of available technology will likely struggle to remain relevant in this fast-moving marketplace.
Challice: The challenges we need to address with the highest priority would be compliance with the three upcoming regulations which will have a specific impact on securities finance. Whilst SFTR and CSDR may be European in origin, they will have an extraterritorial impact and are likely to change trading behaviour. For these, we鈥檇 like to see better industry consensus in terms of operating models; the fact that ISLA continues to have open questions on 50 fields demonstrates the level of uncertainty around how SFTR will be implemented.
There a number of other challenges/inefficiencies related to the industry, many of which are not new but are increasingly in the spotlight as their impact on financial resources becomes more evident. Unfortunately, it鈥檚 impossible for one organisation to fix these in isolation and the market participants mostly seem focused on the implementation of their own
regulatory solutions.
How is the securities finance industry in Europe dealing with Brexit uncertainty?
Challice: There has been an active dialogue with our clients and counterparties with respect to their and our plans to deal with each potential outcome of Brexit. We feel confident, that given our footprint across the UK and Europe, that there will be no disruption of business whatever the outcome.
Jones: From a trading perspective, the Brexit impact has thankfully been relatively light so far. We have witnessed some borrowers open European entities which have led to some contract repapering and new agreements in some instances鈥攖he same for some beneficial owner clients as well. In terms of market specifics, while demand for UK gilts has declined in recent years, this is largely following the trend of other highly-rated sovereign issuers, thus Brexit cannot be fully blamed. In equity markets, there remain pockets of demand for Brexit-related stocks, such as home builders, autos and financial services. However, the full impact will not be known while the political uncertainty remains.
Tomlinson: Looking at the first three quarters of 2018, one would have said Brexit was having little or no impact outside of discussions on operating models post-Brexit, as well as the potential need to set up documentation with new entities that were being considered.
However, in the first quarter, the wider political tensions鈥攐f which Brexit was a part鈥攖ook hold. Leverage was reduced and has not come back. Like BNY Mellon, most firms worked diligently towards the 29 March initial deadline and had everything set up prior to that, so all the extension has done is prolonged the already muted demand to borrow.
Nottage: Many participants have implemented Brexit plans and strategies to support their business in Europe and the UK with the key goal of ensuring that impacted clients continue to have a seamless service and are unaffected by possible political changes in the future.
Looking to the future, what opportunities do you see on the horizon for Europe鈥檚 securities finance industry?
Tomlinson: Despite the slow start this year, I remain confident the future is bright for the industry. The influx of new assets to lending programmes and new routes to market will continue as additional revenue streams are sought; technology will continue to play a huge part in connecting the buy and sell side; regulatory compliance will drive demand for HQLA. This will only increase as phase 4 and 5 of the uncleared margin rules come into force.
Interestingly, these markets seem to be able to shrug off bad news and political tension much more easily than in the past but at some point, volatility will be back providing an opportunity for the market.
Nottage: The ability to offer securities finance solutions through different channels; for example, State Street is developing a new product offering Direct Access. This new product introduces the concept of peer-to-peer lending, bespoke structures and new collateral arrangements, to ensure businesses can run efficiently and profitably in line with the new regulatory regimes. Being able to retain and attract key talent is essential to remaining competitive and developing integrated client-driven solutions. This is where deep client relationships will require a combination of strong business understanding with technology and possible solutions.
Jones: The use of automated processes, algorithms, and self-learning programmes, largely encompassed under 鈥榤achine learning鈥�, offers an exciting opportunity for the industry.
Additionally, beneficial owners who have flexibility within their programme parameters will be well positioned to take advantage of future opportunities. This may be in the form of non-standard collateral acceptance, or via new trading structures or routes to market.
The ongoing expansion of the industry鈥檚 global footprint continues to represent an exciting opportunity. While opportunities in Europe are more limited, the neighbouring Middle East represents an exciting new prospect. As this region looks to diversify their economy away from their reliance on hydrocarbons, governments are seeking to encourage greater foreign investment.
The implementation of securities lending and covered short-selling programmes will be key as they look to develop their capital markets capabilities. In Saudi Arabia, the authorities have already implemented a series of new regulations to help facilitate securities lending and covered short selling, the first for a Gulf state. More work is required to deliver a workable operating model, however, this represents an exciting development in a region that offers significant long-term potential.
Another noticeable change will come from the increasing demands of our clients to offer a suite of products. The days of securities lending as a standalone offering are in the past. Clients are increasingly looking to their asset servicers and agent lenders to provide the infrastructure they need to run their business as efficiently as possible. This may be as simple as mobilising collateral for margin purposes or deploying/raising capital, through to more structured initiatives in order to satisfy regulatory requirements.
