How would you describe the start to 2014 for the Canadian securities lending market and how do you think the year will shape up?
Timothy Smith: A cursory glance at the statistics shows a sort of flat, even keeled business environment for securities lending levels. It could be argued that Canada, while not being affected as badly as other markets during the financial crisis, does not have the same boom and bust or seasonal-type characteristics of emerging and European markets.
Looking below the surface, however, there are some trends visible and of interest. For example, corporate bond activity has fluctuated down by 25 percent in January, but then balances have increased more than that amount since. Equity borrowing has increased by a significant 30 percent, which could be the impact of commodities interest and overall rise in the Canadian market value.
This is, however, a different story than for Australia, which has a high preponderance of commodity stocks, too.
In terms of predicting the rest of the year, too many people have lost too much money by doing so, but in terms of dealing with structural market changes, Canadian securities lending has usually been at the forefront of measured and successful response.
Dave Sedman: Supply (through a number of new mandates) and demand have remained strong in the Canadian market during the beginning of 2014. Although spreads remain on par with 2013, utilisation continues to increase to new highs. Our single global proprietary system provides our traders access to our clients’ portfolios around the globe 24-hours a day, so we are able to maximise these lending opportunities for our clients.
Demand in Canadian equities has been largely driven by dividend yield enhancement trades, dividend reinvestment plan (DRIP) trades and specific directional names. The DRIP trade continues to show attractive returns and is a large driver of revenues for our clients. There have been a few specials that have contributed to a very successful start to the calendar year, too.
Charles Murray: Year to date, 2014 loan balances and fee levels in Canada have been similar to those we saw in 2013. Borrowers have shown increased interest in collateral transformation trades year over year, and particularly in equity versus equity. We expect this trend to continue, though the scale will be influenced by provisions within the US Dodd-Frank Act and Basel III that define credit exposure, risk-weighted asset calculations and capital requirements.
Phil Zywot: Overall, the Canadian market has been off to a very strong start, and we are optimistic about the year ahead. We’ve seen healthy developments on the mergers and acquisitions front, particularly in the resources and healthcare sectors. Secondary offerings have also been quite hot in the energy sector, with CAD$2.7 billion raised in the first quarter alone—a six-fold increase over 2012.
Canadian sovereign bonds remain in high demand owing to Canada’s strong credit ratings, and we have seen record balances against both cash and non-cash collateral. IPO activity has been relatively unimpressive, however, this has been one of the slowest starts since 2001.
Alexa Lemstra: The Canadian securities lending market is consistent in terms of on-loan values, and 2014 has continued in that trend. On-loan values fluctuated 11 percent from 1 January to 1 April, with a high of $139 billion in mid-March. Fees for securities borrowed in the Canadian market came down toward the end of 2013 and have stayed flat into the beginning of 2014.
The Canadian market in 2014 will likely continue as the strong general collateral market it historically has been, maintaining consistent on-loan volumes and fees.
How will Canada’s changes in requirements for short selling activities affect the industry there?
Sedman: The Investment Industry Regulatory Organization of Canada (IIROC) introduced amendments with respect to short sales and failed trades a while ago. Two of the major changes were the repeal of the tick test and the introduction of a pre-borrow requirement. IIROC repealed the restriction requiring a short sale of a security to be made at a price greater than or equal to the last sale price. Short sales will no longer be subject to the tick test.
Under the new pre-borrow amendments, a participant is required to locate a lender where the security may be borrowed before entering a short sale of: any listed security on behalf of a client that previously had an extended fail for 13 consecutive days, any listed security on behalf of the firm if the firm had an extended fail for 13 consecutive days, or any security that IIROC designates as a ‘pre-borrow security’. If any of these conditions exist, a locate requirement will be required. These changes have not had any material impacts on our securities lending business.
Zywot: Canadian regulators and participants recognise the role that short selling plays in the markets in terms of efficiency, price discovery and hedging strategies. Most of the regulatory impacts to Canadian participants are in fact from global regulation, for example, a financial transaction tax has put a temporary damper on demand from Europe.
Murray: We’ve seen very little impact on the industry. The repeal of the tick test, the use of the ‘short exempt’ designation, pre-borrow requirements and increased regulatory reporting have neither increased nor decreased short activity. Borrowers’ and their clients’ various trading strategies continue to drive lending needs.
Smith: Canada is not alone in seeking to obtain a better understanding and more transparency and reporting around short selling and securities lending activities. An early warning reporting regime and other methods are all aimed at making sure that regulators are as up to date in their thinking as the other market participants.
