No longer born equal
07 June 2016
Experts discuss the possible Brexit, fears over the future of repo and how business is faring in Europe, as well as their most vivid memories of the past 25 years with the ISLA conference coming up later in June
Image: Shutterstock
This month marks ISLA’s 25th anniversary conference. What have been your highlights during the past quarter of a century in securities lending?
Robert Chiuch: Using 1991 as a reference point, I was then on the ‘equity loan post’ at Levesque Beaubien (now National Bank Financial) in Toronto. Ignoring the various stress events and bubbles over that period, three industry themes come immediately to mind: industry consolidation, technology and globalisation. I nostalgically recall dealing with BNP Paribas, Chemical Bank, Chase Manhattan Bank and Salomon Brothers, to name a few, each as distinctly separate entities. MS Office 1.0 launched in 1990. Google officially launched in the 1990s, and it’s amazing how truly global this business has become.
Personally, being part of the team that helped launch the CIBC Mellon JV, being a co-founder and the first president of the Canadian Â鶹´«Ã½ Lending Association, and being invited to join BNY Mellon in the US, were among my highlights.
Dan Copin: In those 25 years, we have seen the evolution of securities lending from a back office service to a front-office profit centre. There has also been a marked increase in product sophistication (synthetics, financing, liquidity and collateral management), which has grown in line with the complexity of the capital markets. This increasing complexity, and the 2008 market crisis, has led to numerous initiatives seeking to better regulate business, such as the naked short selling ban, Basel, the European Â鶹´«Ã½ and Markets Authority (ESMA), Solvency I and II, and strengthened regulatory reporting requirements.
Alex Lawton: In the 42 years that State Street’s securities finance programme has been operating, there have been three events that stand out as transformational developments in relation to the structure of the industry.
First was the founding of EquiLend by State Street and nine other major industry participants in 2000. This was a quantum leap in improving the automation and efficiency of the industry, and Next Generation Trading (NGT) will soon take this to the next level.
Second was the impact of regulatory change following the Lehman Brothers collapse and subsequent financial crisis. This has rendered the securities lending market almost unrecognisable today versus its pre-Lehman state, and the effects of this will continue to impact how we approach risk, liquidity and capital for years to come.
Third was the launch of State Street’s enhanced custody product in 2010. This was created in response to client demand and highlighted a need for safer, differentiated financing solutions and an alternative to the traditional prime brokerage model.
Laurence Marshall: Over the last 25 years, the industry has shared many highlights. The 1990s delivered great expansion of the securities lending and repo markets, both with the globalisation of markets and legal, regulatory and fiscal barriers removed to support the growth. In 1996, the UK market opened up, lifting the restrictions and removing the privileges of the gilt-edged market makers and stock exchange money brokers. As global capital markets grew, so did the securities finance markets, with more and more participants increasing the level of competition. The marketplace has developed and matured with the creation and increasing use of trading venues and third-party providers supporting an increasingly complex trading lifecycle.
Throughout this time, the securities finance market has of course also had to overcome the occasional bump. Helping to identify and deliver a new structure with the International Â鶹´«Ã½ Lending Association and creating the CEO role of the industry organisation when we did remains a pleasing memory.
Felix Oegerli: In the rather early stages of international securities lending, there were a few visionaries who foresaw the emergence of a combined securities lending, repo and collateral trading market and they have now seen this vision become reality. Of course, in retrospect, this has happened in an evolutionary way and in their eyes with a delay of at least a decade.
I am very proud of how the business has evolved. Twenty-five years ago securities lending markets were opaque and the business was managed opportunistically. The product was only to a certain extent strategic in nature but made a lot of money, which one may of course also call strategic. It has now become a key element of financial markets while being a strategic business function of larger intermediaries. Collateral velocity, further standardisation as a basis for the growing importance of electronic trading/matching venues and more effective post-trade services such as clearing are still ongoing challenges. The future for securities finance is still bright.
Paul Wilson: Two things really stand out for me. Firstly, during this time the industry faced two material defaults, with the collapse of Lehman Brothers clearly being the largest and most complex. It was really the first time that the ‘model’ and unwind were put to the test. And while the industry learned some lessons in the process, the unwind event occurred for the most part exactly like it was supposed to. I think for our clients and for beneficial owners contemplating lending for the first time, they can take great comfort from this. One could possibly argue that with the lower volumes and higher levels of capital supporting the industry today compared to that at the time of Lehman’s demise, the industry is even better placed to handle something similar in magnitude in the future.
Secondly, the securities lending and financing industry has proved to be remarkably resilient with an ability to adapt. In this regard it has gained great credibility. Seldom now do you see debates on questioning the relative merits of lending—the positive case for the liquidity it brings to the market (even more important today) and the earnings it brings to beneficial owners (much of which ends up in the hands of savers and pensioners via pensions funds or mutual funds) has pretty much been won. The industry has innovated and continues to adapt to demand, regulations, client needs. It has also continued to find ways to generate positive returns for participants.
