Bringing together funds industry specialists and custody banks that offer lending programmes, Funds Europe
discusses recent market developments, including volumes and revenues in the Ucits business.
(head of securities finance, Aviva Investors)Maurice Leo
(senior managing director, State Street Global Markets)Steve Kiely
(head of securities lending, BNY Mellon)Xavier Bouthors
(seniorportfolio manager, treasury, NN Investment Partners)Matt Chessum
(investment dealer, Aberdeen Asset Management)
Funds Europe: What are the positive trends and opportunities in securities lending from which beneficial owners can harness a greater return?
Steve Kiely, BNY Mellon:
A year ago, it was only the vanguards taking advantage of equities as collateral. Now it’s the majority – certainly against equity loans.
Beneficial owners are starting to look at ‘term’ as a way of increasing returns. In equity financing, the difference between rolling overnight and three-month evergreen can be as much as an extra 50%-60% return. The IMN published stats in September suggesting overnight trades have gone from 96% of all the trades done globally to 84%.
Mick Chadwick, Aviva Investors:
The critical thing is you need both from a mandate perspective. So much of it is increasingly liquidity-driven demand for term financing facilities and that requires any client to have (a) the ability to contemplate term structures, but (b) at least a modicum of flexibility in their collateral profile to take advantage of these kinds of opportunities.
Maurice Leo, State Street Global Markets:
There is more momentum. ‘Term’ [lending] is definitely there. Collateral flexibility is definitely your friend in the current environment, and each broker has their own preferences of what it wants to post as collateral.
High quality liquid assets (HQLA) remain very much in vogue, tied into term, tied into equity collateral. We’ve seen innovation around transaction frameworks so some of the counterparties are looking at ways to be more capital efficient than typical title transfer of collateral.
Matt Chessum, Aberdeen:
We lend on behalf of Ucits funds, so there’s been relatively fewer opportunities in relation to the market. We have spent time looking at the additional risks in relation to lending versus equity collateral and we’re happy to start accepting equities as collateral. It has given us a few more opportunities in terms of who we can lend to, and more flexibility over how we manage our books.
Xavier Bouthors, NN Investment Partners:
I agree with what has been said. For non-Ucits funds and insurance companies, we also see more opportunities on collateral upgrade trades. For Ucits funds, we interact more with the counterparties on corporate action trades. There’s more interaction with portfolio managers on these corporate action opportunities to try to capture the yield.
What I’ve noticed over the last year is a lot more people reaching out to asset managers directly to offer them lending solutions in different aspects of asset management in general.
Funds Europe: What’s the difference between a pledge and a title transfer?
A pledge tends to be a more common form of transferring collateral under US agreements. When dealing with US counterparties it tends to be pledge, and the European market is geared towards title transfer.
The regulatory treatment between pledge and title transfer is different.
Pledge is more advantageous for the borrower, as they get better treatment from a capital perspective.
There’s no balance sheet impact in a pledge, whereas in a title transfer it leaves the balance sheet or goes on to the balance sheet.
We see some issues in a pledge because you attract different jurisdictions depending on where the pledge sits and where the lender sits.
Because the European market has evolved as an almost exclusively title transfer environment, a lot of our clients need to see a business case before they look at an alternative structure. It’s important if the pledge structure is beneficial to the borrower that the benefit gets passed on in the form of either greater volumes or higher fees.
Funds Europe: How are regulatory and market trends impacting the securities lending and collateral management landscape? For lenders, is the environment becoming easier?
It’s becoming increasingly difficult for Ucits funds to engage in securities lending in the same way they did before. Our book hasn’t changed much – we retain broadly the same risk profile, and we’re doing what we did before. However, opportunities coming our way are probably going to be fewer and fewer. We have more regulation to deal with, meaning new reporting requirements and having to enhance processes already in place. We’ve got AIFMD, we’ve got Ucits V, we’ve got new transparency directives.
One recurrent theme is a much more onerous reporting obligation. There’s a hope and expectation that some of the reporting plumbing built to meet one regulatory need can be recycled, leveraged and applied to meet others. When you are working in multiple jurisdictions, there’s more work to do in terms of meeting multiple reporting obligations. An agent can do some of the heavy lifting, but ultimately it’s the fund’s responsibility.
It’s difficult to know how each jurisdiction in Europe will apply the same rules. We have Swiss funds that lend, we’ve got UK Oeics that lend, we’ve got Luxembourg C-Caps that lend, so we need to make sure any piece of regulation can be overlaid across all jurisdictions.
Funds Europe: In the Ucits business, is lending generally down on last year? Are Ucits funds being cut off from securities lending as a source of revenue?
