Nick Fitzpatrick chaired a wide-ranging discussion among leading securities finance experts. Topics include the role of Ucits funds in securities lending, and regulation affecting the industry. Basel III, where banks will need to borrow high-quality assets for funding purposes, is considered a game-chaning opportunity for beneficial owners. But fund boards face the challenge of understanding the risks of lending.
John Arnesen (head of agency lending, BNP Paribas SS), Xavier Bouthors (senior investment manager, treasury and liquidity ING IM)
Jayne Forbes (head of securities finance, AXA IM), Pierre Khemdoudi (director of securities finance, Markit)
Stephen Kiely (head of new business development, securities finance, BNY Mellon)
Maurice Leo (head of relationship management, EMEA securities finance, State Street Global Markets)
Kevin McNulty (chief executive, International Securities Lending Association)
Funds Europe: What impact are high equity markets having on lending? Do beneficial owners feel less need to lend as much in this environment? And is more M&A supporting the demand for lending?
John Arnesen, BNP Paribas: Lenders don’t consider whether markets are bullish or bearish when letting their portfolios participate in lending. They leave that to our discretion. If we consider one aspect of securities lending as a utility that allows directional short-selling, then there may be less of that during periods of bull markets. However, a better environment in the industry or the capital markets as a whole will perhaps lead to more M&A activity and therefore the securities lending industry would benefit from that in some way.
Maurice Leo, State Street: Yes, people don’t necessarily look at the comparative returns of a securities lending programme relative to the core portfolio management function. It is more a complementary analysis. Therefore, you witness a certain continuity as opposed to an ebb and flow in participation, depending on whether you’re in a bull or bear market cycle.
The supply metrics available through data and analytic providers indicate a healthy enrolment pattern by beneficial owners, whether mutual funds, pension funds or sovereign investors.
Pierre Khemdoudi, Markit: The lendable base has increased 35% from January 2012 to now. Although we are seeing very high valuations in equities, we are in a very low interest rate environment, which changes the game. This is probably why we see quite a lot of interest in securities lending.
Stephen Kiely, BNY Mellon: This year I have seen a lot more interest in securities lending from index-tracking equity managers and more often than not they’re looking at lending from a benchmark perspective. So whether the markets are up or down, they’re still judged on that benchmark.
Kevin McNulty, ISLA: Securities lending returns stand out more when investment returns are generally lower, but market movements don’t make that much difference. Arguably, securities lending returns are more relevant now than perhaps before because commentators suggest that available returns from traditional investments will not be as good in the next 20 years as they have been in the past 20 years.
Beneficial owners like pension funds are looking to all available sources of return and securities lending has a role to play. Although it is considered to be a modest-return and low-risk activity, those modest returns can add up to some meaningful numbers over the years.
Jayne Forbes, Axa IM: If there’s a merger or an acquisition and there’s a vote, then you’ll see retraction. From an asset management perspective it can have the opposite effect because investors are closely looking at whether there is any sort of aggressive action to be expected.
Xavier Bouthors, ING IM: If markets go down, it won’t affect the intention to lend because we are participating in lending to capture opportunities and performance by lending our assets. Equity markets going up or down would just affect the volume we have out on loan. If we see more corporate events, this could mean additional opportunities for yield, adding to the fund’s performance.
Khemdoudi: If we look at the volumes of securities lending generated by M&A over the past three years, we can see they are a notch down compared to two years ago. The same for revenue. So we’re seeing less revenue and smaller volumes but more profitable trades and higher fees.
Leo: Beyond M&A and other traditional sources of demand, over the past three or four years we have seen demand associated with the forms of capital-raising financial institutions undertake to strengthen their regulatory capital positions. Similarly, we have witnessed growing demand focused on shareholder distributions with optionality in the form of stock or cash entitlements.
FE: How can Ucits boards play a more active role in the oversight of securities lending programmes? What are their priorities – and how aware of these priorities are they?
Bouthors: As a result of regulations, management companies are more involved in securities lending. This means they are more aware of operational and legal risks, and the volume and revenue performance. They need frequent reporting, meetings and a deep level of understanding of the activity. Information is included in the fund prospectus and the annual report.
Forbes: It all starts with product engineering. The prospectus contains the details of the product risks so investors are made aware of downside product offering. There are several reports from an oversight perspective, like the annual report and the collateral report. There are also regular meetings where the Ucits board has to understand and monitor activity – which is the key thing, together with the fund governance.