Sunil Daswani: Overall, we have seen securities lending evolve into being a more efficient and impactful business for our clients. For Northern Trust, highlights include significant expansion in our client reporting, the creation of custom funds for non-cash collateral, and the expansion of our collateral and borrower options.
The growth of securities lending into new markets has been significant. Over the last few years alone, Northern Trust has entered new markets such as South Korea in 2002, Israel in 2010, Taiwan and Poland in 2012, and Brazil in 2015. We have also expanded the location of our trading desks strategically around the world so our business can function 24 hours a day. Australia is a key focus for our capital markets business this year and going forward. We currently have desks in London, Hong Kong and Toronto to enhance our service to clients and further underscore our commitment to the market.
The period has also been marked by increased collaboration within the industry. In particular, Northern Trust, along with nine other leading securities lenders and borrowers, founded EquiLend to connect borrowers and lenders through a common, standards-based global lending platform.
This platform facilitates market liquidity through increased efficiency and speed—ultimately reducing both cost and risk—and has proved to be an extremely positive industry development.
In the past year, what developments have most affected your day-to-day business, either positively or negatively, in Europe?
Wilson: Macroeconomic issues and challenges both inside and outside of Europe have been a significant influence on the business environment. Only recently, I was reviewing year-to-date performance and loan activity with one of our sovereign clients, and it was remarkable how evident these macro themes were both in terms of positive earnings uplift year-over-year but also in places where earnings have fallen, such as yield enhancement.
Technology continues to be front, line and center of our business strategy. We have made great progress in replacing our legacy lending platforms and we continue to focus on enhancing the tools on the trading desk, including NGT, as well as delivering enhanced reporting and analytics to our clients. With the industry of the cusp of potential change, technology is critical to embracing and taking advantage of changing business models as well growing our third-party/non-custody business.
Daswani: Regulatory rules on capital have been at the front and centre of everyone’s agenda in the past 12 months. These rules have introduced different drivers of demand from our borrowers and an increased focus on the cost of capital from the agent’s perspective. Today, they are a significant additional factor in our decision making.
Automation and efficiency remain at the heart of what we do on a day-to-day-basis, so investments in that area also have been a particular focus for our program recently, including the introduction of Equilend’s NGT. NGT is scheduled to be implemented later this year and will enable more automation of loan execution across general collateral and ‘specials’, allowing traders to take advantage of attractive lending opportunities.
Marshall: Clients continued to focus on extracting greater value from our platform, which remains a positive development for us at EquiLend. The launch of Swaptimization, our swaps matching platform, in both the UK and US has delivered great value to our clients and increased the breadth of product that we deliver to them. More and more of my time these days is spent on the regulatory agenda, particularly our project plan to enable us to meet our Markets in Financial Instruments Directive (MiFID) II requirements.
Copin: The main factor that affect the daily securities lending business is regulation from the buy side, including ESMA, Solvency I and II and other national regulations. On the sell side, it has been mainly naked short selling, reporting, risk-weighted assets and liquidity ratios.
Clearly, market uncertainty has also been a key element affecting the daily business, as we’ve seen much volatility and experienced negative interest rates.
Lawton: The UCITS V implementation in March 2016 was significant because the additional liabilities it placed on depositories meant that it was no longer viable for agent lenders to accept collateral on a pledge basis for UCITS funds. Any borrowers using an Master Â鶹´«Ã½ Loan Agreement instead of a Global Master Â鶹´«Ã½ Lending Agreement (GMSLA)—mostly US and Canadian entities—had to be either turned off for UCITS clients or re-papered with a non-pledge agreement. For State Street, this resulted in approximately $300 million of loans having to be either swapped to non-UCITS clients or non-US and Canadian borrower entities with GMSLAs.
On the fixed income side, European Central Bank (ECB) policy and the move to negative interest rates had a direct impact on cash reinvestment processes. Traditional repo collateral has become less liquid in short dates and, for clients that cannot reinvest in longer duration, this has limited the balances that can be run over month/quarter-ends as the risk of uninvested cash has significantly increased.
On the trading side, are there any emerging trends you’ve noted so far in 2016? How is European business faring?
Marshall: The year started very strongly with increased flow in European securities across our trading platform, driven primarily by activity in the UK as well as in fixed income—both corporate and sovereign bonds. March was a slightly slower month with a decrease in activity, but volumes bounced back in April, with the trend continuing upward.
Lawton: The continuing decline in demand for European equities during peak season has been the most notable impact. Based on aggregated industry data from Markit, peak loan balances from agent lenders in Europe fell 14.8 percent from the 2015 peak, and that number was down 18.9 percent from the 2014 peak. That’s a 31 percent drop in peak European equity balances in two years.
While demand for European equities has fallen across the board in Q2, Germany has been the most impacted market by far. Aggregated data from Markit shows that peak loan balances in Germany have fallen 62.3 percent versus the peak of 2015 and 70.2 percent versus two years ago.
