How would you describe the last 12 months for the Canadian market?
Dave Sedman: Utilisation rates grew throughout 2014 while fees remained flat. Demand for Canadian equities was largely driven by dividend yield enhancement trades, dividend reinvestment plan (DRIP) trades and specific directional names. The DRIP trade continued to produce attractive returns and was a large driver of revenue for our clients. Borrower demand for the DRIP trade continued to provide a significant source of revenue, however, in the wake of lower crude oil prices, most of the oil and gas sector companies discontinued their DRIP offerings for the fourth Q4 2014.
Structured collateral upgrade trades with equities pledged as collateral also remained popular. Northern Trust also experienced a significant growth in revenue for equity loans with equity as collateral.
In response to regulatory changes, borrowers continued to pursue trading strategies that resulted in more efficient use of balance sheet. These include term-funding transactions and the use of a broader range of non-cash collateral types. With the need to satisfy new financial regulations imposed by Basel III and the Dodd-Frank Act (which requires banks and institutions to hold longer term financing), demand increased substantially for term borrows.
Charles Murray: The Canadian securities lending market—like others—has shifted focus in the last year, with a much greater emphasis on viewing opportunities through the prism of regulation, including the need to optimise capital usage.
Generally, we’ve seen lower equity deal flow and fewer specials than in prior years. On the other hand, a greater focus on Basel III and liquidity coverage ratio and net stable funding ratio requirements have created new opportunities for collateral upgrade and term trades for those able to transact.
Nathalie Bockler: The Canadian market has been influenced by the volatility/decline in oil prices and observed in the foreign exchange rate. The TSX has lagged, while globally markets have rallied.
Phil Zywot: The Canadian market has seen healthy growth over the last year, reaching record balances—most notably in the fixed income area, which has set high water marks for each of balances, spreads and specials based on liquidity pressures. The reduced liquidity in the market has been reflected in the record amounts of overnight liquidity that the Bank of Canada has provided via its securities lending facility. Increased spreads and demand, especially on the Canadian fixed income side, has in turn led many beneficial owners to expand participation in lending of their Canadian fixed income supply. On the equities front, the market has remained steady, with the main driver of activity being the resource sector.
Canada has always been seen as a conservative market. Why is this and what does it mean for investors?
Bockler: I would not say ‘conservative’. Canada is well known for the high quality of its asset manager and pension investment professional communities. They are definitely prudent and apply thorough due diligence. When looking specifically at the securities lending market, the main difference with the US is the lower interest in cash collateral for ‘yield searches’. Transactions are viewed more on a risk/reward basis. I would add that Canadian investors were early adopters of asset swaps, or upgrade/downgrade transactions, as a means of increasing the yield on their assets.
Zywot: The conservative approach taken by Canada’s financial market participants and stakeholders gained considerable global attention during and following the 2008 market downturn, but has been the culture here for many years. Canadian participants tend to place a very strong focus on diligence, risk management and governance. For example, in terms of securities lending, these traits tend to manifest in an approach that focuses on achieving a risk-reward balance that is right for participants, as well as an appetite for clear and transparent reporting.
Our measured approach continues to be a key attractor for global investors seeking stability. Canada remains one of the few countries with a triple-A credit rating—one of the factors that drives so much demand for our government bonds.
Canada is also notable for the collaborative approach taken by the country’s regulators, releasing regulations well in advance and taking industry input into account, which, for example, led to the regulatory move to enable exchange-traded funds and real estate investment trusts to participate in lending activities on a level playing field with other types of investment fund structures. In securities lending and elsewhere, Canada remains a very attractive proposition.
Sedman: Canada is seen as a very stable market. Canadian banks are run conservatively with very healthy balance sheets and capital ratios, which are more than adequate with respect to Basel requirements. Additionally, Canadian government debt is AAA-rated. So one could understand how Canada may be viewed in that light.
However, I would argue that the Canadian market is quite mature and is starting to shed its conservative label. While it is true that Canada is a fairly ‘general collateral’ market, borrowers and lenders continue to look for new and more efficient ways to transact loans.