Kiely: I hope and wish they become more involved. Often when a client comes and says ‘We want to look at lending’, they obviously think lending is a good idea because they’ve approached you. However, after you put a package together and you convince the client, they then tell you they have to convince the board of trustees.
For people on that board, lending is just a small part of what they do and often they don’t fully understand all aspects of lending, including risks. This is what sometimes practitioners don’t understand because for us it’s everything.
If there were a bit more education and understanding they’d be more open.
Arnesen: The Ucits regulations can be pretty daunting. They are important regulations that have to be adhered to by all funds. So when it comes to the Ucits boards’ involvement, the first thing they need to be sure of is that they understand the regulations required to engage in efficient portfolio management techniques.
The regulation is geared around investment protection and that has led to management companies engaging staff dedicated to oversight. But lack of clarity over fees has led some management companies to push securities lending back to portfolio managers, despite having been engaged with bringing securities lending to the fund. Although they have oversight of it, they’re not getting paid any more for it; therefore they hand the decision over to the portfolio managers.
Historically, the relationship between lending and portfolio managers hasn’t been based on a lot of mutual understanding but that’s changed. We engage directly with portfolio managers much more than with the management company.
Leo: To sustain performance, managers and fund boards have had to heighten their engagement around the product due to the regulatory and market influences that shape their respective lending programmes. These effects are not always direct, as in the case of ESMA [European Securities and Markets Authority] on Ucits. Basel III, the Dodd-Frank Act, and FSB [Financial Stability Board] evaluations are influencing the demand side of the business, and as a board member it’s a challenge to retain that broader awareness of influences.
At the same time, investors are asking more questions about the participation framework for a fund in lending. They want to understand guidelines and risk characteristics, etc. So it’s a more challenging environment that requires greater time and commitment.
Beyond Ucits, boards of funds that are not directly affected by regulation – whether they’re pension funds or sovereign investors, for example – increasingly consider what is best practice elsewhere in terms of governance and programme structure.
Bouthors: Funds need a securities lending policy that includes governance and to which the management company can refer.
Kiely: My worry is that because people struggle to do this properly or understand it, they choose not to do it. As mentioned, there has been a step back by some of the management companies and decisions are being pushed more to the portfolio managers, which has led to a more fractious relationship.
McNulty: Boards of funds generally, not just Ucits, and their directors or trustees are representatives of th e end investor. They have a responsibility to understand what’s going on within those investment portfolios. First and foremost, directors or trustees in Europe should understand the benefits and risks of their funds being involved in securities lending.
They need to understand the increasingly complex regulations that govern their funds, which is quite a challenge. Securities lending activity is an important but small part of what they are concerned with.
Market participants show a genuine desire to see boards, directors and trustees getting engaged in the securities lending business and there’s potentially quite a lot of advantage for them to do so. There are several new opportunities driven by changing regulation and changing market dynamics. A securities lending programme set up with a very prescriptive policy several years ago might not be optimal given the new environment, and those funds may do rather less well than funds that are able to adapt.
FE: What’s indemnity’s role in a securities lending contract and are indemnities evolving in favour of the beneficial lender or agent?
McNulty: There is a lot of discussion around indemnity and that’s important since it is likely that the cost of providing indemnity is going to go up as a result of banks’ capital regulation. At this stage, no one’s sure exactly how much the costs are going to go up by, but investors may be faced with interesting choices.
A lot of beneficial lenders do value the indemnity quite highly, and it may well be difficult for them to give it up. However, you could argue that indemnities are of somewhat questionable value, as I’m not aware of anyone actually drawing on an indemnity in any material way because other layers of protection tend to work very effectively. So on the one hand, whilst we know beneficial owners value them, some may conclude that they are happy to lend without one if they can benefit from a lower-cost service.
Arnesen: The notion of questionable value comes in when discussing what indemnities cost. During the 1990s and 2000s, [and] up to 2006, the industry was in such a competitive frenzy that people, particularly custodians, were throwing indemnification into the contracts as a given. It became the “free toaster”.
Now we’re in a situation where indemnification is going to cost more and this cost can make it prohibitive. This will either force lenders to have difficult conversations with their underlying clients or not have every transaction indemnified. When we understand the true cost of indemnity provision, the market will fragment yet again.
Bouthors: We should not base the decision to enter into securities lending on whether we receive an indemnification or not. We are responsible for our funds and we should be assessing the risk profile, approving and reviewing the counterparties, and deciding on the collateral the funds can receive. Indemnification is the cherry on the cake.
Khemdoudi: Yes, indemnification is the cherry on the cake and should not make the decision for you. If you take the indemnification, then you take on counterparty risk from your agent because if your agent defaults, your indemnification is worth nothing. So you should first assess your own risk parameters.
