How is business at Northern Trust the moment?
Sunil Daswani: Our securities lending business is doing well. Client interest in securities lending continues to grow with new participants joining securities lending programmes and current clients increasing their securities available to lend. Clients are interested in extracting incremental return from their portfolio so long as they have the ability to manage risk. It is a good time for clients to review potential securities lending opportunities and to establish a programme that fits their risk and return objectives, allowing them to capitalise on dynamic market opportunities going forward.
How did the agent lending business in Asia change in the wake of the financial crisis?
John Irwin: The securities lending business in Asia, although not immune to the financial crisis, did show more resilience than other regions, which was largely supported by robust demand for the emerging market space. This demand continues, particularly in South Korea and Taiwan, as spreads and revenue prospects remain compelling.
Despite this trend, the regulatory environment has proven challenging at times amid the imposition of various short selling requirements. Complying with these requirements has demanded careful attention from industry participants, and in many cases, the requirements have been restrictive.
The cost of funding has become increasingly prominent and has driven some borrowers to internalise supply, contributing to lower overall general collateral balances in the market. Ultimately, this has driven lenders to focus even more on maximising incremental revenue from ‘hard to borrow’ securities. The desire from borrowers to pledge cheaper forms of collateral has required lenders to adopt a more flexible product offering to secure business, and this remains a major theme in the region.
For Northern Trust, Asia has increasingly become a more prominent market for clients in terms of incremental revenue as demand continues to outweigh supply, both in emerging and more developed markets, particularly Hong Kong, which has grown into one of the most important and active markets over the last year.
What regulation do you think will change securities lending the most and why?
Daswani: The global regulatory environment is a prominent topic of 2012 with the roll-out of new rules from a multitude of regulations. In Europe, Solvency II, which is the EU directive that codifies and harmonises regulations applicable to insurance companies that are domiciled in the EU, may affect the securities lending industry. As an important investment tool for EU insurers, securities lending transactions and associated collateral fall within the scope of investments and holdings, so we are currently working to ensure that we are able to provide our EU insurance clients with the required granularity of reporting to ensure that they can meet their future regulatory obligations.
In the US, the Volcker Rule as part of the Dodd-Frank Act may have an impact on the industry. The Volcker Rule generally restricts banking entities from engaging in proprietary trading and investing in or sponsoring unregistered private equity funds and hedge funds. In theory, such a restriction should have little impact on securities lending. However, the Volcker Rule’s broad definitions of ‘hedge fund’ and ‘private equity fund’ also encompass certain unregistered cash collateral reinvestment pools that are sponsored by agent lenders. As a result, lending agents may need to consider alternative investment strategies or structures for cash collateral reinvestment.
Northern Trust’s securities lending experts are active in industry associations around the world, allowing us to provide valuable input to the various agencies that are responsible for drafting these new regulations. Our involvement also puts us at the forefront of regulatory and market changes, which ultimately benefits our clients.
What is of particular concern to agent lending?
Irwin: At this time, I would say that there are two topics that most lending agents are focusing on. The first is attempting to anticipate changes in the regulatory environment and their impact given the large variety of rules being rolled out. The second is dealing with subdued levels of trading activity, mostly due to uncertainty surrounding the eurozone and the long bias that hedge funds continue to maintain.
What are collateral demands like in Asia?
Irwin: The ability of a lender to be flexible and accept a variety of collateral provides a competitive advantage as borrowers increasingly look to manage their balance sheets more efficiently in this environment. The cost of pledging US cash and sovereign debt collateral has risen in Asia, as it has in Europe, and therefore, for the majority of borrowers, equity collateral on both a single and cross currency basis has remained a priority for some time. However, there are further flexible forms of collateral that have emerged in Asia, including corporate bonds, JGBs (Japanese government bonds) and yen cash collateral.
What is more important to your clients: quality collateral or high quantities of collateral?
Daswani: Probably both! I would have to say higher quality of collateral given the continued uncertainty in the market. Our clients know that, at Northern Trust, we mark-to-market daily, and if necessary, collateral that is requested each morning is required the same day. We continue to expand the variety of collateral that we can accept on behalf of our clients and provide them with the opportunity to customise the collateral that they accept.
Who are the traditional beneficial owners in Asia and what is their supply like at the moment?
Daswani: Generally, the beneficial owners that are domiciled in Asia and who are clients of Northern Trust are government entities and sovereign wealth funds. Their supply continues to be global across all asset classes and stable in nature.
What about equity supplies?
Irwin: Global equity supply has substantially recovered to the levels that were seen prior to the financial crisis in 2008. This recovery has not only been driven by overall higher equity valuations since the crisis but also, notably, by lenders re-engaging in securities lending. We have seen beneficial owners that had either reduced exposures to the securities lending markets or exited the market entirely re-entering our securities lending programme, as they acknowledge the benefits of participation.
How have hedge funds responded to equity supplies in terms of demand?
Irwin: In general, hedge fund demand has been lower for the last couple of years, as it has been affected by volatility in equity markets and global macroeconomic factors have contributed to uncertainty and a broad-based lack of conviction on the part of investors. Compounding these effects is the uncertainty around the final form of the global financial markets regulatory framework. Many hedge funds continue to be net-long holders of equities, employing possibly little leverage and holding excess levels of liquidity as compared to historical levels. A lack of merger and acquisition activity also contributes to lower demand from arbitrage trading opportunities arising from such events.
Despite overall lower levels of demand, we do continue to see strong interest for borrowing equities in a wide variety of market sectors that are affected by the ongoing global economic slowdown. In addition, ETFs have experienced an uptick in demand as they are generally very liquid and provide investors with relatively easy exposure to the market.
One area experiencing demand away from the hedge fund space is in broker/dealer funding. New regulations are requiring broker/dealers to fund more of their business on a term, rather than an overnight, basis. We have witnessed an increase in collateral-based trades, where borrowers are funding their long holdings by pledging those as collateral for borrows of highly rated sovereign debt or equities; the ‘collateral upgrade’ trade. In addition, regulations requiring that derivatives be collateralised will be a new source of demand in the near future.
How important is technology to Northern Trust’s agent lending business?
Daswani: Northern Trust consistently invests in its technology. We achieve efficiency in technology through our single, global proprietary trading platform. Organic growth enables us to develop and evolve our trading platform, which is a key technological advantage, allowing us to quickly capitalise on trades that others cannot. Our efficient technology and market expertise make us a more attractive partner for global borrowers, allowing us to lend more of our clients’ securities.
Northern Trust’s competitive advantage is gained via a distinctive global infrastructure. Our global presence and single system enable us to optimally connect our clients’ supply with borrower demand around the world at all times.
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