Volumes are definitely down, but I wouldn’t say revenues are. You need to consider lending as you would any other investment activity. One year you might do very well, another you might not, depending on the stocks you’re holding and the value they have in the lending markets. We’re long-term investors so we look at lending returns from that perspective.
Ucits are effectively shut out of participating in certain types of trade. That said, demand for ‘traditional’ specials has held up pretty well this year.
One key area I’d pick up on is indemnification and the regulatory impact there. Basel III has significantly increased the regulatory capital impact for indemnification.
Agents for the most part are being more judicious when committing to business now, trying to delineate pricing between different types of business and finding a better balance between client and shareholder value.
Indemnification is an interesting subject. When clients are used to having something ostensibly for free, it’s difficult to then ask them to pay for it or take a limited form of it. It’ll be an exceptionally brave first mover who sticks their head up above the parapet and says, “We’re not going to indemnify.” If you’re the first to make that move, you’ve got franchise risk.
For an agent lender, return on capital has never been more important than right now in terms of what the market refers to as ‘indemnification’. Basel III will have some implications for existing lenders but a limited impact overall. A year ago, price was split between indemnified and unindemnified.
We’re going to move to a stage where, within a programme, there will be different fee splits for different trade types, because the return on capital for the agent lender is enormously different in terms of the type of assets lent and the type taken as collateral.
From a beneficial owner’s perspective, it’s a great time to shop around. There are a lot of agent lenders out there. The smaller agent lenders tend to have less of these issues because they have fewer clients.
A possible issue with smaller firms is they may not have the balance sheets to back up indemnification.
Indemnification is there to protect against the loss of a borrowing counterparty. If you’re prudent and cautious in your counterparty borrowing selection, chances are your counterparty will be a large systemically important bank.
The question is to what extent can you rely on indemnification provided by another large, systemically important bank, given that the correlation coefficient between those two default events is not zero?
Bouthors: Don’t forget, as lender you have selected the collateral backing the trades and you have your counterparty selection, with daily mark to market – so what’s the indemnification providing?
It’s a pity indemnification grew up as part and parcel of what clients expect. The quantum of risk involved in this is low to begin with. Anybody who thinks indemnification is the be-all and end-all in terms of the risk mitigation in their programme is not really looking at the right thing.
I’d be interested to hear what you think about indemnification. It’s an all-or-nothing thing, by and large. You’re either indemnified or you’re not. Would there be an appetite for limiting the indemnification so you’d be covered for a certain amount of loss, but after that it would be your risk?
You could have a proposal whereby you’ll be indemnified, provided the collateral portfolio is restricted to these assets or you’ll be indemnified up to a certain threshold and after that, you’re on your own.
For years, indemnification hasn’t just been sold as an insurance policy – it’s been sold as a way of ensuring the interests of a beneficial owner are firmly aligned with agent lenders. If you take that away, you remove a guarantee – and a great sales pitch. At the same time, if securities lending becomes too complex and there’s too much regulation, certain areas of the market will just walk away.
It’s not becoming easier, it’s becoming more complex. The beneficial owner has a lot more to consider now. However, the programme the beneficial owner ends up with is even more transparent.
Funds Europe: Should regulators be concerned about the securities lending activity of asset managers?
The things regulators are really worried about are shadow banking practices, such as maturity transformation and collateral rehypothecation. If you’re a Ucits fund and you’re not doing either of those things, systemic risk would apply if those funds weren’t lending because of the risk to the liquidity and efficiency of the underlying securities market.
The interconnectedness between lending and cash has decreased. When you look where the industry is going, 60% of balances according to ISLA’s latest survey are in the form of non-cash.
That may be cyclical, partly due to the interest rate environment, so it could change at some point – but it’s nowhere near as strong as it was back in 2007.
Regulators are definitely looking at systemic risk and stability of supply, trying to profile what different institutional investors would do in a shock scenario.
A lack of liquidity concerns everyone. Some of the regulations limiting lending activities of certain owner types, such as Ucits, could contribute to a lack of liquidity in times of a crunch. That could be an unintended consequence of some of the things we’re seeing.
In respect of HQLA trades, on the one hand you’ve got Emir [European Market Infrastructure Regulation] and Dodd-Frank, which creates a huge amount of demand for HQLAs. At the same time, banking regulations rely on a certain amount of collateral velocity and collateral reuse. Then you’ve got regulation on the buy-side that is restricting precisely that type of activity. Sometimes, regulation seems to be applied inconsistently.
