Our securities lending specialists discuss recent priorities, routes to market, collateral eligibility, performance-monitoring, decision-making and technological advances.
Xavier Bouthors (senior investment manager, treasury, NN Investment Partners)
Mick Chadwick (director, global head of securities finance, Aviva Investors)
Matthew Chessum (investment director, liquidity management, Aberdeen Standard Investments)
Kabin George (global head of the securities finance product team, IHS MarkIt)
Graeme Perry (head of agency lending EMEA, BNP Paribas Securities Services)
Funds Europe – What have been the priority issues that have shaped your securities lending strategy over the past 12 months? And what have been the major discussion points around the water cooler?
Matthew Chessum, Aberdeen Standard Investments – Foremost in our priorities have been steps to optimise efficiency of collateral management across the organisation, including securities lending, repurchase agreements (repo), OTC [over-the-counter] derivatives trading and other collateralised activities – and to ensure this aligns with the liquidity management strategies that we operate internally.
In terms of market opportunities, Aberdeen Standard Investments is predominantly an intrinsic lender. There have been some attractive ‘specials’ linked to IPO activity, particularly in the US, and this has offered attractive rates to companies holding these stocks. However, in some cases there was an initial lock-up period after the IPO date, which limited the number of people that had access to these shares.
On the fixed income side, we have had some good exclusive lending activity for high yield debt and for emerging market corporate debt assets that we hold in portfolio.
Mick Chadwick, Aviva Investors – For Aviva Investors, revenue generated from our securities lending programme is slightly down year-on-year from 2018, in line with what we’re seeing across the broader industry. Loan demand has been affected by an ongoing ‘deleveraging’ of the sell side, with risk appetite currently dialled down across the hedge fund and prime brokerage sectors. There have been selective opportunities linked to IPO activity, as Matthew mentioned, but if you do not own those securities, you are not in a position to take advantage.
As head of securities finance, my team’s responsibilities are broader than securities lending. We do not view securities lending as a product in isolation, but rather as part of a suite of collateralised financing solutions that include repo, reverse repo and collateralisation of OTC derivatives trading. Our focus continues to be on maximising efficiency of collateral and liquidity management across all of the business areas that we support.
Like many across the industry, our preparations for the Securities Financing Transaction Regulation (SFTR) have consumed a lot of time and resources over the past 12 months and this will doubtless continue into 2020.
Xavier Bouthors, NN Investment Partners – A priority during 2019 has been to ensure that our securities lending programme aligns with NN IP’s ongoing commitment to sustainable and impact investing. It is essential that all assets and collateral utilised in the programme meet our ESG standards and sustainability guidelines.
A second project focuses on collateral optimisation – on ensuring we mobilise and allocate collateral efficiently across the product areas and geographical locations in which NN IP is active. We have launched a product called the ‘collateral channel’ focused on delivering efficient collateral management across our business and to clients.
In line with others’ comments, revenue from the equity component of our securities lending programme has been down for the year to date relative to 2018. On the positive side, we have been building our lending activity in high yield debt and emerging market debt.
Kabin George, IHS Markit – Global securities revenues during Q3 2019 were $2.6 billion (€2.3 billion) and for the year to date these stand at $7.6 billion, down 9% compared with the first three quarters of 2018. The standout activity has been the high level of demand for ‘special’ or hard-to-borrow equities in North America. A stream of recent IPOs [initial public offerings] drove appetite for equity specials. For Beyond Meat, which manufactures plant-based meat-alternative foodstuffs, borrowing fees were higher than 300% during the latter part of June. LYFT and Uber also generated a high level of demand. Beneficial owners that held these attractive stocks generated healthy revenue, although it was otherwise rather a bleak picture globally for the first half of 2019. While Q3 was particularly strong for equity specials in North America, some of those specials from Q3 have declined in Q4.
A particularly significant event last autumn was the repo price spike in the US on September 17. Banks that use repurchase (‘repo’) agreements to access short-term funding experienced a surge in their cost of borrowing. In response, the Federal Reserve injected more than $50 billion of liquidity to offset this high demand for liquidity and to stabilise rates in the US overnight funding market.
In comparing publicly disclosed data for US short-selling activity with loan supply data that we collate from the lender community, we find that the former is approximately 30% higher than reported loan supply. This is partly the result of rising levels of ‘internalisation’, where prime brokers are sourcing securities internally to supply the borrow to a hedge fund, rather than sourcing this from an agent lender or other external loan source.
