An industry at a crossroads
It should be clear that standing still is not an option, as Ross Bowman, who works in securities finance business development at BNP Paribas Securities Services, explains
Over the course of the last few years, the securities lending industry has been the focus of a multitude of regulations that have affected its function and place in the capital markets, culminating in an unprecedented increase in the capital cost of the business, which has resulted in a reduction in revenues from some asset classes.
The securities lending industry is coming to terms with the fact that there is a significant cost associated with almost every aspect of the activity, from a balance sheet perspective and also from new and onerous reporting obligations that impact all market participants, whether a beneficial owner, agent or borrower.
We are now standing at a crossroads. These regulations combined with the current revenue context, bring to the fore a renewed focus on optimising cost savings for market participants, preserving the lending activity on one hand and extracting the most value of pockets of opportunity on the other.
These developments are paving the way to meet the multiple objectives of the securities lending industry.
The tentative emergence of electronic platforms
The market has seen some success in the development of trade matching and execution platforms, which would streamline operational and technical process of a securities lending transaction. However, the bespoke nature of lender and borrower requirements have made the mass automation of trade execution in securities lending a very complex business.
Whether lending equities or bonds, taking cash or securities as collateral or whether trading on an open or term basis, there are still many aspects of a securities lending transaction that have thus far prevented the execution from being fully automated and from moving to an ‘on-exchange’ facility. Matching and settling via electronic platforms, occur only when lender and borrower criterion permit.
A great number of securities lending transactions are still negotiated and executed between the trading desks of lenders, agent banks and borrowers, effectively trading ‘off-exchange’ and outside of any multilateral trading facility (MTF). Collateral upgrade and high-quality liquid asset (HQLA) fixed income term trades, high-value specials and yield enhancement trades are all good examples.
Transition to a central counterparty model
The use of a central counterparty (CCP) is looked on favourably by market regulators affecting the capital implication and altering the way in which agents and lenders transact with borrowers. However, mass adoption has so far eluded many market participants for a variety of reasons, so clearly further work is needed by all to understand the efficiencies such a model could deliver to the broader market.
Appetite for pledge agreements
Borrowers are also increasingly looking to reduce the capital costs incurred with running their securities financing operations. In the current securities lending market where supply outstrips demand, the regulatory driven needs of the borrower mean that the ‘sell-side’ is calling the shots and therefore agents and lenders can expect to see increasing demand from borrowers to provide collateral in ‘pledge’ form rather than as ‘title transfer’.
Such a practice, to further strengthen capital preservation, is already standard within the derivatives market for initial and variation margining, and it is only a matter of time before we can expect to see demand increase for pledge collateral in the securities lending market.
Reporting and transparency requirements
A fully transparent process and minutiae reporting requirements are becoming the new norm. From an operational perspective, lenders need robust systems, capable of processing data from different sources to meet the demands of transparency for the full end-to-end process.
Reporting capabilities and their costs need to be managed not only from the point of view of cost optimisation, but also to enable lending programmes to grow and develop as a finely calibrated tool to aid the efficient management of a portfolio of securities.
Complimenting these reporting challenges are the application of best practices and code of conduct obligations that oversee the behavioural expectations of participating businesses.
All these principles and disciplines support and compliment the level of governance that securities lending clients and regulators expect to see.
All should now be considered modus operandi for securities lending programmes and factored into the cost of doing business.
Pockets of opportunity
Looking beyond operational and efficiency savings, lenders are positioning their programmes to optimise opportunities that arise from market movements and trends affecting the underlying cash equity markets. SCRIP dividends, specials, settlement fail coverage and directional short covering all represent pockets of additional revenue available to lenders.
Since 2015, the much welcomed HQLA upgrade trade in Europe has proven to be the stalwart for fixed income lending revenues as other sources of revenue income have shrunk.
Different dynamics are shifting demand in this market creating trends that mitigate demand on one hand while stimulating it on the other. Basel III regulation has increased the cost of holding equity inventory on-balance sheet for banks.
However, banks have worked to reduce the value of equities they hold and have thereby reduced the volume of equities they need to re-finance. This has resulted in a plateauing in the demand to borrow HQLA to satisfy liquidity ratio requirements.
Conversely, global central bank quantitative easing programmes have reduced the volume of government securities available to borrow in the market.
As a consequence, the market has witnessed a sharp increase in borrowing rates for HQLA over key reporting periods, such as quarter end and year end, which have benefited those lenders holding HQLA.
Consensus for change
Where do we see the industry in five years? Regulation has already paved the way in guiding change.
Operational systems, settlement and billing technologies, trading utilities and collateral management platforms, are all common place in the securities lending market today.
However, there are still many processes that can be automated further.
Maximum automation of middle- and back-office functions will be critical to the effective profitability of the securities lending product, whether managed internally or through the use of an external vendor.
CCP and collateral utility links will need to be optimised to maximise the capital cost reductions that can be shared through the chain, as the requirements of a given borrower change from month to month and balance sheets are managed with fluidity.
Businesses should be prepared to streamline their operational processes as much as possible as automation will drive down unit processing costs and increase the ease of further automation in the future as the product develops.
The technical and operational infrastructure needed to execute and settle securities lending transactions has always been as significant in size and scope as the trading, operational and collateral management expertise required to support the product.
Such infrastructure investment requires commitment and resources that beneficial owners rarely have available when considering the various routes to market.
The writing has been on the wall for change for some time now and consensus among market participants will be key to driving the industry to where it needs to go, as it should be very clear to everyone now: standing still is not an option.