Challice: Putting a positive spin on my previous comment, if the industry gets this right we will all have better, timelier data in standardised syntax which will then allow both pre- and post-trade inefficiencies to be addressed.
Before that, though, the settlement discipline which CSDR requires will create new demands to borrow securities (to facilitate timely settlement), as will the third of the three regulations we mentioned鈥擯hases 4 and 5 of the uncleared margin rules. While this isn鈥檛 directly related to securities finance, the need for a joined-up solution to let clients mobilise their assets in the most efficient way--alpha generation from lending versus cheapest-to- deliver to meet their margin obligations鈥攃alls for a joined-up approach between custody, collateral management and agency securities lending. We believe this to be a large opportunity for organisations who can provide a connected outsourced solution to clients to achieve that goal, and is a key priority for us.
Bowman: Charles Darwin said that 鈥渢he species that survives is the one that is able to adapt and adjust best to the changing environment in which it finds itself鈥�. Our industry is no different. Revenue opportunities continue for lenders of specials, general collateral and collateral swap/high-quality liquid assets transactions. However, the extent of these opportunities is a fundamental question. Annual lending returns fluctuate as a result of underlying market volatility and macro-economic and political events. A successful lending industry will, therefore, need to continue to adapt to change. Pledge, CCPs, regulation, adoption of environmental, social, and governance criteria, amongst others, will play an increasingly important role in the development of the industry over the coming years, to maintain revenue stability and growth.
Senior relationship manager, securities lending
BNP Paribas
Ben Challice
Global head of trading services
J.P. Morgan
Mark Jones
Head of securities lending, EMEA
Northern Trust
Simon Nottage
Head of product development, EMEA
State Street 麻豆传媒 Finance
Simon Tomlinson
Head of trading agency securities finance, EMEA
and Americas
BNY Mellon Markets
How is the European securities finance market currently faring and what trends are you seeing?
Simon Tomlinson: It鈥檚 certainly been a mixed start to the year and follows on from a slower Q4 2018, with revenues down year-on-year.
The European securities finance space is feeling the effects of the political stalemate over Brexit and while there was a hope we might see a second-half jump in demand after a March exit from the EU for the UK, the delay until late October has in all likelihood pushed that back into 2020. This is further compounded by the US and China trade tensions and the potential knock-on effects that will be felt in Europe.
Negative interest rates, general spread compression, lack of specials, a short sale ban in Wirecard, de-leveraging and political tension do not make for good reading and these are all playing their part in the current market conditions.
Mark Jones: It鈥檚 been a challenging start to the year following strong performance from multiple asset classes last year. Continued focus on regulatory capital with borrowers maintaining investigations into methods which encourage efficiencies. Borrowers are seeking access to capital efficient beneficial owners, or those with less challenging netting opinions, so-called 鈥榮egregated lending鈥� or 鈥榮mart buckets鈥�.
The recent addition of pledge, as opposed to the traditional title transfer, also highlights the strong desire of our counterparts to seek capital efficiencies. Specifically, collateral switches continue to be sought in fixed income markets as banks look to satisfy liquidity ratios, though a narrower basis swap has led to a reduction in returns more recently. In equity markets, we have seen a further shift in demand from hedge funds with a quant bias. These strategies typically employee low latency execution and require the highest level of trade automation. Northern Trust has benefitted in this respect given our commitment to automated trading.
Ben Challice: Last year was a watermark year in many respects, but the European securities finance market in 2019 remains robust. On the demand side, trends include a further drive towards efficient borrowing鈥攂orrower defined lending, 鈥榮mart bucketing鈥欌�攁long with greater levels of borrower internalisation. This is translating into demand from borrowers for more tailored trade structures and increasingly automated solutions, resulting in more efficient borrowing. We see little sign of this abating.
While pledge has been an industry hot topic and key ask from borrowers for several years, uptake to date has been somewhat muted. Several factors could be contributing to this, starting with the current business cycle where the absolute binding constraint seems to be revenues rather than balance sheet or capital. Other contributors are greater levels of internalisation, use of synthetic structures and even central counterparties (CCPs). Despite limited use, pledge remains a core part of our offering and we expect to see balances increase steadily through 2019 and into 2020.
