SEC LENDING ROUNDTABLE: Both a borrower and a lender be

Industry heavyweights, including agent lenders, discuss issues affecting the securities lending sector such as regulation and the types of collateral being used. Matthew Chessum (securities lending and equity execution trading at Aberdeen Asset Management)
Jayne Forbes (deputy global head of trading and securities financing at Axa Investment Managers)
Mick Chadwick (head of trading, securities finance at Aviva Investors)
Ross Bowman (business development, securities finance, BNP Paribas Securities Services)
Steve Kiely (head of sales and relationship management, securities finance EMEA, BNY Mellon) Funds Europe: After a bit of a bumpy 2015, what have been the main investment trends in stock lending over the past year and how do these trends relate to the economic and risk environment? Matthew Chessum, Aberdeen Asset Management: Our book has been more dominated by deep specials that are lasting for more protracted periods of time. We’re seeing a lot more scrip trading, which is contributing to the main peaks in on loan balances throughout the year. We’re seeing an increased interest in borrowing of ADRs, GDRs and ETFs in particular. These patterns are related to the regulatory environment, given that we lend on behalf of Ucits and AIF funds, which is reflective of the economic and risk environment. Mick Chadwick, Aviva Investors: At the start of the year, there was probably a fair amount of pessimism in the industry as far as the outlook for programme revenues were concerned, given the demise of various outperformance trades driven  by withholding tax arbitrage. We’ve actually been surprised on the upside and a lot of that has been around scrips, around specials, around corporate actions and idiosyncratic events, company-specific events. On the fixed income side, liquidity-driven demand for high-quality liquid assets remains robust. Steve Kiely, BNY Mellon: The fixed income side is definitely driven by the regulatory environment. In the equity space, scrips especially and corporate event lending has almost replaced the yield enhancement part of the book in terms of how much it equates to the overall revenue generation. Hedge fund activity definitely is down. and the volatility in Q1 this year discouraged investment – therefore, they just haven’t got the equity that needs financing like they used to have. And the other factor is regulatory, in that we’re doing a lot more euro versus euro cash, dollar versus dollar cash, because of the cross-currency haircuts that are applied, when there is a currency mismatch from the regulatory capital perspective. So we’re seeing the equity fall back a bit and cash start to raise a little flag. Chessum: The fact that you’ve got the return of something resembling a yield curve in cash. Kiely: That does help, but, it’s been an interesting year. Sure, if you speak to most FX departments, they’ll say the best things for them this year have been Brexit and Trump, assuming they’re the right way around on that transaction. Jayne Forbes, Axa Investment Managers: What’s of real interest to me, though, is the sophistication that the securities lending business now has. Because with every trade you’re transacting, there’s actually a counter-synthetic trade that is proposed and you could potentially look at the two techniques. We too have Ucits, AIFs, and mandates. Term structures need to be closely analysed before execution because it’s a volatile market for the fund managers, isn’t it? We’re close to the fund managers and we have to ensure the programme meets their needs.  It’s the sophistication of the market that’s been the biggest thing this year, making sure that we’re trained in that. That’s actually driven a reorganisation. But we have had a good year, an unexpectedly good year. Ross Bowman, BNP Paribas: Changes in portfolio asset allocation have impacted trends this year. Managers looking for yield have increased their allocation to equity and multi-strategy funds and we are going to see more of this change going forward. Additionally, managers will be looking at alternative asset classes for investment, such as real estate and private equity. As a result, ‘specials’ are going to continue to play an important role in revenue generation for securities lenders, as they have done this year. A continuation of this trend will be what we anticipate seeing going forward into next year. Chessum: We lend fixed income assets on behalf of Ucits funds. You hear a lot about HQLA and the demand that’s out there and you could think that that was the only trade going on. But it’s not, because this year we’ve seen a lot of demand for exclusives in certain niche areas like emerging market corporate debt, high yield bonds, whether they’re European or global. Running exclusives on those sorts of funds has been quite a significant contributor to the revenues that we generated on the securities lending programme as a whole. Forbes: We’ve already reallocated the underlying assets within the funds and then specials, high yield has been great for us. Because how the industry used to be, it was sophisticated but it was a bit predictable. Kiely: If you had to predict last year how much someone would make on, say, a US equity portfolio, all it would take is three or four names in that portfolio to literally make a huge difference. That unpredictability is everything. Bowman: If you consider the fact that a large portion of your revenue will be generated from dynamic specials that occur now and again, how are you going to factor this in when pricing an exclusive deal versus a traditional agency discretionary programme? Kiely: We have a number of specials-only programmes. So we have clients who will lend nothing for months and then will put a couple of specials on and they’re very happy with that revenue. Chessum: But this is what I’ve always said, in terms of beneficial owners, you should not look at your programme on a year-by-year basis. You should look at it like any other investment activity, you