How has the securities lending industry in Canada fared over the past 12 months?
Dave Sedman: The Canadian securities lending business has continued to show strong demand over the past 12 months. Beneficial owners have received a steady stream of earnings and continue to see value from the securities lending product. Although spreads continued to tick upwards, utilisation has remained stable. With the collapse in commodity prices, 2014 saw heightened demand in the oil and gas sector and mortgage finance companies, particularly Home Capital Group and Genworth Financial.
The dividend reinvestment plan continued to produce attractive returns and was a large contributor to revenues for our clients. Non-cash collateral continues to be preferred over cash collateral because beneficial owners are rewarded for taking an expanded set of collateral such as equities.
Non-cash collateral is used in Canada more than other regions and accounts for approximately 80 percent of collateral pledged for Canadian securities lending transactions. Cash collateral can provide additional diversification, and in some cases, incremental revenue, however, very low interest rates have continued to support the benefits and simplicity of taking non-cash collateral. There has also been an increased focus on capital usage and continued demand on collateral alternatives and trading structures.
Alexa Lemstra: On the market data front, in 2015 we saw relatively steady on-loan balances and utilisation as well as some upward movement in fees. More recently this year, we have seen overall utilisation increase along with higher fees in the market in the healthcare, information technology and materials sectors.
Canada’s on-loan balances are following the global trend of increases. In Canada specifically, we are seeing balances increase primarily in the financials, utilities and telecommunications sectors. From a business perspective, we are also seeing firms allocating more resources to technology and enhancing systems. Balance sheet, regulation and collateral flexibility are key topics for our clients.
Charles Murray: The strength of both the borrower and lender base in Canada has ensured sound growth in the securities lending industry over the past 12 months as the needs of both sides of the street have been well aligned.
Don D’Eramo: During the past year, volatility and strong corporate activity within the Canadian market led to increased demand from global borrowers for Canadian equities. Evolving financial regulation continued to be a factor influencing borrower behaviour, including a heightened focus on balance sheet management. As a result, demand for high-quality liquid assets (HQLAs) remained strong especially on a term basis.
Phil Zywot: The Canadian securities lending industry has performed well over the last year, despite the low level of oil prices and other commodities—and the associated negative impacts to Canadian equities. Being a resource-based market, the Canadian economy has experienced dampened growth, similar to other energy-producing countries. In terms of securities lending, borrower interest for Canadian fixed income has remained strong and we continue to notice high demand for HQLAs. We have also seen a resurgence in Canadian equity specials, specifically in companies that have exposure to the oil patch or the resource sector.
John Loynd: Overall, 2015 was a pretty steady year, even with the Canadian Stock Exchange down 11 percent and the Canadian dollar down 19 percent. Deal flows were down in Canada and hedge funds continued to de-lever, but the volatility in the markets created great trading opportunities as firms took shorter term views on positions.
We took advantage of the markets and diversified our businesses to capture more US activity, along with more fixed income business via our prime brokerage platform. With Canadian hedge funds outperforming their peers this year, we see great potential in balances continuing to head in the right direction.
Canada is already the world’s second largest securities lending market. Is it still growing?
Zywot: The stability and transparency of Canada’s banking and regulatory environment, combined with its AAA debt rating and status as a stable and mature market, has helped Canada maintain its position as the second largest securities lending market in the world. The Canadian federal government’s deficit spending plan is intended to bolster the Canadian economy, and one way it plans to fund fiscal stimulus is by increasing the supply of new Canadian government issues. The government is reintroducing three-year bonds, and Canada’s gross bond issuance is expected to be CAD 133 billion (US $102.2 billion), representing an increase of approximately CAD 41 billion (US $31.52 billion) from the previous year’s levels.
Those developments should help contribute to the growth of the Canadian securities lending market, given market demand for HQLAs. On the equity side, we have noticed a surge in merger and acquisition activity involving Canadian companies in Q1 2016 and this trend also contributes to further growth in our space.
Murray: The market is growing as demand for funding and term trades increases. Historically, Canada has not been an especially attractive market for specials in both the fixed income and equity space for a variety of reasons, but mainly due to size and regulatory oversight.
Our market continues to grow largely due to the sophistication and high credit quality of its participants. These qualities allow for innovative initiatives, such as term structures and various collateral upgrade trades, as well as client-driven initiatives, to take root and grow.