Following the inclusion of Saudi Arabia in the MSCI, we鈥檙e seeing an increase in borrowing enquiries. We welcome the work that the International 麻豆传媒 Lending Association (ISLA) cross-industry working group is doing to help open this potential new lending market.
On the supply side, we have seen more assets come into lending programmes across beneficial owner sectors/types and a diverse ange of counterparty types. This increase in supply, against a relatively flat borrower demand, poses a challenge for agent lender on two fronts: seeking the right type of assets to bring into lending pools (along with the right type of collateral flexibility), and developing solutions to ensure their client base remains relevant and attractive to borrowers.
Finally, while environmental, social and governance (ESG)-focused investing has been on beneficial owners鈥� agendas for some time, we are seeing renewed interest especially across recalls for voting and demand for wider ESG-compliant collateral sets. We expect ESG to increase in prominence and are working with our clients and the wider industry to provide ESG-enabled solutions.
Simon Nottage: The landscape is changing as a response to increased regulation and developments in technology. Trends including the adoption of technology, combined with increased levels of transparency, have resulted in higher levels of engagement across market participants looking for integrated financing solutions. Overall, there has been a reduction in yield enhancement trading, which when combined with tightening spreads, has ultimately led to increased volumes and activity. The move to non cash collateral and collateral optimisation has continued to develop and will remain a core component of the securities finance ecosystem.
Ross Bowman: Although often viewed as slow to adopt change, the securities lending industry has demonstrated its resilience to all manner of events over the years and continues to deliver strong returns. Last year was a good revenue year for the market, with double-digit revenue percentage increases over 2017.
Against a backdrop of low capital market volatility, as seen through the CBOE VIX Index, lendable and on loan balance inventories remained stable across Q1 2018/19, seeing only a marginal 4 percent drop in average utilisation across all asset classes.
However, the return to lendable (RTL) over the same period fell by 12 percent as traditional European equity seasonal trading volumes reduced and spreads on high-quality liquid assets (HQLA) government bonds fell, impacted by the reduction in demand to finance bank balance sheet assets and the termination of the ECB PSPP in December 2018.
This picture was echoed in the hedge fund industry as, although alpha generation on the whole has been positive in Q1 2019, long biased fund strategies have been the success story as global equity indices have continued to climb.
With the Brexit and US/China trade negotiations still in play and the potential for broader market volatility and financing costs to increase, it is likely that there will be a positive knock-on impact on securities lending revenues.
Are you seeing increased automation in Europe鈥檚 securities lending market?
Challice: Yes, absolutely. When we talk about automation in securities lending, it鈥檚 important to think how creating and harnessing automation in and across pre-trade and post-trade enables a more seamless end-to-end transaction flow and better client experience.
The use of tools such as next-generation trading (NGT) has allowed far greater connectivity and automation over the last few years. The need for this connectivity is evident: at an industry level, there are ~$2.2 to $2.3 trillion of on loan balances at any one time, of which 80 percent are classified as general collateral (GC), typically below 20 basis points. This volume simply can鈥檛 be processed manually, and NGT offers an elegant solution. We have approximately 70 percent of all agency trade flows already automated with further growth expected, driven by fixed income borrowing (particularly government bonds).
Automation significantly reduces operational costs and risks, and also allows trading teams to focus on more high-value revenue opportunities and the overall client experience, where technology and data are vital enablers. The ability to aggregate and analyse large data sets support better-informed trading decisions, the identification of new revenue opportunities aligned with each beneficial owner鈥檚 investment mandate, and enhanced performance information.
Nottage: The environment is developing along with two key themes; automating pre- and post-trade processing and the adoption of new technologies. Participants are developing and integrating automation. Part of the securities finance strategy is to adopt and leverage platforms to improve the pre- and post-trade efficiencies. The adoption of new technologies, such as artificial intelligence (AI) and distributed ledger technologies (DLT), is happening as part of a wider transformational change at group levels which will feed into securities finance. This combined approach is necessary to maintain market position and deliver innovative client solutions.
Jones: The levels of automated trading deployment continue at a pace but there is still some way to go. Northern Trust has invested heavily to position ourselves as a market leader and benefits greatly from frictionless trading. The aforementioned growth in quantitative-based trading strategies is emphasising this all the more. Borrowers are increasingly focused on executing and pricing securities lending transactions with lenders in as frictionless a way as possible, as they seek to reduce execution latency and reduce human touch in the trade lifecycle.
EquiLend鈥檚 NGT is viewed as an important tool to leverage in this regard, as the industry looks at ways to increase efficiencies across global trading desks. Northern Trust鈥檚 significant capital investment in the integration of NGT within its proprietary trading platform is allowing us to continue to be recognised as a market leader in this increasingly important part of an agent lenders product offering.
