ROUNDTABLE: Incremental value

Our specialist panel looks at securities lending from the point of view of Ucits fund managers, considering the hurdles and the benefits.

Matthew Chessum (investment dealer, Aberdeen Standard Investments)
Mick Chadwick (head of securities finance, Aviva Investors)
John Arnesen (head of agency lending sales, Emea & Americas, BNP Paribas Securities Services)
Pierre Khemdoudi (managing director, IHS Markit)

Funds Europe – Can you highlight one area of demand for securities lending over the past year and what was the driver?

Pierre Khemdoudi, IHS Markit Very much in the vein of the previous year, high-quality liquid assets (HQLA) and bonds are where the demand is. The large, more attractive returns come from trading term structures. Term duration is going up as a consequence of regulation and capital constriction.

There are less returns on the equity side in Asia, Europe, the US, across the board, with a couple of exceptions – for example ETFs, where revenues are on the rise. In the more shorted sectors, energy is still at the top. Bonds, on the one hand, are going up because of capital restrictions and balance sheet optimisation, and while equity is a bit on the low side, we have also seen more volatility in the returns.

John Arnesen, BNP Paribas SS Corporate actions trading has been a key focus for [BNP Paribas SS] on the equities front. Our focus has been on ensuring that we capture for our clients any returns where a sub-optimal corporate election has been made by their managers. A significant number of opportunities exist in European markets, and through communication with our clients, we ensure that we maximise this key revenue generator on their behalf.

Matthew Chessum, Aberdeen Standard – From our perspective – which is long-only, actively managed, predominantly equity-lent portfolios – there hasn’t been a huge amount of demand across the board.

The revenues have been fairly average and the specials have been few and far between. We’ve seen healthy activity and demand in new markets such as Russia. This is where we are generally seeing higher fees.

Other than that, it’s been a fairly average year.

Mick Chadwick, Aviva Investors – A whole industry is emerging that is coming up with new names for old trades. Whether you call it collateral transformation or collateral swaps or liquidity swaps, it’s all the same.

In terms of the flow demand, I wouldn’t necessarily be quite as negative as others, though it is true that the sell-side has not got its mojo back completely.

I would [highlight] a point about the scrip dividend business. One change isn’t so much about where the demand comes from, but how the borrowing community is trying to access that demand in terms of new types of trading structure. For example, they’ll maybe look to borrow simply the rights themselves, rather than the full underlying, just because it’s more cost-efficient.

Funds Europe – Has the predicted supply squeeze surrounding HQLAs manifested?

Arnesen – Utilisation in the HQLA space remains below 50%. Supply remains strong due to the increased participation by beneficial owners within this space. At BNP, we are focused on ensuring our clients are aware of the opportunities that exist to optimise their returns on HQLA. We have seen clients looking to maximise yield through co-ordinating their lending with their investment horizons.

Chadwick – There is a growing consensus that there is enough collateral in the system. The question is, is it in the right place?

The concern is that capital markets in facilitating the movement of collateral from A to B may not work as efficiently as they should. Historically, it’s been the banks who have been the primary conduits. If the post-crisis Basel III regulatory set-up makes it increasingly expensive for banks to provide that intermediation service, then that’s potentially where the market gets gummed up. That’s why participants are looking at alternative routes to market, such as peer-to-peer trading platforms or central clearing initiatives.

Chessum – Yes, it is almost punitive now to do an overnight repo transaction as a bank. It can be challenging to do from a capital point of view. There has been a rise in peer-to-peer platforms in the last 18 months – but they’re only going to be successful if the crowd goes to one or another, and the jury’s out on that at the moment.

Khemdoudi – We see the premium going up around the evergreen and that kind of structured financing, which unlocks the opportunities on the side of the liquidity provider in the sense that it’s now worth doing. As we see the capital constriction and capital optimisation structures implemented across the market, and as the market structure evolves, we will see more and more liquidity trickling through.

Funds Europe – How does the anticipated return to normal interest rate policies affect securities lending providers and participants?

Chadwick – People have been anticipating a return to normal interest rates for a while now.