Kiely: It’s encouraging to hear that a beneficial owner doesn’t just take indemnification at face value and understands that although it is a safety net, you can’t step away from the responsibility of managing the programme. It is not always understood what indemnification means and what is being indemnified. I agree about the two-tier pricing that will see some trades indemnified and some not. We’ll get to a stage where a programme won’t be indemnified but certain parts of it, or types of trades or collateral, will be.
Leo: Investor governance and responsibility are reflected in the structuring and monitoring of customised programme guidelines – for example,eligible counterparties, collateral, and the associated margining. The indemnification is a tertiary line of defence.
With evolving regulatory influences on the cost of capital, there will be a further focus on the equilibrium between client and shareholder value. All products will be considered through that lens, and there will be greater diversity in the manner that borrower-default indemnification is extended within programmes.
FE: Which regulation is most pressing on securities lending and why? Which area of regulation will dominate the next 12 months and what does it mean for lenders?
McNulty: It’s quite difficult to pick a winner among all the regulations affecting the market because there are quite a few of them. The Basel III reforms and their potential impact on the demand for securities is interesting. Some of these may be positive and fuel new demand for borrowing, while others may reduce banks’ capacities to do more business.
The positive aspect is related to some of the liquidity management requirements under Basel III, where borrowers are required to have access to high-quality liquid assets. One way of achieving this is to borrow them from the marketplace. This will drive borrowing demand for these types of securities and is an opportunity.
Leo: There is an opportunity within some of the regulations, particularly around the liquidity coverage ratio and the need for term funding, and this may hold promise for certain client segments. These client segments are less likely to be Ucits funds due to regulatory considerations. They’re more likely to be pension funds and sovereign investors who have a more longer-term investment character, and different regulatory profile, and they may be beneficiaries of a migration in borrower demand to term lending. That said, they may present different issues for borrowers from a regulatory capital standpoint and that may be an area where central counterparties (CCPs) have a role to play in the future.
Some of the regulations are slated for adoption in 2018 and 2019. However, as was seen with other regulatory standards, there may be a tendency for institutions to accelerate their implementation of these standards. Collectively as an industry, we need to be conscious that much of this regulation-driven change may occur sooner than formally required.
Arnesen: Yes, there always seems to be a determination to be compliant way ahead of the date. In fact, the capital requirements have now been delayed but many banks were compliant a year ago or at the beginning of 2013 and have maintained that as a ratio. You make a good point about the net stable funding ratios and borrowers will need to have much longer funding. Basel III is a game changer.
Kiely: Yes, Basel III is the regulation that affects everyone. In the past, it seemed like all the players in a securities lending agreement wanted the same thing. Now there is fragmentation and segmentation among the client base, especially around term and liquidity. The traditional, central bank sovereign wealth-type fixed-income lenders understand term or are more used to term, a lot more than the equity pension fund, which wants that flexibility to not be locked in. So, as a result, we will see not a two-tier, but segments where some clients will do this and some clients will do something else.
Bouthors: The concern around Basel III is whether the demand from brokers will meet the market supply and what the impact of that will be. It will impact the volume on the market and it might shift to more term lending for lenders able to do so, but I don’t know to what extent.
Kiely: The FTT [financial transaction tax] will impact every single person around the table and those not represented here.
Leo: The ambiguity around its reach and timing means it has to be on the agenda. However, will its eventual span be as broad as has been indicated and will it adhere to its currently stated timetable?
FE: How does the panel view the evolution of collateral management? Are collateral management service providers innovating enough? Are their services differentiated in a helpful or unhelpful way? Are they competitive?
Kiely: As a custodian, an agent lender and one of the largest collateral managers, it’s not up to me to say whether we’re competitive or innovating enough. That is something our users can decide. However, collateral management is one of those catch-all phrases that people often use and don’t understand exactly. Collateral is one of those areas where beneficial owners would benefit from understanding more, asking more questions of their current provider. They would just take what was offered and as long as the collateral had a certain rating they were happy.
It needs to be more complex than that; collateral managers need to be able to provide a lot more transparency to the beneficial owner around the details of the collateral that’s held.
Forbes: I agree that the notion of collateral is becoming more complex. Collateral needs to be managed in similar ways to managing a fund.
McNulty: What’s interesting about collateral is that the securities lending has, for many decades, been a user and consumer of collateral. However, since the crisis we are seeing a growth in demand for collateral by other participants in the financial system, driven partly by risk aversion and partly by regulation, like Basel III and EMIR [European Market Infrastructure Regulation].
