Beneficial owners and industry experts met in New York to discuss programme performance and what’s in store for the securities lending market in 2018
- Andrew Neil, securities finance editor, Global Investor Group
- Nancy Allen, global product owner, DataLend
- Bill Kelly, global head of agency securities finance, BNY Mellon
- Mike Pate, manager, M&A and securities lending, Western & Southern Financial Group
- Eric Pollackov, global head of ETF capital markets, Invesco PowerShares
- Paul Sachs, principal, Mercer Sentinel Group
- Michael Saunders, head of securities lending investments & trading, BNP Paribas
- Bill Smith, managing director, Americas sales executive, J.P. Morgan
Neil: Which types of lending programmes, trades and securities performed well in 2017?
Allen: Beneficial owners with diversified programmes and flexible collateral guidelines captured more value than others in 2017. On the upside we saw an increase in fixed income lending revenues. A significant portion of that balance was out on a term basis and very much focused on sovereign debt. On the equity front, specials activity weakened. The top five securities in 2017 generated around $360 million compared to $800 million in 2016. At the end of 2017 the equities market picked up some steam. However, this was not due to an increase in specials, fees or demand, but rather the equity bull market resulting in higher market values on loan. The industry hit $19 trillion of lendable at the end of 2017, an all-time record.
Saunders: Our programme globally in 2017 experienced what others have witnessed as well- the number specials in the global markets declined in 2017. There were opportunities which we were able to monetize for our clients. The demand for ETFs was robust, for both specific asset classes and individual related countries on the back of various geo-political pressures. We’ve also seen an uptick in demand for issues linked to specific sectors, namely the retail, healthcare and commodity linked sectors. Post-IPO activity and M&A deal-related names resulted in strong demand which has helped offset some the lack of specials in the market. Finally, utilizing client holdings of HQLA afforded additional opportunities which continue to be a large driver of our programme revenues.
Pate: We saw rates on lendables trade within a range. We noticed either the rebate or the amount lent in our energy holdings adjusted with oil prices. Our Ft. Washington team positioned the portfolio for rising rates on the short end with anticipation of Fed rate increases. This helped us maintain loan balance and income.
Kelly: Diversified asset holders that were able to take advantage of the shift from equities to fixed income did well in 2017. Such investors include large pension funds or sovereign wealth funds that typically are positioned to have one asset class compensate for the other and entertain collateral flexibly with the transformation trades. However, this isn’t an egalitarian system. There are certain types of asset owners that are not eligible for that particular type of transaction. It’s interesting to see who can and who can’t and how they react to those particular circumstances. Certain clients recalibrated their intrinsic value and recognised that the market was different in 2017 versus 2016.
Bill Kelly, BNY Mellon
Smith: It wasn’t that rising tides lifted all programmes, though falling tides pushed them all in the same direction. There are a lot of different parameters between the different client types. The shift from predominantly cash to predominantly non-cash collateral has a greater effect on some of our clients who don’t have as much flexibility around accepting equities as a specific case of non-cash collateral. Trend-wise, I would certainly agree that many clients saw their revenues fall in 2017 because of their concentration in securities types that have been special for the last few years. The types of clients that will continue to take value out of this market are beginning to change again. Post-crisis, everyone fell to the mean and de-risked. Now many clients are more open-minded and willing to look at other avenues.
Sachs: I work with a global team of specialists that focus on the governance and implementation of investment operations. One portion of our remit is to advise clients on securities lending. There was a fairly quiet period from 2010-2015 where there wasn’t a lot of interest from end investors. Early in 2017, we started seeing more enquiries than we’d seen in the previous two or three years together. Not all of those enquiries resulted in new commitments to programmes, but it’s a marked difference from 2012. People are starting to warm up securities lending. The tide has turned.
Pollackov: I run a global team that deals with capital markets for the power shares ETFs specifically. In terms of revenue generation from lending for the ETF business alone, actually there is no revenue generation for Invesco shareholders, it’s actually a revenue generation for the ETF shareholder. All the proceeds go back to the NAV in terms of reinvesting, except for a small percentage that gets consumed by the actual lending agents that we use as a third party. We’re ultra conservative in that space, at least here in the US. We’re so conservative in Europe that we stopped doing it in 2016 altogether.
Allen: ETF lending is one area to watch over the next couple of years. The lendable value has increased 50% year-over-year for ETF availability. We recently reviewed ETF activity in our Client Performance Reporting tool, which allows agent lenders to assess beneficial owner clients’ program performance, and we saw a 21% increase in the number of accounts enrolled in lending that are now holding ETFs. There are challenges that remain – regulatory, liquidity, settlement concerns – but it is definitely a growth area.
