When it comes to securities lending, Luxembourg is not a headline market in terms of volume or market breadth, but it boasts other virtues that allow it to hold its own in the crowded EU marketplace. Compared to some of its heavyweight neighbours, such as Germany and France, who have an average daily on loan balance of €130.7 billion and €103.4 billion, respectively, the small nation nestled in the heart of Europe may seem easy to overlook, but do so at your peril. Like many less financially established markets around the globe, Luxembourg has cornered the market in a niche area of financial services where it can compete on the global stage on its own terms—and for securities lending, this was UCITS funds.
UCITS are synonymous with Luxembourg’s financial market, primarily because it was the first EU member state to implement a framework for the highly-regulated fund-type back in 1988.
Back then, the country attracted a large number of promoters from outside the EU who still use Luxembourg as a gateway to the European market. However, there is fierce competition from other European securities lending markets, most notably Ireland and Germany, who rival Luxembourg in terms of volumes of assets under management.
Calmer waters ahead?
Today, Luxembourg has found itself as the beneficiary of several opportunities, created from a combination of internal self-improvement and external geopolitical and economic developments, that may soon mean the country could be punching well above its weight.
The past 12 months saw the Association of the Luxembourg Fund Industry (ALFI) hailing the fact that Luxembourg-domiciled funds now tips the scales at a record €4 trillion of assets under management as of September, while the small financial hub also managed to woo Northern Trust and Liberty Speciality Markets partly away from the UK into relocating their EU hubs to its capital.
But what does the future hold, especially for much-converted UCITS funds, as the prospect of pledge trading promises to revolutionise their traditionally underutilised assets available for lending? And what about the chance of playing host to some of the market participants that may be displaced by Brexit? Luxembourg has the chance to be the world’s bridge into Europe but it is competing with several other major markets for that honour. Although many industry experts think Luxembourg is up to the task of remaining relevant on the global securities lending stage, the path ahead is littered with obstacles.
UCITS: navigating the waves
For Luxembourg’s securities lending market growth, the main hurdles ahead revolve around the fact that its primary offering, UCITS funds, are hamstrung by stringent lending rules that mean they are a consistently underrepresented market demographic, despite having some of the richest lending asset portfolios.
Mutual funds, regulated as UCITS in Europe, currently account for roughly half of lendable securities globally (46 percent), according to the International Securities Lending Association’s (ISLA’s) August 2017 market report, but their proportion of all open trades still remains disproportionately low at roughly 14 percent.
There are two key regulatory hurdles holding UCITS back from a wider presence in the lender community. These rules were originally designed to reduce risks but indirect consequences are crippling their lending flexibility. First, UCITS cannot enter into lending transactions lasting more than seven days. Second, they can only receive collateral by title transfer, not by pledge, which rules them out of activity facilitated by CCPs—for now. Combined, these limitation make UCITS assets significantly less attractive compared to other lenders.
ISLA argues that these measures act against a key aim of the European Commission’s Capital Market Union initiative. “A deep and vibrant secondary market for equities is dependent at least in part on a robust securities lending market,” says ISLA CEO, Andrew Dyson, “the commission needs to think holistically about market liquidity”.
As Don D’Eramo, managing director of securities finance at RBC Investor & Treasury Services, states: “within strict risk parameters, Luxembourg still utilises additional products to maximise returns to end investors”. But where UCITS have their benefits, the current UCITS process can be bad for collateral liquidity.
As part of its initiative to improve the UCITS situation ISLA held its first Irish Roundtable discussion in Dublin (the second largest UCITS hub) back in November, attracting over 50 industry delegates that represented funds, legal advisors, banks, consultants, and regulators.
Those involved in the session explored some of the biggest instigators for change from a regulatory perspective, specifically, pledge trading.
ISLA said: “Whilst UCITS constructs (a feature of the Irish market) have certain restrictions around collateral and tenor that limit opportunities from a securities lending perspective, it was highlighted that many of these funds generate strong revenues from engaging in the activity.”
UCITS funds, which are already some of the most highly-regulated fund types participating in securities lending, did avoid constraints back in September after a long debate between the industry and EU regulators. The European Securities and Markets Authority backed down over proposed asset segregation rules that would inadvertently ruled them out of the lending pool.
The decision was praised by many securities lending industry participants, including ISLA, which stated in August that “the EU framework should ensure that assets are clearly identifiable as belonging to the UCITS or alternative investment fund, consistent with any reuse”.
Despite the obstacles and constraints, UCITS funds still boomed in Europe in the past year and have added to the success of Luxembourg’s funds and development of securities lending.
As Simon Lee, manager director of eSecLending, comments: “The success of the UCITS brand stretches beyond Europe, with fund managers increasingly distributing Luxembourg-domiciled products on a global basis, and similarly, a growing number of fund managers based outside of Europe using the UCITS brand to distribute their products into Europe.”
ALFI reported that at the end of September 2017, 4,110 investment funds were domiciled in Luxembourg, 1,880 of them were UCITS.
By the end of Q2 2017, UCITS funds across Europe registered net inflows of €174 billion, according to the European Fund and Asset Management Association (EFAMA).
The largest net inflows into UCITS were recorded in Luxembourg (€70 billion), closely followed by Ireland (€68 billion). Luxembourg also recorded the third largest net asset growth of 0.9 percent, after Germany and Ireland who saw a boost of 2 percent and 1.5 percent, respectfully.
Lee adds: “Looking specifically at securities lending, there are particular regulatory considerations that UCITS funds have to take into account.”
“But, outside of that, the primary focus of those fund managers is the same as any other asset owner around the globe that participates in securities lending programmes—revenue optimisation, risk management, agent costs, programme structure, and routes to market.”
Brexit: the eye of the storm?
The UK is expected to leave the EU in March 2019, notwithstanding, any transitional agreements. Until then the rest of the world awaits the outcome of current negotiations.
At Sibos 2017, an audience poll predicted that Frankfurt could be set to displace London as a global financial centre after Brexit. Over 45 percent of audience members said they think Frankfurt will be the next big financial centre. Could this affect Luxembourg?
D’Eramo explains the way forward post-Brexit may be the increased practice of custody lending in Luxembourg, as he says, it remains the Luxembourg’s biggest trend in securities lending.
“Custody lending remains a preferred option for many lenders in Luxembourg as it offers operational efficiency, no interruption to the investment management process and ability to capture large volumes of trades which would be cost inefficient in other models,” D’Eramo explains.