Chadwick – A number of factors are driving this growth in supply. The cost pressures facing the industry dictate that no responsible investor can afford to leave money on the table. The incremental revenue from securities lending may be worth just a few basis points, but if you own a portfolio worth $10 billion, every basis point is a million dollars per annum in low-risk revenue. Institutional investors cannot simply disregard this revenue stream.
To Kabin’s point, the hedge fund and prime brokerage sectors are refining their strategies for sourcing borrowed stock to support long-short activity, internalising a lot of this activity and sometimes using synthetics to meet their requirements. We have noted the impact this has had on loan demand.
Chessum – The asset management sector is playing catch-up with the sell side in this area. Whereas we are managing our internalisation initiatives now – improving our ability to mobilise loan securities and to optimise collateral allocation across the organisation – the sell side has, in many cases, already done a lot of this work. Because all organisations are under such enormous cost pressure, we all need to find ways of making our securities finance activities more efficient.
George – A more general observation is that beneficial owners that had abstained from the securities lending market since 2008 are continuing to return. A wide range of risk metric tools are now available, from data specialists such as IHS Markit and from agent lenders, that help lenders to monitor and manage their risk. Many now feel comfortable to resume their securities lending activity.
Graeme Perry, BNP Paribas Securities Services – It has been a good year for our agency lending programme at BNP Paribas Securities Services, but it has not delivered the highs of 2018. This comes back to a fundamental question, “Where is the demand?” A lot of loan supply has entered the market – although it is interesting that a number of beneficial owners are reviewing longstanding relationships with agent lenders, widening their routes to market and diversifying their lending channels.
If we are to identify a question that is most discussed around the water cooler, it might be whether the highs of 2018 are an anomaly or whether 2019 is a new norm. Supply has grown, demand has dropped off, spreads have narrowed and there is a concern that we may all be chasing a golden egg that is never to return.
Against this background, it is clear that the industry faces challenges. However, I am confident that we are meeting these challenges. There is certainly demand out there – but this requires looking beyond the traditional set of counterparty names that have driven demand historically. It may also require looking outside of your local region for opportunities – we have already reflected, for example, on strong demand driven by corporate actions in North America in recent months. We are ensuring that we cover A through to Z, bringing securities lending opportunities globally from the Americas to Asia.
A parallel question is whether high-quality liquid asset (HQLA) securities lending activity, and collateral transformation trades designed to meet HQLA demand, are now slowing down.
Chadwick – The HQLA market is certainly thinner than it was two or three years ago. We all remember the predictions that regulatory changes – particularly mandatory central clearing for OTC derivatives – would suck high-quality liquid assets out of the system, resulting in a major shortage of high-grade collateral. In practice, this has not really materialised.
Across our broader franchise, we are monitoring potential implications of Uncleared Margin Rules (UMR) for buy-side firms when they are implemented in 2020 – imposing a requirement to post initial margin, and to report this activity, for non-cleared OTC derivatives. We anticipate this may provide a trigger for a pick-up in the HQLA trade. But in the current monetary policy environment, with very low interest rates, flattened yield curves and narrow credit spreads, it is hard to see HQLA lending revenues come roaring back. US Treasuries are currently a premium general collateral (GC) asset class and I wish we had more of this in our programme.
Chessum – It is interesting to reflect on the repo rate spike in the US last September. With heavy recent issuance of US government securities to meet government expenditure requirements, one explanation is that a large number of US Treasury bills were due for payment on that day and this left the market short of liquidity.
Chadwick – The repo rate spike illustrates the relative brittleness of the market ecosystem currently and the amount of capacity that has been taken out of the system by a series of post-crisis regulatory initiatives which were designed to reduce risk in the banking system. In reality, banks no longer have the balance sheet capacity to stand in the middle and trade as principal, acting as a shock absorber in funding markets. Consequently, distortions like we saw last September now feed straight through into the price and we see much more price volatility as a result.
Bouthors – Banks are constrained by balance sheet restrictions under Basel III rules and have become more limited in their ability to provide liquidity to the market. For the buy side, this can create difficulties in accessing funding and in meeting our collateral obligations - for example, in posting initial margin (IM) and cash variation margin (VM) against cleared and non-cleared derivatives positions. There is currently a dislocation between what banks can provide to the market and the buy-side liquidity needs.
Chadwick – The conventional wisdom three or four years ago was that interbank lending was moving to zero and we would all need to find alternative channels to meet financing requirements. That concern has abated somewhat, but the recent US repo price spike illustrates that liquidity events can escalate very quickly.