Pollackov: Securities lending requires scale, programmes, compliance and all the associated fund infrastructure and reporting. What we try to think about in the ETF landscape, particularly when it comes to securities lending, is how to differentiate ourselves from our competitors. This means thinking about how to use the proceeds from lending. Some of my competitors use it as a revenue source for their bottom line and their own shareholders as opposed to the ETF shareholders, we try to differentiate ourselves there. From a revenue perspective, international smallcaps are important in terms of the spaces where we do the best on returning those numbers back to our ETF shareholders.
Neil: Can you outline examples of changes being made by asset owners to their securities finance activities?
Saunders: The overriding theme is a higher level of engagement from our clients who have an increased level of understanding and interest in learning about the market opportunities. Our clients are keen to understand how to better utilise securities lending, collateral management, and securities finances as a whole to their benefit. Its clients looking to be educated about the differences and the opportunities in cash and noncash collateral programmes, as well as clients are seeking a higher level of education that probably best summarizes BNP Paribas’s experience in 2017. That’s all very positive. It’s not everyone, of course. It seems to be once again the sophisticated entities that have a certain risk profile and specific objective.
Bill Smith, JP Morgan
Kelly: At BNY Mellon we’ve organised ourselves to recognise the changes occurring in the global collateral services space. There is a greater connection between liquidity, securities finance and collateral. This intersection is where clients are attempting to solve for the new margin rules, segregation rules and liquidity rules related to derivatives, both cleared and OTC. As such, clients need to think about managing their resources in order to optimize their use.
Pate: We are evaluating introducing additional portfolios to lending. In addition, we manage our cash collateral primarily internally. We continue to look at technology to create more risk management and benchmarking. There are a range of new options that seem to come out every year that can bring more clarity to the decision makers, and also help improve programmes or try to generate some additional income. Risk return is key. I’m always asking ‘Is the risk I’m taking compensating me correctly?’ Some of these analytic programmes and software available help solve that question and allow us to see if someone else may be getting a better risk return than we are.
Allen: Over the last couple of years we have seen beneficial owners looking for more data, either through their agent lenders or directly through us. More recently there has been an uptick in the number of beneficial owners allocating budget for data; they are willing to pay for data to help them better manage their programs and extract additional revenue, which more than covers the cost of data.
Kelly: Data and access to data has certainly improved from an asset owner to an agent lender perspective. Along that food chain there is the opportunity for lots of transparency around levels, activity and just the overall amount of information. This is what regulators are looking for as they assess how big this market is and the interconnectedness associated with the activities that are going on in the securities finance space.
Pollackov: We purchased data in 2017 on the securities lending rates of our products. Previously, we’d get a call from a client to say, ‘How much can I short?’ and I’d call an agency lending desk and say, ‘How much do you have in inventory?’ and kind of just mish-mash it together and say, ‘Here’s what we know.’ Now there is more focus on aggregating all of these data points and actually publishing them. We’re keen to get our hands on these metrics. I’ve put budget into this area and will look at products again in 2018.
Smith: It’s easier to project which types of portfolios might have a higher likelihood of succeeding, especially if they’re new entries into the market. The data shows that, in general terms, the market is heavily oversupplied. In that type of market, you need to find those things which are less oversupplied. We have become more disciplined in the types of portfolios we bid for and how we bid for them. We’re trying to make sure that we’re adding clients and their portfolios into our programme which we believe have a higher than average likelihood of providing success for that client.
Saunders: Some beneficial owners are also looking to increase the number of providers they have. This trend is not necessarily geographical, it may be based upon specialisation, and some of that may be a willingness to use general collateral as an example, to lend your own collateral, it may be an ability to engage in collateral transformation. At BNP Paribas, we are leveraging our expertise and pursuing those pockets of business. There are differentiating factors amongst providers in today’s
market each with excelling at certain strategies.
Neil: To what extent would today’s beneficial owners continue to participate in the securities lending market without indemnification?
Pate: I can only speak for ourselves. We recognize that there is a cost to indemnification. Our program was approved and designed with indemnification. It is unlikely we would proceed without it. Peers I have spoken with have had a similar reaction.
Sachs: I have run into large investors with the credit resources to do analysis and go direct. However, they are very few and far between. Once you get outside of those mega-funds, indemnification appears to be a requirement for most to participate in securities lending. We don’t see indemnification going anywhere.