The role of new technology such as AI and robotics undoubtedly have a role to play in the future evolution of the industry. At Northern Trust, we are actively working with these new technologies in order to identify ways to enrich everything from trading strategies and data analytics to operational efficiencies.
We also believe that blockchain (or DLT) can have a transformative impact on the industry, as has been discussed over recent years. We believe this technology has multiple applications and can help deliver significant benefits, including increased transparency, enhanced risk management, and operating efficiency. What is interesting is the increase in the practical application of the technology in various markets that are now occurring, there鈥檚 a new story on this almost every day. Northern Trust already has a track record of integrating this technology into other areas of its business, and we remain focused on exploring opportunities to deploy it across our capital markets business.
Bowman: Yes. However, due to the over-the-counter (OTC) and un-commoditised nature of the securities lending market, automation has largely been confined to back-office reconciliation processes through the application of technologies offered by companies such as Pirum and DataLend to drive operational efficiency. Triggered, at least initially, by the broad-based adoption of trading technologies such as DataLend, NGT, and more recently spurred on by the enhanced connectivity that will be required under the 麻豆传媒 Financing Transactions Regulation (SFTR), there is a palpable sense that true innovation within the industry lies just around the corner. More than at any other time in the history of the industry, we have seen an explosion in technology start-ups right across banking and capital markets businesses, all looking for opportunities to disintermediate the historic chains that have been synonymous within the securities lending industry, particularly: beneficial owner鈥攁gent鈥� borrower鈥攈edge fund. With the overwhelming drive by banks to efficiently manage collateral inventory across their businesses, technologies that help firms reduce the significant capital costs of doing business and generate enhanced automation across all aspects of the product life-cycle will help drive down fixed costs. Businesses that are service providers within these participant chains will need to be more nimble than ever, adopting change through a combination of in-house and externally-sourced solutions.
Tomlinson: Yes, automation is key to any successful participant in this business. This ranges from the basic straight-through processing (STP) trading of the low margin, high volume business via a platform like Equilend or directly via our own trading platform up to the use of AI and machine learning to improve pricing and the way we look to distribute our client鈥檚 assets.
At BNY Mellon, we have made a major commitment to our securities finance business in terms of technology and infrastructure. For example, in December we purchased the securities lending intellectual property from Trading Apps. After a successful multi-year relationship and the accelerated pace of change taking place in the industry, we felt it advantageous to firmly take control of the direction of the product positioning us to lead change, quickly being able to adapt the programme and position us to deliver increased opportunities to our clients.
We are excited by the potential ahead of us.
Ultimately, we are all being asked to do more with less and there is only one real way you can do that which is by automating manual processes, improving connectivity and creating smart solutions for both clients and counterparties.
How can technology be leveraged in the collateral space?
Nottage: Technology is a key driver in providing collateral management and optimisation solutions. The new transparency regimes will make data more readily available and force increased automation to improve settlement levels. The application of prudential regulations (Basel III) has led to an increase in the use of non-cash collateral and structures to manage the risk-weighted asset (RWA) usage, such as English law pledge. It is anticipated that the improved market-wide data and digitisation of the operating environments will allow further developments in collateral management with portfolios to be actively managed across different limits. This will also allow increased correlation and new structures to be added.
Tomlinson: Technology already plays a huge part in the collateral space, as lenders and borrowers would not be able to manage the complexity of their collateral requirements without it.
In the near term, the digitisation of collateral schedules and the workflow around their agreements will reduce the time to market. With the mobilisation and optimisation of collateral a key factor for any borrower, the ability to do that easily across multiple collateral boxes becomes a huge differentiator for any tri-party service provider.
BNY Mellon鈥檚 tri-party offering has these capabilities either live or due imminently, and during the course of this year we will see wider use of our online collateral schedule platform, RULE, which simplifies the schedule set up and maintenance, and ECPO, which provides continuous portfolio optimisation across borrowers; various collateral holdings.
Beyond these important developments, the discussion around tokenisation continues and it will be interesting to see how that progresses.
Bowman: Technology will continue to play an increasing role in supporting securities lending players鈥� crucial needs for efficient management of their collateral pool. The integration between Tri-party collateral agents and trading or matching platforms is now offering a full STP post-trade chain for collateral management and a solution to meet SFTR requirements.
