You’ve recently taken over as co-heads of the European securities lending business in Europe—will this mean any changes to the direction of the business?
John Wallis: It’s been a really exciting time to join the business in Europe and it’s great to be part of a team that is so focused on the future and taking our programme to the next level. We each have our own strengths and insights that we bring to the table and Rob and I are committed to building on the growth we’ve seen during 2014 and 2015 so far, and developing our offering in Europe.
In terms of strategy, our programme was built on intrinsic value lending and this continues to be a proven approach. For us, the next step is really about how we can build on this by creating new opportunities for our clients and providing greater levels of control and transparency.
I come from a technology background and previously headed up Brown Brothers Harriman’s (BBH) infomediary business in Europe, a product that underpins much of BBH’s securities lending connectivity—so having worked closely with the team throughout my time at BBH, it really does feel like an ideal point of convergence, especially as we start to consider how some of the broader financial technology trends could intersect with the securities lending industry.
Rob Lees: Having worked for the BBH securities lending business in the US, Europe, the Middle East and Asia now, it’s great to see the level of engagement and enthusiasm the team has here in Europe, in spite of a pretty challenging environment in recent years.
As John mentioned, intrinsic value lending was our founding philosophy and is an approach that increasingly resonates with not just beneficial owners, but also other agent lenders. Regulation continues to put balance sheets under pressure, forcing some to move away from general collateral lending as the trade’s profitability comes into question.
Considering the difference in nature of an intrinsic value programme in terms of balance sheet impact and profitability, as well as our experience in intrinsic value lending throughout all market cycles, we feel well positioned to continue executing upon this strategy for our clients.
You mentioned that the demand environment in Europe has been challenging in recent years—how has it changed? Are there really positives for beneficial owners in today’s market?
Lees: Recent years have no doubt challenged the industry and circumstances caused participants on all sides to pause and reflect. However, it’s important to note that most industries have cyclical lows and there are definitely reasons to be positive about the long-term resilience of the market, as well as its ability to adapt and identify new revenue opportunities.
We have begun to see real signs of a sustained recovery and from an intrinsic value perspective, fundamental demand drivers have not really changed, with directional and event driven strategies representing key value drivers. For strategies more focused on general collateral lending however the combination of balance sheet constraints and a prolonged interest rate environment has affected demand more negatively.
We feel optimistic about future opportunities, especially in the US and Asia where markets are either normalising post-stimulus measures or are continuing to develop and grow.
The picture in Europe is more mixed, as we have central bank intervention, concern around the fragility of the eurozone and of course an evolving regulatory environment, all of which could negatively affect activity. That said, there is an improving economic picture that could very well lead to increased opportunities, such as mergers and acquisitions.
Wallis: We definitely think there are reasons to feel optimistic and challenging times can often force you to find more efficient ways of doing things. We think there is real opportunity for us to provide clients with greater control, transparency and insight into specific opportunities. Improving demand is of course fundamentally important in creating opportunities for our clients, but our ability to present new opportunities transparently will make a difference in achieving the marginal gains that can really enhance a portfolio’s lending performance.
What are you seeing in terms of demand in Asia, given the recent volatility in the Chinese economy?
Lees: The main development in Asia has been the Shanghai-Hong Kong Stock Connect scheme and already it has become an integral component of Asia’s capital markets. After a rather tepid launch, the Stock Connect scheme has witnessed strong volumes and, in recent months, increased volatility. From a securities lending perspective, although very much in its nascent stages, it has opened up access to some longer-term opportunities. Since the start of the year we have seen significant borrowing interest across several sectors in Hong Kong such as brokerage, commodities, consumer and luxury retail, and property, with demand partly being spurred by increased trading volumes in
Elsewhere in the region, there have been developments in the Taiwanese onshore lending market that could potentially lead to increased volumes, such as local brokers being permitted to onward lend securities. That said, this is balanced somewhat by continued restrictions on short selling and the subsequent negative impacts on end-user demand.
More broadly speaking, the market volatility we have witnessed in China of late has led to some investors taking a more cautious approach, especially given the recent devaluation in the renminbi. Many investors are digesting the activities of recent weeks and fine tuning their strategy accordingly. Larger investors will be more likely to take a more balanced and longer-term approach, but will need to factor in some changes given recent developments.
Have beneficial owners been able to ‘sit tight’ and wait for the upturn, or have they had to adapt?
Lees: It’s true that some have had to adjust their programmes more than others. Even in improving market conditions, borrowers’ selectiveness in how they use their balance sheet and borrow securities has again exposed the importance of strategically structuring a programme to optimise performance—a ‘one-size-fits-all’ no longer works.
Wallis: Importantly, our clients recognise that you do not need to increase risk by lending a large percentage of your portfolio to generate revenue, unless you posses a small number of high-value securities and can therefore command a higher fee. Our clients are more interested in assessing special lending opportunities at the individual security level rather than just the portfolio level, but this requires a greater degree of transparency.
What is the industry doing to improve transparency?
Wallis: The industry has taken great strides to improve transparency in the past few years, but the focus has been very much on the post-trade environment. We think that given the over-the-counter nature of the market, there are real opportunities to improve pre-trade transparency and ultimately, change the way beneficial owners engage in lending.
For beneficial owners partly or fully engaged in lending, as well as those considering whether it is an activity for them, greater transparency will certainly provide more insight into opportunities, affording them more control and the ability to lend on their own terms.
What are your predictions for the future of lending?
Lees: The discussion around indemnification is set to continue as agent lenders evaluate balance sheet usage versus the commercial viability of some lending activity and relationships. As the true cost of providing an indemnity becomes fully priced across the industry, we may find the provision of indemnities as a default are no longer commonplace.
The topic of central counterparties (CCPs) is also a conversation gaining momentum within the industry, as participants work to understand the strengths and weaknesses of proposed structures. There are still questions around risk in relation to counterparty default, but CCPs could be a new distribution channel for certain trades and clients due to regulatory constraints. As CCPs reduce the barriers for entry and expand coverage across markets and jurisdictions, we expect the model will gain traction and, when it is right model, should have its place in the industry.
Wallis: There are also significant macro trends in play, such as greater demand for transparency, as we mentioned, as well as the active versus passive investment debate and financial technology trends that could intersect with the securities lending industry and cause significant structural change.
Increasing demand for low-cost investing has seen an increase in flow towards passive investments. Many exchange-traded funds (ETFs) and passive fund providers engage in securities lending as lending revenue is seen as a way to off-set the already low management fees. Lending will become an increasingly useful tool for passive funds looking to gain competitive edge.
In the case of financial technology trends, innovations such as Blockchain and Uber are clear illustrations of how some industries can become rapidly disintermediated. The idea of this applying to the securities lending industry might seem farfetched, but with the increasing adoption of CCPs and triparties alleviating some of the credit counterparty concerns, it poses the question of whether this could become a reality for lending.
While the impact of broader trends remains up for debate, it is clear that structuring a programme for relevancy will be critical to optimising performance and realising incremental gains in a changing environment.