How are European trading trends shaping up this year?
Mark Jones: European equity markets have performed well to-date, drawing strength from the European Central Bank’s quantitative easing (QE) programme. This injection of cheaper capital has been a catalyst for a regional rotation of hedge fund capital into Europe, helping support hedge fund growth in the region. However, sustained growth in Europe’s equity indices have seen hedge funds maintain a net long bias, constraining significant growth balance in the region.
On-going regulatory scrutiny around capital adequacy levels in Europe’s banking sector continues to be catalyst for capital raising across the sector. Hedge fund demand has been driven by arbitrage opportunities associated with resultant rights or convertible bond issuances. Regulatory pressures, coupled with Europe’s low interest rate environment, are expected to see this theme continue.
Regulatory change continues to influence execution decisions for both lenders and prime brokers alike. Balance sheet and capital cost sensitivities continue to act as a catalyst for the industry to explore more efficient routes to market.
The introduction of new technological efficiencies, such as EquiLend and BondLend’s Next Generation Trading (NGT) capabilities, due later this year, will play an essential role in helping achieve some of these efficiencies.
Laurence Marshall: The European securities finance industry is vibrant. DataLend shows $504 billion in total on-loan value, $3.6 trillion in total lendable value and more than 10,000 unique securities currently out on loan in Europe. As far as automated trading on EquiLend and BondLend, trading activity has steadily increased in Europe over the past several years. In fact, the number of European securities trades on EquiLend and BondLend has doubled in the past five years alone, from May 2010 to May 2015.
Fixed income corporate securities, in particular, have seen incredible growth on our platform in Europe, with a ten-fold rise in BondLend activity in Europe since 2010. On June 4 this year, we hit a record high of 31,775 trades on EquiLend and BondLend overall (counting one side of each trade), indicating that automated trading remains healthier than ever.
Maurice Leo: We see two key trends. The move toward non-cash collateral has been well underway for more than two years. Many borrowers see beneficial balance sheet treatment when trades are transacted versus non-cash. Balance sheet usage is obviously important in the context of calculating many ratios under Basel III. The other major trend is evergreen and extendable structures on collateral transformation trades, for which borrowers receive relief under liquidity coverage ratio requirements and, to a lesser extent, net stable funding ratio requirements.
What are the most pressing regulatory burdens right now?
Jones: While hardly a new topic, the most prevalent issue in the regulatory space at present is capital and balance sheet usage and the way that recent regulatory changes have influenced the way that the market approaches almost all its activity. Virtually all market participants have been affected by these changes and have to rethink and adjust the way they do business as a result.
This represents the biggest challenge for borrowers and lenders alike at the moment, and adding into the mix macro themes such as market transparency, financial transaction taxes, and other jurisdiction-specific regulation such as UCITS and the Alternative Investment Fund Managers Directive (AIFMD), and there clearly remains a heavy regulatory agenda for the market to contend with.
Leo: Regulation is the all-consuming issue for most practitioners in our business right now. Aside from the usual risk-weighted asset and return on capital headwinds, numerous regulations in the pipeline will impact how the industry conducts business.
In the Europe, the Middle East and Africa region, we have the Securities Finance Transactions Regulation (SFTR). UCITS V, expected by March 2016, will also bring new lending challenges for funds already facing the implementation of the European Securities and Markets Authority (ESMA) UCITS guidelines. A big challenge is the restriction on collateral pledge arrangements. Because UCITS funds won’t be able to accept collateral via pledge, they also won’t be able to undertake securities finance with North American counterparts under master securities lending agreements that use pledge for collateral. The AIFMD asset segregation consultation could lead to additional challenges for managing and holding collateral for alternative investment funds. The results of this consultation are anticipated to be added to the UCITS regulations and the impact could be much broader.
Solvency II comes into force January 2016 and presents challenges for insurers, particularly those in the UK looking to adopt matching adjustment structures that could limit an insurer’s lending activity. However, the Prudential Regulation Authority appear to have adopted a more benign approach if the insurer satisfies the eligibility criteria. We also have the Markets in Financial Instruments Directive (MiFID) II, the implementation of the Resolution Stay Protocol, the Transparency Directive and the Financial Transaction Tax (FTT), which all have the ability to fundamentally affect the way we do business.
Marshall: While burden may not be the most appropriate term, there are indeed a number of regulations in the pipeline that will have a significant impact on the securities finance industry both in Europe and globally. Regulators are becoming more interested in and engaged with the securities finance industry. One significant example is the Financial Stability Board (FSB), which is currently advising on increased transparency in the securities lending market. We have been actively engaged in these conversations and believe increased transparency will have a positive impact on the securities finance industry.