From a securities lending perspective, you can describe what we do as providing liquidity to the street, whether in the form of securities, cash or HQLA. In an environment where liquidity is abundant and cheap, there is a ceiling on how much profit margin we can make from providing liquidity when you’ve got central banks priming the pump and flooding the market, and ultra-low interest rates.

If you do see a return to ‘normal’ levels of interest rates, then as a liquidity provider, that raises the ceiling in terms of our upside.

Chessum – I’m bound to say this, but I think securities lending always wins out. It’s quite a nimble industry and we can function in most environments.

There is always going to be a certain sector of the market that’s going to benefit from securities lending in general, though it all depends on what assets you’ve got and what the actual margin is at that point in time.

Arnesen – Securities lending is a spread-based business and although interest rates across Europe continue to be challenging for investors, our US clients have already started to see the revenue benefits from an increasing US interest rate environment. In particular, as cash is the predominant collateral preference in the US lending market, our clients have already seen a marked increase in returns from the reinvestment of their cash into Libor-based products.

In Europe, the predominant collateral preference is securities and therefore revenues are typically generated from a loan fee as opposed to a rebate from a prevailing interest rate. However, as our clients have experienced in past years, as interest rates increase, so do the loan fees typically earned on specials, which will in turn increase revenues for all our clients.

Chadwick – Absolutely. When you’ve got ultra-low interest rates, it tends to lead to a natural compression of specials rates.

Chessum – You could also argue that there has been a lack of shorts in the market recently because companies are able to finance themselves relatively cheaply. If interest rates go up, then that becomes more expensive, and those companies may not look as solid as they did previously. You may therefore get more hedge funds come into play in terms of shorting activity, which may in turn drive stronger borrowing demand.

Arnesen – We have also seen some borrowers look to complement their lending activity with alternative forms of financing, away from traditional stock lending. The low interest rate environment has made raising cash through debt issuance historically cheap for banks and brokers and a method that does not dilute their existing shareholder base, which equity rights issues do. Additionally, the all-time low CDS rates have also made this type of self-financing much cheaper than ever before.

Funds Europe – Is there yet any meaningful move for ETFs to be used as collateral?

Arnesen – The outstanding demand for ETFs has dramatically improved, even in the last year. We have a very active demand in the US for them.

As for the ETF market in Europe, the demand to borrow has yet to materialise – and because the demand isn’t there, we do not get it as collateral either. We would be open to accept ETFs as collateral.

Chessum – MiFID II means that every trade will have to be printed and one of the problems with many ETFs is that you cannot properly see the liquidity because, at the moment, trading data is not always published. So, from next year you’re really going to be able to see – in a centralised place – how much liquidity is actually going through the market. This should improve ETF eligibility as collateral, because there is increased transparency in trading volumes which will assist credit teams in deciding whether they are liquid enough to hold as collateral.

Chadwick – It’s a very good point about MiFID. To figure out collateral eligibility criteria, you need to have some sense of how liquid these assets are. Also, the majority of collateral management within the securities lending industry is performed by tri-party agents. Therefore you need to come up with some rules-based methodology that will allow you to distinguish between the larger liquid ETFs and the rest.

In many ways the debate about the suitability of ETFs is a microcosm of the broader conversation about ETFs – namely, if you end up in a situation where the ETF is somehow magically more liquid than the underlying components, then there is a disconnect.

Khemdoudi – We have a project gathering all the underlying ETF data and are now plugged into pretty much everyone who is issuing, trading and market-making ETFs. When we talk to market-makers in Europe, they see there is not enough availability for them on the borrowing side. There is definitely a break in the chain. Consider the way the ETF market is structured: in the US, it is very concentrated and there is only one marketplace, while in Europe, it’s completely disparate, with the same ETFs traded in multiple marketplaces. That breaks down the liquidity somewhat, plus it’s very difficult to navigate the market.

ETFs are definitely an asset with a lot of momentum. Banks are really on it – they see it as a major avenue of revenue generation over the next few years. The issuers are really looking at securities lending in an active fashion because it definitely offsets a large portion of their fees and makes their ETFs interesting.

Funds Europe – Do you anticipate that some ETF fees may move to zero, with revenues made purely from stock lending?