Kelly: Clients who are engaged and sophisticated enough to have the ability in-house to do the risk assessment can make a determination that, ‘If there is a cost to the indemnification and I can secure a fee-sharing arrangement that enhances my return absent the indemnification in exchange for the activity that I’m giving the agent to
perform for me, I’m comfortable with that.’
Paul Sachs, Mercer
Smith: Most clients still desire to have the benefit of that credit intermediation. It will be interesting to see as time moves forward with CCPs, where asset owners can potentially be direct participants, if this condition continues. If they are dealing with highly rated entities, they might look at that and say, ‘Okay, I’m part of this enterprise that’s a CCP,’ that may provide some comfort somewhere down the road. For the moment, our experience has been that clients are consistently attracted to having the credit intermediation and they value it.
Allen: It depends on the approach the beneficial owner takes to lending and the resources they have dedicated to the practice. Many of the larger beneficial owners, with dedicated internal resources, have always considered lending without credit intermediation. Beneficial owners should weigh the risk against the returns. Not only will the beneficial owner consider the creditworthiness of the counterparty, but they also must be prepared to have the proper controls and procedures in place to manage the operational risk throughout the lifecycle of the loan.
Kelly: We’re looking at alternative borrowers. Traditionally, it was the domain of prime brokers looking to diversify their access to supply. Now lenders are entertaining hedge funds, or perhaps asset owners that are running long-short strategies and Liquid Alts that they may potentially consider lending directly to. It’s going to be with the benefit and the confidence of that indemnification where we determine that this is good business and whether it could be helpful for our clients.
Saunders: We’ve looked at a variety of other initiatives which have the potential to benefit the programme’s client experience. Regarding utilising central counterparties or direct lending, our client base just isn’t there yet. The mentality and perhaps misconception is one of cost-benefit. We frequently hear; does the legwork at the board or program level justify the benefit especially if program performance is above market average. Of course, our client base is open to these suggestions, especially if increased revenues can still be obtained under a similar risk profile but the immediate question is a) who controls the risk and b) what do I get out of it in terms of revenue?’ Those are difficult questions to answer.
Smith: We do have a subset of activity for some of our clients that we do today on a non-indemnified basis. It’s a small portion of our business but it is evidence that there are some asset owners in the world who have the wherewithal, whether it be the credit infrastructure and/or the longterm view, to enter into transactions like that if the returns, structure and risk are things they can get comfortable with.
Neil: Has the US securities finance market evolved to reflect efficiency and transparency that can be afforded by modern technology?
Pollackov: We have quarterly meetings with each one of the lenders that we employ to talk about what happened that quarter, what worked, what didn’t work, and then of course some portion of the conversation is always dedicated to, ‘Hey, what are you doing differently? What’s on the horizon? What’s going to be better next quarter or next year?’ Technology is always part of the conversation for anything that we do.
Pate: On the technology side, you have the third party data providers that are bringing in data analytics that can be used by all parties, they have taken some huge steps that have helped everyone move forward, but there is still a grey area from the beneficial owners’ perspective on data, which is the other side of the transaction. If we were to see what the borrower rates with prime brokerage were that would be another level of transparency within data analytics.
Mike Pate, Western & Southern
Allen: As a fintech company, we see first-hand how the market is embracing technology. EquiLend launched an enhanced trading platform NGT in 2015, and since then we’ve seen the daily trade flow increase by over 50%. When we look at the US market we’re seeing more and more non-GC trades coming through NGT, which means that the market is getting comfortable with managing their warms and their hots in a more automated fashion.
Kelly: We’re following the trajectory that Nancy described in terms of take-up on efficiency, recognising shorter settlement cycles and straight through processing, which is going to be absolutely essential – the more the industry drives that, the better. The other aspect is shifting the tasks of trading teams so that they are becoming more analytical, so they’re looking at trends, they’re looking at patterns, and even artificial intelligence. We’re processing over 300,000 transactions a month, and that’s just a tremendous amount of trades that we need to keep track of.
Saunders: BNP Paribas is committed to implementing modern technology to realise increased levels of efficiency and transparency. We have floors and teams of people looking at artificial intelligence and blockchain. We’re going in the right direction of course, but we’re too large an industry to try to stay ahead of it. Some people say, ‘Is a custodial bank really a tech firm?’ In the future it probably is. If you’re going to look at, even using blockchain as an example, professionals outside the industry are all saying, ‘This industry is ideal for that type of technology.’
Neil: What are the most significant direct and potential regulatory impacts on the securities finance industry?