should benchmark it like any other investment over the appropriate time frames. Forbes: I agree with Matt. Fund Managers need performance and additional yield and non-intrusive methods can be acceptable. The agent’s role is to generate revenues within the predetermined framework and additional opportunities can always be reviewed with a beneficial owner. A low-volume, high-value programme is a workable dynamic. Chessum: In an asset management world of more passive investments where active management is under pressure in terms of costs and fees, then you can understand why questions may be asked one year when your revenues are slightly down on previous years. One year’s revenues in the current environment, however, are not representative of what may be generated in the next. Funds Europe: Is the regulatory framework in which stock lending by Ucits funds takes place aiding Ucits managers to take advantage of this facility? Chadwick: Is regulation making it easier for Ucits, yes or no? Then the answer is no. There are certain trades and certain strategies that effectively are ruled out for Ucits. And you can argue that that’s a denial of revenue opportunity. But equally, the counter-argument would be that that’s necessary for investor protection. The other issue which is still out there – there was a big concern earlier this year about the Esma guidelines around asset segregation, which potentially prevents Ucits and other regulated funds from participating in triparty. Kiely: And that’s still ongoing, that argument. Chadwick: The mood music seems to be that Esma are listening but we haven’t had a resolution of that yet, have we? Kiely: No, we haven’t. Chadwick: And then the final thing on Ucits is with SFTR coming in, there’s just a much higher hurdle rate in terms of transparency and disclosure and everything that has to go into the fund prospectus and the annual report. Now, to a certain extent, there’s nothing conceptually wrong with any of that. It just moves the needle a little bit in terms of the aggro factor. There may be some funds where they look at the aggro versus the revenue and decide it’s not worth it. Chessum: I don’t think there’s too much that’s being asked that a well-run securities lending programme shouldn’t already be doing anyway. But I do agree that in terms of reporting and transparency, it is becoming more difficult and you have to interact with a lot more teams internally to make sure that the information that you’re providing is available. Kiely: The supply of European assets from Ucits structures was something like 48%. The on-loan balance from those same structures was 18%. So it obviously shows that they are disadvantaged, or less attractive in some way. Forbes: A Ucits manager would require the product to deliver a good return to be lendable, that that’s the comparative, isn’t it? Kiely: Yes. Forbes: We explain to the Ucits management companies changes impacting the product as we compare revenues on a year-on-year basis. Fund managers are impacted by the same regulatory bodies and they too have had to adapt. It’s less about the amount on loan any more – it’s about revenue generation, providing an explanation of year-to-previous-year changes and informing them about future changes and new opportunities. Chadwick: Any lending on Ucits is by definition probably higher-margin, lower-volume activity than on seg mandates, just because that is the nature of the activity that they are permitted by regulation. Kiely: Let’s say there’s a fixed income special and there’s supply from a fixed income Ucits. Borrowers tell us they want to take down as much as we’ve got from clients who can take equity collateral. Only once that collateral class is filled will they go to clients who will accept bond collateral. This brings into scope the fixed income Ucits, but they’re not going to be involved in that first trade, so they might get filled on the specials, but their supply is less attractive. Chessum: The market’s changed compared to where it was back in 2008, so regulation has had an impact. When you look at Ucits funds and what they lend, then they are much more special-driven now, just because participants have acknowledged the fact that they do not need to have large balances out earning low revenues. It’s not necessarily punitive at the moment. Whether the market changes, I can’t see that happening anytime soon. Chadwick: There are some Ucits regulations that needlessly constrain revenue whilst offering no meaningful risk mitigation in return. Forbes: HQLA is maxed out. But the regulation on the other side actually has given us new revenue flows, hasn’t it? Kiely: If we’re talking about Ucits, my concern would be that it’s not just about loss of revenue to the investors in those Ucits, it’s about loss of liquidity in the market as a whole. Because if lending drops away that much – we all saw this post-Lehman where clients either paused or pulled out – there will be increasing fails in the underlying cash market. Bowman: Ucits funds have been removed of their ability to enter into HQLA term transactions. However, as we perhaps see more and more special activity, Ucits funds will continue to benefit from this revenue stream. But as some of the traditional sources of revenue for a securities lending investor have disappeared, or rather are disappearing, this dynamic has worked against them from a revenue perspective. That said, there is still value in lending Ucits portfolios and it will come down to a trade-off between risk and reward when considering entering or remaining in the securities lending market. Kiely: It has greatly improved transparency, and that can only be a good thing for all concerned. Chessum: A fund shouldn’t really be in a lending programme if it’s not going to benefit the owners of those assets. Funds Europe: How would a Ucits fund management firm optimise itself on all levels to gain advantage from stock lending and make itself resilient in the face of any difficulties? Kiely: To make themselves as flexible as possible within