Despite this, State Street’s European business is faring well. We have secured several new clients and upsells, many of them bringing new sources of revenue, which will not cannibalise existing business, and demand for sovereign debt remains strong, particularly on a term upgrade basis.
Wilson: Overall, while there have been some ups and some downs, European business across the industry has fared fairly well so far this year. Within equities trading, corporate events and rights trades, short coverage, and opportunities in financing structures such as bond floor and single-line term, have helped to partially offset the long predicted and expected decline in yield enhancement.
Within fixed income, while Germany has traded at a slight premium, most notably the 10-year maturities, the market has generally remained fairly even keeled, with solid demand for high-quality liquid assets (HQLAs). Demand for corporate bonds, notably in financial and commodity-based issues, has been very strong, especially in Q1. There has been a bit of a slowdown more recently due to the equity sell-off and dealers’ being short of equity inventory, but the demand for collateral upgrade and capital- and balance sheet-effective trades has continued.
We have found our client base very open minded to these, especially investors with a longer term investment horizon, such as pension funds, insurance companies and sovereigns. We have also seen a material pick up in the demand for third-party, non-custody lending. This is driven by a change in the business models, approach and areas of focus by agent lenders, which has in turn meant that beneficial owners are looking to match agents to their risk/reward profile more than ever. We anticipate these trends and themes will continue throughout 2016.
Copin: The new regulatory framework drives participants to seek out new business ideas and set industry trends rolling. We note that there is an emerging trend seeking to optimise all the positions held. Furthermore, product customisation initiatives see the development of bespoke solutions for client, and counterparties alike.
Daswani: Borrowers are focusing more on complex term maturity structures, both for financing long positions and for maintaining adequate levels of HQLAs to satisfy regulatory-driven requirements.
While we maintain strong volumes in our open book of transactions, we have reacted to market change by terming assets in well-laddered maturity tenors—in both fixed bullet and evergreen structures—where sufficient risk reward is priced.
Our counterparty base continues to focus on collateral mobilisation, with lenders benefiting from the ability to better react to market evolution. Beneficial owners that can adopt a more flexible approach in their lending guidelines, both in terms of collateral type and maturity profiles, will be better positioned to take advantage of any trading opportunities.
Chiuch: There are probably fewer emerging trends these days as opposed to existing trends that are evolving. Many of the themes remain the same: regulation, central counterparties (CCPs), technological innovation, collateral optimisation and so on. I believe what’s generally different for 2016 is the intensity of engagement around implementation schedules regarding looming deadlines or even, perhaps, in response to reactive competitive forces.
What impact do you think the UK leaving the EU might have on securities lending?
Daswani: A so-called ‘Brexit’ would likely speak uncertainty in capital markets over a number of areas. These would include the exchange rate of sterling, UK interest rates and the country’s credit rating. In the short-term, there could also be concerns over the overall stability of the UK economy and financial system.
While the Bank of England is prepared to provide liquidity to calm potentially volatile markets, we would expect a downshift in yield curves and a flight to quality trade, further depressing yields in the highest quality issuers. However, demand for gilts is unlikely to see much change, while appetites for UK equities will continue to be mainly driven by microeconomic factors.
Most financial institutions have a significant presence in the UK as a gateway into the EU market. Depending on the final terms of an exit, we could see market participants opening new offices or transferring staff to EU jurisdictions. These changes will increase costs through reduced efficiencies that are currently gained by having a single trading location for the eurozone.
Lawton: The most significant direct impact is likely to be market volatility. However, it’s difficult to predict whether that will be positive or negative. Understandably, a potential weakening of GBP could reduce UK returns for borrowers or lenders whose budgets are set in USD or EUR, but market volatility can create stronger directional interest in sectors or specific securities, which creates higher demand.
The most likely other direct impact is that certain banks or broker dealers decide to relocate out of the UK due to MiFID passporting requirements or some other less favourable treatment. Theoretically this is not a problem as the industry is very familiar with cross-border relationships and legal agreements, but it will depend on the regulatory framework established between the UK and the EU.
Marshall: I am concerned that a vote to leave will have a negative impact on financial services in Europe, particularly in the UK. Would it lead to firms relocating activities to a country within the EU to continue to enjoy the cross-border activity? If so, it is likely that the securities finance activity transacted from London will decline. The threat to the passport across Europe is a concern for us and something that we need to plan for if the UK were to leave the union.
European repo has been hammered in the past year. Is this a temporary feature during a period of industry adjustment to new regulations and low interest rates, or more permanent?
Daswani: Increased regulation, namely Basel III, has played a major part in reducing banks’ balance sheets globally and the return required to justify the business is higher—which ultimately widens spreads. In addition, actions by central banks such as the introduction of negative rates, asset purchases and targeted long-term refinancing operations have contributed greatly to the sharp decline mentioned above. Although the environment is unlikely to change in the near future, the decline should ease over the longer-term. Banks are already conforming to Basel III and the outlook for more aggressive easing by the ECB, as we saw in March, is less likely.
