The Securities Lending Industry in 2013—Turning Crisis into Opportunity
In 1959 John F. Kennedy said, "In the Chinese language, the word 'crisis' is composed of two characters, one representing danger and the other, opportunity."1
For the securities lending business, both aspects of that statement are significant. Market participants need to be attuned to the challenges and risks to their activities. However, they also need to be able to navigate these to exploit the opportunities that exist in a climate that might otherwise only be viewed as negative. The financial crisis of 2008 and its immediate aftermath are behind us, and while some participants have fallen by the wayside or have completely disappeared, others have survived, recalibrated their business models and even thrived.
These themes are under constant scrutiny within organisations, as the regulatory environment relating to the securities lending business continues to develop while multiple jurisdictions and regulators propose and implement new regulations. The potential impact of these regulatory measures on the securities lending business is illustrated in figure 1.
A sounder footing for securities lending
Whilst the securities lending industry continues to experience significant change, opportunities are also apparent.
Market data clearly shows that between 2010 and 2013 there has been a significant increase in the lendable inventory that is available in the market, even allowing for market lift. Our own experience at J.P. Morgan during 2012 confirms this trend— we saw a number of new beneficial owners joining our programme, particularly from the Nordic region. So there are a greater number of lenders in the business today and more supply is being made available.
But the real story remains the depressed state of the demand side of the supply-demand equation with loan volumes being, at best, flat in real terms. McNulty also described how the relationship between loans conducted against cash and noncash collateral has inverted. Sixty percent of the business is now being transacted against securities or noncash collateral as beneficial owners have been attracted to the most secure forms of collateral in the wake of the financial crisis. McNulty went on to speculate whether the muchvaunted collateral shortfall, predicted in the light of the clearing reforms envisaged under Dodd-Frank and EMIR, would create new opportunities for growth. Hundreds of billions of dollars' worth of CCP-eligible securities remain available but un-lent in global securities lending programmes, as agents and beneficial owners alike weigh the risks and rewards associated with lending these highly rated securities against more diversified and lower quality collateral.
Industry response to regulatory changes
These are challenging times for an industry body such as ISLA. The volume of work associated with representing its members' interests is rapidly multiplying. While the dialogue between the industry and regulators is positive and constructive, it is clear that more beneficial owner involvement would be desirable. One has only to look at ESMA's website and the lack of beneficial owner responses lodged to the consultation on ESMA's regulatory guidelines for ETFs and other UCITS issues, to see that collectively the industry needs to invest more time in supporting the work of its trade association.2 Beneficial owners and stakeholders clearly have an important role to play in augmenting the work of ISLA and helping to shape the way the industry develops.
The market consensus now seems to be that the proposed EU short-selling rules and Financial Transaction Taxes (FTT) on repo, securities lending and collateral movements are likely to negatively impact borrowing, financing and repo. These regulations are also likely to affect the securities lending market in general, producing important revenue streams for longterm investors (notwithstanding the critical role that securities lending is acknowledged to play in the provision of liquidity to secondary markets for bonds and equities). Since ISLA calculates that more than 65 percent of the European securities lending market would be directly impacted by FTT, it is clear that a consistent approach is required to introduce these measures in a coordinated and sensible way.
The development of CCPs is another area where market participants, driven by risk considerations and regulatory sentiment, remain divided. This divergence of views was again illustrated at J.P. Morgan's Securities Lending Forum. When polled, 46 percent of the audience felt that the mandatory introduction of CCPs for securities lending was unlikely and a further 68 percent felt that the use of CCPs for securities lending is undesirable. Commenting on these results, a representative from the Bank of England said, "this doesn't surprise me at all. The challenge of getting CCPs to work in such a heterogeneous market is huge."
Market data clearly shows that between 2010 and 2013 there has been a significant increase in the lendable inventory that is available in the market, even allowing for market lift.
In contrast, enhanced transparency is generally seen as a good thing for securities lending, a business that has long been viewed as niche, secretive and opaque. The post-crisis world has evolved, and it is generally recognized that service providers have made great strides in providing not only more information, but relevant information that can be rapidly accessed in at-a–glance, dashboard-style formats. A healthy 74 percent of those polled at J.P. Morgan's Securities Lending Forum felt that more disclosure to investors will help to build lenders' confidence in the stock loan market and thereby help it grow.
"Securities lending provides useful fee income to USS that helps to offset operational costs and provides a vital source of liquidity to financial markets.”
- Leandros Kalisperas, Universities Investment Management Limited (USS), July 2013
So although the regulatory and macro-economic environment remains challenging, we agree with ISLA's view that the securities lending industry has moved onto a sounder footing and believe that attractive opportunities can be found within selective areas. Calendar year 2012 was certainly characterised by beneficial owners displaying a healthier appetite for securities lending than at any time since 2008. Whilst none of them are in the business of taking on inappropriate risks, they are willing to investigate the re-calibration of their programmes to capture the available incremental revenue. Specific areas of focus are:
- Yield enhancement— Notwithstanding a challenging and volatile market, opportunities remain in Japan, Australia (DRIP trading) and the traditional European markets of Germany, France, Sweden, Switzerland and Finland.
- Flexible collateral strategies— As beneficial owners review their securities lending programmes, they are increasingly considering alternative forms of collateral to the highest grade and safest forms of government assets, such as equity indices. Recognizing that managing a diversified pool of collateral is not in itself an additional risk creates opportunities to work with agents and borrowers alike to extract value within closely managed and appropriate clientdefined guidelines. Some of this activity is related to the collateral transformation debate, whereby beneficial owners are not now just asking "can I lend my securities?" but are increasingly posing questions around the ability of their investment portfolios to generate collateral that can be used to pledge against CCPs and derivative transactions.
- Emerging markets— Securities lending traditionally follows demand-driven flows, which in the last three or four years have been into emerging markets, both in bonds and equities. Asian securities lending markets, such as Taiwan, Korea and Malaysia, continue to provide lucrative revenue streams, and in Latin America, Brazil offers good value. Additionally, there are a number of markets that remain under review, including Russia, Indonesia, India and China.
These frontier markets are often structured very differently to European and U.S. markets and frequently have operational hurdles that need to be overcome so that agency lending can take place. Nonetheless, a first-mover advantage undoubtedly reaps premium fees. Our clients are therefore pushing us to aggressively capture these revenues by pursuing a "first to market" strategy.
Whilst the securities lending industry continues to experience significant change and intense scrutiny from all quarters, opportunities are also apparent. The overarching sentiment is that the situation in which the market now finds itself is Darwinian, in that it is not the strongest of the species nor the most intelligent that survives. It is the one that is the most adaptable to change
1John F. Kennedy, speech given at the convocation of the United Negro College Fund, Indianapolis, Indiana, 12 April 1959, www.jfklibrary.org.