the guidelines and rules in which they operate. So, for example, if a fixed income Ucits can only take fixed income collateral, they’re not going to earn a huge amount of money if that fixed income collateral has to be AAA government bond. Chadwick: All I would say to that, though, is almost by definition, any Ucits lending is likely to be the specials, high-margin, low-volume end of the business where a conversation about collateral flexibility – given that we’re talking about callable trades only – is it really going to move the needle in terms of utilisation? Chessum: That is exactly where a Ucits fund can optimise its security lending business, making sure that it is part of the programme. Funds Europe: What are the most obvious trends in collateral management? Which are the most used types of collateral and is cash still a prevalent feature? Kiely: For some clients, cash is still very popular and at BNY Mellon, we have about 50/50 in terms of non-cash/cash collateral. If I go back a year, the non-cash split itself was around 60/40 in favour of equities, but they are now back in parity. Chessum: There’s a bit of concern around accepting equities as collateral because they’re seen to be riskier in comparison to government bonds. But there is a very strong case to accept equities as collateral as long as you have the appropriate haircuts and you have appropriate controls in place. When you speak of accepting equity to many beneficial owners, they usually have a look of concern on their faces and say, well, why on earth would I ever do that? Kiely: That’s because they’re still very concerned with credit and not with liquidity. And it should all be about the liquidity. Chessum: Yes, well, liquidity is just as important. Kiely: Yes. Our experience leads some to believe that a government bond, especially something like a eurozone government bond, is inherently less risky than say, a US tech stock. But is Apple stock really more risky than certain eurozone governments? Chadwick: Particularly if you can make the comparison between main index equities and investment grade corporate bonds, the empirical lesson of the 2008/09 crash was that the asset class which proved to be problematic from a liquidity perspective was corporate bonds. A lot of beneficial owners think that somehow what you lend versus what you receive as collateral have to be highly correlated, because that’s a less risky way to construct a programme. The reality is – given that the purpose of that collateral is to turn it into cash – secondary market liquidity in a stressed market environment is a much more important collateral consideration than correlation with the securities being lent. Chessum: This is the conversation that I have with fund managers all the time. They say to me, well, there’s FX risk. So I will say, so you’re telling me … when I lend a Turkish equity, you want to receive a Turkish asset back as collateral? Well, that’s probably not the case. You’d like to receive something that’s a lot more liquid in a developed market that’s got a bid and an offer, that you can sell at the drop of a hat. Kiely: Incidentally, in the middle of the financial crisis, there were AAA-rated bonds where 80% of them were owned by one institution. So the credit was very high, but the liquidity was very poor. Chadwick: Yes. And the triparty agent marks it at 90 cents on the dollar and that’s great. You phone up a market maker and he’ll bid you 75 for half a million when you’re sitting on 25 million. Kiely: So the way we get around that with equities is the amount, the concentration we have on our equities is correlated to the 90-day traded average. So the less liquid an index gets, the less of it we can take as collateral. Chadwick: And that is… the beauty of equities as collateral, compared with corporate bonds, is because they trade on an exchange, you can determine a prudent set of concentration limits based on market turnover. Kiely: For the first time this  year, I had a client come to me rather than the other way around and say, can I take ETFs as collateral? Because this client believes that in a time of crisis, a physical ETF which is commoditised and priced on exchange will be more liquid than a basket of equities. Chessum: But I understand, under MiFID II, all dealing in ETFs has to be reported. So when that happens, and you’re able to see how much is trading on a daily basis, I think that it will help. Kiely: Because the commoditisation will allow for a lot more comfort. Funds Europe: So, is cash making a comeback? Kiely: It is. Cash reinvestment still suffers from the reputation it gained during the crisis. But to people that dismiss it out of hand, I would say that when managed in a transparent, well- administered programme, it can provide a low-risk route to incremental revenue increases. What damaged its reputation was the lack of transparency. Bowman: If you look at global loan balances since 2009, they have remained largely unchanged, at around $1.8 trillion. Furthermore, US treasuries are only around 35% utilised and if you take a look at the European government bond market, you will see that German government bonds, probably the most sought-after European government bond for HQLA purposes, is only 47% utilised. So we can clearly see a large amount of assets supposedly in high demand sitting within the securities lending universe that remain un-lent. So when considering whether non-cash or cash is prevalent, we should first consider where is the demand to borrow these assets, because without the demand to borrow, there is no demand to obtain collateral. Forbes: The new trend of ‘collateral management’ is already there – it’s what we do every day, but the new requirement is consolidation, valuation and revenue maximisation whilst meeting obligations, i.e the consolidation of derivatives collateral management and derivatives trading, TRSs lending, repo, reverse repo. I would ask the question of you guys, are you looking at the integration of all of these product offerings by way of