Copin: It is impossible to tell at this stage as too much uncertainty remains with new regulations coming into force, compounded by the low interest rate situation. The market is still trying to adapt its strategy to this new situation.
The only thing the industry is sure of is that the situation cannot continue in a long run and will eventually have to change as it always has done in the past.
Chiuch: Low interest rates and new regulations have combined to challenge the euro fixed income repo market. Repo balances have deteriorated and we have seen some borrowers generally exit the repo space, except for strategic funding trades, due to the heavy balance sheet costs. Part of this problem is in theory temporary, meaning eventual growth in the eurozone may lead to higher interest rates. That likely won’t happen any time soon, though, especially as they have recently cut rates and expanded quantitative easing in response to poor growth. Regulation, however, is probably secular in nature with a full pending implementation list.
Lawton: The question is when and how will central banks’ policy on negative rates and quantitative easing be reversed. Regulation is here to stay for the foreseeable future and that will continue to drive the need for HQLAs and term funding. Until this policy is reversed, it is likely to continue to limit short-end funding until such time as banks see balance sheets growing, but that does not appear to be imminent.
Wilson: Over the past few years, the repo market has been affected as banks adjust to meet the new regulatory framework. This has perhaps been most significantly felt through the impact of the leverage ratio, which has been reducing repo activity for highly-rated securities (such as government paper), which are low margin and balance sheet-intensive. The effects of these changes are likely to be largely permanent as their adoption, albeit with global implementation proceeding at varying paces and with some slight variation, will be a binding factor on bank activity, and will affect how they allocate limited balance sheet. However, these changes may also allow for increased scope for non-bank repo participants.
Additionally, the decision by the ECB to lower interest rates into negative territory, provide targeted longer-term refinancing operations and quantitative easing programmes, while signalling a willingness to do more if required, has left front-end rates compressed into negative territory for large segments of the curve for a prolonged period of time. This very cheap central bank funding, alongside wider repo market bid/ask spreads, and with market levels often trading close to the deposit rate, has meant the ECB has become both lender and borrower of first resort respectively to different segments of the market (cash seekers and cash holders).
While this central bank policy has softened the impact of market adjustments in the new post-crisis regulatory regime, the ECB balance sheet will eventually decline and central bank funding will be replaced by market funding. Consequently, there are some concerns about how the repo market would function without this ECB liquidity support to the market.
Looking forward, what topics do you see dominating the industry in Europe in the second half of this year?
Chiuch: On the surface, a number of themes will likely dominate the spotlight. These themes would include: CCPs and ongoing discussions on some remaining practical challenges of implementation; the EU Financial Transaction Tax and the Â鶹´«Ã½ Financing Transactions Regulation (SFTR); and evolving technological innovation with an emphasis on emerging digital ledger platforms (think Blockchain). To that end, I’m not certain one can single out a particular region these days. These are examples of global themes that will affect not only business transacted in Europe but, rather, European business, et al, done globally.
Copin: Regulation will remain a top priority, but we will see the emergence of alternative trading ideas which take into account the impacts of new regulation and the ongoing market volatility to generate new revenues. The onward march of automation will continue, but we don’t see new tech taking over the industry in the near future. We are of the opinion that change brings opportunity, so we welcome any new developments.
Lawton: If the UK votes to leave the EU in the referendum on 23 June, so-called Brexit discussions will certainly dominate the industry for the near future.
From a technology perspective, the industry will continue to focus on EquiLend’s NGT model and the improved interaction it will allow on fee negotiations, notably for specials which have historically been traded manually.
On the regulatory side, SFTR requirements will become a necessary topic as the detailed technical standards are confirmed later in 2016 and the industry is forced to agree on a consolidated solution.
Marshall: Clearly the SFTR will become an increasingly bigger focus industry-wide, with a consultation paper due in Q3 in advance of the draft technical standards being submitted to the commission. I also believe firms will place additional focus on market structure and identify their optimum solutions to support new models.
Daswani: Regulation will continue to dominate with efforts around SFTR, the Central Â鶹´«Ã½ Depositories Regulation, and the Resolution Stay Protocol being key themes. At the same time, CCP clearing for securities lending is likely be an area of further development, as greater numbers of market participants engage with the industry and begin to see the benefits of the CCP model.
There has been a great deal of discussion around blockchain, an initiative created to provide a secure solution for the trading of assets, and how the industry can utilise the technology to its benefit. Market participants will be spending time investigating its potential uses and benefits, not just for this year but also for many to come.
Wilson: Macroeconomic issues will continue to dominate revenue generation both positively and negatively for the remainder of 2016. In terms of topics and themes, there are a number of things we consider will dominate, including: agent indemnification and the value it brings, the cost of it, and the depth and breadth of what it covers (or not), which will in my view lead to some inevitable changes taking place within the industry. Business models will be reviewed, reevaluated and repositioned including who each agent lends to and who they lend for. No longer are lenders, borrowers and collateral born equal and changes will start to take place to adapt to this. The overall cost of being in this business is not going down, so technology and investment in technology are critical to driving efficiencies/reducing costs, improving client experience and adapting to the changing industry and business landscape.