It is a basic tenet, however, that when regulators meddle with the market in order to prevent wild swings one way or the other, this tends to have the opposite effect. However, political factors of being seen to be doing something often prevail. Given the years of uncertainty regarding regulation we have all faced, we are probably as well placed as we ever have been for every eventuality.
Consequently, for Canada, I am still seeing and feeling a business as normal and ‘we will cope’ approach that has been its hallmark over the years.
What do you think appropriate collateral requirements from a risk, liquidity and efficient market perspective are?
Murray: Market participants must first consider regulatory requirements—including those to be set by the Financial Stability Board—when it comes to margins and acceptable collateral types. Each lender must also consider its individual risk appetite.
Broadly, however, the nature of risk in securities lending is that of market risk contingent on borrower default. To protect our lending programme and individual clients from potential losses after a borrower default, we—like other lending agents—implement oversight procedures to address the two major risk components, borrower credit risk and collateral (market) risk. We conduct fundamental credit analyses of all borrowers in our programme, including internal credit ratings and ongoing credit due diligence.
On the collateral risk management front, we continuously review margin levels, diversification and liquidity limits, stress tests, and other controls to mitigate potential market risk exposure.
Sedman: Northern Trust believes that securities lending is not a one-size-fits-all business. As such, we provide our clients with the opportunity to select the collateral that best fits their risk and return profile. Our securities lending team is one of the most experienced in the market and works with clients to define the lending and collateral parameters for their programmes.
While government of Canada bonds, provincials and other high quality debt continue to be the collateral of choice, clients are expanding to equities and corporate bonds as a way to diversify their collateral and increase their securities lending opportunities.
Zywot: Collateral requirements continue to evolve from both borrower and beneficial owner perspectives. Borrowers are constantly looking optimise collateral, so the greater the flexibility in terms of collateral acceptability from the agent lender and the beneficial owner, the greater the return and utilisation within securities lending.
The specific types of collateral accepted can in many cases make or break the execution of a given trade. As global regulation continues to evolve, collateral flexibility from all three participants in the loan (borrower, agent and ultimate lender) will become more important and likely more valuable.
When evaluating the collateral requirements for a given trade, the ‘appropriate’ requirements are that the trade makes sense for the participants from a risk-adjusted return basis, from a governance perspective and based on guidelines provided by both lenders and regulators.
In mid-2012, BNY Mellon established its global collateral services business in anticipation of changing client needs across the investments lifecycle in the face of global regulatory reform efforts. Global collateral services brings together a set of related services and capabilities including collateral management, liquidity, derivatives consulting and securities lending.
Has the trend of collateral transformation been adopted in Canada?
Zywot: It all depends on how you define collateral transformation. Certain types of collateral optimisation have a long history in the Canadian marketplace—for example, participants have been borrowing Canadian government bonds while lodging provincial government bonds for many years. Some markets in recent years have embraced the practice of lending bonds while taking equities as collateral, but Canadian market participants have always been quite conservative in terms of adopting new strategies, so I would say this activity is not as widespread here. As always, trades need to make sense from a risk-adjusted-return basis, the owners’ internal guidelines for participation, and of course the guidance from regulators.
Sedman: Collateral transformation has been a part of the Canadian securities lending market for quite some time, although it has continued to evolve over the years. Collateral transformation is an important part of our programme at Northern Trust and will remain so in the future. The efficient financing of long positions continues to be a major focus for borrowers.
Since Canada is one of the last AAA-rated sovereigns, it is likely that demand will grow for Canadian government and government-backed collateral. Clients with greater flexibility and broader collateral guidelines will likely see increased loan balances and securities lending revenues.
Smith: Over the years there have been various ‘phrases du jour’ that have become over-used. The latest one would appear to be ‘collateral transformation’, which, depending upon context and intonation, appears to be used to denote an opportunity for or a dubious use of securities lending. The real truth is that as more and more regulations are imposed to require more and better quality collateral for more types of transactions, then collateral has to be ‘transformed’ in order to comply.
Murray: In Canada, and globally, borrowers have a renewed desire to fund different types of securities. The scope of transformation will depend on new regulations affecting all banks.
What were the effects of Canada’s regulatory change in October that expanded the definition of a ‘qualified security’?
Murray: The expanded definition has widened the pool of available lendable securities, creating new revenue opportunities for securities lending clients. For example, the ruling clarified the status of non-Canadian trust units as qualified securities, clearly exempting distributions from these foreign trust units from non-resident withholding tax. Including foreign exchange-traded funds (ETFs) as qualified securities has also been a positive development, given their growing use by investors.
Zywot: The expansion of the definition of “qualified securities” to include exchange-traded assets has been quite positive for the market. We’ve seen an increase in lendable assets and revenues for income trusts and ETFs in Canada.