organisational shifts or internal partnerships? Because on the asset management side, it’s a must – we have to. We all have to work together. Chadwick: This concept of collateral as an asset class in its own right, that requires expertise and management and can be traded and regarded as an asset class in its own right, is something that’s definitely gaining traction. Funds Europe: Are there any implications here for collateral management such as liquidty risk? Chadwick: But a theme that should come through will be concern about the potential impact of CSDR on bond market liquidity. Kiely: Especially at a time when government bonds are still relatively expensive and QE is still biting a little bit. Bowman: Yes. Collateral liquidity remains key and perhaps one aspect that needs to be considered is the accessibility of that collateral and any delay in obtaining it, under a BRRD resolution stay protocol. Should a borrower default under an indemnified programme, the agent will need to be able to access and liquidate the collateral quickly and efficiently, so a liquid and readily tradeable form of collateral is key. So to Steve’s early point, there are many different elements that have to be taken into consideration when reviewing collateral selection. Chadwick: The bigger-picture liquidity risk for bond market and bond market funds is nothing to do with the financing business. It’s the underlying investment. You’ve got these vehicles that are marketed as having daily liquidity, daily pricing. Where that liquidity isn’t there, there is a potential liquidity risk. Chessum: Fund managers are having to buy bond ETFs for a number of different reasons, but they might contain bonds that they may not have otherwise have bought because they weren’t happy with the liquidity. But because those bonds are part of the index, you naturally have to buy it as part of the ETF. Funds Europe: How do you see the industry developing over the next 12 months? Kiely: We’ll see more fragmentation. We’ll see greater diversification of revenue sources. So it’s not all coming from the traditional routes. And in the next 12 months, we’ll finally see CCP trades coming on – not just the test trades, etc. Chadwick: When it comes to market innovations and changing market infrastructures like CCP, peer-to-peer platforms, all the rest of it, lending agents and their clients have a duty to at least consider these routes to market.You can debate the merits of whether the Basel rules on risk capital make sense or not, but there is a compelling incentive for the sell-side to look at putting business through those kind of structures. Sooner or later, that’s going to transmit itself back to intermediaries and beneficial owners. Having said that, the risk is that industry participants lose sight of the fact that for most underlying clients, this is a discretionary activity. If you make it hard, if you make it complicated, if you make it expensive, they always have the option not to do it at all. Bowman: Over the next 12 months, we anticipate a greater level of equity and fixed income market volatility. This will, in turn, increase the volume of specials in the securities lending market across the US, the UK and Europe and APAC. We also anticipate an increase in volumes traded across CCP platforms. Although I don’t think it’s necessarily going to be huge volumes to begin with, however, as we begin to evaluate the potential benefits to participants in this structure, the broader industry will begin to review its potential in earnest. In the same context, we also anticipate discussions developing further on the use of pledge collateral arrangements for securities lending transactions. Chessum: Peer-to-peer lending is going to become more prominent and this will become a new potential route to market. There will be more fintech firms entering this space offering a number of related services as well. Active managers are going to become a lot more strategic in their approach to make sure that they really are getting the best risk-reward out of their programmes, given the increased regulatory and cost landscape that they’re facing. Chadwick: Securities lending will become less of a siloed product and more part of the mainstream portfolio and risk management conversation. Chessum: The conversations that you have now are very different to conversations you probably had five years ago. With the cost differential between active and passive management, more managers are willing to listen and have a conversation about securities lending than they once were. Forbes: A big driver for lending revenues will continue to be from the provision of collateral (front-office view). Derivative activity being cleared or uncleared demands mobilisation and efficiency within the back-office collateral management function. Beneficial owners are probably going to take more control of their securities lending activity. I think the basic product will become even more automated and there will be a shift of resource to provide more in-depth analytics to clients for alternative revenue opportunities. Front-office collateral management will become part of the analytics for any new derivative programme. Product sophistication continues to grow, with client engagement being on a different level of engagement. Beneficial owners may start a ‘revolution’ – they no longer want to hear about borrower and agent lender ‘demands’. They like the securities lending product, its yield, and also recognise that regulations provide both obligations and opportunity to them. The supply of fintech firms launching products for collateral consolidation to meet obligations is obviously a key part of a collateral management solution (back office). However, it’s collateral valuation, i.e. the front-office function, which agent lender expertise provides. I just think that that is a unique space, it’s young and exciting. But beneficial owners will start to drive this as well. That’s what they’ll want. ©2016 funds europe

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