Robert Chiuch: Using 1991 as a reference point, I was then on the ‘equity loan post’ at Levesque Beaubien (now National Bank Financial) in Toronto. Ignoring the various stress events and bubbles over that period, three industry themes come immediately to mind: industry consolidation, technology and globalisation. I nostalgically recall dealing with BNP Paribas, Chemical Bank, Chase Manhattan Bank and Salomon Brothers, to name a few, each as distinctly separate entities. MS Office 1.0 launched in 1990. Google officially launched in the 1990s, and it’s amazing how truly global this business has become.
Personally, being part of the team that helped launch the CIBC Mellon JV, being a co-founder and the first president of the Canadian Â鶹´«Ã½ Lending Association, and being invited to join BNY Mellon in the US, were among my highlights.
Dan Copin: In those 25 years, we have seen the evolution of securities lending from a back office service to a front-office profit centre. There has also been a marked increase in product sophistication (synthetics, financing, liquidity and collateral management), which has grown in line with the complexity of the capital markets. This increasing complexity, and the 2008 market crisis, has led to numerous initiatives seeking to better regulate business, such as the naked short selling ban, Basel, the European Â鶹´«Ã½ and Markets Authority (ESMA), Solvency I and II, and strengthened regulatory reporting requirements.
Alex Lawton: In the 42 years that State Street’s securities finance programme has been operating, there have been three events that stand out as transformational developments in relation to the structure of the industry.
First was the founding of EquiLend by State Street and nine other major industry participants in 2000. This was a quantum leap in improving the automation and efficiency of the industry, and Next Generation Trading (NGT) will soon take this to the next level.
Second was the impact of regulatory change following the Lehman Brothers collapse and subsequent financial crisis. This has rendered the securities lending market almost unrecognisable today versus its pre-Lehman state, and the effects of this will continue to impact how we approach risk, liquidity and capital for years to come.
Third was the launch of State Street’s enhanced custody product in 2010. This was created in response to client demand and highlighted a need for safer, differentiated financing solutions and an alternative to the traditional prime brokerage model.
Laurence Marshall: Over the last 25 years, the industry has shared many highlights. The 1990s delivered great expansion of the securities lending and repo markets, both with the globalisation of markets and legal, regulatory and fiscal barriers removed to support the growth. In 1996, the UK market opened up, lifting the restrictions and removing the privileges of the gilt-edged market makers and stock exchange money brokers. As global capital markets grew, so did the securities finance markets, with more and more participants increasing the level of competition. The marketplace has developed and matured with the creation and increasing use of trading venues and third-party providers supporting an increasingly complex trading lifecycle.
Throughout this time, the securities finance market has of course also had to overcome the occasional bump. Helping to identify and deliver a new structure with the International Â鶹´«Ã½ Lending Association and creating the CEO role of the industry organisation when we did remains a pleasing memory.
Felix Oegerli: In the rather early stages of international securities lending, there were a few visionaries who foresaw the emergence of a combined securities lending, repo and collateral trading market and they have now seen this vision become reality. Of course, in retrospect, this has happened in an evolutionary way and in their eyes with a delay of at least a decade.
I am very proud of how the business has evolved. Twenty-five years ago securities lending markets were opaque and the business was managed opportunistically. The product was only to a certain extent strategic in nature but made a lot of money, which one may of course also call strategic. It has now become a key element of financial markets while being a strategic business function of larger intermediaries. Collateral velocity, further standardisation as a basis for the growing importance of electronic trading/matching venues and more effective post-trade services such as clearing are still ongoing challenges. The future for securities finance is still bright.
Paul Wilson: Two things really stand out for me. Firstly, during this time the industry faced two material defaults, with the collapse of Lehman Brothers clearly being the largest and most complex. It was really the first time that the ‘model’ and unwind were put to the test. And while the industry learned some lessons in the process, the unwind event occurred for the most part exactly like it was supposed to. I think for our clients and for beneficial owners contemplating lending for the first time, they can take great comfort from this. One could possibly argue that with the lower volumes and higher levels of capital supporting the industry today compared to that at the time of Lehman’s demise, the industry is even better placed to handle something similar in magnitude in the future.
Secondly, the securities lending and financing industry has proved to be remarkably resilient with an ability to adapt. In this regard it has gained great credibility. Seldom now do you see debates on questioning the relative merits of lending—the positive case for the liquidity it brings to the market (even more important today) and the earnings it brings to beneficial owners (much of which ends up in the hands of savers and pensioners via pensions funds or mutual funds) has pretty much been won. The industry has innovated and continues to adapt to demand, regulations, client needs. It has also continued to find ways to generate positive returns for participants.
Sunil Daswani: Overall, we have seen securities lending evolve into being a more efficient and impactful business for our clients. For Northern Trust, highlights include significant expansion in our client reporting, the creation of custom funds for non-cash collateral, and the expansion of our collateral and borrower options.