Lemstra: According to DataLend data, Canadian on-loan balances were fairly steady in 2015 with a slight trend downward. However, in Q1 this year, as in much of the rest of the world, they are trending higher again and are back to April 2015 levels. Lendable values have followed the same trend.
General collateral volumes are holding steady, and we are seeing small increases in specials activity in the healthcare, information technology and materials sectors. Canada is a very established market. While the market may see some gradual shifts in on-loan balances and fees, as a whole it tends to be a very steady market.
Loynd: The Canadian market continues to evolve and grow. The exchange-traded fund market keeps hitting new asset under management highs every quarter, boosting borrowing needs. Legislation on liquidity rules from Basel and the Investment Industry Regulatory Organization of Canada have created a need for higher-quality collateral, driving demand for collateral optimisation trades and moving balances significantly higher over the past year. This will continue to grow as more liquidity and funding regulations come online in coming years.
D’Eramo: Participation and supply within Canada continue to grow as new lenders and borrowers enter the market.
Sedman: The Canadian securities lending model is straightforward and transparent, underpinned by strong financial institutions that participate both on the borrowing and lending side of the transaction. Given the strength of the borrower counterparties and the continued growth in the Canadian capital markets and fund management business, we expect that Canada will see continued growth throughout the year.
What may have an impact on the securities lending market is a general slowdown in the natural resource-rich Canadian economy which could be impacted by a global slowdown. However, the securities lending market has historically benefitted in a variety of economic cycles and we expect continued growth going forward.
What is the supply-to-demand ratio like in Canada and how does that affect your day-to-day business?
D’Eramo: Canadian equities enjoy one of the highest utilisation rates globally. Supply and demand are dependent on a number of factors including the volume and quality of lendable assets, as well as the risk appetite and type of lender. In Canada, regulation plays a significant role in relation to supply and demand. For example, mutual funds governed by national instrument 81-102 are unable to accept equity collateral, while pension and insurance funds, which are governed by the Office of the Superintendent of Financial Institutions Guideline B-4, are able to do so.
Sedman: As the fund management business grows and more beneficial owners enter the market, there has been a larger shift globally towards a more specials-driven market. Increases in supply are met with greater demand for specific securities which can dramatically boost a client’s earnings. What has become increasingly difficult is predicting which securities will trade special and produce the greatest revenue.
Northern Trust encourages clients to participate fully, but have the technology and client service expertise to customise each client’s programme to meet their specific requirements.
Lemstra: Canadian banks see demand for inter-listed securities, dividend-related activity, HQLAs such as Canadian government bonds, non-cash collateral borrowing and collateral upgrades. We are seeing lots of supply, with a steady 13 to 14 percent utilisation averaged across all asset types in this market.
Murray: There is a big variance depending on the type of transactions in question. As we continue to move into an increasingly funding-centric marketplace, demand continues to grow for collateral upgrade trades. Depending on how esoteric the collateral offered is, we could often see demand outstrip supply.
Due to the growing trend to accept equities as collateral, the market has witnessed a supply bump with a slower paced increase in demand. For general collateral trades, government for government as an example, we will often see a situation where supply far exceeds demand.
Loynd: On an overall basis, supply has kept up with demand in most asset classes. Certain sectors in the equity space came under duress as the markets took a downturn. Where we have seen the largest deficiency in supply is on the debt side. With so much demand for government bonds in the collateral optimisation space, supply is lagging behind.
However, the regulatory changes that came into effect late last year, which reduced the need for financial disclosure from certain types of funds, gave borrowers the ability to approve principals otherwise untapped by the investor. We have started to see supply catch up to demand. Along with traditional avenues for borrowing, we have branched out to look at alternative ways to get supply in-house with non-traditional securities lenders either via a swap or repo.
Zywot: Supply in the Canadian marketplace has remained relatively steady over the last year. The recent market downturn in the commodity space—specifically for oil—has sparked more interest in Canadian equities and corporate bonds.
As such, we’ve seen increased demand in specials in this sector along with more borrower interest in the secondary markets that are exposed to the Canadian oil patch such as mortgage and financing companies, and the housing sector in Western Canada.
In terms of day-to-day impacts, the result of this market activity has contributed to higher fees and revenues in the Canadian equities and corporate bonds space.