One area likely to attract further attention is asset managers offering indemnification over their lending programmes, which changes fundamental risk profiles. The indemnification commitment has an associated regulatory capital charge for certain groups of custodian banks and third party lenders.
At the moment, asset managers offering indemnification may not be subject to that same approach. I suspect we’ll see a convergence over time.
Should regulators be worried about it? It depends. Should they be looking at it? Probably. A lot of these changes have happened since the crisis, and the regulation that came in was to look at what happened before the crisis. It’s definitely something that should be looked at, to make sure we don’t end up in the same situation as in 2008.
There’s a broader question for the asset management industry to answer about systemic risk, particularly if they’re offering a product that gives clients instant access and liquidity. If you get a rush for the door, how liquid is it? It’s a much broader issue than securities lending. As far as securities lending is concerned, if you know your customer, you should have a lending programme consistent with their liquidity profile.
Clients who need to retrieve their capital instantly shouldn’t necessarily be looking at term stuff. On the other hand, if you’ve got sovereign wealth funds or insurance and pension funds with a longer-dated liquidity horizon, the need for that kind of instant liquidity isn’t necessarily there in the same way.
Liquidity also depends on the asset class you’re lending. We see an increased need for collateral on different instruments traded. This has to be taken into account to assess the liquidity profile of the portfolio.
You could argue asset managers are systemically risky as they pass on risk and pain to underlying policyholders. Money market funds historically used to be constant net asset value, but increasingly they’re moving to variable net asset value. This means if there’s a run on the fund or a major liquidity event, the pain is felt by policyholders as the value of the fund is marked down, and not necessarily transmitted to the wider system.
You already have various regulations like Esma with collateral diversification requirements and cash reinvestment rules.
Funds Europe: What impact will central clearing of securities through central counterparties (CCPs) have on securities lending, and should beneficial owners favour this model?
If one considers how long CCPs have been around, and the amount of traction these platforms have got, you could be forgiven for wondering what the fuss is about. That said, it is a no-brainer for the sell side to use CCPs and it’s only a matter of time before that transmits itself in the form of commercial pressure on lenders to look to adopt that model.
CCP should be part of the whole route to market. However, some CCPs still lack on the operational side and on the legal documentation side, it’s a work in progress. There will be some traction, but there’s still some work to be done there.
Many clients have already had to look at CCPs for their OTC [over-the-counter] derivatives business. A lot of clients regard their derivative business as non-discretionary; it’s a core part of their portfolio trading strategy, so they’ve had no choice but to engage with this model. Securities lending for the majority is still a discretionary add-on. If you make it harder and more complicated for them to engage, they may decide it’s not worth the hassle.
I’m very happy with who I lend to, what I lend against and the indemnification against potential losses. Putting everything through a CCP, where I lose some of the control over my operations, isn’t too attractive to me. However, if all borrowers say, ‘“This is the only way I’m going to be able to lend my securities,” then I haven’t much choice.
The thing that interests me most is there is obviously going to be a price differential, because it is economically better in the round for the borrower to borrow via a CCP.
Most buy-side clients won’t be able to flip this switch and start lending via a CCP within a matter of days or weeks. It’s a due diligence exercise that will take months. Most buy-side underlying beneficial owners have got so many other things on their plate. Unless and until you get a tangible differential in black and white from the borrowers on price and volume, it’s going to be difficult to get an initiative such as this prioritised internally.
Funds Europe: What is your outlook for the year ahead? What would you most like to see happen to benefit the lending industry?
Positive. You’ve got Emir coming in the back end of next year, which will give a spur to the HQLA demand we’re already seeing. Event-driven demand in the equity space looks set to continue. I’d like to see regulators continue their dialogue with the industry and look again at some of the regulations designed for the underlying cash market, particularly the regulation of pooled vehicles such as Ucits.
I’m cautiously optimistic. I’d most like to see continued dialogue between agent lenders and beneficial owners as to trading opportunities that come up from time to time for the benefit of all.
My outlook is likewise positive. We still see opportunities, and the greater transparency and dialogue within the industry is also welcome. We are making more portfolio managers aware of the potential of securities lending.
The outlook is relatively positive, even for Ucits funds. We know what the regulation entails, we know where we’re positioned, we know what we can and can’t do. In the active management space, it’s also positive. There’s a lot of competition from passive funds, so managers need to step up and add extra income to funds wherever possible.
In terms of the industry, I’d like to see a slow and steady approach with no blow-ups and no issues, just to make sure we can carry on showing the real benefits of securities lending without having to deal with unintended potential issues that aren’t necessarily applicable to all lenders across the board, such as the fiasco of 2008.
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