Given the time required to adapt for many long-only buy-side firms, it is important to be addressing these problems in advance and not waiting until they are in the teeth of the next shock. To paraphrase a recent UK chancellor, it is important to fix the roof while the sun is shining – to find new routes to market that will provide insurance against this type of liquidity shock. However, to extend the metaphor, there do at least need to be clouds on the horizon for us to justify the prioritisation and commitment of resources required to make these changes.
Funds Europe – From a securities lending standpoint, what steps are beneficial owners taking to diversify their routes to market and to extend their lending options?
Chadwick – From an Aviva Investors perspective, we need to distinguish between our securities lending programme and our broader securities finance franchise.
For most traditional long-only institutions, securities lending is a discretionary activity. If it becomes complicated, expensive or market conditions make it unattractive, institutions have the choice simply not to lend. By contrast, as part of a liability-driven investment (LDI) mandate, repo trading is not a discretionary activity – it is an integral component of the trading strategy. As a result, we’ve seen a lot of the front-running in terms of finding new ways to market and employing alternative market structures on the repo side, rather than for securities lending – at least in the first instance. The fact that government bond repo trading tends to be a higher-volume, lower-margin activity means that there’s greater motivation to seek capital and balance sheet-optimising solutions.
Chessum – This is a primary reason why some beneficial owners are taking their securities lending programmes in house. They are building the expertise and infrastructure to access the repo market, to do collateral upgrade and downgrade trades themselves. This capability is important so they can price this activity themselves and keep their counterparties honest. But, also, as Xavier has indicated, they need this to access new pockets of supply to ensure they can meet their collateral obligations.
With UMR approaching, this has opened everybody’s eyes – and the securities lending area has benefited. Internal stakeholders are now recognising that securities lending is not just about borrowing stock to close out short positions. Rather, it is a central part of our liquidity management activities across the organisation.
Bouthors – Absolutely right. In managing an LDI strategy, for example, we need to mobilise a broad range of our portfolio assets to use as collateral, using transformation trades to provide eligible collateral to meet IM and cash VM requirements, but also having the ability to forecast our future liquidity requirements, in coming months or years, and having the collateral infrastructure in place to meet these requirements. In discussing new routes to market, we are also exploring where we can diversify our range of financing counterparties, exploring whether we should be more flexible on the collateral side, including pledge.
Funds Europe – To what extent are lenders widening their collateral eligibility criteria?
Chessum – We have definitely observed advances in beneficial owners’ understanding around collateral flexibility. It is not the case that every beneficial owner has dramatically widened its collateral eligibility parameters, but there is much wider acceptance of equity collateral, for example, -than was the case two or three years ago.
Chadwick – The debate on collateral flexibility is interesting. For several years, borrowers have been saying to the lender community, “You need to accept more flexible collateral sets, that is how you differentiate yourself from other sources of supply, that is how you get better utilisation and generate higher fees.” However, now there is a considerable amount of supply that does have a flexible collateral mandate. With this, we are now being asked to widen our collateral eligibility parameters even further – to accept convertible bonds, emerging markets debt, high yield …
Bouthors – Even unsecured transactions …
George – For general collateral (GC) buckets, collateral flexibility is changing significantly. There is a rising number of lenders who are taking a more liberal approach on collateral containing bonds, equities and ETFs. One reason is that there is a wider range of tools and data that enable them to evaluate – when they amend their collateral flexibility to include Tier II equities or ETFs, for example – how this will impact their associated risk. These measurement tools are enabling beneficial owners to go to the management committee and say, “For two basis points of additional risk, we could potentially realise another 6bps of expected return. Shall we refine our collateral profile?”
Perry – The message traditionally coming from borrowers is, “If the lender doesn’t make its collateral parameters more flexible, then it won’t get utilisation.” The reverse side of that conversation from a lender standpoint is, “If I agree to the collateral flexibility that you propose, I expect to get utilisation and also expect a reasonable fee.”
There will be examples where the borrower appears to be taking quite a hardline stance. “If you don’t lend at minimal haircut, against a highly flexible collateral set, then you won’t get any utilisation.” But in many cases the same borrower is willing to resume discussion a short time later ¬– and these starting positions provide the basis for a healthy negotiation. Often then borrower and lender are able to agree on a reasonable middle ground.