Kelly: Regulatory certainty is something that we all are seeking. What we are also looking for is the avoidance of unintended consequences. It is really about trying to make sure securities finance activity can continue providing liquidity to the marketplace. Now everyone is digging through the finalised Basel III (IV) amendments to try to understand what those really mean. Fundamentally, those amendments are going to provide some additional relief and it appears we’re going to get the clarity the industry needs in order to continue providing liquidity to the markets.
Smith: J.P. Morgan has a deeper breadth of service than some of our competitors that focus on financial services or custody and trust businesses, so we always have to look at this through a more multi-faceted lens. What we’ve seen in terms of the pending/enacted regulation in that in some cases, it’s improved the environment for one portion of the bank but may make it more difficult for other portions of the bank. Anything that helps us have longer term regulatory clarity will help us and our clients.
Michael Saunders, BNP Paribas
Saunders: We’re looking forward to the pause button being hit and getting to a place where there is not a new regulatory challenge every three months. BNP Paribas remains focused on getting our business model to where it needs to be to efficiently utilize our firm’s capital. In addition, our counterparties and borrowers can finally get to a place where they’re efficiently deploying their capital. I would sense that over the past five or six years it’s been back and forth, give and take between agent lenders and the borrower community as all parties analysed how to best maximise capital and their balance sheets in accordance with developing regulations. Whether it’s various legal structures, innovative types of transactions, offshore entities, whatever it may be, it’s a welcome pause and the market is primed to move forward.
Pollackov: We acquired a larger business this year that has a large UCITS foundation, and we had a small UCITS business there in the ETF space. That business is mostly swap-based, so there is a whole line of collateralisation that needs to be disclosed. To be quite honest with you, as an asset manager it’s a hassle because reporting and monitoring how it gets collected is a real lift. However, it’s all available datawise, so we just have to figure out how to consume it and how to produce it properly and so it complies with the appropriate regulations.
Neil: What impact will Europe’s Securities Finance Transactions Regulation (SFTR) have on US market participants?
Kelly: There’s going to be a lot of data, because you’re going to have two-way reporting with SFTR and it’s not going to be symmetrical. It will be interesting to see how regulators determine the interconnectivity of risk. Until you have a single repository of all this transaction information under one jurisdiction, I don’t know that the regulators are going to be able to globally accomplish what they hope to accomplish. It’s not for lack of trying, it’s just the extraterritoriality of the challenges associated with reaching over into this jurisdiction or that jurisdiction.
Saunders: One of the main shifts after 2009/10 has been the insatiable appetite from clients for more data and greater transparency. BNP Paribas has met this challenge and invested heavily in providing a plethora of data to program participants in a variety of formats. Because of our transparency initiative, the impact of SFTR was not substantial in terms of changing our mentality of transparency. Under SFTR, now we’re taking that data and sharing it with a wider audience. However, SFTR has a cost associated with it which will need to be addressed at the client level as clients may not have a full grasp on the heavy lift placed on the industry to share this information.
Allen: Market participants should be thinking about what they can do with the data once it goes to the regulator— specifically what benefits they can reap from the resulting standardised and more-timely data, which they can use for better data analytics. That is one of the positives that will come out of SFTR. Also, while the market is going to have to produce the data to comply with the regulation, which will come at a cost, if you look longer term hopefully it will reduce some of the manual processes and be a cost saver over time.
Smith: It’s too soon to tell how the specifics of SFTR will affect loan balances. There’s an awful lot of other variables that go into that. It’s also too soon to assess how STFR will impact US clients and their loan programs. SFTR will certainly require a significant amount of tech investment by market participants, including lending agents, as the scale of the data reporting requirement is going to be extremely large.
Sachs: SFTR may be a very big cost for the industry, which means there may be big upfront costs for all parties. The question is, what comes out of that in terms of improved productivity, and what’s the lag of that? Is that a 3-year lag or is it an 8-year lag? I do believe that there is going to be a benefit but it might be painful upfront.
Neil: What factors will compel clearing activity and increased transparency in the US market?
Allen: We established the EquiLend Clearing Services (ECS) business to make connectivity to the CCPs easier for the market. The benefits of CCPs are primarily regulatory driven and include balance sheet optimisation, lower risk-weighted assets (RWA) and netting, which frees up balance sheet for additional business as well. It will be interesting to see when and how beneficial owners get involved in that trade and what will incentivize them to start trading through their agent to a CCP. The economics have to make sense, and the CCPs need to really demonstrate that they have the operational procedures and controls in place. Our ECS business continues to grow, and we’re looking at offering connectivity to CCPs all over the globe, so it’s a space to watch for us.
