Covid-19 has made strategic approaches to securities lending difficult this year. At the same time, digitalisation, ESG integration and regulatory drivers are transforming practices. Moderated by Bob Currie.

Xavier Bouthors (senior portfolio manager, investment solutions, NN Investment Partners)
Matthew Chessum (investment director, securities lending, collateral management and money markets, Aberdeen Standard Investments)
Andrew Dyson (CEO, International Securities Lending Association)
Ben Meaden (head of trading, securities finance, Aviva Investors)
Donia Rouigueb (head of sales, securities finance and repo, Caceis)

Funds Europe – Which major events and developments have had the most impact on securities lending and financing markets over the past 12 months? How has this caused you to refine your strategy, if at all?

Matthew Chessum, Aberdeen Standard – It will come as little surprise that the Covid-19 pandemic has had a major impact on securities lending revenue. Typically, volatility is good for securities lending, but the volatility we have witnessed during 2020 has not helped us, when considered alongside the high levels of economic uncertainty that have prevailed throughout the year.

At the start of 2020, economic commentators were speculating about the possibility of a rise in UK interest rates and there was optimism for a strong year for securities lending revenues – but that feels like a distant memory. When the pandemic hit, markets plummeted and this has been unfavourable to asset owners with exclusive lending agreements, eroding the fees these have generated. 

Hedge funds have moved to ‘risk off’ and this has suppressed loan demand. There has been too much volatility for most hedge funds to be confident in trading long-short strategies, for example. There was strong demand for certain Covid-related ‘specials’ in the early weeks after the pandemic took hold, but this subsided as we moved into the summer months and, from August, there has been very limited activity. To compound this, short-selling bans in some markets have also dampened demand to borrow securities.

Donia Rouigueb, Caceis – It has been a difficult year for securities lending, as Matthew has outlined. There were some strong opportunities in March and April – given the volatility, there was demand from borrowers for high-grade collateral. There was also an appetite for ‘specials’, particularly from special situations funds wanting to take advantage of market opportunities.

For the securities finance business, there was high demand for liquidity in the early weeks of the crisis, with customers fearing that a liquidity squeeze may develop like that seen in 2008. Central banks intervened with huge liquidity injections to counter these fears, but there was a short window prior to this that provided a strong pull for liquidity through our repo desk.

We have benefited through supporting a broad array of client types through our securities lending and financing programme, including collective investment funds, hedge funds, pension and insurance funds.

Ben Meaden, Aviva Investors – The onset of the pandemic triggered an initial squeeze on liquidity. Throughout the market, we saw some institutional clients become nervous about their liquidity profiles and pull out of trades or increase haircuts during the early weeks of the crisis. Insurance clients were a prime example, taking early measures to safeguard access to liquidity against fears that the pandemic would trigger a surge in claims and a sharp rise in their cash requirements. 

By Q3, most of these clients had become more comfortable with their liquidity positions, given the huge central bank interventions from March. Subsequently, the market has been awash with liquidity and spreads in repo markets have become very thin. UK policy rates were cut to 10bps in March and the US Federal Reserve also dramatically lowered its target range for the federal funds rate. For liquidity funds that we support through our securities financing desk, any sort of yield pick-up in the current liquidity environment is a challenge, given the tight restrictions in their fund documentation regarding where they can invest, the types of collateral they will accept and the term they can consider. We are exploring many different ways of trying to generate yield for these fund clients.

Chessum – You asked in your initial question how we have refined our securities lending and financing strategy in response to the global pandemic. In truth, it has been hard to make clear strategic choices in the current economic climate. Given the uncertainty in financial markets throughout 2020, it has been difficult to commit to major changes when there is little certainty about what lies around the corner. For many firms, it is a case of getting the tin hats on and weathering the current period of uncertainty. 

There have been some short-term opportunities that have become available as the pandemic has taken hold. With the sharp reduction in the US federal funds rate in March, for example, this has provided openings for those holding USD cash collateral to generate a yield pick-up through reinvestment in money market or prime funds. Beyond this, our focus, as always, has been on maintaining high risk-management standards around our lending and financing strategies. We continue to look closely at counterparty selection, ensuring that we have a strong list of stable counterparties – and this might mean more opportunity to look at peer-to-peer solutions.

Andrew Dyson, Isla – This has been a different type of financial shock to that witnessed in 2007-08. We have not seen major corporate insolvencies, as we did during the global financial crisis, when counterparty defaults were a feature of the early days of the crisis. This may be testament to the steps taken by financial authorities since 2008 requiring banks to strengthen their capital positions and to quantify and manage their credit risk exposures more effectively. Banks are now better equipped to withstand these types of stress.

One consequence, however, is many banks are now reluctant to take risk. This is counterintuitive, given that taking risk is fundamental to traditional banking business. But banks now face a disincentive to take on credit risk from a risk-weighted capital standpoint, given changes imposed under the Basel III Capital regime. This has important consequences for how financial markets operate. When points of illiquidity were developing in the past, investment banks typically used to provide a buffer, performing a ‘market-maker’ role through purchasing assets (e.g. government bonds, corporate bonds) and extending liquidity, providing a dampening effect that kept the markets fluid. However, given the constraints on their balance sheets and restrictions on proprietary trading activity, dealer firms are now limited in their capacity to intermediate the markets in this way. In the early days of the recent crisis, banks absorbed sales of government bonds from market participants searching for liquidity – but they had neither the risk appetite nor the balance-sheet capacity to meet further demand as liquidity concerns heightened.

With investment banks no longer able or willing to provide this intermediation, systemic risk has moved from the banking sector to the markets. Particularly in the US, the central bank is no longer just a lender of last resort, but also increasingly a market maker of last resort. We are dealing with a different type of crisis as a result. In light of this, there may be a case for giving banks more freedom to take on risk, given that they have expertise in evaluating market risk and credit risk and putting appropriate mitigants in place. There have been historical examples where this can go wrong, as we saw in the last financial crisis, but over time, banks have established a track record of providing this type of market intervention.

Xavier Bouthors, NN Investment Partners – It has certainly been a different crisis than 2008. At that time, banks were returning everything on their loan books to ensure they could recover their collateral. In 2020, buy-side firms have focused on ensuring they could meet their liquidity requirements, covering possible redemptions and the need to meet margin calls. A lot of banks were knocking on our door to access high-quality collateral, particularly core European government bonds and US Treasuries, which were in high demand in March, for example, versus Japanese government bonds (JGBs) triggered by the widening of FX basis swaps with JPY.

A point of difference on this occasion was that banks were not simply looking to lock in these high-grade assets for one month or less – rather, they were looking to borrow for three, six and sometimes nine months. The message we were getting in March was, ‘If this crisis is as bad as our modelling predicts, we need to lock in some high-quality government bonds towards year-end.’

Like Ben, we manage a number of different types of internal client. We are supporting sizeable Ucits portfolios, but also have pension and insurance portfolios within NN IP. Inevitably, OTC [over-the-counter] derivatives positions were heavily impacted by the high levels of volatility, requiring that we were watchful of their liquidity needs both in terms of covering potential redemptions, but also maintaining a liquidity buffer to meet margin calls on derivatives positions.