The growth of securities lending into new markets has been significant. Over the last few years alone, Northern Trust has entered new markets such as South Korea in 2002, Israel in 2010, Taiwan and Poland in 2012, and Brazil in 2015. We have also expanded the location of our trading desks strategically around the world so our business can function 24 hours a day. Australia is a key focus for our capital markets business this year and going forward. We currently have desks in London, Hong Kong and Toronto to enhance our service to clients and further underscore our commitment to the market.
The period has also been marked by increased collaboration within the industry. In particular, Northern Trust, along with nine other leading securities lenders and borrowers, founded EquiLend to connect borrowers and lenders through a common, standards-based global lending platform.
This platform facilitates market liquidity through increased efficiency and speed—ultimately reducing both cost and risk—and has proved to be an extremely positive industry development.
In the past year, what developments have most affected your day-to-day business, either positively or negatively, in Europe?
Wilson: Macroeconomic issues and challenges both inside and outside of Europe have been a significant influence on the business environment. Only recently, I was reviewing year-to-date performance and loan activity with one of our sovereign clients, and it was remarkable how evident these macro themes were both in terms of positive earnings uplift year-over-year but also in places where earnings have fallen, such as yield enhancement.
Technology continues to be front, line and center of our business strategy. We have made great progress in replacing our legacy lending platforms and we continue to focus on enhancing the tools on the trading desk, including NGT, as well as delivering enhanced reporting and analytics to our clients. With the industry of the cusp of potential change, technology is critical to embracing and taking advantage of changing business models as well growing our third-party/non-custody business.
Daswani: Regulatory rules on capital have been at the front and centre of everyone’s agenda in the past 12 months. These rules have introduced different drivers of demand from our borrowers and an increased focus on the cost of capital from the agent’s perspective. Today, they are a significant additional factor in our decision making.
Automation and efficiency remain at the heart of what we do on a day-to-day-basis, so investments in that area also have been a particular focus for our program recently, including the introduction of Equilend’s NGT. NGT is scheduled to be implemented later this year and will enable more automation of loan execution across general collateral and ‘specials’, allowing traders to take advantage of attractive lending opportunities.
Marshall: Clients continued to focus on extracting greater value from our platform, which remains a positive development for us at EquiLend. The launch of Swaptimization, our swaps matching platform, in both the UK and US has delivered great value to our clients and increased the breadth of product that we deliver to them. More and more of my time these days is spent on the regulatory agenda, particularly our project plan to enable us to meet our Markets in Financial Instruments Directive (MiFID) II requirements.
Copin: The main factor that affect the daily securities lending business is regulation from the buy side, including ESMA, Solvency I and II and other national regulations. On the sell side, it has been mainly naked short selling, reporting, risk-weighted assets and liquidity ratios.
Clearly, market uncertainty has also been a key element affecting the daily business, as we’ve seen much volatility and experienced negative interest rates.
Lawton: The UCITS V implementation in March 2016 was significant because the additional liabilities it placed on depositories meant that it was no longer viable for agent lenders to accept collateral on a pledge basis for UCITS funds. Any borrowers using an Master Â鶹´«Ã½ Loan Agreement instead of a Global Master Â鶹´«Ã½ Lending Agreement (GMSLA)—mostly US and Canadian entities—had to be either turned off for UCITS clients or re-papered with a non-pledge agreement. For State Street, this resulted in approximately $300 million of loans having to be either swapped to non-UCITS clients or non-US and Canadian borrower entities with GMSLAs.
On the fixed income side, European Central Bank (ECB) policy and the move to negative interest rates had a direct impact on cash reinvestment processes. Traditional repo collateral has become less liquid in short dates and, for clients that cannot reinvest in longer duration, this has limited the balances that can be run over month/quarter-ends as the risk of uninvested cash has significantly increased.
On the trading side, are there any emerging trends you’ve noted so far in 2016? How is European business faring?
Marshall: The year started very strongly with increased flow in European securities across our trading platform, driven primarily by activity in the UK as well as in fixed income—both corporate and sovereign bonds. March was a slightly slower month with a decrease in activity, but volumes bounced back in April, with the trend continuing upward.
Lawton: The continuing decline in demand for European equities during peak season has been the most notable impact. Based on aggregated industry data from Markit, peak loan balances from agent lenders in Europe fell 14.8 percent from the 2015 peak, and that number was down 18.9 percent from the 2014 peak. That’s a 31 percent drop in peak European equity balances in two years.
While demand for European equities has fallen across the board in Q2, Germany has been the most impacted market by far. Aggregated data from Markit shows that peak loan balances in Germany have fallen 62.3 percent versus the peak of 2015 and 70.2 percent versus two years ago.
Despite this, State Street’s European business is faring well. We have secured several new clients and upsells, many of them bringing new sources of revenue, which will not cannibalise existing business, and demand for sovereign debt remains strong, particularly on a term upgrade basis.