Chadwick – This phenomenon can be observed in any kind of passive low-cost, low-fee product where the economics of securities lending can potentially move the needle in terms of the viability of these products for the provider. The zero figure is obviously the lower bound. Some of the big US passive providers are now looking to muscle in on Europe, with some fairly aggressively priced products, so it’s not beyond the realm of possibility, put it that way.

Funds Europe – Are there any regulatory hurdles to this?

Chadwick – There is sometimes a misconception that if an asset is lent and collateral received, then somehow that fundamentally alters the economic profile of the fund. To be fair, in some jurisdictions accounting rules might lead you to conclude that there has been some sort of transfer of economic ownership. Obviously, the reality is that no such transfer takes place.

Greater disclosure is, almost without exception, always and everywhere a good thing. People in the industry moan about the heavy lifting that the Securities Financing Transactions Regulation (SFTR) will entail, but you can’t argue with the principle of increased transparency.

The SFTR will also force participants to tighten up procedures and be more robust in terms of how certain activities are documented and managed from a risk perspective.

Arnesen – Esma’s problem with securities financing fundamentally comes down to the fact that they do not want it to be OTC [over-the-counter] any more. In part, SFTR will lead us closer than ever before to having some kind of exchange-traded platform.

There are a number of companies within our industry that continue to explore the potential to move the lending business to an exchange-traded model, but market participants will need to be very careful around how general collateral trades are priced through this model, as the cost to trade and clear could easily outweigh the value that trading through such a platform would offer.

Funds Europe – Can you outline the regulatory environment affecting Ucits funds and their role in lending? Is it the case that Ucits assets are generally seen as less attractive to borrowers?

Chessum – It is always argued that is the case, but it’s not necessarily true. We only lend on Ucits funds and we still make decent revenues year after year. It depends what’s happening in the market. It doesn’t really matter so much what Ucits funds have to do or the type of collateral that they have to take. They have been given stricter guidelines than some other investment vehicles, but that is not necessarily as prohibitive as some participants try to make out.

Chadwick – At the margin it’s harder to lend on Ucits than on unconstrained life and pension funds or big sovereign wealth funds. But if the fund owns assets for which there is demand, then it’s still a viable proposition. The issues specific to Ucits are broader than just securities lending, though. The maximum seven-day term is an issue, as is the inability to re-use or rehypothecate. The asset segregation obligations are potentially an issue too, although the industry has done a reasonably effective job of making sure that some of the worst-case scenarios are unlikely to crystallise.

In any regulated fund structure, whether it’s a Ucits or a ‘NIR’s or an ‘AIF’, mobilising those assets can often be a more painful and bureaucratic process – you have the ACD [authorised corporate director], the management company, the depository, and you’ve got a more onerous set of disclosure obligations within the prospectus.

The easiest assets to lend are basically segregated mandates, which are just basically a bilateral arrangement between two consenting adults who agree what is to be done and get on with it. But while Ucits are always going to be harder to lend than less constrained mandates, the idea that they are somehow toxic from a securities lending perspective is a million miles from the truth.

Arnesen – Ucits are clearly constrained from an HQLA point of view because the maximum permitted loan tenure of seven days does not work with current market demand. But the regulation is known and understood so the restrictions are clear to all.

That said, we have many Ucits fund clients within our lending programme and we work with each of our clients to ensure we optimise loan balances and revenues in all ways possible. Although lending HQLA is a challenge for Ucits funds, lending specials remains a key revenue driver and if there is value in the loan we will be able to get government collateral against it.

Chadwick – There is an advocacy and a lobbying effort on behalf of the industry to try and address some of these problematic friction issues with Ucits. My own personal view is there isn’t any appetite from Esma to reopen the Ucits rule book.

There is so much new primary legislation already agreed and filling the pipeline, it is unlikely they’re going to reinvent a regulation that is done with as far as they’re concerned.

Chessum – That’s why they had a consultation period. That was the time to address it.

Arnesen – The segregation requirements from a collateral point of view are problematic in that there are providers of collateral management that are not Ucits-compliant, so we’re restricted in who we can use. Either there was a misunderstanding as to what the requirement would be, or they didn’t have the bandwidth to develop that properly in time for the legislation.

