Our securities lending panel in London discusses the 2018 market and the outlook for 2019.
Matthew Chessum (investment manager, liquidity management, Aberdeen Standard Investments)
Adnan Hussain (global head of agency lending, BNP Paribas Securities Services)
Stephen Kiely (head of new business development, securities finance, BNY Mellon)
Funds Europe – How has the rise in market volatility during 2018 affected securities lending demand? More broadly, how would you describe the market this year?
Adnan Hussain, BNP Paribas – Certainly volatility did return in 2018, though it would be a broad statement to apply to all markets. In the US, for example, there was a significant bull run in certain sectors. Some of the rises in interest rates in the UK, Canada and the US had a significant impact, too. There was also uncertainty from a geopolitical perspective with Brexit, Russia and the trade war tensions with China. All in all, 2018 was a better year for a majority of portfolios that would be considered balanced, due to increased market volatility from a combination of higher interest rates and geopolitical tensions.
Finally, opportunities remained robust throughout 2018 for clients willing to add bespoke strategies to their lending programme, including transactions with longer tenors and non-traditional collateral.
Matthew Chessum, Aberdeen Standard – There have been some strong pockets of demand across the securities lending industry in general. Not a broad sweep of positive returns for every portfolio, but there has been, particularly in Asia, some good returns generated. Our Asian smaller companies fund, Japanese smaller companies fund, and Japanese equities in particular have provided strong returns.
In the fixed income arena, we’ve seen a lot of interest in high yield bonds. In fact we’ve seen the best returns from a securities lending perspective on those portfolios since the inception of the programme ten to 15 years ago.
There’s a lot of market-making activity in this area. Market makers like to have the supply available to them, so there is always demand to borrow. The returns on those holdings have been very good, mainly down to more interest in that sector in general.
Stephen Kiely, BNY Mellon – So far this year, some portfolios have performed better than they have in previous years. On balance, most people have had a better year. There have been pockets of demand which have been filled and that’s pulled everything up. Volatility helps equity markets more than fixed income. We’ve seen big increases towards the second half of the year, 33% up year-on-year in October. In revenue terms, this is our most successful post-crisis October.
The world is becoming a less stable place as we move into 2019. Brexit doesn’t change by the week or day any more, it changes by the hour. There was activity in Ukraine recently. There is still uncertainty as to the American administration’s position on certain issues. There are a number of financial initiatives, such as the amendment to the French Finance Act 2019 that was announced and which will potentially affect French dividends. With all this suddenly coming out of the woodwork, it’s making everyone feel a little uncertain as to where 2019 is going.
Hussain – In any given year, demand and supply is one of the primary drivers from a securities lending perspective. You will always find that where you do have supply in the context of small to medium-cap firms, those types of portfolios will always lend more positively. For example, a Russell 3000 portfolio has a very different return profile to an S&P 500 portfolio, and 2018 would have highlighted that even more because where you have rising volatility, the securities lending returns on a S&P 500 portfolio would be relatively muted, compared to those of the Russell 3000, due to the components of each index. The volatility as of late is certainly evidence of the supply and demand dynamics driving programme returns.
Chessum – You can do very well if you hold certain equities at certain times. From our perspective as a long-only asset manager, that’s good, because if there are more equities in demand, it means that people are willing to pay high fees for them, so from a risk-reward perspective that’s a good transaction for our underlying investors to be involved in.
Kiely – It proves that you need to be nimble in this market. For example, if you’re a beneficial owner who only lends certain asset classes and you have to go to your investment committee or your board of trustees in order to lend Russian GDRs, that could take six months to get approved, and to a certain extent you might miss the boat. If you’re an agent lender who doesn’t lend that asset class, you can’t take advantage of your clients’ long balances.
Funds Europe – Which have been some of the main corporate actions over the past 12 months that have generated high levels of stock lending activity?
Kiely – 2018 has not been a particularly strong year on the corporate actions front. The Kering Puma spin-off was relatively popular. Year-on-year over the last four or five years, we’re earning more from scrip dividends for our clients, and the proportion of their revenue that comes from that is increasing as well.
Hussain – I agree. Again, it really comes down to portfolio dynamics. It’s very easy when you consider M&A activity – you generally want to see a large-cap name that’s going to impact a wide swathe of participants in a programme or programmes in general. We definitely did not have that in 2018. We did, however, see how securities lending is able to provide value where a manager is looking for cash – for example, making a suboptimal election and therefore leaving money on the table, essentially using securities lending to be able to optimise their return profile. All in all, I agree that there’s generally a larger take-up. The scrip-dividend type of trade in the US has been the main driver rather than M&A.