Technology should now be leveraged to facilitate the negotiation and the day-to-day management of eligibility schedules. But where technology will also need to play a key role is around anticipation and optimisation of collateral allocation across activities. Simulation engines should enable a consolidated view of collateral activity with associated eligibility terms and selection criteria to be built. This should serve to better anticipate needs and make the best use of the collateral to be allocated across all trading relationships.
New ways to exchange collateral and improve settlement using technology such as blockchain will definitely drive us towards new capacities, more flexibility and opportunities.
Challice: While technology has been an increasing differentiator for collateral management for many years, the speed and demand for change is increasing and is multi-faceted. As the collateral ecosystem looks to build increasingly automated and sophisticated tools, all actors within the end-to-end collateral flow have different challenges to solve for. This demands a collaborative approach as one participant cannot create a solution in isolation, and there鈥檚 an opportunity for a solution that targets one problem to have much broader application.
As one example, the drive for increasingly sophisticated optimisation by collateral providers cannot be tackled by developing a best-in-class optimiser as a standalone solution: you need to approach the problem holistically. Without up-to-date eligibility schedules, exposure calculations and available inventory, even the best optimiser will be ineffective. To be effective, optimisation needs eligibility schedules to be digitised in order that they can be automatically consumed. When schedules are digitised, the end-to-end workflow to update them can then be industrialised through user interfaces and application interfaces.
Another example would be asset mobilisation. Industry players and technology need to combine to reduce friction in the movement of assets in order to increase efficiency in liquidity and optimisation. As an enabler, a unified global collateral management platform can help to quickly mobilise and optimise collateral across regions and legal entities. More broadly, tokenisation is widely discussed as a possible technological solution that would foster liquidity, asset mobility and velocity along with other, as-yet-unknown, benefits.
How is regulation impacting the industry in Europe?
Bowman: In recent years, conversation in the industry has been dominated by regulation and its impacts. Regulation focused on investor protection such as the second Markets in Financial Instruments Directive (MiFID II) and the European 麻豆传媒 and Markets Authority (ESMA) has driven changes in market practices and financial conduct, while Basel III regulation has placed additional requirements on banks to maintain higher levels of capital and liquidity.
SFTR and the Central 麻豆传媒 Depositories Regulation (CSDR) are challenging market infrastructure and practices. The real test for the industry will be how the market copes with the reporting obligations under SFTR next year.
Nottage: The new regulatory regimes, such as CSDR and SFTR, are a central focus for market participants and require a significant amount of allocation of both personnel and budget resources. All indications from local regulators seem to suggest that the implementation of a firm鈥檚 regulatory solution will be closely scrutinised and penalties will be applied for insufficient adherence. The increasing cost of providing securities lending may lead to possible market consolidation where smaller participants may exit due to the cost of compliance, while the new market level transparency is encouraging new asset owners to look at participating in a securities finance programme.
Jones: SFTR and CSDR dominate the regulatory agenda at present. We鈥檝e talked about SFTR for a number of years now, and with the deadline now set, efforts across the industry is intensifying.
CSDR presents a different set of challenges but could be potentially just as impactful. The settlement discipline regime that comes into force later in 2020 will demand that the industry becomes as efficient as possible in terms of trade matching and settlement if we are to avoid the fines and mandatory buy-ins that are being introduced.
As a lender, we will need to consider the things we can do to ensure our instructions are timely and that any issues are resolved quickly.
Frequent buy-ins as a result of failing returns would be detrimental to the beneficial owner client base and risk of reduced supply exists if we get this wrong as an industry. The work ISLA are doing around the best practice is going to be helpful, and it鈥檚 interesting that the end goal of efficient trade booking and settlement practices will also have overlapping benefits for SFTR.
Tomlinson: Regulation is not new and has been an ongoing theme since 2008. However, it does feel as though 2020 will finally see the end of the larger development initiatives such as SFTR and CSDR.
Right now you may argue that a significant amount of tech spend and resource has been focused on meeting these regulatory demands, and this has limited the discretionary level of spending on developing solutions to enhance productivity and revenues.
However, you only have to look at how the market has evolved and continues to develop to know that is not the case. Regulation, while in most cases costly to implement, has also brought about a significant opportunity for those able to quickly adapt.
For example, in June 2018 we printed our first pledge transaction and saw steady growth in balances which will continue as more lenders sign up. In H1 2019 we will be looking to clear our first European SFT via Eurex and this again will be something that will gain traction as regulators are keen for this to become more widely utilised. These developments have come about because of the challenges new regulation has placed on businesses and the need to become efficient in the use of financial resources.