Borrowers are exploring collateral alternatives and trading structures, while lenders are earnestly trying to accommodate these requests. We are seeing an increase in requests for term trade and profit sharing structures, as well the expansion of acceptable collateral.
Murray: Non-cash collateral has always been dominant in the Canadian securities lending market, unlike, say, the US market, in which cash has been the predominant form of collateral and cash reinvestment returns were a material part of lending programmes’ total return. For years, the conservative nature of the Canadian market was highlighted by its lack of focus on reinvestment yield as a component of total return. In the past decade, however, cash collateral has played a larger role.
Additionally, alternative forms of collateral have gained importance and popularity as beneficial owners have seen value in the premium available for accepting non-traditional collateral, including equities, corporate bonds, exchange-traded funds and convertible bonds. While lenders are not materially changing their programmes’ risk profile, collateral is increasingly being viewed as part of an asset-liability portfolio, where correlations to underlying loans are considered.
Why does Canada have such high participation rates in securities lending?
Zywot: The global regulatory environment continues to give rise to new and expanded requirements for global participants, in particular by significantly driving up the demand for high quality liquid assets (HQLAs). As a result, highly rated Canadian government bonds have been much in demand, and are likely to continue to see greater uptake.
We also see high participation rates among beneficial owners: many Canadian funds are sophisticated, experienced and well-established players that see securities lending as an opportunity to offset custody costs and generate strong risk-balanced returns in a persistently low interest-rate environment. Strong market uptake helps create additional momentum, as players that might otherwise stay on the sidelines take confidence from the Canadian market’s very strong historical track record as well as their peers’ success in participating in lending.
Murray: Canada has a mature securities lending market that has thrived for more than three decades. High participation rates are the combined result of the market’s custody lending agents’ extensive experience in securities finance markets and beneficial owners’ comfort with securities lending. The latter acknowledge the incremental returns that can be achieved, with relatively low risk taken.
Custodial lending arrangements have also become more customised to lenders’ needs in recent years. Minimum spreads, alternative collateral, enhanced risk management and reporting have all helped to maintain high institutional participation rates.
Sedman: Securities lending participation in Canada is high because Canada is a very stable and mature market and Northern Trust partners with a very sophisticated and educated client base. Participation in a securities lending program is one way for these clients to take advantage of borrower demand and increase the intrinsic value of their holdings, while earning incremental revenue. Many Canadian clients take comfort that securities lending provides is a lower risk investment strategy as the majority of loans in Canada are collateralised with non-cash collateral.
Additionally, we work closely with our clients to customise their securities lending programmes to meet their individual risk and return scenarios through a programme that is tailored to their needs.
Bockler: Canada also has straight-through processing (STP) opportunities and settlement in the Canadian Depository for Securities. This infrastructure is less developed in some countries. In addition, the simple size of available assets is important to the securities lending industry—the Canadian pension market is ranked fourth worldwide with assets under management of more than $1.2 trillion.
What drives cross-border activities?
Zywot: Cross-border activity stems from the large number of Canadian stocks that are inter-listed on US exchanges, as well as the non-cash collateral flexibility of Canadian beneficial owners. Canadian fixed income assets are highly sought-after forms of AAA-rated collateral, and we have seen an increased demand for Canadian product to meet global collateral demands.
Demand also stems from the International Monetary Fund’s (IMF) 2013 addition of the Canadian dollar as an official reserve currency in 2013. As a result, many foreign central banks and sovereign wealth funds have moved to expand their Canadian holdings.
Sedman: Cross-border activities are driven by a variety of factors such as securities trading special, collateral upgrade trades, yield enhancement trading, and mergers and acquisition activity. Over the past year, two large Canadian companies (Amaya Gaming Group and Encana Corporation) have acquired cross-border companies, which resulted in an increase in demand from borrowers as well as an increase in fees.