However, there remains ample opportunity to generate excess return through corporate action trading. Communication between the agent and beneficial owner remains imperative to coordinate responses in a timely manner to monetise each corporate action activity. We have certainly experienced greater levels of dialogue with our clients around corporate actions in 2018.
Kiely – We’ve almost come to expect a yearly increase in scrip dividend activity, but as we move towards more volatility, perhaps we will see a slight pulling back. Statoil and Shell both cancelled scrip dividends in 2018. Companies need to be in a position to issue a dividend in the first place to worry about whether it’s going to be a standard dividend or a scrip.
Chessum – We definitely see value in trade in scrip dividends through our agent lenders. You can assume that a return of greater volatility in the market should see greater revenue attached to those transactions, given the embedded optionality involved in this transaction. We encourage our agent lenders to look at these opportunities, and we encourage our fund managers to take up those opportunities where possible. The pricing of scrip dividends is also becoming quite competitive.
The good thing about scrips is that they’re prevalent in many different markets around the world, so when going back to pockets of revenue streams, there’s some good scrip opportunities throughout many different types of funds and portfolios – whether it’s Asian equities, European equities, there’s money to be made.
Hussain – Some are a lot more vanilla while others are more complex. For example, simple DRIPs in the US offer a direct discount. If you as the beneficial owners are not going to take up that scrip, there is no volatility associated to it. Other events are more complex and require the agent to be much more granular about trading. As an example, if it is a 5% discount and effectively just a stock election and a divestor of the stock itself, taking that on as an agent, we have to acknowledge the risk each side is taking and effectively value on that basis.
Funds Europe – Is the regulatory environment proving accommodating for regulated funds looking to make significant use of securities lending?
Chessum – Regulation on Ucits funds is probably doing what it was intended to do: give confidence to the underlying investor. But it is limiting them to plain vanilla securities lending, nothing more than lending stock against a piece of collateral, and then having it returned. There is no term lending or rehypothecation of collateral. There are also restrictions around the types of collateral a Ucits can take.
How that fits in with the demand that’s coming from the other side of the trade is another question. However, as long as you’ve got the right expectations and the right programme parameters, there are still revenues to be made.
Kiely – Going back to 2015, the supply from entities regulated by Esma [European Securities and Markets Authority] – including Ucits funds – was probably three times the number of loans coming from those entities. You can draw the obvious conclusion, therefore, that they are difficult to borrow from and may be seen as last resort by borrowers.
Since then, as other regulations started to bite, borrowers started turning away from entities where there was no clean-netting opinion, or maybe because of a difficult geopolitical situation. These entities were becoming expensive to borrow from.
Now, this year and next year with the move towards pledge collateral – which is a difficult concept for Ucits funds – it may be that we will see people look away from regulated funds yet again.
I am concerned that certain funds for whom lending is a useful activity for generating moderate income perhaps, to cover their custody or other fixed costs, then the tighter loan limits, the stress testing of collateral and the arrival of SFTR may cause them to pull out. That’s not good for liquidity.
Chessum – Unintended consequences are unfortunately possible as a result of some of these regulations. Look at CSDR, for example, where there are going to be automatic buy-ins. In many liquid equity markets it’s not going to make a difference, but ultimately if you’re going to be lending high yield European bonds, then liquidity in those assets is already tight and the possibility of being cashed out in an on-loan position that a borrower may struggle to return may make some asset owners re-evaluate the risks attached to lending these assets.
The Capital Markets Union project is about making deep liquid European financial markets. Yet people are going to stop lending in those markets because they have a buy-in placed upon them.
On the flip side, you might be able to lend at high rates and therefore generate more revenue, so it will be interesting to see how this plays out.
Hussain – I have a slightly divergent view when it comes to regulation and the impact on Ucits funds, more along the lines of the investment function. Historically, from a Western society perspective, it was a defined benefit (DB)-only market where pension plans made decisions on behalf of their pensioners and ensured there was sufficient savings for retirement. As corporations have moved towards a defined contribution (DC) framework, where individuals are responsible for making their own investment decisions, essentially the money that used to be in these pension houses is slowly moving into the funds businesses.