Wilson: Overall, while there have been some ups and some downs, European business across the industry has fared fairly well so far this year. Within equities trading, corporate events and rights trades, short coverage, and opportunities in financing structures such as bond floor and single-line term, have helped to partially offset the long predicted and expected decline in yield enhancement.
Within fixed income, while Germany has traded at a slight premium, most notably the 10-year maturities, the market has generally remained fairly even keeled, with solid demand for high-quality liquid assets (HQLAs). Demand for corporate bonds, notably in financial and commodity-based issues, has been very strong, especially in Q1. There has been a bit of a slowdown more recently due to the equity sell-off and dealers’ being short of equity inventory, but the demand for collateral upgrade and capital- and balance sheet-effective trades has continued.
We have found our client base very open minded to these, especially investors with a longer term investment horizon, such as pension funds, insurance companies and sovereigns. We have also seen a material pick up in the demand for third-party, non-custody lending. This is driven by a change in the business models, approach and areas of focus by agent lenders, which has in turn meant that beneficial owners are looking to match agents to their risk/reward profile more than ever. We anticipate these trends and themes will continue throughout 2016.
Copin: The new regulatory framework drives participants to seek out new business ideas and set industry trends rolling. We note that there is an emerging trend seeking to optimise all the positions held. Furthermore, product customisation initiatives see the development of bespoke solutions for client, and counterparties alike.
Daswani: Borrowers are focusing more on complex term maturity structures, both for financing long positions and for maintaining adequate levels of HQLAs to satisfy regulatory-driven requirements.
While we maintain strong volumes in our open book of transactions, we have reacted to market change by terming assets in well-laddered maturity tenors—in both fixed bullet and evergreen structures—where sufficient risk reward is priced.
Our counterparty base continues to focus on collateral mobilisation, with lenders benefiting from the ability to better react to market evolution. Beneficial owners that can adopt a more flexible approach in their lending guidelines, both in terms of collateral type and maturity profiles, will be better positioned to take advantage of any trading opportunities.
Chiuch: There are probably fewer emerging trends these days as opposed to existing trends that are evolving. Many of the themes remain the same: regulation, central counterparties (CCPs), technological innovation, collateral optimisation and so on. I believe what’s generally different for 2016 is the intensity of engagement around implementation schedules regarding looming deadlines or even, perhaps, in response to reactive competitive forces.
What impact do you think the UK leaving the EU might have on securities lending?
Daswani: A so-called ‘Brexit’ would likely speak uncertainty in capital markets over a number of areas. These would include the exchange rate of sterling, UK interest rates and the country’s credit rating. In the short-term, there could also be concerns over the overall stability of the UK economy and financial system.
While the Bank of England is prepared to provide liquidity to calm potentially volatile markets, we would expect a downshift in yield curves and a flight to quality trade, further depressing yields in the highest quality issuers. However, demand for gilts is unlikely to see much change, while appetites for UK equities will continue to be mainly driven by microeconomic factors.
Most financial institutions have a significant presence in the UK as a gateway into the EU market. Depending on the final terms of an exit, we could see market participants opening new offices or transferring staff to EU jurisdictions. These changes will increase costs through reduced efficiencies that are currently gained by having a single trading location for the eurozone.
Lawton: The most significant direct impact is likely to be market volatility. However, it’s difficult to predict whether that will be positive or negative. Understandably, a potential weakening of GBP could reduce UK returns for borrowers or lenders whose budgets are set in USD or EUR, but market volatility can create stronger directional interest in sectors or specific securities, which creates higher demand.
The most likely other direct impact is that certain banks or broker dealers decide to relocate out of the UK due to MiFID passporting requirements or some other less favourable treatment. Theoretically this is not a problem as the industry is very familiar with cross-border relationships and legal agreements, but it will depend on the regulatory framework established between the UK and the EU.
Marshall: I am concerned that a vote to leave will have a negative impact on financial services in Europe, particularly in the UK. Would it lead to firms relocating activities to a country within the EU to continue to enjoy the cross-border activity? If so, it is likely that the securities finance activity transacted from London will decline. The threat to the passport across Europe is a concern for us and something that we need to plan for if the UK were to leave the union.
European repo has been hammered in the past year. Is this a temporary feature during a period of industry adjustment to new regulations and low interest rates, or more permanent?
Daswani: Increased regulation, namely Basel III, has played a major part in reducing banks’ balance sheets globally and the return required to justify the business is higher—which ultimately widens spreads. In addition, actions by central banks such as the introduction of negative rates, asset purchases and targeted long-term refinancing operations have contributed greatly to the sharp decline mentioned above. Although the environment is unlikely to change in the near future, the decline should ease over the longer-term. Banks are already conforming to Basel III and the outlook for more aggressive easing by the ECB, as we saw in March, is less likely.
Copin: It is impossible to tell at this stage as too much uncertainty remains with new regulations coming into force, compounded by the low interest rate situation. The market is still trying to adapt its strategy to this new situation.