Securities lenders and borrowers are also facing the impact of Basel III, the European Market Infrastructure Regulation (EMIR), the US Dodd-Frank Act, MiFID II/MiFIR and others, which will affect counterparty risk, liquidity risk, leverage ratios, transaction reporting, and so on. While the securities finance industry is facing an unprecedented level of regulatory impacts, participants in this market are resilient, so we expect they will adapt to the new landscape.
How are regulatory pressures changing collateral habits in Europe?
Jones: There is much more focus on ensuring that collateral is being used in the most efficient manner. This has led to demand for a broader range of collateral to be accepted and different ways of structuring trades to give lender and borrowers as many options as possible to achieve their aims—we believe flexibility is required.
The onset of EMIR is also driving significantly more discussion with participants who previously have not had to pay so much attention to the way they manage their collateral options.
Leo: European trading is very much driven by collateral and balance sheet management. The move to equity collateral is a pronounced trend. The demand to term equity balances in evergreen and extendable structures is growing, which is similar to what we’ve seen in the fixed income space. Demand for European equities over record dates is predominately for short durations and rarely straddles month ends, again due to borrower balance sheet management in light of Basel III.
T2S is upon us—how will this affect securities finance and collateral?
Jones: Making-cross border settlement more efficient and consistent can only help our market in the long run. Clearly the burden of adopting new operational practices and making the necessary systemic adjustments has been challenging, but the benefits of enhancing efficiency and opening up more options in terms of sourcing collateral are clear to see.
Marshall: Target2-Securities will create a more harmonised settlement landscape in Europe, and organisations have now developed plans and strategies for implementation. It is anticipated that this will lead to an adjustment in the services provided and their cost. Creating a common standard across multiple European markets will create settlement efficiency that will benefit the collateral process by increasing netting opportunities, reducing dependencies that help to increase the liquidity of collateral. Clearly the biggest benefits will be achieved once the majority of European volume is achieved and all European central securities depositories commit.
Leo: The more pressing issue under the Central Securities Depositories Regulation is the implementation of the penalties that ESMA is considering. Last year, we saw European markets move to a T+2 settlement regime. Now, the market will be subject to increased settlement disciplines through fines and buy-ins. The proposals implement a daily fine for failing trades, including securities finance transactions, with effect from S+1 through S+4 or S+7, depending on the security’s liquidity.
Thereafter, the failing trade could be subject to a mandatory buy-in. The initial levels of proposed fines were pretty significant and have the potential to revise how a business is operationally managed.
Among beneficial owners, there’s some concern they would need to withdraw from lending if they’re affected by penalties on the back of failed recalls. The rules could present particular challenges for agent lenders that are not aware of or unable to react to client sale activity until T+1, which provides only a single day to return stock from loan to avoid a penalty. This is likely to have a significant impact on how the market operates and will require greater efficiencies within the operational framework that underpins trade notification and liquidity management.
The EU’s SFTR is almost here—what does it demand from the market, and what can data providers do to help?
Jones: The broad theme of transparency under SFTR is one the market is generally well placed to address given clear direction as to what the regulation requires. As an industry we already pool and utilise a vast amount of data via data providers and that could be a useful position to leverage in trying to meet the new requirements. Data providers may be able to promote consistency in data provision to regulators should they choose to integrate themselves into this process.
Marshall: We envisage that reporting obligations are triggered when a securities finance transaction is agreed, terminated or modified for all principle entities that are subject to the requirements. The data providers are ideally placed to provide ‘delegate’ reporting services, but there will be additional data points that entities will need to provide, and we expect that the technical standards will require unique trade identifiers to be included.
Leo: SFTR will present a number of challenges. Various components could have staggered implementation dates, but by far the most demanding will be the mandatory reporting component. The regulation captures the reporting elements for the market from MiFID II and the FSB, and the EU is potentially looking to accelerate the adoption timeframe regionally.
Although final regulations are not expected to be published until later this year, some elements are becoming clearer. Reporting is likely to be required from both lenders and borrowers, and at a beneficial owner level where lenders transact through agents. Outside parties, most likely various trade repositories in the agent lender community, will be allowed to undertake reporting on behalf of their clients.
The definitions are fairly broad and may encompass many transaction types. Loans, collateral and cash reinvestment are all in scope, and reporting will likely have to incorporate legal entity identifiers, unique trade IDs and unique product IDs. Existing data providers have started to take an interest in this upcoming regulation and may be able to offer some solutions to market participants. For entities constrained by cost or size, an external data provider solution may be essential.