So there is harmonisation between the pension scheme and investment funds businesses, and also extending to insurance companies. It would be appropriate, therefore, for there to be a harmonisation from a collateral and regulatory perspective, too. It seems counterintuitive that the same unit holder would not be able to realise the same benefit when moving between investment structures on a mandated basis from a pension plan to an insurance company or an asset manager in harnessing the benefits of securities lending. So from a borrower perspective, I expect to see different types of trades end up becoming a last- resort measure. Some scale will be a factor, but borrowers will generally gravitate towards lenders with the most flexibility in their collateral profiles and permitted longer tenors.
Kiely – Size is a consideration. Comparing regulated funds to the rest of the market, in general you’re looking at smaller beneficial owners or smaller legal entities compared to leviathans such as sovereign wealth funds or central banks. Is some of the perceived underperformance simply due to the fact that they’re not as big? An interesting conclusion can be drawn in a year or two’s time when we look at local authority pension schemes in the UK who have combined together to get better purchasing power, and among those that lend, to see how their performance has changed.
Funds Europe – Is stock lending emerging as a strategic option for funds wishing to reduce their investors’ fees?
Chessum – It always has been. It’s always had an impact on the expense ratio of funds, and that’s why asset managers have wanted to be involved. Anything that boosts returns in a risk-adjusted manner, and which happens in the background, which is fully indemnified, and which has the risk-return metrics that securities lending has, it would be money just left on the table if you did not participate.
Kiely – One of the reasons we’ve seen an increase in securities lending activity from new participants in this market, and why I’m seeing increased or more frequent enquiries in starting a securities lending programme, is because some of these costs are going up due to regulatory compliance or even Brexit. Someone’s got to pay for the battalion of lawyers that are now necessary and that money has got to come from somewhere.
Chessum – When you’ve got active managers competing against passive managers, particularly given the landscape over the last five years, there is a very different cost base between the two, as the skills and techniques used are very different.
One’s all about scale and the other one’s all about pure analysis, and that means that you have to have the right tools and the right people in place, and you have to pay those people.
Tracker funds in particular are where the real competition is for securities lending. Given that they are passive, it’s an obvious choice for them.
Kiely – What about things like the zero-fee index fund and low-cost ETFs? Is this a flash in the pan, or the new normal?
Funds Europe – Is there still a growing consensus that there is enough collateral in the system? Are capital markets facilitating the movement of collateral as efficiently as they should?
Kiely – We are in a ‘boy who cried wolf’ situation, with the doom-mongers warning to beware the collateral cliff. They’ve been saying this for ten years and we haven’t seen a cliff yet. Are we likely to? Probably not. If you were to put me on the spot on the question of whether enough collateral exists, I would say yes. But we as an industry are not moving it around as efficiently as we could.
Hussain – Absolutely. It comes down to change. Currently, market dynamics tend to be dictated by the borrower – trade structure, tenors and collateral flexibility. There is plenty of collateral in the markets. If not enough exists, what are we asking?
That lesser forms of collateral be given to the beneficial owner? Ultimately the answer is no – there is certainly enough collateral out there.
The right collateral for the right trade exists. For example, when you move into pledge structures, it again alludes to the idea that there is not enough collateral in the market, which is incorrect from our viewpoint. Our role as an agent is to enhance and optimise returns for our clients, and in doing so the question has to be asked: If there’s insufficient collateral, what is in it for the beneficial owner who at times is supplying collateral by way of securities lending? The answer to this question ultimately means borrowers do not need to borrow more collateral or source more collateral, then in turn beneficial owners will lend less.
There is an estimated 22 trillion of securities available for loan globally, so BNP Paribas is of the opinion there’s absolutely enough collateral in the marketplace to create ample opportunities. Those securities can be borrowed and act as collateral.
However, there is a cost to this collateral which has always existed but if the market gravitates towards new structures, that ultimately mean borrowers do not need to borrow or source more collateral; then in turn, beneficial owners will lend less or require some sort of concession. These are the types of discussions we are having with our counterparties as we examine new trade structures.
Chessum – The overall answer is yes, there is enough collateral available – but I don’t know for how long. Is Brexit going to lead to disjointed collateral pools in different jurisdictions? If it does, that might create some potential demand, or it might create some potential collateral headaches for certain borrowers.
The introduction of SFTR might cause a few bumps in the road, given sovereign wealth funds are naturally a little bit shy about divulging information about their activities and they comprise at least 50% of all of the government bond balances currently on loan. It all comes down to the function of the market; there’s a lot of upgrade trades or downgrade trades from a beneficial owner’s perspective that are all linked to the amount of the leverage available in the financial system.