So while regulation has, without doubt, had a significant impact on the industry, it has also brought opportunity in the form of new trade structures and routes to market, with more focus on the efficient use of limited resources.
Challice: SFTR is the single biggest shift in the industry on the horizon and, given its scale, could drive consolidation in the securities financing industry. If that consolidation is combined with effective solutions and offers, it could present a significant opportunity to create a more efficient market. SFTR, along with CSDR, will also affect the collateral space. As significant undertakings for the industry as a whole, the hope and expectation is that implementing these regulations might drive further industry collaboration, data standardisation and technology solutions. Uncleared margin rules segregated initial margin rules are quickly coming into scope for the buy side in September 2020. Although primarily a derivatives conversation, providing an end-to-end solution brings together a number of core competencies offered by securities services providers: custodians providing control accounts, collateral managers agreeing and exchanging initial margin and securities financing transforming available securities into eligible collateral. While none of these services is new, served collectively they create a solution that is greater than the sum of the parts for institutions adapting to regulatory driven change.
Across the board, regulation continues to dominate in terms of how both borrowers and lenders manage to binding constraints鈥攄riving the need to find solutions that optimise collateral structures, such as pledge, CCP, collateral allocation methodologies and inter-entity structures.
How is your firm preparing for SFTR?
Challice: We are working closely with all affected parties to prepare for SFTR. On the industry side, we鈥檝e engaged with both ISLA and ICMA to ensure that we are in line with industry best practices for reporting under SFTR as we work through the roadmap, and are working with ISLA to respond to the consultation on guidelines for reporting under articles 4 and 12 of SFTR released by ESMA on 27 May 2019.
We are partnering with our clients to make sure they are aware of SFTR and the service we will provide to them for reporting, and working with borrower counterparties to ensure they are aware of how we aim to share data with them to support their SFTR reporting obligations. The key technology components are in an advanced development phase and we expect to begin testing with vendor partners and counterparties later this year in order to have sufficient time to identify and address any issues. We are also beginning to formulate the target operating model that will support the SFTR reporting service.
Tomlinson: BNY Mellon began its SFTR project around two years ago, and over that time we have been an important contributor in the refining of the regulation, both with the regulator directly and via the excellent work of the industry associations.
As one of the first agent lenders to sign to a vendor solution in the third quarter of 2017, BNY Mellon is leveraging existing post-trade data feeds to provide near real-time, legal entity identifier-level transaction and collateral data, as well as UTI allocation.
As a result, we are already in the early stages of data provision and have the ability to reconcile with similarly connected counterparties. Despite having no direct obligation under SFTR, we fully understand the importance of the role that agent lenders will have to play in the provision of assisted/delegated reporting solutions for their clients and, as importantly, the provision of data to in-scope counterparties. This is also why a partnership with a vendor solution was chosen since the connectivity for both reconciliation and the dispersal of data would have been difficult to achieve in isolation.
In preparation for the April 2020 鈥榞o live鈥�, we intend to continue to dedicate resource to the industry associations in the defining of reporting 鈥榖est practice鈥�, the ongoing collation and refining of loan and collateral data, and look to begin testing as soon as possible as the best way to ensure the accuracy of our data and that of our in-scope borrowers.
Jones: We are in the midst of our preparation for SFTR with multiple workstreams active. We are working closely with our vendor and technology teams on the core system build we need to produce the data in the right way, and at the same time analysing our processes across front office and operations to ensure that the data we are producing is as accurate and complete as possible before it leaves our organisation.
Through this process, we are definitely seeing that a lot of firms we speak to are more comfortable with the mechanics of the requirement, and are switching focus to less obvious impacts such as how their own long-established practices fit in with the regulation and what they might need to change to get their reporting right. Overall, the industry will benefit from this exercise and we鈥檒l come out of it understanding the way our counterparts manage their processes better than ever before. This can only be a good thing for market efficiency, standardisation, and automation.
We鈥檝e also stepped up our client communication programme to ensure the lenders on whose behalf we will be reporting are well informed and have the information they need to be comfortable with the progress and end result of the implementation.
Bowman: SFTR and MiFID II have driven the shift in demand across the securities lending market, where financial regulation has materially impacted the level of balance sheet capital banks and broker-dealers can allocate to borrowing securities. Such regulation has reduced demand as the cost to borrow through a securities lending transaction has increased and alternative financial instruments including the use of synthetics and swaps have emerged to provide banks with a similar level of desired market exposure but at a reduced balance sheet cost.