Murray: While European dividend-related trading activity has been a traditional source of cross-border activity, an increasing amount of borrow activity is being driven by regulatory requirements. Demand for HQLAs such as Canadian government bonds has increased, from both domestic and foreign sources. Those lenders with the broadest collateral and term parameters have derived the greatest benefit from this trend, with the ability to capture higher premiums.
Bockler: Cross-border activities in Canada are driven by a combination of implied index future levels, cross currency and global funding demand.
What are the current trends in collateral?
Sedman: The majority of loans in Canada are collateralised by non-cash collateral as opposed to cash. However, in response to the evolving regulatory environment, borrowers continued to pursue trading strategies that result in more efficient use of balance sheet. This includes the use of a broader range of non-cash collateral.
Bockler: Financial institutions globally have become more and more constrained in balance sheet consumption. As a result, we observed a strong move towards non-cash borrowing and collateral upgrades. This is observable globally and in the Canadian market.
Zywot: In the past, the Canadian collateral market showed significant differences from the US approach. Canada was characterised by non-cash collateral, specifically sovereign debt, as opposed to the US market, which was predominately a US cash collateral market.
In recent years, the two markets have converged with a move towards more cash collateral in Canada, and a move into non-cash collateral in the US. Canada is still an 80 percent non-cash collateral market, but we are definitely seeing a trend of lodging equities as collateral as borrowers look towards collateral and a focus on efficient balance sheet usage.
With the new regulatory framework, the Canadian securities lending space is seeing the term lending of HQLAs continue to gain importance in keeping with the global focus on deploying the right collateral.
CCPs continue to move along. Have there been any major developments or uptake in this area?
Murray: Central clearing has been a discussion topic within the industry for the last several years. Over the past year, with some of the recent regulatory changes having started to impact market participants and diminish capacity to conduct business at existing levels, there has been a renewed focus on the potential for some form of central clearing model to offer value in the securities lending space.
Both borrowers and agent lenders would expect to see certain benefits in terms of meeting regulatory requirements, including a reduction in the capital needed for conducting financing activities for their clients, which would help to preserve current flow and demand.
While most of the central clearing models that exist today are still challenged in terms of being able to service various parts of the industry, the level of engagement on the topic has been increasing and our expectation is that market participants will continue to explore the potential role for central counterparties (CCPs) to play in the future.
Bockler: Unlike the US, swaps are currently not centrally cleared in Canada. We expect a push from banks for a CCP in the future to mitigate credit and operational risk.
Zywot: CCPs have seen renewed interest as a potential distribution channel for agent lenders, in part to the regulatory changes that have been proposed. For example, in February 2015, BNY Mellon announced the formation of a joint venture with State Street and Eurex Clearing to collaborate with Eurex on a securities lending CCP solution.
In comparison to other mature markets, how efficient is the Canadian securities finance business?
Alexa Lemstra: Automation has come a long way in five years. There is a definite technology investment by the market participants in new systems to further efficiency. Canada had to grow in these areas to interact with the other mature markets globally and is a strong global player. We have experienced growth in the EquiLend client base, showing an interest of the Canadian market to focus on automation and STP for their businesses.
New clients continue to approach us for data, trading and post-trade services, and existing clients are looking to leverage our services more.
Sedman: The Canadian market continues to become more efficient and automated. Although not all market participants are completely automated, most are quite advanced from a technology standpoint. Many counterparties utilise AutoBorrow, STP, mark-to-market, Contract Compare and billing automation functionality.
Northern Trust continually invests in technology to ensure that we are at the forefront of automation and execution, and we encourage all of our counterparties to continue advancing toward a more efficient and automated market.
Murray: The Canadian market has made great strides in improving efficiency through automation. While it still lags behind the more developed US market in adoption of STP, there has been a noticeable change in focus to automation and digitisation. Pricing transparency has improved via the wide use of third party benchmarking services, which is visible to client lenders as well as agents and borrowers.
Zywot: In keeping with its generally conservative approach, it’s no surprise that Canadian market players often prefer to implement proven technologies and incorporate lessons learned in other jurisdictions.