How are Canadian lenders and their agents innovating to keep pace with the US?
Zywot: Innovation has been a big focus—Canadian lenders are investing heavily in technology, whether it be upgrading their front-end systems or implementing efficiencies such as new and advanced AutoBorrow capabilities and collateral management systems.
Canadian lenders and beneficial owners have also been widening their collateral capabilities in an effort to capture greater returns, follow global best practices of collateral diversification, and position themselves to respond to emerging regulatory and market demand for expansion in the use of collateral.
Murray: Based on size alone, the US outpaces Canada, but in terms of innovation and creativity in the securities finance business, the opposite holds true. Our strong regulatory regime allowed us to persevere through the crisis in 2008, which made a critical contribution to our ability to strengthen our business and innovate with momentum.
A great deal of the innovation and evolution in our business has been centered on collateral. The Canadian market has historically been a non-cash market, and by that we are not referring to just government securities. Canadian borrowers and lenders have always been pioneers of various types of collateral innovation from convertibles to various types of corporate securities. This innovation is a function of the market leading sophistication of our clients, from pension plans, provincial asset managers, private asset managers, and mutual funds—all thought leaders in our business.
Sedman: The biggest innovations are on the trading desk. The past 10 years saw the emergence of the customised programmes for beneficial owners. The technology and efforts to allow clients to be able to be specific about their participation and provide transparency has really helped strengthen and attract supply to the securities lending market.
Now the focus is on increasing trade automation and maximising the distribution of the supply to the borrowers and end users. For example, the use of EquiLend’s Next Generation Trading (NGT) system has allowed easier access for borrowers and more customisation around the distribution of securities. This is important for our clients because it ensures their securities have the best opportunity to go on loan as supply continues to enter the market.
Loynd: Over the years the lending community has been asking us what we want. The answer has been the same for quite some time: better collateral schedules, term borrows and cross asset trades. It seems that over the past couple of years the conversations have been paying off.
As lenders have seen spreads compress these new avenues into more diverse collateral, cross-asset trades and term borrows have moved the Canadian lenders ahead of a lot of their US counterparts, creating better returns for them and their clients. Lenders that adapted their programmes and conveyed the added revenue to their clients with little to no extra risk are now the first phone call for many borrowers.
Lemstra: While the Canadian market may be smaller than our neighbour to the south, it is still the second largest market in the world and is a strong player in the global securities finance market. Market participants here have been focused on investing in systems and leveraging automation to achieve straight-through processing for their businesses. The EquiLend client base continues to expand, with firms expressing increased interest in data, trading and post-trade reconciliations as our clients look to us to do more for them in the current environment.
Canadian banks have been very engaged in NGT discussions, testing and builds. In some cases, they are ahead of the curve in adopting trading changes and leveraging technology to do it. It is an active and dynamic market that very much embraces new technology to benefit the business.
D’Eramo: Canada has a longstanding reputation as a highly successful and robust securities lending market. While the US is seeing a trend toward the acceptance of non-cash collateral, non-cash lending has been standard practice in Canada for many years. Securities lending is generally becoming more transparent in Canada. Rigorous disclosure and monitoring requirements are driving heightened engagement between lenders and their agents. In addition, lenders are engaging with their agents on a more frequent basis as the demand for alternative collateral types and term loans increases.
On the global regulatory front, what is demand like for HQLAs? Is Canada proving to be a valuable source of these?
Loynd: HQLAs and the liquidity coverage ratio (LCR) have been on the scene now for a few years. Firms are always looking for different solutions to ensure that its LCR is on side. With the continuing creation of central funding teams across the street, the need for optimisation has gone to the front of the line.
Canada as a whole has seen huge demand from US clients looking to improve their LCR but for the most part they will only look at US assets. So even though Canada is doing lots of business to satisfy demand for HQLAs, it is somewhat limited to US collateral. As firms have become more efficient and capable of handling alternative currencies, we have started to notice a little more willingness to take Canadian assets.
Sedman: Regulation has an impact on the business and Canada is in a position to be a net beneficiary as HQLAs and other collateral continue to be in demand and valued by the marketplace. Since Canada is one of the last AAA-rated sovereigns, it is likely that demand will continue to grow for Canadian government and government-backed collateral. What remains to be seen is the impact of the increased cost of capital on borrowers and lending agents, which we feel already has slowed demand in certain segments of the market.
