Matthew Chessum, investment director, liquidity management at Aberdeen Standard Investments (ASI), discusses some of the key collateral management and securities lending issues on beneficial owners’ agendas, including topics such as ESG which continue to gather momentum.
Have you seen an increased focus on collateral optimisation within the beneficial owner community? If so, what do you believe is driving that and how is it shaping attitudes towards securities lending?
Collateral management has grown in importance over the last 18 months in the build up to the implementation of the uncleared margin rules. Beneficial owners are starting to perform more detailed analysis in regards to their ongoing and, more importantly, their future collateral requirements. This analysis focuses mainly on the amount of unencumbered collateral available in a fund, the projected increases/decreases in the amount of required collateral in different market scenarios, the tools available to generate additional collateral if required and, most importantly of all, the most efficient and cost-effective way to manage a fund taking into account any new requirements. The conversations regarding collateral management have helped to improve the reputation of securities lending within the beneficial owner community. There is an improved understanding regarding the benefits that securities lending can bring to an actively managed portfolio as well as the cost savings that can be generated through actively managing a fund’s collateral requirements. These two functions now go hand in hand and are critical in the pursuit of reducing fees and improving performance.
What are the key challenges, or opportunities, facing beneficial owners today?
Both the challenges and opportunities for the buyside are numerous. Every beneficial owner will have their own priorities but some of the main challenges that I would expect other buy-side firms to be facing include managing and calculating the performance drag produced by using different types of collateral, developing the “collateral toolbox” to include repo and reverse repo and the ability to rehypothecate collateral where permissible, enhancing access to securities lending either directly in the market or through proxies, and the standardisation and development of both internal and external reporting capabilities to clearly indicate unencumbered assets. Producing solutions to these challenges and focusing on collateral management across organisations will give rise to a greater level of integration between securities lending and collateral management processes, improved fund performance due to lower collateral costs (posting the cheapest to deliver, substituting collateral depending upon securities lending opportunities, having the ability to transform a fund’s invested assets into permissible collateral), improved flexibility and efficiency when posting and receiving collateral (possibility of hypothecating collateral where possible) and less complex accounting and fund structures acting to reduce both collateral costs and friction.
How has Aberdeen Standard Investments (ASI) looked to optimise its collateral management and securities lending programmes?
ASI has been planning for the upcoming changes to margin rules for some time. ASI is in the fortunate position that following the merger between Aberdeen Asset Management and Standard Life, the combined organisation was able to adopt the best collateral processes from both heritages. This also provided the perfect opportunity to update and improve upon the existing processes across all of our combined mandates. Improvements include providing funds access to securities lending and repo capabilities, the simplification of collateral pool and fund structures and an ability to rehypothecate collateral where permissible.
How do you expect the increasing momentum around ESG to impact collateral management approaches in the industry?
ESG is going to touch everything that we do. The ESG agenda is continually growing in importance and significance. Collateral management and securities lending will not be untouched by this. Going forward I can easily see the introduction of ESG-approved collateral sets, an increase in restricted assets being eligible for collateral purposes and therefore greater complexity, especially in the short and medium term whilst market standards and agreement on specific ESG terms are decided upon. Unfortunately, this may also mean increased costs but as the conversation progresses, market standardisation will help to mitigate these.
Do you envision the move towards digitalisation and the application of emerging technologies – such as the common domain model, smart contracts, blockchain and tokenisation – delivering benefits to beneficial owners’ collateral management and securities lending requirements in the future?
Anything that helps to standardise and improve current processes will add value in the future. The common domain model seems to me to offer the most tangible benefits at this point in time. Being able to access a unique portal holding all of the information necessary to improve and speed up the on-boarding process will be beneficial to all market participants. The ability to improve transparency, align documentation and standardise common work flows will bring greater efficiency to all participants. Blockchain, smart contracts, and tokenisation will all bring benefits and improve liquidity but unfortunately beneficial owners tend to follow and not lead in these types of initiatives.
From a collateral and securities lending market perspective, what do you expect 2020 to bring?
Now that the implementation of margin rules for non-cleared derivatives has been delayed by one year, 2020 will be used to bed down the ongoing process changes that are being implemented to ensure a smooth transition to a more efficient collateral management process. Vendors will no doubt have a busy year as buy-side firms look to add to their competencies in terms of repo, securities lending and arm’s length inter fund dealing. In terms of general collateral requirements, I would expect these to increase slightly towards the end of the year as more buy-side firms become more active in their collateral management processes. I anticipate that the securities lending markets will remain subdued. Brexit uncertainty, recession fears, flattening interest rate curves (along with the possibility of further cuts), trade wars and ongoing political protests in Hong Kong, to name but a few current issues, do not present a very positive macro-economic picture supportive of increased market activity. As always there will be pockets of demand, these will probably be linked to directional opportunities in either individual stocks or specific sectors but other than this I cannot see any great change to the current levels of demand. The internalisation of securities lending desks will be an interesting one to watch over the next 12 to 18 months in terms of both the impact on distribution and supply. Hopefully 2020 will bring increased volumes and opportunities but at this point I would suggest that the market outlook is looking fairly flat.
How would you like to see the collateral landscape evolve over the next 5-10 years, whether that be in terms of regulation, industry collaboration or the collateral management tools/services available to beneficial owners?
There are a few changes that I would like to see over the next few years. The most important would be the easing of regulation for UCITS funds to allow limited forms of rehypothecation of collateral and a clearer understanding regarding the use of pledge collateral structures and therefore CCPs. Rehypothecation of collateral can help to drive efficiencies when a fund is both receiving and posting collateral. It can lead to significant cost reductions, more efficient posting of collateral and a reduction in the performance drag of a fund having to hold eligible collateral assets. Over the medium term, I expect to see a full alignment and integration of the securities lending and collateral management markets. The two are already intertwined but the full integration of agency lending and collateral management services will bring huge benefits to the buy-side. Many agent lenders have started looking into this but there are currently very few complete offerings available. Finally, I would like to see stronger collaboration between beneficial owners. The buy-side in Europe isn’t very active in speaking with a collective voice in these markets and it would be beneficial to all to see stronger collaboration and participation going forward.
This Q&A features in the Collateral in 2020 Guide. Download the full guide here.