Sedman: With the expansion, non-Canadian ETFs, US real estate investment trusts (REITs) and other non-Canadian trust units that are listed on a stock exchange are now included in the scope of “qualified securities”. This expansion has led to increased revenue opportunities for beneficial owners as it allows us to lend these assets as well as accept them as collateral. This has led an increase in lendable base and on loan balances.
Although Canada has typically been a more conservative securities lending market, it continues to adapt and change along with the marketplace. This is another positive step in the continuing evolution of the Canadian securities lending market.
What other regulations are having an impact on the Canadian market?
Murray: Certain provisions within Dodd-Frank and Basel III are expected to have broad market impact, not just in Canada, though the size and scope remain difficult to measure. Transparency requirements, cash collateral investment guidelines and minimum haircuts for securities lending and repo transactions established by the Financial Stability Board will also play a role.
We’ve met with senior regulatory officials, written comment letters to the Federal Reserve and Basel Committee, and participated in meetings with industry associations, such as the Risk Management Association, to address the impact of proposed regulations on agency securities lending programmes.
Sedman: While there are a number of regulatory changes impacting the Canadian market, one of the more recent changes was IIROC’s response to a request for guidance on the interim capital treatment of certain cash and securities lending arrangements. Members had requested relief for cash and securities lending arrangements where either an acceptable counterparty or a regulated entity is the counterparty to the arrangement, or where an acceptable institution agent administers a lending programme on behalf of its acceptable counterparty and regulated entity clients.
IIROC staff concluded that the risk associated with existing principal cash and securities lending arrangements involving acceptable counterparty and regulated entity clients is largely the same as agency arrangements, and that any interim capital treatment afforded to these agency agreements should also be granted to principal cash and securities lending arrangements involving acceptable counterparties and regulated entities.
As a result, many members are now able to apply the same capital treatment to collateral provided to lenders. With the growth of agency arrangements within the Canadian market, this was welcome news to Canadian participants.
Regardless of regulatory changes, the Canadian market should continue to provide investors with an attractive value proposition.
Smith: The Canadian market or rather the securities lending business in Canada is affected by the global regulatory framework changes being discussed and decided upon. As we crawl ever closer to finally getting to the end of the uncertainty, then the impact, either positive or negative, will be seen.
Zywot: Largely, recent regulatory impacts on Canada have been global, with Basel III and Dodd-Frank being major sources of change. Canadian participants are quite prudent and generally maintain very strong balance sheets well above global requirements, but banks and brokers definitely share their international peers’ greater consciousness of the cost of capital and how its use can be maximised.
Perhaps the biggest factor is the ongoing uncertainty about the final state of various regulations and their impacts to Canadian participants.
In what areas of your business are you investing in the most?
Lemstra: We see our clients investing in technology systems to establish infrastructure that can address their needs for scalability, flexibility and straight-through processing. On the trading side, desks want to improve their front-end trading screens, availability feeds and streamline communication. The post-trade teams are leveraging technology for improved workflows across equities and fixed income, finding solutions for manual processes and consolidating vendor platforms.
EquiLend’s focus continues to be adding value for our clients, improving our existing products and offering new services. In 2014, we have already added three new trading desks in the Canadian market, improved DataLend market data, and we are looking forward to releasing the workflow for Next Generation Trading, our project currently underway to integrate automated trading of general collateral, warm and hot securities and market data into a single, consolidated platform.
We have also been further building out our ALD (Agency Lender Disclosure) offering following increased demand from clients on the regulatory side. We are also achieving client take up in new markets such as South Africa and exploring opportunities in Latin American markets, such as Brazil.
Murray: Pending and proposed regulations necessitate, either directly or indirectly, investment in all of those areas. We must invest in technology to make sure our securities finance program continues to operate within the requirements of multiple regulatory regimes.
We’re also actively considering practices that may diminish the impact of proposed regulations, including optimising revenue to credit usage; diversifying borrowers; continuing to develop new routes to market; and investigating potential new lending markets in Asia, Europe and the Americas.
Sedman: Northern Trust continues to make a number of enhancements to our securities lending programme. This includes the expansion of new collateral types, such as Canadian federal agencies and mortgage-backed bonds, new borrowers, enhancements in reporting and technology to provide clients with transparency in their securities lending programme, and programme updates due to regulatory and tax changes. Northern Trust continually invests in its technology to ensure that it is at the forefront of automation and execution.
Smith: From Sungard’s perspective—all of the above. As has been the case over the last 30 years in securities finance, you cannot stand still. There is a definite linkage between all categories, which means that it is not possible to concentrate on a single driver. New regulation creates the need for new more frequent reporting and the spreading of risks among more and different counterparties and to seek more opportunities in new markets