Chadwick – The thing is also, in addition to Esma you’ve then obviously got the National Competent Authorities, some of whom will just copy and paste the Esma guidelines directly into their own regulatory handbook, while others feel the need to gold-plate them or interpret them slightly differently.

In addition, the lack of unanimity and uniformity of approach and consensus within the depositary community is a significant issue for regulated funds.

Chessum – Yes, every depositary we have interprets them in a different manner. And sometimes, dare I say it, there is also a lack of true understanding and that brings up different questions, which brings up different solutions. You’re therefore not always able to send one report to all depositaries and have them all receive the same data.

Funds Europe – Is the Capital Markets Union (CMU) supportive of securities lending?

Chadwick – Brexit rather messes that up, because all of the original architects of CMU were working on the assumption that London was going to be the centre of excellence. Post-Brexit, I’m not quite sure who’s taking on that CMU baton.

Chessum – London would probably remain the centre of excellence.

Chadwick – Absolutely, but not necessarily the continental European one. The European regulatory and policy-making infrastructure is unlikely to be based in London, given the Brexit situation. This goes back to the earlier point about a liquid, efficient capital market needing a liquid and efficient securities financing market to support it, to support liquidity, market-making and efficient distribution of collateral around the system. So if you want an efficient European capital market, you need to have an efficient European securities financing industry. Whether the people crafting the rules of the CMU fully appreciate that statement, I’m not entirely sure.

Funds Europe – Briefly, what’s your outlook for the securities lending industry over the next two years?

Chessum – It’s going to remain very borrower-driven in regards to their requirements, their capital needs and the regulations that they face.

From a lender’s perspective, there is definitely a strong control environment which is beneficial to the investors in funds. Stock lending is a very versatile product, so there will always be revenues to be made, and if there’s a return to greater volatility along with a better interest rate environment, then we should see increased investor activity.

Khemdoudi – Market infrastructure is deemed to evolve pushed by regulation on the one hand, and on the other the emergence of new platforms, the need to have a more streamlined business and providing untapped liquidity to the market. We already see the first impact on market infrastructure as there are at least five or six different new liquidity/collateral-upgrade platforms currently being launched. On the back end, there is the regulatory push to rethink some parts of the workflow that power this industry.

Arnesen – Two years from now market participants will be challenged with the onerous SFTR requirements and the impacts of the regulation could be felt wider than just the reporting requirements on lenders, but it could fundamentally impact the way in which business is conducted. Borrowers are going to have to maintain their omnibus structure – multiple lenders into one transaction – but they need to know exactly who they are facing in each loan transaction, because each client may come with different capital charges and risk-weighted asset charges for the borrower.

In addition, and we are already seeing this, we are approaching securities finance much more as a type of asset management function. We are looking at basis point return or a total return to lendable basis for our clients, trying to appeal to asset managers in the same way they would look at their own businesses, which is to say securities finance is really a tool or another product which can add incremental returns to your fund.

We are also expanding our borrower base in Europe and in Asia, and a number of the markets in and around Asia will likely become much more robust in the way they function. We have looked tentatively at countries such as Vietnam and other periphery countries in Southeast Asia and they may become far more interesting in the coming years.

The winners in these markets will be those institutions that can overcome the credit issue around lending to onshore borrowers. Supply is typically thin across many of the Asian markets but the added returns to lending clients can be significant.

Chadwick – SFTR is likely to be a game-changer in the sense that it’s consistent with the idea that more transparency is required of the industry. There will be a greater oversight obligation for participants in securities lending programmes. That may lead some of them to consider whether or not they still want to participate. It will also potentially change the way the industry behaves, to John’s point about the focus on risk-weighted assets.

Aviva Investors is an asset manager and we have always regarded this product as an asset management product and view it through an asset management lens. Given the competitive pressures within the asset management industry – and the likelihood that interest rates are not likely to go back up to 5% any time soon – then even if securities lending is only yielding you a handful of basis points, the law of large numbers still applies.

Basically, if you’re not lending securities then ultimately you’re short-changing your policyholders.

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