Nonetheless, Canada has recently moved to bring in a number of enhancements to improve efficiencies—for example, technologies such as AutoBorrow, Contract Compare, and triparty collateral facilities. Current execution rates reflect an efficient, transparent and mature market in Canada.
Do you see more automated trading in Canada, manual trading or a combination of both? Is anything else changing on the technology front in the market?
Lemstra: There will always be a need for traders to negotiate and arrange the deal names. Automation is predominately in place for general collateral trading to handle the low-touch, high-volume trades.
That said, with the recent release of Next Generation Trading (NGT), traders will have the ability to automate warmer trades, which we expect in Canada and other markets.
In Canada specifically, we’re working with clients here to leverage NGT’s robust trading capabilities that allow users to conduct their entire trading workflow on a single screen. It is designed to leverage the low-touch automation of STP while allowing traders to trade non-general collateral names in a centralised, easy and fast screen.
Also, market data has become more prevalent in the industry in Canada as firms look to integrate more data analysis and automation into their trading decisions.
Zywot: Automation continues to play an increasing role in the Canadian market. In the current market environment, there is significant focus on efficiency, which has in turn strengthened usage of technology platforms that help participants effectively move forward while meeting stakeholder needs.
In particular, we have seen increased volumes and activity in the AutoBorrow space. Providers are also working to hone their offerings to meet participants’ growing demands around flexibility, connectivity and execution.
We have also seen an increase in the use of Contract Compare as it has helped deal with Canada’s recent record volumes. Transparency continues to improve with recent new market entrants, and advancements in front-end systems continue to improve and streamline securities lending processes.
Murray: Automated trading in Canada will continue to gain acceptance as more and more players adopt automated platforms that can handle larger flows.
Of course, some percentage of trades will continue to be manual in order to allow for the evaluation of specific opportunities.
Sedman: Over the past year, there has been an increase in automated trading in Canada, especially in the autoborrow space.
Although there is still a decent amount of manual trading, the percentage is decreasing.
Most of the increase in AutoBorrow activity is directly tied to general collateral loans.
As these trades are automated, it frees up our trading professionals to focus on securities with the highest intrinsic value.
From a client perspective, Northern Trust continues to make a number of enhancements to our securities lending technology, such as enhancements in reporting, to provide clients with transparent securities lending programmes.
How do you see the rest of 2015 panning out?
Murray: We expect 2015 lending volumes to remain on par with 2014 performance. Dividend yield enhancement trades, along with the DRIP trade, are expected to continue to generate significant interest and revenue for Canadian equities. General collateral volume will likely fall due to borrower balance sheet pressures.
Borrowers will likely focus on balance sheet friendly trades such as equity-for-equity or term, and will look for a broader range of non-cash collateral in order to keep pace with new regulatory requirements. Collateral will likely remain one of the key evolving areas within the Canadian securities lending market.
There may be consolidation in the energy industry during 2015. The 45 percent plunge in crude in 2014 made smaller producers vulnerable to larger buyers both in and outside of Canada, leading to potential mergers and acquisition activity and directional demand.
Sedman: I think the rest of 2015 will continue along the same lines that we’ve seen recently—steady, but with continued pressure from regulatory changes. Lenders, and their agents, that can be flexible and creative in terms of matching the needs of the demand side of the market will see good opportunities.
Lemstra: We are working with Canadian market participants to build out STP for NGT. We anticipate more traction and trading on NGT as clients in Canada and elsewhere realise the benefits of streamlined trading on the platform. We are also in active discussions with several market participants in Canada about joining the platform for data, trading or post-trade services.
Bockler: The financial industry will continue to focus on regulation, collateral management, cross-asset solutions and risk management.
Zywot: In 2015, I think we can expect to see a continued demand for Canadian AAA-rated debt as well as a continued focus on regulatory change, balance sheet and use of capital. The Canadian equity offerings trend is expected to continue—in the first quarter, it surged up to 86 percent year-over-year, and worldwide mergers and acquisitions activity was up 21 percent. The rest of the year looks bright indeed for securities lending participants and stakeholders.