Chessum – Another important development is that beneficial owners are requiring ESG screening for the assets they accept as collateral. At Aberdeen Standard, we approach borrowers for detailed information on loan securities and collateral to ensure this meets with our ESG guidelines. This has reversed the tables somewhat on previous times, when it was typically the borrower approaching the lender (or its lending agent) to provide detailed information on the loan securities and the loan terms.
Chadwick – Historically, when ESG factors have overlapped with securities lending relationships, it has typically been around the ‘G’, or governance, component – principally regarding the importance of having policies in place to manage voting rights on loan stock. A more recent trend is an increased focus on screening collateral for ESG factors.
Chessum – ESG now touches every part of the investment process in most asset management firms. The securities lending programme must be aligned with the investment principles of the fund and, if there is an ESG requirement for that fund, all securities held in portfolio, and all loan securities and collateral, must pass through that ESG process.
Bouthors – If the portfolio is labelled ‘sustainable’ or ‘impact’ investing, it is essential that any instrument or strategy applies the same parameters. We have been working closely with the responsible investment team at NN IP to ensure this consistency is applied to our securities lending programme.
Funds Europe – How are borrowers and lenders using data to monitor performance across their securities lending programmes and to drive their decision-making?
Perry – There is a much deeper pool of high-quality data and a wider range of analytical tools available in the market now. The challenge is to identify what additional information users genuinely require and how will they utilise that.
Bouthors – The range and quality of data has improved, but we are mainly talking about equities. For fixed income investors – those holding high yield debt or emerging market debt for example – the data is still unsatisfactory. One possible reason is that a lot of this is traded to access liquidity via the repo market and there is not a strong pool of data for these instruments. We feel this is one area that can improve substantially.
Chessum – As a lender, we provide data to market data agencies (such as DataLend, FIS Astec Analytics or IHS Markit) and then buy back aggregated data and analytics from these agencies that provide insights on the state of the market. The limitation we have is that we cannot see the other side of the market, the borrower side. It will be interesting to identify what additional transparency that SFTR brings regarding availability of data on how much prime brokers are lending to hedge fund clients, for example. Currently, this data is very difficult to access.
George – That is a longstanding problem associated with collating securities finance data – most firms want to see what others are doing, but few wish to share their data. We had to break the mould in compiling this data for securities lending markets and that took a few years. We agree that improvements can be made in improving the coverage in fixed income instruments. Much government bond activity is traded through repo – and we are getting data from one leg, from the agent lender, but not typically from the prime broker side where there is a reluctance to share this data.
Typically, it is a case of the industry needing to work together to identify where it is beneficial to share this information. We are working on this currently. Lenders are using sophisticated independent securities lending performance measurement tools to analyse the performance of their lending programme against custom peer groups and to assess risk exposure on their loan and collateral profile. Borrowers, in turn, are using powerful cost optimisation tools to view their daily cost and analyse over- and under-performing securities and markets in monetary terms across all open and term transactions.
Chadwick – Mandatory transaction reporting under SFTR will generate a huge volume of data. However, it is still to become clear how this data will be used and what value it will deliver. Because Aviva Investors has a disclosed principal securities lending programme and everything is already fully segregated, we have not needed to re-engineer our business model in preparing for SFTR. For those that are using omnibus structures, SFTR has posed some rather bigger challenges in how they meet this reporting obligation.
Chessum – We have been keeping a watchful eye on the costs associated with SFTR compliance. When we need to pay trade repository fees for the SFTR reporting, this presents a new layer of costs that we have not been faced with previously in this area of the business.
Chadwick – I’ve spoken with regulators about the onerous nature of SFTR preparation – involving the need to report counterparty data, loan and collateral data, margin data and re-use, cash reinvestment and funding sources, split across 155 reportable fields. Many in the industry have questioned how much benefit this will deliver from a systemic risk-management perspective.
Their response was interesting. They recognise that they will not necessarily be able to analyse this huge data volume forensically – at least to begin with. However, their view is that the mere act of compelling market participants to report this information will instil discipline on the industry and bring greater transparency and rigour in areas where this is long overdue.
Perry – The securities finance world has been heavily focused on SFTR, and quite rightly so. But another EU regulation, the Central Securities Depository Regulation (CSDR), will also have a major impact on securities lending activities. CSDR will introduce cash penalties for transactions failing in an EU market on or after settlement date (SD) – and it will impose a mandatory buy-in for a transaction that still has not settled on SD+4 for a liquid asset or SD+7 for an illiquid asset. Market participants need to evaluate the implications of this regulation for their securities lending activity and take prompt action to mitigate associated risk and cost.