At BNP Paribas, we are addressing the needs of our clients who are required to report under SFTR. Under a dedicated bank-wide transversal project, we have partnered with IHS Markit and Pirum, collating all the requirements now known under the final operating model. We are fully committed to providing our clients with the necessary reporting to fulfil their requirements under the regulation, whether this is through providing reporting to our clients or reporting directly on their behalf.
Nottage: State Street is fully engaged and working collaboratively with different parties across the securities finance ecosystem in building a scalable operating model that will support current and future business volumes to provide the data, governance and reporting to meet the regulatory requirements. State Street has engaged with vendor platforms to support the operational matching and reconciliation of trading and the management of collateral to develop the required reporting solutions for the trade repositories. There is an open dialogue with both borrowers and lenders to socialise the State Street solution and our response to these regulations.
What are the biggest challenges that the industry faces?
Bowman: Aside from macro-economic and market factors that impact our industry, enhanced regulation in the form of SFTR and CSDR remain a primary focus of attention for market participants. Although an incredible amount of time and resource is being consumed across the market in readiness for these regulations, they are not the only challenge on the horizon.
Borrower demand and behaviour should also be a key area of focus as the increasing cost of balance sheet capital for a securities lending transaction has reduced borrower demand and pushed banks and broker-dealers towards synthetics and swaps as alternative instruments for financing. The consideration of pledge collateral over title transfer has gained much traction in the last 12 months and it is widely expected that the adoption of Pledge will become increasingly important for the industry鈥檚 longevity going forward.
Nottage: Regulations, and how they are implemented globally, are a central challenge. The new regulatory regimes will disrupt current operating and technology models and necessitate a change in the workforce to be able to respond to these changes. The ability of participants to react and adapt quickly to these changes will be a key challenge.
Tomlinson: In the short term, the regulation still remains the biggest challenge for the industry. A number of the post-crisis rules have come into force already and some of them are due to go live in 2020 and onwards, all bringing with them significant change.
The industry will be focusing on SFTR and CSDR, as they are on the horizon now, the former brings about a reporting regime like nothing we have ever seen before, and the scale and cost of development to meet this requirement is as significant as the amount of information that will be flowing to the regulator.
CSDR will change the way we lend, the buffers that are held, and may reduce liquidity as lenders ensure they do not create unwanted fail activity. This will require significant attention and effort, necessitating both technology and process change.
Jones: Borrowers are increasingly discerning around the clients they wish to transact with. The type and jurisdiction of the underlying beneficial owner have increasingly become a deciding trading factor as country risk classifications drive appetite and RWA usage. This may negatively impact client performance and revenue if remedial measures are not established. This will likely be in the form of pledge, CCPs, collateral expansion, and stability guarantees, for example.
In addition, regulation continues to prompt a greater focus on technology. Firms who have not taken a good look at their systems architecture and made efforts to move with the evolution of available technology will likely struggle to remain relevant in this fast-moving marketplace.
Challice: The challenges we need to address with the highest priority would be compliance with the three upcoming regulations which will have a specific impact on securities finance. Whilst SFTR and CSDR may be European in origin, they will have an extraterritorial impact and are likely to change trading behaviour. For these, we鈥檇 like to see better industry consensus in terms of operating models; the fact that ISLA continues to have open questions on 50 fields demonstrates the level of uncertainty around how SFTR will be implemented.
There a number of other challenges/inefficiencies related to the industry, many of which are not new but are increasingly in the spotlight as their impact on financial resources becomes more evident. Unfortunately, it鈥檚 impossible for one organisation to fix these in isolation and the market participants mostly seem focused on the implementation of their own
regulatory solutions.
How is the securities finance industry in Europe dealing with Brexit uncertainty?
Challice: There has been an active dialogue with our clients and counterparties with respect to their and our plans to deal with each potential outcome of Brexit. We feel confident, that given our footprint across the UK and Europe, that there will be no disruption of business whatever the outcome.
Jones: From a trading perspective, the Brexit impact has thankfully been relatively light so far. We have witnessed some borrowers open European entities which have led to some contract repapering and new agreements in some instances鈥攖he same for some beneficial owner clients as well. In terms of market specifics, while demand for UK gilts has declined in recent years, this is largely following the trend of other highly-rated sovereign issuers, thus Brexit cannot be fully blamed. In equity markets, there remain pockets of demand for Brexit-related stocks, such as home builders, autos and financial services. However, the full impact will not be known while the political uncertainty remains.
