Written by Lynn Strongin Dodds
Lynn Strongin Dodds finds out how the securities market is developing and benefitting from the current low yield environment
Beneficial owners including pension funds, asset managers and insurance companies may be stepping up their securities lending game but they are doing so gingerly. Programmes have been refined and a much more conservative tone has been adopted since the financial crisis. The industry is going back to the future with the intrinsic value model - whereby returns are based on the securities and not the collateral reinvestment - coming back into vogue.
This is not surprising given the stigma attached to cash re-investment. The problems may have been mainly in the US with the high profile Reserve Primary Fund ‘breaking the buck’ - its net asset value dropped below $1 - but the shock waves reverberated around the world. As a result, “the industry has been forced to become more transparent and investors today have a much better understanding of how the lending markets work and the risks involved,” says Citi global product development head, securities finance, Andy Krangel. “This has made them more comfortable and they are considering lending again. We are definitely seeing investors placing a greater focus on intrinsic value and the quality of the loans instead of utilisation which is the proportion of shares in active lending programs which have been lent out. Investors understand utilisation is not a good measure of lending portfolio performance.”
Views differ though as to whether the intrinsic value trend is permanent. For example, J.P. Morgan global head of client management & sales for trading services Paul Wilson acknowledges that there has been a move to the model but he is unconvinced as to whether it reflects a “seismic shift in the industry versus the current dynamics of the market. We will only really know when market and economic conditions improve and we can see whether the intrinsic approach prevails”.
Mercer’s Sentinel Group principal Sonja Spinner also questions whether the model is enough to provide the right level of comfort. “You can put on intrinsic hurdles, but the question that pension funds have to ask is whether the portfolio out on loan which generates a small return is worth the risk. If they are worried about asset allocation then they may go into high yield debt or property which will have a more material impact than securities lending which just tweaks the portfolio.”
Some industry players such as Northern Trust international head of client relations, securities lending, Sunil Daswani, believes there will be a greater move towards bespoke products. “Generally those participating in securities lending have developed customised programmes with a risk return profile to suit their needs. There appears to be little concern by those who are active as long as continuous monitoring and regular service reviews take place. Every programme varies and some clients are more focused on the intrinsic value lending of securities while others participate in a wholesale lending programme. It really depends again on the risk return profile.”
Most agree though that securities lending will continue to gain traction in this low yielding investment climate. Wilson sums it up for many when he says: “Interest rates are virtually zero or close to it in the US, the eurozone and the UK and the yield curve is fairly flat. The levels of return vary tremendously depending on the lender and the securities they own but the average is between three to 15 basis points. Whilst these aren’t substantial, pension funds are looking to eke out any incremental returns in this current market.”
Aviva Investors head of securities finance Mick Chadwick adds: “My own personal view is that the buy side is still concerned about risk and regulatory uncertainty and although supply has come back, they are still not as active as before the crisis. However, most long-only funds are operating in a relative performance culture and securities lending can help generate incremental returns and bump them up, say, to the first from second quartile.”
One challenge though is the lack of demand. The inventory of securities that can be borrowed has almost recovered to pre-crisis levels at $12.9 trillion but the loan balance is woefully under at $1.4 trillion, according to figures from data provider Markit. This can make it difficult to source securities, although firms are plumbing new pools of liquidity. As Wilson notes: “We tend to be thoughtful when we bring on new supply and look at areas where there is strong demand such as in emerging markets, Asian securities and a high quality collateral - bonds, equities and cash.”
The big unknown is whether the greater need for collateral on the back of derivatives regulation embedded in Dodd Frank and the European Market Infrastructure Regulation can stimulate future borrowing demand. The jury is still out. For example, under Basel III, banks will require greater levels of capital and liquidity, which means they will want to borrow high-quality securities for longer periods of time. This translates into a collateral downgrade from the lender’s perspective and Markit director Andy Dyson points out: “The question is whether they will want to exchange higher for lower quality collateral. The main issues revolve around pricing and whether the risks are commensurate with the returns.”
The other uncertainty is the impact of the Financial Stability Board’s (FSB) recent proposals which aim to contain the risks posed by so-called shadow banking. It covers a range of activities that ultimately do the same thing as regulated banks such as lending and borrowing money but are structured so as to avoid the costs and scrutiny of their counterparts. The FSB suggested that securities lending transactions be reported to trade repositories and also mooted a review into directing such trades through CCPs to enhance transparency.
While industry participants debate whether CCPs will play an active role, clearing housesmay launch their own products with Eurex being the first out of the gate. The group owned by exchange group Deutsche Börse recently debuted a pilot phase for its service for the bilateral securities lending market.
Initially, it will cover German and Swiss blue chip equities and exchange traded funds (ETFs) but the plan is to roll it out to include additional European markets, fixed income products (such as European government bonds, corporate and covered bonds) and further ETFs. The aim is to mitigate counterparty risk as well as increase capital efficiency. In addition, it plans to leverage Eurex’s partners for trading and collateral management, by combining the trading capabilities of Eurex Repo’s SecLend Market and Pirum System’s real-time service for bilaterally agreed OTC transactions with the tri-party collateral management services of Clearstream Banking Luxembourg and Euroclear Bank. The service also meets regulatory requirements such as Basel III, capital directive requirements (CRD IV) and International Organisation of Securities Commissions (IOSCO) proposals.
According to the exchange, single counterparty clearing will not only reduce counterparty risk exposure but also eliminate the need for multiple credit evaluations. “Our new product has been designed with support from key market participants who have committed to utilise the service to achieve a substantial reduction in capital allocation,” says Eurex Clearing senior vice president Thomas Wissbach. “Due to the new regulations, collateral is at the top of everyone’s agenda and they are looking to find the right platforms to conduct collateral upgrades; the connection via our CCP will offer them a wider range of borrower counterparties. Today the market is bespoke and manual and we are hoping to make the process more cost effective and efficient. We do not see it as a replacement but a complement to current services.”
Eurex have done a good job of creating a distribution channel that complements the bilateral nature of securities lending transactions, and considers many of the requirements of both beneficial owners and lending agents such as restricting margining requirements only to borrowers. But one of the problems that hasn’t been solved is that clients like to diversify their counterparty risk across different borrowers,” says Brown Brothers Harriman senior vice president, global securities lending, Keith Haberlin. “By using a CCP you take away that diversification and concentrate the risk with the CCP. For this reason we see it as an additional distribution channel, but not a replacement of the traditional bilateral model.”
Written by Lynn Strongin Dodds, a freelance journalist