The only thing the industry is sure of is that the situation cannot continue in a long run and will eventually have to change as it always has done in the past.
Chiuch: Low interest rates and new regulations have combined to challenge the euro fixed income repo market. Repo balances have deteriorated and we have seen some borrowers generally exit the repo space, except for strategic funding trades, due to the heavy balance sheet costs. Part of this problem is in theory temporary, meaning eventual growth in the eurozone may lead to higher interest rates. That likely won’t happen any time soon, though, especially as they have recently cut rates and expanded quantitative easing in response to poor growth. Regulation, however, is probably secular in nature with a full pending implementation list.
Lawton: The question is when and how will central banks’ policy on negative rates and quantitative easing be reversed. Regulation is here to stay for the foreseeable future and that will continue to drive the need for HQLAs and term funding. Until this policy is reversed, it is likely to continue to limit short-end funding until such time as banks see balance sheets growing, but that does not appear to be imminent.
Wilson: Over the past few years, the repo market has been affected as banks adjust to meet the new regulatory framework. This has perhaps been most significantly felt through the impact of the leverage ratio, which has been reducing repo activity for highly-rated securities (such as government paper), which are low margin and balance sheet-intensive. The effects of these changes are likely to be largely permanent as their adoption, albeit with global implementation proceeding at varying paces and with some slight variation, will be a binding factor on bank activity, and will affect how they allocate limited balance sheet. However, these changes may also allow for increased scope for non-bank repo participants.
Additionally, the decision by the ECB to lower interest rates into negative territory, provide targeted longer-term refinancing operations and quantitative easing programmes, while signalling a willingness to do more if required, has left front-end rates compressed into negative territory for large segments of the curve for a prolonged period of time. This very cheap central bank funding, alongside wider repo market bid/ask spreads, and with market levels often trading close to the deposit rate, has meant the ECB has become both lender and borrower of first resort respectively to different segments of the market (cash seekers and cash holders).
While this central bank policy has softened the impact of market adjustments in the new post-crisis regulatory regime, the ECB balance sheet will eventually decline and central bank funding will be replaced by market funding. Consequently, there are some concerns about how the repo market would function without this ECB liquidity support to the market.
Looking forward, what topics do you see dominating the industry in Europe in the second half of this year?
Chiuch: On the surface, a number of themes will likely dominate the spotlight. These themes would include: CCPs and ongoing discussions on some remaining practical challenges of implementation; the EU Financial Transaction Tax and the Â鶹´«Ã½ Financing Transactions Regulation (SFTR); and evolving technological innovation with an emphasis on emerging digital ledger platforms (think Blockchain). To that end, I’m not certain one can single out a particular region these days. These are examples of global themes that will affect not only business transacted in Europe but, rather, European business, et al, done globally.
Copin: Regulation will remain a top priority, but we will see the emergence of alternative trading ideas which take into account the impacts of new regulation and the ongoing market volatility to generate new revenues. The onward march of automation will continue, but we don’t see new tech taking over the industry in the near future. We are of the opinion that change brings opportunity, so we welcome any new developments.
Lawton: If the UK votes to leave the EU in the referendum on 23 June, so-called Brexit discussions will certainly dominate the industry for the near future.
From a technology perspective, the industry will continue to focus on EquiLend’s NGT model and the improved interaction it will allow on fee negotiations, notably for specials which have historically been traded manually.
On the regulatory side, SFTR requirements will become a necessary topic as the detailed technical standards are confirmed later in 2016 and the industry is forced to agree on a consolidated solution.
Marshall: Clearly the SFTR will become an increasingly bigger focus industry-wide, with a consultation paper due in Q3 in advance of the draft technical standards being submitted to the commission. I also believe firms will place additional focus on market structure and identify their optimum solutions to support new models.
Daswani: Regulation will continue to dominate with efforts around SFTR, the Central Â鶹´«Ã½ Depositories Regulation, and the Resolution Stay Protocol being key themes. At the same time, CCP clearing for securities lending is likely be an area of further development, as greater numbers of market participants engage with the industry and begin to see the benefits of the CCP model.
There has been a great deal of discussion around blockchain, an initiative created to provide a secure solution for the trading of assets, and how the industry can utilise the technology to its benefit. Market participants will be spending time investigating its potential uses and benefits, not just for this year but also for many to come.
Wilson: Macroeconomic issues will continue to dominate revenue generation both positively and negatively for the remainder of 2016. In terms of topics and themes, there are a number of things we consider will dominate, including: agent indemnification and the value it brings, the cost of it, and the depth and breadth of what it covers (or not), which will in my view lead to some inevitable changes taking place within the industry. Business models will be reviewed, reevaluated and repositioned including who each agent lends to and who they lend for. No longer are lenders, borrowers and collateral born equal and changes will start to take place to adapt to this. The overall cost of being in this business is not going down, so technology and investment in technology are critical to driving efficiencies/reducing costs, improving client experience and adapting to the changing industry and business landscape.
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