Chadwick – Yes, there are two components here. The automatic fines for late settlement are an additional cost, but something that the industry will bear. The mandatory buy-in rules are potentially more challenging, particularly when buying-in instruments where there is limited secondary market liquidity.
Chessum – This element of CSDR has been introduced to improve liquidity by reducing settlement failures. But by potentially reducing supply from the securities lending market – by discouraging lenders that may not want to risk a fine or buy-in – this may have the opposite effect.
Funds Europe – How are advances in technology, data engineering and data science delivering innovation to securities lending?
Chessum – There has been considerable discussion around standardisation of data representation through application of the common domain model in smart contracts to support transactions on blockchain. This standardisation will be valuable in facilitating KYC [know-your-customer] reporting, for example, providing a standardised format through which to share KYC information.
Chadwick – Automation is important. But, as mentioned previously, securities lending is typically just one part of a suite of products and services that we offer to our institutional clients. This service is still heavily relationship-based and it will be hard to fully automate this relationship component of our industry. A lot would be lost in a fully automated environment.
Perry – In industry surveys, respondents have been predicting for a decade or more that the industry may be automated within three to five years. But still this has not happened. There are automated lending facilities, of course, but these are used for a specific types of trade. For many other lending scenarios, it is particularly hard to automate.
Chadwick – Yes, ten years on from the global financial crisis, it is perhaps surprising how robust, and how relatively unchanged, the institutional securities lending landscape has remained. Beneficial owners continue to appoint agent lenders who trade with prime brokers who service hedge fund clients. There has been some erosion of this model around the edges – but it has remained fairly resilient to date.
Although there is constant debate about who the disruptors to this industry segment will be, it seems quite likely that incumbent providers will embrace new technology and data management applications into their workflow, making themselves more efficient and using this to outcompete one another. It has been hard so far for new competitors to break into this market. In this environment, technology application is likely to deliver evolution rather than revolution.
Chessum – We have seen the launch of new securities lending platforms - and the introduction of new technology that has made existing processes more efficient. But we have seen little so far that will revolutionise the market and change it completely.
Bouthors – Parts of the industry are not ready to change. That has been our experience from some initiatives that we have been working on. The beneficial owners are often open to changes driven by innovation, but the borrower side of the industry can be protective of its franchise and there is a lack of transparency in this segment. When change does come, again, we expect that it may be the securities financing side that moves faster than the securities lending sector pushed by collateral obligations.
George – The more sophisticated beneficial owners and asset managers are using our data for predictive purposes – for example, to identify entry points and exit points for their trading strategies, identify potential turning points and contrarian ideas and also identify shifts in sentiments for single issues, sectors and markets. Sell-side clients predominantly use this data for confirmation purposes like price discovery, to support opportunity screening and understand current market spotlights. Most of the beneficial owners still use our services for confirmation ¬– for example, benchmarking performance of the lending programme against their peer group.
There is growing appetite for application of data science and predictive analytics – for example, to identify a short squeeze or a sharp price correction, providing opportunity for portfolio managers to gain early indication of anticipated price movements and shifts in liquidity. We are seeing rising demand for new data metrics like concentration ratio, liquidity metrics such as days-to-cover ratio, liquidity scores of fixed income instruments volume traded in the cash market, and stability metrics that track the stability of the lendable inventory from beneficial owners based on their turnover of a selection of securities.
Bouthors – We use securities lending data to provide insights to our portfolio managers on the mechanics of trading activity in the market. We may see abnormalities in certain areas of the market, and through talking to our agent lender and counterparties, we identify signals that offer useful insights to our portfolio managers. We also have data scientists looking at historical data to identify patterns that may be valuable to the investment team.
George – On this point, many beneficial owners and asset managers utilise our products and services, but some predominantly want the data to drive their own data science and analytics. This is also being used for compliance reporting and ESG monitoring. It is particularly the large beneficial owners with in-house securities lending operations that are drawing on this type of reporting and are requesting data to drive their own data analytics.
Chessum – Some investment strategies provide a natural home for this type of information. For long-short funds, convertible bond funds, for example, this information is particularly valuable. This is a major reason why securities lending is now much better understood among many beneficial owners and asset managers – and it is a reason why some firms are managing their securities financing activities in-house. Fund managers can pick up useful signals from their securities lending data that can help them in their investment management processes.
Funds Europe – Hasn’t that always been the case – for convertible arbitrage and long-short funds, for example?
Chessum – It has, but the data quality was not as good in the past and this data was not as readily available as it is now.
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