Murray: The Canadian securities lending market has remained resilient in the past 12 months. Demand for Canadian fixed income securities remains relatively strong. As a result, demand for HQLAs has remained robust. Specifically, as Canadian government securities have retained their AAA rating, demand has remained strong for borrowing this asset class. Regulatory forces as well as an active repo market have kept demand stable for Canadian federally issued debt, as well as federally guaranteed agencies. With demand increasing for Canadian government debt from non-traditional borrowers, other classes of fixed income have benefitted and experienced increased demand from these forces as the traditional borrowers have had to source alternate forms of debt.
Provincial debt has seen an increase in overall demand as a result of Canada government debt being redeployed for new sources of demand. Overall, those lenders with the widest array of flexible collateral options have benefitted the most as borrowers seek to optimise the use of available assets into upgrade trades. Beneficial owners of HQLAs that have the ability to enter into term trades have also seen robust demand this year and that demand is only expected to increase, as pressures from regulatory requirements such as LCR and the net stable funding ratio (NSFR) come more into focus.
D’Eramo: There has been a steady increase in the demand for HQLA over the past several years. Highly rated Canadian debt continues to attract significant demand from financial institutions looking to manage their capital ratios, such as the LCR and NSFR. Collateral flexibility remains an important driver of borrower demand in Canada.
Zywot: In the current regulatory environment, the demand for HQLAs continues to remain steady, especially with Canada being one of the beneficiaries. Given that Canadian government bonds are one of the few AAA-rated instruments remaining, these HQLAs are in high demand as a form of collateral for market participants. Canadian bond balances have benefitted over the past couple of years and are expected to continue to do so.
What’s in store for the rest of 2016 as far as your business is concerned?
Murray: The year ahead is expected to remain stable for the Canadian securities lending market. It’s expected that the theme of regulation will continue to drive the need to source HQLAs, with an emphasis on securing that supply for a term. Alternative and non-traditional collateral, such as equities, will continue to remain an important driver in the market as participants feel further pressure to optimise their collateral usage.
Zywot: We expect merger and acquisition activity to continue to increase through 2016, driving demand and revenues in the Canadian equity space. The steady pressure on the resource sector should result in continued specials in Canadian equity and corporate bonds. New regulatory requirements and the cost of capital should continue to gain focus. Finally, we expect to still see strong demand for HQLAs such as Canadian government bonds, which should remain steady for the remainder of the year. Overall, we believe the prospects for the Canadian market remain bright.
D’Eramo: In 2016, corporate activity is expected to continue driving increased demand for securities lending. During the coming year, RBC Investor & Treasury Services will continue engaging with our clients to match their lender profiles (such as term trading, collateral flexibility and risk tolerance) with borrower demand. In addition, we are working with clients that traditionally have not utilised securities lending to capture high-value revenue opportunities through a transaction-based approach.
Sedman: At Northern Trust, our focus is on trade automation and client customisation. The Canadian market continues to provide a stable source of income for our clients and we are committed to providing our world class securities lending service to meet our growing demand in Canada. We expect to see demand for general collateral trades to continue to decrease as borrowers and lenders alike remain focused on efficient capital and balance sheet usage. Borrowers are expected to focus on seeking balance sheet friendly trades and use a broader range of non-cash collateral types, in order to keep pace with new regulatory requirements. The expansion of collateral sets should also continue to evolve within the Canadian securities lending market.
Lemstra: EquiLend continues to work with firms to launch trading workflows on the NGT trading platform. We are also responding to clients wanting to gain more efficiency by offering more services in our new post-trade paradigm. Furthermore, we continue to provide market data to assist clients in their trading decisions.
Loynd: Fiscal 2016 is off to a great start. Market volatility has definitely helped the book and we feel very well positioned to have a strong financial result in the global prime finance group. BMO is in the midst of a multi-year project where we have invested wisely in our technology platform by implementing many tools that will help us automate many of our flows for years to come. We still believe there are excellent opportunities in servicing our Canadian clients in terms of foreign securities, as well as European-based clients who are actively trading US and Canadian securities. We continue to offer clients a one-touch approach as our securities finance, prime brokerage and delta one team can offer a suite of products together as one.