The securities lending market is used to receiving collateral but should it act as a provider of collateral to the market more broadly? This is where some interesting discussions are taking place now. Some service providers are considering tackling collateral in a much broader sense for the market.
Leo: Speaking as a custodian with a depositary function, the depositary has to assume strict liability under AIFMD [Alternative Investment Fund Managers Directive] for a fund’s assets, including collateral received on a transfer of title basis. This will be the case under Ucits V, also. I expect further refinements in the tri-party legal and operating frameworks as depositaries seek to further fine tune what is a sub-custodian appointment for the purposes of safekeeping collateral, whether for securities lending or other secured transaction types.
Beyond the traditional tri-party clearing arena, CCPs are the next port of call. CCPs offer significant advantages in capital treatment to market participants. They will certainly be part of our future ecosystem as certain low margin trades will not remain sustainable in the absence of such capital efficiencies. Further work needs to be done to build out the market coverage of CCPs and to enhance client awareness of their application to securities finance transactions. The same clients are after all using CCPs in other areas of their investment operations.
Khemdoudi: We are even looking at consolidation, not only of costs to the lender but also consolidation in the underlying issuer, whether it’s a bond or an equity, to have holistic approaches.
The other thing in terms of market change is the evolution of two-tier collateral that defines what a high-quality asset is. This is interesting because it allows you to optimise the pool of assets. Something that was viewed as a consequence of a transaction can be considered an avenue of revenue.
Kiely: If we’re talking about collateral as a means to an end in a securities lending environment, I see two things happening which you could argue are almost contradictory. One is more detail, more granularity, [and]more information required by the beneficial owner.
The contradictory bit is the other trend that sees beneficial owners struggling for liquidity, especially in the current regulatory environment, so they would rather take cash as collateral, which they then use themselves.
Arnesen: As a user of collateral management services I can say there is an increasing demand for granularity. We have demands both internally and externally from our client base to have more granularity and correlation. The latest trend, particularly in equity collateral, is clients wanting to monitor the daily average trading volume, which is challenging in itself sometimes.
The other question is whether they are innovative enough and whether they are differentiating themselves. The market’s always been a bit odd in the sense that, as a huge user of collateral management, I don’t pay for it. Collateral management is paid for by the broker dealer or the borrower. However, collateral management contracts are universal and tend to say, ‘We are going to take this collateral and we are going to apply the restrictions and all the guidelines you’ve given us but if we fail to do that, too bad.’ This isn’t going to be good enough in the future. I’m going to need something more concrete otherwise I’m going to have to go back and check the collateral is compliant, which in fact we already do.
The other differentiation is that I don’t want cash collateral. If a borrower fails to deliver, for whatever reason, I’ll end up with cash, which is not doing me any good whatsoever. Therefore, a manager that can guarantee I’ll never receive cash is favourable and that’s something the entire industry should work on.
FE: Where do the key risks for participants in securities lending lie in the year ahead?
Khemdoudi: We aim to have as many clients as we can in the next year so we don’t want to have very restrictive rules that could wipe out the business. So that is one of my concerns.
The industry is digesting the regulation and there are still quite a lot of unknowns. Two or three years down the road the industry will be very different but we don’t yet know which way it’s going to evolve.
Bouthors: The greatest risks lie in understanding the regulation coming next year and in the next few years, complying with it and being aware of the impact it has, and will have.
Arnesen: The key risk would be anything that affects the mainstay revenue stream as we see it now. If there’s anything on the horizon that could have a material impact in how we can earn revenue that would be the big key risk in my view, although I don’t see anything in particular at present.
Forbes: The real risk is forgetting why the beneficial owner really wants to deal in the product. It’s not about the industry, it’s about the beneficial owner so that’s the key thing to remember. Never lose sight of why the beneficial owner wants to use the technique. If we get lost in all of this regulation and what borrowers want and what we want as an industry, sometimes it can give the message that we have lost sight of why we do what we do.
Leo: Reputational risk is a key consideration for all parties. As an industry we manage this exposure against the backdrop of a regulatory and market environment that is evolving with considerable momentum.
McNulty: The FTT is a potential concern. We should learn fairly soon whether or not a political agreement has been reached among the member states that are working on this. The market also needs to manage the imposition of settlement penalty regimes under the CSD [Central Securities Depositories] regulation. I’m optimistic that the market will be prepared when this happens, but there is plenty of work to be done for this.
Kiely: FTT in its current form is the biggest risk in the year ahead.
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