Kiely – A pledge structure is financially more efficient for a borrower in terms of their regulatory capital allocation. We’re moving towards that, but the beneficial owner can still extract more value out of that trade. On the operational side, we live in a world where, because the borrower pays for the collateral movements or the custody of the collateral, it’s always been the borrower that selects the triparty agent. Would beneficial owners be prepared to absorb some of that cost in order to have a greater say in how that collateral is held and reported?
Chessum – With anything linked to cost, my automatic answer is no. It depends how involved the entity is and how important they see securities lending to be within their overall investment strategy. What you’ll tend to find is that it’s a bit of an add-on where perhaps people don’t really want to give this a huge amount of thought.
Hussain – Ultimately there tends to be harmonisation on the demand side about how things progress, but less so on the supply side. Regulation is supposed to create more harmonisation. For example, if 25% of the supply side is able to take on the pledge structure, that then is going to be beneficial to counterparties and will immediately relegate 75% of supply to being a last resort. We believe this to be the case because borrowers will always seek solutions which are the least punitive from a capital and cost perspective.
Kiely – Markets have talked about optimisation as a good thing. It’s good for beneficial owners because likely they would have more pieces of collateral, and smaller pieces too, meaning they would get a more diverse collateral set. It could be argued that reduces concentration rates. But the real benefit is towards the borrower, because the borrower can use assets that maybe couldn’t be used elsewhere. A lot of these efficiencies around that – and the omnibus structure of triparty accounts, the book-entry nature of it – have benefited the borrower. But what would benefit the beneficial owners? We need to get to a point of more up-to-date pricing; and something the market is going to get to sooner or later is ESG collateral sets for certain demographics, where they’re not allowed to invest in certain assets, so they don’t want to take collateral in those.
Chessum – In terms of efficiency of collateral movement, once SFTR comes in and you have to report – and pay to report – every collateral movement, there may be fewer collateral movements taking place, just to reduce costs.
In terms of pledge structures, pledged collateral cannot be rehypothecated. So although it might be more efficient in one trade, given that the borrower who has pledged that collateral can’t reuse it, that might slow things down. It might mean that there’s more opportunity to do certain trades, but the velocity of moving that collateral around the system might get stuck at certain points.
Funds Europe – What is your outlook for the year ahead in securities lending?
Chessum – Increased volatility and a continual increase in interest rates are going to be positive and might lead to more demand. If companies want to refinance loans, they might have some difficulties as loan rates go upwards.
There might be some directional opportunities in the market. Volatility in general tends to lead to more opportunities across the board.
The ESG conversation, here in the UK in particular, is going to become more important. It’s already started, mainly in the Nordics and Continental Europe.
SFTR coming in is going to focus people’s minds on operational efficiencies, which will be positive in general – it will probably improve certain upgrades and help with recalls and matching returns and new loans, and will make the market a whole lot more efficient.
That said, you’ve got a lot of unknowns: Trump, Brexit, trade wars. There are a number of different challenges.
Hussain – There is plenty of sentiment that the market has reached significantly high levels of volatility, which should naturally lead to a better securities lending environment. As interest rates rise, corporate activity should increase in general. I agree with the point about refinancing. Having to do so at a higher interest rate could lead to more M&A-type activity, and that’s positive for a portfolio from a securities lending perspective.
For the past five years, we’ve been talking about pledge structures and the use of central counterparties. Those themes will remain consistent. SFTR has been delayed and will lead to more transparency because people have more time to understand how to approach it while implementing a solution. We do believe the combination of regulation and capital constraints will impact the smaller lender. Europe specifically has a lot of self-lending taking place, larger asset managers that then have their own in-house lending functions, which could prove to be challenging and costly.
2019 will be a positive year for beneficial owners, driven by a combination of higher interest rates and geopolitical tensions. We remain convinced that clients with the proper risk profile – permissible collateral and tenor – will continue to achieve solid performance in the upcoming year.
Kiely – One trend is automation. In October of this year alone, we put $21 billion through EquiLend’s NGT. We couldn’t have done that manually without an army of people. On the performance side, we’re signing more and more borrowers and lenders up to pledge each month, and that will continue until it reaches its natural conclusion.
We’ve talked a lot about equities, but on the bond side 2018 has been a good year for emerging market debt and corporate bonds. If US interest rates continue to rise, then that spread between those assets and the US will widen and there will be even more opportunity.
©2018 funds europe