Are German investment funds keen lenders? How much business do they currently do?
German investment funds are lenders of securities. Our larger members are keen users of securities lending, because they appreciate the profit flowing into their funds. Managers appreciate it, as the additional income stream may be split between the fund and the manager. The larger managers benefit from larger mandates and the support of custodian banks and specialised securities lending agents, which make it easier to conduct the business.
The market is picking up, mainly because of the collaterilsation requirements of laws such as the European Market Infrastructure Regulation. Collateral upgrade trades seem to create more business, especially among our members that hold high quality government bonds, which are in stronger demand. Some members are reporting reluctance because the process of lending securities is quite cumbersome to set up and requires additional funds, so it is not necessarily cheap, and, looking at the margins, some feel it is not a primary business objective for them to engage in.
In summary, securities lending is very important for our larger members because it adds margin, but it also requires substantial investment on both sides. It will not be used by all members, but for those that use it, it’s a welcome and safe income source.
What is the situation with lending limits in Germany?
Theoretically, managers can lend out all the securities of the fund if there is enough demand. In practice, it has not happened because there needs to be a specific interest in equities or bonds on the other side. Besides having to be fully collateralised at all times, the total value of the securities lending transaction with one counterparty must not exceed 10 percent of the portfolio value, which makes it very cumbersome because you’d need 10 lending counterparties to achieve 100 percent. Therefore, the single counterparty limit is a major issue.
How has the regulatory environment in Germany given rise to third party agents such as Euroclear Bank, which manage collateral on lenders’ behalf? Is this good for German investment funds?
The German law provides for two options: one is to engage qualified counterparties on the basis of standardised contracts, so bilateral securities lending transactions, and the other is to use of organised securities lending systems. Euroclear Bank and Clearstream are examples of this, with the main advantages being that the fund can lend out all of its securities without having to observe the 10 percent counterparty limit.
In theory, most lending should go through these systems, but in practice that is not the case. Some report that the margins are not interesting enough for their funds to trade through these systems. Bilateral trades, on the other hand, require a depository bank or custodian, but not all custodian banks are fully equipped for the job. So there has been increased interest in using specialist third party collateral agents, such as State Street, which alongside the custodian would help with the clearing and settlement of the transactions.
Looking at wider Europe, what is the association’s position on ESMA’s guidelines for ETFs and other UCITS funds, particularly on the restrictions on cash collateral reinvestment?
The final European Securities and Markets Authority (ESMA) report on the guidelines came out recently. We have worked on a single basis and in strong coordination with the European Fund and Asset Management Association (EFAMA), especially on the reform of the collateral diversification guidelines. We obtained some relief, so the 20 percent counterparty limit will not apply to government collateral.
While we wait for the final ESMA report to be translated, we still see a huge issue: the restrictions on reinvestment of cash collateral. We think the regulators are blowing it out of proportion. We agree that regulators need to have a grip on long investment chains and systemic risk, so perhaps there needs to be some sort of cut somewhere in the reuse chain. But, in terms of the first level investment of cash, we believe that use of cash as collateral with a central counterparty is as safe as having the cash in place with a regulated bank, or a government security, which are the two investment options the law currently allows for.
We will continue to work with our European association to ensure that we get a reasonable allowance, especially in the central counterparty situation.
How has the association reacted to other regulatory initiatives affecting securities lending?
We participated in the various Financial Stability Board and International Organization of Securities Commissions consultations, while the subject that is near to our hearts is the reform of EU money market funds, and in this context specifically the use of repo in money market funds. The EU’s first money market funds proposals could have essentially killed off the repo business in money market funds by restricting counterparty limits and collateral, such as US treasuries. This would have been a disaster, as the money market funds make up quite a bit of European money overall.
We have worked within EFAMA a lot on that subject, and I am a chair of their Money Market Fund Working Group. With nearly €1000 billion in assets under management, money market funds are an important part of the EU industry, so we need to ensure the products can be used going forward in an adequate manner.