Nancy Allen, DataLend
Pate: As direct lending increases and economics reduce for GC lending, I think more beneficial owners will transition to CCP.
Pollackov: We are putting our clients’ portfolios at risk, potentially. We need to think about what’s the cost-benefit analysis of putting that portfolio at risk, and is it enough to make our shareholders happy? With that being said, I completely echo Mike’s point, we want to be the second through the door, not the first.
Sachs -Two questions right away: ‘Who is servicing over the life of the loan?’ and ‘What happens to indemnification?’ The devil is in the details when it comes to indemnification and servicing. These are not easy problems to solve.
Kelly: I would agree that the incentives to clear include improved pricing in terms of capital relief and the efficiency from a balance sheet optimisation standpoint. That should drive adoption, but the challenge is coming up with the model that the CCPs need to develop so that it can work in concert with the agent model. Financial incentives have been established for SFTs, whereas clearing for derivatives was an edict. It’s fascinating that regulators took two different paths.
Smith: There still are question marks around what the model can and will look like. It’s different to insert an agent in the middle of the way beneficial owners would connect with a CCP. The risk disaggregation model or aggregation model, whichever way you look at it, is important. In addition, in agency transactions the degree to which you’re going to unlock all the benefits of netting is also part of the question. It’s easy to talk about the value of netting, and certainly the borrowers’ side loves to net and bring down their costs, but you’ve got this agent layer in the middle here, and will that impact netting opportunities? That said, the CCP model is certainly something which demonstrates an opportunity for value; it’s certainly something that the regulators seem to have identified as serving a viable purpose.
Saunders: BNP Paribas has a dedicated work stream analysing the role of CCP’s in our securities financing businesses. We envision a role of CCP’s in the future, but many questions remain unanswered. We will continue to conduct our due diligence and monitor the industry developments.
Neil: What’s the long-term strategic direction of the business and how can beneficial owners position for success?
Smith: The industry needs continued avenues for controlled growth. Firms also need to see returns on investments and technology. This is well underway; however, those returns come closer to the end of the cycle than the beginning or middle. If we have a clear and
stabilised regulatory environment then everyone can stop trying to focus on interpreting the regulations and start trying to focus on how to make the business generate value for the clients operating within that regulation. The lending business continues to go through transition and reinvent itself, and it’s made some good progress. The accessibility of data and technology transformation can’t be anything but good things. Turning change into value and monetising it for all the players involved is key.
Allen: The market continues to move towards more balance sheet-efficient structures; to that end, we will continue to see more automation, alternative routes to market, the need for greater flexibility and more transparency. Beneficial owners have become much more involved in their lending programs in recent years, and I expect that trend to continue, especially as data becomes even more enriched by market changes like SFTR regulation. To navigate the future, beneficial owners should take advantage of the availability of data to ensure they have structured a program that will optimise their returns while adhering to their own risk parameters.
Kelly: Active engagement and staying close to the developments on the policy and regulatory front will be important. With policy certainty, capital might move back to being deployed in certain strategies which will inevitably drive demand and drive a modicum of sustainable and manageable volatility. If you believe the soothsayers about the collateral shortfall of $2 to $6 trillion, the securities lending marketplace is a good outlet to provide liquidity to meet that demand.
Eric Pollackov, Invesco PowerShares
Pollackov: This market is still relatively opaque. It’s opened up somewhat but clarity into how this whole system really works will help drive down cost and help technology move faster. As an asset manager that’s managing almost $1 trillion, a couple of basis points starts to add up. Those are the types of things we’re trying to focus on for our shareholders.
Pate: Traditionally, securities lending has been a market where periods of low interest rates and benign credit have led firms to take-on more risk. This is probably the best time to stick to your knitting. Conservative cash collateral and intrinsic spread risk management.
Saunders: At BNP Paribas, we will continue to be client-centric and focus on maximizing the experience of our program participants. We will leverage the expertise and financial strength of our global institution to grow our industry presence in a focused, selective nature. The bank will continue to maximise market opportunities in a customised, risk-controlled fashion to keep clients engaged while growing our market share.
Sachs: We’re hoping for more regulatory clarity, increased use of data, increased creativity shown by lending agents in terms of trying to meet client needs. Those are all positives for asset owners. I feel like we’re in an unusual period with the VIX being so low. One thing about capital markets is that they continue to surprise you. A couple of years from now things will be different.