Tomlinson: Looking at the first three quarters of 2018, one would have said Brexit was having little or no impact outside of discussions on operating models post-Brexit, as well as the potential need to set up documentation with new entities that were being considered.
However, in the first quarter, the wider political tensions鈥攐f which Brexit was a part鈥攖ook hold. Leverage was reduced and has not come back. Like BNY Mellon, most firms worked diligently towards the 29 March initial deadline and had everything set up prior to that, so all the extension has done is prolonged the already muted demand to borrow.
Nottage: Many participants have implemented Brexit plans and strategies to support their business in Europe and the UK with the key goal of ensuring that impacted clients continue to have a seamless service and are unaffected by possible political changes in the future.
Looking to the future, what opportunities do you see on the horizon for Europe鈥檚 securities finance industry?
Tomlinson: Despite the slow start this year, I remain confident the future is bright for the industry. The influx of new assets to lending programmes and new routes to market will continue as additional revenue streams are sought; technology will continue to play a huge part in connecting the buy and sell side; regulatory compliance will drive demand for HQLA. This will only increase as phase 4 and 5 of the uncleared margin rules come into force.
Interestingly, these markets seem to be able to shrug off bad news and political tension much more easily than in the past but at some point, volatility will be back providing an opportunity for the market.
Nottage: The ability to offer securities finance solutions through different channels; for example, State Street is developing a new product offering Direct Access. This new product introduces the concept of peer-to-peer lending, bespoke structures and new collateral arrangements, to ensure businesses can run efficiently and profitably in line with the new regulatory regimes. Being able to retain and attract key talent is essential to remaining competitive and developing integrated client-driven solutions. This is where deep client relationships will require a combination of strong business understanding with technology and possible solutions.
Jones: The use of automated processes, algorithms, and self-learning programmes, largely encompassed under 鈥榤achine learning鈥�, offers an exciting opportunity for the industry.
Additionally, beneficial owners who have flexibility within their programme parameters will be well positioned to take advantage of future opportunities. This may be in the form of non-standard collateral acceptance, or via new trading structures or routes to market.
The ongoing expansion of the industry鈥檚 global footprint continues to represent an exciting opportunity. While opportunities in Europe are more limited, the neighbouring Middle East represents an exciting new prospect. As this region looks to diversify their economy away from their reliance on hydrocarbons, governments are seeking to encourage greater foreign investment.
The implementation of securities lending and covered short-selling programmes will be key as they look to develop their capital markets capabilities. In Saudi Arabia, the authorities have already implemented a series of new regulations to help facilitate securities lending and covered short selling, the first for a Gulf state. More work is required to deliver a workable operating model, however, this represents an exciting development in a region that offers significant long-term potential.
Another noticeable change will come from the increasing demands of our clients to offer a suite of products. The days of securities lending as a standalone offering are in the past. Clients are increasingly looking to their asset servicers and agent lenders to provide the infrastructure they need to run their business as efficiently as possible. This may be as simple as mobilising collateral for margin purposes or deploying/raising capital, through to more structured initiatives in order to satisfy regulatory requirements.
Challice: Putting a positive spin on my previous comment, if the industry gets this right we will all have better, timelier data in standardised syntax which will then allow both pre- and post-trade inefficiencies to be addressed.
Before that, though, the settlement discipline which CSDR requires will create new demands to borrow securities (to facilitate timely settlement), as will the third of the three regulations we mentioned鈥擯hases 4 and 5 of the uncleared margin rules. While this isn鈥檛 directly related to securities finance, the need for a joined-up solution to let clients mobilise their assets in the most efficient way--alpha generation from lending versus cheapest-to- deliver to meet their margin obligations鈥攃alls for a joined-up approach between custody, collateral management and agency securities lending. We believe this to be a large opportunity for organisations who can provide a connected outsourced solution to clients to achieve that goal, and is a key priority for us.
Bowman: Charles Darwin said that 鈥渢he species that survives is the one that is able to adapt and adjust best to the changing environment in which it finds itself鈥�. Our industry is no different. Revenue opportunities continue for lenders of specials, general collateral and collateral swap/high-quality liquid assets transactions. However, the extent of these opportunities is a fundamental question. Annual lending returns fluctuate as a result of underlying market volatility and macro-economic and political events. A successful lending industry will, therefore, need to continue to adapt to change. Pledge, CCPs, regulation, adoption of environmental, social, and governance criteria, amongst others, will play an increasingly important role in the development of the industry over the coming years, to maintain revenue stability and growth.
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